UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-K

 

 

(Mark One)

SECURITIES EXCHANGE ACT OF 1934

 

For the fiscal year ended December 31, 2005

 

OR

 

SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from _ _ to _______________

Commission file number 1-316161

 

 

Registrant’s telephone number, including area code: (310) 788-1999

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

Securities registered pursuant to Section 12(g) of the Act:

NONE

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. YES  x   NO  o

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. YES  o   NO  x

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). YES  o   NO  x

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer  o   Accelerated filer  o   Non-accelerated filer  x

 

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

 

As of June 30, 2005 and March 10, 2006, there were 42,198,119 and 45,267,723 shares of Common Stock, no par value, outstanding, all of which were held by affiliates.

 

Registrant meets the conditions set forth in General Instruction I(1)(a) and (b) of Form 10-K and is therefore filing this form with the reduced disclosure format.

 

 

INTERNATIONAL LEASE FINANCE CORPORATION

 

2005 FORM 10-K ANNUAL REPORT

 

 

TABLE OF CONTENTS

 

 

Item 1.   Business

 

General

 

International Lease Finance Corporation (the “Company,” “ILFC,” “management,” “we,” “our,” “us”) primarily acquires new commercial jet aircraft from The Boeing Company, or Boeing, and Airbus S.A.S., or Airbus, and leases these aircraft to airlines throughout the world. In conjunction with our leasing activity, we regularly sell aircraft from our leased aircraft fleet to other leasing companies, financial services companies, investors, and airlines. In some cases we provide fleet management services to companies with aircraft portfolios for a management fee. We also remarket and sell aircraft owned by others for a fee. In terms of the number and value of transactions concluded, we are a major owner-lessor of commercial jet aircraft.

 

As of December 31, 2005, we owned 746 jet aircraft and had 17 aircraft in the fleet that were classified as finance leases. Additionally, we provided fleet management services for 103 jet aircraft. See “Item 2. Properties — Flight Equipment.” At December 31, 2005, we had committed to purchase 338 new and used aircraft deliverable through 2015 at an estimated aggregate purchase price of $23.3 billion, of which we currently anticipate taking delivery of 96 new aircraft in 2006 with an estimated aggregate purchase price of $6.0 billion. We also had options to purchase an additional 16 new aircraft at an estimated aggregate purchase price of $1.5 billion. The recorded basis of aircraft may be adjusted upon delivery to reflect notional credits provided by the manufacturers in connection with the leasing of aircraft. See “Item 2.  Properties — Commitments. ”

 

We maintain a mix of flight equipment to meet our customers’ needs; and to minimize the time that our aircraft are not leased to customers, we purchase those models of new and used aircraft which we believe will have the greatest airline demand and operational longevity.

 

We typically finance the purchase of aircraft with borrowed funds and internally generated cash flows. Management accesses the capital markets for funds at times and on terms and conditions considered appropriate. We may, but do not usually, engage in financing transactions for specific aircraft. We rely significantly on short- and medium-term financing, and thereby attempt to more closely match the lease terms of our aircraft. To date, we have been able to purchase aircraft on terms which have permitted us to lease our aircraft portfolio at a profit and have been able to obtain the necessary funding from the capital and bank markets.

 

The airline industry is cyclical, economically sensitive and highly competitive. See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. ” Our continued success in the future is partly dependent on management’s ability to develop customer relationships for leasing, sales, remarketing and management services with airlines and other customers best able to maintain their economic viability and survive in the competitive environment in which they operate.

 

The Company is incorporated in the State of California and its principal offices are located at 10250 Constellation Blvd., Suite 3400, Los Angeles, California 90067. Our telephone number, telecopier number and website address are (310) 788-1999, (310) 788-1990, and www.ilfc.com, respectively. We make available our SEC EDGAR filings, free of charge, on our website or by written request to us. The information on our website is not part of or incorporated by reference into this report.

 

We are an indirect wholly owned subsidiary of American International Group, Inc. (“AIG”). AIG is a holding company which through its subsidiaries is engaged in a broad range of insurance and insurance-related activities in the United States and abroad. AIG’s primary activities include both general and life insurance operations. Other significant activities include financial services and retirement savings and asset management. The common stock of AIG is listed on, among others, the New York Stock Exchange.

 

Aircraft Leasing

 

We lease most of our aircraft under operating leases. The cost of the aircraft is not fully recovered over the term of the initial lease, and we retain the benefit as well as assume the risk of the residual value of the aircraft. In accordance with generally accepted accounting principles, rentals are reported ratably as revenue over the lease term, as they are earned. The aircraft under operating leases are included as “Flight equipment” on our Consolidated

Balance Sheets and are depreciated to an estimated salvage value over the estimated useful lives of the aircraft. On occasion we enter into finance and sales-type leases where the full cost of the aircraft is substantially recovered over the term of the lease. With respect to these leases, we record lease payments received as a reduction in the net investment in the finance/sales-type leases and interest income using an interest rate implicit in the lease. The aircraft under finance and sales-type leases are recorded on our Consolidated Balance Sheets in “Net investment in finance leases”. At December 31, 2005, we accounted for 746 aircraft as operating leases and 17 aircraft as finance and sales-types leases.

 

The initial term of our current leases range in length from one year to 17 years. See “Item 2. Properties — Flight Equipment ” for information regarding scheduled lease terminations. We attempt to maintain a mix of short-, medium- and long-term leases to balance the benefits and risks associated with different lease terms and changing market conditions. Varying lease terms help to mitigate the effects of changes in prevailing market conditions at the time aircraft become eligible for re-lease or are sold.

 

All leases are on a “net” basis with the lessee responsible for all operating expenses, which customarily include fuel, crews, airport and navigation charges, taxes, licenses, registration and insurance. In addition, the lessee is responsible for normal maintenance and repairs, airframe and engine overhauls, and compliance with return conditions of flight equipment on lease. Under the provisions of many leases, for certain airframe and engine overhauls, we reimburse the lessee for costs incurred up to but not exceeding related hourly rentals the lessee has paid to us. Such rentals are included in the caption “Rental of flight equipment” in the Company’s Consolidated Statements of Income. We provide a charge to operations based on the estimated reimbursements during the life of the lease. This amount is included in “Provision for overhauls” in our Consolidated Statements of Income. We may, in connection with the lease of a used aircraft, agree to contribute to the cost of certain major overhauls or modifications depending on the condition of the aircraft at delivery.

 

The lessee is responsible for compliance with all applicable laws and regulations with respect to the aircraft. We require our lessees to comply with the standards of either the United States Federal Aviation Administration (the “FAA”) or its foreign equivalent. We periodically inspect our leased aircraft. Generally, we require a deposit as security for the lessee’s performance of obligations under the lease and the condition of the aircraft upon return. In addition, the leases contain extensive provisions regarding our remedies and rights in the event of a default by the lessee and specific provisions regarding the condition of the aircraft upon return of the aircraft. The lessee is required to continue to make lease payments under all circumstances, including periods during which the aircraft is not in operation due to maintenance or grounding.

