UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

AirNet Systems, Inc.

(Exact name of registrant as specified in its charter)

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  ý  No  o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes  o  No  ý

As of November 4, 2004, 10,109,883 of the registrant’s common shares, par value $0.01, were outstanding.

TABLE OF CONTENTS

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AIRNET SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS - Unaudited

See notes to condensed consolidated financial statements

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AIRNET SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS - Unaudited

See notes to condensed consolidated financial statements

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AIRNET SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1.             Basis of Presentation

AirNet Systems, Inc. and its subsidiaries (“AirNet” or the “Company”) operate a fully integrated national air transportation network which provides delivery service for time-critical shipments for customers in the U.S. banking industry and other industries requiring the express delivery of packages.  AirNet also offers passenger charter services and retail aviation fuel sales and related ground services.

The accompanying condensed consolidated financial statements include the accounts of AirNet Systems, Inc. and its subsidiaries.  These financial statements are unaudited and have been prepared in accordance with the instructions for Form 10-Q.  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 as permitted by the instructions for Form 10-Q.  These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in AirNet Systems, Inc.’s Annual Report on Form 10-K for the fiscal year ended December 31, 2003. The results of operations for the quarterly and nine month periods ended September 30, 2004 are not necessarily indicative of the results for the full year.

The financial information included herein reflects all adjustments (consisting of normal recurring adjustments), which are, in the opinion of management, necessary for a fair presentation of the results of interim periods.

The preparation of the condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in those financial statements and accompanying notes thereto.  Actual results could differ from those estimates.

Certain reclassifications have been made in the prior year’s financial statements to conform to the presentation for the three and nine month periods ended September 30, 2004.

2.   Impairment of Assets and Goodwill

AirNet recognizes impairment losses on long-lived assets used in operations in accordance with SFAS No.144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (SFAS No. 144).  AirNet recognizes impairment losses on long-lived assets used in operations, when events or changes in circumstances indicate, in management’s judgment, that the assets might be impaired and the undiscounted cash flows estimated to be generated by those assets are less than the carrying value of those assets.  The net carrying value of the assets not recoverable is reduced to fair market value if lower than carrying value.  In determining the fair market value of the assets, AirNet considers market trends, published market data, and recent transactions involving sales of similar assets.

AirNet’s long-lived assets used in its cargo operations, consisting primarily of aircraft and spare parts, were determined to be impaired as of September 30, 2004.  This determination was made as a result of recent industry trends in the adoption of electronic payment alternatives and evolving electronic alternatives to the physical movement of cancelled checks at a more rapid pace than previously accepted by the industry.  AirNet believes that enactment of the Check 21 Act in October 2004 will contribute to this trend.  Furthermore, recent market data and other disclosures by the Federal Reserve confirm the accelerating decline in cancelled check volume.  AirNet’s cargo airline was originally designed, and continues to operate, primarily to meet the needs of Bank services customers. AirNet believes that its airline capacity will exceed future demand, creating an impairment of the aircraft and related assets. The impairment also reflects the overall decline in the market values of the aircraft in its cargo fleet which have not recovered as in previous economic cycles.  AirNet determined that the expected future undiscounted cash flows from its assets used in its cargo operations were less than the carrying value of those assets and were impaired.  Accordingly, a non-cash impairment charge of $43.0 million was recorded as of September 30, 2004, using estimated aircraft fair values.  The aircraft fair values used for this purpose are based upon published market sources as of September 30, 2004, which are also used under AirNet’s Amended Credit Agreement (See Note 7).

Under SFAS No. 142, “Goodwill and Other Intangible Assets”, AirNet evaluates its goodwill for impairment annually, or more frequently if changes in circumstances indicate impairment may have occurred sooner.  AirNet determined that as a result of the impairment of its long-lived assets used in its cargo operations, the remaining goodwill assigned to the cargo operations should be evaluated for potential impairment.  AirNet evaluates the fair value of its goodwill related to its cargo operations based upon a discounted future cash flow analysis.  As a result of the impairment test AirNet determined that its goodwill was impaired and, accordingly, a non-cash impairment charge of $4.0 million was recorded.

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3.             Stock Plans and Awards

SFAS No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure , requires prominent disclosures in both annual and interim financial statements regarding the method of accounting for stock-based employee compensation and the effect of the method used on reported results.

The Company accounts for its employee and director stock-based compensation plans under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations.  No stock-based employee compensation cost is reflected in net income, as all options granted have an exercise price equal to the market value of the underlying common shares on the date of grant.  Pro forma information regarding net income (loss) and net income (loss) per share, as required by SFAS No. 148, has been determined as if the Company had accounted for its employee stock options under the fair value method of SFAS No. 123, Accounting for Stock-Based Compensation . The fair value of these options was estimated at the date of grant using the Black-Scholes option pricing model.

