1030-1100 tbe managing lease return for low cost

Managing Lease Returns for Lowest Cost

19 October 2011

Copyright TBE International Limited 2011 2

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Who are we? TBE international Limited (TBE) is a boutique Hong Kong based consulting and contracting company incorporated in February 2007, specialising in Aviation and Aviation associated management and advisory services.


1. Operating lease overview 2. Whats important to a lessor and lessee 3. The role of return conditions in a lessors business model 4. Typical return conditions 5. Ways to comply with return conditions 6. Maintenance reserves 7. What are reasonable return conditions 8. Can return conditions be negotiated 9. Case Study: Lease return examples 10. Summary

Agenda

This presentation focuses on aircraft operating leases from an airline perspective but these concepts are equally valid for engine operating lease

management

Copyright TBE International Limited 2011

Aircraft under operational control of next Lessee

Lessor will try to match conditions

4

Typical structure of aircraft operating leases

Aircraft under operational control of Lessee

Out Going/ Return

Condition

In coming/ Delivery

Condition

Governed by Airlines Lease Agreement Governed by next Lease Agreement

Paid by Lessee Paid by next Lessee Financial Risk of Lessor

Lease Term Next Lease Term

In coming/ Delivery

Condition

New Second Hand

Lessee default risk Lessee default risk


Wants of the lessor and lessee

Lessor (Leasing Company):

Preserve value of the aircraft Well maintained

Wants the aircraft returned on time at end of lease term

Lessee does not deteriorate the marketability of the aircraft

Make money

Lessee (Airline):

Operate the aircraft safely Well maintained

Wants the aircraft returned on time at end of lease term

Operate the aircraft as cheap as possible

Make money

The objectives of the leasing company and airline are not too dissimilar

?

/ Should be similar


Residual value of the aircraft is a key consideration in a lessors business model

Role of return conditions in the lessors business case

Consider a simplified leasing business model:

!"#$

!%#$

!$

!'#$

!(#$

#$

(#$

'#$

$

%#$

"#$

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Ca

sh

flo

w

Years

Incremental

Cumulative

Rent Aircraft Sale/Part Out

Aircraft Purchase

The Return Condition of aircraft has a direct effect on the potential residual value A low maintenance life aircraft is worth less than a high maintenance life aircraft

This is only a factor when aircraft are sold or parted out at the end of its life. However this issue is managed by lessors from aircraft acquisition


So what happens lease returns are not managed well?


Help preserve value of the aircraft? Help return aircraft on time? Increase the marketability of the aircraft? Help make money?

Lessee (Airline):

Make aircraft safer? Help return aircraft on time? Reduce operating costs? Help make money?

Generally, neither the leasing company or the returning airline benefit .perhaps the new lessee gets a free ride

When lease returns are poorly managed it results in

Excess Maintenance = $$$$$

So who benefits from excess maintenance?


Generally cause airlines trouble ($)

at return

Generally easily complied with

at return

8

Typical return conditions

What are some typical aircraft return conditions: 1. Minimum return lives and performance/overhaul life (generally engines, APU,

components and landing gear) 2. FAA and/or EASA compliance 3. No component/part fitted >X% total time of Airframe 4. Permanent/flush repairs 5. No locally approved modifications 6. Documentation availability 7. Full repaint redelivery as white tail 8. Same configuration as delivered no unapproved reconfigurations etc 9. Airframe check minimum limitations, eg: fresh from C check 10.Demonstration flight and ground inspection 11.Same engines as delivery 12.ADs complied with at up to X days after the redelivery date 13.Deregister and Export C of A


Solution: Get to know your leases and implement management processes

Solution: (no easy solution) Plan for lease returns early (begin 2 years out) Engage the lessor early and negotiate financial compensation Work with fleet planning department to vary aircraft disposal plan

Solution: Get involved in all leasing negotiations engineering is an important area

1. The aircraft were not managed for a lease return throughout out the lease terms Maintenance department may not know aircraft was leased Maintenance department did not have processes in place to manage

2. Scheduled maintenance does not coincide with return date Fleet planning department unaware of maintenance plan constrains

3. Maintenance department was not involved in lease negotiation process Return conditions are unreasonable

9

Why do certain return conditions cause trouble?

Once an airline is in the lease return process its too late .. Only additional maintenance and cost will rectify the situation.


1. Do the Maintenance

2. Financial Compensation in lieu of Maintenance

Different ways to comply with return conditions

Pros (for an airline)

No burden if maintenance was scheduled

Good solution if maintenance was not scheduled

Use maintenance reserves as a mechanism

Cons (for an airline)

A burden if maintenance wasnt scheduled

Airline may have to do extra maintenance to return aircraft (you cant do structural check!)

Debate on the rate and mechanism of compensation

There are only 2 ways to comply with Return Conditions


Financial compensation is the $ compensation for maintenance time used by airline

So how to calculate? .. Lets take an LLP as an example

Some considerations with financial compensation

Part Cost at Delivery = US$300,000 Life Limit at Delivery = 15,000 cyc

US$300,000 15,000

= US$20/cyc

Easy Right?

Well maybe.. . Consider the situation at Redelivery

Part Cost at Return = US$360,000 Life Limit at Return = 20,000 cyc

US$360,000 20,000

= US$18/cyc

If life limits increase, generally the unit cost goes down . But it could go the other way as well !


Delivery Condition: 50% life Return Condition: financial compensation to 50% life Utilisation: 2,500 cyc / year

12

The real question is: Should maintenance time be costed at the incoming (delivery) or outgoing (redelivery) unit cost?

Lets look at an example using the same LLP at a theoretical zero life return . But first we need to set some delivery/redelivery conditions and operating conditions

Some considerations with financial compensation

Generally outgoing cost adjustment is fairer, but this could go the other way. % based minimum lives can also be a problem

At Delivery 50% Life = At Return 50% Life =

Cycles 7,500

10,000

TOW 3 years 4 years

Equivalent Incoming Unit Cost

US$150k US$200k

Equivalent Outgoing Unit Cost

US$135k US$180k

Incoming Unit Cost Case: Airline gives extra lessor 2,500cyc/1 year life AND pays extra US$50k

Outgoing Unit Cost Case: Airline gives lessor an extra 2,500cyc/1 year life AND pays extra US$30k


Lets look at maintenance reserves from each parties perspective:

Role of maintenance reserves


Hedge against credit risk of Lessee In case of default

Make money Interest on reserves Cash flow (if unpreserved) Retained reserves at end of lease

(depends on situation)

Lessee (Airline):

Increased total operating cost Limits in draw down scope Retained reserves at end of lease Combined with return conditions

Cash flow impact No maintenance honeymoon Double payment if PBH in place

The reality is, if a Lessor sees the Airline as a credit risk, the airline will pay either an increased lease rate and/or maintenance reserves.

Question: Should an airline pay maintenance reserves? Answer: Maybe..

.but the airline might not have any choice


When can maintenance reserves work well for an airline? 1. For short leases limited or no return conditions 2. Leasing second hand aircraft, using a mirror in-out concept for delivery and return

conditions Delivery Condition = Return Condition with up/down financial adjustment via maintenance

reserves

When can maintenance reserves work?

Other considerations for an airline to make maintenance reserves work 1. Limit or remove return condition minimums

allow MRs to act as compensation 2. Insert a betterment clause if minimums exist

if an airline puts in maintenance value over and above return conditions lessor refunds at MR rate

3. Ensure reserve rates cover ONLY the scope covered by draw down 4. Utilise letter of credit for reserves rather than paying cash


Is airline considered a good credit?

15

Remember. . the lessor normally wants to be able to remarket the aircraft after your lease term . there is single no easy answer, each operator and aircraft are different

What are reasonable return conditions?

Consider the following as a simple guide to structure your conditions:

Is lease term

>C check interval?

Yes

Aircraft remarketing candidate?

