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Managing Lease Returns for Lowest Cost

19 October 2011

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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.

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


Governed by Airlines Lease Agreement

Governed by next Lease Agreement

Lease Term

In coming/
Delivery
Condition

Aircraft under operational


control of Lessee

Next Lease Term

Out Going/
Return
Condition

New
Second Hand

In coming/
Delivery
Condition

Aircraft under operational


control of next Lessee

Lessor will try


to match conditions

Financial Risk
of Lessor

Paid by Lessee
Lessee default risk

Paid by next Lessee


Lessee default risk

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Wants of the lessor and lessee


Lessor (Leasing Company):
Preserve value of the aircraft

Lessee (Airline):

Operate the aircraft safely

Wants the aircraft returned on


time at end of lease term

Wants the aircraft returned on


time at end of lease term

Lessee does not deteriorate the


marketability of the aircraft

Operate the aircraft as cheap as


possible

Well maintained

Well maintained

Should be similar

Make money

Make money

The objectives of the leasing company and airline are not too dissimilar
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Role of return conditions in the lessors business case


Residual value of the aircraft is a key consideration in a lessors business model
Consider a simplified leasing business model:
"#$
%#$
&#$

Cashflow

'#$

Rent

Aircraft
Sale/Part Out

(#$

Incremental

#$
!(#$

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

Cumulative

!'#$

Aircraft
Purchase

!&#$
!%#$
!"#$

Years

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

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So what happens lease returns are not managed well?


When lease returns are poorly managed it results in
Excess Maintenance = $$$$$
So who benefits from excess maintenance?
Lessee (Airline):

Lessor (Leasing Company):

Help return aircraft on time?

Increase the marketability of the aircraft?


Help make money?

Help preserve value of the aircraft?

Help return aircraft on time?


Reduce operating costs?
Help make money?

Make aircraft safer?

Generally, neither the leasing company or the returning airline benefit


.perhaps the new lessee gets a free ride
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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

Generally cause
airlines trouble ($)
at return

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

Generally easily
complied with
at return

13.Deregister and Export C of A


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Why do certain return conditions cause trouble?


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
Solution:
Get to know your leases and implement management processes

2. Scheduled maintenance does not coincide with return date

Fleet planning department unaware of maintenance plan constrains

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

3. Maintenance department was not involved in lease negotiation process


Return conditions are unreasonable
Solution:
Get involved in all leasing negotiations engineering is an important area

Once an airline is in the lease return process its too late


.. Only additional maintenance and cost will rectify the situation.
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Different ways to comply with return conditions


There are only 2 ways to comply with Return Conditions
Pros (for an airline)
1. Do the Maintenance

2. Financial Compensation
in lieu of Maintenance

No burden if maintenance
was scheduled

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!)

Good solution if
Debate on the rate and
maintenance was not
mechanism of
scheduled
compensation
Use maintenance reserves
as a mechanism
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Some considerations with financial compensation


Financial compensation is the $ compensation for maintenance time used by airline
So how to calculate?
.. Lets take an LLP as an example

Easy
Right?
US$300,000

Part Cost at Delivery = US$300,000


Life Limit at Delivery = 15,000 cyc

15,000

= US$20/cyc

Well maybe..
. Consider the situation at Redelivery
US$360,000

Part Cost at Return = US$360,000


Life Limit at Return = 20,000 cyc

20,000

= US$18/cyc

If life limits increase, generally the unit cost goes down


. But it could go the other way as well !

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Some considerations with financial compensation


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

Cycles
7,500
10,000

Equivalent
TOW Incoming Unit Cost Outgoing Unit Cost
US$150k
US$135k
3 years
4 years
US$200k
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
Generally outgoing cost adjustment is fairer, but this could go the other way.
% based minimum lives can also be a problem
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Role of maintenance reserves


Lets look at maintenance reserves from each parties perspective:
Lessor (Leasing Company):

Lessee (Airline):

Hedge against credit risk of Lessee

Increased total operating cost

In case of default

Limits in draw down scope


Retained reserves at end of lease
Combined with return conditions

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

Cash flow impact


No maintenance honeymoon
Double payment if PBH in place

Question: Should an airline pay maintenance reserves?


Answer: Maybe..
.but the airline might not have any choice
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.
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When can maintenance reserves work?


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

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
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What are reasonable return conditions?


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
+ EASA or FAA
Consider the following as a simple guide to structure your conditions: + Remove markings
+ Permanent repair
etc
Is lease
0-1 year of operating life
No
term
+ Up/down financial compensation for
>C check
Yes
time used via MRs or lump sum payment
interval?

Yes

No
Pay
maintenance
No
reserves

Is airline
considered a
good credit?

Was the
aircraft new
Yes at delivery

C check interval (typically 2 years)


No operating life
+ Up/down financial compensation for
time used via mirror in mirror out (using
MRs or lump sum payment)

Yes

Aircraft
remarketing
candidate?
(~<20 years old)
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C check interval (typically 2 years)


operating life

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Are return conditions and maint reserves negotiable?


Yes.
. Return conditions and maintenance reserves are commercial in nature so
they are negotiable to a point.
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)
General Rules for maintenance reserves:
Flag carriers and US airlines. Will not pay maintenance reserves
Start-up airlines Will pay maintenance reserves

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A point to remember when negotiating return conditions


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):

Lower
Return Exposure

Higher
Rent Rate

Or
put
another
way

Higher
Return Exposure

Lower
Rent Rate

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)
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PBH and leasing?


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

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
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Case Studies

Lets have a look at some real life examples.

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

Lessee Position:
The lease agreement defines return
compensation as:
Compensation = (A - B) x E
D

+US$2 m

% based reconciliation
but at today's price

Outgoing Unit Cost


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

Compensation= A - B x E
C
D

The issue was caused by the operator fitting


a higher ultimate life LLP during lease term
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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

Return Date
Lease Rate

A/C #1
A/C #2
A/C #3
Due
+12 months +12 months
+$60k/mth Baseline
+$50k/mth

Cost Drivers:
ADDs, cockpit repaint, components <110% TT
50% struct check life remaining, hull repaint

Forecast Lease Return Cost


General Maint
0.5

0.4

0.5

Airframe

4.3

4.3

0.5

Engines

10.2

0.0

11.7

APU

0.6

0.6

0.6

4,000 cyc LLP and performance life


Fresh from SV

Landing Gear

0.0

0.0

1.0

30% life remaining

15.6

5.3

14.3

Total

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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.
Return Date
Lease Rate

A/C #1
Due
+$60k/mth

A/C #1
Due
+$60k/mth

Forecast Lease Return Cost


General Maint
0.5

Managed items:
Remove cockpit repaint, comp <125% TT

0.2

Airframe

4.3

Pay comp >50% of check, no hull repaint

0.8

Engines

10.2

Swap eng from A/C#3 & pay comp on other

3.2

Vary to half life

0.0

APU

0.6

Landing Gear

0.0

Total

15.6

0.0
4.2

Reduction of US$11.4m

An airline needs to be creative and work with lessor early


. in this case discussions started 18 months out
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Summary
Get involved
Be part of the lease negotiation process
Work with the fleet planning department.. you will save money!

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

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

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

There is no magic formula each operator / aircraft is unique


Be creative and employ all management techniques
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Thank You!

TBECapability through people


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For further information please contact:


TBE International Limited
Level 19, Two International Finance Centre.
8 Finance Street,
Central. Hong Kong.
Phone:
Fax:

+852 3101 7286


+852 3101 7287

Email:

enquiries@tbeinternational.com
or
tbemstein@tbeinternational.com (direct)

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