 

Some foreign countries have currency and exchange laws regulating the international transfer of currencies. When necessary we require, as a condition to any foreign transaction, that the lessee or purchaser in a foreign country obtain the necessary approvals of the appropriate government agency, finance ministry or central bank for the remittance of all funds contractually owed in U.S. Dollars. We attempt to minimize our currency and exchange risks by negotiating most of our aircraft leases and all of our sales transactions in U.S. Dollars. All guarantees obtained to support various lease agreements are denominated for payment in the same currency as the lease.

 

To meet the needs of a growing number of airlines, some of our leases are negotiated in Euros. As the Euro to U.S. Dollar exchange rate fluctuates, airlines’ interest in entering into Euro denominated lease agreements will change. Once we agree to the rental payment currency with an airline, the negotiated currency remains for the term of the lease. We have hedged the majority of our future Euro denominated lease payments receivable cash flows. The economic risk arising from foreign currency has, to date, been immaterial to us.

 

Management obtains and reviews relevant business materials from all prospective lessees and purchasers before entering into a lease or extending credit. Under certain circumstances, the lessee may be required to obtain guarantees or other financial support from an acceptable financial institution or other third parties.

 

During the life of the lease, situations may arise whereby we will have to restructure leases with our lessees. Historically, restructurings have involved the voluntary termination of leases prior to lease expiration, the arrangement of subleases from the primary lessee to another airline and the rescheduling of lease payments and extension of the lease terms. In many situations where we repossess an aircraft, we export the aircraft from the lessee’s jurisdiction. In the majority of these situations, we have obtained the lessee’s cooperation and the return and

export of the aircraft was immediate. In some situations, however, the lessees have not fully cooperated in returning aircraft. In those cases we have had to take legal action in the appropriate jurisdictions. This process has delayed the ultimate return and export of the aircraft. In addition, in connection with the repossession of an aircraft, we may be required to pay outstanding mechanic’s, airport, navigation and other liens on the repossessed aircraft. These charges could relate to other aircraft that we do not own but were operated by the lessee.

 

Flight Equipment Marketing

 

We may dispose of our leased aircraft at or before the expiration of their leases. The buyers of our aircraft include the aircraft’s lessee, another aircraft operator, financial institutions, private investors and third party lessors. From time to time, we engage in transactions to buy aircraft for resale. In other cases, we assist our customers in acquiring or disposing of aircraft by providing consulting services and procurement of financing from third parties. Any gain or loss on disposition of leased aircraft is included in the caption “Flight equipment marketing” in our Consolidated Statements of Income. In 2003 and early 2004, we sold aircraft into securitization trusts which were primarily funded and owned by other subsidiaries of AIG and are consolidated by AIG. The transactions were structured as securitizations. The gains, net of expense, are included in “Flight equipment marketing — Securitization” in our Consolidated Statements of Income. See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations — Results of Operations” for more information on these transactions.

 

From time to time, we are engaged as an agent for airlines and various financial institutions in the disposition of their surplus aircraft on a fee basis. We generally act as an agent under an exclusive remarketing contract whereby we agree to sell aircraft on a commercially reasonable basis within a fixed time period. These activities generally augment our primary activities and also serve to promote relationships with prospective sellers and buyers of aircraft. We may, from time to time, participate with banks, other financial institutions and airlines to assist in financing aircraft purchased by others and by providing asset guarantees, put options, or loan guarantees collateralized by aircraft on a fee-basis.

 

We plan to continue to engage in providing marketing services to third parties on a selective basis involving specific situations where these activities will not conflict or compete with, but rather will complement, our leasing and selling activities.

 

Fleet Management Services

 

We provide fleet management services to third party operating lessors who are unable or unwilling to perform this service as part of their own operation. We typically provide the same services that we perform for our own fleet on a non-discriminatory basis. Specifically, we provide leasing, re-leasing and sales services on behalf of the lessor for which we charge a fee. In connection with the sales of aircraft to the trusts discussed above, we were retained to provide fleet management services for the aircraft sold for which we receive fees from the trusts. The fees for fleet management services are included in “Interest and other” in our Consolidated Statements of Income.

 

Financing/Source of Funds

 

We purchase new aircraft directly from manufacturers and used aircraft from airlines and other owners. The purchase price of flight equipment is financed using internally generated funds, secured and unsecured commercial bank financings and the issuance of commercial paper and public and private debt. See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. ”

 

During 2005 and 2004, we had one customer that accounted for 10% or more of total Rental of flight equipment revenue, Air France ($364.6 million or 10.4% in 2005 and $309.5 million or 10.5% in 2004. No single customer accounted for more than 10% of total revenues in 2003).

 

Revenues include rentals of flight equipment to foreign airlines of $3,110,798,000 (2005), $2,662,182,000 (2004), and $2,497,085,000 (2003), comprising 88.9%, 90.1%, and 89.0%, respectively, of total Rentals of flight equipment revenue. See Note J of Notes to Consolidated Financial Statements . Lease revenues from the rental of flight equipment have been reduced by payments received by our customers from the notional accounts established by the aircraft and engine manufacturers.

 

The following table sets forth the dollar amount and percentage of total rental revenues attributable to the indicated geographic areas based on each airline’s principal place of business for the years indicated:

 

 

The following table sets forth revenue attributable to individual countries representing at least 10% of total revenue based on each airline’s principal place of business for the years indicated (2004 United States is shown for comparison):

 

 

Competition

 

The leasing, remarketing and sale of jet aircraft is highly competitive. We face competition from aircraft manufacturers, banks, financial institutions, other leasing companies, aircraft brokers and airlines. Competition for a leasing transaction is based on a number of factors including delivery dates, lease rates, term of lease, other lease

provisions, aircraft condition and the availability in the market place of the types of aircraft to meet the needs of the customer. We believe we are a strong competitor in all of these areas. However, past overcapacity in selected types of aircraft in the market place increased competition from other entities leasing aircraft which caused downward pressure on lease rates, lease revenue and aircraft values. Recently, the overcapacity of certain aircraft types has been absorbed in the market place, and we now see higher lease rates on newly signed leases on those aircraft types.

 

Government Regulation

 

The U.S. Department of State (“DOS”) and the U.S. Department of Transportation (“DOT”), including the FAA, an agency of the DOT, exercise regulatory authority over air transportation in the United States.

 

The DOS and DOT, in general, have jurisdiction over the economic regulation of air transportation, including the negotiation with foreign governments of the rights of U.S. carriers to fly to other countries and the rights of foreign carriers to fly to and within the United States. We are not directly subject to the regulatory jurisdiction of the DOS and DOT or their counterpart organizations in foreign countries related to the operation of aircraft for public transportation of passengers and property.

