10-Q 1 a5037312.txt FIRST AVIATION SERVICES INC. 10-Q United States Securities and Exchange Commission Washington, D.C. 20549 FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended October 31, 2005 ---------------- OR [_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from___________ to ____________ Commission File Number 0-21995 ------- FIRST AVIATION SERVICES INC. (Exact name of registrant as specified in its charter) Delaware 06-1419064 -------- ---------- (State or other jurisdiction (I.R.S. Employer of incorporation or organization) Identification No.) 15 Riverside Avenue, Westport, Connecticut, 06880-4214 ------------------------------------------------------ (Address of principal executive offices) (203) 291-3300 -------------- (Registrant's telephone number) N/A ---------------------------------------------------- (Former name, former address and formal fiscal year, if changed since last report) Indicate by check mark whether the registrant (1) filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [_] Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes [_] No [X] Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [_] No [X] The number of shares outstanding of the registrant's common stock as of December 1, 2005 is 7,346,168 First Aviation Services Inc. Index Part I - Financial Information ------------------------------ Item 1. Financial Statements (Unaudited): Consolidated Condensed Balance Sheets.................................3 Consolidated Condensed Statements of Operations.....................4-5 Consolidated Condensed Statements of Cash Flows.......................6 Notes to Consolidated Condensed Financial Statements...............7-12 Item 2. Management's Discussion and Analysis of Financial Condition, Results of Operations and Liquidity and Capital Resources.........13-18 Item 3. Quantitative and Qualitative Disclosures about Market Risks..........18 Item 4. Controls and Procedures..............................................18 Part II - Other Information --------------------------- Item 1. Legal Proceedings...................................................19 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.................................................19 Item 3. Defaults Upon Senior Securities.....................................19 Item 4. Submission of Matters to a Vote of Security Holders.................19 Item 5. Other Information ..................................................19 Item 6. Exhibits............................................................19 2 PART I - FINANCIAL INFORMATION Item 1. Financial Statements ----------------------------

See accompanying notes. * Balances were derived from the audited balance sheet as of January 31, 2005. 3

See accompanying notes. 4

See accompanying notes. 5 First Aviation Services Inc. Consolidated Condensed Statements of Cash Flows (Unaudited) (in thousands)

See accompanying notes. 6 First Aviation Services Inc. Notes to Consolidated Condensed Financial Statements (Unaudited) (in thousands, except share amounts) October 31, 2005 1. Basis of Presentation First Aviation Services Inc. ("First Aviation"), together with its wholly owned subsidiaries Aerospace Products International, Inc. ("API"), Aircraft Products International, Ltd. ("API Ltd."), and API Asia Pacific Inc. ("API Asia Pacific") (collectively, the "Company"), is one of the premier suppliers of services to the aviation industry worldwide. The services the Company provides the aviation industry include the sale of aircraft parts and components, the provision of supply chain management services, overhaul and repair services for brakes and starter/generators, and the assembly of custom hoses. The Company's principal executive offices are located at 15 Riverside Avenue, Westport, Connecticut 06880. Customers of the Company include original equipment manufacturers, aircraft manufacturers, passenger and cargo airlines, fleet operators, corporate aircraft operators, flight training schools, fixed base operators, certified repair facilities, governments and military services. The accompanying unaudited consolidated condensed financial statements of the Company have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information, and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required for complete financial statements. In the opinion of management, all material adjustments, including the elimination of intercompany balances and transactions, and normal recurring accruals considered necessary for a fair presentation, have been included in the accompanying unaudited consolidated condensed financial statements. Operating results for the three months and six months ended October 31, 2005 are not necessarily indicative of the results that may be expected for the full fiscal year ending January 31, 2006. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company's Form 10-K for the year ended January 31, 2005. 2. Weighted Average Shares Outstanding - Assuming Dilution The following sets forth the denominator used in the computation of net income (loss) per share - assuming dilution:

For the three and nine months ended October 31, 2004, the denominator used in the calculation of loss per share from continuing operations - assuming dilution, was the same as the denominator used for basic loss per share because the effect of options would have been antidilutive. The number of potential shares of common stock that were excluded from the computation of diluted earnings per share because their effect was antidilutive for the three and nine months ended October 31, 2004, were 7,097, and 9,532 shares, respectively. 