Form 10-Q for ALABAMA AIRCRAFT INDUSTRIES, INC
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
The following discussion should be read in conjunction with the Company's consolidated financial statements and notes thereto included herein.
The Company operates primarily in the aerospace and defense industry and its principal business is providing aircraft maintenance and modification services to the U.S. Government and military customers. The Company's services are 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 financial condition of the Company, which operated as a subcontractor to the Boeing Company ("Boeing"), has been impacted by several extraordinary events in connection with the U.S. Air Force ("USAF") KC-135 Program Depot Maintenance ("PDM") program and the related recompetition for the new KC-135 contract award. In summary, from May 2005 through June 2006, the Company worked in cooperation with Boeing to submit a proposal on the new KC-135 contract under a Memorandum of Agreement with Boeing ("MOA"). After filing an initial proposal with the USAF, which included critical financial and operational information on the Company's KC-135 program, the Company believes Boeing breached the MOA due to the USAF's reducing the number of aircraft in the request for proposal. As part of the Company's teaming arrangement with Boeing on the existing KC-135 contract, the Company had already spent several million dollars to meet Boeing's new requirement that the Company adopt its KC-135 methodology. From July 2006 to September 2007, the Company spent another million dollars preparing their own proposal for the new KC-135 contract. The Company's proposal for the KC-135 PDM program was unsuccessful as the contract was awarded to Boeing in September 2007. The Company filed a protest with the Government Accountability Office ("GAO") and the contract was stayed for 100 days pending the results of the protest. On December 27, 2007 the GAO upheld in part the Company's protest on the basis that the USAF failed to conduct a proper analysis of Boeing's cost/price proposal for realism or potential risk. The USAF filed a Request for Reconsideration on January 7, 2008, which was denied by the GAO on February 1, 2008. On March 3, 2008, the USAF advised the Company that in response to the recommendation by the GAO it had completed additional review, documentation and a new award decision and that the Company's proposal was not selected for award. Company officials attended a debriefing from the USAF on the new award decision on March 7, 2008. The Company filed a protest on the new award decision on March 11, 2008 as to the USAF's lack of proper evaluation to meet GAO recommendations and sudden post-award change of work scope under the contract recompete. On May 2, 2008, the GAO dismissed the change of work scope portion of the protest on the basis that the USAF has not made a determination regarding potential changes to the contract requirements. The GAO decision provides the Company the right to re-submit its protest for consideration in the event the USAF subsequently pursues a course of action consistent with the Company's factual allegations. The Company has expended substantial financial resources in connection with these events. If the Company is successful with the protest, it may be able to recover a portion of the cost of the protest.
In order to adjust for and mitigate the effects of the events discussed above, the Company has taken several significant steps. On November 6, 2007 the Company officially qualified with the Small Business Administration as a small business for military contracts. The Company believes that this will provide vital opportunities for defense contracts which were previously unavailable. Management has taken significant steps to reduce costs including headcount reductions, administrative cost reductions, freezing its defined benefit pension plan (the "Pension Plan") for salaried employees as of December 31, 2007, eliminating salary increases for 2008 and restructuring the medical and dental benefit plans. In addition, the Board of Directors, in a unified move to support the Company, has agreed to a 50% reduction in all Board fees in 2008. If the new protest does not result in a positive outcome for the Company, it would have a material adverse effect on the Company's financial condition and prospects, materially harm the Company's business and impair the value of its Common Stock. The Company and Boeing continue to be teamed on the KC-135 Bridge Contract for which the USAF exercised a second six-month option to extend through September 30, 2008. There are no assurances that the Company will receive more than the four aircraft already inducted during these six month extensions of the KC-135 Bridge Contract.
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RESULTS OF OPERATIONS
Three months ended March 31, 2008 versus three months ended March 31, 2007
The table below presents major highlights from the three months ended March 31, 2008 and 2007 excluding the results of discontinued operations, except for net income.
