SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 _________________ FORM 10-Q (MARK ONE) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Quarterly Period Ended September 30, 1998 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 COMMISSION FILE NUMBER: 0-28774 _________________ WILLIS LEASE FINANCE CORPORATION (Exact name of registrant as specified in its charter) Delaware 68-0070656 (State or other jurisdiction of (IRS Employer Identification No.) incorporation or organization) 2320 Marinship Way, Suite 300, Sausalito, CA 94965 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code (415) 331-5281 _________________ 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 --- --- Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: Title of Each Class Outstanding at October 31, 1998 ------------------- ------------------------------- Common Stock, $0.01 Par Value 7,285,813 1
WILLIS LEASE FINANCE CORPORATION INDEX <TABLE> <CAPTION> Page No. -------- <S> <C> PART I FINANCIAL INFORMATION Item 1. Consolidated Financial Statements Consolidated Balance Sheets As of September 30, 1998 and December 31, 1997 3 Consolidated Statements of Income 4 Three and nine months ended September 30, 1998 and 1997 Consolidated Statements of Shareholders' Equity 5 Year ended December 31, 1997 and nine months ended September 30, 1998 Consolidated Statements of Cash Flows 6 Nine months ended September 30, 1998 and 1997 Notes to Consolidated Financial Statements 7 Item 2. Management's Discussion and Analysis of Financial Condition 9 and Results of Operations PART II OTHER INFORMATION Item 6. Exhibits and Reports on Form 8-K 17 </TABLE> 2
WILLIS LEASE FINANCE CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS <TABLE> <CAPTION> SEPTEMBER 30, DECEMBER 31, 1998 1997 ------------- ------------ (Unaudited) <S> <C> <C> ASSETS Cash and cash equivalents $2,926,597 $13,095,303 Deposits 16,701,061 18,461,456 Equipment held for operating lease, less accumulated depreciation of $14,197,951 at September 30, 1998 and $15,267,683 at December 31, 1997 246,312,602 138,535,643 Net investment in direct finance lease 9,391,351 9,821,854 Property, equipment and furnishings, less accumulated depreciation of $436,585 at September 30, 1998 and $275,109 at December 31, 1997 2,274,450 540,856 Spare parts inventory 29,150,797 10,334,113 Maintenance billings receivable 888,898 1,547,765 Operating lease rentals receivable 642,645 520,466 Receivables from spare parts sales 4,865,594 2,908,175 Other receivables 331,721 375,878 Other assets 7,963,459 2,288,547 ------------- ------------- Total assets $321,449,175 $198,430,056 ------------- ------------- ------------- ------------- LIABILITIES AND SHAREHOLDERS' EQUITY Liabilities: Accounts payable and accrued expenses $6,270,112 $4,010,976 Salaries and commissions payable 461,319 1,070,051 Deferred income taxes 11,525,590 8,476,040 Deferred gain 163,406 183,278 Notes payable and accrued interest 214,861,837 101,433,200 Capital lease obligation 2,690,852 2,802,119 Residual share payable 2,402,410 2,092,140 Maintenance reserves 14,360,602 20,018,195 Security deposits 4,176,006 2,435,987 Unearned lease revenue 2,497,213 1,306,613 ------------- ------------- Total liabilities $259,409,347 $143,828,599 ------------- ------------- Shareholders' equity: Common stock, ($0.01 par value and no par value as of September 30, 1998 and December 31, 1997, respectively. 20,000,000 shares authorized; 7,285,813 and 7,177,320 shares issued and outstanding as of September 30, 1998 and December 31,1997, respectively) 72,858 - Paid-in capital in excess of par 41,100,934 40,117,223 Retained earnings 20,866,036 14,484,234 ------------- ------------- Total shareholders' equity 62,039,828 54,601,457 ------------- ------------- Total liabilities and shareholders' equity $321,449,175 $198,430,056 ------------- ------------- ------------- ------------- </TABLE> See accompanying notes to the consolidated financial statements 3
WILLIS LEASE FINANCE CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED) <TABLE> <CAPTION> THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, -------------------------- ------------------------- 1998 1997 1998 1997 ----------- ----------- ----------- ----------- <S> <C> <C> <C> <C> REVENUE Lease revenue $9,077,536 $5,159,969 $22,642,709 $13,703,795 Gain on sale of leased equipment 3,639,707 936,069 9,178,785 1,333,448 Spare part sales 7,229,672 5,581,648 16,828,866 11,459,311 Sale of equipment acquired for resale - 2,600,000 4,093,641 12,747,840 Interest and other income 133,644 90,821 752,876 543,660 ----------- ----------- ----------- ----------- Total revenue $20,080,559 $14,368,507 $53,496,877 $39,788,054 EXPENSES Interest expense 4,214,800 2,068,997 10,416,850 5,225,603 Depreciation expense 2,179,989 1,140,692 5,325,324 2,995,121 Residual share 187,128 226,659 587,387 598,125 Cost of spare part sales 5,037,298 4,044,196 11,923,306 7,751,179 Cost of equipment acquired for resale - 2,033,687 3,573,499 10,671,668 General and administrative 4,325,601 2,434,013 10,693,763 6,358,000 ----------- ----------- ----------- ----------- Total expenses $15,944,816 $11,948,244 $42,520,129 $33,599,696 ----------- ----------- ----------- ----------- Income before income taxes and extraordinary item 4,135,743 2,420,263 10,976,748 6,188,358 Income taxes (1,651,834) (969,327) (4,394,462) (2,456,283) ----------- ----------- ----------- ----------- Income before extraordinary item 2,483,909 1,450,936 6,582,286 3,732,075 Extraordinary item less applicable income taxes - - (200,480) 2,007,929 ----------- ----------- ----------- ----------- Net income $2,483,909 $1,450,936 $6,381,806 $5,740,004 ----------- ----------- ----------- ----------- ----------- ----------- ----------- ----------- Basic earnings per common share: Income before extraordinary item $0.34 $0.27 $0.91 $0.69 Extraordinary item - - (0.03) 0.37 ----------- ----------- ----------- ----------- Net income $0.34 $0.27 $0.88 $1.05 ----------- ----------- ----------- ----------- ----------- ----------- ----------- ----------- Diluted earnings per common share: Income before extraordinary item $0.33 $0.26 $0.88 $0.67 Extraordinary item - - (0.03) 0.36 ----------- ----------- ----------- ----------- Net income $0.33 $0.26 $0.85 $1.03 ----------- ----------- ----------- ----------- ----------- ----------- ----------- ----------- Average common shares outstanding 7,280,130 5,447,117 7,245,404 5,441,292 Diluted average common shares outstanding 7,495,491 5,658,184 7,466,062 5,592,223 </TABLE> See accompanying notes to the consolidated financial statements 4
