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Quarterly Report — Form 10-Q Filing Table of Contents
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500-1780 Wellington Avenue
Winnipeg, Manitoba, Canada R3H 1B3
(Address of Principal Executive Offices and Zip Code)
(204) 987-8860
(Registrant’s Telephone Number, Including Area Code)
Indicate by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months
(or for such shorter period that the registrant was required to file such reports), and (2) has
been subject to such filing requirements for the past 90 days.
Yes þ No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated
filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated
filer” in Rule 12b-2 of the Exchange Act.
Large accelerated filer o Accelerated filer o Non-accelerated filer þ
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of
the Exchange Act). Yes o No þ
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as
of the latest practicable date.
Standard Aero Holdings, Inc. was incorporated on June 20, 2004 in the State of Delaware.
Standard Aero Holdings, Inc. and its subsidiaries (the “Company”) commenced operations on
August 25, 2004. Standard Aero Holdings, Inc. accounts for the following entities:
Name
Country of Incorporation
Standard Aero, Inc.
USA
Standard Aero (US) Inc.
USA
Standard Aero (San Antonio) Inc.
USA
Standard Aero (Alliance) Inc.
USA
Standard Aero (US) Legal Inc.
USA
Standard Aero Materials Inc.
USA
Standard Aero Canada Inc.
USA
Standard Aero Redesign Services, Inc.
USA
Standard Aero de Mexico
Mexico
Standard Aero Limited
Canada
Not FM Canada Inc.
Canada
3091781 Nova Scotia Company
Canada
3091782 Nova Scotia Company
Canada
3091783 Nova Scotia Company
Canada
Standard Aero (Australia) Pty Limited
Australia
Standard Aero International Pty Limited
Australia
Standard Aero (Asia) Pte Limited
Singapore
Standard Aero BV
Netherlands
Standard Aero (Netherlands) BV
Netherlands
The Company is an independent provider of aftermarket maintenance repair and overhaul (“MRO”)
services for gas turbine engines used primarily for military, regional and business aircraft.
The Company repairs and overhauls a wide range of aircraft engines and provides its customers
with comprehensive, value-added maintenance solutions, as well as consultancy and redesign
services related to the MRO process and facilities.
Basis of presentation
The unaudited condensed consolidated financial statements included herein have been prepared in
accordance with accounting principles generally accepted in the United States of America for
interim financial information. Certain information and footnote disclosures normally included
in financial statements prepared in accordance with accounting principles generally accepted in
the United States of America have been condensed or omitted pursuant to such rules and
regulations. The December 31, 2005 Condensed Consolidated Balance Sheet was derived from
audited financial statements but does not include all disclosures required by accounting
principles generally accepted in the United States of America. However, the Company believes
that the disclosures are adequate to make the information presented not misleading.
In the opinion of management, the unaudited condensed consolidated financial statements include
all adjustments necessary for a fair statement of the results of operations for the interim
periods. Results for the interim periods are not necessarily indicative of results that may be
expected for the fiscal year ending December 31, 2006. These interim financial statements
should be read in conjunction with our Annual Report on Form 10-K for the year ended December31, 2005.
5
STANDARD AERO HOLDINGS INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
2
Summary of significant accounting policies
The condensed consolidated financial statements of the Company have been prepared in
accordance with accounting principles generally accepted in the United States of America (“US
GAAP”) and are reported in U.S. dollars.
a)
Stock based compensation
Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards
No. 123(R), “Share-Based Payment”, using the prospective method. The prospective method
requires compensation cost to be recognized for new awards and for awards modified,
repurchased, or cancelled after the required effective date. Under the prospective
method, the Company will continue to account for any portion of awards outstanding at the
date of adoption using the provisions of APB No. 25 whereby no stock option compensation
expense was recognized in the determination of net income in the accompanying statement of
operations. For the nine months ended September 30, 2006, there was no impact of adopting
Statement FAS 123(R) as no new awards were granted or existing awards modified,
repurchased or cancelled.
For all new awards granted, if any, in the future, SFAS 123(R) requires the Company to
estimate the fair value of share based payment awards on the date of grant using an
option-pricing model. The value of the portion of the award that is ultimately expected
to vest is recognized as expense over the requisite service periods in the Company’s
Consolidated Statement of Operations.
b)
Consolidation of Variable Interest Entity
Financial Accounting Standards Board Interpretation No. 46R, “Consolidation of Variable
Interest Entities” (“FIN 46”), which was issued in December 2003, requires the, “primary
beneficiary” of a variable interest entity (“VIE”) to include the VIE’s assets,
liabilities and operating results in its consolidated financial statements. In general, a
VIE is a corporation, partnership, limited —liability corporation, trust or any other
legal structure used to conduct activities or hold assets that either (i) has an
insufficient amount of equity to carry out its principal activities without additional
subordinate financial support; (ii) has a group of owners that are unable to make
significant decisions about its activities; or (iii) has a group of equity owners that do
not have the obligation to absorb losses or the right to receive returns generated by its
operations.
In the normal course of business, the Company enters into agreements to provide engine
repair and maintenance services. Certain of these agreements establish trust accounts,
which the customer will deposit cash into the trust account, generally in advance of the
services to be performed under the contract, based on an agreed upon engine operating fee.
Subject to the terms of each agreement, the Company will generally receive cash
distributions from the trust accounts when maintenance worked is performed. Actual gross
payments by the customer into the trust accounts could exceed the cost of services
performed by the Company. Per the agreements the Company would receive the benefit of the
remaining proceeds in the trust account upon completion of the contract, if any. The
Company has determined that the trust accounts are VIEs and that the Company is the
primary beneficiary. Based on this determination, the Company has consolidated the trust
accounts in its consolidated financial statements during the quarter ended June 30, 2006.
The consolidation of the VIE resulted in restricted cash of $29.3 million and unearned
revenue of $29.3 million as at September 30, 2006.
6
STANDARD AERO HOLDINGS INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
c)
Comparative figures
Certain comparative figures have been reclassified to conform with the current year’s
financial statement presentation.
d)
New accounting standards
In June 2006, the FASB issued FIN 48, “Accounting for Uncertainty in Income Taxes.” FIN 48
prescribes a comprehensive model for how a company should recognize, measure, present, and
disclose in its financial statements uncertain tax positions taken or expected to be taken
on a tax return. Under FIN 48, the tax benefit from an uncertain tax position may be
recognized only if it is more likely than not that the tax position will be sustained,
based solely on its technical merits, with the taxing authority having full knowledge of
all relevant information. The measurement of a tax benefit for an uncertain tax position
that meets the more-likely-than-not threshold is based on a cumulative probability model
under which the largest amount of tax benefit recognized is the amount with a greater than
50 percent likelihood of being realized upon ultimate settlement with a taxing authority
having full knowledge of all relevant information. FIN 48 also requires significant new
annual disclosures. FIN 48 is effective for the Company beginning January 1, 2007. The
Company is currently determining the effect of FIN 48 on the consolidated financial
statements.
In September 2006, the FASB issued SFAS No. 158, “Employers Accounting for Defined Benefit
Pension and Other Postretirement Benefit Plans.” SFAS 158 requires companies to recognize
the overfunded or underfunded status of a defined benefit postretirement plan as an asset
or liability in its statement of financial position. This statement is effective for
financial statements as of the end of fiscal years ending after December 15, 2006. The
Company is currently determining the effect of SFAS 158 on the consolidated financial
statements.
In September 2006, the Securities and Exchange Commission (“SEC”) issued Staff Accounting
Bulletin (“SAB”) No. 108 which provides interpretative guidance on how the effects of the
carryover or reversal of prior year misstatements should be considered in quantifying a
current year misstatement. The SEC staff believes that registrants should quantify errors
using both a balance sheet and an income statement approach and evaluate whether either
approach results in quantifying a misstatement that, when all relevant quantitative and
qualitative factors are considered, is material. We are currently evaluating the impact of
SAB 108 on our consolidated financial statements.
The Company had outstanding bank term loans of $240.0 million at September 30, 2006. The
Company has provided as collateral for the loans substantially all of its assets. The term of
the loans is eight years repayable by installments of $13.3 million in 2011 and $226.7 million
in 2012. At the option of the Company, borrowing under the term loans bears interest at Base
Prime Rate or Eurodollar rate plus an applicable margin. The bank term loans of $240.0 million
are denominated and are repayable in US dollars, and bear interest at 7.60% at September 30,2006 (6.81% at December 31, 2005). The borrowing under the term loans will bear interest
between 1.25% and 1.5% plus the Base Prime Rate or between 2.25% and 2.5% plus the Eurodollar
rate. The applicable margin is determined based on the Company’s leverage ratio as specified in
the credit facility agreement.
The credit agreement also provides Standard Aero Holdings, Inc. with a $50.0 million revolving
credit facility. There were no borrowings outstanding under the revolving credit facility at
September 30, 2006. As of November 10, 2006, there was no amount outstanding under the revolving
credit facility. The revolving borrowings under the credit facility are denominated and are
repayable in US dollars. The revolving credit facility will bear interest between 0.75% and
1.50% plus the Base Prime Rate or between 1.75% and 2.50% plus the Eurodollar rate. The rates
are determined based on the Company’s leverage ratio as specified in the credit facility
agreement. The related commitment fee will equal between 0.375% and 0.5% of the undrawn credit
facility. The commitment fee is $0.2 million for the period January 1 to September 30, 2006.
The Company’s weighted average interest rate of borrowings under the credit agreement was 7.19%
for the period January 1 to September 30, 2006.
In addition, $200 million of senior subordinated unsecured notes were issued with an interest
rate of 8.25%, maturing on September 1, 2014. Prior to September 1, 2007, the Company may
redeem up to 35% of the original principal amount of the notes at a premium. Further, at any
time on or after September 1, 2009, the Company may redeem any portion of the notes at
pre-determined premiums.
Certain of these facilities contain covenants that restrict the Company’s ability to raise
additional financings in the future and the Company’s ability to pay dividends. The financial
covenants are based on long-term solvency ratios calculated from the Company’s consolidated
financial statements, which are prepared in accordance with accounting principles generally
accepted in the United States of America.