(~


Considerations as to how far these are negotiable depend on:

1. Credit worthiness of the airline (real and perceived) 2. The lease rate the airline is prepared to pay 3. Lessor aircraft placement risk post current lease term (depends on aircraft type)

16

Yes. . Return conditions and maintenance reserves are commercial in nature so they are negotiable to a point.

Are return conditions and maint reserves negotiable?

Was the aircraft new

General Rules for maintenance reserves: Flag carriers and US airlines. Will not pay maintenance reserves Start-up airlines Will pay maintenance reserves


Higher Rent Rate Lower

Return Exposure

17

Remember. . Return conditions effect aircraft residual value so they MUST be taken into consideration when assessing a lease proposal

General rule (all other things being equal):

A point to remember when negotiating return conditions

Was the aircraft new

Higher Return Exposure Lower

Rent Rate

Or put

another way

Also Remember. . Nothing comes for free

But make sure you get value for the return condition exposure and maintenance reserves you sign up to (use NPV and cash flow analysis)


Question: Can PBH programs and leasing work?

Answer: Yes .but there are problems with building in return conditions with maintenance reserves

Dual cash flow Draw down of reserves due to pricing and invoicing maintenance visits

PBH and leasing?

The ultimate solution is a transportable cradle to grave PBH which will eliminate the need for return conditions and maintenance reserves

The concept is a good one but

It requires all operators to enter into a PBH There is difficulty in pricing PBH rate for different operators

. But the 787/A380 model gives the opportunity via, TCA, OnPoint, GoldCare, FHS etc


Lets have a look at some real life examples.

Case Studies


% based reconciliation but at today's price Outgoing Unit Cost

20

Case 1: Maintenance compensation of engine LLPs

Situation: Lease return after a 12 year term. Aircraft was subject to a sale and lease back

transaction so went into lease second hand. The airline and lessor are arguing the compensation mechanism

Lessee Position: The lease agreement defines return compensation as:

Compensation = (A - B) x E D

Where: A = Remaining Life at Delivery B = Remaining Life at Redelivery C = Life limit of part at Delivery D = Life limit of part at Redelivery E = List price of part at Redelivery

Lessor Position: ..I see you are using the formula stipulated in XYZ of the lease agreement. However the formula is wrong. It should be.

Compensation= A - B x E C D +US$2 m

The issue was caused by the operator fitting a higher ultimate life LLP during lease term


Case 2: Return cost reduction

Situation: Airline is required to return 1 aircraft, but has anther 2 aircraft due for return with the

same lessor in the next 12 months Return conditions are unusually harsh

Cost Drivers: ADDs, cockpit repaint, components


Case 2: Return cost reduction cont

Strategy: A/C #1 has the highest lease rate so it should be returned if possible Use a combination of serviceable transfers between aircraft, financial compensation

and negotiation to reduce exposure.

Managed items: Remove cockpit repaint, comp 50% of check, no hull repaint Swap eng from A/C#3 & pay comp on other Vary to half life

A/C #1

Return Date DueLease Rate +$60k/mth

Forecast Lease Return Cost

General Maint 0.5

Airframe 4.3

Engines 10.2

APU 0.6

Landing Gear 0.0

Total 15.6

A/C #1

Due

+$60k/mth

0.2

0.8

3.2

0.0

0.0

4.2Reduction of US$11.4m

An airline needs to be creative and work with lessor early . in this case discussions started 18 months out


Summary

Engage the Lessor early Start planning 18-24 months ahead of return date

Hands off lease management does not work Build the management principles into your regular business processes now Need to keep an eye on quality and standards

Get involved Be part of the lease negotiation process Work with the fleet planning department.. you will save money!

When you get to the lease return check its too late At this point is only a question of how much

Be prepared Have paperwork ready for inspection Have all questionable issues resolved prior to lease return check

There is no magic formula each operator / aircraft is unique Be creative and employ all management techniques

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Thank You!


For further information please contact:

TBE International Limited

Level 19, Two International Finance Centre. 8 Finance Street, Central. Hong Kong.

Phone: +852 3101 7286 Fax: +852 3101 7287

Email: [email protected] or [email protected] (direct)

1030-1100 tbe managing lease return for low cost

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