The following discussion should be read in conjunction with the Company's Form 10-K for the year ended December 31, 2017 and the unaudited financial statements and related notes that appear elsewhere in this report.
Pursuant to Instruction 2 to Item 303(b) of Regulation S-K promulgated by the Securities and Exchange Commission, in preparing this discussion, the Company has presumed that readers have access to and have read the discussion under the same heading that appears in the Company's Form 10-K for the year ended December 31, 2017. The following discussion contains forward-looking statements. Please see the cautionary note regarding these statements at the beginning of this report.
AeroCentury provides leasing and finance services to regional airlines worldwide. The Company is principally engaged in providing leasing services of mid-life regional aircraft to carriers, including operating leases and finance leases. In addition to leasing activities, the Company sells aircraft from its operating lease portfolio to third parties, including other leasing companies, financial services companies, and airlines. Its operating performance is driven by the growth of its aircraft portfolio, the terms of its leases, the interest rate of its debt, as well as asset sales.
During the second quarter of 2018, the Company purchased two aircraft. The Company ended the period with a total of twenty-three aircraft and one engine held for lease, with a net book value of approximately $210 million. This represents an 8% increase compared to the net book value at December 31, 2017, as a result of the aircraft purchases, as well as two asset sales during the first quarter of 2018 and depreciation on its remaining assets held for lease. The Company also owns nine aircraft subject to finance leases, three of which were acquired in 2017.
The Company has a globally diversified customer base of eleven airlines in nine countries. Average portfolio utilization was approximately 91% during the second quarter of 2018 compared with approximately 94% during the same period in 2017, and approximately 90% during the first six months of 2018 compared with approximately 95% during the first six months of 2017. The decrease was due to asset sales during 2017 and 2018, as well as the return of several aircraft at lease end in 2017.
In July 2017, the Company expanded its revolving credit facility (referred to as the "Credit Facility" or the "credit facility") from $150 million to $170 million. The unused amount of the Credit Facility was $32,500,000 as of June 30, 2018. The weighted average interest rate on the Credit Facility was 5.51% at June 30, 2018.
The Company has agreed to acquire, by way of merger (the "Merger"), JetFleet Holding Corp. ("JHC"). JHC is the owner of JetFleet Management Corp. ("JMC"), an integrated aircraft management, marketing and financing business that manages and administers the Company's portfolio of leased aircraft assets under the terms of a management agreement (the "Management Agreement"). If the Merger is completed, these management and administration services will be internalized and performed by the Company following completion.
Total revenues and other income for the quarter ended June 30, 2018 decreased by $0.3 million compared to the second quarter of 2017, and total revenues and other income for the six months ended June 30, 2018 decreased by $0.4 million compared to the first six months of 2017, primarily as a result of decreased operating lease revenues and maintenance reserves revenues, the effects of which were significantly offset by increased other income and gains on sales of aircraft parts in the 2018 period versus net losses on sales of assets in the 2017 period.
Net loss for the quarter ended June 30, 2018 was $0.1 million, compared to net income of $0.4 million in the same period of 2017, resulting in basic and diluted earnings per share of $(0.06) and $0.25 respectively. Net income for the six months ended June 30, 2018 was $0.2 million, compared to net income of $1.0 million in the same period of 2017, resulting in basic and diluted earnings per share of $0.17 and $0.67, respectively. Pre-tax profit margin (which the Company calculates as its income before income tax provision as a percentage of its revenues and other income) for the quarter ended June 30, 2018 was (1%) compared to 7% for the second quarter of 2017, and pre-tax profit margin for the six months ended June 30, 2018 was 3% compared to 10% for the same period of 2017 . The second quarters and first six months of 2018 and 2017 included $64,300 and $24,100 and $264,200 and $125,900, respectively, of expenses incurred in connection with the proposed acquisition of JHC by the Company.
Fleet Summary – Assets Held for Lease
Portfolio metrics of the Company's aircraft held for lease as of June 30, 2018 and December 31, 2017 were as follows
.
|
|
June 30,
2018
|
|
|
December 31, 2017
|
|
Number of aircraft and engines held for lease
|
|
|
24
|
|
|
|
24
|
|
|
|
|
|
|
|
|
|
|
Weighted average fleet age
|
|
11.5 years
|
|
|
11.4 years
|
|
Weighted average remaining lease term
|
|
57 months
|
|
|
58 months
|
|
Aggregate fleet net book value
|
|
$
|
210,592,000
|
|
|
$
|
195,098,200
|
|
|
|
For the Six Months
Ended June 30,
|
|
|
For the Three Months
Ended June 30,
|
|
|
|
2018
|
|
|
2017
|
|
|
2018
|
|
|
2017
|
|
Average portfolio utilization
|
|
|
90
|
%
|
|
|
95
|
%
|
|
|
91
|
%
|
|
|
94
|
%
|
The following table sets forth the net book value and percentage of the net book value, by type, of the Company's assets that were held for lease at June 30, 2018 and December 31, 2017.
|
|
June 30, 2018
|
|
|
December 31, 2017
|
|
Type
|
|
Number
owned
|
|
|
% of net book value
|
|
|
Number
owned
|
|
|
% of net book value
|
|
Turboprop aircraft:
|
|
|
|
|
|
|
|
|
|
|
|
|
Bombardier Dash-8-400
|
|
|
4
|
|
|
|
18
|
%
|
|
|
2
|
|
|
|
7
|
%
|
Bombardier Dash-8-300
|
|
|
3
|
|
|
|
5
|
%
|
|
|
3
|
|
|
|
6
|
%
|
Saab 340B Plus
|
|
|
2
|
|
|
|
2
|
%
|
|
|
4
|
|
|
|
3
|
%
|
Saab 340B
|
|
|
1
|
|
|
|
1
|
%
|
|
|
1
|
|
|
|
1
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Regional jet aircraft:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Canadair 900 (*)
|
|
|
5
|
|
|
|
35
|
%
|
|
|
5
|
|
|
|
38
|
%
|
Embraer 175
|
|
|
3
|
|
|
|
14
|
%
|
|
|
3
|
|
|
|
16
|
%
|
Canadair 1000
|
|
|
2
|
|
|
|
13
|
%
|
|
|
2
|
|
|
|
15
|
%
|
Canadair 700
|
|
|
3
|
|
|
|
11
|
%
|
|
|
3
|
|
|
|
13
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Engines:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Pratt & Whitney 150A
|
|
|
1
|
|
|
|
1
|
%
|
|
|
1
|
|
|
|
1
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(*) December 31, 2017 includes a Canadair 705 that was converted to a Canadair 900 in 2018.
At June 30, 2018 and December 31, 2017, the Company also had nine aircraft subject to finance leases.
