News Column

WILLIS LEASE FINANCE CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

May 6, 2014

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"). In 2013, the Company launched a new, wholly-owned subsidiary, Willis Aeronautical Services, Inc. ("WASI"). WASI primarily engages in selling aircraft engine parts and materials through the acquisition or consignment of aircraft and engines from third parties.

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 2013 Form 10-K.

Results of Operations



Three months ended March 31, 2014, compared to the three months ended March 31, 2013:

Lease Rent Revenue. Lease rent revenue for the three months ended March 31, 2014 increased 9.9% to $26.9 million from $24.5 million for the comparable period in 2013. This increase was primarily due to higher utilization rates in the first quarter of 2014 and an increase in the average size of the lease portfolio during the quarter, which translated into a higher amount of equipment on lease. The aggregate of net book value of lease equipment at March 31, 2014 and 2013 was $1,022.5 million and $1,019.3 million, respectively, an increase of 0.3%. The average utilization for the three months ended March 31, 2014 and 2013 was 87% and 84%, respectively. At March 31, 2014 and 2013, respectively, approximately 84% and 82% of equipment held for lease by book value was on-lease.

During the three months ended March 31, 2014, we added $8.0 million of equipment and capitalized costs to the lease portfolio. During the three months ended March 31, 2013, we added $78.7 million of equipment and capitalized costs to the lease portfolio.

Maintenance Reserve Revenue. Our maintenance reserve revenue for the three months ended March 31, 2014 increased 52.2% to $14.0 million from $9.2 million for the comparable period in 2013. The increase was due to higher maintenance reserve revenues recognized related to the termination of long term leases in the three months ended March 31, 2014 than in the year ago period.

Gain on Sale of Leased Equipment. During the three months ended March 31, 2014, we sold two engines and other related equipment generating a net gain of $0.3 million. During the three months ended March 31, 2013, we sold seven engines and other related equipment generating a net gain of $0.7 million.

Other Revenue. Our other revenue consists primarily of management fee income, lease administration fees as well as net spare parts sales and third party consignment commissions earned by our WASI subsidiary. Other revenue increased to $1.8 million from $0.9 million for the comparable period in 2013 primarily due to an increase in fees earned related to engines managed on behalf of third parties which increased in number from the year ago period and revenue resulting from commissions on third party spare parts sales.

Depreciation and Amortization Expense. Depreciation and amortization expense increased 15.4% to $15.7 million for the three months ended March 31, 2014 from $13.6 million in the comparable period in 2013, due to growth in the lease portfolio and changes in estimates of useful lives and residual values on certain older engine types that occurred in 2013 but did not affect the first quarter of 2013. As of July 1, 2013, we adjusted the depreciation for certain older engine types. It is our policy to review estimates regularly to reflect the cost of equipment over the useful life of these engines. The 2013 change in depreciation estimate resulted in a $2.1 million increase in depreciation for the three months ended March 31, 2014. The net effect of the 2013 change in depreciation estimate is a reduction in net income of $1.4 million or $0.17 in diluted earnings per share for the three months ended March 31, 2014 over what net income would have otherwise been had the change in depreciation estimate not been made.

Write-down of Equipment. A write-down of equipment totaling $0.3 million was recorded in the three months ended March 31, 2014 due to a management decision to consign an engine for part out and sale, in which the assets net book value exceeds the estimated proceeds from part-out. There was no write-down of equipment recorded in the three months ended March 31, 2013.

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General and Administrative Expenses. General and administrative expenses increased 17.1% to $9.7 million for the three months ended March 31, 2014, from $8.3 million in the comparable period in 2013, due primarily to increases in consulting and accounting fees ($0.5 million), salary expense ($0.3 million) and travel and entertainment expense ($0.3 million).

Technical Expense. Technical expenses consist of the cost of engine repairs, engine thrust rental fees, outsourced technical support services, engine storage and freight costs. These expenses decreased 9.2% to $1.5 million for the three months ended March 31, 2014, from $1.7 million in the comparable period in 2013 due mainly to decreases in technical support service expenses ($0.2 million) and engine freight expenses ($0.2 million), which was partially offset by a increase in engine maintenance costs ($0.3 million).