 

Our relationship with the FAA consists of the registration with the FAA of those aircraft which we have leased to U.S. carriers and to a number of foreign carriers where, by agreement, the aircraft are to be registered in the United States. When an aircraft is not on lease, we may obtain from the FAA, or its designated representatives, a U.S. Certificate of Airworthiness or a ferry flight permit for the particular aircraft.

 

Our involvement with the civil aviation authorities of foreign jurisdictions consists largely of requests to register and deregister our aircraft on those countries’ registries.

 

The U.S. Department of Commerce (“DOC”) exercises regulatory authority over exports. We are subject to the regulatory authority of the DOS and DOC as it relates to the export of aircraft for lease and sale to foreign entities and the export of parts to be installed on our aircraft. These Departments have, in some cases, required us to obtain export licenses for parts exported to foreign countries.

 

Through its regulations, DOC and the U.S. Department of Treasury (through its Office of Foreign Assets Control) impose restrictions on the operation of U.S. made goods such as aircraft and engines in sanctioned countries. In addition, they impose restrictions on the ability of U.S. companies to conduct business with entities in those countries.

 

The Patriot Act of 2001 gave the U.S. Secretary of State and the U.S. Secretary of the Treasury the authority to (a) designate individuals and organizations as terrorists and terrorist supporters and to freeze their U.S. assets and (b) prohibit financial transactions with U.S. persons, including U.S. individuals, entities and charitable organizations. We comply with the provisions of this Act and we closely monitor our activities with foreign entities.

 

A bureau of the U.S. Department of Homeland Security, U.S. Customs and Border Protection, enforces regulations related to the import of our aircraft into the United States for maintenance or lease and the importation of parts for installation on our aircraft. We monitor our imports and exports for compliance with U.S. Customs regulations.

 

Employees

 

We operate in a capital intensive rather than a labor intensive business. As of December 31, 2005, we had 160 full-time employees, which we considered adequate for our business operations. Management and administrative personnel will expand, as necessary, to meet our future growth needs. None of our employees is covered by a collective bargaining agreement and we believe that we maintain excellent employee relations. We provide certain employee benefits including retirement, health, life, disability and accident insurance plans, some of which are established and maintained by our parent, AIG.

 

Insurance

 

Our lessees are required to carry those types of insurance which are customary in the air transportation industry, including comprehensive liability insurance and aircraft hull insurance. In general, we are an additional insured on liability policies carried by the lessees. We obtain certificates of insurance from the lessees’ insurance brokers. All certificates of insurance contain a breach of warranty endorsement so that our interests are not prejudiced by any act or omission of the operator-lessee.

 

Insurance premiums are paid by the lessee, with coverage acknowledged by the broker or carrier. The territorial coverage is, in each case, suitable for the lessee’s area of operations. The certificates of insurance contain, among other provisions, a “no co-insurance” clause and a provision prohibiting cancellation or material change without at least

30 days advance written notice to the insurance broker, who is obligated to give us prompt notice. Hull/war insurance policies customarily provide seven days advance written notice for cancellation and may be subject to lesser notice under certain market conditions. Furthermore, the insurance is primary and not contributory, and all insurance carriers are required to waive rights of subrogation against us.

 

The stipulated loss value schedule under aircraft hull insurance policies is on an agreed value basis acceptable to us and usually exceeds the book value of the aircraft. In cases where we believe that the agreed value stated in the lease is not sufficient, we purchase additional Total Loss Only coverage for the deficiency. Aircraft hull policies contain standard clauses covering aircraft engines. The lessee is required to pay all deductibles. Furthermore, the aircraft hull policies contain full war risk endorsements, including, but not limited to, confiscation (where available), seizure, hijacking and similar forms of retention or terrorist acts. Lease agreements generally require liability limits to be in U.S. Dollars, which are shown on the certificate of insurance.

 

The comprehensive liability insurance listed on certificates of insurance include provisions for bodily injury, property damage, passenger liability, cargo liability and such other provisions reasonably necessary in commercial passenger and cargo airline operations. Such certificates of insurance list combined comprehensive single liability limits of not less than $250 million. As a result of the terrorist attacks on September 11, 2001, the insurance market unilaterally imposed a sublimit on each operator’s policy for third party war risk liability in the amount of $50 million. We require each lessee to purchase higher limits of third party war risk liability or obtain an indemnity from their government. Additionally, we purchase contingent liability insurance and contingent hull insurance on all aircraft in our fleet. In late 2005 the international aviation insurance market unilaterally introduced exclusions for physical damage to aircraft hulls caused by dirty bombs, bio-hazardous materials and electromagnetic pulsing. It is anticipated that exclusions for the same type of perils will be introduced into liability policies within the next twelve months as well. Our lease agreements require the airlines to obtain the broadest available write-back when it becomes available.

 

We also maintain other insurance covering the specific needs of our business operations. Insurance policies are generally placed or reinsured through AIG subsidiaries. AIG charges us directly for these insurance costs. We believe that our insurance is adequate both as to coverage and amount.

 

Forward-Looking Statements

 

This annual report on Form 10-K contains or incorporates statements that constitute forward-looking statements. Those statements appear in a number of places in this Form 10-K and include statements regarding, among other matters, the state of the airline industry, our access to the capital markets, our ability to restructure leases and repossess aircraft, the structure of our leases, regulatory matters pertaining to compliance with governmental regulations and other factors affecting our financial condition or results of operations. Words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates,” and “should” and variations of these words and similar expressions, are used in many cases to identify these forward-looking statements. Any such forward-looking statements are not guarantees of future performance and involve risks, uncertainties and other factors that may cause our actual results, performance or achievements, or industry results, to vary materially from our future results, performance or achievements, or those of the industry, expressed or implied in such forward-looking statements. Such factors include, among others, general industry economic and business conditions, which will, among other things, affect demand for aircraft, availability and creditworthiness of current and prospective lessees, lease rates, availability and cost of financing and operating expenses, governmental actions and initiatives and environmental and safety requirements. We will not update any forward-looking information to reflect actual results or changes in the factors affecting the forward-looking information.

 

Risk Factors Affecting International Lease Finance Corporation

 

Our business is subject to numerous risks and uncertainties, as described below and in the section titled “Item 7A. Quantitative and Qualitative Disclosures about Market Risk” .