The following table sets forth the net book value and percentage of the net book value of the Company's assets that were held for lease at June 30, 2018 and December 31, 2017 in the indicated regions (based on the domicile of the lessee):
|
|
June 30, 2018
|
|
|
December 31, 2017
|
|
Region
|
|
Net book value
|
|
|
% of
net book value
|
|
|
Net book value
|
|
|
% of
net book value
|
|
Europe
|
|
$
|
113,905,000
|
|
|
|
54
|
%
|
|
$
|
92,108,500
|
|
|
|
47
|
%
|
North America
|
|
|
70,378,100
|
|
|
|
33
|
%
|
|
|
72,270,700
|
|
|
|
37
|
%
|
Asia
|
|
|
5,854,400
|
|
|
|
3
|
%
|
|
|
6,082,100
|
|
|
|
3
|
%
|
Off lease
|
|
|
20,454,500
|
|
|
|
10
|
%
|
|
|
24,636,900
|
|
|
|
13
|
%
|
|
|
$
|
210,592,000
|
|
|
|
100
|
%
|
|
$
|
195,098,200
|
|
|
|
100
|
%
|
For the quarter ended June 30, 2018, approximately 30%, 28%, and 21% of the Company's operating lease revenue was derived from customers in Slovenia, the United States and Spain, respectively. Operating lease revenue does not include interest income from the Company's finance leases. The following table sets forth geographic information about the Company's operating lease revenue for leased aircraft and aircraft equipment, grouped by domicile of the lessee:
|
|
For the Three Months Ended June 30,
|
|
|
|
2018
|
|
|
2017
|
|
Region
|
|
Number
of lessees
|
|
|
% of
operating
lease revenue
|
|
|
Number
of lessees
|
|
|
% of
operating
lease revenue
|
|
Europe
|
|
|
4
|
|
|
|
58
|
%
|
|
|
4
|
|
|
|
53
|
%
|
North America
|
|
|
4
|
|
|
|
37
|
%
|
|
|
4
|
|
|
|
24
|
%
|
Africa
|
|
|
-
|
|
|
|
-
|
|
|
|
1
|
|
|
|
15
|
%
|
Asia
|
|
|
1
|
|
|
|
5
|
%
|
|
|
1
|
|
|
|
4
|
%
|
Australia
|
|
|
-
|
|
|
|
-
|
|
|
|
1
|
|
|
|
4
|
%
|
For the quarter ended June 30, 2018, approximately 70% and 30% of the Company's finance lease revenue was derived from customers in Africa and Europe, respectively.
Results of Operations
(a)
Quarter ended June 30, 2018 compared to the quarter ended June 30, 2017
The Company recorded a net loss of $0.1 million for the quarter ended June 30, 2018, compared to net income of $0.4 million in the same period of 2017.
Operating lease revenue decreased 4% to $6.8 million in the second quarter of 2018 from $7.1 million in the second quarter of 2017, primarily due to (i) the loss of revenue from assets that were on lease during the 2017 quarter, but off lease in 2018 and (ii) the loss of revenue from aircraft that were sold during 2017. Such decreases were partially offset by revenue from assets purchased in mid-2017 and in the 2018 quarter.
Average portfolio utilization decreased to approximately 91% during the second quarter of 2018 from approximately 94% during the second quarter of 2017.
The decrease was due to asset sales during late 2017 and 2018, as well as the return of several aircraft at lease end in 2017.
Maintenance reserves that are retained by the Company at lease end are recorded as revenue at that time. The Company recorded no such revenue during the second quarter of 2018. During the second quarter of 2017, the Company recorded maintenance reserves revenue of $0.4 million related to an economic adjustment when an aircraft was returned at lease expiration and $0.3 million of retained reserves when two aircraft were returned prior to lease expiration.
The Company sold no aircraft during the second quarter of 2018. During the second quarter of 2017, the Company sold two of its spare engines and recorded a loss of $0.2 million.
During the second quarter of 2018, the Company recorded $0.6 million in other income resulting from cash received from the previous lessee of three aircraft that were returned to the Company during 2017. Such payments were for unpaid maintenance reserves, as well as amounts due pursuant to the return conditions of the applicable leases. The Company did not accrue unpaid reserves or return condition amounts at the time of lease termination based on management's evaluation of the creditworthiness of the lessee. Therefore, the Company is accounting for payments as they are received and recorded the amount in other income.
The Company purchased two aircraft subject to operating leases during each of the second quarters of 2018 and 2017.
The average net book value of assets held for lease during the second quarters of 2018 and 2017 was approximately $203.3 million and $190.9 million, respectively. Management fees, which are based on the net book value of the Company's aircraft and engines as well as finance lease receivable balances, were approximately the same in the second quarters of 2018 and 2017.
The Company's interest expense increased by 36% to $2.4 million in the second quarter of 2018 from $1.7 million in the same period of 2017, primarily as a result of both a higher average debt balance and a higher average interest rate in the 2018 period, as well as higher fee amortization.
The Company's maintenance expense decreased by 83% to $0.1 million in the second quarter of 2018 from $0.4 million in the same period of 2017 primarily as a result of a decrease in maintenance performed by the Company on off-lease aircraft to prepare them for sale or re-lease.
During each of the quarters ended June 30, 2018 and 2017, the Company recorded an impairment provision of $0.3 million and $0.5 million, respectively, for an asset held for lease, based on appraised values.
Professional fees, general and administrative and other expenses for the quarters ended June 30, 2018 and 2017 included $64,300 and $24,100, respectively, incurred in connection with the proposed acquisition of JHC.
(b)
Six months ended June 30, 2018 compared to the six months ended June 30, 2017
The Company recorded net income of $0.2 million for the six months ended June 30, 2018, compared to net income of $1.0 million in the same period of 2017.
Operating lease revenue decreased 8% to $13.3 million in the first six months of 2018 from $14.4 million in the second quarter of 2017, primarily due to (i) the loss of revenue from assets that were on lease during the 2017 quarter, but off lease in 2018 and (ii) the loss of revenue from aircraft that were sold during 2017. Such decreases were partially offset by revenue from assets purchased in mid-2017 and in 2018.
Average portfolio utilization decreased to approximately 90% during the first six months of 2018 from approximately 95% during the first six months of 2017.
The decrease was due to asset sales during late 2017 and 2018, as well as the return of several aircraft at lease end in 2017.
During the six months ended June 30, 2018, the Company recorded net gains of $9,900 on the sale of two aircraft and aircraft parts. During the six months ended June 30, 2017, the Company recorded a gain of $297,400 on the sale of an aircraft pursuant to a sales-type finance lease. In the 2017 period, the Company also sold two of its spare engines and recorded a loss of $0.2 million, and recorded gains totaling $39,800 related to the sale of parts from two assets that are held for sale. Additionally, the Company exchanged one of its spare engines for 150,000 shares of the Company's common stock held by a stockholder. The Company recorded no gain or loss related to the exchange.
During the six months ended June 30, 2018, the Company recorded $1.6 million in other income resulting from cash received from the previous lessee of three aircraft that were returned to the Company during 2017. Such payments were for unpaid maintenance reserves, as well as amounts due pursuant to the return conditions of the applicable leases. The Company did not accrue unpaid reserves or return condition amounts at the time of lease termination based on management's evaluation of the creditworthiness of the lessee. Therefore, the Company is accounting for payments as they are received and recorded the amount in other income.
The Company purchased two aircraft subject to operating leases during the first six months of 2018. During the first six months of 2017, the Company acquired two aircraft that are subject to operating leases, as well as three aircraft that the Company leased pursuant to direct financing leases to the seller of such aircraft.
The average net book value of assets held for lease during the six months ended June 30, 2018 and 2017 was approximately $196.8 million and $189.8 million, respectively. Management fees, which are based on the net book value of the Company's aircraft and engines as well as finance lease receivable balances, were 2% lower in the first six months of 2018 as compared to the same period of 2017.
The Company's interest expense increased by 38% to $4.6 million in the six months ended June 30, 2018 from $3.4 million in the same period of 2017, primarily as a result of both a higher average debt balance and a higher average interest rate in the 2018 period, as well as higher fee amortization.