7 3. Stock Options Issued to Employees The Company's non-employee directors receive a portion of their annual compensation in the Company's stock. The value of stock issued is equivalent to the compensation expense, and the number of shares issued is based upon the fair market value per share at the date issued. The Company's non-employee directors receive compensation in cash for committee meetings and special board meetings, excluding the four regularly scheduled board meetings and the annual shareholders' meeting that is paid in stock as part of their annual compensation. For the three months ended October 31, 2005 and 2004, the Company issued 4,617 and 6,457 shares respectively, to directors for board fees. For the nine months ended October 31, 2005 and 2004, the Company issued 21,828 and 25,452 shares respectively, to directors for board fees. The Company generally grants stock options to its employees for a fixed number of shares with an exercise price equal to the fair market value of the stock on the date of grant. As permitted under Statement of Financial Accounting Standard No. ("FAS") 123, "Accounting for Stock-Based Compensation", the Company has elected to follow Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees", and related interpretations in accounting for stock awards to employees. No compensation expense was recognized during the three and nine months ending October 31, 2005 and 2004 because all grants were issued at the fair market value of the Company's common stock at the date of grant. The Company is required to disclose the fair value, as defined, of options granted to employees and the related compensation expense. The fair value of the stock options granted was estimated at the date of grant using a Black-Scholes option-pricing model. The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions, including the expected stock price volatility. In management's opinion, because the Company's employee stock options are not publicly traded, and have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options. The fair value of each option issued was estimated at the date of grant. The following assumptions were used for options issued during the nine months ended October 31, 2005 and 2004: 2005 2004 --------------- --------------- Expected dividend yield 0.0% 0.0% Risk-free interest rate 4.3% 3.6% Expected volatility 31.0% 32.3% Expected life of option 5.0 years 5.0 years Weighted-average fair value of options granted $ 1.40 $ 1.55 8 Using the above noted assumptions and the weighted-average fair value of each option granted, the net income (loss) and earnings (loss) per share that would have been recorded if the estimated fair value of options granted had been recorded as an expense was:

In December 2004, the FASB issued Statement No. 123 (Revised 2004), or Statement 123(R), Share-Based Payment, which is a revision of Statement No. 123, Accounting for Stock-Based Compensation. Statement 123(R) supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and amends Statement No. 95, Statement of Cash Flows. The approach in Statement 123(R) is similar to the approach described in Statement 123; however, Statement 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the statement of operations based on their fair values. Pro forma disclosure, as allowed under Statement No. 123, will no longer be an alternative. In April 2005, the Securities and Exchange Commission ("SEC") announced the adoption of a new rule that amends the compliance dates for Statement 123(R). The SEC's new rule allows companies to implement Statement No. 123(R) at the beginning of their next fiscal year, instead of the reporting period that begins after June 15, 2005. The Company plans to adopt Statement 123(R) for the period beginning February 1, 2006. The impact of adoption of Statement 123(R) cannot be predicted at this time because it will depend on levels of share-based payments granted in the future, among other factors. The Company is currently evaluating the impact that the adoption of Statement 123(R) will have on its consolidated results of operations, financial position and cash flows. 4. Accumulated Other Comprehensive Income (Loss) The accumulated other comprehensive income (loss) resulted from the translation of accounts into U.S. dollars where the functional currency is the Canadian dollar. The increase to net income to arrive at comprehensive income during the three and nine months ended October 31, 2005 was due to a decrease in the value of the U.S. dollar relative to the Canadian dollar. Comprehensive income (loss) for the periods shown was as follows: 9

5. Income Taxes The Company recorded a provision (benefit) for income taxes related to foreign income tax expense estimates for operations in Canada and the Philippines. No provision is made for U.S. taxation because the Company has sufficient net operating loss carryforwards that would be utilized to offset any provision for pre-tax income. No deferred tax provision is recorded because it would be offset by a change in the deferred tax valuation allowance. The Company does not record a tax benefit for U.S. tax purposes due to the deferred tax valuation allowance recorded, as it is more likely than not that some portion or all of the deferred tax asset will not be realized. 6. Related Parties The Company and First Equity Development Inc. ("First Equity"), the wholly-owned subsidiary of First Equity Group, Inc., and the majority stockholder of the Company, have an agreement relating to the allocation of potential investment and acquisition opportunities in the aerospace parts distribution and logistics businesses. The agreement was approved by the independent members of the Board of Directors on a month-to-month basis effective February 1, 2004. First Equity Group, Inc. is beneficially owned by Mr. Aaron P. Hollander and Mr. Michael C. Culver, respectively Chairman of the Board and Chief Executive Officer of the Company. Pursuant to the agreement, neither First Equity nor any of its majority-owned subsidiaries will consummate any acquisition of a majority interest in any aerospace parts distribution and logistics business anywhere in the world (a "Covered Acquisition"), without first notifying the Company and providing the Company with the opportunity to effect the Covered Acquisition for its own account. The Company's decision as to whether to effect the Covered Acquisition will be made by the independent members of the Board of Directors of the Company. The agreement can be terminated by either party upon 30 days written notice to the other party. The agreement does not apply to any proposed acquisition by First Equity of any business that generates less than 15% of its aggregate net sales from aerospace parts distribution or logistics, or to any advisory services performed by First Equity on behalf of third parties. The Company and First Equity also had an advisory agreement, approved by the independent members of the Board of Directors on a month-to-month basis effective February 1, 2004. Pursuant to the terms of this agreement, First Equity provided the Company with investment and financial advisory services relating to potential acquisitions and other financial transactions. The agreement could be terminated by either party upon 30 days' written notice to the other party. The Company paid First Equity a $30 monthly retainer, and reimbursed First Equity for its out-of-pocket expenses. In addition, upon the successful completion of certain transactions, the Company would pay a fee to