WILLIS LEASE FINANCE CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY YEAR ENDED DECEMBER 31, 1997 AND NINE MONTHS ENDED SEPTEMBER 30, 1998 <TABLE> <CAPTION> Issued and outstanding Paid-in Total shares of Common Capital in Retained shareholders' common stock Stock Excess of Par earnings equity ------------ ----------- ------------- ---------- ------------ <S> <C> <C> <C> <C> <C> Balances at December 31, 1996 5,426,793 $16,055,689 $ - $7,146,563 $23,202,252 Shares issued 25,527 221,244 - - 221,244 Common stock issued and proceeds from secondary offering, net 1,725,000 23,840,290 - - 23,840,290 Net income - - - 7,337,667 7,337,667 --------- ----------- ----------- ----------- ----------- Balances at December 31, 1997 7,177,320 $40,117,223 $ - $14,484,230 $54,601,453 Shares issued 108,493 586,490 137,848 - 724,338 Tax benefit from disqualified dispositions of qualified shares - - 332,231 - 332,231 Conversion to par value stock - (40,630,855) 40,630,855 - - Net income - - - 6,381,806 6,381,806 --------- ----------- ----------- ----------- ----------- Balances at September 30, 1998 (unaudited) 7,285,813 $72,858 $41,100,934 $20,866,036 $62,039,828 --------- ----------- ----------- ----------- ----------- --------- ----------- ----------- ----------- ----------- </TABLE> See accompanying notes to the consolidated financial statements 5
WILLIS LEASE FINANCE CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS <TABLE> <CAPTION> NINE MONTHS ENDED SEPTEMBER 30, --------------------------- 1998 1997 ------------- ------------ <S> <C> <C> CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 6,381,806 $ 5,740,004 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation of equipment held for lease 5,155,698 2,905,016 Depreciation of property, equipment and furnishings 169,626 90,105 Loss on sale of property, equipment and furnishings 15,536 (45,122) Gain on sale of leased equipment (9,178,785) (1,333,448) Increase in residual share payable 310,270 598,125 Changes in assets and liabilities: Deposits 1,760,395 (620,199) Spare parts inventory (18,816,684) (5,511,768) Receivables (1,376,574) (1,414,577) Other assets (2,300,171) (667,171) Accounts payable and accrued expenses 2,259,136 (608,914) Salaries and commission payable (608,732) 371,324 Deferred income taxes 3,049,550 3,030,693 Deferred gain (19,872) (19,872) Accrued interest (172,694) (364,270) Maintenance deposits (5,657,593) 6,244,630 Security deposits 1,740,019 501,887 Unearned lease revenue 1,190,600 90,410 ------------ ------------ Net cash (used in) provided by operating activities (16,098,469) 8,986,853 CASH FLOWS FROM INVESTING ACTIVITIES: Proceeds from sale of equipment held for operating lease (net of selling expenses) 28,676,239 12,083,807 Proceeds from sale of property, equipment and furnishings 16,300 80,500 Purchase of equipment held for operating lease (132,430,111) (53,582,728) Deposits made in connection with inventory purchases (3,374,741) - Purchase of property, equipment and furnishings (1,935,060) (174,341) Principal payments received on direct finance lease 430,503 133,967 ------------ ------------ Net cash used in investing activities (108,616,870) (41,458,795) CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from issuance of notes payable 157,685,170 104,038,706 Proceeds from issuance of common stock 1,056,569 221,244 Principal payments on notes payable (44,083,839) (71,635,450) Principal payments on capital lease obligation (111,267) (122,754) ------------ ------------ Net cash provided by financing activities 114,546,633 32,501,746 (Decrease) increase in cash and cash equivalents (10,168,706) 29,804 Cash and cash equivalents at beginning of period 13,095,303 6,573,241 ------------ ------------ Cash and cash equivalents at end of period $ 2,926,597 $ 6,603,045 ------------- ------------ ------------- ------------ Supplemental information: Net cash paid for: Interest 10,589,544 5,589,873 ------------- ------------ Income Taxes 3,013,122 188,600 ------------- ------------ Non-cash financing activities: Disqualified disposition of qualified shares resulted in a $332,231 tax benefit. </TABLE> See accompanying notes to the consolidated financial statements 6
WILLIS LEASE FINANCE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. BASIS OF PRESENTATION CONSOLIDATED FINANCIAL STATEMENTS The accompanying unaudited consolidated financial statements of Willis Lease Finance Corporation and its subsidiaries (the "Company") have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission for reporting on Form 10-Q. Pursuant to such rules and regulations, certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted. The accompanying unaudited interim financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto, together with Management's Discussion and Analysis of Financial Condition and Results of Operations, contained in the Company's Annual Report to Shareholders incorporated by reference in the Company's Annual Report on Forms 10-K and 10-KA for the fiscal year ended December 31, 1997. In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments (consisting of only normal and recurring adjustments) necessary to present fairly the financial position of the Company as of September 30, 1998, and December 31, 1997, and the results of its operations for the three and nine month periods ended September 30, 1998 and 1997 and its cash flows for the nine month periods ended September 30, 1998 and 1997. The results of operations and cash flows for the periods ended September 30, 1998, are not necessarily indicative of the results of operations or cash flows which may be reported for the remainder of 1998. 2. MANAGEMENT ESTIMATES The preparation of financial statements, in conformity with generally accepted accounting principles, 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 revenue and expenses during the reporting period. Actual results could differ from those estimates. 