2008 2007 % Change
Revenue $ 21.13 $ 22.39 (5.6 )%
Gross profit 4.09 3.11 31.6 %
Operating income (loss) from continuing operations 1.21 (0.35 ) 445.7 %
Income (loss) from continuing operations before taxes 1.01 (0.54 ) 287.0 %
Income (loss) from continuing operations 0.83 (0.30 ) 376.7 %
Net income 0.83 0.90 (7.8 )%
EBITDA from continuing operations 1.65 0.12 1275.0 %
The Company defines operating income (loss) from continuing operations, as shown in the above table, as revenues less cost of revenues, less selling, general, and administrative expenses.
EBITDA from continuing operations for the quarters ended March 31, 2008 and 2007 was calculated using the following approach:
Income (loss) from continuing operations $ 0.83 $ (0.30 )
Interest expense 0.20 0.19
Income tax expense (benefit) 0.17 (0.24 )
Depreciation and amortization 0.45 0.47
EBITDA from continuing operations $ 1.65 $ 0.12
The Company presents Earnings Before Interest, Taxes, Depreciation and Amortization, more commonly referred to as EBITDA from continuing operations, 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 in the United States ("GAAP") and should not be considered as a substitute for or superior to other measures of financial 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 from continuing operations by operating segment for the three months ended March 31, 2008 and 2007.
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2008 2007 Change % Change
GSS $ 19.61 $ 19.63 $ (0.02 ) (0.1 )%
MCS 1.52 2.76 (1.24 ) (44.9 )%
Total $ 21.13 $ 22.39 $ (1.26 ) (5.6 )%
GSS 2008 revenue was consistent with 2007 revenue. Revenue from the KC-135 PDM program increased $1.4 million during the first quarter of 2008 versus the first quarter of 2007. The KC-135 program, which accounted for 77% of revenue in the first quarter of 2008 and 67% of revenue in the first quarter of 2007, allows for the Company to provide services on PDM aircraft, drop-in aircraft, and other aircraft related areas. During each of the first quarter of 2008 and first quarter of 2007, the Company delivered four PDM aircraft and no drop-ins. Revenue increased on the KC-135 program in the first quarter of 2008 versus the first quarter of 2007 due to an increase in the contractual price for each aircraft delivered. The Company delivered one P-3 aircraft in the first quarter of 2008 versus two P-3 aircraft in the first quarter of 2007, resulting in a decrease in P-3 revenue of $1.2 million. The delivery of the P-3 aircraft in the first quarter of 2008 represented the final delivery of P-3 aircraft under the current contract. The Company is continuing to pursue additional contracts to perform maintenance services on P-3 aircraft. Revenue decreased $0.2 million under contracts to perform non-routine maintenance work on other aircraft, primarily USAF C-130 aircraft.
Gross profit at GSS increased from $2.6 million during the first quarter of 2007 to $4.2 million during the first quarter of 2008. Gross profit on KC-135 revenue increased $1.2 million due to increased revenue. Cost of revenue on the KC-135 program decreased as a percentage of revenue due to increased efficiencies on the KC-135 maintenance line. Gross profit increased $0.5 million as a result of losses on the P-3 program in the first quarter of 2007 for which there were no comparable losses in the first quarter of 2008. Selling, general and administrative ("SG&A") expenses of GSS increased $0.1 million during the first quarter of 2008 compared to the first quarter of 2007 because of increased allocation of corporate SG&A expenses as a result of the sale of PWAS.
MCS revenue decreased $1.2 million in the first quarter of 2008 versus the first quarter of 2007 due to decreases on a large software contract of $0.5 million, a large GPS receiver contract of $0.5 million and a launch vehicle structures contract of $0.3 million. Revenue in 2008 was adversely affected because Space Vector Corporation ("SVC") was in the completion stage of several large contracts and any follow-on contracts had not fully begun.
