AeroCentury 10QSB September 30, 2006
UNITED
STATES
SECURITIES
AND EXCHANGE COMMISSION
WASHINGTON,
DC 20549
FORM
10-QSB
(Mark
One)
x
|
Quarterly
Report Under Section 13 or 15(d) of the Securities Exchange Act of
1934
|
For
the
quarterly period ended September 30, 2006
o
|
Transition
Report Under Section 13 or 15(d) of the Securities Exchange Act of
1934
|
For
the
transition period from ____________ to ____________
Commission
File Number:
001-13387
AeroCentury
Corp.
(Exact
name of small business issuer as specified in its charter)
Delaware
|
|
94-3263974
|
(State
or other jurisdiction of incorporation or organization)
|
|
(I.R.S.
Employer Identification No.)
|
1440
Chapin Avenue, Suite 310
Burlingame,
California 94010
(Address
of principal executive offices)
(650)
340-1888
(Issuer’s
telephone number)
None
(Former
name, former address and former fiscal year, if changed since last
report)
Check
whether the Issuer: (1) filed all reports required to be filed by Section 13
or
15(d) of the Securities Exchange Act of 1934 during the past 12 months (or
for
such shorter period that the registrant was required to file such reports),
and
(2) has been subject to such filing requirements for the past 90
days.
Yes
x No
o
Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act).
Yes
o No
x
State
the
number of shares outstanding of each of the issuer’s classes of common equity,
as of the latest practicable date: As of November 13, 2006 the Issuer had
1,606,557 Shares
of
Common Stock, par value $0.001 per share, issued, of which 63,300 are held
as
Treasury Stock.
Transitional
Small Business Disclosure Format (check one):
Yes
o No
x
PART
I
FINANCIAL
INFORMATION
Forward-Looking
Statements
This
Quarterly Report on Form 10-QSB includes "forward-looking statements" within
the
meaning of Section 27A of the Securities Act of 1933, as amended (the
“Securities Act”) and Section 21E of the Securities Exchange Act of 1934, as
amended (“the Exchange Act”). All statements in this Report other than
statements of historical fact are "forward looking statements" for purposes
of
these provisions, including any statements of plans and objectives for future
operations and any statements of assumptions underlying any of the foregoing.
Statements that include the use of terminology such as "may," "will," "expects,"
"plans," "anticipates," "estimates," "potential," or "continue," or the negative
thereof, or other comparable terminology are forward-looking statements.
Forward-looking statements include: (i) in Item 1 "Financial Statements, Note
1"
the statement regarding the Company's belief that its current tax positions
are
highly certain and that implementation of FASB Interpretation No. 48 will not
have any material effect on its tax accounts, balances or provisions; and the
Company’s belief that SAB
108
will have a material impact on the Company’s results of operations but will not
have a material impact on the Company’s financial position
(ii) in
Item 1 “Financial Statements, Note 5” the statement that future taxable income
will likely be sufficient to realize the tax benefits of all the deferred tax
assets on the balance sheet; (iii) in Item 2 "Management's Discussion and
Analysis or Plan of Operation -- Liquidity and Capital Resources," statements
regarding the Company's belief that it continue to be in compliance with all
covenants of its credit facility; and that it will have adequate cash flow
to
meet its ongoing operational needs; (iv) in Item 2 "Management's Discussion
and
Analysis or Plan of Operation -- Outlook," statements regarding the Company's
belief that the lease for an aircraft that expires in November 2006 will be
extended; and that the Company’s adoption of a new method for accounting of
planned major maintenance will lead to a greater fluctuation in quarterly
earnings; and (v) in Item 2 "Management's Discussion and Analysis or Plan of
Operation -- Factors that May Affect Future Results,” statements regarding the
Company's belief that it will be able to meet its short term cash flow needs;
that it will have sufficient cash to fund any required repayments under its
credit facility caused by borrowing base limitations as a result of assets
scheduled to come off lease in the near term; that it will have sufficient
funds
to pay increased Sarbanes-Oxley compliance costs; that it will acquire primarily
used aircraft and expect to concentrate in a limited number of airframe and
aircraft engine types; that overseas markets present business opportunities;
that the Company is competitive because of JMC's experience and operational
efficiency and will benefit because of JMC's reputation in the marketplace.
These
forward-looking statements involve risks and uncertainties, and it is important
to note that the Company's actual results could differ materially from those
projected or assumed in such forward-looking statements. Among the factors
that
could cause actual results to differ materially are the factors detailed under
the heading "Management's Discussion and Analysis or Plan of Operation --
Factors That May Affect Future Results," including the compliance of the
Company's lessees with obligations under their respective leases; risks related
to use of debt financing for acquisitions; the Company’s success in finding
additional financing and appropriate assets to acquire with such financing;
general economic conditions, particularly those that affect the air travel
industry; unanticipated sharp increases in interest rates; further disruptions
to the air travel industry due to terrorist attacks; and future trends and
results which cannot be predicted with certainty. The cautionary statements
made
in this Report should be read as being applicable to all related forward-looking
statements wherever they appear herein. All forward-looking statements and
risk
factors included in this document are made as of the date hereof, based on
information available to the Company as of the date hereof, and the Company
assumes no obligation to update any forward-looking statement or risk factor.
You should consult the risk factors listed from time to time in the Company's
filings with the Securities and Exchange Commission.
AeroCentury
Corp.
Condensed
Consolidated Balance Sheet
Unaudited
ASSETS
|
|
|
|
|
September
30, 2006 |
|
|
|
|
|
|
Assets:
|
|
|
|
|
Cash
and cash equivalents
|
|
$
|
3,245,260
|
|
Accounts
receivable
|
|
|
947,140
|
|
Aircraft
and aircraft engine held for lease,
net
of accumulated depreciation of $20,767,730
|
|
|
90,044,570
|
|
Prepaid
expenses and other
|
|
|
730,610
|
|
|
|
|
|
|
Total
assets
|
|
$
|
94,967,580
|
|
|
|
|
|
|
|
|
|
|
|
LIABILITIES
AND STOCKHOLDERS’ EQUITY
|
|
|
|
|
|
Liabilities:
|
|
|
|
|
Accounts
payable and accrued expenses
|
|
$
|
896,810
|
|
Notes
payable and accrued interest
|
|
|
54,813,300
|
|
Maintenance
reserves and accrued costs
|
|
|
13,995,480
|
|
Security
deposits
|
|
|
4,092,860
|
|
Prepaid
rent
|
|
|
515,710
|
|
Deferred
taxes
|
|
|
1,243,130
|
|
Taxes
payable
|
|
|
10,490
|
|
|
|
|
|
|
Total
liabilities
|
|
|
75,567,780
|
|
|
|
|
|
|
Stockholders’
equity:
|
|
|
|
|
Preferred
stock, $0.001 par value, 2,000,000 shares
authorized,
no shares issued and outstanding
|
|
|
-
|
|
Common
stock, $0.001 par value, 3,000,000 shares
authorized,
1,606,557 shares issued and outstanding
|
|
|
1,610
|
|
Paid
in capital
|
|
|
13,821,200
|
|
Retained
earnings
|
|
|
6,081,060
|
|
|
|
|
19,903,870
|
|
Treasury
stock at cost, 63,300 shares
|
|
|
(504,070
|
)
|
|
|
|
|
|
Total
stockholders’ equity
|
|
|
19,399,800
|
|
|
|
|
|
|
|
|
$
|
94,967,580
|
|
The
accompanying notes are an integral part of these statements.
AeroCentury
Corp.
Condensed
Consolidated Statements of Operations
Unaudited
|
|
For
the Nine Months
Ended
September 30,
|
For
the Three Months
Ended
September 30,
|
|
|
|
2006
|
|
|
2005
|
|
|
2006
|
|
|
2005
|
|
Revenues
and other income:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Operating
lease revenue
|
|
$
|
11,454,940
|
|
$
|
8,216,510
|
|
$
|
3,920,000
|
|
$
|
2,956,410
|
|
Gain/(loss)
on sale of aircraft
|
|
|
408,840
|
|
|
(59,550
|
)
|
|
-
|
|
|
-
|
|
Other
income
|
|
|
2,400,700
|
|
|
94,600
|
|
|
9,510
|
|
|
130
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
14,264,480
|
|
|
8,251,560
|
|
|
3,929,510
|
|
|
2,956,540
|
|
Expenses:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Depreciation
|
|
|
3,708,520
|
|
|
2,935,430
|
|
|
1,247,560
|
|
|
1,030,030
|
|
Interest
|
|
|
3,687,380
|
|
|
2,456,860
|
|
|
1,271,750
|
|
|
877,000
|
|
Management
fees
|
|
|
2,061,720
|
|
|
1,705,960
|
|
|
678,460
|
|
|
594,470
|
|
Maintenance
|
|
|
3,554,920
|
|
|
219,870
|
|
|
221,600
|
|
|
169,440
|
|
Professional
fees and general
and
administrative
|
|
|
413,450
|
|
|
405,420
|
|
|
124,690
|
|
|
129,500
|
|
Insurance
|
|
|
183,000
|
|
|
242,140
|
|
|
53,760
|
|
|
75,160
|
|
Bad
debt expense
|
|
|
48,820
|
|
|
88,110
|
|
|
-
|
|
|
-
|
|
Provision
for impairment in
value
of aircraft
|
|
|
-
|
|
|
12,180
|
|
|
-
|
|
|
-
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
13,657,810
|
|
|
8,065,970
|
|
|
3,597,820
|
|
|
2,875,600
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Income
before taxes
|
|
|
606,670
|
|
|
185,590
|
|
|
331,690
|
|
|
80,940
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Tax
provision
|
|
|
196,970
|
|
|
47,770
|
|
|
112,580
|
|
|
28,840
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
income
|
|
$
|
409,700
|
|
$
|
137,820
|
|
$
|
219,110
|
|
$
|
52,100
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted
average common
shares
outstanding
|
|
|
1,543,257
|
|
|
1,543,257
|
|
|
1,543,257
|
|
|
1,543,257
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic
and diluted earnings per share
|
|
$
|
0.27
|
|
$
|
0.09
|
|
$
|
0.14
|
|
$
|
0.03
|
|
The
accompanying notes are an integral part of these statements.
AeroCentury
Corp.