 

Overall Airline Industry Risk

 

We operate as a supplier and financier to airlines. The risks affecting our airline customers are generally out of our control and impact our customers to varying degrees. As a result, we are indirectly impacted by all the risks facing airlines today. Our ability to succeed is dependent on the financial strength of our customers and their ability to compete effectively in the market place and manage these risks has a direct impact on us. These risks include:

 

 

To the extent that our customers are affected by these risk factors, we may experience:

 

 

Airframe, Engine and Other Manufacturer Risks

 

The supply of jet transport aircraft, which we purchase and lease, is dominated by two airframe manufacturers, Boeing and Airbus, and a limited number of engine manufacturers. As a result, we are dependent on the manufacturers’ success in remaining financially stable, producing aircraft and related components which meet the airlines’ demands, both in type and quantity and fulfilling their contractual obligations to us. Further, competition between the manufacturers for market share is escalating and may cause instances of deep discounting for certain aircraft types and may negatively impact our competitive pricing. Should the manufacturers fail to respond appropriately to changes in the market environment or fail to fulfill their contractual obligations, we may experience:

 

 

Borrowing Risks

 

Liquidity  — We are heavily dependent on our ability to borrow the necessary funds to finance the purchase of aircraft and to have sufficient funds to repay our existing debt obligations. Our liquidity is dependent on having continued access to debt markets and maintaining our credit ratings. We manage this risk by maintaining access to many debt markets throughout the world. With insufficient liquidity we could potentially experience:

 

 

Interest Rate Risks  — We are impacted by fluctuations in interest rates. Our lease rates are generally fixed over the life of the lease. Changes, both increases and decreases, in our cost of borrowing, as reflected in our composite interest rate, directly impact our lease margin. We manage the interest rate volatility and uncertainty by maintaining a balance between fixed and floating rate debt, through derivative instruments and through matching debt maturities with lease maturities.

 

Other Risks

 

Residual Value  — We bear the risk of re-leasing or selling the aircraft in our fleet that are subject to operating leases at the end of their lease terms. If demand for aircraft decreases, our average fleet age may increase because of an inability to sell aircraft, and market lease rates may decrease. Should this condition continue for an extended period, it could affect the market value of aircraft in our fleet and may result in impairment charges in accordance with SFAS No. 144 “Accounting for the Impairment or Disposal of Long-lived Assets” (“SFAS 144”). See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations — Critical Accounting Polices and Estimates — Flight Equipment. ”

 

Obsolescence Risk  — Aircraft are long-lived assets requiring long lead times to develop and manufacture. As a result, aircraft of a particular model and type tend to become obsolete and less in demand over time, when newer more advanced and efficient aircraft are manufactured. This life cycle, however, can be shortened by world events, government regulation or customer preferences. As aircraft in our fleet approach obsolescence, demand for that particular model and type will decrease. This may result in lease margins compressing or may result in impairment charges in accordance with SFAS 144.

 

Key Personnel  — Our future success is dependent upon, among other things, the retention of our executive management team. There can be no assurance that we will be able to retain our executive officers and other key employees. The loss of the services of any of our executive officers or key employees could disrupt our operations.

 

Foreign currency exchange rate risk  — We negotiate some of our leases in Euros to meet the demands of a growing number of airlines. If the Euro exchange rate to the U.S. Dollar deteriorates, as it did during 2004, we will record less lease revenue on those lease payments that are not hedged.

 

Relationship with AIG —  While neither AIG nor any of its subsidiaries is a co-obligor or guarantor of our debt securities, circumstances affecting AIG can have an impact on us. For example, concurrent with ratings actions taken by Standard & Poor’s, a division of The McGraw-Hill Companies, Inc. (“S&P”), Moody’s Investors Service,

Inc. (“Moody’s”) and Fitch, Inc. (“Fitch”) with respect to AIG in 2005, the following ratings actions were taken or statements were made with respect to our ratings: (i) S&P retained our long-term debt rating at AA- on Negative Long Term Rating Outlook and our short-term rating at A-1+, (ii) Moody’s affirmed our (A1/Stable/P-1) rating with a Stable outlook and (iii) Fitch lowered our long-term rating to A+ and short-term rating to F-1 and continues to have us on Rating Watch Negative. Accordingly, we can give no assurance how further changes in circumstances related to AIG would impact us.

 

None

Item 2.   Properties

 

Flight Equipment

 

Management frequently reviews opportunities to acquire suitable commercial jet aircraft based not only on market demand and customer airline requirements, but also on our fleet portfolio mix criteria and leasing strategies. Before committing to purchase specific aircraft, management takes into consideration factors such as estimates of future values, potential for remarketing, trends in supply and demand for the particular type, make and model of aircraft and engines, and anticipated obsolescence. As a result, certain types and vintages of aircraft do not necessarily fit the profile for inclusion in our portfolio of aircraft owned and used in our leasing operations.

 

At December 31, 2005, all of our fleet was Stage III compliant. This means that the aircraft hold or are capable of holding a noise certificate issued under Chapter 3 of Volume 1, Part II of Annex 16 of the Chicago Convention or have been shown to comply with the Stage III noise levels set out in Section 36.5 of Appendix C of Part 36 of the Federal Aviation Regulations of the United States. At December 31, 2005, the average age of aircraft in our fleet was 5.62 years.

 

The following table shows the scheduled lease terminations (for the minimum noncancelable period) by aircraft type for our operating lease portfolio at December 31, 2005:

 

 

As of March 10, 2006, leases covering 36 of the 43 aircraft with lease expiration dates in 2006 had been extended or leased to other customers.

 

 

 

At December 31, 2005, we had options to purchase the following new aircraft at an estimated aggregate purchase price (including adjustment for anticipated inflation) of approximately $1.5 billion for delivery as shown below. The recorded basis of aircraft may be adjusted upon delivery to reflect notional credits given by the manufacturers in connection with the leasing of aircraft.

 

 

 

We anticipate that a significant portion of the aggregate purchase price will be funded by incurring additional debt. The exact amount of the indebtedness to be incurred will depend, in part, upon the actual purchase price of the aircraft, which can vary due to a number of factors, including inflation. See “Item 7.  Management’s Discussion and Analysis of Financial Condition and Results of Operations. ”

 

The new aircraft listed above are being purchased pursuant to master agreements with each of Boeing and Airbus. These agreements establish the pricing formulas (which include certain price adjustments based upon inflation and other factors) and various other terms with respect to the purchase of aircraft. Under certain circumstances, we have the right to alter the mix of aircraft type ultimately acquired. As of December 31, 2005, we had made non-refundable deposits (exclusive of capitalized interest) with respect to the aircraft which we have committed to purchase of approximately $421.2 million with Boeing and $548.3 million with Airbus.

 

Under arrangements with manufacturers, in certain circumstances the manufacturers establish notional accounts for our benefit, to which amounts are credited by the manufacturers in connection with the purchase by and delivery to us and the lease of aircraft. Amounts credited to the notional accounts are used at our direction to protect us from certain events, including loss when airline customers default on lease payment obligations, to provide lease subsidies and other incentives to our airline customers in connection with leases of certain aircraft and

to reduce our cost of aircraft purchased. The amounts credited are recorded as a reduction in flight equipment under operating leases.

 

As of March 10, 2006, we had entered into contracts for the lease of new aircraft scheduled to be delivered through 2010 as follows:

 

 

We will need to find customers for aircraft presently on order and not subject to contract and any new aircraft ordered, and we will need to arrange financing for portions of the purchase price of such equipment. Although we have been successful to date in placing new aircraft on lease and have been able to obtain adequate financing in the past, there can be no assurance as to the future continued availability of lessees or of sufficient amounts of financing on acceptable terms.