First Equity (the "Success Fee"). The amount of any Success Fee would be established by the independent members of the Board of Directors and would be dependent upon a variety of factors, including, but not limited to, the services provided and the size and the type of transaction. Up to one year's worth of retainer fees paid could be applied as a credit against any Success Fee, subject to certain limitations. The advisory agreement was terminated by First Equity on January 31, 2005. During the three and nine months ended October 31, 2005, and 2004, the Company paid First Equity retainer fees of $0 and $90, and $0 and $270, respectively, and no Success Fee. 10 The Company and First Equity had entered into an arrangement whereby First Equity provided the Company with various additional services to assist the Company. These services were not part of the advisory agreement, described above, but derived from the work First Equity performed under the agreement. Therefore, First Equity did not charge the Company additional fees in connection with providing such services under the advisory agreement, because the services were derived from the work First Equity performed under the advisory agreement consistent with their role as financial advisor. The advisory agreement expired on January 31, 2005. These services included (i) detailed financial modeling for new business proposals, (ii) Board of Directors presentation analysis, (iii) investor relations marketing and presentations, (iv) various analysis for API, including benchmarking, financial analysis, and competitive market analyses, and (v) other financial analyses for the Company, including stock buy-back, valuations, and capital structure analyses. The Company's CEO and CFO had unlimited access to these resources when requested. These services were also terminated by First Equity with the expiration of the advisory agreement on January 31, 2005, as described above. The Company subleases from First Equity approximately 3,000 square feet of office space in Westport, Connecticut. The leased space is utilized by the Company as its corporate headquarters. First Equity also utilizes space in the same premises. The sublease, which became effective on April 21, 1997, is for a period of ten years, and is cancelable by either party with six months notice. The Company has the option to renew the sublease for two additional five-year periods. Lease payments under this sublease totaled approximately $22, for the three months ended October 31, 2005, and 2004 and $67 and $62, for the nine months ended October 31, 2005, and 2004. The Company and First Equity also share certain common expenses that arise from sharing office space in Westport, CT. The Company reimburses First Equity and vice versa, for expenses each entity incurs related to the common usage of the office space. The amounts are included in the Company's corporate expenses, and include expenses such as telephone, computer consulting, office cleaning, office supplies and utilities. The expenses are allocated based on base salaries of the Company's and First Equity's personnel working in the shared space. Common expenses are approved by the Company and First Equity, prior to expenditure, when not of a recurring nature. The allocations are reviewed by the Company's CFO and the Controller of First Equity each month. In addition, a member of the Company's audit committee reviews the allocation of expenses quarterly. Some business development expenses, such as joint marketing expense and business organizational dues, are shared on an equal basis. Management believes this method of allocation is reasonable. In addition, the amounts reimbursed by the Company are the actual costs incurred for the expense. The Company reimbursed First Equity, $12 and $13, for the three months ended October 31, 2005, and 2004, respectively, and $32 and $39, for the nine months ended October 31, 2005, and 2004, respectively. In order to simplify the administration of payroll, certain employees of the Company who are authorized to perform services for both the Company and First Equity are paid through the payroll of First Equity. Employees of the Company who work exclusively for the Company are paid through the payroll of API, the Company's principal subsidiary. 7. Interest income (expense) and other The components relate to interest income on investments, interest expense on external debt, realized and unrealized foreign exchange gain (loss) on Canadian dollar transactions by the Canadian operations, and other charges.

11 8. Replacement of Revolving Line of Credit On July 29, 2005, Aerospace Products International Inc., (the "Borrower") a direct wholly-owned subsidiary of First Aviation Services, Inc. (the "Guarantor") entered into a Commercial Revolving Loan and Security Agreement (the " Agreement") and Guaranty Agreement (the "Guaranty") by and among the Borrower, Guarantor and Hudson United Bank (the "Lender"). The facility created by the Agreement replaces the Borrower's previously existing, $20 million revolving credit facility scheduled to expire July 31, 2006. The Agreement has a commitment expiration date of September 1, 2007. The Guaranty replaces the previously existing guaranty agreement that existed on the previous credit facility. The Agreement provides a 25 month senior revolving credit facility (the "Facility I") to the Borrower in the amount of $20 million, subject to terms and conditions set forth in the Agreement. The facility may be increased by $5 million to $25 million should the Company make an acquisition of assets of another company, subject to the Lender's approval. In October 2005, the lender approved the increase in the facility to $25 million after the Company made a large initial inventory purchase in September 2005 from a leading aircraft OEM. The proceeds of any loans made under the Agreement will be used for working capital purposes in the ordinary course of business of the Borrower. The Agreement also provides for a one-time advance (the "Facility II") in an amount up to $3 million, subject to borrowing availability. The Facility II advance is repaid over 60 months at a fixed rate determined at the time of the drawdown of the advance, with the portion of the advance to be repaid within one year reported in current liabilities on the balance sheet. Borrowings under Facility I bear interest equal to LIBOR plus 1.5% and are limited to specified percentages of eligible trade receivables and inventories of API. The Agreement contains a number of covenants, including restrictions on mergers, consolidations and acquisitions, the incurrence of indebtedness, transactions with affiliates, the creation of liens, and limitations on capital expenditures. Pursuant to the terms and conditions of the Agreement, the payment of dividends on API's common stock is prohibited, except with the lender's consent, and API is required to maintain minimum levels of net worth and specified interest expense coverage ratios. Substantially all of API's domestic assets are pledged as collateral under the Agreement, and First Aviation guarantees all borrowings under the Agreement. 