9
STANDARD AERO HOLDINGS INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
6
Employee benefit plans
The Company provides defined contribution pension plans and a defined benefit pension
plan covering substantially all of its employees. The Company does not provide any other
post-retirement benefits or supplemental retirement plans.
Costs for the defined contribution pension plans for each of the nine months ended
September 30, 2006 and September 30, 2005 were $4.8 million and $4.9 million,
respectively.
The Company’s effective tax rate for the three months ended September 30, 2006 was a benefit
of 12%, which is lower than the U.S. statutory rate of 35% primarily due to $2.5 million of
provision-to-return adjustments recorded in the third quarter to reconcile the
Company’s 2005 tax provision to its 2005 tax returns.
The Company’s effective tax rate for the nine months ended September 30, 2006 was an
expense of 10%, which is lower than the U.S. statutory rate of 35% primarily due
to $2.5 million of provision-to-return adjustments recorded in the third quarter to
reconcile the Company’s 2005 tax provision to its 2005 tax returns, a change in
foreign jurisdiction future tax rates enacted in the second quarter, a change
in tax law in the state of Texas, and the impact of foreign exchange rates on deferred tax balances.
Approximately $1.6 million of the provision-to-return adjustments was due to the
correction of errors in the calculation of the 2005 tax provision. Management has determined these adjustments
are not material to prior year interim and annual periods.
Similarly the Company’s effective tax rate was 47% and 32% for the three and nine months ended
September 30, 2005, respectively, which is different than the U.S. statutory rate of 35% primarily
because of a change in foreign jurisdiction future tax rates enacted in the second quarter and
the impact of foreign exchange rates on deferred tax balances.
The estimated annual effective rate is calculated quarterly based on the projected full year
income projections by legal entity in each corresponding tax jurisdiction and the Company’s
corporate structure. The effective rate will fluctuate primarily as changes in income by tax
jurisdiction occur.
8
Commitments and contingencies
Commitments
The Company leases facilities, office equipment, machinery, computer, and rental engines under
non-cancellable operating leases having initial terms of more than one year.
Contingent liabilities
The Company is involved, from time to time, in legal actions and claims arising in the ordinary
course of business. While the ultimate result of these claims cannot presently be determined,
management does not expect that these matters will have a material adverse effect on the
financial condition, statement of operations or cash flows of the Company.
The Company has facilities that are located on land that has been used for industrial purposes
for an extended period of time. The Company has not been named as a defendant to any
environmental suit. Management believes that the Company is currently in substantial
compliance with environmental laws. The Company incurs capital and operating costs relating to
environmental compliance on an ongoing basis. Management does not, however, believe that the
Company will be required under existing environmental laws to expend amounts that would have a
material adverse effect to its financial condition or results of operations as a whole.
10
STANDARD AERO HOLDINGS INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
Kelly Air Force Base subcontract
During the fourth quarter of 2005, Kelly Aviation Center, L.P. (“KAC”) indicated it disagreed
with the Company’s interpretation regarding the terms of the subcontract with KAC under which
the Company provides maintenance, repair and overhaul (“MRO”) services for U.S. Government T56
engines managed by the U.S. Air Force and that it did not intend to make a decision whether to
exercise the option to extend the subcontract for periods beyond February 2007. On January 25,2006, the Company was formally notified by KAC that it did not intend to extend the subcontract
beyond February 2007.
On July 11, 2006, the Company reached agreement with KAC regarding the terms of the
subcontract. In connection with the agreement, the parties have amended the terms of the KAC
subcontract, which was filed by the Company as Exhibit 10.21 to its Registration Statement on
Form S-4 filed with the Commission on July 14, 2005.
The following are the material terms of the amendment to the KAC subcontract:
•
The amendment provides that each extension of KAC’s prime contract with the U.S. Air
Force, Oklahoma City Air Logistic Center will result in the KAC subcontract being extended
as well. As a result, the KAC subcontract has been extended until February of 2010 and
will be extended for additional years to February 2014 if and when annual option years are
awarded to the prime contractor.
•
The amendment provides that commencing in the government’s fiscal year ending September30, 2007, the Company will be subject to annual performance evaluations based on objective
criteria. In the event that the Company fails to perform satisfactorily it will be
required to pay liquidated damages to KAC. These liquidated damages are initially capped
at $2 million in any year, but may be as high as $4 million in certain circumstances if
the Company fails to perform satisfactorily in successive years. Based on the past five
years of performance on the contract, the Company estimates that it would have incurred an
aggregate of approximately $500,000 of liquidated damages had the performance evaluation
criteria been in place during those years.
•
The amendment provides for a commitment by the Company to provide cost savings to KAC
in the form of a reduction in the prices that the Company charges to KAC for MRO services.
The revised terms will result in a pre-determined cost savings for the twelve months
ended September 30, 2007. The cost savings to KAC for each 12-month period thereafter will
be determined by a formula that includes several variables.
During the year ended December 31, 2005, the Company recorded impairment charges on intangible
assets and goodwill and reviewed for impairment certain other long-lived asset groups due to
the potential loss of or changes to the subcontract. These impairment reviews were based on a
series of probability-weighted cash flow forecasts. These projections were based on several
different potential outcomes that were weighted based upon management’s best estimate of future
cash flows using all evidence available about the situation that prevailed as of December 31,2005.
11
STANDARD AERO HOLDINGS INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
9
Stock based compensation
Certain employees of the Company are eligible to participate in the Company’s parent Standard
Aero Acquisition Holdings, Inc.’s (SAAHI) Stock Option Plan (the “Plan”) which was approved by
the Company’s Board of Directors in December 2004. A total of 425,000 stock options have been
approved for issuance under this Plan. As of September 30, 2006, SAAHI has 175,725 stock
options outstanding, each of which may be used to purchase one share of SAAHI common stock. The
options have a ten year life and an exercise price of one hundred dollars per share, which was
equivalent to the exercise price at that date. Approximately 32% of the options are time
vesting options that will vest on or prior to December 31, 2008. Approximately 46% of the
options are performance vesting options that will vest on the day immediately preceding the
seventh anniversary of the date of grant, provided the option holder remains continuously
employed with the Company. However, all or a portion of such performance vesting options may
vest and become exercisable over a five-year period, starting with 2004, if certain performance
targets relating to earnings and debt repayment are met. Approximately 22% of the options are
performance vesting options that will vest between December 31, 2006 and December 31, 2008 if
certain performance targets relating to earnings are met. In addition, these options vest upon
the occurrence of certain stated liquidity events, as defined in the Plan.
Weighted average remaining life as of September 30
4.2 years
5.5 years
Options exercisable as of September 30
38,939
17,952
Weighted average exercise prices
$100 per share
$100 per share
Aggregate intrinsic value
—
—
10
Related party transactions
At September 30, 2006, the Company has an outstanding payable of $3.9 million to its parent,
Standard Aero Acquisition Holdings, Inc. (SAAHI), for cash advanced by SAAHI. The payable is
non-interest bearing and has no repayment terms, however is payable on demand.
The Carlyle Group charges the Company a monthly management fee of $125,000.
12
STANDARD AERO HOLDINGS INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
11
Guarantees
The Company issues letters of credit, performance bonds, bid bonds or guarantees in the
ordinary course of its business. These instruments are generally issued in conjunction with
contracts or other business requirements. The total of these instruments outstanding at
September 30, 2006 was approximately $3.6 million (September 30, 2005 — $2.7 million).
Warranty guarantee
Reserves are recorded to reflect the Company’s contractual liabilities relating to warranty
commitments to customers. Warranty coverage of various lengths and terms is provided to
customers depending on standard offerings and negotiated contractual agreements.
Changes in the carrying amount of accrued warranty costs for the nine-month period ended
September 30 are summarized as follows:
2006
2005
(In thousands)
Balance at January 1
$
(3,986
)
$
(6,907
)
Warranty costs incurred
2,554
1,811
Warranty accrued
(2,744
)
(97
)
Balance at September 30
$
(4,176
)
$
(5,193
)
12
Segment information
The Company has two principal operating segments, which are Aviation Maintenance Repair and
Overhaul (Aviation MRO) and Enterprise Services. The Aviation MRO segment provides gas turbine
engine maintenance repair and overhaul services primarily for the aviation market. The
Enterprise Services segment provides services related to the design and implementation of lean
manufacturing operational redesigns. These operating segments were determined based on the
nature of the products and services offered. Operating segments are defined as components of an
enterprise about which separate financial information is available that is evaluated regularly
by the chief operating decision-maker in deciding how to allocate resources and in assessing
performance. The Company’s chief executive officer has been identified as the chief operating
decision-maker. The Company’s chief operating decision-maker directs the allocation of
resources to operating segments based on profitability and cash flows of each respective
segment.
Certain administrative and management services are shared by the segments and are
allocated based on direct usage, revenue and employee levels. Corporate management expenses
and interest expense are not allocated to the segments.
STANDARD AERO HOLDINGS INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
13
Guarantor information
Separate financial statements of the Guarantor Subsidiaries are not presented because
guarantees of the Notes are full and unconditional and joint and several. The Guarantor
Subsidiaries guarantee the senior subordinated notes. The Guarantor Subsidiaries are 100%
owned by the Company.
Condensed Consolidating Statements of Operations
For the three months ended September 30, 2006
(Unaudited)
Subsidiary
Subsidiary
Combining
Parent
Guarantors
Non-Guarantors
Adjustments
Total
(In thousands)
Revenues
$
—
$
174,345
$
21,991
$
(253
)
$
196,083
Operating expenses
Cost of revenues
—
145,981
24,704
(253
)
170,432
Selling, general and
administrative expense
1,211
6,172
1,123
—
8,506
Amortization of intangible assets
—
2,146
—
—
2,146
Total operating expenses
1,211
154,299
25,827
(253
)
181,084
Income (loss) from operations
(1,211
)
20,046
(3,836
)
—
14,999
Interest expense
9,530
297
102
—
9,929
Income (loss) before income taxes
(10,741
)
19,749
(3,938
)
—
5,070
Income tax expense (benefit)
(5,338
)
5,393
(663
)
—
(608
)
Income (loss) before equity
earnings of subsidiaries
The parent and certain of the Guarantor Subsidiaries file a consolidated tax return. The
losses of the parent reduce the income taxes payable of the consolidated group. The taxes
receivable of the parent are reported in the due from related parties.