The following table illustrates the effect on net income (loss) and net income (loss) per share as if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation (in thousands, except per share data):

4.             Income (Loss) Per Share From Continuing Operations

The following table sets forth the computation of basic and diluted income (loss) per common share from continuing operations (in thousands, except per share data):

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Common shares subject to outstanding stock options excluded from the diluted adjusted weighted average shares outstanding calculation were 771,207 and 742,927 for the three and nine month periods ended September 30, 2004, respectively.  These options were antidilutive and excluded from the calculation because (1) the exercise price of these options was greater than the average fair market value of the underlying common shares in the respective periods or (2) the losses for the three and nine month periods ended September 30, 2004 caused the options to be antidilutive.

5.  Comprehensive Income

Comprehensive income is comprised of net income of the Company and the change in the fair value of interest rate swap agreements, net of income taxes.  Comprehensive income (loss) for the nine months ended September 30, 2004 and September 30, 2003 was ($29,642,000) and $2,081,000, respectively. Comprehensive income (loss) for the three months ended September 30, 2004 and 2003 was ($30,184,000) and $1,060,000, respectively.

6.   Discontinued Operations

On August 11, 2003, AirNet Systems, Inc. completed the sale of substantially all of the assets of its Mercury Business Services unit to Mercury Business Services, Inc., a Delaware corporation owned by a group that include the original owners of the Mercury business.

The sales price of the transaction was approximately $1.1 million.  Mercury Business Services, Inc. paid approximately $455,000 of the sales price through the issuance of a ninety day promissory note secured by the assets being sold and guaranteed by each of the shareholders of Mercury Business Services, Inc.  Under the terms of the Asset Purchase Agreement, approximately $536,000 of the purchase price was paid with AirNet Systems, Inc. common shares owned by the shareholders of Mercury Business Services, Inc., including 56,000 common shares tendered to AirNet Systems, Inc. prior to closing at $4.30 per share (the closing price of the AirNet Systems, Inc. common shares on the NYSE on July 25, 2003) and 68,494 common shares tendered to AirNet Systems, Inc. on the closing date at $4.31 per share (the average closing price of the AirNet Systems, Inc. common shares on the NYSE on August 4-6, 2003).  The balance of the sales price was paid in cash.

AirNet accounted for these operations as discontinued operations.

The Mercury Business Services unit had revenues of $1.0 million and $5.9 million for the three and nine month periods ended September 30, 2003, respectively.

Pre-tax loss for AirNet’s Mercury Business Services unit was $41,000 and $13,000 for the three and nine month periods ended September 30, 2003, respectively.

7.   Bank Financing Matters

In June 2004, AirNet entered into an amended and restated term loan and revolving loan credit facility (collectively, the “Amended Credit Agreement”) with its banks. The Amended Credit Agreement provides AirNet with a secured revolving credit facility with up to $35.0 million available and a secured term loan in the aggregate amount of $14.0 million.  The amount of revolving loans available under the Amended Credit Agreement is further limited to a borrowing base equal to the aggregate of 80% of eligible accounts receivable, plus 50% of eligible inventory, plus 70% of the market value of certain fixed assets, reduced by the aggregate amount of AirNet’s outstanding letters of credit. As of September 30, 2004, $16.0 million and $12.0 million were outstanding under the secured revolving credit facility and secured term loan, respectively.  As of September 30, 2004, AirNet had approximately $19.0 million available to borrow on its secured revolving loan facility.

The revolving credit facility under the Amended Credit Agreement expires on September 30, 2005 and the secured term loan matures on September 30, 2007.  As of September 30, 2004, approximately $16.0 million of the revolving credit facility was reclassified on AirNet's Condensed Consolidated Balance Sheet as current liabilities.  Quarterly principal payments of $1.0 million are required for the secured term loan beginning in June 2004 and continuing through September 30, 2007. The Amended Credit Agreement is secured by a first lien on all of the property of AirNet and its subsidiaries, other than any interest in real estate and certain excluded fixed assets.  The Amended Credit Agreement permits AirNet and its subsidiaries to incur other indebtedness for the purpose of purchasing or refinancing aircraft and related tangible fixed assets, subject to certain annual limitations.  AirNet has also pledged the interests in its subsidiaries, and each of AirNet’s

