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ACY > SEC Filings for ACY > Form 10-K on 12-Mar-2014All Recent SEC Filings

Show all filings for AEROCENTURY CORP

Form 10-K for AEROCENTURY CORP


12-Mar-2014

Annual Report


Item 7.Management's Discussion and Analysis of Financial Condition and Results of Operations.

Overview

The Company owns regional aircraft and engines, which are typically leased to customers under triple net leases with terms that are less than the useful life of the assets. A "triple net operating lease" is an operating lease under which, in addition to monthly rental payments, the lessee is generally responsible for the taxes, insurance and maintenance and repair of the aircraft arising from the use and operation of the aircraft during the term of the lease. The acquisition of such equipment is generally made using debt financing. The Company's profitability and cash flow are dependent in large part upon its ability to acquire equipment, obtain and maintain favorable lease rates on such equipment, and re-lease or sell equipment that comes off lease. The Company is subject to the credit risk of its lessees, both as to collection of rental payments and as to performance by lessees of their obligations to maintain the equipment. Since lease rates for assets in the Company's portfolio generally decline as assets age, the Company's ability to maintain and grow revenue and earnings is primarily dependent upon the Company's ability to acquire and lease additional assets.

The Company's primary uses of cash are for purchases of aircraft and engines, maintenance expense, debt service payments, management fees, insurance and professional fees.

The Company's most significant non-cash expenses include aircraft and engine depreciation, amortization of costs associated with the Company's indebtedness, which is included in interest expense, and, in some years, impairment provisions, which are affected by significant estimates.

Critical Accounting Policies, Judgments and Estimates

The Company's discussion and analysis of its financial condition and results of operations are based upon the financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets and liabilities, revenues and expenses, and the related disclosure of contingent assets and liabilities at the date of the financial statements. In the event that actual results differ from these estimates or the Company adjusts these estimates in future periods, the Company's operating results and financial position could be materially affected. For a discussion of Critical Accounting Policies, Judgments and Estimates, refer to Note 1 to the Company's financial statements in Item 8 of this Annual Report on Form 10-K.

Maintenance Reserves

Maintenance reserves are determined by mutual agreement of the Company and its lessee at inception of the lease and are based on the Company's estimate of the total maintenance cost at some future point resulting from the lessee's usage. Reserve rates are typically subject to an annual adjustment provision that accounts for inflation of maintenance costs. If a lessee is required to repair a component during the lease or perform a repair at lease end in order to comply with aircraft return conditions, it will be entitled to collect the reserves related to that repair from the Company, and any excess costs would then be the responsibility of the lessee. Therefore, if maintenance rates do not accurately reflect the true cost of a repair, the Company will not incur any financial impact. If, however, the Company repossesses an aircraft upon a lessee default, and the maintenance reserves collected under that defaulted lease are less than the actual maintenance costs, the Company is responsible for such excess costs. It is also possible that, in order to remarket a repossessed aircraft, certain inspections and repairs may need to be performed earlier than otherwise required by the manufacturer or regulatory specifications. In such a case, the collected reserves from the defaulted lessee, which were established assuming a normal interval between repairs, would likely be insufficient to cover the total cost incurred by the Company. For a discussion of the Company's accounting policies regarding Maintenance Reserves, refer to Note 3 to the Company's financial statements in Item 8 of this Annual Report on Form 10-K.

Results of Operations

The Company recorded net income of $3.2 million in 2013 compared to net income of $5.2 million in 2012.

Annual operating lease revenue decreased 21% from $23.7 million in 2012 to $18.8 million in 2013, primarily reflecting lower portfolio utilization and lower revenue received from those lessees from which the Company records revenue only on cash receipt as a result of substantial uncertainty of collectability. The effects of these decreases were partially offset by increases in operating lease revenue from assets purchased during 2012 and 2013.

The average net book value of assets held for lease during 2013 and 2012 was approximately $143.2 million and $138.6 million, respectively, representing an increase of 3%. The average portfolio utilization during 2013 and 2012 was 76% and 84%, respectively.

Maintenance reserves revenue for the year ended December 31, 2013 increased 117% to $8.9 million from $4.1 million in 2012. The increase was principally due to the recognition of $6.5 million maintenance reserves revenue in 2013 for funds received upon assignment of two leases in 2012 from one lessee to a second lessee, as described in Note 3 to the Company's financial statements in Item 8 of this Annual Report on Form 10-K. The effect of this increase was partially offset by decreases resulting from lower portfolio utilization and lower revenue received from those lessees from which the Company records revenue only on cash receipt as a result of substantial uncertainty of collectability in 2013 than in 2012.