9. Notes Payable API entered into an initial parts purchase agreement on September 20, 2005 with a leading aircraft original equipment manufacturer ("OEM") to purchase $8.3 million of inventory, including a long-term agreement to sell parts. As of October 31, 2005, API had received approximately $7.1 million of this inventory. The OEM vendor agreed to partially finance the purchase with two promissory notes from API of $2.5 million and $1.8 million, with the Company entering into a guarantee agreement to ensure payment by API. The promissory note for $2.5 million is for a term of 4 years, at 5.0% interest per annum. The promissory note for $1.8 million is a non-interest bearing short-term note due within one year. The vendor financing promissory notes are subordinated to the Company's revolving line of credit. Subsequent purchases from this OEM will be on standard vendor terms, and the Company has purchased an additional $4.8 million of inventory from the OEM as of October 31, 2005. 10. Repurchase of Preferred Stock of Subsidiary Pursuant to an agreement dated June 20, 2005, API repurchased 10,407 shares of API Series A Cumulative Convertible Preferred Stock (Preferred Stock) for an aggregate purchase price of $500, from Signature Combs, Inc. (f/k/a AMR Combs, Inc.). The Preferred Stock was all the issued and outstanding preferred stock of API, issued in conjunction with the Company's purchase of API in 1997 from AMR Combs, Inc. The difference between the repurchase price of the Preferred Stock and the book value of $541 was credited to Paid-in Capital in June 2005. 11. Other Income In July 2005, the Company received $567 in settlement of a distribution agreement contract dispute between API and a vendor. The settlement consisted of $417 in damages recorded in other income, and $150 recorded as a reduction in inventory from the repurchase of inventory held by API. 12 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Safe Harbor Statement Under the Private Securities Litigation Reform of Act 1995. Certain statements discussed in Item 2, "Management's Discussion and Analysis of Financial Condition and Results of Operations", Item 3, "Quantitative and Qualitative Disclosures about Market Risks", Item 1 of Part II, "Legal Proceedings" and elsewhere in this Quarterly Report on Form 10-Q constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are not statements of historical facts, but rather reflect the Company's current expectations concerning future events and results. Such forward-looking statements, including those concerning the Company's expectations, involve known and unknown risks, uncertainties and other factors, some of which are beyond the Company's control, that may cause the Company's actual results, performance or achievements, or industry results, to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Such risks, uncertainties and other important factors include, the Company's ability to obtain parts and components from its principal suppliers on a timely basis, depressed domestic and international market and economic conditions, especially those currently facing the aviation industry as a whole, the impact of changes in fuel and other freight-related costs, relationships with its customers, the ability of the Company's customers to meet their financial obligations to the Company, the ability to obtain and service supply chain management contracts, changes in regulations or accounting standards, the ability to consummate suitable acquisitions and expand, the loss of the use of facilities and distribution hub in Memphis, significant failure of our computer systems or networks, efforts to comply with section 404 of the Sarbanes-Oxley Act of 2002, and other items that are beyond the Company's control and may cause actual results to differ from management's expectations. In addition, specific consideration should be given to the various factors described in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations", in the Company's Annual Report on Form 10-K for the year ended January 31, 2005, and Item 3, "Quantitative and Qualitative Disclosures about Market Risks", in this report for the quarter and nine months ended October 31, 2005. The Company undertakes no obligation to update any forward-looking statements or cautionary factors. General First Aviation Services Inc. ("First Aviation"), together with its wholly owned subsidiaries, Aerospace Products International, Inc. ("API"), Aircraft Parts International, Ltd. ("API Ltd."), and API Asia Pacific Inc. ("API Asia Pacific") (collectively, the "Company"), is one of the premier suppliers of services to the aviation industry worldwide. The services the Company provides the aviation industry include the sale of aircraft parts and components, the provision of supply chain management services, overhaul and repair services for brakes and starter/generators, and the assembly of custom hoses. The Company's principal executive offices are located at 15 Riverside Avenue in Westport, Connecticut 06880. Certain filings that First Aviation makes with the U.S. Securities and Exchange Commission are available on First Aviation's corporate website at www.favs.com. These public filings also can be obtained by calling our investor relations department, by e-mail at first@firstaviation.com, or on the SEC website at www.sec.gov. Critical Accounting Policies There have been no significant changes in those accounting policies the Company considers critical from those described under the caption "Critical Accounting Policies", included in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations", in the Company's Annual Report on Form 10-K for the year ended January 31, 2005. Results of Operations Net Sales The Company's net sales consist of sales of services to the aviation industry, including parts and components supply services, supply chain management services, and component overhaul and repair services. Net sales are recorded when parts and components are shipped and title transfers to the customer, when