Condensed
Consolidated Statements of Cash Flows
Unaudited
|
For
the Nine Months
Ended
September 30,
|
|
2006
|
2005
|
|
|
|
Net
cash provided by operating activities
|
$
6,007,910
|
$
3,240,390
|
|
|
|
Investing
activities:
|
|
|
Payments
received on note receivable
|
-
|
210,080
|
Proceeds
from disposal of assets
|
1,434,770
|
7,900,130
|
Purchase
of aircraft
|
(1,015,760)
|
(14,488,870)
|
Net
cash provided/(used) by investing activities
|
419,010
|
(6,378,660)
|
|
|
|
Financing
activities:
|
|
|
Issuance
of notes payable
|
1,650,000
|
10,941,000
|
Repayment
of notes payable
|
(5,450,570)
|
(8,800,690)
|
Net
cash (used)/provided by financing activities
|
(3,800,570)
|
2,140,310
|
|
|
|
Net
increase/(decrease) in cash and cash equivalents
|
2,626,350
|
(997,960)
|
|
|
|
Cash
and cash equivalents, beginning of period
|
618,910
|
2,403,630
|
|
|
|
Cash
and cash equivalents, end of period
|
$
3,245,260
|
$
1,405,670
|
During
the nine months ended September 30, 2006 and 2005, the Company paid interest
totaling $3,454,330 and $2,492,450, respectively, and income taxes totaling
$48,800 and $1,780,380, respectively.
The
accompanying notes are an integral part of these statements.
AeroCentury
Corp.
Notes
to
Condensed Consolidated Financial Statements (Unaudited)
September
30, 2006
1. Organization
and Summary of Significant Accounting Policies
(a)
Basis
of Presentation
AeroCentury
Corp. (“AeroCentury”), a Delaware corporation, uses leveraged financing to
acquire leased aircraft assets. The Company (as defined below) purchases used
regional aircraft on lease to foreign and domestic regional carriers. Financial
information for AeroCentury and its wholly-owned subsidiaries, AeroCentury
Investments V LLC (“AeroCentury V LLC”) and AeroCentury Investments VI LLC
(“AeroCentury VI LLC”) (collectively, the “Company”), is presented on a
consolidated basis. All intercompany balances and transactions have been
eliminated in consolidation.
(b) Cash
and Cash Equivalents/Deposits
The
Company considers highly liquid investments readily convertible into known
amounts of cash, with original maturities of 90 days or less from the date
of
acquisition, as cash equivalents.
(c) Aircraft
and Aircraft Engine Held For Lease and Held for Sale
The
Company’s interests in aircraft and aircraft engines are recorded at cost, which
includes acquisition costs. The Company purchases only used aircraft. It is
the
Company’s policy to hold aircraft for approximately twelve years unless market
conditions necessitate earlier disposition. Depreciation is computed using
the
straight-line method over the twelve year period to an estimated residual value
based on appraisal.
Decreases in the market value of aircraft could not only affect the current
value, but could also affect the assumed residual value. The Company
periodically obtains a residual value appraisal for its assets and,
historically, has not written down any estimated residuals. The Company’s
aircraft which are held for sale are not subject to depreciation.
(d) Impairment
of Long-lived Assets
The
Company periodically reviews its portfolio of assets for impairment in
accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144,
“Accounting for the Impairment or Disposal of Long-lived Assets." Such
review necessitates estimates of current market values, re-lease rents, residual
values and component values. The estimates are based on currently
available market data and are subject to fluctuation from time to
time.
The Company initiates its review periodically, whenever events or changes in
circumstances indicate that the carrying amount of a long-lived asset may not
be
recoverable. Recoverability of an asset is measured by comparison of its
carrying amount to the expected future undiscounted cash flows (without interest
charges) that the asset is expected to generate. Any impairment to be
recognized is measured by the amount by which the carrying amount of the asset
exceeds its fair market value. Significant management judgment is required
in the forecasting of future operating results which are used in the preparation
of projected undiscounted cash flows and, should different conditions prevail,
material write downs may occur.
AeroCentury
Corp.
Notes
to
Condensed Consolidated Financial Statements (Unaudited)
September
30, 2006
1. Organization
and Summary of Significant Accounting Policies (continued)
(e) Loan
Commitment and Related Fees
To
the
extent that the Company is required to pay loan commitment fees and legal fees
in order to secure debt, such fees are amortized over the life of the related
loan.
(f) Maintenance
Reserves and Accrued Costs
Maintenance
costs under the Company’s triple net leases are generally the responsibility of
the lessees. The accompanying consolidated balance sheet reflects liabilities
for maintenance reserves and accrued costs, which include refundable and
non-refundable maintenance payments received from lessees based on usage. At
September 30, 2006, the Company’s maintenance reserves and accruals consisted of
the following:
Refundable
maintenance reserves
|
|
$
|
1,634,880
|
|
Non-refundable
maintenance reserves
|
|
|
8,454,510
|
|
Accrued
costs
|
|
|
3,906,090
|
|
|
|
$
|
13,995,480
|
|
Maintenance
reserves received by the Company are accounted for as a liability, which is
reduced when maintenance work is performed during the lease. Maintenance
reserves which are refundable to the lessee are refunded after all return
conditions specified in the lease and, in some cases, any other payments due
under the lease, are satisfied. Any refundable reserves retained by the Company
to satisfy return conditions are reclassified to the Company’s own maintenance
payable account at lease end. Maintenance reserves which are non-refundable
to
the lessee are recorded as income at lease end. If an aircraft is returned
early, any collected reserves are reclassified to the Company’s own maintenance
payable account.
The
Company periodically reviews its maintenance reserves and maintenance accruals
for adequacy in light of the number of hours flown, airworthiness directives
issued by the manufacturer or government authority, and the return conditions
specified in the lease, as well as the condition of the aircraft upon return
or
inspection. As a result of such review, when it is probable that the Company
has
incurred costs for maintenance in excess of amounts accrued, the Company records
an expense for the additional work to be performed. Such costs include
maintenance such as engine and propeller overhauls, structural inspections
and
work to comply with airworthiness directives.
When
an
aircraft is sold, any remaining accrual is reversed and included in the
Company’s gain or loss on sale calculation. During the nine months ended
September 30, 2006 and 2005, $378,770 and $282,030,
respectively, of excess accruals were so included.
AeroCentury
Corp.
Notes
to
Condensed Consolidated Financial Statements (Unaudited)
September
30, 2006
1. Organization
and Summary of Significant Accounting Policies (continued)
(f) Maintenance
Reserves and Accrued Costs (continued)
Additions
to and deductions from the Company’s accruals during the nine months ended
September 30, 2006 and 2005 for maintenance work were as follows:
|
|
For
the Nine Months Ended
September
30,
|
|
|
|
2006
|
|
|
2005
|
|
Additions:
|
|
|
|
|
|
|
|
Charged
to expense
|
|
$
|
3,175,220
|
|
$
|
196,800
|
|
Charged
to other -
|
|
|
|
|
|
|
|
Reclassification
of reserves collected from lessees to the Company’s own liability
account
|
|
|
359,450
|
|
|
40,050
|
|
|
|
|
3,534,670
|
|
|
236,850
|
|
Deductions:
|
|
|
|
|
|
|
|
Paid
for previously accrued maintenance
|
|
|
2,588,390
|
|
|
316,570
|
|
Reversals
of over-accrued maintenance
|
|
|
11,850
|
|
|
760
|
|
Included
in gain/(loss) on sale of aircraft and aircraft engines
|
|
|
378,770
|
|
|
282,030
|
|
|
|
|
2,979,010
|
|
|
599,360
|
|
|
|
|
|
|
|
|
|
Net
increase/(decrease) in accrued maintenance costs, in excess of amounts
received under the leases
|
|
|
555,660
|
|
|
(362,510
|
)
|
|
|
|
|
|
|
|
|
Balance,
beginning of period
|
|
|
3,350,430
|
|
|
2,296,520
|
|
|
|
|
|
|
|
|
|
Balance,
end of period
|
|
$
|
3,906,090
|
|
$
|
1,934,010
|
|
(g) Security
deposits
The
Company’s leases are typically structured so that if any event of default occurs
under a lease, the Company may apply all or a portion of the lessee’s security
deposit to cure such default. If such application of the security deposit is
made, the lessee typically is required to replenish and maintain the full amount
of the deposit during the remaining term of the lease. All of the security
deposits received by the Company are refundable to the lessee at the end of
the
lease, upon satisfaction of all lease terms.
(h) Income
Taxes
As
part
of the process of preparing the Company’s consolidated financial statements,
management is required to estimate income taxes in each of the jurisdictions
in
which the Company operates. This process involves estimating the Company’s
current tax exposure under the most recent tax laws and assessing temporary
differences resulting from differing treatment of items for tax and accounting
purposes. These differences result in deferred tax assets and liabilities,
which
are included in the consolidated balance sheet. Management must also assess
the
likelihood that the Company’s deferred tax assets will be recovered from future
taxable income, and, to the extent management believes it is more likely than
not that some portion or all of the deferred tax assets will not be realized,
the Company must establish a valuation allowance. To the extent the Company
establishes a valuation allowance
AeroCentury
Corp.
Notes
to
Condensed Consolidated Financial Statements (Unaudited)
September
30, 2006
1. Organization
and Summary of Significant Accounting Policies (continued)
(h) Income
Taxes (continued)
or
changes the allowance in a period, the Company reflects the corresponding
increase or decrease within the tax provision in the consolidated statement
of
operations.
(i) Revenue
Recognition and Allowance for Doubtful Accounts
Revenue
from leasing of aircraft assets is recognized as operating lease revenue on
a
straight-line basis over the terms of the applicable lease agreements. The
Company estimates and charges to income a provision for bad debts based on
its
experience in the business and with each specific customer, the level of past
due accounts, and its analysis of the lessees’ overall financial condition. If
the financial condition of the Company’s customers deteriorates, it could result
in actual losses exceeding any estimated allowances.
(j) Use
of Estimates
The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities
and
disclosures of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates. The Company
bases its estimates on historical experience and on various other assumptions
that are believed to be reasonable for making judgments that are not readily
apparent from other sources.
The
most
significant estimates with regard to these financial statements are the residual
values of the aircraft, the useful lives of the aircraft, the amount and timing
of cash flow associated with each aircraft that are used to evaluate impairment,
if any, accrued maintenance costs in excess of amounts received from lessees,
the amounts recorded as bad debt allowances and accounting for income
taxes.