The Company's maintenance expense decreased by 76% to $0.2 million in the first half of 2018 from $0.7 million in the same period of 2017, as a result of a decrease in maintenance performed by the Company on off-lease aircraft to prepare them for sale or re-lease.
During each of the six months ended June 30, 2018 and 2017, the Company recorded an impairment provision of $0.3 million and $0.5 million, respectively, for an asset held for lease, based on appraised value.
Professional fees, general and administrative and other expenses for the six months ended June 30, 2018 and 2017 included $264,200 and $125,900, respectively, incurred in connection with the proposed acquisition of JHC.
The Company's provision for income taxes decreased by 73% to $0.2 million in the first six months of 2018 from $0.6 million in the same period of 2017 as a result of lower pre-tax income in 2018, as well as lower tax rates provided in the Tax Act of 2017.
Liquidity and Capital Resources
The Company is currently financing its assets primarily through debt financing and excess cash flows.
(a)
Credit Facility
The Company has a $170 million Credit Facility that matures on May 31, 2019, as described in Note 4(a) to the Company's condensed consolidated financial statements in Item 1 of this Quarterly Report on Form 10-Q. In addition to payment obligations, the Credit Facility contains financial covenants with which the Company must comply, including, but not limited to, positive earnings requirements, minimum net worth standards and certain ratios, such as debt to equity ratios. The Company was in compliance with all covenants at June 30, 2018 and December 31, 2017.
If the Company were to become out of compliance with any of its Credit Facility covenants at future calculation dates, the Company would need to request waivers or amendment of applicable covenants from its lenders if such compliance failure is not timely cured. The Company is currently negotiating new financing terms with its current lenders and other financing sources.
Although the Company believes that the assumptions it has made in forecasting its compliance with the Credit Facility covenants are reasonable in light of experience, actual results could deviate from such assumptions and there can be no assurance that the Company's beliefs will prove to be correct. Among the more significant factors that could have an impact on the accuracy of the Company's covenant compliance forecasts are (i) unanticipated decreases in the market value of the Company's assets, or in the rental rates deemed achievable for such assets that cause the Company to record an impairment charge against earnings, (ii) lessee non-compliance with lease obligations, (iii) inability to locate new lessees for returned equipment within a reasonable remarketing period, or at a rent level consistent with projected rates, (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, or (vi) inability to timely dispose of off-lease assets at prices commensurate with their market value.
Any default under the Credit Facility, if not cured in the time permitted under the facility or waived by the lenders, could result in the Company's inability to borrow any further amounts under the Credit Facility, the acceleration of the Company's obligation to repay amounts borrowed under the Credit Facility, or foreclosure upon any or all of the assets of the Company.
(b)
Special purpose financings
In August 2016, the Company acquired, using wholly-owned special purpose entities, two regional jet aircraft, using cash and third-party financing (referred to as "special purpose financing or "SPE Financing") separate from its Credit Facility, as described in Note 4(b) to the Company's condensed consolidated financial statements in Item 1 of this Quarterly Report on Form 10-Q.
(c)
Cash flow
The Company's primary sources of cash are payments due under the Company's operating and finance leases, maintenance reserves, which are billed monthly to lessees based on asset usage, and proceeds from the sale of aircraft and engines.
The Company's primary uses of cash are for (i) purchases of assets, (ii) Credit Facility and special purpose financing interest and principal payments, (iii) maintenance expense and reimbursement to lessees from collected maintenance reserves, (iv) management fees and expense reimbursement owed to JMC, and (v) professional fees, including legal, accounting and directors' fees costs.
The Company's payments for maintenance consist of reimbursements to lessees for eligible maintenance costs under their leases and maintenance incurred directly by the Company for preparation of off-lease assets for re-lease to new customers. The timing and amount of such payments may vary widely between quarterly and annual periods, as the required maintenance events can vary greatly in magnitude and cost, and the performance of the required maintenance events by the lessee or the Company, as applicable, are not regularly scheduled calendar events and do not occur at uniform intervals throughout any calendar period. 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 fees paid by the Company are relatively predictable because they are based on the net asset value of the Company's portfolio and finance lease receivable balances. As discussed above in
Results of Operations
, the Company and JHC agreed to the waiver of certain fees beginning April 1, 2018, in exchange for reimbursement of certain expenses by the Company to JMC. Because of this, the risk of increased costs for employee salaries and benefits, worldwide travel related to the management of the Company's aircraft portfolio, office rent, outside technical experts and other overhead expenses became the responsibility of the Company rather than JMC beginning with the second quarter of 2018. The shift in responsibility for these expenses is expected to continue if and after the Merger is completed, since the management and administrative services currently performed by JMC will be internalized and the Company will no longer pay a management fee to an unconsolidated third party in exchange for the performance of these services. As a result, the Company expects the types, timing and amounts of, and patterns and trends with respect to, its recorded expenses to change as a result of the Merger, but the manner and extent of these changes remains uncertain until the Company begins to internally perform and control these functions.
The amount of interest paid by the Company depends primarily 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. Interest related to the Company's special purpose financings is payable at a fixed rate.
Management believes that the Company will have adequate cash flow to meet its ongoing operational needs, including any required repayments under the Credit Facility based upon its estimates of future revenues and expenditures, which include assumptions regarding (i) revenues for assets to be re-leased, (ii) cost and anticipated timing of maintenance to be performed, (iii) required debt payments, (iv) timely use of proceeds of unused debt capacity for additional acquisitions of income producing assets, (v) interest rates and (vi) the amount, timing and patterns of management and administrative expenses to be borne by the Company after completion of the Merger.
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. As discussed above, in "Liquidity and Capital Resources – (a) Credit Facility," and below in
Outlook
and
Factors that May Affect Future Results and Liquidity
, there are a number of factors that may cause actual results to deviate from such forecasts. If these assumptions turn out to be incorrect and the Company's cash requirements exceed its cash flows, the Company would need to pursue additional sources of financing to satisfy these requirements, which may not be available when needed, on acceptable terms, or at all. See
Factors that May Affect Future Results and Liquidity
below for more information about financing risks and limitations.
(i)
Operating activities
The Company's cash flow from operations increased by $2.5 million in the first half of 2018 compared to the same period in 2017. As discussed below, the increase in cash flow was primarily a result of increases in payments received for other income and operating lease revenue, as well as a decrease in payments for management fees. This positive effect was partially offset by increases in payments for interest and maintenance and a decrease in payments received for security deposits.
(A)
|
Payments for other income
|
During the first half of 2018, the Company recorded $1.6 million in other income resulting from cash received from the previous lessee of three aircraft that were returned to the Company during 2017. Such payments were for unpaid maintenance reserves, as well as amounts due pursuant to the return conditions of the applicable leases. The Company did not accrue unpaid reserves or return condition amounts at the time of lease termination based on management's evaluation of the creditworthiness of the lessee. Therefore, the Company is accounting for payments as they are received and recorded the amount in other income.
(B)
|
Payments for operating lease revenue
|
Rent receipts from lessees increased by $0.6 million in the first half of 2018 compared to the same period in 2017, primarily due to higher rent from assets purchased and leased to customers during 2017 and 2018.
As of the date of this filing, the Company is receiving no lease revenue for six aircraft held for lease that are off lease. The total book value of these assets is $20.4 million, representing 10% of the Company's total assets held for lease.