Gross profit at MCS decreased $0.5 million in the first quarter of 2008 versus the first quarter of 2007. SVC recorded a reserve for contract loss in cost of revenue of $0.4 million during the first quarter of 2008 due to contract overruns on a large battery contract. Gross profit also decreased $0.1 million as a result of the decrease in revenue. SG&A expenses at SVC decreased $0.2 million in the first quarter of 2008 versus the first quarter of 2007 due to headcount reductions of administrative personnel.
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Consolidated Unallocated Corporate SG&A Expenses, Interest Expense and Income Taxes
During the first quarter of 2008, the Company forgave a related party receivable and accrued interest of $0.5 million (See "RELATED PARTY TRANSACTIONS" discussed below). During the first quarter of 2007, the Company incurred $0.9 million of corporate SG&A expenses that previously had been allocated to PWAS for segment reporting purposes. Under accounting principles generally accepted in the United States, these allocated amounts are recorded in continuing operations rather than discontinued operations.
Total interest expense, including amounts in discontinued operations ($0.8 million in 2007), decreased to $0.2 million in the first quarter of 2008 from $1.0 million in the first quarter of 2007. Interest expense decreased primarily as a result of extinguishing a large portion of the Company's debt when PWAS was sold.
During the first quarter of 2008, the Company recorded income tax expense at an effective rate of 17.3% for continuing operations as a result of utilizing net operating loss carryforwards which previously were subject to a deferred tax valuation allowance. At March 31, 2008 and December 31, 2007, all deferred tax assets were subject to a deferred tax valuation allowance. During the first quarter of 2007, the Company recorded income tax benefits at an effective rate of 44.2% for continuing operations and income tax expense at an effective rate of 44.7% for discontinued operations. The effective income tax rate is impacted by the allocation of taxable gains or losses between operations in Alabama and California. Net operating loss carry forwards for discontinued operations in California were subject to a deferred tax valuation allowance in the first quarter of 2007.
LIQUIDITY AND CAPITAL RESOURCES
The table below presents the major indicators of financial condition and
(In Thousands, Except Ratios)
March 31, December 31,
2008 2007 Change
Cash $ 9,846 $ 8,750 $ 1,096
Working capital 14,286 16,193 (1,907 )
Debt and capital lease obligations 5,070 5,082 (12 )
Stockholders' equity 17,944 16,326 1,618
Debt to equity ratio 0.28 x 0.31 x (0.03 )
The Company has no current arrangements with respect to sources of additional financing, and its negative results of operations in prior years and the current lack of long-term contracts, exacerbated by the current state of the credit markets, will likely make it more difficult and expensive for the Company to raise additional capital that may be necessary to continue its operations.
The Company's primary sources of liquidity and capital resources include cash-on-hand, cash flows from operations (primarily from collection of accounts receivables and conversion of work-in-process inventory to cash) and potential borrowing capability through lenders. Principal factors affecting the Company's liquidity and capital resources position include, but are not limited to, the following: results of operations; the results of the Company's protest of the USAF award of the KC-135 contract to The Boeing Company; collection of accounts receivable; funding requirements associated with the Pension Plan; settlements of various claims; and potential divestitures. The Company anticipates that cash-on-hand will be sufficient to fund operations, make minimal capital expenditures and make scheduled payments on debt obligations for the next twelve months. However, the Company has proposed and is expecting to propose on several government programs in the next twelve months. If the Company is successful in winning some or all of these programs, additional financing may be needed to fund working capital requirements related to the buildup of accounts receivable and inventory on the projects. Moreover, the Company does not have sufficient cash to make the required contributions to the Pension Plan without negatively impacting the cash and liquidity of the Company by the end of 2008. Therefore, the Company applied on February 29, 2008 to the Internal Revenue Service for a waiver of contributions to the Pension Plan through December 31, 2008. Without a waiver of contributions, the Company would be required to contribute approximately $3.7 million for the 2007 plan year by September 15, 2008. While contribution calculations for the 2008 plan year have not been completed, the Company currently
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estimates that the quarterly payments for the 2008 plan year will be approximately $1.1 million to $1.2 million with the first quarterly payment due April 15, 2008. The Company did not make the first quarterly contribution due April 15, 2008. Several events could significantly impact the generation, availability and uses of cash over the next twelve months including:
• whether the Company is successful in its protest of the USAF award of the KC-135 contract to The Boeing Company;
• whether the Company is granted a waiver of contributions to the Pension Plan through December 31, 2008;
• whether the Company sells its subsidiary, SVC, although no decision has been made with regards to selling SVC;
• whether the Company is able to win additional contracts, including in part as a result of qualifying with the Small Business Administration as a small business under certain North American Industry Classification System codes;
• whether the Company is able to get additional funding from lenders to fund working capital increases needed if additional contracts are won; and
• whether the $5.0 million Senior Secured Note maturing on February 15, 2009 is extended.