(k) Comprehensive
Income
The
Company does not have any comprehensive income other than the revenue and
expense items included in the consolidated statements of operations. As a
result, comprehensive income equals net income for the three months and nine
months ended September 30, 2006 and 2005.
(l) Recent
Accounting Pronouncements
SFAS
153,
Exchanges
of Nonmonetary Assets,
addresses the measurement of exchanges of nonmonetary assets. It eliminates
the
exception from fair value measurement for nonmonetary exchanges of similar
productive assets in paragraph 21(b) of APB Opinion No. 29, Accounting
for Nonmonetary Transactions,
and
replaces it with an exception for exchanges that do not have commercial
substance. SFAS 153 specifies that a nonmonetary exchange has commercial
substance if the future cash flows of the entity are expected to change
significantly as a result of the exchange. The provisions of SFAS 153 are
effective for nonmonetary asset exchanges occurring in fiscal periods beginning
after June 15, 2005. The adoption of SFAS 153 had no effect on the Company’s
consolidated financial condition or results of operations.
AeroCentury
Corp.
Notes
to
Condensed Consolidated Financial Statements (Unaudited)
September
30, 2006
1. Organization
and Summary of Significant Accounting Policies (continued)
(l) Recent
Accounting Pronouncements (continued)
In
March
2005,
the
FASB issued
interpretation FIN No. 47, Accounting
for Conditional Asset Retirement Obligations ("FIN
47"). FIN 47 clarifies
that the term conditional
asset retirement obligation as
used
in SFAS 143, Accounting
for Asset Retirement Obligations,
refers
to a legal obligation to perform an asset retirement activity in which the
timing and (or) method of settlement are conditional on a future event that
may
or may not be within the control of the entity. FIN 47 is applicable to fiscal
years ending after December 15, 2005. The
adoption of FIN 47 had no material effect on the Company’s consolidated
financial condition or results of operations.
SFAS
123(R), Share-based
Payment,
requires compensation cost relating to share-based payment transactions be
recognized in financial statements. SFAS 123(R) is effective for small business
issuers as of the beginning of the first interim or annual reporting period
that
began after December 15, 2005, supercedes APB Opinion No. 25, Accounting
for Stock Issued to Employees,
and
replaces SFAS No. 123, Accounting
for Stock-based Compensation.
The
pro-forma disclosure previously permitted under SFAS No. 123 is no longer an
acceptable alternative to recognition of expenses in the financial statements.
The adoption of SFAS 123(R) had no effect on the Company’s consolidated
financial condition or results of operations.
In
July
2006, the FASB issued Interpretation No. 48, Accounting
for Uncertainty in Income Taxes - an Interpretation of FASB Statement
109.
Interpretation No. 48 is effective for fiscal years beginning after December
15,
2006. Interpretation No. 48 prescribes a comprehensive model for how a company
should recognize, measure, present, and disclose in its financial statements
uncertain tax positions that a company has taken or expects to take on a tax
return (including a decision whether to file or not to file a return in a
particular jurisdiction). Under the Interpretation, the financial statements
will reflect expected future tax consequences of such positions presuming the
taxing authorities' full knowledge of the position and all relevant facts,
but
without considering time values. The Company is required to implement
Interpretation No. 48 in the year beginning January 1, 2007; however, the
Company believes that its current tax positions are highly certain and therefore
that such implementation will not have any material affect on its tax accounts,
balances or provisions.
FASB
Staff Position AUG AIR-1, Accounting
for Planned Major Maintenance Activities (“FSP
AUG
AIR-1”), was posted on September 8, 2006 and prohibits the use of the
accrue-in-advance method of accounting for planned major maintenance activities
in annual and interim financial reporting periods. FSP AUG AIR-1 must be applied
to the first fiscal year beginning after December 15, 2006. The Company is
evaluating the impact of adoption of FSP AUG AIR-1 on its consolidated financial
statements.
On
September 13, 2006, the SEC staff issued Staff Accounting Bulletin (“SAB”) No.
108 (SAB Topic 1N), “Considering the Effects of Prior Year Misstatements when
Quantifying Misstatements in Current Year Financial Statements,” which outlines
the approach it believes registrants should use to quantify the misstatement
of
current year financial statements that results from misstatements of prior
year
financial statements. Implementing the approach outlined in SAB 108 may
require the Company to make significant adjustments in its 2006 annual financial
statements. The SAB will change practice by requiring registrants to use a
combination of two approaches, the “rollover” approach, which quantifies a
misstatement based on the amount of the error originating in the current year
income statement and the “iron curtain” approach, which quantifies a
misstatement based on the effects of correcting the misstatement existing in
the
balance sheet at the end of the current year. The SAB requires registrants
to
adjust their financial statements if the new approach results in a conclusion
that an error is material. SAB 108 is effective for fiscal years ending
after November 15, 2006. The Company is required to adopt SAB 108 in the year
ending December 31, 2006. Management believes the impact of adopting SAB
108 will have a material impact on results of operations but will not have
a
material impact on the Company’s financial position.
AeroCentury
Corp.
Notes
to
Condensed Consolidated Financial Statements (Unaudited)
September
30, 2006
2. Aircraft
and Aircraft Engine Held for Lease
At
September 30, 2006, the Company owned eleven deHavilland DHC-8s, three
deHavilland DHC-6s, fourteen Fokker 50s, two Saab 340As, three Saab 340Bs and
one turboprop engine which are held for lease. At
September 30, 2006, all of the Company’s aircraft were on lease. The Company’s
spare turboprop engine was leased in November 2006.
3. Notes
Payable and Accrued Interest
(a) Credit
facility
In
November 2005, the Company’s $50 million credit facility was renewed through
October 31, 2007. In connection with the renewal, certain financial covenants
were modified, including the applicable margin which is added to the index
rate
for each of the Company’s outstanding loans under the credit facility. The
margin, which is determined by certain financial ratios, was revised from a
range of 275 to 375 basis points to a range of 275 to 325 basis
points.
In May
2006, a
participant was added to the Company’s credit facility and the amount of the
facility was increased to $55 million. During the first nine months of 2006,
the
Company repaid $3 million of the outstanding principal under its credit
facility. As
a
result of maintenance expense in connection with preparing one of the Company’s
aircraft for lease in the second quarter, on June 30, 2006, the Company was
out
of compliance with a financial ratio covenant which is based on net income.
The
Company obtained a waiver from its banks regarding that covenant for the quarter
then ended. As
of
September 30, 2006, the Company was in compliance with all covenants under
its
credit facility agreement, $46,996,000 was outstanding under the credit
facility, and interest of $655,260 was accrued.
(b) Special
purpose financing
In
September 2000, a special purpose subsidiary acquired a deHavilland DHC-8
aircraft using cash and bank financing separate from its credit facility. The
financing resulted in a note obligation in the amount of $3,575,000, due April
15, 2006, which bore interest at
the
rate of one-month LIBOR plus 3%.
The
note
was collateralized by the aircraft and was non-recourse to the Company.
Payments
due under the note consisted of monthly principal and interest and a balloon
principal payment due on the maturity date. The
financing also provided for a six month remarketing period at the expiration
or
early termination of the lease. This note obligation was refinanced in April
2006, using
bank financing from another lender, and the subsidiary was dissolved. The
aircraft was transferred to AeroCentury VI LLC, a newly formed special purpose
limited liability company, which borrowed $1,650,000, due October 15, 2009.
The
note bears interest at an adjustable rate of one-month LIBOR plus 3%.
The
note
is collateralized by the aircraft and the Company’s interest in AeroCentury VI
LLC and is non-recourse to the Company. Payments
due under the note consist of monthly principal and interest through April
20,
2009, interest only from April 20, 2009 until the maturity date, and a balloon
principal payment due on the maturity date. If the aircraft lease agreement
is
terminated on April 15, 2008 pursuant to a lessee early termination option,
the
note will be due October 15, 2008, and the interest only period will be from
April 20, 2008 through October 15, 2008. During the first nine months of 2006,
these two special purpose subsidiaries repaid $1,785,530 of principal. The
balance of the note payable at September 30, 2006 was $1,495,360 and interest
of
$3,810 was accrued. As of September 30, 2006, the Company was in compliance
with
all covenants of this note obligation.
AeroCentury
Corp.
Notes
to
Condensed Consolidated Financial Statements (Unaudited)
September
30, 2006
3. Notes
Payable and Accrued Interest (continued)
(b) Special
purpose financing (continued)
In
November 2005, the Company refinanced two DHC-8 aircraft that had been part
of
the collateral base for its credit facility. The financing, by a bank separate
from its credit facility, was provided to a newly formed special purpose
subsidiary, AeroCentury V LLC, to which the aircraft were transferred. The
financing resulted in a note obligation in the amount of $6,400,000, due
November 10, 2008, which bears interest at
the
rate 7.87%.
The
note
is collateralized by the aircraft and is non-recourse to the Company.
Payments
due under the note consist of monthly principal and interest through April
22,
2008, interest only from April 22, 2008 until the maturity date, and a balloon
principal payment due on the maturity date. During the first nine months of
2006, AeroCentury V LLC repaid $665,040 of principal. The balance of the note
payable at September 30, 2006 was $5,651,750 and interest of $11,120 was
accrued. As of September 30, 2006, the Company was in compliance with all
covenants of this note obligation.
4. Stockholder
Rights Plan
On
April
8, 1998, the Company’s Board of Directors adopted a stockholder rights plan
granting a dividend of one stock purchase right for each share of the Company’s
common stock outstanding as of April 23, 1998. The rights become exercisable
only upon the occurrence of certain events specified in the plan, including
the
acquisition of 15% of the Company’s outstanding common stock by a person or
group. Each right entitles the holder to purchase one one-hundredth of a share
of Series A Preferred Stock of the Company at an exercise price of $66.00 per
one-one-hundredth of a share. Each right entitles the holder, other than an
“acquiring person,” to acquire shares of the Company’s common stock at a 50%
discount to the then prevailing market price. The Company’s Board of Directors
may redeem outstanding rights at a price of $0.01 per right.