3. SHAREHOLDERS' EQUITY The Company changed its state of incorporation from California to Delaware through a merger of Willis Lease Finance Corporation into its wholly-owned Delaware subsidiary. The reincorporation, approved by the Company's shareholders at the May 12, 1998 Annual Meeting of Shareholders, results in a change only of the Company's legal domicile. It does not result in any change in the Company's name, operations, locations, management, reporting obligations, NASDAQ National Market trading symbol or assets and liabilities. In connection with this reincorporation, the Company converted no par value common stock to $0.01 par value common stock. The Company has a 1996 Employee Stock Purchase Plan (the "Purchase Plan") under which 75,000 shares of common stock have been reserved for issuance. This plan became effective in September 1996. Eligible employees may designate not more than 10% of their cash compensation to be deducted each pay period for the purchase of common stock under the Purchase Plan, and participants may purchase not more than $25,000 of common stock in any one calendar year. Each January 31 and July 31 shares of common stock are purchased with the employees' payroll deductions over the immediately preceding six months at a price per share of 85% of the lesser of the market price of the common stock on the purchase date or the market price on the date of entry into an offering period. During the nine month 7
WILLIS LEASE FINANCE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) period ended September 30, 1998, the Company issued 15,755 shares of Common Stock as a result of employee stock purchases under the Purchase Plan. Under the 1996 Stock Option/Stock Issuance Plan, as amended and restated February 24, 1998, 1,025,000 shares of the Company's shares have been set aside to provide eligible persons with the opportunity to acquire a proprietary interest in the Company. The plan includes a Discretionary Option Grant Program, a Stock Issuance Program, and an Automatic Option Grant Program for eligible nonemployee Board Members. During the nine month period ended September 30, 1998, 67,500 options were exercised. In connection with the exercise of a portion of these options, the Company recognized a $332,231 tax benefit. In conjunction with its initial public offering, the Company sold five-year purchase warrants for $.01 per warrant covering an aggregate of 100,000 shares of common stock exercisable at a price equal to 130% of the initial public offering price. The warrants are exercisable commencing 24 months after the effective date of the initial public offering or earlier, but not earlier than 12 months after the initial public offering, if and when the Company files a registration statement for the sale by the Company of shares of common stock or securities exercisable for, convertible into or exchangeable for shares of common stock (other than pursuant to a stock option or other employee benefit or similar plan, or in connection with a merger or an acquisition). The common stock offering in December 1997 constituted such a registration. The warrants' exercise price and the number of shares of Common Stock are subject to adjustment to protect the warrant holders against dilution in certain events. In February 1998, a holder of 50,000 of the warrants exercised the warrants under the net issuance rights of the warrants. Based on the closing price on such date, the exercise resulted in the issuance of 25,238 shares to the holder of the warrants. 4. FINANCING In September 1998, the Company amended and restated its revolving credit facility, increasing the facility to $150 million. This credit facility is available to finance the acquisition of aircraft engines, aircraft and high-value spare parts for sale or lease as well as for general working capital purposes. At September 30, 1998, the interest rate on this facility was LIBOR plus 1.75%. This facility has a two-year revolving period followed by a four-year term-out period. The facility is renewable annually. In March 1998, the Company repaid a loan that had residual sharing provisions. The repayment resulted in an extraordinary expense of $0.2 million, net of tax. 5. COMMITMENTS In June 1998, the Company commenced a new lease of office space for its Sausalito operations. The initial term of this lease is five years and the annual rental commitments under the lease are approximately $0.3 million. In April 1998, the Company commenced lease of a warehouse and office facility for Willis Aeronautical Services, Inc. ("WASI") in San Diego, California. WASI moved its South San Francisco operations into this facility in June 1998. The initial term of this lease is six years and the annual rental commitments under the lease are approximately $0.4 million. The Company has committed to purchase, during 1998 and 1999, additional used aircraft and engines for its operations. Certain deposits were made in connection with these commitments. The Company's current, remaining commitment to such purchases is not more than $28.6 million. A portion of these purchases will take place in 1998 and the remainder in 1999. 8
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW The Company's core business is acquiring and leasing, primarily pursuant to operating leases, commercial aircraft spare engines, aircraft and other aircraft equipment. The Company, through WASI, also specializes in the purchase and resale of aftermarket airframe and engine parts, engines, modules and rotable components. In July 1998, the Company formed Pacific Gas Turbine Center, Incorporated ("PGTC"). Currently, PGTC provides engine disassembly services to WASI and third parties from the Company's San Diego location. In addition, the Company engages in the selective purchase and resale of commercial aircraft engines. The Company changed its state of incorporation from California to Delaware through a merger of Willis Lease Finance Corporation into its wholly-owned Delaware subsidiary. The reincorporation, approved by the Company's shareholders at the May 12, 1998 Annual Meeting of Shareholders, resulted in a change only of the Company's legal domicile. It did not result in any change in the Company's name, operations, locations, management, reporting obligations, NASDAQ National Market trading symbol or assets and liabilities. Revenue consists primarily of lease revenue, income from the sale of spare parts and components and income from the sale of engines and equipment. RESULTS OF OPERATIONS THREE MONTHS ENDED SEPTEMBER 30, 1998 COMPARED TO THE THREE MONTHS ENDED SEPTEMBER 30, 1997: Revenue is summarized as follows: <TABLE> <CAPTION> Nine Months Ended September 30, ------------------------------------- 1998 1997 ---- ----- Amount % Amount % ------------------------------------- (dollars in thousands) <S> <C> <C> <C> <C> Lease revenue. . . . . . . . . . . . . . . . 9,077 45% 5,160 36% Gain on sale of leased equipment . . . . . . 