(C)
|
Payments for management fees
|
Payments for management fees decreased by $1.1 million in the first half of 2018 compared to the same period in 2017, primarily as a result of a difference in the timing of payments from year to year and due to the contingent waivers of certain fees subject to the consummation of the JHC merger.
(D)
|
Payments for interest
|
Payments for interest increased by $1.0 million in the first half of 2018 compared to the first quarter of 2017 as a result of a higher average debt balance and higher rates during the 2018 period.
(E)
|
Payments for maintenance
|
Payments for maintenance decreased by $1.2 million in the first half of 2018 period compared to the same period in 2017 period as a result of decreased maintenance
performed by the Company on off-lease aircraft to prepare them for sale or re-lease
(ii)
Investing activities
During the six months ended June 30, 2018 and 2017, the Company received net cash of $5.8 million and $1.5 million, respectively, from the sale of assets. During the first six months of 2018 and 2017, the Company used cash of $22.6 million and $29.4 million, respectively, for acquisitions of aircraft.
(iii)
Financing activities
During the first six months of 2018 and 2017, the Company borrowed $21 million and $26 million, respectively, under the Credit Facility. In the first six months of 2018 and 2017, the Company repaid $17.5 million and $2.8 million, respectively, of its total outstanding debt under the Credit Facility. Such repayments were funded by excess cash flow and, in the 2018 period, the sale of assets. During the first six months of 2018 and 2017, the Company's special purpose entities repaid $2.1 million and $2.0 million, respectively, of SPE Financing principal.
Outlook
The Company has identified three principal factors that it believes may materially affect the Company's growth and operating results in the near term. These and other factors that could impact the Company's business, performance and liquidity are described in more detail under
Factors that May Affect Future Results and Liquidity
below.
•
The Company entered into an Agreement and Plan of Merger to acquire JHC on October 26, 2017.
There are several conditions to the closing of the Merger between the Company and JHC, most of which are out of the control of the Company. On February 22, 2018, the State of California Department of Business Oversight ("DBO") held a hearing regarding the Merger pursuant to Section 25142 of the California Corporations Code, to determine whether the terms and conditions of the issuance of AeroCentury's shares of Common Stock in the Merger to JHC's shareholders are fair. Following the hearing, a permit was issued by the DBO, which will allow the issuance of the Company's common stock in the Merger transaction to be exempt from federal securities registration under Section 3(a)(10) of the Securities Act. The Company has received the consent of JHC's shareholders to the Merger. The Company intends to hold a special meeting of the Company's stockholders on August 31, 2018 in order to approve the issuance of AeroCentury Common Stock in connection with the Merger as required under the applicable listing rules of the NYSE American exchange on which AeroCentury's common stock is traded. Approval of the Merger is not required under Delaware or California corporate law. If the AeroCentury shareholders approve the issuance of AeroCentury Common Stock, the Merger is anticipated to be consummated in the third quarter of 2018 or shortly thereafter, but there can be no assurance that such closing will occur, or that it will occur in the anticipated time frame.
The Company believes that the combination of the management function performed by JMC and the portfolio held by the Company will be accretive to the Company and will create shareholder value for the shareholders of the combined post-Merger company, but such accretion may not be realized until after transaction and integration costs in connection with the Merger have been incurred or at all.
The Company, however, will incur certain non-recurring, non-tax deductible Merger expenses in the periods leading up to the Merger, and immediately following, as well as having to record, for accounting purposes, a settlement loss at the time of consummation of the Merger
,
which could negatively affect the Company's results for those periods.
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Increased production of aircraft types in the Company's market niche has resulted in some manufacturers offering competitive pricing for new aircraft to regional aircraft customers. In addition, notwithstanding recent interest rate increases in the U.S., competition for assets in the Company's market niche of worldwide regional aircraft has continued to increase. Some of the Company's newer competitors are funded by investment banks and private equity firms seeking higher yields on investment assets than are currently available from traditional income investment types. The increased competition has resulted in higher acquisition prices for many of the aircraft types that the Company has targeted to buy and, at the same time, continues to put downward pressure on lease rates, resulting in lower margins and, therefore, fewer acceptable acquisition opportunities for the Company. The Company anticipates this trend will continue for the short- to medium-term, but could change if and when yields on alternative investments return to a more normal historical range.
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The Company has not identified re-lease or sale customers for six turboprop aircraft that are currently off lease. The Company is analyzing the amount and timing of maintenance required to remarket these assets, the amount of which may differ significantly if the assets are sold rather than re-leased. These aircraft are older types that are no longer in production, so it is not unusual that market demand for them is weak and, therefore, they may remain off lease for significant periods of time.
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The Company is currently negotiating new financing terms with its current lenders and other financing sources. If the Company is not successful, the Company's ability to grow and remain in compliance with its current debt covenants would be negatively affected. In the event of any non-compliance, the Company would need to request waivers or amendment of applicable covenants from its lenders if such compliance failure is not timely cured.
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 included in this report, 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 or during the applicable reporting period. 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 1 of this Quarterly Report on Form 10-Q.
Factors that May Affect Future Results and Liquidity
The Company's business, financial condition, results of operations, prospects and reputation could be affected by a number of factors. In addition to matters discussed elsewhere in this discussion, the Company believes the following are the most significant factors that may impact the Company; however, additional or other factors not presently known to the Company or that management deems immaterial could also impact the Company and its performance.
Availability of Financing.
The Company's credit facility expires on May 31, 2019. The Company's continued growth will depend on its ability to continue to obtain capital, either through debt or equity financings. The Company is currently negotiating new financing terms with its current lenders and other financing sources. There can be no assurance that the Company's belief regarding the availability of financing under the current credit facility will prove to be correct, or that the Company will succeed in finding additional financing, and if such financing is found, it may be on terms less favorable than the Company's current debt financing. One of the current primary limiters on the Company's ability to draw under the current credit facility or incur any other additional debt is the covenant limitation on the Company's maximum debt to equity ratio. Under the current terms, even if the credit facility limit were increased, in order to utilize the higher limit, the Company would need to source additional equity capital in order to remain in compliance with the debt to equity ratio covenant to utilize the higher limit. Thus, the Company would need to raise additional equity capital to accompany any increase in the current credit facility, or, in the alternative, would need to refinance its credit facility debt with a new lender with more favorable financial covenants not limited by the Company's current equity capitalization. One of the motivations for the Company to acquire JHC was to remove the outside management structure of the Company which was believed to be an impediment to attracting capital sources. Even if the Merger is consummated, there can be no assurance that the Company will obtain such additional equity capital in the future or that it will be successful in obtaining more favorable credit facility financing, as a successful capital raising transaction depends on many factors, some of which are outside the Company's control.
Noncompliance with Debt Financial Covenants.
The Company's use of debt as the primary form of acquisition financing subjects the Company to increased risks associated with leverage. In addition to payment obligations, the Company's debt agreements include financial covenants, including some requiring the Company to have positive earnings, meet minimum net worth standards and be in compliance with certain other financial ratios. Any default under a debt agreement, if not cured in the time permitted or waived by the respective lender, could result in the Company's inability to borrow under the Credit Facility, the acceleration of the Company's debt obligations, or the foreclosure upon any or all of the assets of the Company.
Consummation of Merger May Subject the Company to Additional Risks.