5. Income
Taxes
The
items
comprising income tax expense are as follows:
|
|
For
the Nine Months Ended
September
30,
|
|
|
|
2006
|
|
|
2005
|
|
Current
tax provision:
|
|
|
|
|
|
|
|
Federal
|
|
$
|
-
|
|
$
|
175,390
|
|
State
|
|
|
11,140
|
|
|
1,630
|
|
Current
tax provision
|
|
|
11,140
|
|
|
177,020
|
|
|
|
|
|
|
|
|
|
Deferred
tax provision/(benefit):
|
|
|
|
|
|
|
|
Federal
|
|
|
202,540
|
|
|
(103,330
|
)
|
State
|
|
|
(16,710
|
)
|
|
(25,920
|
)
|
Deferred
tax provision/(benefit)
|
|
|
185,830
|
|
|
(129,250
|
)
|
Total
provision for income taxes
|
|
$
|
196,970
|
|
$
|
47,770
|
|
AeroCentury
Corp.
Notes
to
Condensed Consolidated Financial Statements (Unaudited)
September
30, 2006
5. Income
Taxes (continued)
Total
income tax expense differs from the amount that would be provided by applying
the statutory federal income tax rate to pretax earnings as illustrated
below:
|
|
For
the Nine Months Ended
September
30,
|
|
|
|
2006
|
|
|
2005
|
|
Income
tax provision at statutory federal income tax rate
|
|
$
|
206,450
|
|
$
|
63,100
|
|
State
tax provision, net of federal benefit
|
|
|
9,060
|
|
|
1,090
|
|
Adjustment
to asset tax basis
|
|
|
-
|
|
|
10,100
|
|
Tax
rate differences
|
|
|
(23,200
|
)
|
|
(26,520
|
)
|
Other
|
|
|
4,660
|
|
|
-
|
|
Total
income tax provision
|
|
$
|
196,970
|
|
$
|
47,770
|
|
Tax
rate
differences resulted from a decrease in the Company's effective state tax rates
due to changes in state apportionment percentages.
Temporary
differences and carry-forwards that give rise to a significant portion of
deferred tax assets and liabilities as of September 30, 2006 are as
follows:
Deferred
tax assets:
|
|
|
|
|
Deferred
maintenance
|
|
$
|
1,748,050
|
|
Maintenance
reserves
|
|
|
2,463,590
|
|
Current
year tax losses
|
|
|
847,550
|
|
Prepaid
rent and other
|
|
|
195,930
|
|
Deferred
tax assets
|
|
|
5,255,120
|
|
Deferred
tax liabilities:
|
|
|
|
|
Depreciation
on aircraft and aircraft engines
|
|
|
(6,387,100
|
)
|
Other
|
|
|
(111,150
|
)
|
Net
deferred tax liabilities
|
|
$
|
(1,243,130
|
)
|
No
valuation allowance is deemed necessary, as the Company has concluded that,
based on an assessment of all available evidence, it is more likely than not
that future taxable income will be sufficient to realize the tax benefits of
all
the deferred tax assets on the consolidated balance sheet. The current year
tax
losses, if not utilized in the current year, will be available to offset taxable
income in each of the two preceding tax years and in future years through
2026.
AeroCentury
Corp.
Notes
to
Condensed Consolidated Financial Statements (Unaudited)
September
30, 2006
6. Related
Party Transactions
The
Company has no employees. Its portfolio of leased aircraft assets is managed
and
administered under the terms of a management agreement with JMC, which is an
integrated aircraft management, marketing and financing business and a
subsidiary of JetFleet Holding Corp. ("JHC"). Certain officers of the Company
are also officers of JHC and JMC and hold significant ownership positions in
both JHC and the Company. Under the management agreement, JMC receives a monthly
management fee based on the net asset value of the assets under management.
JMC
may also receive an acquisition fee for locating assets for the Company,
provided that the aggregate purchase price, including chargeable acquisition
costs and any acquisition fee, does not exceed the fair market value of the
asset based on appraisal, and a remarketing fee in connection with the sale
or
re-lease of the Company’s assets. The Company recorded management fees of
$2,061,720 and
$1,705,960
during
the nine months ended September 30, 2006 and 2005, respectively. Because the
Company did not acquire any aircraft during the first nine months of 2006,
no
acquisition fees were paid to JMC for this period. The Company accrued
acquisition fees totaling $520,900 payable to JMC during the first nine months
of 2005. The
Company recorded remarketing fees totaling $44,000 and $73,250 to JMC in
connection with the sale of aircraft in the first nine months of 2006 and 2005,
respectively.
Item
2. Management’s
Discussion and Analysis or Plan of Operation.
Overview
The
Company is a lessor of turboprop aircraft and engines which are used by
customers pursuant to triple net operating
leases. The acquisition of such equipment is generally made using debt
financing. The Company’s profitability and cash flow are dependent in large part
upon its ability to acquire equipment, obtain and maintain favorable lease
rates
on such equipment, and re-lease or sell owned equipment that comes off lease.
The Company is subject to the credit risk of its lessees, both as to collection
of rent and to performance by the lessees of obligations for maintaining the
aircraft. Since lease rates for assets in the Company’s portfolio generally
decline as the assets age, the Company’s ability to maintain revenue and
earnings is dependent upon the Company’s ability to grow its asset portfolio.
The
Company’s principal expenditures are for interest costs on its financing,
management fees, and maintenance of its aircraft assets. Maintenance
expenditures are generally incurred only when aircraft are off lease, are being
prepared for re-lease, or require maintenance in excess of lease return
conditions.
The
most
significant non-cash expenses include accruals of maintenance costs to be borne
by the Company and aircraft depreciation, both of which are the result of
significant estimates. Maintenance expenses are estimated and accrued based
upon
utilization of the aircraft. Depreciation is recognized based upon the estimated
residual value of the aircraft at the end of their estimated lives. Deviation
from these estimates could have a substantial effect on the Company’s cash flow
and profitability.
Critical
Accounting Policies, Judgments and Estimates
The
discussion and analysis of the Company’s financial condition and results of
operations are based upon the consolidated financial statements, which have
been
prepared in accordance with accounting principles generally accepted in the
United States of America. The preparation of these financial statements requires
management to make estimates and judgments that affect the reported amounts
of
assets and liabilities, revenues and expenses, and the related disclosure of
contingent assets and liabilities at the date of the financial statements.
Actual results may differ from these estimates under different assumptions
or
conditions.
The
Company’s significant accounting policies are described in Note 1 to the
consolidated financial statements. The Company believes that the most critical
accounting policies include the following: Impairment of Long-lived Assets;
Depreciation Policy, Maintenance Reserves and Accrued Costs; Revenue Recognition
and Allowance for Doubtful Accounts; and Accounting for Income
Taxes.
a. Impairment
of Long-lived Assets
The
Company periodically reviews its portfolio of assets for impairment in
accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144,
“Accounting for the Impairment or Disposal of Long-lived Assets." Such
review necessitates estimates of current market values, re-lease rents, residual
values and component values. The estimates are based on currently
available market data and third-party appraisals and are subject to fluctuation
from time to time.
The Company initiates its review periodically, whenever events or changes in
circumstances indicate that the carrying amount of a long-lived asset may not
be
recoverable. Recoverability of an asset is measured by comparison of its
carrying amount to the expected future undiscounted cash flows (without interest
charges) that the asset is expected to generate. Any impairment to be
recognized is measured by the amount by which the carrying amount of the asset
exceeds its fair market value. Significant management judgment is required
in the forecasting of future operating results which are used in the preparation
of projected undiscounted cash flows and should different conditions prevail,
material write downs may occur.
b. Depreciation
Policy
The
Company’s interests in aircraft and aircraft engines are recorded at cost, which
includes acquisition costs. The Company purchases only used aircraft. It is
the
Company’s policy to hold aircraft for approximately twelve years unless market
conditions necessitate earlier disposition. Depreciation is computed using
the
straight-line method over the twelve year period to an estimated residual value
based on appraisal. Decreases in the market value of aircraft could not only
affect the current value, discussed above, but could also affect the assumed
residual value. The Company periodically obtains a residual value appraisal
for
its assets and, historically, has not written down any estimated
residuals.
c. Maintenance
Reserves and Accrued Costs
Maintenance
costs under the Company’s triple net leases are generally the responsibility of
the lessees. Maintenance reserves and accrued costs in the accompanying
consolidated balance sheet include refundable and non-refundable maintenance
payments received from lessees. The Company periodically reviews maintenance
reserves for each of its aircraft for adequacy in light of the number of hours
flown, airworthiness directives issued by the manufacturer or government
authority, and the return conditions specified in the lease, as well as the
condition of the aircraft upon return or inspection. As a result of such review,
if it is probable that the Company has incurred costs for maintenance in excess
of amounts received from lessees, the Company accrues its share of costs for
work to be performed.
Significant
management judgment is required in determining aircraft condition and estimating
maintenance costs. Absent fixed price maintenance agreements, these costs cannot
be determined until such work is completed. Because of the potential magnitude
of maintenance costs, even slight changes in work scope may have a material
impact on operating results.
With
respect to estimated maintenance costs, the Company has found its accruals
to be
generally accurate. Its accruals, however, are based on the assumption that
aircraft will be returned at lease end in accordance with the return conditions
of the lease. Consequently, as a result of two past situations, the Company
has
incurred significant maintenance expense when aircraft were returned early
and
in a condition worse than required by the lease and for which the Company was
unable to recover the costs of non-compliance from the lessees.
d. Revenue
Recognition and Allowance for Doubtful Accounts
Revenue
from leasing of aircraft assets is recognized as operating lease revenue on
a
straight-line basis over the terms of the applicable lease agreements. The
Company estimates and charges to income a provision for bad debts based on
its
experience in the business and with each specific customer, the level of past
due accounts, and its analysis of the lessees’ overall financial condition. If
the financial condition of the Company’s customers deteriorates, it could result
in actual losses exceeding the estimated allowances.
e. Accounting
for Income Taxes
As
part
of the process of preparing the Company’s consolidated financial statements,
management is required to estimate income taxes in each of the jurisdictions
in
which the Company operates. This process involves estimating the Company’s
current tax exposure under the most recent tax laws and assessing temporary
differences resulting from differing treatment of items for tax and accounting
purposes. These differences result in deferred tax assets and liabilities,
which
are included in the consolidated balance sheet. Management must also assess
the
likelihood that the Company’s deferred tax assets will be recovered from future
taxable income, and, to the extent management believes it is more likely than
not that some portion or all of the deferred tax assets will not be realized,
the Company must establish a valuation allowance. To the extent the Company
establishes a valuation allowance or changes the allowance in a period, the
Company reflects the corresponding increase or decrease within the tax provision
in the consolidated statement of operations.