There are no assurances that the Company will be successful in any of these respects and negative outcomes could adversely impact the Company's ability to meet financial obligations as they become due.
Cash Flow Overview
Operating activities provided $1.1 million during the first quarter of 2008, compared to $0.9 million during the first quarter of 2007. Cash payments to fund the Company's Pension Plan exceeded pension expense by $1.0 million in the first quarter of 2007 versus pension expense exceeding contributions to the Pension Plan by $0.6 million in the first quarter of 2008 due to the Company not making any contributions in 2008. Cash of $27,000 and $111,000 was used during the first quarters of 2008 and 2007, respectively, for minimal capital expenditures. Financing activities used $0.8 million in the first quarter of 2007, as the Company used $0.8 million to service the revolving credit facility and long-term debt during the first quarter of 2007.
Future Capital Requirements
The Company's potential capital requirements over the next twelve months include: required minimum funding of the Pension Plan (noted below), principal and interest payments of long-term debt, the cost of protesting the award of the KC-135 PDM contract to Boeing, and working capital required to fund increases in accounts receivable, inventory and equipment if GSS is awarded new contracts.
The Pension Plan covers substantially all employees at the Company's Birmingham, Alabama facility. The Pension Plan's assets consist primarily of equity mutual funds, bond mutual funds, hedge funds 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 Pension Plan during 2002 and 2001, coupled with an increase in actuarial liability resulting from lower interest rates, increased mortality rates and the terms of the collective bargaining agreements entered into in 2005, the Pension Plan was under-funded by approximately $9.2 million and $18.8 million at December 31, 2007 and 2006, respectively.
The Company does not have sufficient cash to make the required contributions to the Pension Plan without negatively impacting the cash and liquidity of the Company by the end of 2008. Therefore, the Company applied on February 29, 2008 to the Internal Revenue Service for a waiver of contributions through December 31, 2008. Without a waiver of contributions, the Company would be required to contribute approximately $3.7 million for the 2007 plan year by September 15, 2008. While contribution calculations for the 2008 plan year have not been completed, the Company currently estimates that the quarterly payments for the 2008 plan year will be approximately $1.1 million to $1.2 million, with the first quarterly payment due April 15, 2008. There are no assurances that the waiver will be granted. If the waiver is not granted, the Company may not have sufficient internal resources to fund operations for the next twelve months and will have to pursue external financing which may or may not be available.
Senior Secured Debt
On February 15, 2006, the Company entered into a Note Purchase Agreement with Silver Canyon Services, Inc. ("Silver Canyon") pursuant to which the Company issued to Silver Canyon a senior secured note in the principal amount of $5.0 million (the "Note"). The Note accrues interest at an annual rate of 15%, which is payable quarterly in arrears. The Company may, at its election, redeem the Note at a price equal to 100% of the principal amount then outstanding, together with accrued and unpaid interest thereon. The Note contains customary events of default and the payment of all outstanding principal, interest and other amounts owed under the Note may be declared immediately due and payable by the lender upon the occurrence of an event of default. On July 31, 2006, Silver Canyon sold the Note and assigned the Note Purchase Agreement to the Special Value Bond Fund, LLC, which is managed by Tennenbaum Capital Partners, LLC, a related party of the Company.