3,640 18 936 6 Spare parts sales. . . . . . . . . . . . . . 7,230 36 5,582 39 Sale of equipment acquired for resale. . . . -- -- 2,600 18 Interest and other income. . . . . . . . . . 133 1 91 1 ------------------------------------- Total. . . . . . . . . . . . . . . . . . . . 20,080 100% 14,369 100% ------------------------------------- ------------------------------------- </TABLE> LEASE PORTFOLIO. During the quarter ended September 30, 1998, seven engines, and additional spare parts were added to the Company's lease portfolio at a total cost of $31.0 million. Four engines were sold from the lease portfolio. LEASING ACTIVITIES. Lease revenue for the quarter ended September 30, 1998 increased 76% to $9.1 million from $5.2 million for the comparable period in 1997. This increase reflects lease revenues from additional engines, aircraft and spare parts packages. GAIN ON SALE OF LEASED EQUIPMENT. During the quarter ended September 30, 1998, the Company sold four engines from the lease portfolio which resulted in a gain of $3.6 million. During the quarter ended September 30, 1997 the Company sold two engines from the lease portfolio which resulted in a gain of $0.9 million. 9
SPARE PARTS SALES. Revenues from spare parts sales in the quarter ended September 30, 1998 increased 29% to $7.2 million from $5.6 million in the comparable 1997 period. The gross margin was 30% in the third quarter of 1998, and 28% in the corresponding period in 1997. SALE OF EQUIPMENT ACQUIRED FOR RESALE. During the quarter ended September 30, 1997, the Company sold five engines for $2.6 million resulting in a gain of $0.6 million. The Company had no such sales during the comparable 1998 period. INTEREST AND OTHER INCOME. Interest and other income for the quarter ended September 30, 1998 was $0.1 million compared to $0.1 million for the quarter ended September 30, 1997. INTEREST EXPENSE AND RESIDUAL SHARING. Interest expense related to all activities increased 104% to $4.2 million for the quarter ended September 30, 1998, from the comparable period in 1997, due to an increase in average debt outstanding during the period. Residual sharing expense decreased 17% to $187,128 for the quarter ended September 30, 1998 from $226,659 for the comparable period in 1997. The decline was due to the repayment, in March 1998, of one of the Company's loans which had residual sharing provisions. This expense is calculated by comparing the net book value of the engines subject to such agreements to their related debt balances and adjusting the residual share payable to the appropriate amount representing the sharing percentage of any excess of the net book value over the corresponding debt balance for such engines. DEPRECIATION EXPENSE. Depreciation expense increased 91% to $2.2 million for the quarter ended September 30, 1998, from the comparable period in 1997, due to the larger average asset base in the third quarter of 1998. GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses increased 78% to $4.3 million for the quarter ended September 30, 1998 from $2.4 million in the comparable period in 1997. This increase reflects expenses associated with staff additions, relocation of facilities, increased rent due to the expansion of the Company's office and warehouse facilities, expenses associated with Pacific Gas Turbine Center, as well as increases in professional fees, insurance expense and expenses related to promotional and marketing activities. INCOME TAXES. Income taxes, exclusive of tax on extraordinary items, for the quarter ended September 30, 1998, increased to $1.7 million from $1.0 million for the comparable period in 1997. This increase reflects an increase in the Company's pre-tax earnings. NINE MONTHS ENDED SEPTEMBER 30, 1998 COMPARED TO THE NINE MONTHS ENDED SEPTEMBER 30, 1997: Revenue is summarized as follows: <TABLE> <CAPTION> Nine Months Ended September 30, ------------------------------------ 1998 1997 ---- ---- Amount % Amount % ------------------------------------- (dollars in thousands) <S> <C> <C> <C> <C> Lease revenue. . . . . . . . . . . . . . . . 22,643 42% 13,704 35% Gain on sale of leased equipment . . . . . . 9,179 17 1,333 3 Spare parts sales. . . . . . . . . . . . . . 16,829 32 11,459 29 Sale of equipment acquired for resale. . . . 4,093 8 12,748 32 Interest and other income. . . . . . . . . . 753 1 544 1 ------------------------------------- Total. . . . . . . . . . . . . . . . . . . . 53,497 100% 39,788 100% ------------------------------------- ------------------------------------- </TABLE> 10
LEASE PORTFOLIO. During the period ended September 30, 1998, twenty-eight engines, one spare parts package and two aircraft were added to the Company's lease portfolio at a total cost of $132.5 million. Eight engines and one spare parts package were sold or transferred from the lease portfolio. LEASING ACTIVITIES. Lease revenue for the period ended September 30, 1998 increased 65% to $22.6 million from $13.7 million for the comparable period in 1997. This increase reflects lease revenues from additional engines, aircraft and spare parts packages. GAIN ON SALE OF LEASED EQUIPMENT. During the period ended September 30, 1998, the Company sold eight engines from the lease portfolio which resulted in a gain of $9.2 million. This compares with gains in the period ended September 30, 1997 of $1.3 million from sales of three engines. SPARE PARTS SALES. Revenues from spare parts sales in the period ended September 30, 1998 increased 47% to $16.8 million from $11.5 million in the comparable 1997 period. The gross margin decreased to 29% in the first nine months of 1998, from 32% in the corresponding period in 1997. The decrease in margin was primarily the result of the Company's decision to sell, shortly after their acquisition, certain of the engines acquired under its agreement with United Airlines to acquire used aircraft. In doing so, the Company avoided disassembly, inventory and financing costs that would have been incurred had the Company disassembled, inventoried and sold, over a period of time, the engines in a piece part matter. SALE OF EQUIPMENT ACQUIRED FOR RESALE. During the period ended September 30, 1998, the Company sold one engine for $4.1 million resulting in a gain of $0.5 million. During the period ended September 30, 1997, the Company sold ten engines for $12.7 million which resulted in gains of $2.1 million. INTEREST AND OTHER INCOME. Interest and other income for the period ended September 30, 1998 was $0.7 million compared to $0.5 