Significant
management judgment is required in determining the Company’s future taxable
income for purposes of assessing the Company’s ability to realize any benefit
from its deferred taxes. 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.
Results
of Operations
a. Revenues
and other income
Operating
lease revenue was approximately $3,238,000 and $964,000 higher in the nine
months and three months ended September 30, 2006 versus the same periods in
2005, primarily because of increased operating lease revenue from aircraft
purchased beginning in April 2005 and revenue from two aircraft which had been
off lease in 2005.
Gain
on
sale of aircraft was approximately $409,000 for the nine months ended September
30, 2006 as a result of the sale of an aircraft in April 2006. Loss on sale
of
aircraft was approximately $60,000 for the nine months ended September 30,
2005
as a result of the sale of an aircraft in February 2005.
Other
income was approximately $2,306,000 higher in the nine months ended September
30, 2006 versus the same period in 2005, primarily as a result of $2,396,000
of
non-refundable maintenance reserves retained by the Company which were recorded
as income at lease end in 2006. Other income was approximately the same in
the
three month periods of both years.
b. Expense
items
Depreciation
was approximately $773,000 and $218,000 higher in the nine months and three
months ended September 30, 2006, respectively, versus the same periods in 2005.
These increases were primarily because of purchases of aircraft beginning in
April 2005, the effect of which was partially offset by the sale of two
aircraft, one in November 2005 and the second in April 2006. Management fees,
which are calculated on the net book value of the aircraft owned by the Company,
were approximately $356,000 and $84,000 higher in the nine month and three
month
periods of 2006 compared to 2005, respectively, for the same
reasons.
Interest
expense was approximately $1,231,000 and $395,000 higher in the nine months
and
three months ended September 30, 2006 versus the same periods in 2005 primarily
as a result of increases in the index rates upon which the Company’s interest
rates are based and a higher average principal balance in 2006 compared to
2005,
the effect of which was partially offset by a lower margin in 2006 than in
2005.
Maintenance
expense was approximately $3,335,000 higher in the nine months ended September
30, 2006 versus the same period in 2005. In 2006, the Company retained
non-refundable maintenance reserves when two aircraft were returned to the
Company at lease end and recorded such amounts as other income, discussed above.
Based on the condition of the aircraft at the time of return, the Company
accrued approximately $2,392,000 of maintenance expense for which the Company
is
responsible. In 2006, the Company also accrued approximately $1,163,000 of
expense to prepare several aircraft for re-lease. In 2005, the Company accrued
approximately $220,000 of maintenance expense, for the storage and preparation
for re-lease of several aircraft. Maintenance expense was approximately $52,000
higher in the three months ended September 30, 2006 compared to the same period
in 2005, primarily because of the expense to prepare an aircraft for re-lease.
The
Company's insurance expense consists primarily of insurance for off-lease
aircraft and aircraft engines, which varies depending on the type of assets
insured during each period and the length of time each asset is insured. As
a
result of the combination of assets insured during each period and the length
of
time each was insured, insurance expense was approximately $59,000 and $21,000
lower in the nine months and three months ended September 30, 2006,
respectively, versus the same periods in 2005.
During
the first quarter of 2006, the Company recorded bad debt expense of
approximately $49,000 for rent receivable which was written off in connection
with a lessee’s early return of an aircraft. During the second quarter of 2005,
the Company recorded bad debt expense of approximately $88,000, to fully reserve
the balance of a note receivable from a former lessee, based on a notice
received from the lessee that it had filed for reorganization.
The
Company did not record any impairment charges in the first nine months of 2006.
In the first nine months of 2005, the Company recorded an
impairment charge of approximately $12,000 for one of its aircraft, based on
the
estimated net sales proceeds pursuant to an agreement to sell the aircraft.
The
Company’s effective tax rates for the nine months ended September 30, 2006 and
2005 were approximately 32% and 26%, respectively. The change in rate was
primarily a result of the recognition of tax benefits relating to different
state tax rates that had been accrued in prior years. Since the Company earned
less income for the period ended September 30, 2005 than it earned for the
period ended September 30, 2006, the recognition of tax benefits related to
the
reduced state tax rates acted to reduce the Company’s effective tax rate more
for the period ended September 30, 2005 than it did for the period ended
September 30, 2006. In addition, during the period ended September 30, 2006,
the
Company leased more aircraft within the United States which resulted in
additional state tax expense than for that period than for the period ended
September 30, 2005.
Liquidity
and Capital Resources
The
Company is currently financing its assets primarily through credit facility
borrowings, special purpose financing and excess cash flow.
(a) Credit
facility
In
November 2005, the Company’s credit facility was renewed through October 31,
2007. In connection with the renewal, certain financial covenants were modified,
including the applicable margin which is added to the index rate for each of
the
Company’s outstanding loans under the credit facility. The margin, which is
determined by certain financial ratios, was revised from a range of 275 to
375
basis points to a range of 275 to 325 basis points. In May 2006, a
participant was added to the Company’s credit facility and the amount of the
facility was increased from $50 million to $55 million.
During
the first nine months of 2006, the Company repaid $3 million of the outstanding
principal under its credit facility. The
balance of the note payable at September 30, 2006 was $46,996,000 and interest
of $655,260 was accrued.
As
a
result of maintenance expense in connection with preparing one of the Company’s
aircraft for lease in the second quarter, on June 30, 2006, the Company was
out
of compliance with a financial ratio covenant which is based on net income.
The
Company obtained a waiver from its banks regarding that covenant for the quarter
then ended. The
Company is currently in compliance with all covenants and, based on its current
projections, the Company believes it will continue to be in compliance with
all
covenants of its credit facility, but there can be no assurance of such
compliance in the future. See "Factors
That May Affect Future Results - 'Credit Facility Obligations' and 'Risks of
Debt Financing',"
below.
The
Company's interest expense in connection with the credit facility generally
moves up or down with prevailing interest rates, as the Company has not entered
into any interest rate hedge transactions for the credit facility indebtedness.
Because aircraft owners seeking financing generally can obtain financing
through either leasing transactions or traditional secured debt financings,
prevailing interest rates are a significant factor in determining market lease
rates, and market lease rates generally move up or down with prevailing interest
rates, assuming supply and demand of the desired equipment remain constant.
However, because lease rates for the Company’s assets typically are fixed
under existing leases, the Company normally does not experience any positive
or
negative impact in revenue from changes in market lease rates due to interest
rate changes until existing leases have terminated and new lease rates are
set
as the aircraft is re-leased.
(b) Special
purpose financing
In
September 2000, a special purpose subsidiary acquired a deHavilland DHC-8
aircraft using cash and bank financing separate from its credit facility. The
financing resulted in a note obligation in the amount of $3,575,000, due April
15, 2006, which bore interest at
the
rate of one-month LIBOR plus 3%.
The
note
was collateralized by the aircraft and was non-recourse to the Company.
Payments
due under the note consisted of monthly principal and interest and a balloon
principal payment due on the maturity date. The
financing also provided for a six month remarketing period at the expiration
or
early termination of the lease. This note obligation was refinanced in April
2006, using
bank financing from another lender, and the subsidiary was dissolved. The
aircraft was transferred to AeroCentury VI LLC, a newly formed special purpose
limited liability company, which borrowed $1,650,000, due October 15, 2009.
The
note bears interest at an adjustable rate of one-month LIBOR plus 3%.
The
note
is collateralized by the aircraft and the Company’s interest in AeroCentury VI
LLC and is non-recourse to the Company. Payments
due under the note consist of monthly principal and interest through April
20,
2009, interest only from April 20, 2009 until the maturity date, and a balloon
principal payment due on the maturity date. If the aircraft lease agreement
is
terminated on April 15, 2008 pursuant to a lessee early termination option,
the
note will be due October 15, 2008, and the interest only period will be from
April 20, 2008 through October 15, 2008. During the first nine months of 2006,
these two special purpose subsidiaries repaid $1,785,530 of principal. The
balance of the note payable at September 30, 2006 was $1,495,360 and interest
of
$3,810 was accrued. As of September 30, 2006, the Company was in compliance
with
all covenants of this note obligation and is currently in
compliance.
In
November 2005, the Company refinanced two DHC-8 aircraft that had been part
of
the collateral base for its credit facility. The financing, by a bank separate
from its credit facility, was provided to a newly formed special purpose
subsidiary, AeroCentury V LLC, to which the aircraft were transferred. The
financing resulted in a note obligation in the amount of $6,400,000, due
November 10, 2008, which bears interest at
the
rate 7.87%.
The
note
is collateralized by the aircraft and is non-recourse to the Company.
Payments
due under the note consist of monthly principal and interest through April
22,
2008, interest only from April 22, 2008 until the maturity date, and a balloon
principal payment due on the maturity date. During the first nine months of
2006, AeroCentury V LLC repaid $665,040 of principal. The balance of the note
payable at September 30, 2006 was $5,651,750 and interest of $11,120 was
accrued. As of September 30, 2006, the Company was in compliance with all
covenants of this note obligation and is currently in compliance.
The
availability of special purpose financing in the future will depend on several
factors including (1) the availability of funds to be used for the equity
portion of the financing, (2) the type of asset being financed, (3) the
creditworthiness of the underlying lessee and (4) continued compliance with
the
Company’s credit facility covenants. The availability of funds for the equity
portion of the financing will be dependent on the Company's cash flow, as
discussed in "Cash
Flow,"
below.
(c) Cash
flow
The
Company's primary source of revenue is lease rentals of its aircraft assets.
It
is the Company’s policy to monitor each lessee’s needs in periods before leases
are due to expire. If it appears that a customer will not be renewing its lease,
the Company immediately initiates marketing efforts to locate a potential new
lessee or purchaser for the aircraft. The goal of this procedure is to reduce
the time that an asset will be off lease. The Company’s aircraft are subject to
leases with varying expiration dates through November 2010.
Management
believes that the Company will have adequate cash flow to meet its ongoing
operational needs, including required repayments under its credit facility,
based upon its estimates of future revenues and expenditures. The Company’s
expectations concerning such cash flows are based on existing lease terms and
rents, as well as numerous assumptions, including (i) rents on assets to be
re-leased, (ii) sale proceeds of certain assets currently under lease, (iii)
the
cost and anticipated timing of maintenance to be performed and (iv) acquisition
of additional aircraft and the lease thereof at favorable lease terms. While
the
Company believes that the assumptions it has made in forecasting its cash flow
are reasonable in light of experience, actual results could deviate from such
assumptions. Among the more significant external factors outside the Company’s
control that could have an impact on the accuracy of cash flow assumptions
are
(i) an increase in interest rates that may negatively affect the Company’s
profitability and may cause the Company to violate covenants of its credit
facility, requiring repayment of some or all of the amounts outstanding under
its credit facility, (ii) lessee non-performance or non-compliance with lease
obligations (which may affect credit facility collateral limitations as well
as
revenue and expenses) and (iii) an unexpected deterioration of demand for
aircraft equipment.
(i) Operating
activities
The
Company’s cash flow from operations for the nine months ended September 30, 2006
versus the nine months ended September 30, 2005 increased by approximately
$2,768,000. The change in cash flow is a result of changes in several cash
flow
items during the period, including principally the following:
Lease
rents and security deposits
Payments
received from lessees for rent were approximately $3,560,000 higher in the
nine
months ended September 30, 2006 versus 2005, due primarily to the effect of
increased lease revenue from aircraft purchased beginning in April 2005.
Although increased demand generally in the turboprop market has caused lease
rates to stabilize and, in some cases, rise, it cannot be predicted that rental
rates on aircraft to be re-leased will not decline, so that, absent additional
acquisitions by the Company, aggregate lease revenues for the current portfolio
could decline over the long term.
Security
deposits received increased by approximately $793,000 in the nine months ended
September 30, 2006 versus the same period in 2005, because of the cash deposits
received in connection with the re-lease of aircraft in 2006.
Expenditures
for maintenance
Expenditures
for maintenance were approximately $2,286,000 higher in the first nine months
of
2006 versus 2005 primarily as a result of payments during 2006 for maintenance
performed to ready several of the Company’s aircraft for remarketing. The effect
of these expenditures was partially offset by lower payments for maintenance
performed by lessees, which were funded by the payout of maintenance reserves
held by the Company. The amount of expenditures for maintenance in future
periods will be dependent on the amount and timing of maintenance paid from
lessee maintenance reserves held by the Company and the off-lease status of
the
Company’s aircraft.
Expenditures
for interest
Expenditures
for interest increased by approximately $962,000 in the nine months ended
September 30, 2006 versus the same period in 2005, primarily as a result of
higher average interest rates and a higher average principal balance in 2006.
Interest expenditures in future periods will be a product of prevailing interest
rates and the outstanding principal balance on financings, which may be
influenced by future acquisitions and/or required repayments resulting from
changes in the collateral base.
Expenditures
for management fees
Expenditures
for management fees increased by approximately $575,000 in the nine months
ended
September 30, 2006 versus the same period in 2005, as a result of aircraft
purchases since April 2005.
Income
taxes
Income
tax payments were approximately $1,732,000 lower in the first nine months of
2006 compared to the same period in 2005 primarily because the Company made
payments of approximately $1,704,000 in 2005 for 2004 tax expense which was
the
result of the sale of a portfolio of engines in December 2004. In addition,
the
Company had lower taxable income in 2006 than in 2005.
(ii) Investing
activities
The
$6,798,000 increase in cash flow provided by investing activities in the first
nine months of 2006 versus the same period in 2005 was primarily due to a
decrease in the amount invested in aircraft assets which was partially offset
by
a decrease in the amount received from aircraft sales in 2006.
(iii) Financing
activities
The
Company borrowed approximately $9,291,000 less in the first nine months of
2006
versus the same period in 2005 for aircraft financing and repaid approximately
$3,350,000 less of its outstanding debt in 2006. In 2006, the Company’s
borrowings included $1,650,000 for the refinancing of an aircraft and repayments
included approximately $1,566,000 which was repaid from the refinancing
proceeds.
Outlook
The
Company’s future growth will depend on the availability of additional financing
for acquisitions of leased assets which, due to rising interest rates, will
need
to be leased at increased rental rates to offset the anticipated stable or
decreased lease rates resulting from future re-leases of the Company’s current
portfolio. The
Company is continuing to pursue additional sources of acquisition financing.
All
of
the Company’s aircraft are currently on lease. The next scheduled expiration of
one of the Company’s aircraft leases is in November 2006, and the Company
expects it will be extended at that time.
The
Company continually monitors the financial condition of its lessees to prevent
unanticipated creditworthiness issues, and where necessary, works with lessees
to ensure continued compliance with both monetary and non-monetary obligations
under their respective leases. Currently, the Company is closely monitoring
the
performance of two lessees with a total of three aircraft under lease. The
Company continues to work closely with these lessees to ensure compliance with
their current obligations. During
2006, the Company incurred $49,000 of bad debt expense related to amounts owed
by a former lessee at the time the Company and the lessee agreed to the early
termination of the lease. If any of the Company's current lessees are unable
to
meet their lease obligations, the Company's future results could be materially
impacted.
Any
weakening in the aircraft industry may also affect the performance of lessees
that currently appear to the Company to be creditworthy. See "Factors
that May Affect Future Results - General Economic Conditions,"
below
Due
to
the recent adoption of FASB Staff Position AUG AIR-1, as discussed in Footnote
1
to the Financial Statements, the Company must discontinue the accrue-in-advance
method of accounting for planned major maintenance for financial reporting
periods beginning on January 1, 2007. Under the accrue-in-advance method of
accounting, the collection of non-refundable maintenance reserves for planned
major maintenance and disbursements from reserves to lessees to pay for
maintenance performed was reflected only on the Company's balance sheet. The
Company is still evaluating the impact of the adoption of this new staff
position and determining which alternative method of accounting it will use
going forward. In any event, the new mandated accounting methods will require
receipt of non-refundable maintenance reserves for planned major maintenance
from the Company's lessees to be reflected as income on the income statements,
and release of maintenance reserves to be reflected as an expense when
maintenance is actually performed. Therefore, beginning in the first quarter
of
2007, the Company believes that the Company's reported net income may be subject
to greater fluctuations from quarter to quarter than would have been the case
had the Company continued its use of the accrue-in-advance method of accounting
for planned major maintenance activities. Furthermore, because this guidance
must be applied retroactively, the Company anticipates that, beginning with
its
March 31, 2007 financial reporting requirements, the balance sheet will reflect
a catch-up cumulative adjustment to retained earnings as of January 1, 2006,
as
a result of the change to the new accounting method.
Factors
that May Affect Future Results
Need
for Additional Financing. As
there
is limited availability under the Company's $55 million credit facility, in
order to continue increasing its asset base, it will need additional sources
of
financing. The Company is currently actively seeking additional debt financing
through an increase in the amount of the credit facility and through other
sources of acquisition financing, but there is no assurance that it will be
able
to obtain such financing on terms that are acceptable to the Company. In the
absence of such financing, the Company will likely be able to meet its
short-term cash flow needs, but over the long term, its revenues will decrease
consistently as the Company’s existing asset base ages and lease rates decline
as the assets age.
Risks
of Debt Financing.
The
Company’s use of debt as the primary form of acquisition financing subjects the
Company to increased risks of leveraging. With respect to the credit facility,
the loans are secured by the Company’s existing assets as well as the specific
assets acquired with each financing. In addition to payment obligations, the
credit facility also requires the Company to comply with certain financial
covenants, including a requirement of positive annual earnings, interest
coverage and net worth ratios. Any default under the credit facility, if not
waived by the lenders, could result in foreclosure upon not only the asset
acquired using such financing, but also the existing assets of the Company
securing the loan. It is possible that some form of subordinated debt may be
issued by the Company to fund acquisitions if the credit facility is not
increased, or in combination with an increase in the credit facility. Such
financing may have separate, more restrictive covenants, and may magnify the
adverse consequences of a lessee default.
Interest
Rate Risk.
The
Company’s current credit facility and the indebtedness of one of its special
purpose subsidiaries carry a floating interest rate based upon either the
lender’s prime rate or a floating LIBOR rate. Lease rates, generally, but not
always, move with interest rates, since market demand for the asset also affects
lease rates. Because lease rates are fixed at the origination of leases,
interest rate increases during the term of a lease have no effect on existing
lease 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 lower net earnings. Further, even if
significant lease origination occurs following such rate increases, if the
contemporaneous aircraft market forces result in lower or flat rental rates,
the
Company could experience lower net earnings as well.
Recent
actions by the Federal Reserve Board indicate that its previous moves to
increase the prevailing short term borrowing rates have ceased for the time
being, but there is no assurance that economic circumstances may not cause
the
Board to resume moving short term borrowing rates higher. The Company has not
hedged its variable rate debt obligations and such obligations are based on
short-term interest rate indexes. Consequently, if an interest rate increase
were great enough, the Company might not be able to generate sufficient lease
revenue to meet its interest payment and other obligations and comply with
the
net earnings covenant of its credit facility.
Credit
Facility Obligations.
The
Company is obligated to make repayment of principal under the credit facility
in
order to maintain certain debt ratios with respect to its assets in the
borrowing base. Assets that come off lease and remain off-lease for a period
of
time are removed from the borrowing base. The Company believes it will have
sufficient cash funds to make any payment that arises due to borrowing base
limitations caused by assets scheduled to come off lease in the near term.
The
Company’s belief is based on certain assumptions regarding renewal of existing
leases, a lack of extraordinary interest rate increases, continuing
profitability, no lessee defaults or bankruptcies, and certain other matters
that the Company deems reasonable in light of its experience in the industry.
There can be no assurance that the Company’s assumptions will prove to be
correct. If the assumptions are incorrect (for example, if an asset in the
collateral base unexpectedly goes off lease for an extended period of time)
and
the Company has not obtained an applicable waiver or amendment of applicable
covenants from its lenders to mitigate the situation, the Company may have
to
sell a significant portion of its portfolio in order to maintain compliance
with
covenants or face default on its credit facility.
Concentration
of Lessees and Aircraft Type.
Currently, the Company’s five largest customers are located in Belgium, Taiwan,
the Caribbean, Norway and Sweden, and currently account for approximately 15%,
13%, 12%, 11% and 10%, respectively, of the Company’s monthly lease revenue. A
lease default by or collection problems with one of these customers could have
a
disproportionate negative impact on the Company’s financial results, 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. Such concentration of lessee credit risk will diminish
in the future only if the Company is able to lease additional assets to new
lessees.