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On July 31, 2007, the Company entered into an Amended and Restated Senior Secured Note with Special Value Bond Fund, LLC, in which the maturity date for the principal amount of the Note was extended until February 15, 2009.
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 using existing cash and cash equivalents, the incurrence of additional indebtedness through secured or unsecured borrowings and the reinvestment of proceeds from the potential disposition of SVC. Additional capital may not be available at all, or may not be available on terms favorable to the Company. While not planned, any additional issuance of equity or equity-linked securities through the sale of equity or debt securities through public offerings or private placements 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 generally been in a consolidation phase. As a consequence, the Company sometimes receives and sometimes initiates inquiries with respect to corporate combinations. However, there can be no assurances that the Company will be party to any such transactions in the future.
RELATED PARTY TRANSACTIONS
On April 23, 2002, the Company loaned Ronald A. Aramini, its President and Chief Executive Officer, approximately $0.4 million under the terms of a promissory note. The promissory note carried a fixed interest rate of 5% per annum and was payable within 60 days of Mr. Aramini's termination of employment with the Company. On March 26, 2007, Mr. Aramini paid the accumulated interest on the promissory note. On February 1, 2008, the Company forgave in full the loan represented by the promissory note, including all accrued and unpaid interest to date, in recognition of Mr. Aramini's dual role as Chief Executive Officer of the Company and as acting President of the Company's former subsidiary, PWAS, including Mr. Aramini's critical role in the successful sale of PWAS.
On December 28, 2006, the Company and Mr. Aramini entered into a Second Amendment (the "Second Amendment"), to the Executive Deferred Compensation Agreement, dated as of May 3, 2002 (the "Agreement"), between the Company and Mr. Aramini. The Agreement, as amended, provided for annual contributions by the Company to an associated rabbi trust for the benefit of Mr. Aramini over the term of his employment agreement. The Company contributed $359,861 during January 2007 for the 2006 calendar year. Pursuant to the Second Amendment to the Agreement, the Company's obligation to make a final $380,326 lump sum trust contribution for the 2007 calendar year was eliminated. Company contributions to the trust are invested by the trustee and are to be disbursed to Mr. Aramini in accordance with the terms of the Agreement. In February 2008, the Plan disbursed approximately $2.1 million to Mr. Aramini from the deferred compensation plan assets thereby reducing the deferred compensation plan liabilities by $2.1 million.
As discussed above, on February 15, 2006, the Company entered into a Note Purchase Agreement with Silver Canyon, pursuant to which the Company issued the Note to Silver Canyon. On July 31, 2006, Silver Canyon assigned the Note Purchase Agreement and sold the Note to Special Value Bond Fund, LLC, which is managed by Tennenbaum Capital Partners, LLC. Michael E. Tennenbaum is the Senior Partner of Tennenbaum Capital Partners, LLC and is Chairman of the Board of Directors of the Company. The Note Purchase Agreement was amended on July 31, 2007 to extend the maturity date of the Note to February 15, 2009.
INTERNAL CONTROLS AND PROCEDURES
During the audit of 2006 financial statements, the Company's independent registered public accounting firm identified a material weakness in internal control over financial reporting due to the resignation of the Director of Corporate Accounting and Manager of Financial Reporting in December 2006 which created a lack of resources in the financial close and reporting process and caused the Company to rely more heavily on qualified outside contractors. In addition, it was noted that the Chief Financial Officer had the ability to make journal entries although no entries were made during the year ended December 31, 2006. As a result of the lack of financial reporting resources, the Company's independent registered public accounting firm identified miscellaneous audit adjustments. The Company added temporary resources to compensate for the departure of the accounting personnel. However, the Company experienced a significant level of turnover of financial personnel in 2007 and experienced a reduction of full-time finance employees. As a result thereof, the Company determined that the material weakness due to the lack of financial resources remained at March 31, 2008 and December 31, 2007. The Company is currently re-evaluating the staffing of its accounting function both in terms of number of . . .