million for the period ended September 30, 1997. INTEREST EXPENSE AND RESIDUAL SHARING. Interest expense related to all activities increased 99% to $10.4 million for the period ended September 30, 1998, from the comparable period in 1997, due to an increase in average debt outstanding during the period. Residual sharing expense decreased 2% to $587,387 for the period ended September 30, 1998 from the $598,125 for the comparable period in 1997. This expense is calculated by comparing the net book value of the engines subject to such agreements to their related debt balances and adjusting the residual share payable to the appropriate amount representing the sharing percentage of any excess of the net book value over the corresponding debt balance for such engines. In March 1998, the Company repaid one of its loans which had residual sharing provisions. (See "Extraordinary Items" below). DEPRECIATION EXPENSE. Depreciation expense increased 78% to $5.3 million for the period ended September 30, 1998, from the comparable period in 1997, due to the larger average asset base in the first nine months of 1998. GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses increased 68% to $10.7 million for the period ended September 30, 1998 from $6.4 million in the comparable period in 1997. This increase reflects expenses associated with staff additions, relocation of facilities, increased rent due to the expansion of the Company's office and warehouse facilities, expenses associated with Pacific Gas Turbine Center, as well as increases in professional fees, insurance expense and expenses related to promotional and marketing activities. INCOME TAXES. Income taxes, exclusive of tax on extraordinary items, for the period ended September 30, 1998, increased to $4.4 million from $2.5 million for the comparable period in 1997. This increase reflects an increase in the Company's pre-tax earnings. EXTRAORDINARY ITEMS. In March 1998, the Company repaid a loan that had residual sharing provisions. The repayment resulted in an extraordinary expense of $0.2 million, net of tax. In February 1997, the Company obtained a new loan agreement for $41.5 million to replace an existing loan of $44.2 million. The transaction resulted in an extraordinary gain of $2.0 million, net of tax. 11
ACCOUNTING PRONOUNCEMENTS In June 1997, the Financial Accounting Standards Board issued a new statement: SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information," which establishes annual and interim reporting standards for a public Company's operating segments and related disclosures about its products, services, geographic areas, and major customers. This statement is effective for the Company's fiscal year ended December 31, 1998, with earlier application permitted. The effect of adoption of the statement will be limited to the form and content of the Company's disclosures and will not impact the Company's results of operations, cash flow, or financial position. In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities", which standardizes the accounting for derivative instruments, including certain derivative instruments embedded in other contracts, by requiring that an entity recognize those items as assets or liabilities in the statement of financial position and measure them at fair value. This statement is effective for all quarters of fiscal years beginning after June 15, 1999. The Company is reviewing the effect this standard will have on the Company's consolidated financial statements. LIQUIDITY AND CAPITAL RESOURCES Historically, the Company has financed its growth through borrowings secured by its equipment lease portfolio. Cash of approximately $157.7 million and $104.0 million, in the nine month periods ended September 30, 1998 and 1997, respectively, was derived from this activity. In these same time periods $44.1 million and $71.6 million, respectively, was used to pay down related debt or the capital lease. In December 1997, net proceeds from a follow-on common stock offering were approximately $23.8 million. In September 1996, net proceeds from the initial public offering were approximately $15.9 million. Cash flow from operating activities used approximately $16.1 million in the nine month period ended September 30, 1998 and cash flows from operating activities generated $9.0 million in the nine month period ended September 30, 1997. The deficit cash flow from operations was primarily attributable to the acquisition of used aircraft for WASI's inventory and deposits made in connection with future, committed inventory purchases. Such deposits are carried as other assets on the Company's consolidated balance sheet. The Company's primary use of funds is for the purchase of equipment for lease. Approximately $132.4 million and $53.6 million of funds were used for this purpose in the nine month periods ended September 30, 1998 and 1997, respectively. At September 30, 1998, the Company had a $150.0 million revolving credit facility to finance the acquisition of aircraft engines, aircraft and spare parts for sale or lease as well as for general working capital purposes. Assuming compliance with the facility's terms, including sufficiency of collateral, at September 30, 1998, $47.5 million was available under this facility, respectively. The facility has a two-year revolving period followed by a four-year term-out period. The facility is renewable annually. The Company has an $80.0 million debt warehouse facility (the "WLFC Funding Corp. Facility"), to a fully-owned special purpose finance subsidiary of the Company, for the financing of jet aircraft engines transferred by the Company to such finance subsidiary. This transaction's structure facilitates future public or private securitized note issuances by the special purpose finance subsidiary. The subsidiary is consolidated for financial statement presentation purposes. The facility has an eight-year initial term and is partially guaranteed by the Company. This facility requires the issuer to hedge a certain portion of the facility against interest rate changes. In May 1998, a three year $15 million interest rate swap was executed to hedge a portion of the interest expense under this facility. Additionally, in August 1998, a five year $10.0 million interest rate swap was executed. Assuming compliance with the facility's terms, including sufficiency of collateral, as of September 30, 1998, $20.3 million was available under this facility. Approximately $2.5 million of the Company's debt is repayable during the remainder of 1998. Such repayments consist of scheduled installments due under term loans. 12
The Company believes that its current equity base, internally generated funds and debt facilities are sufficient to fund the Company's anticipated operations for the remainder of 1998 and into early 1999, at which time additional capital will be required to fund projected growth. As of September 30, 1998, the Company had four engines and four spare parts packages which had not been financed. The Company may seek financing for this equipment, although no assurance can be given that such financing will be available on favorable terms, if at all. In addition, certain of the Company's engines have been financed under floating rate facilities. Until fixed rate financing for these assets is in place, the Company is subject to interest rate risk, since the underlying lease revenue is fixed. See "Management - Interest Rate Exposure" below. The Company has committed to purchase, during 1998 and 1999, additional used aircraft and engines for its operations. Certain deposits were made in connection with these commitments. The Company's current, remaining commitment to such purchases is not more than $28.6 million. A portion of these purchases will take place in 1998 and the remainder in 1999. MANAGEMENT OF INTEREST RATE EXPOSURE At September 30, 1998, $165.4 million of the Company's borrowings were on a variable rate basis at various interest rates tied to either LIBOR or the prime rate. The Company's equipment leases are generally structured at fixed rental rates for specified terms. To date, this variable rate borrowing has resulted in lower interest expense for the Company. Increases in interest rates could narrow or eliminate the spread, or result in a negative spread, between the rental revenue the Company realizes under its leases and the interest rate that the Company pays under its borrowings. In September 1996, the Company purchased an amortizing interest rate cap in order to limit its exposure to increases in interest rates on a portion of its variable rate borrowings. Pursuant to this cap, the counter party will make payments to the Company, based on the notional amount of the cap, if the three month LIBOR rate is in excess of 7.66%. As of September 30, 1998, the notional principal amount of the cap was $34.3 million which will decline to $26.0 million at the end of its term. The cost of the cap is being amortized as an expense over its remaining term. WLFC-Funding Corp. purchased a three year $15 million interest rate swap in May 1998 and purchased a five year $10 million interest rate swap in August 1998. The weighted average fixed rate under these swaps is 5.88%. The Company will be exposed to credit risk in the event of non-performance of the interest rate hedge counter parties. The Company anticipates that it will hedge additional amounts of its floating rate debt during the next several months. FACTORS THAT MAY AFFECT FUTURE RESULTS Except for historical information contained herein, the discussion in this report contains forward-looking statements that involve risks and uncertainties, such as statements of the Company's plans, objectives, expectations and intentions. The Company's actual results could differ materially from those discussed here. Factors that could cause or contribute to such differences include those discussed below as well as those discussed elsewhere herein and in the Company's report on Forms 10-K and 10-KA for the year ended December 31, 1997. The cautionary statements made in this report should be read as being applicable to all related forward-looking statements wherever they appear in this report or in other written or oral statements by the Company. The Company leases its portfolio of aircraft engines, aircraft and spare parts packages primarily under operating leases as opposed to finance leases. Operating leases require the Company to re-lease or sell aircraft equipment in its portfolio in a timely manner upon termination of the lease in order to minimize off-lease time and recover its investment in the aircraft equipment. The Company also engages in the selective purchase and resale of commercial aircraft engines and engine components in the aftermarket. On occasion, the Company purchases engines or components without having a commitment for their sale. Numerous factors, many of which are beyond the control of the Company, may have an impact on the Company's ability to re-lease or sell aircraft equipment on a timely basis. Among the factors are general market conditions, regulatory changes (particularly those imposing environmental, maintenance and other requirements on the operation of aircraft engines), changes in the supply or cost of the aircraft equipment and technological developments. Further, the value of a particular used aircraft engine or aircraft varies greatly depending upon its condition, the number of hours remaining until the next major maintenance of the aircraft equipment is required and 13
general conditions in the airline industry. In addition, the success of an operating lease depends in part upon having the aircraft equipment returned by the lessee in marketable condition as required by the lease. Consequently, there can be no assurance that the Company's estimated residual value for the aircraft equipment will be realized. If the Company is unable to lease, re-lease or sell the aircraft equipment on favorable terms, its business, financial condition, cash flow, ability to service debt and results of operations could be adversely affected. A lessee may default in performance of its lease obligations and the Company may be unable to enforce its remedies under a lease. The Company's inability to collect receivables due under a lease or to repossess aircraft equipment in the event of a default by a lessee could have a material adverse effect on the Company's business, financial condition or results of operations. A number of airlines have experienced financial difficulties, certain airlines have filed for bankruptcy and a number of such airlines have ceased operations. In most cases where a debtor seeks protection under Chapter 11 of Title 11 of the United States Code (the "Bankruptcy Code"), creditors are automatically stayed from enforcing their rights. The scope of Section 1110 has been the subject of significant litigation and there can be no assurance that the provisions of Section 1110 will protect the Company's investment in an aircraft, aircraft engines or parts in the event of a lessee's bankruptcy. In addition, Section 1110 does not apply to lessees located outside of the United States and applicable foreign laws may not provide comparable protection. A substantial portion of the Company's lease revenue was generated by leases to foreign customers worldwide, including but not limited to Asian customers. Such international leases may present greater risks to the Company because certain foreign laws, regulations and judicial procedures may not be as protective of lessor rights as those which apply in the United States. In addition, many foreign countries have currency and exchange laws regulating the international transfer of currencies. The Company has experienced some collection problems under certain leases with foreign airlines, and there can be no assurance that the Company will not experience such collection problems in the future. The Company may also experience collection problems related to the enforcement of its lease agreements under foreign local laws and the attendant remedies in such locales. Consequently, the Company is subject to the timing and access to courts and the remedies local laws impose in order to collect its lease payments and recover its assets. In addition, political instability abroad and changes in international policy also present risk of expropriation of the Company's leased engines. The operating lease business is a capital intensive business. Accordingly, the Company's ability to successfully execute its business strategy and to sustain its operations is dependent, in a large part, on the availability of debt and equity capital. There can be no assurance that the necessary amount of such capital will continue to be available to the Company on favorable terms, or at all. If the Company were unable to continue to obtain required financing on favorable terms, the Company's ability to add new aircraft engines, aircraft and spare parts packages to its portfolio, add inventory to support its spare parts sales or to conduct profitable operations with its existing asset base would be impaired, which would have a material adverse effect on the Company's business, financial condition and results of operations. Furthermore, a portion of the Company's debt facilities are repayable during the current calendar year. Should the Company be unable to meet the terms of repayment of these facilities, and/or refinance or extend these facilities, it would have a material adverse effect on the Company's financial condition and its ability to conduct business. Factors that could cause equity or debt financing to be more expensive or unavailable include changes in interest rates, financial conditions of the lessee or the Company, prospects for the airline industry or the asset type as well as general economic, equity market and debt market conditions. The Company's equipment leases are generally structured at fixed rental rates for specified terms while many of the Company's borrowing arrangements are at a floating rate. Increases in interest rates could narrow or eliminate the spread, or result in a negative spread between the rental revenue the Company realizes under its leases and the interest rate that the Company pays under its lines of credit or loans. The Company, through WASI, acquires aviation equipment such as whole aircraft engines and aircraft which can be dismantled and sold as parts. Before parts may be installed in an aircraft, they must meet certain standards of condition established by the Federal Aviation Administration. Parts must also be traceable to sources deemed acceptable by the FAA. Parts owned by the Company may not meet applicable standards or standards may change, causing parts which are already in the Company's inventory to be scrapped or modified. Engine manufacturers may also develop new parts to be used in lieu of parts already contained in the Company's inventory. In all such cases, to the extent the Company has such parts in its inventory, their value may be reduced. In addition, if the Company does not sell airframe and engine 14
component parts that it purchases in the time frame contemplated at acquisition, the Company may be subject to unanticipated inventory financing costs as well as all the risks of ownership. Certain of the Company's competitors have substantially greater resources than the Company, including greater name recognition, larger inventories, a broader range of material, complementary lines of business and greater financial, marketing and other resources. In addition, original equipment manufacturers ("OEMs"), aircraft maintenance providers, FAA certified repair facilities and other aviation aftermarket suppliers may vertically integrate into the aircraft engine/spare parts sales industry, thereby significantly increasing industry competition. A variety of potential actions by any of the Company's competitors, including a reduction of product prices or the establishment by competitors of long-term relationships with new or existing customers, could have a material adverse effect on the Company's business, financial condition and results of operations. There can be no assurance that the Company will continue to compete effectively against present and future competitors or the competitive pressures will not have a material adverse effect on the Company's business, financial condition or results of operations. The Company has recently experienced significant growth in assets and revenues. Such growth has placed, and is expected to continue to place, a significant strain on the Company's managerial, operational and financial resources. There can be no assurance that the Company will be able to effectively manage the expansion of its operations, or that the Company's systems, procedures or controls will be adequate to support the Company's operations. An inability to effectively manage growth could have a material adverse effect on the Company's business, financial condition or results of operations. With the new millennium approaching, many institutions around the world are reviewing and modifying their computer systems (IT systems) to ensure that they are Year 2000 compliant. The issue, in general terms, is that many existing computer systems and microprocessors with data functions, including those in non-information technology equipment and systems (non-IT systems), use only two digits to identify a year in the date field with the assumption that the first two digits of the year are always "19". Consequently, on January 2000, computers that are not Year 2000 compliant may read the year as 1900. This could result in a failure of IT systems and non-IT systems in the year 2000, causing disruption of operation of the Company, its lessees, customers, vendors, or business partners. The Company has assessed the Year 2000 issue as it affects the Company's internal IT and non-IT systems. As a result of its assessment, the Company expects to have no interruption of operations as a result of internal IT and non-IT systems. The Company is in the process of assessing Year 2000 issues relating to third parties on which the Company's operations depend. Certain of the Company's officers have oversight of these assessments. Significant uncertainties remain about the affect of third parties who may not be Year 2000 compliant and on which the Company depends. The Company plans to circulate to significant third parties on which the Company depends (including lessees, customers, vendors and financial institutions) a written request for their plans and progress in addressing the Year 2000 issue; evaluate the responses; and develop contingency plans to address risks of non-compliance by such third parties. The Company intends to complete this process by June 1999. The costs associated with assessing the Year 2000 issue, including developing and implementing the above plan are expected to be nominal. The Company has not and does not expect to incur any significant costs relating to internal IT and non-IT systems as a result of the Year 2000 issue. The Company is not aware of any significant Year 2000 systems issues with respect to the airworthiness of its aircraft, aircraft engines or spare parts; however, should such issues result in Airworthiness Directives or other manufacturer recommended maintenance for leased assets, the implementation and the majority of the cost of such implementation would generally be the responsibility of the lessee. Any resulting costs to the Company cannot be estimated at this time. Non-compliance on the part of a third party could result in lost revenue and an inability to make lease or other payments to the Company. Non-compliance by the third party's financial institution could also affect the ability to process payments. The Company will attempt to mitigate such risks by inquiring of each third party about its Year 2000 plans, including whether they have addressed the issue with their financial institution. A worst case scenario would be that a large number of third parties (including lessees and spare parts customers) will be unable to operate and generate revenues and as a result unable to make lease payments or purchase parts. The Company is unable to estimate the likelihood or the magnitude of the resulting lost revenue at this time. Should this occur, the Company would attempt to repossess leased engines, aircraft and spare parts from non-compliant third parties and place such assets with compliant 15
third parties. No assurances can be given that the Company would be able to re-lease such assets at favorable terms or at all. Similarly, the Company would attempt to find compliant customers for its spare parts sales. If a significant number of leased assets could not be released at favorable terms or at all, or their re-lease is delayed, or if compliant customers for spare parts sales were unavailable, the Company's business, financial condition and results of operations would be adversely affected. The Company's leasing activities generate significant depreciation allowances that provide the Company with substantial tax benefits on an ongoing basis. In addition, the Company's lessees currently enjoy favorable accounting and tax treatment by entering into operating leases. Any change to current tax laws or accounting principles that make operating lease financing less attractive could adversely affect the Company's business, financial condition or results of operations The Company may experience fluctuations in its quarterly operating results. Such fluctuations may be due to a number of factors, including the timing of sales of engines and spare parts, fluctuation in aircraft equipment marketing activities, fluctuation of margins on such activities, unanticipated early lease terminations, the timing of aircraft equipment acquisitions or a default by a lessee. Downturns in the air transportation industry affect the Company's business. In particular, substantial increases in fuel costs or interest rates, increased fare competition, slower growth in air traffic, or any significant downturn in the general economy could adversely affect the air transportation industry and may therefore negatively impact the Company's business, financial condition and results of operations. As a result, the Company believes that comparisons to the results of its operations for preceding quarters are not necessarily meaningful and that results for any prior quarter should not be relied upon as an indication of future performance. In the event the Company's revenues or earnings for any quarter are less than the level expected by securities analysts or the market in general, such shortfall could have an immediate and significant adverse impact on the market price of the Company's common stock. 16
PART II OTHER INFORMATION ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits <TABLE> <CAPTION> EXHIBIT NUMBER DESCRIPTION <S> <C> 3.1 Certificate of Incorporation, filed on March 12, 1998 together with Certificate of Amendment of Certificate of Incorporation filed on May 6, 1998. Incorporated by reference to Exhibits 4.01 and 4.02 of the Company's report on Form 8-K filed on June 23, 1998. 3.2 Bylaws. Incorporated by reference to Exhibit 4.03 of the Company's report on Form 8-K filed on June 23, 1998. 4.1 Specimen of Common Stock Certificate. Incorporated by reference to Exhibit 4.1 of the Company's report on form 10-Q for the quarter ended June 30, 1998. 10.1* Amended and Restated Credit Agreement dated September 30, 1998. 11.1 Statement regarding computation of per share earnings. 27.1 Financial Data Schedule. </TABLE> - ----------------------------------------- *Portions of this exhibit have been omitted pursuant to a request for confidential treatment. (b) Reports on Form 8-K None 17
SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. Date: November 13, 1998 Willis Lease Finance Corporation By: /s/ James D. McBride ---------------------------- James D. McBride Chief Financial Officer 18