In October 2017, the Company announced its agreement to acquire JHC, the parent of the Company's management company, JMC, by way of a reverse triangular merger. There can be no assurance that the Merger will be consummated as there are numerous closing conditions that must be satisfied, some of which are out of the control of the Company. The entry into the Agreement and Plan of Merger subjects the Company to additional risks, including the following:
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Merger Expenses
. In addition to legal, accounting and financial advisory fees incurred prior to the execution of the Agreement and Plan of Merger, in order to consummate the Merger, the Company will need to incur significant additional expenses, including legal and third-party consulting fees, which will be payable whether or not the Merger eventually occurs.
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Settlement Loss Effect on Covenant Compliance.
The Company believes that if the acquisition by merger of JHC is consummated, it may record a settlement loss related to its existing obligations under the management agreement with JMC on the closing date of the Merger in an amount equal to a substantial portion of the purchase consideration to be paid in the Merger. The amount of the loss cannot be ascertained exactly until the Merger closes, as it depends on several variables, including final adjustments to the agreed purchase price, the quoted market price of AeroCentury Common Stock on the Merger closing date and the total difference between the accrued aggregate Contract Fees for the period between April 2018 and the Merger Closing, and the expenses paid by the Company to JMC under the waiver and reimbursement agreement, as discussed in
Results of Operations
. In December 2017, the Company obtained the consent of the Credit Facility lenders to the Merger, and modifications to the Credit Facility for post-Merger periods to prevent certain expense items arising from the Merger causing a default under the Credit Facility agreement covenants. The modifications impose a limit on the amount of settlement loss and merger costs that will be disregarded for covenant purposes, but the Company believes that they are sufficient to avoid these from causing a default under the Credit Facility financial covenants.
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Assumption of Expenses Covered under Management Agreement; Interim Waiver of Management Fee.
Under the Management Agreement, the Company pays a management fee to JMC based upon the book value of the Company's aircraft assets, an acquisition fee for each asset purchased by the Company, and a remarketing/re-lease fee for each sale or re-lease transaction entered into with respect to the Company's aircraft. In return, JMC provides the Company with comprehensive management services, under which JMC has full responsibility for payment of all employee salaries and benefits, outside technical services, worldwide travel needed to promote the Company's business, office space, utilities, IT and communications, furniture and fixtures, and other general administrative and overhead costs. Under the Management Agreement, if the fees collected are not enough to cover JMC's expenses in managing the Company's portfolio, such losses are borne entirely by JMC.
In April 2018, subsequent to the execution of the Merger Agreement for the acquisition of JHC, JHC agreed to waive its right to receive management and acquisition fees ("Contract Fees") otherwise owed by the Company to JHC pursuant to the Management Agreement for all periods after March 31, 2018 and until the earlier of the consummation of the Merger or August 15, 2018. In return, the Company agreed to reimburse JMC for expenses ("Management Expense") incurred in providing management services set forth under the Management Agreement. In July 2018, JHC agreed to extend the expiration of this agreement (the "Waiver and Reimbursement Agreement") through October 15, 2018. Thus, if the Merger Agreement is terminated on or before October 15, 2018 or the Merger otherwise does not close by October 15, 2018, the Company would become obligated to JMC pay
any excess (the "JMC Margin") of (i) the Contract Fees that would have been paid to JMC since April 1, 2018
in the absence of the Waiver and Reimbursement Agreement over (ii) the Management Expenses actually paid by the Company to JMC since April 1, 2018.
For the quarter and six months ended June 30, 2018, contractual fees exceeded the reimbursed management fees by $497,200 of management fees and $494,400 of acquisition fees. Notwithstanding the Waiver and Reimbursement Agreement, until the closing or termination of the Merger Agreement, the Company will accrue as an expense the total Contract Fees that would have been due under the Management Agreement. If the Merger closes on or before October 15, 2018, the Waiver and Reimbursement Agreement for the period beginning on April 1, 2018, and ending on the consummation of the Merger will be considered in the acquisition accounting for the calculation of the settlement loss recognized by the Company when the Merger is consummated.
In any event, if and when the Merger closes, the financial arrangement created by the waiver and reimbursement agreement will become permanent, as the third-party outside management structure will be eliminated by the Merger. As a result, the Company's expenses in connection with management of its assets will be solely the Company's liability, and will no longer be limited to the amount of the management fee, as was the case under the third party management structure with JMC. Consequently, the risk of any unexpected post-Merger cost overruns or unanticipated expenses in asset management will be borne solely by the Company and no longer shifted to a third party management company.
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AeroCentury's Management Will Become Internalized.
If the Merger is consummated, JHC will become a wholly-owned subsidiary of the Company and sole responsibility for management of the combined company will fall upon its management. If the Company is dissatisfied with management services following consummation of the Merger, the Company would have to address the shortcomings internally, and if they cannot be resolved with the existing management and personnel, the Company may be required to reorganize its management structure and replace personnel or seek new third party management services, either of which could result in the Company incurring significant expense and use of resources.
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Assumption of JHC Liabilities.
By acquiring JHC in a reverse triangular merger, JHC will become a wholly-owned subsidiary of the Company. To the extent that JHC or any of its subsidiaries have liabilities, these will become liabilities of the Company on a consolidated basis. While the Merger Agreement provides for limited indemnification by JHC shareholders for certain liabilities of JHC or its subsidiaries that arise from pre-Merger occurrences, and the Company has performed due diligence reviews of the liabilities of JHC and its subsidiaries, the indemnification is limited to the consideration paid by the Company to JHC and such due diligence reviews are inherently non-exhaustive and may not have uncovered all known or contingent liabilities or presently unknown liabilities that could emerge after the Merger is completed.
Credit Facility Debt Limitations.
The amount available to be borrowed under the Credit Facility is limited by asset-specific advance rates. Lease arrearages or off-lease periods for a particular asset that is collateral under the Credit Facility may reduce the loan advance rate permitted with respect to that asset and, therefore, reduce the permitted borrowing under the facility or require repayments. Amounts subject to payment deferral agreements also reduce the amount of permitted borrowing. The Company believes it will have sufficient borrowing availability under the Credit Facility to meet its anticipated capital needs in the near term in spite of these limitations and it will have sufficient cash funds to make any required principal repayment that arises due to any such borrowing limitations, but actual cash levels could deviate from these assumptions.
Ownership Risks.
The Company's leases typically are for a period shorter than the entire, anticipated, remaining useful life of the leased assets. As a result, the Company's recovery of its investment and realization of its expected yield in such a leased asset is dependent upon the Company's ability to profitably re-lease or sell the asset following the expiration of the lease. This ability is affected by worldwide economic conditions, general aircraft market conditions, regulatory changes, changes in the supply or cost of aircraft equipment, and technological developments that may 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 typically 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, airline consolidations, the number of new aircraft on order, an excess supply of newly manufactured aircraft or used 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 or decrease for certain aircraft types that become more or less desirable based on market conditions and changing airline capacity. Because the Company's ability to borrow under its credit facility is subject to a covenant setting forth an upper limit on the ratio of (i) the outstanding debt under the facility to (ii) the appraised value of the collateral base of aircraft assets securing the credit facility, a significant drop in the appraised market value of the portfolio could require the Company to make a substantial prepayment of outstanding principal under the credit facility in order to avoid a default under the credit facility and limit the utility of the credit facility as a source of future funding.