The
acquisition of eight Fokker 50 aircraft and six DHC-8 aircraft in 2004 and
2005
made these two aircraft types the dominant aircraft types in the portfolio,
constituting 14 and 11, respectively, of the 33 aircraft currently in the
portfolio and representing 38% and 50%, respectively, based on book value.
As a
result, a change in the desirability and availability of either or both of
these
types of aircraft, which would in turn affect valuations of such aircraft,
would
have a disproportionately large impact on the Company’s portfolio value. Such
aircraft type concentration will diminish if the Company acquires additional
assets of other types. Conversely, acquisition of additional Fokker 50 or DHC-8
aircraft will increase the Company’s risks related to its concentration of those
aircraft types.
Increased
Compliance Costs.
Current
Sarbanes-Oxley Act requirements applicable to the Company effective for the
year
ended December 31, 2007, relating to internal controls and auditors'
responsibilities to review and opine on those controls, could result in
significantly higher fees and expenses in connection with auditor services
beginning in the second half of 2006. The increase will generally arise from
increased auditor responsibilities, including broadening of the scope of the
auditor's examination to include the Company's internal controls. If the
regulations remain unchanged, the Company anticipates that it will have
sufficient funds to pay for the increased compliance costs.
Lessee
Credit Risk. If
a
customer defaults upon its lease obligations, the Company may be limited in
its
ability to enforce remedies. Most of the Company’s lessees are small regional
passenger airlines, which may be even more sensitive to airline industry market
conditions than the major airlines. As a result, the Company’s inability to
collect rent under a lease or to repossess equipment in the event of a default
by a lessee could have a material adverse effect on the Company’s revenue. If a
lessee that is a certified U.S. airline is in default under the lease and seeks
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 for a period of 60 days. After the 60-day period has passed, the
lessee must agree to perform the obligations and cure any defaults, or the
Company will have the right to repossess the equipment. This procedure under
the
Bankruptcy Code has been subject to significant recent litigation, however,
and
it is possible that the Company’s enforcement rights may be further adversely
affected by a declaration of bankruptcy by a defaulting lessee. Most of the
Company’s lessees are foreign and not subject to U.S. bankruptcy laws but there
may be similar applicable foreign bankruptcy debtor protection schemes available
to foreign carriers.
Leasing
Risks.
The
Company’s successful negotiation of lease extensions, re-leases and sales may be
critical to its ability to achieve its financial objectives, and involves a
number of risks. Demand for lease or purchase of the assets depends on the
economic condition of the airline industry which is, in turn, sensitive to
general economic conditions. The ability to remarket equipment at acceptable
rates may depend on the demand and market values at the time of remarketing.
The
Company anticipates that the bulk of the equipment it acquires will be used
aircraft equipment. The market for used aircraft is 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,
increased fuel costs, the number of new aircraft on order and the number of
aircraft coming off-lease. The Company’s expected concentration in a limited
number of airframe and aircraft engine types (generally, turboprop equipment)
subjects the Company to economic risks if those airframe or engine types should
decline in value. If “regional jets” were to be used on short routes previously
served by turboprops, even though regional jets are more expensive to operate
than turboprops on those routes, the demand for turboprops could lessen. This
could result in lower lease rates and values for the Company’s existing
turboprop aircraft.
Risks
Related to Regional Air Carriers. Because
the Company has concentrated its existing leases, and intends to concentrate
on
future leases, to regional air carriers, it is subject to additional risks.
Some
of the lessees in the regional air carrier market are companies that are
start-up, low capital, low margin operations. Often, the success of such
carriers is dependent upon arrangements with major trunk carriers, which may
be
subject to termination or cancellation by such major carrier. These types of
lessees result in a generally higher lease rate on aircraft, but may entail
higher risk of default or lessee bankruptcy. In the event of a business failure
of the lessee or its bankruptcy, the Company can generally regain possession
of
its aircraft, but the aircraft could be in substantially worse condition than
would be the case if the aircraft were returned in accordance with the
provisions of the lease at lease expiration.
The
Company evaluates the credit risk of each lessee carefully, and attempts to
obtain a third party guaranty, letters of credit or other credit enhancements,
if it deems them necessary. There is no assurance, however, that such
enhancements will be available or that if obtained they will fully protect
the
Company from losses resulting from a lessee default or bankruptcy. Also, a
significant area of growth of this market is in areas outside of the United
States, where collection and enforcement are often more difficult and
complicated than in the United States. During
2006 and 2005, the Company incurred bad debt expense related to amounts owed
by
a total of three former lessees. This expense materially affected the Company's
financial performance. If any of the Company's current lessees are unable to
meet their lease obligations, the Company's future results could be materially
impacted.
Reliance
on JMC. All
management of the Company is performed by JMC under a management agreement
which
is in the ninth year of a 20-year term and provides for an asset-based
management fee. JMC is not a fiduciary to the Company or its stockholders.
The
Company’s Board of Directors 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, the officers of JMC are also officers of the Company, and in that
capacity owe fiduciary duties to the Company and the stockholders by virtue
of
holding such offices with the Company. In addition, certain officers of the
Company hold significant ownership positions in the Company and JHC, the parent
company of JMC.
The
JMC
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. All of the officers of JMC are also
officers of the Company, and certain directors of the Company are also directors
of JMC. Consequently, the directors 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.
JMC
has
acted as the management company for two other aircraft portfolio owners,
JetFleet III, which raised approximately $13,000,000 from investors, and
AeroCentury IV, Inc. (“AeroCentury IV”), which raised approximately $5,000,000
from investors. In the first quarter of 2002, AeroCentury IV defaulted on
certain obligations to noteholders. In June 2002, the indenture trustee for
AeroCentury IV’s noteholders repossessed AeroCentury IV’s assets and took over
management of AeroCentury IV’s remaining assets. JetFleet III defaulted on its
bond obligation of $11,076,350 in May 2004. The indenture trustee for JetFleet
III bondholders repossessed JetFleet III’s unsold assets in late May
2004.
Ownership
Risks. The
Company’s portfolio is leased under operating leases, where the terms of the
leases are less than the entire anticipated useful life of an asset. The
Company’s ability to recover its purchase investment in an asset subject to an
operating lease is dependent upon the Company’s ability to profitably re-lease
or sell the asset after the expiration of the initial lease term. Some of the
factors that have an impact on the Company’s ability to re-lease or sell include
worldwide economic conditions, general aircraft market conditions, regulatory
changes that may make an asset’s use more expensive or preclude use unless the
asset is modified, changes in the supply or cost of aircraft equipment and
technological developments which cause the asset to become obsolete. 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. If the Company is unable to remarket its aircraft
equipment on favorable terms when the operating leases for such equipment
expire, the Company’s business, financial condition, cash flow, ability to
service debt and results of operations could be adversely affected.
Furthermore,
an asset impairment charge against the Company’s earnings may result from the
occurrence of unexpected adverse changes that impact the Company’s estimates of
expected cash flows generated from such asset. The Company periodically reviews
long-term assets for impairments, in particular, when events or changes in
circumstances indicate the carrying value of an asset may not be recoverable.
An
impairment loss is recognized when the carrying amount of an asset is not
recoverable and exceeds its fair value. The Company may be required to recognize
asset impairment charges in the future as a result of a prolonged weak economic
environment, challenging market conditions in the airline industry or events
related to particular lessees, assets or asset types.
International
Risks.
The
Company has focused on leases in overseas markets, which the Company believes
present opportunities. Leases with foreign lessees, however, may present
somewhat different credit risks than those with domestic lessees.
Foreign
laws, regulations and judicial procedures may be more or less protective of
lessor rights than those which apply in the United States. The Company could
experience collection or repossession problems related to the enforcement of
its
lease agreements under foreign local laws and the remedies in foreign
jurisdictions. The protections potentially offered by Section 1110 of the
Bankruptcy Code do not apply to non-U.S. carriers, and applicable local law
may
not offer similar protections. Certain countries do not have a central
registration or recording system with which to locally establish 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.
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. On the other hand, a foreign economy may remain strong even though
the
U.S. economy does not. A foreign economic downturn may impact a foreign lessee’s
ability to make lease payments, even though the U.S. and other economies remain
stable. Furthermore, foreign lessees are subject to risks related to currency
conversion fluctuations. Although the Company’s current leases are all payable
in U.S. dollars, the Company may agree in the future to leases that permit
payment in foreign currency, which would subject such lease revenue to monetary
risk due to currency fluctuations. Even with U.S. dollar-denominated lease
payment provisions, the Company could still be affected by a devaluation of
the
lessee’s local currency that would make it more difficult for a lessee to meet
its U.S. dollar-denominated lease payments, increasing the risk of default
of
that lessee, particularly if its revenue is primarily derived in the local
currency.
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, and aircraft noise requirements. Although it is
contemplated that the burden and cost of complying with such requirements will
fall primarily upon lessees of equipment, 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.
Competition.
The
aircraft leasing industry is highly competitive. The Company competes with
aircraft manufacturers, distributors, airlines and other 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 and more experience than
the Company. However, the Company believes that it is competitive because of
JMC’s experience and operational efficiency in identifying and obtaining
financing for the transaction types desired by regional air carriers. This
market segment, which is characterized by transaction sizes of less than $10
million and lessee credits that may be strong, but are generally unrated, is
not
well served by the Company’s larger competitors in the aircraft industry. JMC
has developed a reputation as a global participant in this segment of the
market, and the Company believes that JMC’s reputation will benefit the Company.
There is, however, no assurance that the lack of significant competition from
the larger aircraft leasing companies will continue or that the reputation
of
JMC will continue to be strong in this market segment.
Casualties,
Insurance Coverage.
The
Company, as 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. Further, some protection may be provided by the United States Aviation
Act with respect to the Company’s aircraft assets. It is, however, not clear to
what extent such statutory protection would be available to the Company, and
the
United States Aviation Act may not apply to aircraft operated in foreign
countries. Also, although the Company’s leases generally require a lessee to
insure against likely risks, there may be certain cases where the loss is not
entirely covered by the lessee or its insurance. Though this is a remote
possibility, an uninsured loss with respect to the equipment, or an insured
loss
for which insurance proceeds are inadequate, would result in a possible loss
of
invested capital in and any profits anticipated from, such equipment, as well
as
a potential claim directly against the Company.