supply chain management services have been provided to the customer, or when overhauled and repaired items are completed and shipped back to the customer. Shipping and handling billed to customers are included in net sales. The terms and nature of supply chain management services are stipulated in a long-term 13 contract between the Company and the customer. The Company provides its facilities, personnel and systems to provide the services at less cost to the customer. In providing services where the Company distributes inventory on behalf of its customer, the Company may use its own inventory or hold its customers' inventory without taking ownership of such inventory. In cases where the Company does not take ownership of its customers' inventory, net sales generally are recognized as a fee based on the sales value of the product shipped through the Company's facilities, and not the sales value of the product itself. Alternatively, the Company, when providing services to handle customer's inventory without taking ownership, can take a fee based on the cost of providing services, and not on the sales value of the product. Net sales for the three months ended October 31, 2005 increased $1.6 million, or 4.9%, to $33.6 million from $32.0 million for the three months ended October 31, 2004. The increases were largely due to increases in the corporate aviation sectors the company serves, a rebound in general aviation related sales, offset by lower sales to original equipment manufacturers ("OEM"), the airlines and airline maintenance providers. Net sales for the nine months ended October 31, 2005 increased $5.0 million, or 5.3%, to $98.3 million from $93.3 million for the nine months ended October 31, 2004. The reasons for the increase in net sales for the nine months ended October 31, 2005, compared to the comparable period of the prior year, was due to the reasons described above, except general aviation sales, excluding corporate aviation and retail, were down approximately 5% as of the quarter ending October 31, 2005. Sales increased in the three and nine months ended October 31, 2005 versus the comparable prior year periods in three of the four foreign geographic regions the Company services. Sales in Asia improved for the three and nine months ended October 31, 2005 over the similar periods ended October 31, 2004 due to increases in airline sales. Sales in Canada for the three and nine months ended October 31, 2005 improved in the general aviation and retail customer sectors, compared to the three and nine month periods ended October 31, 2004. Sales in Europe for the three and nine months ended October 31, 2005, increased in the independent airline and corporate maintenance repair and overhaul facilities sectors, versus the comparable periods ended October 31, 2004. The Company's sales in the Latin America region decreased for the three and nine month period ended October 31, 2005 over the same periods ended October 31, 2004. The Company continues to be cautious with respect to providing credit to customers in the Latin American region, and this has had a negative impact on sales. Freight revenue is a component of net sales and represents freight billed to customers. Freight revenue for the three and nine months ended October 31, 2005 decreased 6.1%, to $479,000 from $510,000 for the prior year three month period ended October 31, 2004, and decreased 10.9% or $177,000 to $1,440,000 for the comparable nine month period. These decreases were primarily due to increases in customer incentives resulting from promotional activities and industry competition. This had an adverse effect on gross profit margin explained below under the caption "Gross Profit". Cost of Sales Cost of sales consists of costs of inventory sold, direct costs to overhaul and repair parts and components, and direct costs of providing services. Freight costs for parts and components sold are also included in cost of sales. Cost of sales for the three months ended October 31, 2005 increased $1.3 million, or 4.8%, to $28.0 million from $26.7 million for the three months ended October 31, 2004. Cost of sales for the nine months ended October 31, 2005 increased $3.9 million, or 5.0%, to $81.5 million from $77.6 million in the prior year period ended October 31, 2004. Cost of sales for the three and nine months ended October 31, 2005 increased compared to the prior year as a direct result of the increase in net sales. As a percentage of net sales, cost of sales decreased for the periods ended October 31, 2005, to 83.2% from 83.3%, and 82.9% from 83.1%, for the three and nine months, respectively, over the three and nine month periods ended October 31, 2004. The decrease in the percentage of cost of sales compared to net sales for the three and nine months ended October 31, 2005 compared to the three and nine months ended October 31, 2004, was primarily due to the reasons described above. 14 Gross Profit Gross profit for the three months ended October 31, 2005 of $5.6 million exceeded the prior year quarter gross profit by $290,000 or 5.4%. With the increase in gross profit in the current year quarter versus the prior year quarter, gross profit as a percentage of net sales increased slightly to 16.8% for the three months ended October 31, 2005, from 16.7% for the three months ended October 31, 2004, due primarily to the increase in gross margin for the general aviation related and airline sectors. Gross profit for the nine months ended October 31, 2005 of $16.8 million was increased by $1.1 million, or 7.0% compared to gross profit for the nine months ended October 31, 2004. Gross profit as a percentage of net sales improved correspondingly to 17.1% for the nine months ended October 31, 2005, from 16.9% for the nine months ended October 31, 2004. Gross profit margin for the nine months ended October 31, 2005 increased compared to the comparable period of the prior year principally due to margins increases in the general aviation related and airline sectors. Gross profit is also impacted by net freight expense, which represents freight expense recorded in cost of sales, less freight billed to customers in net sales. Net freight expense decreased gross profit by 6.3% for the three and nine month periods ended October 31, 2005, compared to decreases of 5.9% and 5.3% in the comparable 2004 periods. These decreases were due primarily to increased customer incentives and promotional activities offering customers reduced freight on shipments and competition. Selling, General and Administrative Expenses Selling, general and administrative expenses for the