During 2013, the Company recorded net gains totaling $3.7 million related to the sale of five aircraft and an engine, as well as the disposal of a Tay 650-15 engine. During 2012, the Company recorded gains totaling $1.4 million related to the sale of two aircraft and an engine. The Company also leased an engine pursuant to a finance lease in each of 2012 and 2013 and recorded related gains of $0.1 million in each of those years.

During 2013, the Company recorded $0.5 million of other income related to retention of a lessee's security deposits upon early termination of two leases following its bankruptcy in January 2013.

The Company's maintenance expense increased 115% to $8.8 million in 2013 from $4.1 million in 2012, as a result of increases in maintenance performed by lessees using non-refundable reserves and maintenance performed by the Company on off-lease aircraft. During 2013 and 2012, previously-collected non-refundable maintenance reserves, which had been recorded as revenue when earned, funded $4.8 million and $1.8 million, respectively, of the Company's maintenance expense in those years.

During 2013 and 2012, the Company added equipment to the lease portfolio of approximately $24.7 million and $30.5 million, respectively. The Company sold equipment with a book value of approximately $8.7 million and $4.9 million during 2013 and 2012, respectively. Depreciation and management fees in 2013 increased by 19% and 4%, respectively, over the previous year, primarily as a result of acquisitions and changes in residual assumptions from year to year.

The Company's interest expense decreased by 12%, from $4.6 million in 2012 to $4.1 million in 2013, primarily as a result of a lower average Credit Facility balance and lower amortization of Credit Facility fees in 2013.

The Company's insurance expense increased 35%, from $0.9 million in 2012 to $1.2 million in 2013, primarily due to aircraft that were on lease in 2012 but off lease in 2013.

Liquidity and Capital Resources

The Company is currently financing its assets primarily through debt financing and excess cash flows.

(a)Credit Facility

In March 2013, the Company's Credit Facility was increased to $130 million and extended to September 30, 2015. The Credit Facility is secured by all of the assets of the Company, including its aircraft and engine portfolio.

In November 2013, the Company obtained a waiver of compliance with a lessee concentration covenant under its Credit Facility agreement at the September 30, 2013 and December 31, 2013 calculation dates. This covenant is intended to monitor the concentration of recognized lease revenue attributable to the Company's largest lessees, as measured against the total recognized lease revenue from all lessees. The non-compliance resulted primarily from the Company's decision to recognize lease revenues from certain lessees from whom collectability was deemed not reasonably assured on a cash basis rather than an accrual basis (as is normally done for the Company's lessees), thereby reducing the rent attributable to those lessees and the Company's total lease revenue. As a result, lease revenue attributable to other lessees exceeded the percentage permitted in the covenant. The Company was in compliance with all other covenants under the Credit Facility agreement at December 31, 2013, and was in compliance with all covenants at December 31, 2012.

There can be no assurance that the Company will be in compliance with this covenant or any of the other covenants under the Credit Facility through its term, and in the event of any failure to be in compliance, the Company will need to seek additional waivers or amendment of applicable covenants from its lenders if such compliance failure is not timely cured. Any default under the Credit Facility, if not cured within the time permitted under the facility or waived by the lenders, could result in foreclosure upon any or all of the assets of the Company.

The Company's interest expense generally increases and decreases with prevailing interest rates. The Company has the ability to enter into interest rate swaps to economically hedge against interest rate increases in its floating rate debt under the Credit Facility and has done so in the past.

For additional information regarding the Company's credit facility, refer to Note 6 to the Company's financial statements in Item 8 of this Annual Report on Form 10-K.

(b)Cash flow

The Company's primary sources of cash are (i) rent payments due under the Company's operating and finance leases and (ii) refundable and non-refundable maintenance reserves billed monthly to lessees based on asset usage. The Company's leases do not require that cash collected by the Company for maintenance reserves and security deposits be segregated and, therefore, such cash is included in cash and cash equivalents on the Company's balance sheets.

The Company's primary uses of cash are for purchase of aircraft and engines, maintenance expense, management fees, professional fees, insurance, and Credit Facility interest and principal payments. The amount of interest paid by the Company depends on the outstanding balance of its Credit Facility, which carries a floating interest rate as well as an interest rate margin, and is therefore also dependent on changes in prevailing interest rates.