15
STANDARD AERO HOLDINGS INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
Condensed Consolidating Statements of Operations
For the three months ended September 30, 2005
(Unaudited)
Subsidiary
Subsidiary
Combining
Parent
Guarantors
Non-Guarantors
Adjustments
Total
(In thousands)
Revenues
$
—
$
176,693
$
22,633
$
(1,059
)
$
198,267
Operating expenses
Cost of revenues
—
144,345
20,166
(1,059
)
163,452
Selling, general and
administrative expense
1,958
8,988
1,356
—
12,302
Amortization of intangible assets
—
2,346
—
—
2,346
Restructuring costs
—
2,014
1,201
—
3,215
Total operating expenses
1,958
157,693
22,723
(1,059
)
181,315
Income (loss) from operations
(1,958
)
19,000
(90
)
—
16,952
Interest expense
8,769
221
82
—
9,072
Income (loss) before income taxes
(10,727
)
18,779
(172
)
—
7,880
Income tax expense (benefit)
(3,758
)
7,414
29
—
3,685
Income (loss) before equity
earnings of subsidiaries
Net cash (used in) provided by operating
activities
(19,608
)
23,816
(9,775
)
—
(5,567
)
Investing activities
Acquisitions of property, plant and equipment
—
(6,373
)
(681
)
—
(7,054
)
Proceeds on disposal of property, plant and
equipment
—
51
—
—
51
Acquisition of rental assets
—
(10,114
)
(2,926
)
—
(13,040
)
Proceeds on disposal of rental assets
—
5,528
1,300
—
6,828
Net cash used in investing activities
—
(10,908
)
(2,307
)
—
(13,215
)
Financing activities
Repayment of debt
(15,000
)
(969
)
(274
)
—
(16,243
)
Increase in revolving credit facility
8,000
—
—
—
8,000
Change in due to and (from) related companies
23,193
(25,222
)
8,214
—
6,185
Net cash (used in) provided by financing
activities
16,193
(26,191
)
7,940
—
(2,058
)
Effect of exchange rate changes on cash and
cash equivalents
—
(530
)
(36
)
—
(566
)
Net decrease in cash and cash
equivalents
(3,415
)
(13,813
)
(4,178
)
—
(21,406
)
Cash and cash equivalents – Beginning of
period
4,116
18,521
5,254
—
27,891
Cash and cash equivalents – End of period
$
701
$
4,708
$
1,076
$
—
$
6,485
22
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Special Note Regarding Forward Looking Statements
Certain statements included in Management’s Discussion and Analysis of Financial Condition and
Results of Operations, other than purely historical information, including estimates, projections,
statements relating to our business plans, objectives and expected operating results, and the
assumptions upon which those statements are based, are “forward-looking statements” within the
meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act
of 1933 and Section 21E of the Securities Exchange Act of 1934. These forward-looking statements
generally are identified by the words “believes,”“project,”“expects,”“anticipates,”“estimates,”“intends,”“strategy,”“plan,”“may,”“will,”“would,”“will be,”“will continue,”“will likely
result,” and similar expressions. Forward-looking statements are based on current expectations and
assumptions that are subject to risks and uncertainties which may cause actual results to differ
materially from the forward-looking statements, including those risks and uncertainties described
under the caption “ Risk Factors” herein and in our Annual Report on Form 10-K for the year ended
December 31, 2005. We undertake no obligation to update or revise publicly any forward-looking
statements, whether as a result of new information, future events or otherwise.
Overview
We are a leading independent provider of aftermarket maintenance repair and overhaul (“MRO”)
services for gas turbine engines used primarily for military, regional and business aircraft. We
also supply repair and overhaul services for gas turbine engines used in marine, co-generation and
energy supply, as well as consultancy and redesign services related to the MRO process and
facilities.
Generally, manufacturer specifications, government regulations and military maintenance
regimens require that engines undergo MRO servicing at regular intervals or upon the occurrence of
certain events during the serviceable life of each engine. As a result, the aggregate volume of MRO
services required for any particular engine platform is a function of three factors:
•
the number of engines in operation (the “installed base”);
•
the age of the installed base; and
•
the utilization rate of the installed base.
Because we provide our MRO services with respect to specific engine platforms, the services we
provide, and thus our revenues, are influenced to a significant degree by the size, age and
utilization rate of the installed base of those engine platforms.
We typically provide MRO services to our customers under “time-and-materials” arrangements,
pursuant to which we charge our customers a price based on the specific work to be performed on
each engine. In some cases, this price is based on negotiated hourly rates for labor and for
replacement parts. We also provide MRO services under fixed price contracts or under fixed price
per engine utilization arrangements, a variation of a fixed-price arrangement pursuant to which
customers pay us a negotiated price per hour or cycle that each engine is operated.
23
Kelly Air Force Base Subcontract
We generated approximately 27.6% and 31.2% of our revenues for the nine months ended September30, 2006 and the year-ended December 31, 2005, respectively, by providing MRO services to the
United States Air Force as a subcontractor to Kelly Aviation Center, L.P., or KAC, a joint venture
between Lockheed Martin, General Electric and Rolls-Royce. The original subcontract was awarded in
1999 and ran through February 2006, and KAC previously exercised an option to extend the
subcontract for one year to February 2007.
On January 25, 2006, KAC informed us that it did not intend to extend the subcontract beyond
February 2007.
On July 11, 2006, we reached agreement with KAC regarding the terms of the subcontract. In
connection with the agreement, the parties have amended the terms of the KAC subcontract.
The following are the material terms of the amendment to the KAC subcontract:
•
The amendment provides that each extension of KAC’s prime contract with the U.S. Air
Force, Oklahoma City Air Logistic Center will result in the KAC subcontract being extended
as well. As a result, the KAC subcontract has been extended until February 2010 and will be
extended for additional years to February 2014 if and when annual option years are awarded
to KAC under the prime contract.
•
The amendment provides that commencing in the government’s fiscal year ending September30, 2007, we will be subject to annual performance evaluations based on objective criteria.
In the event that we fail to perform satisfactorily we will be required to pay liquidated
damages to KAC. These liquidated damages are initially capped at $2.0 million in any year
but may be as high as $4.0 million in certain circumstances if we fail to perform
satisfactorily in successive years. Based on the past five years of performance on the
contract, we estimate that we would have incurred an aggregate of approximately $500,000 of
liquidated damages had the performance evaluation criteria been in place during those
years.
•
The amendment provides for a commitment by us to provide cost savings to KAC in the form
of a reduction in the prices that we charge to KAC for MRO services. The revised terms
will result in a pre-determined cost savings for the twelve months ended September 30,2007. The cost savings to KAC for each 12-month period thereafter will be determined by a
formula that includes several variables.
While we expect that the cost savings commitment will materially reduce our revenues and Adjusted
EBITDA (as defined in our senior credit facility) generated under the KAC subcontract, due to the
variability of external factors affecting pricing and profitability under the subcontract, we
cannot predict with certainty the impact of the amendment on our results of operations. However,
we expect that the cost savings commitment will reduce our Net Income and Adjusted EBITDA generated
under the KAC subcontract during 2006 by approximately $2.0 to $3.0 million and $4.0 to $5.0
million, respectively, and during 2007 by approximately $8.0 to $11.0 million and $14.0 to $17.0
million, respectively, in each case compared to expected results under the subcontract without the
cost savings commitment and assuming historical MRO volumes. We do not anticipate that the cost
savings commitment will result in noncompliance with the financial covenants in our senior credit
facility.
Trends Affecting Our Business
Military MRO. The MRO services, including redesign services, that we provide to military aviation
end-users contributed in excess of 45% of our revenues for the year ended December 31, 2005 and 48%
of our revenues during the nine months ended September 30, 2006. A significant portion of our
military aviation end-user revenues are generated by the MRO services we provide directly or
indirectly to the United States military, including those provided under the Kelly Air Force Base
subcontract. The demand for these MRO services is driven to a large extent by U.S. military
outsourcing practices, Department of Defense budgets, serviceable stock levels and the utilization
rate of the types of aircraft engines for which we provide MRO services. Utilization and funding
for the U.S. military has been at a historically high level during the past several years due to
the increased operational tempo of
the U.S. military related to the war on terror. We believe that this increased utilization and
spending peaked during 2004 for the principal military engine that we service, the Rolls-Royce T56,
which powers the C-130 Hercules, P-3 Orion, and C-2 Greyhound aircraft.
24
We believe that there are over 3,800 T56 engines installed in the U.S. military fleet. The
U.S. military utilization rate of this engine returned to pre-2001 levels during 2005 and we expect
that its utilization rate will continue to gradually decline as P-3 Orions and C-130 models A
through H are retired and replaced with the C-130J, which is powered by the AE2100 engine.
Nevertheless, we expect that revenues lost due to the decreased size of the T56 installed base will
be partially offset by revenues generated by providing MRO services for AE2100 engines.
Our 2004 revenues benefited from the historically high utilization rate for aircraft equipped
with the T56 engine and the conversion of certain parts from government supplied to contractor
supplied. However, due to decreases in fleet utilization, some aircraft retirements and increases
in serviceable engine stock levels, we have experienced a decrease in demand by the U.S. military
for T56 MRO services in recent periods. As a result, our revenues from T56 MRO services were down
approximately 13% in 2005 compared to 2004. Our T56 MRO revenues, Adjusted EBITDA and Net Income
will also be affected by cost-savings commitments contained in the amended agreement made with KAC,
see “Risk Factors” and “—Kelly Air Force Base Subcontract.” We do not anticipate that T56 MRO
revenues, provided directly or indirectly, to the U.S. military will return to 2004 levels in the
foreseeable future. Our T56 MRO services were approximately 5% lower for the nine months ended
September 30, 2006 compared to the nine months ended September 30, 2005 and 16% lower than the nine
months ended September 30, 2004.