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subsidiaries has guaranteed AirNet’s obligations under the Amended Credit Agreement.  The Amended Credit Agreement contains limitations on operating leases, indebtedness, significant corporate changes including mergers and sales of assets, investments in subsidiaries and acquisitions, liens, capital expenditures, transactions with affiliates, sales of accounts receivable, sale and leaseback transactions and other off-balance sheet liabilities, contingent obligations and hedging transactions.  The Amended Credit Agreement also contains financial covenants that require AirNet to maintain a minimum consolidated tangible net worth and to not exceed fixed charge coverage and leverage ratios specified in the Amended Credit Agreement. As a result of the impairment charge taken in September 2004 as described in Note 2, AirNet was not in compliance with the fixed charge coverage ratio and the leverage ratio calculated as of September 30, 2004, and AirNet would not be in compliance with the minimum consolidated tangible net worth requirement to be calculated as of December 31, 2004 (pursuant to the Amended Credit Agreement, this ratio is calculated annually as of December 31, AirNet’s fiscal year-end).  Effective as of November 12, 2004, AirNet and its lenders under the Amended Credit Agreement executed a waiver of any defaults or potential defaults under the Amended Credit Agreement which resulted or may have resulted from the non-compliance with the foregoing financial covenants caused by the impairment charge.  Additionally, effective as of November 12, 2004, AirNet and its lenders under the Amended Credit Agreement executed a Change in Terms Agreement which modified the foregoing financial covenants so that, on a going-forward basis, the impairment charge does not cause a default or potential default of these financial covenants in the future.

The Amended Credit Agreement bears interest, at AirNet’s option, at (a) a fixed rate equal to LIBOR plus a margin determined by AirNet’s leverage ratio as defined in the Amended Credit Agreement, or (b) a floating rate based on the greater of the sum of (i) the prime rate established by The Huntington National Bank from time to time plus a margin determined by AirNet’s leverage ratio and (ii) the sum of 0.5% plus the federal funds rate in effect from time to time.  After the effective date of the Amended Credit Agreement, AirNet paid off its three five-year term loans totaling approximately $3.4 million incurred during first quarter 2002.

During the second quarter 2004, AirNet entered into four seven-year term loans totaling $22.5 million with fixed interest rates of approximately 6.7%. As of September 30, 2004, there was $22.3 million outstanding on these secured term loans, and the net book value of the aircraft securing the loans totaled approximately $28.5 million.  In July 2004, AirNet financed two additional passenger charter Learjet 60’s for the Passenger Charter fleet at $5.0 million each with fixed rates of approximately 6.5%, for a total of $32.5 million in financing related to AirNet’s Passenger Charter services.  AirNet has pledged the interests in its subsidiaries, and each of AirNet’s subsidiaries has guaranteed AirNet’s obligations under the term loans.  Each of the term loans is secured by aircraft used in the Passenger Charter fleet.

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AIRNET SYSTEMS, INC.

additional disclosures regarding AirNet’s significant accounting policies and Item 7 of that Annual Report on Form 10-K includes a summary of AirNet’s critical accounting policies. The information appearing therein may be useful when reading this discussion and analysis of financial condition and results of operations.

Results of Operations

Net Revenues

AirNet has experienced overall net revenue growth for the three months and nine months ended September 30, 2004 over the same periods of the prior year.  This can be attributed to several factors including increased Express shipment volume and growth in Passenger Charter services as well as additional fuel surcharge revenues.

Bank Services Revenues

Bank weekday revenues decreased in the quarter and year-to-date 2004 as compared to the same periods of the prior year.  The third quarter decrease was primarily due to a decrease in the total number of shipments as well as the number of pounds per shipment by the Company’s bank customers, while the year-to-date decrease was primarily due to a decrease in the number of pounds per shipment.  Increased fuel prices in the third quarter and year-to-date 2004 resulted in significantly higher fuel surcharge revenues compared to the same quarter and year-to-date 2003.  AirNet believes that lower check delivery volume as a result of historically low interest rates, the declining use of checks, and the Check 21 Act which became effective in October 2004, will contribute to a significant reduction in bank revenues in future periods, as will increased competitive factors from regional carriers and transportation cost reduction initiatives by AirNet’s Bank customers.

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Express Services Revenues

Express services revenues continue to increase as a percentage of total revenues, increasing from 24.4% to 29.2% of total revenue for the quarter and from 24.1% to 28.2% year-to-date compared to the same periods of the prior year.  Shipments using AirNet’s air transportation network were up 4% and 5% for the quarter and year-to-date, respectively. Shipments sent via commercial airlines increased 23% and 36% for the quarter and year-to-date, respectively, and point to point surface shipments increased 34% and 38% for the quarter and year-to-date, respectively.  Commercial air and point to point surface shipments generally incur higher courier costs compared to shipments using AirNet’s airline.  The increase in shipments sent via commercial airlines is principally due to an increase in shipments outside the AirNet airline’s scheduled delivery times and locations, which generally results in lower gross margins per shipment than shipments carried on AirNet’s airline.

Passenger Charter Services Revenues