The timing and amount of the Company's payments for maintenance vary, depending on the timing of lessee-performed maintenance that is eligible for reimbursement, the aggregate amount of such claims and the timing and amount of maintenance incurred in connection with preparation of off-lease assets for re-lease to new customers. The Company's maintenance payments typically constitute a large portion of its cash needs, and the Company may from time to time borrow additional funds under the Credit Facility to provide funding for such payments.

Management believes that the Company will have adequate cash flow to meet its ongoing operational needs, including any required repayments under the Credit Facility due to borrowing base limitations, based upon its estimates of future revenues and expenditures, which include assumptions regarding (i) revenues for assets to be re-leased, (ii) required debt payments, (iii) interest rates, (iv) the cost and anticipated timing of maintenance to be performed and (v) timely use of proceeds of unused debt capacity toward additional acquisitions of income producing assets.

Although the Company believes that the assumptions it has made in forecasting its cash flow are reasonable in light of experience, actual results could deviate from such assumptions. Among the more significant factors that could have an impact on the accuracy of cash flow assumptions are (i) lessee non-compliance with lease obligations, (ii) inability to locate new lessees for returned equipment within a reasonable remarketing period, or at a rent level consistent with projected rates for the asset, (iii) lessee performance of maintenance, and payment of related maintenance claims, earlier than anticipated, (iv) inability to locate and acquire a sufficient volume of additional assets at prices that will produce acceptable net returns, (v) increases in interest rates, (vi) inability to timely dispose of off-lease assets at prices commensurate with their market value, and (vii) any one or a combination of the above factors that causes the Company to violate covenants under the Credit Facility agreement, which may in turn require repayment of some or all of the amounts outstanding.

(i)Operating activities

The Company's cash flow from operations decreased by $18.0 million in 2013 compared to 2012. As discussed below, the change in cash flow was primarily a result of decreases in payments received for operating lease revenue and maintenance reserves and an increase in payments for maintenance.

Payments for operating lease revenue and maintenance reserves

Payments received from lessees for rent decreased by $5.4 million in 2013 compared to 2012, primarily due to an increase in the number of off-lease assets and payment delinquencies in the 2013 period. Payments received for maintenance reserves decreased by $7.6 million in 2013 compared to 2012. Cash received for maintenance reserves revenue in 2012 included a $6.5 million payment from assignment of two leases from one lessee to a second lessee, as described in Note 3 to the Company's financial statements in Item 8 of this Annual Report on Form 10-K. In addition, the Company received less cash related to maintenance reserves revenue in 2013 as a result of payment delinquencies and assets that were on lease in 2012, but off lease in 2013.

The Company is receiving no lease revenue for its assets that are currently off lease, which assets are comprised of four Fokker 50 aircraft, one Saab 340B aircraft, six Fokker 100 aircraft, one General Electric CF34-8E engine, and one Tay 650-15 engine. The Tay 650-15 engine, which was acquired during the first quarter of 2013, is being held as a spare and used in connection with required maintenance on the Company's Fokker 100 aircraft.

Payments for maintenance

Payments for maintenance increased by $2.8 million in 2013 compared to 2012, primarily as a result of an increase in maintenance costs for off-lease aircraft. The amount of payments for maintenance in future periods will depend on the amount and timing of maintenance paid as reimbursement to lessees for maintenance reserves claims, which are dependent upon utilization and required maintenance intervals, and maintenance paid for off-lease assets.

(ii)Investing activities

During 2013 and 2012, the Company received cash of $11.0 million and $5.3 million, respectively, from the sale of assets. During the same time periods, the Company used cash of $25.0 million and $30.6 million, respectively, for purchases and capital improvement of aircraft.

(iii)Financing activities

The Company borrowed $19.0 million and $19.9 million under the Credit Facility during 2013 and 2012, respectively. In these same time periods, the Company repaid $9.3 million and $17.3 million, respectively, of its total outstanding debt under the Credit Facility. Such repayments were funded by excess cash flow. During 2013 and 2012, the Company paid $2.1 million and $1.6 million of fees related to the extension of the Company's Credit Facility. Such fees are amortized over the term of the Credit Facility.