We have benefited in recent periods from an increasing reliance by the U.S. military on
outsourcing its MRO services, including aircraft engine MRO services such as those that we provide
under the Kelly Air Force Base subcontract and our MRO redesign and transformation services. In the
second quarter of 2005, the United States Air Force awarded Columbus, Ohio based Battelle a 10-year
contract to redesign the MRO processes and industrial facilities at the Oklahoma City Air Logistics
Center. Our Enterprise Services business was chosen to be the prime subcontractor to Battelle to
provide a significant portion of the redesign and transformation services under that contract.
Revenues under this contract commenced in the third quarter of 2005. We continue to perform
transformation work for the USAF at the Ogden-Air Logistics Center and have teams in place pursuing
similar transformation and process improvement requirements at other U.S. military bases.
In recent years the U.S. Department of Defense and foreign military organizations have started
to award outsourcing contracts on the basis of performance based logistics (PBL), contractor
logistics support (CLS), and other forms of performance-based, end-to-end support that bundle
aircraft, engine, and other systems MRO and support into a single contract. This type of
contracting trend may limit the number of potential prime contractors that qualify to bid on such
contracts and may limit the number of engine-only outsourcing opportunities. In order to position
ourselves to compete in this evolving military contracting environment, we intend to seek
opportunities to partner with other types of service providers that will enable us to be part of a
team that can provide bundled MRO and other aircraft services. On July 7, 2006 we were awarded a
subcontract to support the U.S. Navy P&WC PT6A powered T-33 and T-34 trainer fleet of aircraft
under CLS Sikorsky Support Services Inc. We currently provide PT6A engine maintenance and support
on the US Army C-23 Sherpa fleet under a CLS prime contractor, M7 Aerospace.
Regional Jet Engine MRO. We have invested significant capital in our MRO programs for the
AE3007 and CF34 engines, which are primarily used on 35- to 90-seat regional jets. Our investments
in this regard have primarily been associated with obtaining OEM authorizations and licenses for
these engines and in the advanced facilities in which we provide MRO services for them. We do not
expect to begin to fully realize the benefit of our investment in the CF34 platform until 2007,
when we expect that scheduled CF34 overhauls will increase. Until that time our gross profit
margins will be offset by the fixed costs of this program. We expect that AE3007 revenues will
continue to provide a significant portion of our revenues for the foreseeable future and that the
AE3007 platform will continue to be an important part of our business strategy. However, AE3007
revenues were 31% lower in 2005 than they were in 2004 and were approximately 27% lower in the nine
months ended September 30, 2006 compared to the nine months ended September 30, 2004 primarily as a
result of changes Rolls-Royce made to the MRO service requirements for the engine. We do not expect
AE3007 revenues to return to 2004 levels for the foreseeable future.
25
The demand for regional jet travel continued to increase during the third quarter of 2006, and
we expect it to continue to increase in the remainder of 2006 and the foreseeable future.
Nevertheless, changes in competitive and economic factors affecting the major U.S. airlines, such
as increased fuel costs, have created uncertainty as to the future characteristics of the regional
jet business. Prospects for regional jet operators are uncertain as several major U.S. airlines
review their business operations or reorganize under bankruptcy protection. Changes in the industry
may, for instance, result in the renegotiation of capacity and codeshare agreements with regional
air carriers in an effort by the major airlines to reduce expenses or could result in the failures
of major airlines and potentially regional airlines. Alternatively, it may be that changes in the
industry could allow the major U.S. airlines to increase their outsourcing to regional airlines,
which could give the independent regional airlines the opportunity to expand their operations.
We believe that changes in the regional jet market present both opportunities and risks for us
and that, in any event, these changes will require us to remain nimble and focused on remaining
competitive, flexible and responsive. To the extent that independent regional airlines are able to
take advantage of these changes and grow their position in the market, we anticipate that the
majority of their engine MRO work would be outsourced to OEMs and independent MRO service providers
such as us. If major airlines begin to increase in-sourcing of regional jet operations, we expect
they will outsource engine servicing to the extent that they do not have the capability or cannot
be competitive. In any event, we expect that competition to provide MRO services would remain
intense and that we would need to continue to take advantage of our many strengths and to be
aggressive in bidding for opportunities to provide these MRO services. We believe that we would
continue to occupy a strong position to compete for these workloads.
Turboprop MRO. We experienced growth in revenues from providing turboprop MRO services in 2005
as a result of increased utilization of turboprop-powered aircraft, in part due to the superior
fuel efficiency characteristics of these engines in some applications. Demand for new single engine
turboprops remains strong, bolstered by increased production of training aircraft and a resurgence
in the use of business aircraft using turboprop engines. Driven by high fuel prices, demand has
also increased for turboprops in the commuter and small regional airline markets, especially in
Europe and Asia. We expect these conditions to provide near term stability in the turboprop engine
lines we service. Over the long term, however, we anticipate that the demand for turboprop MRO will
decrease as aircraft using turboprop engines are replaced over time by jet-powered aircraft. Our
turboprop MRO service revenues were approximately 3% lower in the nine months ended September 30,2006 compared to the nine months ended September 30, 2005 and 23% higher compared to the nine
months ended September 30, 2004.
Financial statement presentation
The following discussion provides a brief description of certain items that appear in our
consolidated financial statements and the general factors that impact these items.
Revenues. Revenues represents gross sales principally resulting from the MRO services and
parts that we provide. Revenues related to our Enterprise Services are based on services provided
to the end customer pursuant to the contractual terms and conditions of the service agreements.
Cost of revenues. Cost of revenues includes all direct costs required to provide our MRO
services. These costs include the cost of parts, labor for engine disassembly, assembly and repair,
spare engines, subcontracted services and overhead costs directly related to the performance of MRO
services. Overhead costs include the cost of our MRO facilities, engineering, quality and
production management, commercial credit insurance, depreciation of equipment and facilities and
amortization of the cost to acquire OEM authorizations. Cost of revenues related to our Enterprise
services business include the cost of labor, subcontracted services and overhead costs directly
related to the performance of these services.
26
Selling, general and administrative expense. Selling, general and administrative (“SG&A”)
expense includes the cost of selling our services to our customers and maintaining a global sales
support network, including salaries of our direct sales force. General costs to support the
administrative requirements of the business such as finance, accounting, human resources and
general management are also included.
Critical accounting policies
The accounting policies discussed below are important to the presentation of our results of
operations and financial condition and require the application of judgment by our management in
determining the appropriate assumptions and estimates. These assumptions and estimates are based on
our previous experience, trends in the industry, the terms of existing contracts and information
available from other outside sources and factors. Adjustments to our financial statements are
recorded when our actual experience differs from the expected experience underlying these
assumptions. These adjustments could be material if our experience is significantly different from
our assumptions and estimates. Below are those policies applied in preparing our financial
statements that management believes are the most dependent on the application of estimates and
assumptions.
Revenue recognition. We generally recognize revenues generated by our services or parts sales
when the services are completed or repaired parts are shipped to the customer. Amounts that are
received in advance from our customers are recorded as unearned revenue. Lease income associated
with the rental of engines or engine modules to customers is recorded based on engine usage as
reported by the customer. In connection with fixed price per engine utilization contracts that we
have with our customers, we recognize revenue and related cost of revenue when the services are
completed or repaired parts are shipped to the customer. We estimate the profit margins on these
contracts based on an estimate of the overall contract profitability. We take into consideration
such factors as future contractual revenue, projected future direct maintenance costs and each
contract’s specific terms and conditions related to future revenue and direct maintenance cost
increases. We accrue losses under our fixed price contracts when it is probable that the future
contractual direct maintenance costs will exceed the future revenue and the amount of the loss can
be reasonably estimated. We receive payments from customers under these contracts in advance of
completion of services or shipment of repaired parts to the customer, which are recorded as
unearned revenue. These payments are based on contractual terms and conditions pursuant to which
customers pay for services or products based on engine usage.
Reserve for warranty costs. We provide reserves to account for estimated costs associated with
current and future warranty claims. Warranty claims arise when an engine we service fails to
perform to required specifications during the relevant warranty period. The warranty reserve is
provided for by increasing our cost of revenues by an estimate based on our current and historical
warranty claims and associated repair costs.
Reserve for doubtful accounts receivable. We provide a reserve for doubtful accounts
receivable that accounts for estimated losses that result from our customers’ inability to pay for
our MRO services. This reserve is based on a combination of our analyses of history, aging
receivables, financial condition of a particular customer and political risk. Our estimates are net
of credit insurance coverage that we maintain for most of our commercial customers. The
provision for doubtful accounts receivable is charged against operating income in the period
when such accounts are determined to be doubtful, and has historically been immaterial in amount.
Nevertheless, we believe that ongoing analysis of this reserve is important due to the high
concentration of revenues within our customer base.
Goodwill and intangible assets. Goodwill and other intangible assets with indefinite lives are
not amortized, but are subject to impairment testing both annually and when there is an indication
that an impairment has occurred, such as an operating loss or a significant adverse change in our
business. Impairment testing includes use of future cash flow and operating projections, which by
their nature, are subjective. If we were to determine through such testing that an impairment has
occurred, we would record the impairment as a charge against our income. We amortize intangible
assets that we have determined to have definite lives, including OEM authorizations and licences,
customer relationships, and technology and other over their estimated useful lives. We amortize
intangible assets that have definite lives over periods ranging from one to 20 years. Our specific
OEM licenses and authorizations are amortized over four to 17 years. All of our trademarks are
classified as having indefinite lives.
27
Impairment of long-lived assets. We review long-lived assets for impairment whenever events or
changes in circumstances indicate that the carrying amount of such assets may not be recoverable in
accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets.
Recoverability of assets to be held and used is measured by a comparison of the carrying amount of
an asset to undiscounted estimated future net cash flows expected to be generated by the assets. If
such assets are considered to be impaired, the impairment to be recognized is measured by the
amount by which the carrying amount of the assets exceeds the fair value of the assets and charged
against our income.