three months ended October 31, 2005 increased slightly by $26,000, or 0.4% to $5.0 million for the three months ended October 31, 2004. The increase for the three months ended October 31, 2005, over the comparable prior year period is due primarily to an increase in the bad debt expense of $107,000, mainly due to a customer receivable write-off for a regional airline that filed for bankruptcy protection under chapter 11 of the U.S. federal bankruptcy law, just prior to the October 17, 2005 effective date for changes in the U.S. federal bankruptcy law that generally is less favorable to debtors. This regional airline was a feeder carrier for a large international carrier that also filed for protection under chapter 11 of the U.S. federal bankruptcy law in September 2005. Increases in contract labor for IT systems maintenance, and higher depreciation charges, were mostly offset by lower payroll expenses, advertising, legal, and insurance charges. Selling general and administrative expense as a percentage of revenues decreased to 14.8% for the three months ended October 31, 2005 versus 15.4% for the three months ended October 31, 2004. Selling, general and administrative expenses for the nine months ended October 31, 2005 of $14.8 million increased slightly by $66,000 compared to the expense incurred for the nine months ended October 31 2004. Increases in contract labor for IT systems maintenance, higher depreciation charges, communications, and bad debt expense were almost completely offset by lower payroll expenses, travel, postage, and other expenses. Selling general and administrative expense as a percentage of revenues decreased to 15.0% for the nine months ended October 31, 2005 versus 15.7% for the nine months ended October 31, 2004. Corporate Expenses Corporate expenses decreased by $45,000 or 7.5% to $557,000 for the three months ended October 31, 2005 from $602,000 incurred during the three months ended October 31, 2004. The decrease in corporate expenses in the quarter ended October 31, 2005 resulted primarily from reductions due to First Equity Development's termination of an advisory agreement on January 31, 2005, lower costs related to the board of directors and other expenses. The expense reductions in the quarter ended October 31, 2005 described above, were partially offset by increases in payroll and insurance costs. Corporate expenses for the nine months ended October 31, 2005 decreased $633,000, or 26.6%, to $1.7 million, from the $2.4 million incurred during the nine months ended October 31, 2004. The decrease in corporate expenses in the nine months ended October 31, 2005 resulted from substantially lower legal fees related to corporate governance regulations and a dissident shareholder's proxy contest incurred in the prior year period, as well as the reasons cited above for the quarter. 15 Net Interest Income (Expense) and Other During the three months ended October 31, 2005, net interest income (expense) and other decreased $143,000 as a result of a $79,000 decrease on gains reported from foreign currency transactions in the quarter, due primarily to the relative strengthening of the Canadian dollar that is used as the functional currency of the Canadian subsidiary. Interest expense for the three months ended October 31, 2005 was $53,000 or $50,000 higher than the amounts recorded in the three months ended October 31, 2004 due to increased interest rates and average borrowing levels, and interest income was $14,000 lower than the $18,000 reported in 2004 due to lower amounts in interest bearing investments. During the nine months ended October 31, 2005, net interest income (expense) and other decreased $98,000 in the nine months ended October 31, 2005, to $4,000 as gains on foreign currency transactions of $75,000 and interest income of $45,000 was offset by interest expense on borrowings of $116,000 for the nine months ended October 31, 2005, versus interest income of $40,000, foreign currency transaction gains of $94,000, and interest expense of $32,000 in the comparable nine months ended October 31, 2004. Other Income During the nine months ended October, 31, 2005, the Company recorded income of $417,000 as the result of a cash settlement from a distribution agreement contract dispute between API and a vendor. Provision for Income Taxes The Company recorded a provision for income taxes related to foreign income tax expense estimates for operations in Canada and the Philippines. No provision is made for U.S. taxation because the Company has sufficient net operating loss carryforwards that would be utilized to offset any provision for pre-tax income. No deferred tax provision is recorded because it would be offset by a change in the deferred tax valuation allowance. The Company does not record a tax benefit for U.S. tax purposes on any operating losses incurred due to the deferred tax valuation allowance recorded as it is more likely than not that some portion or all of the deferred tax asset will not be realized. Net Income (Loss) and Net Income (Loss) per Share The Company had net income of $90,000, or $0.01 per share for the three months ended October 31, 2005, compared to a net loss of ($130,000), or ($0.02) per share for the three months ended October 31, 2004 and net income of $674,000, or $0.09 per share for the nine months ended October 31, 2005, compared to a net loss of ($1.4) million, or ($0.19) per share for the comparable prior year period ended October 31, 2004. The income in the current year periods versus the losses in the prior year periods was due to the reasons described in the preceding sections. Liquidity and Capital Resources ------------------------------- The Company's liquidity requirements arise principally from its working capital needs. In addition, the Company has liquidity requirements to fund capital expenditures to support its current operations, and facilitate growth and expansion. The Company funds its liquidity requirements with a combination of cash on hand, cash flows from operations and from borrowings. The Company manages its cash and debt to minimize its interest expense. Cash and cash equivalents at any time may consist of a combination of demand deposits, money market or short-term, high-grade bond funds, and short-term certificates of deposit. For the nine months ended October 31, 2005 the Company used $6.9 million in cash for operating activities, compared to $0.4 million cash provided by operating activities for the nine months ended October 31, 2004. The use of cash in the nine months ended October 31, 2005 versus the cash provided in the prior year nine month period was due to increases in inventory due to a large purchase of inventory parts from a leading aircraft OEM, and additional inventory opportunity buys resulting from price/volume discounts, and an increase in trade receivables offset by an increase in accounts payable. On September 20, 2005, API made an initial inventory purchase of $8.3 million, of which approximately $7.1 was received as of October 31, 2005. The OEM vendor agreed to partially finance the purchase with two promissory notes from API of $2.5 million and $1.8 million, with the Company entering into a guarantee agreement to ensure payment by API. The promissory note for $2.5 million is for a term of 4 years, at 5.0% interest per annum. The promissory note for $1.8 million is a non-interest 16 bearing short term note due within one year. The vendor financing promissory notes are subordinated to the Company's revolving line of credit. In addition, subsequent to the initial purchase and pursuant to a separate transaction with the same OEM, API made an additional purchase of $4.8 million of inventory to broaden the product line offering, pursuant to usual vendor terms with payment due before year-end. Substantially all of the $4.8 million in inventory was received by October 31, 2005. The Company continues to focus on managing its overall working capital. Cash used in investing activities was $2.2 million and $0.6 million during the nine months ended October 31, 2005 and 2004, respectively, due primarily to purchases related to systems upgrades, and a new ERP implementation of SAP software. The Company expects that its aggregate capital expenditure requirements for the year ending January 31, 2006 will range from approximately $2.5 million to $3.0 million. Management expects to fund these requirements from cash on hand, cash flows from operations, and from borrowings. Net cash used in financing activities during the nine months ended October 31, 2005 was $0.5 million, compared to zero for the nine months ended October 31, 2004, as the Company borrowed $41.5 million and repaid $41.5 million, and repurchased preferred stock of API for $500,000. Effective July 29, 2005 API has a new $20 million revolving line of credit facility which under certain conditions may be increased to $25 million, through a Commercial Revolving Loan and Security Agreement ("Agreement"). This Agreement which expires on September 1, 2007 replaces the Company's prior facility which was scheduled to expire July 1, 2006. Borrowings under this facility bear interest equal to LIBOR plus 1.5% and are limited to specified percentages of eligible trade receivables and inventories of API. The Agreement contains a number of covenants, including restrictions on mergers, consolidations and acquisitions, the incurrence of indebtedness, transactions with affiliates, the creation of liens, and limitations on capital expenditures. Pursuant to the terms and conditions of the Agreement, the payment of dividends on API's common stock is prohibited, except with the lender's consent, and API is required to maintain minimum levels of net worth and specified interest expense coverage ratios. Substantially all of API's domestic assets are pledged as collateral under the Facility, and First Aviation guarantees all borrowings under the Agreement. In October 2005, the lender agreed to increase the line to $25 million due to a large inventory purchase made by the Company in September 2005. At October 31, 2005, borrowings under the facility totaled $14.5 million, at an interest rate of approximately 5.4%. This amount represented a draw on the facility just prior to October 31, 2005, and shortly after the quarter end, the Company repaid $8.0 million of the borrowings that were outstanding at quarter-end. The Company regularly draws down on the facility just prior to quarter end, holds this cash, and then repays some or all of the amount drawn shortly after the quarter end. The purpose of these draw downs is to indicate that the Company has access to cash for potential acquisitions or other investment opportunities that may arise. Approximately $7.6 million was available under the facility at October 31, 2005. The new facility extended the maturity to September 1, 2007, therefore, borrowings under the facility are classified as long term. Management believes that the carrying amount of the Company's borrowings approximates fair market value because the interest rate is variable and resets frequently. At this time, the Company anticipates that all future earnings will be retained for use in the Company's business. Any payment of cash dividends in the future on the Company's common stock will be dependent upon the Company's financial condition, its results of operations, current and anticipated cash requirements, plans for expansion, the ability of its subsidiaries to pay dividends or otherwise make cash payments or advances to it, and restrictions, if any, under any future debt obligations, as well as any other factors that the Board of Directors deems relevant. In conjunction with the Company's acquisition of API in 1997, AMR Combs, Inc. ("AMR Combs") purchased 10,407 shares of API Series A Convertible Preferred Stock, $0.001 par value, with annual dividends of $4.00 per share, payable quarterly (the "Convertible Preferred Stock"). On March 5, 1999, AMR Combs was acquired by Signature Flight Support, an affiliate of BBA Group Plc. On June 20, 2005, all of the outstanding shares of Preferred Stock were repurchased by the Company for $500,000. The difference between the carrying value and the purchase price was recorded as additional paid-in capital. Based upon current and anticipated levels of operations, the Company believes that cash flow from operations, combined with cash on hand, and the availability under the Facility, will be sufficient to meet its current and anticipated operating cash requirements for the foreseeable future, including scheduled interest and principal payments, capital expenditures, minority interest requirements, working capital needs, and cash required for acquisitions that the Company may pursue. 17 Contractual Obligations ----------------------- API entered into an initial parts purchase agreement on September 20, 2005 with a leading aircraft OEM to purchase $8.3 million of inventory. As part of the purchase financing, API entered into two promissory notes of $2.5 million and $1.8 million, with the Company entering into a guarantee agreement to ensure payment by API. The promissory note for $2.5 million is for a term of 4 years, at 5.0% interest per annum. The promissory note for $1.8 million is a non-interest bearing short-term note due within one year. The vendor financing promissory notes are subordinated to the Company's revolving line of credit. As of October 31, 2005, there have been no material changes outside the ordinary course of the Company's business in the Company's specified contractual obligations disclosed in the Company's Annual Report on Form 10-K for the year ended January 31, 2005. Item 3. Quantitative and Qualitative Disclosures about Market Risks ------------------------------------------------------------------- The Company's Canadian operations utilize the Canadian dollar as their functional currency, while the Company's Asian operation utilizes the U.S. dollar as its functional currency. The Company has transactions denominated in Canadian dollars and Philippine pesos. The Company is exposed to market risk from foreign exchange rates. Foreign currency transaction exposure principally arises from the transfer of foreign currency to and/or from U.S. dollars from one subsidiary to another within the Company, and from foreign currency denominated trade receivables. Currency transaction and translation exposures are not hedged. Foreign currency transaction gains and losses are included in earnings, and gains or losses will increase in significance with the growth of the Canadian operations. Unrealized currency translation gains and losses resulting from the translation of foreign subsidiaries balance sheets to U.S. dollars are not recorded as income or expense, but are recognized in the Balance Sheet as other comprehensive income or loss as a component of Stockholder's Equity. The Company does have risk principally relating to the translation of accounts in which the Canadian dollar is the functional currency. Sensitivity analysis of foreign currency exchange rate risk assumes an instantaneous 10% change in the foreign currency exchange rates from their level at October 31, 2005, with all other variables held constant. A 10% strengthening of the Canadian dollar versus the U.S. dollar would result in a decrease of approximately $143,111 in the net liability position of financial instruments at October 31, 2005. A 10% weakening of the Canadian dollar versus the U.S. dollar would result in an increase of approximately $174,918 in the net liability position of financial instruments at October 31, 2005. During the three months ended October 31, 2005, the Company experienced a foreign currency translation gain of $63,000, due to an increase in the value of the Canadian dollar relative to the U.S. dollar. During the nine months ended October 31, 2005 the Company experienced a foreign currency translation gain of $83,000, due to an increase in the value of the Canadian dollar relative to the U.S. dollar. Borrowings of the Company are denominated in U.S. dollars. Management believes that the carrying amount of the Company's borrowings approximates fair value because the interest rates are variable and reset frequently. Item 4. Controls and Procedures ------------------------------- The Company's management evaluated, with the participation of the Company's principal executive and principal financial officers, the effectiveness of the Company's disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act")), as of October 31, 2005. Based on their evaluation, the Company's principal executive and principal financial officers concluded that the Company's disclosure controls and procedures were effective as of October 31, 2005. There has been no change in the Company's internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the Company's fiscal quarter ended October 31, 2005, that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting. 18 PART II - OTHER INFORMATION --------------------------- Item 1. Legal Proceedings ------------------------- The Company's business exposes it to possible claims for personal injury, death or property damage that may result from a failure of certain parts serviced by the Company or spare parts and components sold by it, or in connection with the provision of its supply chain management services. The Company takes what it believes to be adequate precautions to ensure the quality of the work it performs and the traceability of the aircraft parts and components that it sells. The original equipment manufacturers that manufacture the parts, components and supplies that the Company sells carry liability insurance on the products they manufacture. In addition, the Company maintains what it believes is adequate liability insurance to protect it from any claims. In the normal conduct of its business, the Company also is involved in various claims and lawsuits, none of which, in the opinion of the Company's management, will have a material, adverse impact on the Company's consolidated financial position. The Company maintains what it believes is adequate liability and other insurance to protect it from such claims. However, depending on the amount and timing, unfavorable resolution of any of these matters could have a material effect on the Company's consolidated financial position, results of operations or cash flows in a particular period. Item 2. Unregistered Sales of Equity Securities and Use of Proceeds ------------------------------------------------------------------- NONE Item 3. Defaults Upon Senior Securities --------------------------------------- NONE Item 4. Submission of Matters to a Vote of Security Holders ----------------------------------------------------------- NONE Item 5. Other Information ------------------------- NONE Item 6. Exhibits ---------------- 31.1 Certification of Chief Executive Officer required by Rule 13a-14(a). 31.2 Certification of Chief Financial Officer required by Rule 13a-14(a). 32.1 Certification of Chief Executive Officer required by Rule 13a-14(b) and 18 U.S.C. Section 1350 (furnished herewith). 32.2 Certification of Chief Financial Officer required by Rule 13a-14(b) and 18 U.S.C. Section 1350 (furnished herewith). 19 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. First Aviation Services Inc. ---------------------------- (Registrant) Date: December 15, 2005 /S/ Michael C. Culver ------------------------------------------- Michael C. Culver, President, Chief Executive Officer and Director (Principal Executive Officer) Date: December 15, 2005 /S/ Robert G. Costantini ------------------------------------------- Robert G. Costantini, Chief Financial Officer (Principal Financial and Accounting Officer) 20

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