 

Facilities

 

Our principal offices are located at 10250 Constellation Blvd., Suite 3400, Los Angeles, California. We occupy space under a lease which expires in 2015. As of March 10, 2006, we occupied approximately 127,000 square feet of office space. The lease provides for annual rentals of approximately $9 million, and the rental payments thereunder are subject to certain indexed escalation provisions.

 

In connection with the January 3, 2004 crash of our 737-300 aircraft on lease to Flash Airlines in Egypt, lawsuits were filed by the families of 124 of the 148 victims on the flight against us, Boeing, Honeywell International Inc., and Parker-Hannifin Corporation in the Court of First Instance at Bobigny in France. These plaintiffs have also sued Flash Airlines and its insurer in the same French court. In addition, lawsuits have been filed by the families of two of the victims on the flight against us, Ozark Aircraft Systems LLC and several individuals (including one ILFC employee) in the U.S. District Court for the Western District of Arkansas. We believe we are adequately covered in all of these cases by the liability insurance policies carried by Flash Airlines and we have substantial defenses to the actions. We do not believe the outcome of these lawsuits will have a material effect on our liquidity, financial condition or results of operations.

 

Between December 2001 and March 2003, we restructured the ownership of aircraft in certain lease transactions in Australia. The Australian Tax Office (“ATO”) has investigated how the goods and services tax laws of Australia (“GST”) relate to these transactions. In September 2004, we filed a Summons in the Supreme Court of New South Wales seeking declaratory relief affirming our positions on the technical GST aspects of the restructurings. In April 2005, the ATO issued their final compliance report and assessments against both ILFC Australia (“ILFCA”) and Interlease Aircraft Trading (“IATC”), both wholly owned subsidiaries of ILFC and parties to the restructuring. The assessments were made for the full tax credits claimed, including penalties and interest against both parties. Our request for declaratory relief was dismissed as a result of the assessments issued. In November 2005, our appeal of the dismissal was denied. Management believes that there are substantial arguments in support of our position and we have appealed the assessments. In January 2006, the ATO began recovery proceedings against ILFCA to collect the outstanding assessments, and we have initiated activities to stay the recovery proceeding and settle the matter. In March 2006, we reached an agreement in principle to settle all outstanding matters with the ATO. The settlement approximates amounts accrued as of December 31, 2005.

PART II

 

The Company is an indirect wholly owned subsidiary of AIG and the Company’s common stock is not listed on any national exchange or traded in any established market. We paid cash dividends to our parent company of $37.0 million (2005), $35.5 million (2004), and $49.0 million (2003). It is our intention to pay our parent company

an annual dividend of at least 7% of net income subject to the dividend preference of any preferred stock outstanding. Under the most restrictive provisions of our borrowing arrangements, consolidated retained earnings at December 31, 2005 in the amount of approximately $2.0 billion were unrestricted as to the payment of dividends.

 

On August 11, 2005, we issued 3,069,604 shares of common stock to AIG subsidiaries for approximately $400 million. This sale was made in reliance upon the exemption from the registration requirements of the Securities Act of 1933 contained in section 4(2) of that Act.

Item 6.  Selected Financial Data

 

The following table summarizes selected consolidated financial data and certain operating information of the Company. The selected consolidated financial data should be read in conjunction with the Consolidated Financial Statements and notes thereto and “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations ” included elsewhere in this Form 10-K.

 

 

See notes on following page

 

 

 (d) See Exhibit 12.

 

 (e) See “Item 2. Properties — Flight Equipment. ”

 

Overview and Industry Condition

 

ILFC primarily acquires new jet transport aircraft from Boeing and Airbus and leases these aircraft to airlines throughout the world. In addition to our leasing activity, we sell aircraft from our leased aircraft fleet to other leasing companies, financial services companies and airlines. In some cases, we provide fleet management services to investors and/or, owners of aircraft portfolios for a management fee. We have also provided asset value guarantees and loan guarantees to buyers of aircraft or to financial institutions for a fee. We also remarket and sell aircraft owned or managed by others for a fee.

 

As of December 31, 2005, we owned 746 aircraft, had 17 aircraft in the fleet that were classified as finance leases, and provided fleet management services for 103 aircraft. We have contracted with Airbus and Boeing to buy 336 new aircraft for delivery through 2015 with an estimated purchase price of $23.3 billion, 96 of which will deliver during 2006. The recorded basis of aircraft may be adjusted to reflect notional credits provided by the manufacturers to support the leasing of aircraft.

 

Our sources of revenue are principally from scheduled and charter airlines and companies associated with the airline industry. The airline industry is cyclical, economically sensitive and highly competitive. Airlines and related companies may be affected by political or economic instability, terrorist activities, changes in national policy, competitive pressures on certain air carriers, fuel prices and shortages, labor stoppages, insurance costs, recessions, and other political or economic events adversely affecting world or regional trading markets. Our revenues and income will be affected by our customers’ ability to react to and cope with the volatile competitive environment in which they operate, as well as our own competitive environment.

 

Despite rising fuel prices which significantly impacted the airline industry during 2004 and 2005, overall airline industry trends showed continued improvement, particularly outside the United States. As a result, starting in 2004, and continuing in 2005, we saw an increase in demand for newer, modern, fuel efficient aircraft that comprise the bulk of our fleet, and an overall strengthening of lease rates. Although lease rates strengthened during 2004 and 2005, there is a lag between changes in market conditions and their impact on our results, as contracts signed during times of lower lease rates are still in effect, including a number of new aircraft that delivered in 2004 and 2005. Therefore, the improvement in the airline industry has yet to be completely reflected in our financial performance. We believe we are well positioned in the current industry environment with signed lease agreements for all of our 2006 deliveries of new aircraft as of December 31, 2005, and placement of 76% of our 2007 new aircraft deliveries as of March 10, 2006. During 2005, we sold aircraft from our lease portfolio to six repeat buyers of our aircraft as well as to three new buyers. As well, we experienced an increasing level of interest from third party investors and debt providers regarding the purchase of aircraft from our fleet.

 

Our primary source of revenue is from operating leases. One measure of profitability we use is a ratio called Lease Margin, (see “Item 7. Management’s Discussion and Analysis — Non-GAAP Financial Measures”) . Our lease margin decreased 1.3% for the year ended December 31, 2005 compared to the same period in 2004. The primary reasons for the decline are (i) increasing interest rates are starting to affect our margins and (ii) an increase in the overhaul provision rate. In addition, increased lease rates have yet to fully materialize in our revenue. Our average composite borrowing rate for the year increased 0.22% to 4.66% compared to the same period in 2004. Increasing interest rates, along with other risk factors, may impact our future results. (See “Item 1A. Risk Factors”. )

 

We have received tax benefits under the Foreign Sales Corporation (“FSC”) law and its successor regime, the Extraterritorial Income Act (“ETI”). In October 2004, Congress passed a bill, the American Jobs Creation Act of 2004, repealing the corporate export tax benefits under the ETI, after the World Trade Organization (“WTO”) ruled the export subsidies were illegal. Under the bill, ETI export tax benefits for corporations will be phased out in 2006 and cease to exist for the year 2007. On January 26, 2006, the WTO ruled the American Jobs Creation Act fails to fully implement the recommendations from the Dispute Settlement Body as long as it includes transitional and grandfathering measures. We expect our effective tax rate to rise to a rate consistent with the “expected” statutory rate as these benefits cease to exist.