Inventory. We value our inventory at standard cost using the first-in first-out, or FIFO,
method, and state our inventories at the lower of cost or net realizable value. In making such
determinations, cost represents the actual cost of raw materials, direct labor and an allocation of
overhead in the case of work in progress. We write down our inventory for estimated obsolescence or
unmarketable inventory on a part-by-part basis using aging profiles. Aging profiles are determined
based upon assumptions about future demand and market conditions. If actual future demand or market
conditions are less favorable than those projected, then inventory adjustments may be required.
Income taxes. We account for income taxes in accordance with SFAS No. 109, Accounting for
Income Taxes. Deferred tax assets and liabilities are recognized for the future tax consequences
attributable to differences between financial statement carrying amounts of existing assets and
liabilities and their respective tax bases. Deferred tax assets and liabilities are estimated using
enacted tax rates expected to apply to taxable income in the years in which those temporary
differences are expected to be recovered or settled. We do not provide taxes on undistributed
earnings of foreign subsidiaries that are considered to be permanently reinvested. If undistributed
earnings were remitted, foreign tax credits would substantially offset any resulting U.S. tax
liability.
Revenues. Total revenues decreased $2.2 million, or 1%, to $196.1 million for the three months
ended September 30, 2006 from $198.3 million for the three months ended September 30, 2005. This
decrease was primarily attributable to a $9.5 million decrease in revenue in our Aviation MRO
operating segment primarily attributable to a decrease in our revenues from our T56 military
contracts partially offset by an increase in our regional airline
turboprop and business aircraft turboprop service revenues during the period. Revenue in our
Enterprise Services business increased $7.3 million as we were fully operational and earning
revenues under our subcontract agreements with Battelle to provide redesign services to the United
States Air Force at Tinker Air Force Base in Oklahoma City, Oklahoma and Hill Air Force Base in
Ogden, Utah.
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Gross profit. Gross profit was $25.7 million, or 13% of total revenues, for the three months ended
September 30, 2006 and was $34.6 million, or 17% of total revenues, for the three months ended
September 30, 2005. Gross profit during the 2006 period was lower than in the 2005 period
primarily due to decreased revenues in our Aviation MRO business, a $3.5 million charge for losses
under a contract whereby we are paid a fixed price per engine utilization, a $0.9 million adverse
change related to foreign exchange offset by gross profit related to increased revenues in our
Enterprise Services business.
Selling, general and administration expense. SG&A expense was $8.5 million, or 4% of total
revenues, for the three months ended September 30, 2006 and was $12.3 million, or 6% of total
revenues, for the three months ended September 30, 2005. SG&A expense during the 2006 period
reflects a $1.4 million decrease in personnel expenses, a $0.9 million decrease in professional
fees and a general reduction in SG&A expense.
Amortization of intangible assets. Amortization of intangible assets was $2.1 million, or 1% of
total revenues, for the three months ended September 30, 2006 and was $2.3 million, or 1% of total
revenues, for the three months ended September 30, 2005. The decrease in amortization of
intangible assets during the 2006 period reflects that certain of our intangible assets have been
fully amortized.
Restructuring costs. There were no restructuring costs for the three months ended September 30,2006. Restructuring costs for the three months ended September 31, 2005 were $3.2 million which
primarily relate to severance costs associated with the reduction in staff, for which there remains
no outstanding liability.
Income from operations. Income from operations was $15.0 million, or 8% of total revenues, for the
three months ended September 30, 2006 and was $17.0 million, or 9% of total revenues, for the three
months ended September 30, 2005. Income from operations during the 2006 period was lower than in
the 2005 period principally from a charge for losses under a contract whereby we are paid a fixed
price per engine utilization offset by a reduction in restructuring costs and the items described
under gross profit and SG&A above.
Interest expense. Interest expense was $9.9 million, or 5% of total revenues, for the three
months ended September 30, 2006 and was $9.1 million, or 5% of total revenues, for the three months
ended September 30, 2005. The increase in interest expense reflects the increase in interest rates
to 7.64% for the 2006 period from 5.76% for the 2005 period on our senior indebtedness, partially
offset by lower average debt levels during the period.
Income
tax expense. The effective tax rate for the three months ended September 30, 2006 was a benefit of 12%
as compared to the U.S. statutory rate of 35% primarily due to adjustments recorded in the third
quarter to reconcile our 2005 tax provision to our 2005 income tax returns. During the third quarter of 2006,
we recorded approximately $2.5
million of provision-to-return adjustments related to our 2005 income tax returns. Approximately
$1.6 million was due to correction of errors in the calculation of the 2005 tax provision and we have
determined they are not material to prior year interim and annual periods. The effective tax rate
for the three months ended September 30, 2005 was 47% as compared to the U.S. statutory rate of 35%
primarily due to a change in foreign jurisdiction future tax rates enacted in the second quarter
and foreign exchange changes on deferred tax balances.
Revenues. Total revenues increased $24.8 million, or 4%, to $582.3 million for the nine months
ended September 30, 2006 from $557.5 million for the nine months ended September 30, 2005. This
increase was primarily attributable to a $24.2 million increase in revenues in our Enterprise
Services business as during the 2006 period we became fully operational and earning revenues under
our subcontract agreements with Battelle to provide redesign services to the United States Air
Force at Tinker Air Force Base in Oklahoma City, Oklahoma and Hill Air Force Base in Ogden, Utah.
Revenue in our Aviation MRO operating segment increased $0.5 million primarily attributable to an
increase in our turbofan service revenues offset by a decline in our regional airline turboprop and
business aircraft turboprop and US T56 military service revenues during the period.
Gross profit. Gross profit was $89.8 million, or 15% of total revenues, for the nine months ended
September 30, 2006 and was $95.6 million, or 17% of total revenues, for the nine months ended
September 30, 2005. Gross profit during the 2006 period was lower than in the 2005 period
primarily due to an adverse mix and price change in our Aviation MRO business, a $3.5 million
charge for losses under contract whereby we are paid a fixed price per engine utilization, a $3.1
million adverse change related to foreign exchange rates offset by gross profit on increased
revenues in our Enterprise Services business and an adjustment to our inventory cost estimates.
Selling, general and administration expense. SG&A expense was $35.8 million, or 6% of total
revenues, for the nine months ended September 30, 2006 and was $37.8 million, or 7% of total
revenues, for the nine months ended September 30, 2005. SG&A expense during the 2006 period
reflects a $1.3 million decrease in personnel expenses and a general reduction in expenses offset
by a $1.2 million increase in professional fees and increase provision for uncollectable accounts.
Amortization of intangible assets. Amortization of intangible assets was $6.4 million, or 1% of
total revenues, for the nine months ended September 30, 2006 and was $7.2 million, or 1% of total
revenues, for the nine months ended September 30, 2005. The decrease in amortization of intangible
assets during the 2006 period reflects that certain of our intangible assets have been fully
amortized.
Restructuring costs. There were no restructuring costs for the nine months ended September 30,2006. Restructuring costs for the nine months ended September 31, 2005 were $3.2 million, which
primarily relate to severance costs associated with the reduction in staff, for which there remains
no outstanding liability.
30
Income from operations. Income from operations was $47.5 million, or 8% of total revenues, for the
nine months ended September 30, 2006 and was $47.4 million, or 9% of total revenues for the nine
months ended September 30, 2005. Income from operations during the 2006 period was higher than in
the 2005 period principally from a reduction in restructuring costs and the items described under
gross profit and SG&A above.
Interest expense. Interest expense was $29.0 million or 5% of total revenues, for the nine months
ended September 30, 2006 and was $26.9 million or 5% of total revenues, for the nine months ended
September 30, 2005. The increase in interest expense reflects the increase in interest rates to
7.19% for the 2006 period from 5.41% for the 2005 period on our credit agreement, partially offset
by lower average debt levels during the period.
Income tax expense. The effective tax rate for the nine months ended September 30, 2006 was 10% as
compared to the U.S. statutory rate of 35% primarily due to adjustments recorded in the third
quarter to reconcile our 2005 tax provision to our 2005 income tax returns, a change in foreign
jurisdiction tax rates enacted in the second quarter, a change in tax law in the State of Texas and
foreign exchange change on deferred tax balances. During the third quarter of 2006, we recorded
approximately $2.5 million of provision-to-return adjustments related to our 2005 income tax returns.
Approximately $1.6 million was due to correction of errors in the calculation of the 2005 tax
provision and we have determined they are not material to prior year interim and annual periods.
The effective tax rate for the nine months ended September 30, 2005 was 32% as compared to the U.S.
statutory rate of 35% primarily due to a change in foreign jurisdiction future tax rates enacted in
the second quarter and foreign exchange change on deferred tax balances.
The Company has determined that it operates in two operating segments: (1) Aviation MRO, and (2)
Enterprise Services. The following table reconciles segment revenue and income from operations to
total revenue and net income:
Revenues. Aviation MRO revenues decreased $9.5 million, or 5%, to $186.4 million for the three
months ended September 30, 2006 from $195.9 million for the three months ended September 30, 2005.
The Aviation MRO revenue decrease was primarily attributable to a $14.5 million decrease in our
military T56 MRO services primarily from the United States Air Force under our subcontract
agreement with KAC. Revenues from our non-aviation engine platforms decreased $2.2 million during
the period due to timing of maintenance events under certain service contracts. Our turbofan
revenues increased $4.3 million as a result of increased inputs on the AE3007 engine platform.
Revenues from our regional airline turboprop and business aircraft turboprop end users increased
$2.5 million during the period.
Segment income from operations. Aviation MRO segment income from operations was $15.7 million for
the three months ended September 30, 2006 and was $23.3 million for the three months ended
September 30, 2005. The decrease in Aviation MRO segment income from operations during the 2006
period resulted from decreases in gross profit associated with the decreased revenues during the
period, a $3.5 million charge for losses under a contract whereby we are paid a fixed price per
engine utilization and an adverse change in foreign exchange rates, partially offset by
improvements in our SG&A expenses.