Net finance costs. Net finance costs increased 1.4% to $9.4 million for the three months ended March 31, 2014, from $9.2 million net finance costs in the comparable period in 2013, due primarily to an increase in the average debt outstanding which was partially offset by lower average one-month LIBOR in the first quarter of 2014. Notes payable balance at March 31, 2014 and 2013, was $767.1 million and $757.1 million, respectively, an increase of 1.3%. As of March 31, 2014, $392.3 million of our debt is tied to one-month U.S. dollar LIBOR which decreased from an average of 0.20% for the three months ended March 31, 2013 to an average of 0.15% for the three months ended March 31, 2014 (average of month-end rates). As of March 31, 2014 and 2013, one-month LIBOR was 0.15% and 0.20%, respectively.

To mitigate exposure to interest rate changes, we periodically enter into interest rate swap agreements. As of March 31, 2013, one swap agreement had a notional outstanding amount of $100.0 million with a remaining term of eight months and a fixed rate of 2.10%. This interest rate swap agreement matured in November 2013. In the three months ended March 31, 2013, $0.4 million was realized on the statement of income as an increase in interest expense as a result of this swap. No swap agreements existed during the three months ended March 31, 2014.

Income Tax Expense. Income tax expense for the three months ended March 31, 2014 and 2013 was $2.4 million and $1.0 million, respectively. The effective tax rate for the three months ended March 31, 2014 and 2013 was 35.7% and 38.5%, respectively. The Company records tax expense or benefit for unusual or infrequent items discretely in the period in which they occur. 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 July 2013, the FASB issued Accounting Standards Update ("ASU") 2013-11, "Income Taxes - Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists" which is part of Accounting Standards Codification ("ASC") 740: Income Taxes. The new guidance requires an entity to present an unrecognized tax benefit and an NOL carryforward, a similar tax loss, or a tax credit carryforward on a net basis as part of a deferred tax asset, unless the unrecognized tax benefit is not available to reduce the deferred tax asset component or would not be utilized for that purpose, then a liability would be recognized. We adopted this ASU as of January 1, 2014. 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 $5.0 million and $69.0 million in the three-month periods ended March 31, 2014 and 2013, respectively, was derived from this activity. In these same time periods, $25.5 million and $8.9 million, respectively, was used to pay down related debt. Cash flow from operating activities was $18.8 million and $18.6 million in the three-month periods ended March 31, 2014 and 2013, respectively.

At March 31, 2014, $8.8 million in cash and cash equivalents and restricted cash were held in foreign subsidiaries. We do not intend to repatriate the funds held in foreign subsidiaries to the United States. In the event that we decide to repatriate these funds to the United States, we would be required to accrue and pay taxes upon the repatriation.

Our primary use of funds is for the purchase of equipment for lease. Purchases of equipment (including capitalized costs) totaled $7.9 million and $79.6 million for the three-month periods ended March 31, 2014 and 2013, respectively.

Cash flows from operations are driven significantly by payments made under our lease agreements, which comprise lease revenue, security deposits and maintenance reserves, and are offset by net finance costs and general and administrative costs. Note that cash received from maintenance reserve arrangements for some of our engines on lease are restricted per our WEST II debt agreement. Cash from WEST II engine maintenance reserve payments, that can be used to fund future

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maintenance events, are held in the restricted cash account equal to the maintenance obligations projected for the subsequent six months, and are subject to a minimum balance of $9.0 million. The lease revenue stream, in the short-term, is at fixed rates while a portion 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 and operating cash flows. Revenue and maintenance reserves are also affected by the amount of equipment off lease. Approximately 84%, by book value, of our assets were on-lease at March 31, 2014 compared to 82% at March 31, 2013. The average utilization rate was 87% and 84% for the three month periods ended March 31, 2014 and March 31, 2013, respectively. 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, 2014, Notes Payable consists of loans totaling $767.1 million, payable over periods of approximately 6 months to 8 years with interest rates varying between approximately 2.4% and 5.5%.