 

During 2005, we derived 88.9% of our revenues from airlines outside of the United States, as compared with 90.1% in 2004 and 89.0% in 2003. A key factor in our success has been a concentrated effort to maximize our lease

placements in regions that are strengthening, such as in Asia, Europe and the Middle East, and to minimize placements in regions that are under stress, such as the United States. We have no aircraft on lease to United Airlines, Delta, or Northwest Airlines.

 

Revenues from rentals of flight equipment for the year ended December 31, 2005 include $105.2 million of revenue from lessees that are presently under bankruptcy protection. To date there has been no indication, other than as discussed below, that they will cease operations. If the lessees default on the leases, we would have to remarket those aircraft and may incur costs related to re-leasing those aircraft.

 

On June 17, 2005, one of our customers, Varig S.A. (lessee of eleven aircraft) filed for bankruptcy protection under Brazilian Bankruptcy Law. The airline is still operating and the eleven aircraft remained on lease to Varig S.A. at December 31, 2005. Varig S.A. is currently meeting all rental obligations under the leases. In 2005, we took a charge in the amount of $6.7 million related to receivables of restructured rents from Varig S.A. The charge is included in Selling, general and administrative on the December 31, 2005 Consolidated Statement of Income.

 

One of our customers, Independence Air, Inc. (lessee of eight aircraft) filed for bankruptcy protection under Chapter 11 of the United States Bankruptcy Code on November 7, 2005, and ceased operations in January 2006. All aircraft previously leased to Independence Air Inc. were subsequently leased to other airlines.

 

On March 7, 2006, Airbus announced that it had decided to phase out its A300s and A310s final assembly. At December 31, 2005, we had seven A310-300s and six A300-600Rs in our fleet, all of which were leased to airlines. We believe that the market place had already reflected this event and we have considered the event in our most recent impairment analysis. The analysis did not result in an impairment charge.

 

Critical Accounting Policies and Estimates

 

Management’s discussion and analysis of our financial condition and results of operations are based upon our 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, liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to revenue, depreciation, overhaul reserves, and contingencies. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. The results form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions and conditions.

 

We believe the following are our critical accounting policies, some of which require significant judgments and estimates, used in the preparation of the consolidated financial statements.

 

Lease Revenue : As lessor, we lease flight equipment principally under operating leases and report rental income ratably over the life of the lease. The difference between the rental income recorded and the cash received under the provisions of the lease is included in “Accrued interest, other receivables and other assets” on our Consolidated Balance Sheets. Past-due rentals are recognized on the basis of management’s assessment of collectibility. In certain cases, leases provide for additional rentals based on usage. The usage may be calculated based on hourly usage or on the number of cycles operated, depending on the lease contract. A cycle is defined as one take-off and landing. The usage is typically reported monthly by the lessee. Rentals received, but unearned under the lease agreements, are recorded in “Rentals received in advance” on our Consolidated Balance Sheets until earned. Lease revenues from the rental of flight equipment have been reduced by payments received directly by us or by our customers from the aircraft and engine manufacturers.

 

Costs related to reconfiguration of aircraft cabins and other lessee specific modifications are capitalized and amortized over the life of the lease.

 

Flight Equipment Marketing : We market flight equipment and recognize gains and losses when leased equipment is sold and the risk of ownership of the equipment is passed to the new owner. We also engage in marketing aircraft on behalf of independent third parties. We recognize revenue for these transactions when services are rendered and an obligation to pay exists in accordance with the contract. The portion of sales proceeds as a result

of payments made to buyers directly by the aircraft manufacturers are not included in marketing revenue but are recorded as a reduction to the overall basis of the flight equipment.

 

Flight Equipment : Flight equipment under operating leases is stated at cost. Purchases, major additions and modifications and capitalized interest are capitalized. Normal maintenance and repairs, airframe and engine overhauls and compliance with return conditions of flight equipment returned from lease are provided for and paid for by the lessee. Generally, aircraft, including aircraft acquired under capital leases, are depreciated using the straight line method over a 25 year life from the date of manufacture to a 15% residual value. Because of the significant cost of aircraft carried in “Flight equipment under operating leases” in our Consolidated Balance Sheets, any change in the assumption of useful life or residual values for all aircraft could have a significant impact on our results of operations.

 

Under arrangements with the manufacturers, in certain circumstances the manufacturers establish notional accounts for our benefit, to which amounts are credited by them in connection with the purchase by and delivery to us and the lease of aircraft. Amounts credited to the notional accounts are used at our direction to protect us from certain events, including loss when airline customers default on lease payment obligations, to provide lease subsidies and other incentives to our airline customers in connection with leases of certain aircraft and to reduce our cost of aircraft purchased. The amounts credited to the notional accounts are recorded as a reduction to the basis of aircraft purchased at the time the amounts are available to us. Since cost is reduced, future depreciation is also reduced.

 

Out of production aircraft types are depreciated using the straight line method over a 25 year life from the date of manufacture to an established residual value for each aircraft type.

 

At the time assets are retired or sold, the cost and accumulated depreciation are removed from the related accounts and the difference, net of proceeds, is recorded as a gain or loss.

 

Management is very active in the airline industry and reviews issues affecting our fleet on a quarterly basis, including events and circumstances that may affect impairment of aircraft values (e.g. residual value, useful life and current and future revenue generating capacity). Management evaluates aircraft in the fleet, as necessary, based on these events and circumstances in accordance with SFAS 144. SFAS 144 requires that long-lived assets be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. These evaluations for impairment are significantly impacted by estimates of future revenues and other factors which involve some amount of uncertainty. Recoverability of assets is measured by comparing the carrying amount of an asset to future undiscounted net cash flows expected to be generated by the asset. Estimated cash flows consist of current contractual lease rates, future projected lease rates and estimated scrap values for each aircraft. The factors considered in estimating the undiscounted cash flows may change in future periods due to changes in contracted lease rates, economic conditions, technology, airline demand for a particular aircraft type and many of the risk factors discussed in Item 1A. “Risk Factors .” We have, to date, not recorded any impairment charges related to aircraft.

 

Capitalized Interest : We borrow funds to finance progress payments for the construction of flight equipment ordered. We capitalize interest incurred on such borrowings. This amount is calculated using our composite borrowing rate (see ‘‘Financial Condition” below) and is included in the cost of the flight equipment. Any change in our composite borrowing rate will change future amount capitalized.