General
Economic Conditions. The
Company’s business is dependent upon general economic conditions and the
strength of the travel and transportation industry. The industry has experienced
a severe cyclical downturn which began in 2001. There are signs that the
industry is beginning to recover from the downturn, but it is unclear whether
any recovery will be a sustained one. Any recovery could be stalled or reversed
by any number of events or circumstances, including the global economy slipping
back into recession, or specific events related to the air travel industry,
such
as terrorist attacks, or an increase in operational or labor costs. Recent
spikes in oil prices, if they persist, may have a negative effect on airline
profits and increase the likelihood of weakening results for airlines that
have
not hedged aircraft fuel costs, and in the most extreme cases, may initiate
or
accelerate the failure of many already marginally profitable
carriers.
Since
regional carriers are generally not as well-capitalized as major air carriers,
any economic setback in the industry may result in the increased possibility
of
an economic failure of one or more of the Company’s lessees, particularly since
many carriers are undertaking expansion of capacity to accommodate the
recovering air passenger traffic. If lessees experience financial difficulties,
this could, in turn, affect the Company’s financial performance.
During
any periods of economic contraction, carriers generally reduce capacity, in
response to lower passenger loads, and as a result there is a reduced demand
for
aircraft and a corresponding decrease in market lease rental rates and aircraft
values. This reduced market value for aircraft could affect the Company’s
results if the market value of an asset or assets in the Company’s aircraft
portfolio falls below carrying value, and the Company determines that a
write-down of the value on the Company’s balance sheet is appropriate.
Furthermore, as older leases expire and are replaced by lease renewals or
re-leases at decreasing lease rates, the lease revenue of the Company from
its
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 specific regions of the world exclusively. As the Company’s
portfolio is not entirely globally diversified, a localized downturn in one
of
the key regions in which the Company leases aircraft (e.g., Europe or Asia)
could have a significant adverse impact on the Company.
Possible
Volatility of Stock Price.
The
market price of the Company’s common stock could be subject to fluctuations in
response 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, some
of
which may be unrelated to the Company’s performance. Also, because the Company
has a relatively small capitalization of approximately 1.5 million shares,
there
is a correspondingly limited amount of trading of the Company’s shares.
Consequently, a single or small number of trades could result in a market
fluctuation not related to any business or financial development concerning
the
Company.
Item
3. Controls
and Procedures.
Quarterly
evaluation of the Company’s Disclosure Controls and Internal
Controls.
As of
the end of the period covered by this report, the Company evaluated the
effectiveness of the design and operation of its “disclosure controls and
procedures” (“Disclosure Controls”), and its “internal controls over financial
reporting” (“Internal Controls”). This evaluation (the “Controls Evaluation”)
was done under the supervision and with the participation of management,
including the Company’s Chief Executive Officer (“CEO”) and Chief Financial
Officer (“CFO”). Rules adopted by the Securities and Exchange Commission (“SEC”)
require that in this section of the Report the Company present the conclusions
of the CEO and the CFO about the effectiveness of our Disclosure Controls and
Internal Controls based on and as of the date of the Controls
Evaluation.
CEO
and CFO Certifications.
Attached
as exhibits to this report are two separate forms of “Certifications” of the CEO
and the CFO. The first form of Certification is required in accordance with
Section 302 of the Sarbanes-Oxley Act of 2002 (the “Section 302 Certification”).
This section of the report is the information concerning the Controls Evaluation
referred to in the Section 302 Certifications and this information should be
read in conjunction with the Section 302 Certifications for a more complete
understanding of the topics presented.
Disclosure
Controls and Internal Controls.
Disclosure Controls are procedures that are designed with the objective of
ensuring that information required to be disclosed in the Company’s reports
filed under the Exchange Act, such as this report, is recorded, processed,
summarized and reported within the time periods specified in the SEC’s rules and
forms. Disclosure Controls are also designed with the objective of ensuring
that
such information is accumulated and communicated to the Company’s management,
including the CEO and CFO, as appropriate to allow timely decisions regarding
required disclosure. Internal Controls are procedures which are designed with
the objective of providing reasonable assurance that (1) the Company’s
transactions are properly authorized; (2) the Company’s assets are safeguarded
against unauthorized or improper use; and (3) the Company’s transactions are
properly recorded and reported, all to permit the preparation of the Company’s
consolidated financial statements in conformity with generally accepted
accounting principles.
Limitations
on the Effectiveness of Controls.
The
Company’s management, including the CEO and CFO, does not expect that its
Disclosure Controls or its Internal Controls will prevent all errors and all
fraud. A control system, no matter how well conceived and operated, can provide
only reasonable, not absolute, assurance that the objectives of the control
system are met. Further, the design of a control system must reflect the fact
that there are resource constraints, and the benefits of controls must be
considered relative to their costs. Because of the inherent limitations in
all
control systems, no evaluation of controls can provide absolute assurance that
all control issues and instances of fraud, if any, within the Company have
been
detected. These inherent limitations include the realities that judgments in
decision-making can be faulty, and that breakdowns can occur because of simple
error or mistake. Additionally, controls can be circumvented by the individual
acts of some persons, by collusion of two or more people, or by management
override of the control. The design of any system of controls also is based
in
part upon certain assumptions about the likelihood of future events, and there
can be no assurance that any design will succeed in achieving its stated goals
under all potential future conditions; over time, control may become inadequate
because of changes in conditions, or the degree of compliance with the policies
or procedures may deteriorate. Because of the inherent limitations in a
cost-effective control system, misstatements due to error or fraud may occur
and
not be detected.
Scope
of the Controls Evaluation.
The
CEO/CFO evaluation of the Company’s Disclosure Controls and the Company’s
Internal Controls included a review of the controls objectives and design,
the
controls implementation by the Company and the effect of the controls on the
information generated for use in this report. In the course of the Controls
Evaluation, the CEO and CFO sought to identify data errors, controls problems
or
acts of fraud and to confirm that appropriate corrective action, including
process improvements, were being undertaken. This type of evaluation is done
on
a quarterly basis so that the conclusions concerning controls effectiveness
can
be reported in the Company’s quarterly reports on Form 10-QSB and annual report
on Form 10-KSB. The Company’s Internal Controls are also evaluated on an ongoing
basis by other
personnel in the Company’s finance organization and by the Company’s independent
auditors in connection with their audit and review activities. The overall
goals
of these various evaluation activities are to monitor the Company’s Disclosure
Controls and the Company’s Internal Controls and to make modifications as
necessary; the Company’s intent in this regard is that the Disclosure Controls
and the Internal Controls will be maintained as dynamic systems that change
(including with improvements and corrections) as conditions
warrant.
Among
other matters, the Company sought in its evaluation to determine whether there
were any “significant deficiencies” or “material weaknesses” in the Company’s
Internal Controls, or whether the Company had identified any acts of fraud
involving personnel who have a significant role in the Company’s Internal
Controls. This information was important both for the Controls Evaluation
generally and because item 5 in the Section 302 Certifications of the CEO and
CFO require that the CEO and CFO disclose that information to the Audit
Committee of the Company’s Board and to the Company’s independent auditors and
to report on related matters in this section of the Report. In the professional
auditing literature, “significant deficiencies” are referred to as “reportable
conditions”; these are control issues that could have a significant adverse
effect on the ability to record, process, summarize and report financial data
in
the financial statements. A “material weakness” is defined in the auditing
literature as a particularly serious reportable condition where the internal
control does not reduce to a relatively low level the risk that misstatements
caused by error or fraud may occur in amounts that would be material in relation
to the financial statements and not be detected within a timely period by
employees in the normal course of performing their assigned functions. The
Company also sought to deal with other controls matters in the Controls
Evaluation, and in each case if a problem was identified, the Company considered
what revision, improvement and/or correction to make in accordance with our
on-going procedures.
In
accordance with SEC requirements, the CEO and CFO note that there has been
no
significant change in Internal Controls that occurred during our most recent
fiscal quarter that has materially affected or is reasonably likely to
materially affect our Internal Controls.
Conclusions.
Based
upon the Controls Evaluation, the Company’s CEO and CFO have concluded that, (i)
the Company’s Disclosure Controls are effective to ensure that the information
required to be disclosed by the Company in the reports that it files under
the
Exchange Act is recorded, processed, summarized and reported, within the time
periods specified in the Commission’s rules and forms and then accumulated and
communicated to Company management, including the CEO and CFO, as appropriate
to
make timely decisions regarding required disclosures, and (ii) that the
Company’s Internal Controls are effective to provide reasonable assurance that
the Company’s consolidated financial statements are fairly presented in
conformity with generally accepted accounting principles.
PART
II
OTHER
INFORMATION
Items
1, 2, 3, 4 and 5 have been omitted as they are not
applicable.
Item
6. Exhibits
Exhibits
Exhibit
Number
|
Description
|
|
|
|
|
-
|
|
10.1
|
Form
of Waiver to Credit Agreement, dated July 19, 2006, by and among
the
Company, National City Bank, as agent, and National City Bank, California
Bank & Trust, First Bank d.b.a. First Bank & Trust, and Bridge
Bank, N.A., as lenders (1)
|
31.1
|
Certification
of Neal D. Crispin, Chief Executive Officer, pursuant to Section
302 of
the Sarbanes-Oxley Act of 2002.
|
31.2
|
Certification
of Toni M. Perazzo, Chief Financial Officer, pursuant to Section
302 of
the Sarbanes-Oxley Act of 2002.
|
32.1*
|
Certification
of Neal D. Crispin, Chief Executive Officer, pursuant to
Section
906 of the Sarbanes-Oxley Act of 2002.
|
32.2*
|
Certification
of Toni M. Perazzo, Chief Financial Officer, pursuant to
Section
906 of the Sarbanes-Oxley Act of 2002.
|
|
|
|
(1)
Incorporated by reference to Exhibit 10.1 of the Company’s Form 8-K, as
filed with the Securities and Exchange
Commission on July 24,
2006.
|
*
These
certificates are furnished to, but shall not be deemed to be filed with, the
Securities and Exchange Commission.
SIGNATURES
In
accordance with the requirements of the Exchange Act, the registrant caused
this
report to be signed on its behalf by the undersigned, thereunto duly
authorized.
|
|
|
|
AEROCENTURY
CORP. |
|
|
|
Date: November
13,.2006 |
By: |
/s/
Toni
M.
Perazzo |
|
|
|
Title Senior
Vice President-Finance and Chief Financial
Officer |