At March 31, 2014, we had a $450.0 million revolving credit facility to finance the acquisition of aircraft engines for lease as well as for general working capital purposes. As of March 31, 2014 and December 31, 2013, $101.0 million and $88.0 million was available under this facility, respectively. The revolving credit facility ends in November 2016. Based on the Company's debt to equity ratio of 3.87 as calculated under the terms of the revolving credit facility at December 31, 2013, the interest rate on this facility is LIBOR plus 3.00% as of March 31, 2014. Under the revolving credit facility, all subsidiaries except WEST II and WOLF 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 17, 2012, we closed an asset-backed securitization ("ABS") through a newly-created, bankruptcy-remote, Delaware statutory trust, Willis Engine Securitization Trust II, or "WEST II", of which the Company is the sole beneficiary. WEST II issued and sold $390 million aggregate principal amount of Class 2012-A Term Notes (the "Notes") and received $384.9 million in net proceeds. We used these funds, net of transaction expenses and swap termination costs, in combination with our revolving credit facility to pay off the prior WEST notes totaling $435.9 million. At closing, 22 engines were pledged as collateral from WEST to the Company's revolving credit facility, which provided the remaining funds to pay off the WEST notes.

The assets and liabilities of WEST II will remain on the Company's balance sheet. The current portfolio of 71 commercial jet aircraft engines and leases thereof secures the obligations of WEST II under the ABS. The Notes have no fixed amortization and are payable solely from revenue received by WEST II from the engines and the engine leases, after payment of certain expenses of WEST II. The Notes bear interest at a fixed rate of 5.50% per annum. The Notes may be accelerated upon the occurrence of certain events, including the failure to pay interest for five business days after the due date thereof. The Notes are expected to be paid 10 years from the issuance date by September 17, 2022. The legal final maturity of the Notes is September 15, 2037.

In connection with the transactions described above, effective September 17, 2012, the Company entered into a Servicing Agreement and Administrative Agency Agreement with WEST II to provide certain engine, lease management and reporting functions for WEST II in return for fees based on a percentage of collected lease revenues and asset sales. Because WEST II is consolidated for financial statement reporting purposes, all fees eliminate upon consolidation.

At March 31, 2014 and December 31, 2013, $366.1 million and $370.6 million of WEST II term notes were outstanding, respectively. The assets of WEST II are not available to satisfy our obligations or any of our affiliates other than the obligations specific to WEST II. WEST II is consolidated for financial statement presentation purposes. WEST II'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 II's maintenance of adequate reserves and capital. Under WEST II, 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, a portion of maintenance reserve payments and all lease security deposits are accumulated in restricted accounts and are available to fund future maintenance events and to secure lease payments, respectively. Cash from maintenance reserve payments are held in the restricted cash account equal to the maintenance obligations projected for the subsequent six months, and are subject to a minimum balance of $9.0 million.

On September 18, 2013, we completed the acquisition of the fifty percent membership interest held by the other joint venture partner in WOLF, with the transaction being accounted for as an asset acquisition. With this acquisition, WOLF is consolidated for financial statement presentation purposes. Two term notes with an original principal amount of $36.0 million, with a current balance outstanding of $27.8 million and $30.0 million as of March 31, 2013 and December 31, 2013, respectively, are included in Notes payable. The two term notes are non-recourse, have a maturity date of May 28, 2017 and interest is payable at one-month LIBOR plus 4.0%.

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The assets of WOLF are not available to satisfy our obligations or any of our affiliates other than the obligations specific to WOLF. WOLF's ability to make distributions to the Company is subject to the prior payments of all of its debt and other obligations. Under WOLF, cash related to parts sales and leasing of engine assets is collected in a restricted account and used to pay certain operating expenses, service the debt, and upon full debt repayment are distributed to the Company.

On January 10, 2014, we extended the term of an existing loan that was scheduled to mature on January 11, 2014. The loan has a term of 4 years with a maturity date of January 11, 2018. Interest is payable at one-month LIBOR plus 2.25% and principal and interest is paid quarterly. The loan is secured by three engines. The balance outstanding on this loan is $15.5 million and $15.8 million as of March 31, 2014 and December 31, 2013, respectively.