Revenues. Enterprise Services revenues increased $7.3 million to $9.7 million for the three months
ended September 30, 2006 from $2.4 million for the three months ended September 30, 2005. This
increase was primarily a result of our subcontract agreements with Battelle to provide redesign
services to the United States Air Force at Tinker Air Force Base in Oklahoma City, Oklahoma and
Hill Air Force Base in Ogden, Utah.
Segment income from operations. Enterprise Services segment income from operations was $0.6 million
for the three months ended September 30, 2006 and was a loss of $0.7 million for the three months
ended September 30, 2005. The increase in income from operations is a result of our revenue
generating activities under our Battelle contracts.
The Company has determined that it operates in two operating segments: (1) Aviation MRO, and (2)
Enterprise Services. The following table reconciles segment revenue and income from operations to
total revenue and net income:
Revenues. Aviation MRO revenues increased $0.5 million to $555.0 million for the nine months ended
September 30, 2006 from $554.5 million for the nine months ended September 30, 2005. The Aviation
MRO revenue increase was primarily attributable to a $9.9 million increase in our turbofan revenues
primarily as a result of increased inputs for our MRO services on the AE3007 engine platform.
Revenues from our non-aviation engine platforms increased $2.3 million during the period due to
volumes under new contracts and timing of maintenance events under certain service contracts. Our
military T56 MRO services decreased $9.0 million during the period primarily due to decreased T56
revenues from the United States Air Force under our subcontract agreement with KAC. Revenues from
our regional airline turboprop and business aircraft turboprop end users declined $3.5 million
during the period.
Segment income from operations. Aviation MRO segment income from operations was $55.1 million for
the nine months ended September 30, 2006 and was $61.8 million for the nine months ended September30, 2005. The decrease in Aviation MRO segment income from operations during the 2006 period
resulted from decreased gross profit associated with adverse contract price and mix changes, a $3.5
million charge for losses under a contract whereby we are paid a fixed price per engine
utilization, an increased provision for uncollectable accounts and an adverse change in foreign
exchange rates offset by improvements in our SG&A expenses.
Revenues. Enterprise Services revenues increased $24.2 million to $27.2 million for the nine months
ended September 30, 2006 from $3.0 million for the nine months ended September 30, 2005. This
increase was primarily a result of our subcontract agreements with Battelle to provide redesign
services to the United States Air Force at Tinker Air Force Base in Oklahoma City, Oklahoma and
Hill Air Force Base in Ogden, Utah.
Segment income from operations. Enterprise Services segment income from operations was $0.1 million
for the nine months ended September 30, 2006 and was a loss of $3.4 million for the nine months
ended September 30, 2005. The increase in income from operations is a result of our revenue
generating activities under our Battelle contracts.
Liquidity and capital resources
Liquidity requirements
Our principal cash requirements
are to fund working capital, to fund capital expenditures and to
service our indebtedness.
In recent periods and during the period ended September 30, 2006, our capital expenditures have
been divided between annual capital projects, net rental engine pool investments and continuing
investments in our CF34 program. During the period ended September 30, 2006, we made capital
expenditures (including the net change in our rental engine pool) of $7.7 million. We expect to
make approximately $12.0 million in net capital expenditures in 2006.
our senior credit facilities, consisting of an eight-year term loan facility, under
which we had outstanding indebtedness of $240.0 million, and a $50.0 million six-year
revolving credit facility, under which we had not outstanding indebtedness; and
•
$200.0 million in aggregate principal amount of our 81/4% senior subordinated notes due
2014.
Restricted cash represents the balance of payments made by our customers in advance of the MRO
services to be performed under contract. These amounts remain in a trust account until such time
as we perform a MRO service covered under the contract and upon completion, the funds are
transferred to us. At September 30, 2006 our restricted cash balance was $29.3 million.
Based on our current operations, we believe that cash on hand, together with cash flows from
operations and borrowings under the revolving credit portion of our new senior credit facilities,
will be adequate to meet our working capital, capital expenditure, debt service and other cash
requirements for the next 12 months. However, our ability to make scheduled payments of principal,
pay interest, refinance our indebtedness, including the senior subordinated notes, to comply with
the financial covenants under our debt agreements and to fund our other liquidity requirements will
depend on our ability to generate cash in the future, which is subject to general economic,
financial, competitive, legislative, regulatory and other factors that are beyond our control. We
cannot assure you that our business will generate cash flows from operations or that future
borrowings will be available under our new senior credit facilities in an amount sufficient to
enable us to service our indebtedness, including the notes, or to fund our other liquidity needs.
Any future acquisitions, joint ventures or other similar transactions will likely require
additional capital and there can be no assurance that any such capital will be available to us on
acceptable terms, if at all.
34
Senior credit facilities
Borrowings under our senior credit facilities bear interest at either a floating base rate or a
LIBOR rate plus, in each case, an applicable margin. At September 30, 2006, our borrowings under
our senior credit facilities bore interest based on LIBOR. In addition, we pay a commitment fee in
respect of unused revolving commitments. Subject to certain exceptions, our senior credit
facilities require mandatory prepayments of the loans with 50% of our annual excess cash flow (as
defined in the senior credit facilities) and with the net cash proceeds of certain assets sales or
other asset dispositions and issuances of debt securities. The obligations under our senior credit
facilities are guaranteed by all of our existing and future wholly-owned U.S. and Canadian
subsidiaries (except for unrestricted subsidiaries) and by our parent, and are secured by a
security interest in substantially all of our assets and the assets of our direct and indirect
restricted U.S. subsidiaries that are guarantors, including a pledge of all of our capital stock,
the capital stock of each of our restricted U.S. subsidiaries and 65% of the capital stock of
certain of our non-U.S. subsidiaries that are directly owned by us or one of our restricted U.S.
subsidiaries.
We made optional prepayments under the term loan portion of our senior credit facilities of $40.0
million in 2004, $15.0 million in 2005, $15.0 million on January 27, 2006, $5.0 million on February24, 2006 and $10.0 on September 27, 2006. These prepayments have been applied against our future
scheduled prepayments and we do not have a scheduled payment until December 2011.
From time to time we have drawn down on our revolving credit facility in order to provide short
term liquidity. Such borrowings have ranged from $2.0 million to $16.0 million and have been repaid
within approximately 12 weeks from the draw down date.
We enter into interest rate hedging arrangements for the purpose of reducing our exposure to
adverse fluctuations in interest rates. On October 12, 2004, we entered into a series of
sequential collar transactions. The following table summarizes our outstanding collar transaction:
Our senior credit facilities contain various restrictive operating and financial covenants.
Compliance with these covenants is essential to our ability to continue to meet our liquidity
needs, as a failure to comply could result in a default under our senior credit facilities and
permit our senior lenders to accelerate the maturity of our indebtedness. Such an acceleration of
our indebtedness would have a material adverse affect on our liquidity, including on our ability to
make payments on our other indebtedness and our ability to operate our business. We believe that
the two most material financial covenants under our senior credit facilities are the consolidated
leverage ratio and the consolidated net interest coverage ratio, which are both based on Adjusted
EBITDA, as defined in our senior credit facilities.
The consolidated leverage ratio measures the ratio of our outstanding debt net of cash at
fiscal-year end to our Adjusted EBITDA for the fiscal year then ended, and requires the ratio not
exceed certain limits. This covenant required us to have a ratio of outstanding debt net of cash
to Adjusted EBITDA of no more than 5.75 to 1 at September 30, 2006. At September 30, 2006, our
outstanding debt net of cash was $438.8 million and Adjusted EBITDA for the last twelve months
ended September 30, 2006 was $100.2 million, resulting in a consolidated leverage ratio at September30, 2006 of 4.38 to 1, compared to outstanding debt net of cash of $448.5 million at December 31,2005 and Adjusted EBITDA of $97.8 million for the year ended December 31, 2005, resulting in a
consolidated leverage ratio at December 31, 2005 of 4.58 to 1.
The consolidated net interest coverage ratio covenant measures the ratio of our Adjusted EBITDA for
any period of four consecutive quarters to our cash interest expense during the same four quarters.
The minimum interest coverage ratio covenant required us to have a ratio of Adjusted EBITDA to cash
interest expense of at least 2.25 to 1 at September 30, 2006. For the four quarters ended September30, 2006, our cash interest expense was $35.6 million, resulting in an interest coverage ratio of
2.82 to 1 at September 30, 2006, compared to cash interest expense of $33.5 million for the four
quarters ended December 31, 2005, resulting in an interest coverage ratio of 2.92 to 1 at December31, 2005.
We are currently in compliance in all material respects with the covenants in the senior credit
facilities. We do not anticipate that the cost savings commitment under the KAC settlement will
result in noncompliance with the financial covenants in our senior credit facility. For additional
discussion of the risks associated with such non-compliance, see “Risk Factors” herein and in our
Annual Report on Form 10-K for the year ended December 31, 2005 and “—Kelly Air Force Base
Subcontract.”
We have included information concerning Adjusted EBITDA because we use this measure to evaluate our
compliance with covenants governing our indebtedness and because of the importance of that
compliance to our liquidity and our business. Under our senior credit facilities, Adjusted EBITDA
represents net income before provision for income taxes, interest expense, and depreciation and
amortization and also adds or deducts, among other things, unusual or non-recurring items,
restructuring charges, transaction fees, and management fees pursuant to our management agreement
with The Carlyle Group. Adjusted EBITDA is not a recognized term under GAAP. Adjusted EBITDA should
not be considered in isolation or as an alternative to net income, net cash provided by operating
activities or other measures prepared in accordance with GAAP. Additionally, Adjusted EBITDA is not
intended to be a measure of free cash flow available for management’s discretionary use, as such
measure does not consider certain cash requirements such as working capital, capital expenditures,
tax payments and debt service requirements. Adjusted EBITDA, as included herein, is not necessarily
comparable to similarly titled measures reported by other companies.
36
The following table presents a reconciliation of Adjusted EBITDA, as defined in the senior credit
facilities to net income:
We incurred $6.1 million in costs associated with a charge under a fixed price per engine
utilization contract, professional fees and other costs associated with the KAC contractual
review and a fixed asset write-off during the nine month period ended September 30, 2006. We incurred $2.5 million in
non-recurring professional fees associated with contractual review and employee exit costs
during the period October 1, 2005 to December 31, 2005.