 

Provision for Overhauls : Under the provisions of many leases, we receive overhaul rentals based on the usage of the aircraft. For certain airframe and engine overhauls, the lessee is reimbursed for costs incurred up to, but not exceeding, related overhaul rentals paid by the lessee for usage of the aircraft.

 

Overhaul rentals are included under the caption “Rental of flight equipment” in our Consolidated Statements of Income. We provide a charge to operations for estimated future reimbursements at the time the overhaul rentals are paid by the lessee. The charge is based on overhaul rentals received and the estimated reimbursements during the life of the lease. The historical payout rate is subject to significant fluctuations. Using its judgment, management periodically evaluates the appropriateness of the reserve for these reimbursements and its reimbursement rate, and then adjusts the provision for overhauls accordingly. This evaluation requires significant judgment. If the

reimbursements are materially different than our estimates, there will be a material impact on our results of operations.

 

Derivative Financial Instruments: In the normal course of business we utilize derivative instruments to manage our exposure to interest rate risks and foreign currency risks. We account for derivative instruments in accordance with SFAS No. 133 “Accounting for Derivative Instruments and Hedging Activities”, as amended and interpreted (“SFAS 133”). Accounting for derivatives is very complex. All derivatives are recognized on the balance sheet at their fair value. We obtain the values on a quarterly basis from the counter party of the derivative contracts, a related party. When hedge treatment is achieved under SFAS 133, the changes in market values related to the effective portion of the derivatives are recorded in other comprehensive income or in income, depending on the designation of the derivative as a cash flow hedge or a fair value hedge. The ineffective portion of the derivative contract is calculated and recorded in income at each quarter end. At inception of the hedge, we choose a method of ineffectiveness calculation, which we must use for the life of the contract. We use the “change in variable cash flows method” for calculation of hedges not considered to be perfectly effective. The calculation involves a comparison of the present value of the cumulative change in the expected future cash flows on the variable leg of the swap and the present value of the cumulative change in the expected future interest cash flows on the floating-rate asset or liability. The difference is the calculated ineffectiveness and is recorded in income.

 

Financial Condition

 

We borrow funds to purchase new and used flight equipment (see “Item 2. Properties — Commitments ”), including funds for progress payments during aircraft construction, and to pay off maturing debt obligations. The funds are borrowed principally on an unsecured basis from various sources. During 2005, we borrowed $7.4 billion (excluding commercial paper) and $2.3 billion was provided by operating activities to meet our needs. As of December 31, 2005, we had committed to purchase 338 new and used aircraft from Boeing, Airbus and an airline at an estimated aggregate purchase price of approximately $23.3 billion for delivery through 2015, of which we currently anticipate taking delivery of 96 aircraft in 2006 with an estimated aggregate purchase price of $6.0 billion. We also hold options to purchase 16 additional new aircraft at an estimated aggregate purchase price of approximately $1.5 billion. The recorded basis of aircraft may be adjusted to reflect notional credits given by the manufacturers to support the leasing of aircraft. We currently expect to fund expenditures for aircraft and to meet liquidity needs from a combination of available cash balances, internally generated funds and financing arrangements. Our borrowing strategy will, over time, result in approximately 15% or less of our debt, excluding commercial paper, maturing in any one year. Management continues to explore new funding sources and ways to diversify our investor base. Our debt financing and capital lease obligations were comprised of the following at the following dates:

 

The above amounts represent our anticipated settlement of our outstanding debt obligations. Certain adjustments required to present currently outstanding debt obligations have been recorded and presented separately on the face of the Consolidated Balance Sheets, including adjustments related to foreign currency and interest rate hedging activities. We have eliminated the currency exposure arising from foreign currency denominated notes by either hedging the notes through swaps or through the offset provided by operating lease receipts denominated in the related currency. Foreign currency denominated debt is translated into U.S. Dollars using exchange rates as of each balance sheet date. The foreign exchange adjustments for the foreign currency denominated debt at December 31 were $197.0 million (2005), $1,215.8 million (2004) and $839.7 million (2003). Composite interest rates and the percentage of total debt at fixed rates reflect the effect of derivative instruments.

 

 

 

 

 

 

Capital Lease Obligations

 

We had Export Credit Lease financings which provided ten year, amortizing loans in the form of capital lease obligations. The interest rate on 62.5% of the original financed amount was 6.55% and the interest rate on 22.5% of the original financed amount was fixed at rates varying between 6.18% and 6.89%. These two tranches were guaranteed by various European Export Credit agencies. We prepaid the remaining 15% of the original financed amount in 2000. At December 31, 2005, all capital lease obligations had matured.

 

Bank Term Debt

 

In January 1999, we entered into an Export Credit Facility, for up to a maximum of $4.3 billion, for aircraft delivered through 2001. We used the facility to fund 85% of each aircraft’s purchase price. The facility was guaranteed by various European Export Credit agencies. We financed 62 aircraft using $2.8 billion under this facility over ten years with interest rates from 5.753% to 5.898%. The debt is collateralized by a pledge of the shares of a subsidiary of ours which holds title to the aircraft financed under the facility. At December 31, 2005, $1.2 billion was outstanding under this facility.

 

From time to time we enter into funded bank financing agreements. As of December 31, 2005, we had a total of $1.4 billion outstanding, which have varying maturities through 2010. One tranche of one of the loans totaling

$410 million was funded in Japanese Yen and swapped to U.S. Dollars. The interest rates are LIBOR based with spreads ranging from .325% to 1.625% at December 31, 2005.

 

In May 2004, we entered into an Export Credit Facility for up to a maximum of $2.64 billion, to finance Airbus aircraft to be delivered in 2004 and 2005, subsequently extended through May 2006. The facility is used to fund 85% of each aircraft’s purchase price. This facility becomes available as the various European Export Credit agencies provides their guarantees for aircraft based on a six-month forward-looking calendar. The financing is for a ten-year fully amortizing loan per aircraft at an interest rate determined through a bid process. We have collateralized the debt by a pledge of the shares of a subsidiary which holds title to the aircraft financed under this facility. As of December 31, 2005, 23 aircraft were financed under this facility and $1.4 billion was outstanding.

 

In August 2004, we received a commitment for an Ex-Im Bank comprehensive guarantee in the amount of $1.68 billion to support the financing of up to 30 new Boeing aircraft. The delivery period initially extended from September 1, 2004 through August 31, 2005. We have extended the delivery period to August 31, 2006. As of December 31, 2005, we had not financed any aircraft under this facility.

 

Junior Subordinated Debt

 

In December of 2005, ILFC entered into two tranches of junior subordinated debt totaling $1.0 billion. Both mature on December 21, 2065, but each tranche has a different call option. The $600 million tranche has a call date of December 21, 2010 and the $400 million tranche has a call date of December 21, 2015. The note with the 2010 call date has a fixed interest rate of 5.90% for the first five years. The note with the 2015 call date has a fixed interest rate of 6.25% for the first ten years. Both tranches have interest rate adjustments if the call option is not exercised. The new interest rate is a floating quarterly reset rate based on the initial credit spread plus the highest of (i) 3 month LIBOR, (ii) 10-year constant maturity treasury and (iii) 30-year constant maturity treasury.