On September 28, 2012, we closed on a loan for a five year term totaling $8.7 million. Interest is payable monthly at a fixed rate of 5.50% and principal is paid quarterly. The loan is secured by one engine. The funds were used to purchase the engine secured under the loan. The balance outstanding on this loan is $8.1 million and $8.2 million as of March 31, 2014 and December 31, 2013, respectively.

On September 30, 2011, we closed on a 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 $0.7 million and $1.0 million as of March 31, 2014 and December 31, 2013, respectively.

As of March 31, 2014 and 2013, one-month LIBOR was 0.15% and 0.20%, respectively.

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.

At March 31, 2014, we are in compliance with the covenants specified in the revolving credit facility Credit Agreement, including the Interest Coverage Ratio requirement of at least 2.50 to 1.00, and the Total Leverage Ratio requirement to remain below 4.75 to 1.00. At March 31, 2014, the Company's calculated Minimum Consolidated Tangible Net Worth exceeded the minimum required amount of $199.3 million. As defined in the revolving credit facility Credit Agreement, the Interest Coverage Ratio is the ratio of Earnings before Interest, Taxes, Depreciation and Amortization and other one-time charges (EBITDA) to Consolidated Interest Expense and the Total Leverage Ratio is the ratio of Total Indebtedness to Tangible Net Worth. At March 31, 2014, we are in compliance with the covenants specified in the WEST II indenture and servicing agreement.

Approximately $25.5 million of our debt is repayable during the next 12 months. 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, 2014:

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 $ 767,108$ 25,545$ 411,519$ 72,470$ 257,574 Interest payments under long-term debt obligations 163,908 32,692 57,823 31,768 41,625 Operating lease obligations 4,217 1,139 1,788 1,290 - Purchase obligations 34,227 34,227 - - - Total $ 969,460$ 93,603$ 471,130$ 105,528$ 299,199



We have estimated the interest payments due under long-term debt by applying the interest rates applicable at March 31, 2014 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.

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We have made purchase commitments to secure the purchase of three engines and one aircraft and related equipment for a gross purchase price of $36.2 million, for delivery in 2014. As of March 31, 2014, non-refundable deposits paid related to these purchase commitments were $2.0 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 order with CFM for one engine represents deferral of engine deliveries originally scheduled for 2009 and are included in our commitments to purchase in 2014.

We occupy space in Novato under a lease that covers approximately 20,534 square feet of office space and expires September 30, 2018. The remaining lease rental commitment is approximately $2.4 million. Equipment leasing, financing, sales and general administrative activities are conducted from the Novato location. We sub-lease office and warehouse space for our operations in San Diego, California. This lease expires October 31, 2014, and the remaining lease commitment is approximately $88,000. We lease office and warehouse space in Shanghai, China. The office lease expires December 31, 2014 and the warehouse lease expires July 31, 2017 and the remaining lease commitments are approximately $49,000 and $24,000, respectively. We lease office space in London, United Kingdom. The lease expires December 21, 2015 and the remaining lease commitment is approximately $131,000. We lease office space in Blagnac, France. The lease expires December 31, 2014 and the remaining lease commitment is approximately $15,000. We lease office space in Dublin, Ireland. The lease expires May 15, 2017 and the remaining lease commitment is approximately $37,000. We lease office and warehouse space in Boynton Beach, Florida. The lease expires October 29, 2019 and the remaining lease commitment is approximately $1.3 million.

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. We are discussing additions to our capital base with our commercial and investment banks. 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, 2014, $392.3 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 periodically enter 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 no interest rate swap agreements in place.

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. 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 (deceased) / increased net finance costs by ($0.1 million) and $0.4 million for the three months ended March 31, 2014 and March 31, 2013, respectively. This incremental cost for the swaps effective for hedge accounting was included in net finance costs for the respective periods. For further information see Note 6 to the unaudited consolidated financial statements.

For any interest rate swaps that we enter into, we will be exposed to risk in the event of non-performance of the interest rate hedge counter-parties. We anticipate that we may hedge additional amounts of our floating rate debt in the future.


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