(2)
We incurred $77.1 million in goodwill and intangible asset impairment in accordance with SFAS
144 and SFAS 142 related to the potential loss of, or changes to, the Kelly Air Force Base
subcontract during the period October 1, 2005 to December 31, 2005.
37
Senior subordinated notes
Our senior subordinated notes have an interest rate of 81/4% and mature on September 1, 2014. We are
required to make interest payments on these notes each year on March 1 and September 1. Prior to
September 1, 2007, we may redeem up to 35% of the original principal amount of the notes at a
premium with the proceeds of certain equity issuances. Additionally, prior to September 1, 2009, we
may redeem all or a portion of the notes at a redemption price equal to the principal amount of the
notes redeemed, plus an applicable premium and at any time on or after September 1, 2009, we may
redeem all or a portion of the notes at pre-determined premiums. The notes are guaranteed on a
senior subordinated basis by all of our subsidiaries that provide guarantees under our senior
credit facilities.
Cash flows
The following table sets forth our combined cash flows for the periods indicated:
Net cash provided by (used in) operating activities
$
16,880
$
(5,567
)
Net cash used in investing activities
(7,697
)
(13,215
)
Net cash used in financing activities
(32,555
)
(2,058
)
Effect of exchange rate changes on cash and cash
equivalents
550
(566
)
Net decrease in cash and cash equivalents
$
(22,822
)
$
(21,406
)
Net cash provided by (used in) operating activities
Net cash provided by operating activities for the nine months ended September 30, 2006 was $16.9
million. The net cash provided was primarily attributable to net income and a $10.7 million
increase in accounts payable levels. This net cash provided by operating activities was offset by
a $10.1 million increase in accounts receivable and a $16.4 million increase in inventory,
primarily work in process, as shop levels continue to be strong.
Net cash used in operating activities for the nine months ended September 30, 2005 was $5.6
million. The net cash used was a result of a $6.6 million increase in accounts receivable levels
and a decrease in accounts payable associated with the repayment of $32.9 million payable relating
to our use of U.S. government-owned inventory at the former Kelly Air Force Base. This was offset
by net income during the period and a decrease of $1.9 million in inventory, prepaid expenses and
other current assets.
Net cash used in investing activities
Historically, net cash used in investing activities has been for capital expenditures on property,
plant and equipment, rental engines and OEM authorizations, offset by proceeds from the disposition
of property, plant and equipment and rental engines. Net cash used in investing activities for the
nine months ended September 30, 2006 was $7.7 million, which was primarily due to capital
expenditures related to net changes in our rental engine pool. Net cash used in investing
activities for the nine month period ended September 30, 2005 was $13.2 million, which was
primarily due to capital expenditures related to our CF34 program and net changes in our rental
engine pool.
38
Net cash used in financing activities
Net cash used in financing activities during the nine months ended September 30, 2006 was $32.6
million. We made an optional prepayment of $15.0 million on January 26, 2006, an optional
prepayment of $5.0 million on February 28, 2006 and on September 27, 2006 we made an optional
prepayment of $10.0 million under the term loan portion of our senior credit facilities. These
payments have been applied against our future scheduled prepayments, and we do not have a scheduled
payment until December 2011. At September 30, 2006, we had no outstanding draws on our revolving
credit facility.
Net cash used in financing activities during the nine months ended September 30, 2005 was $2.1
million. On February 28, 2005, we made an optional prepayment of $15.0 million under the term loan
portion of our senior credit facilities. This payment has been applied against our future
scheduled prepayments and we do not have a scheduled payment until December 2011. This prepayment
has been offset by $8.0 million of borrowings against our revolving credit facility. In March 2005
we received a payment of $4.7 million as a result of the final post-closing adjustments to the
purchase price paid in the acquisition of the maintenance, repair and overhaul businesses of Dunlop
Standard Aerospace Group Limited from Meggitt PLC.
39
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Market risk is the potential economic loss that may result from adverse changes in the fair value
of financial instruments. Our results could be impacted by changes in interest rates or foreign
currency exchange rates. We use financial instruments to hedge our exposure to fluctuations in
interest rates and foreign currency exchange rates. We do not hold financial instruments for
trading purposes. Our policies are reviewed on a regular basis.
Interest rate risks. We are subject to interest rate risk in connection with borrowings under
our senior credit facilities. As of September 30, 2006, we have $240.0 million outstanding under
the term-loan portion of our senior credit facilities, bearing interest at variable rates. Each
change of 0.125% in interest rates would result in a $0.3 million change in annual interest expense
on term-loan borrowings. In addition, any borrowings under the revolving credit portion of the
senior credit facilities will bear interest at variable rates. Assuming the revolving credit
facility is fully drawn, each 0.125% change in interest rates would result in a $0.1 million change
in annual interest expense on our revolving loan facility. Any debt we incur in the future may also
bear interest at floating rates. Pursuant to the terms of our credit agreement we have entered into
interest rate hedging arrangements for the purpose of reducing our exposure to adverse fluctuations
in interest rates. The credit agreement requires that 50% of total debt is fixed and, or, covered
under interest rate protection arrangements described in Item 2, “Management’s Discussion and
Analysis of Financial Condition and Results of Operations– Liquidity and Capital Resources.”
Derivatives used to hedge the variable cash flows associated with $75.0 million of existing
variable-rate debt with interest rate collar is as follows
Maximum and minimum interest rates exclude the effect of the Company’s credit
spread on the variable rate debt.
Currency risks. Our assets and liabilities in foreign currencies are translated at the
period-end rate. Exchange differences arising from this translation are recorded in our statement
of operations. Currency exposures can arise from revenues and purchase transactions denominated in
foreign currencies. Generally, transactional currency exposures are naturally hedged; that is,
revenues and expenses are approximately matched, but where appropriate, are covered using forward
exchange contracts and options. We expect to continue to enter into financial hedges, primarily
option contracts, to reduce foreign exchange volatility. We are exposed to credit losses in the
event of non-performance by the other party to the derivative financial instruments. We mitigate
this risk by entering into agreements directly with a number of major financial institutions that
meet our credit standards and that we expect to fully satisfy their contractual obligations. We
view derivative financial instruments purely as a risk management tool and, therefore, do not use
them for speculative trading purposes. To the extent the hedges are ineffective, gains and losses
on the contracts are recognized in the current period. At September 30, 2006, we had purchased
foreign currency option contracts with an aggregate notional amount of $15.7 million to buy
Canadian Dollars at 1.15 and sold option contracts with an aggregate notional amount of $15.3
million to sell Canadian Dollars at 1.1772. In addition, we had purchased foreign currency option
contracts with an aggregate notional amount of $3.0 million to buy Euros at 1.21 and sold option
contracts with an aggregate notional amount of $2.9 million to sell Euros at 1.19.
40
ITEM 4. CONTROLS AND PROCEDURES.
Evaluation of Disclosure Controls and Procedures
We maintain disclosure controls and procedures that are designed to ensure that information
required to be disclosed in our Exchange Act reports is recorded, processed, summarized and
reported within the time periods specified by the SEC’s rules and forms, and that such information
is accumulated and communicated to our management, including our Chief Executive Officer and Chief
Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure. In
designing and evaluating the disclosure controls and procedures, management recognized that any
controls and procedures, no matter how well designed and operated, can provide only reasonable
assurance of achieving the desired control objectives, and management necessarily was required to
apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
We carried out an evaluation, under the supervision and with the participation of our management,
including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the
design and operation of our disclosure controls and procedures as of September 30, 2006. Based upon
that evaluation, our management concluded that our disclosure controls and procedures were not
effective at the reasonable assurance level as of September 30, 2006 due to the restatement of
previously issued financial statements and the existence of the material weaknesses in our internal
control over financial reporting at September 30, 2006 described below. Notwithstanding the
material weaknesses discussed below, the Company’s management has concluded that the consolidated
financial statements included in this Quarterly Report on Form 10-Q fairly present in all material
respects the Company’s financial condition, results of operations and cash flows for the periods
presented in conformity with GAAP.
Material Weaknesses
As previously reported in our annual report on Form 10-K for the fiscal year ended December 31,2005, management concluded that two material weaknesses in our internal control over financial
reporting existed at December 31, 2005. The Public Company Accounting Oversight Board’s Audit
Standard No. 2 defines a material weakness as a control deficiency, or combination of control
deficiencies, that results in more than a remote likelihood that a material misstatement of the
annual or interim financial statements will not be prevented or detected. The following material
weaknesses have been identified as having been in existence as of December 31, 2004 and through
September 30, 2006.
•
We failed to maintain effective controls over the valuation and presentation of our
loss-contract accrued liability. Specifically, our controls over the application and
monitoring of accounting policies with respect to loss contracts acquired in connection
with a purchase business combination were ineffective to ensure that such contracts were
recorded in accordance with generally accepted accounting principles.
In connection with the audit of our financial statements for the year ended December 31, 2005 and
the preparation of our Annual Report on Form 10-K for 2005, our independent registered public
accounting firm, PricewaterhouseCoopers LLP (“PwC”), identified errors with respect to our
valuation and accounting for a loss-making contract at the time of the acquisition in August 2004
and our recording of losses under that loss-contract in subsequent periods. Our management
determined that these errors resulted because our controls over the application and monitoring of
accounting policies applicable to loss contracts acquired in purchase business combinations were
ineffective to ensure that such contracts were recorded in accordance with generally accepted
accounting principles.
41
This control deficiency resulted in the restatement of our consolidated financial statements for
the restated periods as well as an audit adjustment to the 2005 annual consolidated financial
statements. Additionally, this control deficiency could result in a misstatement of the inventory,
goodwill, accrued liabilities, cost of revenues and interest expense accounts that would result in
a material misstatement to the annual or interim consolidated financial statements that would not
be prevented or detected. Accordingly, management determined that this control deficiency
constitutes a material weakness.