 

Commercial Paper

 

We currently have a $6.0 billion Commercial Paper Program. Under this program, we may borrow in minimum increments of $100,000 for periods from one day to 270 days. It is our intention to only sell commercial paper to a maximum amount of 75% of the total amount of the backup facilities available (see “Bank Commitments” below). The weighted average interest rate of the outstanding commercial paper was 4.17%, 2.34% and 1.07%, at December 31, 2005, 2004, and 2003, respectively.

 

Bank Commitments

 

During 2005, we had two $500 million, 180 day revolving credit agreements with banks, each with a one-year term out option. Both loans matured prior to December 31, 2005. As of December 31, 2005, we had committed revolving credit agreements with 30 banks aggregating $6.0 billion, including a $2.0 billion 364-day tranche that expires in October of 2006, with a one-year term out option, a $2.0 billion five-year tranche that expires in October of 2009, and a $2.0 billion five-year tranche that expires in October of 2010. These revolving loans and lines of credit provide for interest rates that vary according to the pricing option in effect at the time of borrowing. Pricing options include prime, a range from .25% over LIBOR to 1.85% over LIBOR based upon utilization, or a rate determined by a competitive bid process with the banks. The revolving loans and lines of credit are subject to facility fees of up to .10% of amounts available. This financing is used as backup for our maturing debt and other obligations. We expect to replace or extend these credit agreements on or prior to their expiration dates. At December 31, 2005, we had not drawn on our revolving loans and lines of credit.

 

Other Variable Interest Entities

 

We have sold aircraft to entities owned by third parties and from time to time we have issued asset value guarantees or loan guarantees related to the aircraft sold. We have determined that ten such entities, each owning one aircraft, are Variable Interest Entities (“VIEs”) in which we are deemed the primary beneficiary. In accordance with Financial Accounting Standards Board Interpretations (“FIN”) No. 46R, “Consolidation of Variable Interest Entities” (“FIN46R”), we consolidate these entities. The assets and liabilities of these entities are presented separately on our Consolidated Balance Sheets. We do not control or own the assets, nor are we directly obligated for the liabilities of these entities. At adoption of FIN 46R in 2003 we recorded after-tax charges of $11.0 million

related to those entities and an additional $2.4 million related to sale-lease-back transactions as a cumulative effect of an accounting change. See Note H of Notes to Consolidated Financial Statements .

 

We have contributed an aircraft to a joint venture (“JV”) that leases the aircraft to a third party. We have determined that the JV is a VIE, but we are not the primary beneficiary and we do not consolidate the entity. See Note D of Notes to Consolidated Financial Statements .

 

We have not established any other unconsolidated entities for the purpose of facilitating off-balance sheet arrangements or for other contractually narrow or limited purposes. We have, however, from time to time established subsidiaries, entered into joint ventures or created other partnership arrangements with the limited purpose of leasing aircraft or facilitating borrowing arrangements.

 

Derivatives

 

In the normal course of business, we employ a variety of derivative products to manage our exposure to interest rates risks and foreign currency risks. We enter into derivative transactions only to economically hedge interest rate risk and currency risk and not to speculate on interest rates or currency fluctuations. These derivative products include interest rate swap agreements and currency swap agreements. At December 31, 2005, we had the following derivative contracts that did not qualify for hedge accounting under SFAS 133:

 

 

When a derivative contract does not qualify for hedge treatment under SFAS 133, the changes in market values are recorded in income. The related mark to market gains reported in income for the year ended December 31, 2005 was $10.4 million.

 

When interest rate and foreign currency swaps are effective as accounting hedges under the technical requirements of SFAS 133, they offset the variability of expected future cash flows or changes in the fair values of assets and liabilities, both economically and for financial reporting purposes. We have historically used such instruments to effectively mitigate foreign currency and interest rate risks. The effect of our inability to apply hedge accounting for the swaps is that changes in their fair values must be recorded in earnings each reporting period. As a result, reported net income will be directly influenced by changes in interest rates and currency rates.

 

The counterparty to our derivative instruments is AIG Financial Products Corp. (“AIGFP”), a related party. The derivatives are subject to a bilateral security agreement which, in certain circumstances, may allow one party to the agreement to require the second party to the agreement to provide collateral. Failure of the instruments or counterparty to perform under the derivative contracts will have a material impact on our results of operations.

 

Common Stock

 

During the year ended December 31, 2005, we issued 3,069,604 shares of our common stock to an existing shareholder for approximately $400 million. AIG has no obligation to contribute additional equity.

 

Market Liquidity Risks

 

We are in compliance with all covenants or other requirements set forth in our credit agreements. Further, we do not have any rating downgrade triggers that would automatically accelerate the maturity dates of our debt. However, a downgrade in our credit rating could adversely affect our ability to borrow on, renew existing, or obtain access to new financing arrangements and would increase the cost of such financing arrangements. For example, a downgrade in credit rating could reduce our ability to issue commercial paper under our current program.

While we have been able to borrow the funds necessary to finance operations in the current market environment, turmoil in the airline industry or political environment could limit our ability to borrow funds from our current funding sources. Should this occur, we would seek alternative sources of funding, including securitizations and manufacturer’s financings, drawings upon our revolving loans and lines of credit facilities or seek additional short term borrowings. If we were unable to obtain sufficient funding, we could negotiate with manufacturers to defer deliveries of certain aircraft.

 

The following summarizes our contractual obligations at December 31, 2005 and the possible effect of such obligations on our liquidity and cashflows in future periods.

 

 

 

 

 

 

 

 

Non-GAAP Financial Measures

 

Lease Margin

 

Lease Margin is defined as Rental of flight equipment less total expenses, adjusted for VIE expenses related to Other Variable Interest Entities and other expenses we consider not related to our core business operations, divided by Rental of flight equipment. Other expenses consists of a charge in the amount of $38.3 million related to prior year estimated aircraft ownership restructuring transactions, a write-down of notes receivable in the amount of $11.7 million (2005) and a charge we took related to a customer’s bankruptcy filing (2004). Lease Margin is a measure by which we isolate and evaluate the overall profitability of our contractual leasing operations, which constitute our primary revenue generating activity. Beginning in 2003, coinciding with the adoption of FIN 46R and to more accurately portray the trend of our core leasing operations, we adjust total expenses in the calculation of Lease Margin by excluding VIE expenses and other expenses we consider not related to our core business operations. Related VIE revenues are included in Interest and other and are by definition excluded from the calculation of Lease Margin. The most directly comparable GAAP financial measure is Profit Margin. Lease margin may not be comparable to those of other entities, as not all companies and analysts calculate this non-GAAP measure in the same manner. The following is a reconciliation of Profit Margin to Lease Margin: