Overview

Our core business is acquiring and leasing, primarily pursuant to operating leases, commercial aircraft engines and related aircraft equipment; and the selective purchase and sale of commercial aircraft engines (collectively "equipment").

Critical Accounting Policies and Estimates

There have been no material changes to our critical accounting policies and estimates from the information provided in Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Critical Accounting Policies and Estimates included in our 2011 Form 10-K.

Results of Operations

Three months ended March 31, 2012, compared to the three months ended March 31, 2011:

Lease Rent Revenue. Lease rent revenue for the three months ended March 31, 2012 decreased 11.8% to $24.1 million from $27.3 million for the comparable period in 2011. This decrease primarily reflects lower portfolio utilization in the current period and a decrease in the size of the lease portfolio, which translated into a lower amount of equipment on lease. The aggregate of net book value of lease equipment at March 31, 2012 and 2011 was $974.3 million and $998.9 million, respectively, a decrease of 2.5%. The average utilization for the three months ended March 31, 2012 and 2011 was 84% and 89%, respectively. At March 31, 2012 and 2011, approximately 85% of equipment held for lease by book value was on-lease.

During the three months ended March 31, 2012, we added $14.6 million of equipment and capitalized costs to the lease portfolio. During the three months ended March 31, 2011, we added $37.9 million of equipment and capitalized costs to the lease portfolio.

Maintenance Reserve Revenue. Our maintenance reserve revenue for the three months ended March 31, 2012 increased 4.3% to $8.6 million from $8.2 million for the comparable period in 2011, primarily as a result of higher maintenance reserve revenues generated for engines on short term leases, for which usage was higher in the current period than in the year ago period .

Gain on Sale of Leased Equipment. During the three months ended March 31, 2012, we sold five engines and other related equipment generating a net gain of $2.6 million. During the three months ended March 31, 2011, we sold three engines and other related equipment generating a net gain of $5.1 million.

Other Income. Our other income consists primarily of management fee income and lease administration fees. Other income increased to $0.5 million from $0.2 million for the comparable period in 2011 due to an increase in the number of engines managed on behalf of third parties.

Depreciation Expense. Depreciation expense decreased 5.2% to $12.5 million for the three months ended March 31, 2012 from the comparable period in 2011, due to decreased lease portfolio value and changes in estimates of useful life and residual values on certain older engine types that occurred in 2011 but did not affect the first quarter of 2011.

Write-down of Equipment. There was $0.3 million in equipment write-down recorded in the three month period ended March 31, 2012 related to the sale of two engines in April 2012 for which the net book value exceeds the proceeds from sale. There was no equipment write-down in the three month period ended March 31, 2011.

General and Administrative Expenses. General and administrative expenses increased 6.4% to $8.7 million for the three months ended March 31, 2012, from the comparable period in 2011, due mainly to increases in employment related costs ($0.2 million), computer system upgrade expenses ($0.2 million) and legal and consulting fees ($0.1 million).

Technical Expense. Technical expenses consist of the cost of engine repairs, engine thrust rental fees, outsourced technical support services, sublease engine rental expense, engine storage and freight costs. These expenses decreased 42.8% to $1.3 million for the three months ended March 31, 2012, from the comparable period in 2011 due mainly to a decrease in engine maintenance costs due to lower repair activity ($0.6 million), lower engine thrust rental fees due to a decrease in the number of engines being operated at higher thrust levels under the CFM thrust rental program ($0.2 million) and decreased sub-lease rental expense resulting from the termination of a sublease rental program in June 2011 ($0.2 million).

Net Finance Costs. Net finance costs include interest expense and interest income. Interest expense decreased 14.0% to $7.9 million for the three months ended March 31, 2012, from the comparable period in 2011, due primarily to a decrease in the notional value of swaps in place during the current quarter and a decrease in the average debt outstanding. Notes payable balance at March 31, 2012 and 2011, was $705.0 million and $746.8 million, respectively, a decrease of 5.6%. All but $23.2 million of our debt is tied to one-month U.S. dollar LIBOR which remained flat at an average of 0.25% for the three months ended March 31, 2012 and 2011 (average of month-end rates). At each of March 31, 2012 and 2011, one-month LIBOR was 0.24%.