•
We failed to maintain effective controls over the valuation of discounts for parts that
are recorded within our accounts receivable account. Specifically, we lacked effective
controls, including monitoring, to ensure that our receivable account relating to the
embodiment discount was appropriately valued and recorded.
During the fourth quarter of 2005 our senior accounting staff identified errors that occurred in
the fourth quarter of 2004 with respect to the calculation of a discount that we receive from one
of our major parts manufacturers that is recorded within our accounts receivable account. Our
management determined that these errors resulted because our controls and procedures in effect at
the time of the miscalculation, which required that the calculation of the discount to be
reconciled and confirmed on a monthly basis by a member of our accounting staff located outside of
our corporate headquarters in Winnipeg, were not being observed. Our management also determined
that our senior accounting staff in Winnipeg failed to monitor the operation of the control that
was in place, and as a result the error remained undetected until almost a year after it occurred.
This control deficiency resulted in the restatement of our consolidated financial statements for
2004 and each of the first three quarters of 2005. Additionally, this control deficiency could
result in a misstatement of accounts receivable and cost of revenues that would result in a
material misstatement of our annual or interim consolidated financial statements that would not be
prevented or detected. Accordingly, management determined that this control deficiency constitutes
a material weakness.
Plans for Remediation
To remediate the material weakness relating to valuation of the loss contract, we are developing a
written policy that requires:
• that certain members of our accounting staff receive training regarding the application of SFAS
141;
• our accounting staff to take prescribed steps in the event of certain non-routine transactions,
which steps will include: engaging external accounting advisors, establishing working groups,
action plans, or monitoring meetings based on the nature of the event, in each case in an effort to
ensure that individuals from the appropriate departments are involved, communication is thorough,
and action items are addressed; and
• that significant and nonrecurring events be brought to the attention of senior management and the
audit committee.
To remediate the material weakness relating to the recording of the receivable account related to
the embodiment discount, we have put in place procedures and have adopted a written policy
regarding the calculation of the discount, which requires:
• that the calculation of the discount be performed by a member of our accounting team and be
confirmed by our assistant controller and that each of them be properly trained with respect to
such calculation and confirmation;
• that the confirmation of the discount calculation has been centralized in Winnipeg; and
• that issues arising with respect to calculation of the discount be brought to the attention of
senior management and the audit committee.
42
Although we have implemented and continue to implement remediation efforts, a material weakness
indicates that there is more than a remote likelihood that a material misstatement of our financial
statements will not be prevented or detected in a future period. In addition, we cannot assure you
that we will not in the future identify additional material weaknesses or significant deficiencies
in our internal controls over financial reporting that we have not
discovered to date. We are taking steps to improve our internal control over financial reporting to
comply with our obligations under the Exchange Act. The remediation efforts we have taken and
continue to take are subject to continued management review supported by confirmation and testing
by management and audit committee oversight. As a result, additional changes are expected to be
made to our internal control over financial reporting. Other than the foregoing initiatives since
the date of the evaluation supervised by our management, there have been no material changes in our
disclosure controls and procedures, or our internal control over financial reporting, that have
materially affected, or are reasonably likely to materially affect, our disclosure controls and
procedures or our internal control over financial reporting.
Changes in Internal Control over Financial Reporting
There were no changes in our internal control over financial reporting during the Company’s most
recent fiscal quarter that have materially affected, or are reasonably likely to materially affect,
our internal control over financial reporting.
43
PART II OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
We are, from time to time, involved in certain legal proceedings arising in the normal course of
our business. These proceedings primarily involve commercial claims, product liability claims,
personal injury claims and workers compensation claims. We establish reserves in a manner that is
consistent with Generally Accepted Accounting Principles for costs associated with such matters
when liability is probable and those costs are capable of being reasonably estimated. We cannot
predict the outcome of these lawsuits, legal proceedings and claims with certainty. Nevertheless,
we do not believe that the outcome of any currently existing proceedings, either individually or in
the aggregate, is likely to have a material adverse effect on our business or our consolidated
financial position.
ITEM 1A. RISK FACTORS
Investors should carefully consider the updated risk factor below and the other risk factors in our
Annual Report on Form 10-K, in addition to the other information in our Annual Report and in this
quarterly report on Form 10-Q.
A significant portion of our revenues are derived under a single contract that has been the subject
of a dispute and that may be terminated in certain circumstances, some of which are beyond our
control.
Approximately 31.2% and 27.6% of our revenues for the year ended December 31, 2005 and the nine
months ended September 30, 2006, respectively, were generated from providing MRO services to the
U.S. Air Force pursuant to our contract with Kelly Aviation Center, LP, or KAC. While we anticipate
that the proportion of our revenues that we earn under the Kelly Air Force Base subcontract will be
reduced in future periods due to the amendment to the subcontract as described in Part I, Item 2,
“Management’s Discussion and Analysis of Financial Condition and Results of Operations — Kelly Air
Force Base Subcontract,” this subcontract will remain a key to our future prospects and the loss
of, or further materially adverse changes to, the amended Kelly Air Force Base subcontract would
have a material adverse effect on our revenues and liquidity. Additionally, if this subcontract is
terminated for any reason, including future disputes with KAC, because KAC is not awarded further
extensions under the prime contract with the U.S. Air Force, as a result of its expiration or
otherwise, our results of operations and liquidity would be materially adversely affected. For
further discussion, see Item 7, “Management’s Discussion and Analysis of Financial Condition and
Results of Operations — Kelly Air Force Base Subcontract” and “Management’s Discussion and Analysis
of Financial Condition and Results of Operations — Liquidity and Capital Resources.”
Senior
Subordinated Note Indenture with respect to the 81/4%
Senior Subordinated Notes due 2014, between Standard Aero Holdings, Inc., Wells Fargo Bank
Minnesota, National Association, as trustee, and the Guarantors listed on the signature
pages thereto, dated as of August 20, 2004 (incorporated by reference to Exhibit 4.1 of
Standard Aero Holdings, Inc.’s Registration Statement No. 333-124394).
4.2
Supplemental Indenture, dated as of August 24, 2004, among Dunlop Standard Aerospace
(Nederland) BV and Standard Aero BV, Standard Aero Holdings, Inc. and Wells Fargo Bank,
National Association, as trustee (incorporated by reference to Exhibit 4.2 of Standard
Aero Holdings, Inc.’s Registration Statement No. 333-124394).
4.3
Supplemental Indenture, dated as of August 24, 2004, among Dunlop Standard Aerospace (US)
Inc., Dunlop Standard Aerospace (US) Legal Inc., Standard Aero, Inc., Dunlop Aerospace
Parts, Inc., Standard Aero (San Antonio) Inc., Standard Aero (Alliance) Inc., Standard
Aero Canada, Inc., 3091781 Nova Scotia Company, 3091782 Nova Scotia Company, 3091783 Nova
Scotia Company, Standard Aero Limited, Not FM Canada Inc., Standard Aero Holdings, Inc.
and Wells Fargo Bank, National Association, as trustee (incorporated by reference to
Exhibit 4.3 of Standard Aero Holdings, Inc.’s Registration Statement No. 333-124394).
4.4
Supplemental Indenture, dated as of March 3, 2005, among Standard Aero (US), Inc. (f/k/a
Dunlop Standard Aerospace (U.S.) Inc.); Standard Aero (US) Legal, Inc. (f/k/a Dunlop
Standard Aerospace (US) Legal, Inc.); Standard Aero Inc.; Standard Aero Materials, Inc.
(f/k/a Dunlop Aerospace Parts Inc.); Standard Aero (San Antonio) Inc.; Standard Aero
(Alliance) Inc.; Standard Aero Canada, Inc.; 3091781 Nova Scotia Company; 3091782 Nova
Scotia Company; 3091783 Nova Scotia Company; Standard Aero Limited; Not FM Canada Inc.;
Standard Aero (Netherlands) B.V. (f/k/a Dunlop Standard Aerospace (Nederland) BV) and
Standard Aero BV, Standard Aero Holdings, Inc. and Wells Fargo Bank, National Association,
as trustee (incorporated by reference to Exhibit 4.4 of Standard Aero Holdings, Inc.’s
Registration Statement No. 333-124394).
4.5
Supplemental Indenture, dated as of March 31, 2005, among Standard Aero (US), Inc. (f/k/a
Dunlop Standard Aerospace (U.S.) Inc.); Standard Aero (US) Legal, Inc. (f/k/a Dunlop
Standard Aerospace (US) Legal, Inc.); Standard Aero Inc.; Standard Aero Materials, Inc.
(f/k/a Dunlop Aerospace Parts Inc.); Standard Aero (San Antonio) Inc.; Standard Aero
(Alliance) Inc.; Standard Aero Canada, Inc.; 3091781 Nova Scotia Company; 3091782 Nova
Scotia Company; 3091783 Nova Scotia Company; Standard Aero Limited; Not FM Canada Inc. and
Standard Aero Redesign Services Inc., Standard Aero Holdings, Inc. and Wells Fargo Bank,
National Association, as trustee (incorporated by reference to Exhibit 4.5 of Standard
Aero Holdings, Inc.’s Registration Statement No. 333-124394).
10.24
Amendment No. 92 to Subcontract No. LMKAC-98-0001 between Standard Aero and Lockheed,
dated as of July 11, 2006 (incorporated by reference for Exhibit 10.1 of Standard Aero
Holdings, Inc.’s Form 10-Q for the quarterly period ended June 30, 2006, filed August 14,2006).
31.1
Certification of Chief Executive Officer pursuant to Rule 15d-14(a) (17 CFR 240.15d-14(a)).
31.2
Certification of Chief Financial Officer pursuant to Rule 15d-14(a) (17 CFR 240.15d-14(a)).
32.1
Certification of Chief Executive Officer pursuant to Rule 15d-14(b) (17 CFR 240.15d-14(b))
and 18 U.S.C. Section 1350.
32.2
Certification of Chief Financial Officer pursuant to Rule 15d-14(b) (17 CFR 240.15d-14(b))
and 18 U.S.C. Section 1350.
45
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused
this report to be signed on its behalf by the undersigned thereunto duly authorized.