In addition, a successful investment in an asset subject to an operating lease depends in part upon having the asset returned by the lessee in the condition as required under the lease. Each operating lease obligates a customer to return an asset to the Company in a specified condition, generally in a condition that will allow the aircraft to be readily re-leased to a new lessee, and/or pay an economic settlement for redelivery that is not in compliance with such specified conditions. The Company strives to ensure this result through onsite management during the return process. However, if the lessee were to become insolvent during the term of its lease and the Company had to repossess the asset, it is unlikely that the lessee would have the financial ability to meet these return obligations. In addition, if the lessee filed for bankruptcy and rejected the aircraft lease, the lessee would be required to return the aircraft but would be relieved from further lease obligations, including return conditions specified in the lease. In either case, 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.
Several of the Company's leases with financially strong lessees 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 occurred under such a lease, the Company would be left with the costs of unperformed repair and maintenance under the applicable lease and the Company would likely 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 could result in an asset impairment charge against the Company's earnings. The Company periodically reviews long-term assets for impairment, particularly when events or changes in circumstances indicate the carrying value of an asset may not be recoverable. An impairment charge is recorded when the carrying amount of an asset is estimated to be not recoverable and exceeds its fair value. The Company recorded impairment charges for some of its aircraft in 2016 and 2017, and may be required to record asset impairment charges in the future as a result of a prolonged weak economic environment, challenging market conditions in the airline industry, events related to particular lessees, assets or asset types or other factors affecting the value of aircraft or engines.
Interest Rate Risk.
The Credit Facility carries a floating interest rate based upon short-term interest rate indices. Lease rates typically, but not always, move over time with interest rates, but market demand and numerous other asset-specific factors also affect lease rates. Because the Company's typical lease rates are fixed at lease origination, interest rate changes during the lease term have no effect on existing lease rental payments. Therefore, if interest rates rise significantly and there is relatively little lease origination by the Company following such rate increases, the Company could experience decreased net income as additional interest expense outpaces revenue growth. Further, even if significant lease origination occurs following such rate increases, other contemporaneous aircraft market forces may result in lower or flat rental rates, thereby decreasing net income.
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 losses resulting from a lessee default or bankruptcy.
If a lessee that is a certified U.S. airline were in default under a lease and sought protection under Chapter 11 of the United States Bankruptcy Code, Section 1110 of the Bankruptcy Code would automatically prevent the Company from exercising any remedies against such lessee for a period of 60 days. After the 60-day period had passed, the lessee would have to agree to perform the lease obligations and cure any defaults, or the Company would have the right to repossess the equipment. However, this procedure under the Bankruptcy Code has been subject to significant litigation, and it is possible that the Company's enforcement rights would be further adversely affected by a bankruptcy filing by a defaulting lessee.
Lessees located in low-growth or no-growth areas of the world carry heightened risk of an unanticipated lessee default. The Company has had customers that have experienced significant financial difficulties, become insolvent, or have entered bankruptcy proceedings. An insolvency or bankruptcy of a customer usually results in a total loss of the receivables from that customer, as well as the Company incurring additional costs in order to repossess and, in some cases, repair the aircraft. The Company closely monitors the performance of all of its lessees and its risk exposure to any lessee that may be facing financial difficulties, in order to guide decisions with respect to such lessee that would mitigate losses in the event the lessee is unable to meet or rejects its lease obligations. There can be no assurance that additional customers will not become insolvent or file for bankruptcy or that the Company will be able to mitigate any of the resultant losses.
It is possible that the Company may enter into deferral agreements for overdue lessee obligations. When a customer requests a deferral of lease obligations, the Company evaluates the lessee's financial plan, the likelihood that the lessee can remain a viable carrier, and whether the deferral will be repaid according to the agreed schedule. The Company may elect to record the deferred rent and reserves payments from the lessee on a cash basis, which could have a material effect on the Company's financial results in the applicable periods. Deferral agreements with lessees also reduce the Company's borrowing capacity under its Credit Facility.
Concentration of Lessees and Aircraft Type.
For the month ended June 30, 2018, the Company's four largest customers accounted for a total of approximately 77% of the Company's monthly operating lease revenue. A lease default by or collection problem with one or a combination of any of these significant customers could have a disproportionate negative impact on the Company's financial results and borrowing base under the Credit Facility, and, therefore, the Company's operating results are especially sensitive to any negative developments with respect to these customers in terms of lease compliance or collection. In addition, if the Company's revenues become overly concentrated in a small number of lessees, the Company could fail to comply with certain financial covenants in its Credit Facility related to customer concentration. In the event of any non-compliance that is not cured in the time permitted under the Credit Facility, the Company would need to seek waivers or amendment of the applicable covenants if such compliance failure is not timely cured. Any default under the Credit Facility, if not cured in the time permitted under the Credit Facility or waived by the lenders, could result in foreclosure upon any or all of the assets of the Company.
The Company's aircraft portfolio is currently focused on a small number of aircraft types and models compared to the variety of aircraft used in the commercial air carrier market. A change in the desirability and availability of any of the particular types and models of aircraft owned by the Company could affect valuations and future rental revenues of such aircraft, and would have a disproportionately significant impact on the Company's portfolio value. In addition, the Company is dependent on the third-party companies that manufacture and provide service for the aircraft types in the Company's portfolio. The Company has no control over these companies, and they could decide to curtail or discontinue production of or service for these aircraft types at any time or significantly increase their costs, which could negatively impact the Company's prospects and performance. These effects would diminish if the Company acquires assets of other types. Conversely, acquisition of additional aircraft of types currently owned by the Company will increase the Company's risks related to its concentration of those aircraft types.
Competition.
The aircraft leasing industry is highly competitive. The Company competes with aircraft manufacturers, distributors, airlines and aircraft operators, equipment managers, leasing companies, equipment leasing programs, financial institutions and other parties engaged in leasing, managing or remarketing aircraft, many of which have significantly greater financial resources. Competition in the Company's market niche of regional aircraft, however, has increased significantly recently as a result of new entrants to the acquisition and leasing market and consolidation of certain competitors. As competition increases, it has and will likely continue to create upward pressure on acquisition prices for many of the aircraft types that the Company has targeted to buy and, at the same time, create downward pressure on lease rates, resulting in lower margins for the Company and, therefore, fewer acceptable acquisition opportunities for the Company.
Risks Related to Regional Air Carriers.
The Company's continued focus on its customer base of regional air carriers subjects the Company to additional risks. Many regional airlines rely heavily or even exclusively on a code-share or other contractual relationship with a major carrier for revenue, and can face financial difficulty or failure if the major carrier terminates the relationship or if the major carrier files for bankruptcy or becomes insolvent. Some regional carriers may depend on contractual arrangements with industrial customers such as mining or oil companies, or franchises from governmental agencies that provide subsidies for operating essential air routes, which may be subject to termination or cancellation on short notice. Furthermore, many lessees in the regional air carrier market are start-up, low-capital, and/or low-margin operators. A current concern for regional air carriers is the supply of qualified pilots. Due to recently imposed FAA regulations requiring a higher minimum number of hours to qualify as a commercial passenger pilot, many regional airlines have had difficulty meeting their business plans for expansion. This could in turn affect demand for aircraft and the Company's business.
General Economic Conditions and Lowered Demand for Travel.
While the United States economy has seen substantial improvement since its most recent global recession, not all global regions are experiencing growth, and some remain in recession. The Company does not anticipate any worsening of the financial condition of its overall customer base, but believes that there may be further shakeouts of weaker carriers in economically troubled regions. Any such shakeouts or any continued or new economic recession or downturn in the regions in which the Company's lessees operate could negatively impact the financial condition and viability of certain of the Company's customers and, in turn, the Company's performance.