- 6 -

Outlook

(a)General

The slow recovery from the global downturn has resulted in a significant reduction in airline passenger volume and, in reaction to that, a reduction in the number of aircraft and aircraft engines needed for operation by carriers in nearly all geographic areas, especially Europe. This presents a challenging environment for the Company in three respects:

There is an increased possibility of an unanticipated lessee default, as evidenced by the bankruptcies of two of the Company's customers in each of 2012 and 2013. A lessee's default and the unscheduled return of an asset to the Company for remarketing could result not only in reduced operating lease revenue but also in unanticipated, unrecoverable expenses arising from the lessee's default on its maintenance and return condition obligations. The Company monitors the performance of all of its customers and has noted that several of the Company's customers have experienced weakened operating results and have not yet achieved financial stability.

There is an increased possibility that the Company's current lessees will choose to return leased assets at lease expiration rather than renew the existing leases, notwithstanding that any such lessee may incur significant expenses to satisfy return conditions. Due to decreased demand for aircraft capacity, it is likely that the Company will experience lower on-lease utilization rates and longer lead times for remarketing of returned assets, as well as lower rental rates for remarketed assets, as was the case with several lease extensions and re-leases since 2011. This trend is expected to continue to affect the Company's operating revenue through 2014.

Finally, in the current environment of diminished demand for leisure and business air travel and consequently reduced capacity by carriers, there is likely to be a significant decrease in the pool of customers requiring aircraft. Any decrease in the pool of customers requiring aircraft could increase the Company's reliance on a small number of lessees, which increases the Company's risk of financial covenant compliance (see "Factors That May Affect Future Results - Concentration of Lessees and Aircraft Type," below).

(b)Operating Segments

The Company operates in one business segment, the leasing of regional aircraft to foreign and domestic regional airlines, and therefore does not present separate segment information for lines of business.

At February 28, 2014, the dominant types of aircraft in the Company's portfolio were as follows:

                         Number        % of net
Model                     owned       book value
Bombardier Dash-8-300          9               19 %
Bombardier CRJ-700             3               17 %
Fokker 100                     7               16 %
Bombardier Dash-8-Q400         3               14 %
Bombardier CRJ-705             1               10 %

- 7 -

For the month ended February 28, 2014, the Company's most significant sources of operating lease revenue were from the following regions:

                                     % of
                  Number           operating
Region          of lessees       lease revenue
North America             2                  26 %
Africa                    2                  22 %
Asia                      4                  17 %
Caribbean                 1                  15 %
Europe                    4                  15 %

(c)Remarketing Efforts

In March 2014, the Company sold a Fokker 50 aircraft. The Company is seeking remarketing opportunities for three Fokker 50 aircraft and one Saab 340B aircraft, which were returned in the second quarter of 2012, as well as a General Electric CF34-8E5 engine, which was returned in the fourth quarter of 2013.

In October 2013, the Company delivered a Fokker 100 aircraft to a new customer, and that customer has indicated that it may lease another of the Company's Fokker 100 aircraft, six of which were off lease at December 31, 2013. The Company has a signed letter of intent for the lease of two of the off-lease Fokker 100 aircraft, received an initial deposit and expects to deliver the aircraft during the second quarter of 2014. Although the Company had a signed letter of intent for the lease of the other three off-lease Fokker 100 aircraft with a start-up airline and received an initial deposit in 2013, the Company returned the deposit in early 2014 after a change in the customer's business plan. The Company is seeking remarketing opportunities for these Fokker 100 aircraft.

Unless they are renewed, leases for four of the Company's assets will expire during the first half of 2014 and the assets will be returned to the Company.

Two of the assets to be returned in 2014 are Dash-8-300 aircraft, which are on lease to a customer that is replacing its fleet with a different type of aircraft. The customer expects to return these aircraft, as well as two other Dash-8-300 aircraft it leases from the Company, in 2014 and early 2015. The Company will likely incur substantial maintenance expense in late 2014 or early 2015 related to the return of one of the aircraft when the customer uses non-refundable maintenance reserves to meet the return conditions of the lease. Such reserves, expected to total approximately $1.2 million, have been recorded as maintenance reserves revenue during the lease. Although the Company does not hold maintenance reserves for the remaining two aircraft to be returned, it holds security deposits of $1.0 million for each aircraft, which will be returned to the customer upon completion of the maintenance work required by the leases. Management believes that, given the current market for Dash-8-300 aircraft, it will be able to re-lease or sell the four returned aircraft in a timely manner.