To mitigate exposure to interest rate changes, we have entered into interest rate swap agreements. As of March 31, 2012, such swap agreements had notional outstanding amounts of $315.0 million, remaining terms of between sixteen and thirty-seven and fixed rates of between 2.10% and 3.62%. As of March 31, 2011, such swap agreements had notional outstanding amounts of $415.0 million, remaining terms of between two and forty-nine months and fixed rates of between 2.10% and 5.05%. In the three months ended March 31, 2012 and 2011, $2.4 million and $3.4 million was realized through the income statement as an increase in interest expense, respectively, as a result of these swaps.

Interest income for the three months ended March 31, 2012, decreased to $0.03 million from $0.04 million for the three months ended March 31, 2011, due to a decrease in deposit balances.

Income Tax Expense. Income tax expense for the three months ended March 31, 2012 and 2011 was $2.1 million and $3.1 million, respectively. The effective tax rate for the three months ended March 31, 2012 and 2011 was 38.8% and 38.3%, respectively. Our tax rate is subject to change based on changes in the mix of assets leased to domestic and foreign lessees, the proportions of revenue generated within and outside of California, the amount of executive compensation exceeding $1.0 million as defined in IRS code 162(m) and numerous other factors, including changes in tax law.

Recent Accounting Pronouncements

In May 2011, the FASB issued Accounting Standards Update ("ASU") No. 2011-04, "Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs" ("ASU 2011-04"). This ASU clarifies the concepts related to highest and best use and valuation premise, blockage factors and other premiums and discounts, the fair value measurement of financial instruments held in a portfolio and of those instruments classified as a component of shareholder's equity. The guidance includes enhanced disclosure requirements about recurring Level 3 fair value measurements, the use of nonfinancial assets, and the level in the fair value hierarchy of assets and liabilities not recorded at fair value. The guidance provided in ASU 2011-04 is effective for interim and annual periods beginning on or after December 15, 2011 and is applied prospectively. The adoption of this ASU did not have a material impact on our Consolidated Financial Statements.

In June 2011, the FASB issued Accounting Standards Update ("ASU") No. 2011-05, "Presentation of Comprehensive Income" ("ASU 2011-05"). This ASU intends to enhance comparability and transparency of other comprehensive income components. The guidance provides an option to present total comprehensive income, the components of net income and the components of other comprehensive income in a single continuous statement or two separate but consecutive statements. This ASU eliminates the option to present other comprehensive income components as part of the Statement of Shareholder's Equity and Comprehensive Income. The guidance provided in ASU 2011-05 is effective for interim and annual period beginning on or after December 15, 2011 and should be applied retrospectively. The adoption of this ASU did not have a material impact on our Consolidated Financial Statements.

In November 2011, the FASB issued Accounting Standards Update ("ASU") No. 2011-11, "Balance Sheet Disclosures about Offsetting Assets and Liabilities" ("ASU 2011-11"). This ASU requires companies to provide information about trading financial instruments and related derivatives in expanded disclosures. This ASU is the result of a joint project conducted by the FASB and the IASB to enhance disclosures and provide converged disclosures about financial instruments and derivative instruments that are either offset on the statement of financial position or subject to an enforceable master netting arrangement or similar agreement, irrespective of whether they are offset on the statement of financial position. The guidance provided in ASU 2011-11 is effective for interim and annual period beginning on or after January 1, 2013 and should be applied retrospectively. We do not expect the adoption of this ASU to have a material impact on our Consolidated Financial Statements.

In December 2011, the FASB issued Accounting Standards Update ("ASU") No. 2011-12, "Comprehensive Income Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05" ("ASU 2011-12"). This ASU defers only those changes in ASU 2011-05 that relate to the presentation of reclassification adjustments. The amendments are being made to allow the Board time to re-deliberate whether to present on the face of the financial statements the effects of reclassifications out of accumulated other comprehensive income on the components of net income and other comprehensive income for all periods presented. All other requirements in ASU 2011-05 are not affected by this ASU, including the requirement to report comprehensive income either in a single continuous financial statement or in two separate but consecutive financial statements. The guidance provided in ASU 2011-12 is effective for interim and annual period beginning on or after December 15, 2011 and should be applied retrospectively. The adoption of this ASU did not have a material impact on our Consolidated Financial Statements.

Liquidity and Capital Resources

We finance our growth through borrowings secured by our equipment lease portfolio. Cash of approximately $20.0 million and $45.4 million, in the three-month periods ended March 31, 2012 and 2011, respectively, was derived from this activity. In these same time periods $33.3 million and $30.4 million, respectively, was used to pay down related debt. Cash flow from operating activities was $7.9 million and negative $0.9 million in the three-month periods ended March 31, 2012 and 2011, respectively. Cash receipts resulting from WEST engine sales have increased the restricted cash balance at March 31, 2012 and have reduced cash flows from operating activities by $9.8 million for the three-month period ended March 31, 2012. Cash receipts resulting from WEST engine sales have increased the restricted cash balance at March 31, 2011 and have reduced cash flows from operating activities by $17.8 million for the three-month period ended March 31, 2011.

Our primary use of funds is for the purchase of equipment for lease. Purchases of equipment (including capitalized costs) totaled $14.3 million and $36.0 million for the three-month periods ended March 31, 2012 and 2011, respectively.

Cash flows from operations are driven significantly by payments received under our lease agreements, which comprise lease revenue and maintenance reserves, and are offset by general and administrative expenses and interest expense. Note that cash received from maintenance reserve arrangements for some of our engines on lease are restricted per our debt arrangements. The lease revenue stream, in the short-term, is at fixed rates while virtually all of our debt is at variable rates. If interest rates increase, it is unlikely we could increase lease rates in the short term and this would cause a reduction in our earnings. Revenue and maintenance reserves are also affected by the amount of equipment off lease. Approximately 85%, by book value, of our assets were on-lease at March 31, 2012 and at March 31, 2011 and the average utilization rate for the three months ended March 31, 2012 was 84% compared to 89% in the prior year. If there is any increase in off-lease rates or deterioration in lease rates that are not offset by reductions in interest rates, there will be a negative impact on earnings and cash flows from operations.

At March 31, 2012, Notes payable consists of loans totaling $705.0 million (net of discount of $2.0 million), payable over periods of nine months to fourteen years with interest rates varying between approximately 1.5% and 8.0% (excluding the effect of our interest rate derivative instruments).

Our significant debt instruments are discussed below:

At March 31, 2012, we had a $345.0 million revolving credit facility to finance the acquisition of aircraft engines for lease as well as for general working capital purposes. We closed on this facility on November 18, 2011 and the proceeds of the new facility, net of $3.3 million in debt issuance costs, was used to pay off the balance remaining from our prior revolving facility. As of March 31, 2012, $116.0 million was available under this facility. The revolving facility ends in November 2016. Based on the Company's debt to equity ratio of 2.97 as calculated under the terms of the revolving credit facility, the interest rate on this facility decreased to LIBOR plus 2.5% as of March 31, 2012. Under the revolver facility, all subsidiaries except Willis Engine Securitization Trust ("WEST") and WEST Engine Funding LLC jointly and severally guarantee payment and performance of the terms of the loan agreement. The guarantee would be triggered by a default under the agreement.

On September 30, 2011, we closed on a term loan for a three year term totaling $4.0 million. Interest is payable at a fixed rate of 3.94% and principal and interest is paid monthly. The loan is secured by our corporate aircraft. The funds were used to refinance the loan for our corporate aircraft. The balance outstanding on this loan is $3.3 million as of March 31, 2012.

On January 11, 2010, we closed on a new term loan for a four year term totaling $22.0 million. Interest is payable at a fixed rate of 4.50% and principal and interest is paid quarterly. The loan is secured by three engines. The funds were used to pay down our revolving credit facility. The balance outstanding on this facility is $18.4 million as of March 31, 2012.

At March 31, 2012, we had $425.2 million of WEST term notes outstanding. Included in the term notes outstanding are the Series 2007-A2 and Series 2007-B2 warehouse notes that converted to term notes effective February 14, 2011. The term notes are divided into $96.0 million Series 2005-A1 notes, $159.1 million Series 2007-A2 notes, $23.1 million Series 2007-B2 notes and $147.0 million Series 2008-A1 notes. At March 31, 2012, the interest rate on the Series 2005-A1 notes is one-month LIBOR plus a margin of 1.25%. At March 31, 2012, the interest rate on the Series 2007-A2 notes is one-month LIBOR plus a margin of 2.25%. At March 31, 2012, the interest rate on the Series 2007-B2 notes is one-month LIBOR plus a margin of 4.75%. At March 31, 2012, the interest rate on the Series 2008-A1 notes is one-month LIBOR plus a margin of 1.50%. The Series 2005-A1 and 2008-A1 term notes expected maturity is July 2018 and March 2021, respectively. The Series 2007-A2 and 2007-B2 notes expected maturity is January 2024 and January 2026, respectively.

The Series 2008-B1 notes were issued on March 28, 2008 in the original principal amount of $20.3 million. On June 30, 2008, we purchased the WEST Series 2008-B1 notes for $19.8 million (the unpaid principal amount of the 2008-B1 notes at that date) with the proceeds of a $20.0 million term loan made by an affiliate of the prior note holder. This term loan is secured by a pledge of the WEST Series 2008-B1 notes to the lender. The term loan was originally for a term of two years with maturity on July 1, 2010 with no amortization with all amounts due at maturity. The term loan has since been amended and extended several times. On March 29, 2012, the Company further extended the maturity date from June 30, 2012 to December 31, 2012. The interest rate remains at one-month LIBOR plus 4.00% and the loan continues to amortize on a monthly basis, with a $13.0 million bullet payment required at the December 31, 2012 maturity date. The balance outstanding on this term loan is $13.9 million as of March 31, 2012.

On January 18, 2011, we purchased the WEST Series 2005-B1 notes for $17.9 million (the unpaid principal amount of the 2005-B1 notes at that date) with the proceeds of a term loan made by the bank which was the prior note holder. This term loan is secured by a pledge of the WEST Series 2005-B1 notes to the lender. The interest rate on this term loan is one-month LIBOR plus a margin of 3.00%. The term of this loan is five years and the loan amortization is consistent with the amortization on the underlying WEST Series 2005-B1 notes, with a bullet payment required at the end of the five year term. The balance outstanding on this term loan is $15.7 million as of March 31, 2012.

WEST's ability to make distributions and pay dividends to the Company is subject to the prior payments of its debt and other obligations and WEST's maintenance of adequate reserves and capital. Under WEST, cash is collected in a restricted account, which is used to service the debt and any remaining amounts, after debt service and defined expenses, are distributed to the Company. Additionally, maintenance reserve payments and lease security deposits are accumulated in restricted accounts and are not available for general use. Cash from maintenance reserve payments are held in the restricted cash account and are subject to a minimum balance established annually based on an engine portfolio maintenance reserve study provided by a third party. Any excess maintenance reserve amounts remain within the restricted cash accounts and are utilized for the purchase of new engines.

The assets of WEST, WEST Engine Funding LLC and any associated Owner Trust are not available to satisfy the Company's obligations or the obligations of any of our affiliates. WEST is consolidated for financial statement presentation purposes.

At March 31, 2012 and December 31, 2011, we had revolving credit facilities totaling $345.0 million. At March 31, 2012 and December 31, 2011, respectively, $116.0 million and $117.0 million were available under these facilities.

At each of March 31, 2012 and 2011, one-month LIBOR was 0.24%.

Virtually all of the above debt is subject to our ongoing compliance with the covenants of each financing, including debt/equity ratios, minimum tangible net worth and minimum interest coverage ratios, and other eligibility criteria including customer and geographic concentration restrictions. In addition, under these facilities, we can typically borrow 70% to 83% of an engine's net book value and approximately 70% of spare part's net book value. Therefore we must have other available funds for the balance of the purchase price of any new equipment to be purchased or we will not be permitted to draw on these facilities. The facilities are also cross-defaulted against other facilities. If we do not comply with the covenants or eligibility requirements, we may not be permitted to borrow additional funds and accelerated payments may become necessary. Additionally, much of the above debt is secured by engines to the extent that engines are sold, repayment of that portion of the debt could be required. We were in compliance with all covenants at March 31, 2012.

Approximately $65.1 million of our debt is repayable during the next 12 months, which includes $13.9 million owing under our senior term loan. Such repayments consist of scheduled installments due under term loans. Repayments are funded by the use of unrestricted cash reserves and from cash flows from ongoing operations. The table below summarizes our contractual commitments at March 31, 2012:

                                                                Payment due by period (in thousands)
                                                       Less than                                    More than
                                          Total         1 Year        1-3 Years      3-5 Years       5 Years
Long-term debt obligations              $ 706,953     $    65,068     $  117,472     $  332,260     $  192,153
Interest payments under long-term
debt obligations                           83,288          17,428         29,899         22,345         13,616
Operating lease obligations                 4,045             945          1,236          1,025            839
Purchase obligations                       36,132           9,000         18,088          9,044             -
Interest payments under derivative
rate instruments                           13,180           6,956          6,134             90             -

Total                                   $ 843,598     $    99,397     $  172,829     $  364,764     $  206,608

We have estimated the interest payments due under long-term debt by applying the interest rates applicable at March 31, 2012 to the remaining debt, adjusted for the estimated debt repayments identified in the table above. Actual interest payments made will vary due to changes in the rates for one-month LIBOR.

We have made purchase commitments to secure the purchase of four engines and related equipment for a gross purchase price of $37.5 million for delivery in 2012 to 2015. As at March 31, 2012, non-refundable deposits paid related to this purchase commitment were $1.4 million. In October 2006, we entered into an agreement with CFM International ("CFM") to purchase new spare aircraft engines. The agreement specifies that, subject to availability, we may purchase up to a total of 45 CFM56-7B and CFM56-5B spare engines over a five year period, with options to acquire up to an additional 30 engines. Our outstanding purchase orders with CFM for three engines represent deferral of engine deliveries originally scheduled for 2009 and are included in our commitments to purchase in 2013 to 2015.

We entered into a lease effective November 1, 2007 for our offices in Novato, California that covers approximately 18,375 square feet of office space. This lease was amended on January 6, 2012 to cover an additional 2,159 square feet of office space. The total remaining rent commitment is approximately $3.4 million and expires September 30, 2018. The sub-lease of our premises in San Diego, California expires October 31, 2013 and the remaining lease commitment is approximately $0.2 million. We also lease office space in Shanghai, China. The lease expires December 31, 2012 and the remaining lease commitment is approximately $48,600. We also lease office and living space in London, United Kingdom. The living space lease expires on January 3, 2013 and the office space lease expires on December 18, 2012 and the remaining lease commitments are approximately $0.2 million and $0.1 million, respectively. We also lease office space in Blagnac, France. The lease expires December 31, 2012 and the remaining lease commitment is approximately $39,400. We lease office space in Dublin, Ireland. The lease expires May 31, 2012 and the remaining lease commitment is approximately $4,700.

We believe our equity base, internally generated funds and existing debt facilities are sufficient to maintain our level of operations for the next twelve months. A decline in the level of internally generated funds, such as could result if the amount of equipment off-lease increases or there is a decrease in availability under our existing debt facilities, would impair our ability to sustain our level of operations. If we are not able to access additional capital, our ability to continue to grow our asset base consistent with historical trends will be impaired and our future growth limited to that which can be funded from internally generated capital.

Management of Interest Rate Exposure

At March 31, 2012, all but $23.2 million of our borrowings were on a variable rate basis at various interest rates tied to one-month LIBOR. Our equipment leases are generally structured at fixed rental rates for specified terms. Increases in interest rates could narrow or result in a negative spread, between the rental revenue we realize under our leases and the interest rate that we pay under our borrowings. We have entered into interest rate derivative instruments to mitigate our exposure to interest rate risk and not to speculate or trade in these derivative products. We currently have interest rate swap agreements which have notional outstanding amounts of $315.0 million, with remaining terms of between sixteen and thirty-seven months and fixed rates of between 2.10% and 3.62%. The fair value of the swaps at March 31, 2012 was negative $12.1 million, representing a net liability for us.

We record derivative instruments at fair value as either an asset or liability. We use derivative instruments (primarily interest rate swaps) to manage the risk of interest rate fluctuation. While substantially all our derivative transactions are entered into for the purposes described above, hedge accounting is only applied where specific criteria have been met and it is practicable to do so. In order to apply hedge accounting, the transaction must be designated as a hedge and the hedge relationship must be highly effective. The hedging instrument's effectiveness is assessed utilizing regression analysis at the inception of the hedge and on at least a quarterly basis throughout its life. All of the transactions that we have designated as hedges are accounted for as cash flow hedges. The effective portion of the gain or loss on a derivative instrument designated as a cash flow hedge is reported as a component of other comprehensive income and is reclassified into earnings in the period during which the transaction being hedged affects earnings. The ineffective portion of these hedges flows through earnings in the current period. The hedge accounting for these derivative instrument arrangements increased interest expense by $2.4 million and $3.4 million for the three months ended March 31, 2012 and March 31, 2011, respectively. This incremental cost for the swaps effective for hedge accounting was included in interest expense for the respective periods. For further information see Note 6 to the unaudited consolidated financial statements.

We will be exposed to risk in the event of non-performance of the interest rate derivative instrument counterparties. We anticipate that we may hedge additional amounts of our floating rate debt during the next year.

Related Party and Similar Transactions

Island Air: Gavarnie Holding, LLC, a Delaware limited liability company ("Gavarnie") owned by Charles F. Willis, IV, purchased the stock of Aloha Island Air, Inc., a Delaware Corporation, ("Island Air") from Aloha AirGroup, Inc. . . .