A growing concern arises from the fact that much of the recent growth in demand for regional aircraft in developing countries has arisen from mining or other resource extraction operations by Chinese enterprises in these countries. A future, sustained major downturn in the Chinese domestic economy that reduces demand for imported raw materials could have a significant negative impact on the demand for business and regional aircraft in these developing countries, including in some of the markets in which the Company does, or seeks to do, business.
Furthermore, any further upheavals due to instability in Europe due to newly imposed U.S. sanctions against Russia, and the Russian and European reaction to such sanctions, or due to other factors, could have a negative impact on intra-European carriers with which the Company does business. Also, Brexit and any further departures from the European Union ("EU") could threaten "open-sky" policies under which EU based carriers operate freely within the EU. Losing open-sky flight rights could have a significant negative impact on the health of the Company's European lessees and, as a result, the financial performance and condition of the Company.
If international conflicts erupt into military hostilities, heightened visa requirements make international travel more difficult, or terrorist attacks involving aircraft or airports occur, or a major flu outbreak occurs, passengers may avoid air travel altogether, and global air travel worldwide could be significantly affected. This would have an adverse impact on many of the Company's customers.
Airline reductions in capacity in response to lower passenger loads can result in reduced demand for aircraft and aircraft engines and a corresponding decrease in market lease rental rates and aircraft values. This reduced market value could affect the Company's results if the market value of an asset or assets in the Company's portfolio falls below carrying value, and the Company determines that a write-down of the value on its balance sheet is appropriate. Furthermore, if older, expiring leases are replaced with leases at decreased lease rates, the lease revenue from the Company's existing portfolio is likely to decline, with the magnitude of the decline dependent on the length of the downturn and the depth of the decline in market rents.
Economic downturns can affect certain regions of the world more than others. As the Company's portfolio is not entirely globally diversified, a localized downturn in one of the key regions in which the Company leases assets could have a significant adverse impact on the Company. The Company's significant sources of operating lease revenue by region are summarized in
Fleet Summary – Assets Held for Lease,
above.
International Risks.
The Company leases assets in overseas markets. Leases with foreign lessees, however, may present different risks than those with domestic lessees. Most of the Company's expected growth is outside of North America.
A lease with a foreign lessee is subject to risks related to the economy of the country or region in which such lessee is located, which may be weaker than the U.S. economy. An economic downturn in a particular country or region may impact a foreign lessee's ability to make lease payments, even if the U.S. and other foreign economies remain stable.
Foreign lessees are subject to risks related to currency conversion fluctuations. The Company currently has one customer with rent obligations payable in Euros, and the Company may, from time to time, agree to additional leases that permit payment in foreign currency, which would subject such lease revenue to monetary risk due to currency fluctuations. During the periods covered by this report, the Company considers the estimated effect on its revenues of foreign currency exchange rate fluctuations to be immaterial; however, the impact of these fluctuations may increase in future periods if additional rent obligations become payable in foreign currencies.
Even with U.S. dollar-denominated lease payment provisions, the Company could still be affected by a devaluation of the lessee's local currency and a stronger U.S. dollar that would make it more difficult for a lessee to meet its U.S. dollar-denominated payments, increasing the risk of default of that lessee, particularly if its revenue is primarily derived in the local currency.
Foreign lessees that operate internationally may also face restrictions on repatriating foreign revenue to their home country. This could create a cash flow crisis for an otherwise profitable carrier, affecting its ability to meet its lease obligations. Foreign lessees may also face restrictions on payment of obligations to foreign vendors, including the Company, which may affect their ability to timely meet lease obligations to the Company.
Foreign lessees are not subject to U.S. bankruptcy laws, although there may be debtor protection similar to U.S. bankruptcy laws available in some jurisdictions. Certain countries do not have a central registration or recording system which can be used to locally record the Company's interest in equipment and related leases. This could make it more difficult for the Company to recover an aircraft in the event of a default by a foreign lessee. In any event, collection and enforcement may be more difficult and complicated in foreign countries.
Ownership of a leased asset operating in a foreign country and/or by a foreign carrier may subject the Company to additional tax liabilities that are not present with aircraft operated in the United States. Depending on the jurisdiction, laws governing such tax liabilities may be complex, not well formed or not uniformly enforced. In such jurisdictions, the Company may decide to take an uncertain tax position based on the best advice of the local tax experts it engages, which position may be challenged by the taxing authority. If the taxing authority later assesses a liability, the Company may be required to pay penalties and interest on the assessed amount, which penalties and interest would not give rise to a corresponding foreign tax credit on the Company's U.S. tax return.
The Trump administration and members of the U.S. Congress have made public statements indicating possible significant changes in U.S. trade policy and have taken certain actions that may impact U.S. trade, including imposing tariffs on certain goods imported into the United States. Any changes in U.S. trade policy could trigger retaliatory actions by affected countries, resulting in "trade wars," which could generally increase the cost of aircraft, aircraft and engine components and other goods regularly imported by our customers, thereby increasing costs of operations for our air carrier customers that are located in the affected countries. The increased costs could materially and adversely impact the financial health of affected air carriers, generally, which in turn could have a negative impact on the Company's business opportunities, and if the Company's lessees are significantly affected, could have a direct impact on the Company's financial results. Furthermore, the Company often incurs maintenance or repair expense not covered by lessees in foreign countries, which could increase the Company's own maintenance and repair expense if such countries are affected by such a trade war.
Investment in New Aircraft Types.
The Company intends to continue to focus solely on regional aircraft. Although the Company invested in a limited number of turboprop aircraft types in the past, including two in its most recently completed quarter, the Company has also acquired several regional jet aircraft types, which now comprise a larger percentage of the Company's portfolio based on number of aircraft and net book value. The Company may continue to seek acquisition opportunities for new types and models of aircraft used in the Company's targeted customer base of regional air carriers. Acquisition of aircraft types not previously acquired by the Company entails greater ownership risk due to the Company's lack of experience managing those assets. The Company believes, however, that its overall industry expertise may permit the Company to effectively manage such new aircraft types. Further, the broadening of the asset types in the aircraft portfolio may have a benefit of diversifying the Company's portfolio (see
Factors That May Affect Future Results and Liquidity – Concentration of Lessees and Aircraft Type
, above).
Reliance on JMC.
All management of the Company is currently performed by JMC under a Management Agreement between the Company and JMC that expires in August of 2025 and provides for an asset-based management fee. JMC is not a fiduciary of the Company or its stockholders. The Company's board of directors (the "Board") has ultimate control and supervisory responsibility over all aspects of the Company and owes fiduciary duties to the Company and its stockholders. The Board has no control over the internal operations of JMC, but the Board does have the ability and responsibility to manage the Company's relationship with JMC and the performance of JMC's obligations to the Company under the Management Agreement, as it would have for any third-party service provider to the Company. While JMC may not owe any fiduciary duties to the Company by virtue of the Management Agreement, all of the officers of JMC are also officers of the Company, and, in that capacity, owe fiduciary duties to the Company and its stockholders. In addition, an officer of the Company holds significant ownership positions in the Company and JHC, the parent company of JMC, and JHC is the Company's largest shareholder. Therefore, the economic interests of the Company should be aligned with the interests of JHC and JMC, and JMC should have substantial incentive to make financial decisions as the management company for the Company that are in the best interests of the Company. These assumptions, however, could prove to be incorrect, in which case JMC may act in a manner that is in its interest but is not in the interest of the Company or its stockholders.
The Management Agreement may be terminated if JMC defaults on its obligations to the Company. However, the agreement provides for liquidated damages in the event of its wrongful termination by the Company. A director of the Company is also a director of JMC and, as discussed above, the officers of the Company are also officers of JMC, and one such officer holds significant ownership positions in both the Company and JHC, the holding company for JMC. Consequently, the director and officers of JMC may have a conflict of interest in the event of a dispute between the Company and JMC. Although the Company has taken steps to prevent conflicts of interest arising from such dual roles, such conflicts may still occur.
There can be no assurance that the proposed Merger with JHC, the parent of JMC, will be consummated. If the Merger is consummated, the Company would have control over JMC's operations and it is expected that the foregoing risks would be largely mitigated. However, operating costs previously borne by JMC in managing the Company's assets would be borne by the Company, and there can be no assurance that such costs will be less than the fees previously paid to JMC.
Management Fee Structure.
All decisions regarding acquisitions and disposal of aircraft from the Company's portfolio are currently made by JMC. JMC is paid a management fee based on the net asset value of the Company's portfolio. It may also receive a one-time asset acquisition fee upon purchase of an asset by the Company, and a one-time remarketing fee in connection with the sale or re-lease of an asset. Optimization of the results of the Company depends on timing of the acquisition, lease yield on the acquired assets, and re-lease or sale of its portfolio assets. Under the current management fee structure, a larger volume of acquisitions generates acquisition fees and also increases the periodic management fee by increasing the size of the aircraft portfolio. Since the Company's current business strategy involves continued growth of its portfolio, with the intention to buy and hold assets until the appropriate time to sell them, a compensation structure that results in greater compensation with an increased portfolio size is consistent with that strategy. The compensation structure does, nonetheless, create a situation where a decision by JMC for the Company to forego an asset transaction deemed to be an unacceptable business risk due to the lessee or the aircraft type or other factors is in conflict with JMC's own short-term pecuniary interest. As a result, the compensation structure could act to incent greater risk-taking by JMC in asset acquisition decision-making. However, because JMC's sole business and source of revenue arises from and is expected to continue arising from acting as the management company for the Company, the long-term financial health and viability of the Company are important to JMC's own long-term health and viability. Therefore, in assessing risk-taking in the Company's acquisition transactions, JMC's and the Company's motivations are closely aligned, as JMC is incented to make asset acquisitions that are expected to contribute to the long-term viability of the Company. In addition, the Company has established objective target guidelines for yields on acquired assets and the Company's Board, including a majority of the outside independent directors, must approve any acquisition that involves a new asset type. While the Company currently believes the foregoing are effective mitigating factors against undue compensation-incented risk-taking by JMC, there can be no assurance that such mechanisms can entirely and effectively eliminate such risk.
If the Merger is consummated, the management fee would be internalized and it is expected that the foregoing risks would be largely mitigated.
Government Regulation.
There are a number of areas in which government regulation may result in costs to the Company. These include aircraft registration safety requirements, required equipment modifications, maximum aircraft age, and aircraft noise requirements. Although it is contemplated that the burden and cost of complying with such requirements will fall primarily upon lessees, there can be no assurance that the cost will not fall on the Company. Furthermore, future government regulations could cause the value of any non-complying equipment owned by the Company to decline substantially. Moreover, any failure by the Company to comply with the government regulations applicable to it could result in sanctions, fines or other penalties, which could harm the Company's reputation and performance.
Casualties, Insurance Coverage.
The Company, as an owner of transportation equipment, may be named in a suit claiming damages for injuries or damage to property caused by its assets. As a triple-net lessor, the Company is generally protected against such claims, since the lessee would be responsible for, insure against and indemnify the Company for such claims. A "triple net lease" is a 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. Although the United States Aviation Act may provide some protection with respect to the Company's aircraft assets, it is unclear to what extent such statutory protection would be available to the Company with respect to its assets that are operated in foreign countries where such provisions of the United States Aviation Act may not apply.
The Company's leases generally require a lessee to insure against likely risks of loss or damage to the leased asset, and liability to passengers and third parties pursuant to industry standard insurance policies and require lessees to provide insurance certificates documenting the policy periods and coverage amounts. The Company tracks receipt of the certificates and calendars their expiration dates. Prior to the expiration of an insurance certificate, if a replacement certificate has not been received, the Company reminds the lessee of its obligation to provide current insurance certificates to avoid a default under the lease.
Despite these requirements and procedures, there may be certain cases where the loss is not entirely covered by the lessee or its insurance. The Company believes the possibility of such an event is remote, but any such uninsured loss with respect to the equipment or insured loss for which insurance proceeds are inadequate might result in a loss of invested capital in and any profits anticipated from, such equipment, as well as a potential claim directly against the Company.
Compliance with Future Environmental Regulations.
Compliance with future environmental regulations may harm the Company's business. Many aspects of aircraft operations are subject to increasingly stringent environmental regulations, and growing concerns about climate change may result in the imposition by the U.S and foreign governments of additional regulation of carbon emissions, aimed at either requiring adoption of technology to reduce the amount of carbon emissions or putting in place a fee or tax system on carbon emitters. It is likely that any such regulation will be directed at the Company's customers, as operators of aircraft, or at the Company, as owner of aircraft. Under the Company's triple-net lease arrangements, the Company would likely shift responsibility for compliance to its lessees, but there might be some costs of complying with these regulations that the Company could not shift and would itself have to bear. Although it is not expected that the costs of complying with current environmental regulations will have a material adverse effect on the Company's financial position, results of operations, or cash flows, no assurance can be given that the costs of complying with environmental regulations adopted in the future will not have such an effect.
Cyber-Security Risks.
The Company believes that its main vulnerability to a cyber-attack would be interruption of the Company's email communications internally and with third parties, loss of customer and lease archives, and loss of document sharing between the Company's offices and remote workers. Such an attack could temporarily impede the efficiency of the Company's operations; however, the Company believes that sufficient replacement and backup mechanisms exist in the event of such an interruption such that there would not be a material adverse financial impact on the Company's business. A cyber-hacker could also gain access to and release proprietary information of the Company, its customers, suppliers and employees stored on the Company's data network. Such a breach could harm the Company's reputation and result in competitive disadvantages, litigation, lost revenues, additional costs, or liability to third parties. While the Company believes that it has sufficient cyber-security measures in place commensurate with the risks to the Company of a successful cyber-attack or breach of its data security, its resources and technical sophistication may not be adequate to prevent all types of cyber-attacks.
Possible Volatility of Stock Price.
The market price of the Company's common stock is subject to fluctuations following developments relating to the Company's operating results, changes in general conditions in the economy, the financial markets, the airline industry, changes in accounting principles or tax laws applicable to the Company or its lessees, or other developments affecting the Company, its customers or its competitors, or arising from other investor sentiment unknown to the Company. Because the Company has a relatively small capitalization of approximately 1.4 million shares outstanding, there is a correspondingly limited amount of trading and float of the Company's shares. Consequently, the Company's stock price is more sensitive to a single large trade or a small number of simultaneous trades along the same trend than a company with larger capitalization and higher trading volume and float. This stock price and trading volume volatility could limit the Company's ability to use its capital stock to raise capital, if and when needed or desired, or as consideration for other types of transactions, including strategic collaborations, investments or acquisitions. Any such limitation could negatively affect the Company's performance and liquidity.