The Company is considering selling some or all of its off-lease aircraft. The Company is analyzing the amount and timing of maintenance required to remarket the aircraft, the amount of which may differ significantly if the aircraft are sold rather than re-leased.

(d)Credit Facility

As discussed above in Liquidity and Capital Resources - Credit Facility, in November 2013, the Company obtained a waiver of compliance with a customer concentration covenant under its Credit Facility agreement at the September 30, 2013 and December 31, 2013 calculation dates.

The Company believes that available borrowings under the Credit Facility, considering possible lessee arrearages or off-lease periods, will be sufficient to meet its continuing obligations and to fund anticipated acquisitions. However, there can be no assurance the Company's beliefs will prove to be correct and that the Company will have sufficient cash to make any required Credit Facility repayments. In addition, there can be no assurance that the Company will be in compliance with the covenants under the Credit Facility through its term, and in the event of any non-compliance, the Company will need to seek waivers or amendment of applicable covenants from its lenders if such compliance failure is not timely cured. Any default under the Credit Facility, if not cured in the time permitted under the facility or waived by the lenders, could result in foreclosure upon any or all of the assets of the Company.

- 8 -

Factors that May Affect Future Results

Ownership Risks. The Company's leases are typically less than the entire anticipated remaining useful life of the leased assets. The Company's ability to recover its investment in an asset subject to such a lease is dependent upon the Company's ability to profitably re-lease or sell the asset after the expiration of the lease term. Some of the factors that have an impact on the Company's ability to re-lease or sell the asset include worldwide economic conditions, general aircraft market conditions, regulatory changes that may make an asset's use more expensive or preclude use due to the age of the aircraft or unless the asset is modified, changes in the supply or cost of aircraft equipment and technological developments that cause the asset to become obsolete. If the Company is unable to remarket its assets on favorable terms when the leases for such assets expire, the Company's financial condition, cash flow, ability to service debt and results of operations could be adversely affected.

The Company acquires used aircraft equipment. The market for used aircraft equipment has been cyclical, and generally reflects economic conditions and the strength of the travel and transportation industry. The demand for and value of many types of used aircraft in the recent past has been depressed by such factors as airline financial difficulties, the number of new aircraft on order and the number of aircraft coming off lease, as well as introduction of new aircraft models and types that may be more technologically advanced, more fuel efficient and/or less costly to maintain and operate. Values may also increase for certain aircraft types that become desirable based on market conditions and changing airline capacity.

In addition, a successful investment in an asset subject to a lease depends in part upon having the asset returned by the lessee in the condition as required under the lease. Each lease typically obligates a customer to return an asset to the Company in a specified condition, which generally requires it be returned in equal or better condition than at delivery to the lessee. If the lessee becomes insolvent during the term of its lease and the Company has to repossess the asset, it is unlikely that the lessee will have the financial ability to meet these return obligations and it is likely that the Company would be required to expend funds in excess of any maintenance reserves collected to return the asset to a remarketable condition. If the lessee files for bankruptcy and rejects the aircraft lease, although the lessee is required to return the aircraft, the lessee is relieved from all further obligations under the lease, including the obligation to return the aircraft in the condition required under the lease. In that case, it is also likely that the Company would be required to expend funds in excess of any maintenance reserves collected to return the asset to a remarketable condition.

Several of the Company's leases do not require payment of monthly maintenance reserves, which serve as the lessee's advance payment for its future repair and maintenance obligations. If repossession due to lessee default or bankruptcy occurs under such a lease, the Company will be left with the costs of unperformed repair and maintenance under the applicable lease and the Company may incur an unanticipated expense in order to re-lease or sell the asset.

Furthermore, the occurrence of unexpected adverse changes that impact the Company's estimates of expected cash flows generated from an asset may result in an asset impairment charge against the Company's earnings. The Company periodically reviews long-term assets for impairment, in particular, when events or changes in circumstances indicate the carrying value of an asset may not be recoverable. An impairment loss is recognized when the carrying amount of an asset is estimated to be not recoverable and exceeds its fair value. The Company may be required to recognize asset impairment charges in the future as a result of a prolonged weak economic environment, challenging market conditions in the airline industry or events related to particular lessees, assets or asset types.

Lessee Credit Risk. The Company carefully evaluates the credit risk of each customer and attempts to obtain a third party guaranty, letters of credit or other credit enhancements, if it deems them necessary in addition to customary security deposits. There can be no assurance, however, that such enhancements will be available, or that, if obtained, will fully protect the Company from . . .

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