Commercial jet aircraft leasing today presents a historic buying opportunity. It is historic because never before has traffic been so impacted by events, never liquidity been in such short supply, never before have values been so depressed. It provides investors the opportunity to acquire long life, slow obsolescence revenue generating assets with a worldwide market at price levels never seen before. The price of those assets bears no relationship to their economic productive ability. Assets are available at a fraction of their economically indicated value.

BCI prices its transactions at a discount off currently projected future values, which are gloomy. The risk of additional downside is low. Macroeconomic factors predict that asset values will appreciate very strongly in the coming 3-6 years. If this recovery is anything like every other one in the past, values will rebound strongly to economically compensatory levels that reflect inherent productive ability. A portfolio of sound investments using reasonable levels of leverage can provide superior returns with an elevated level of safety.

BCI is uniquely placed to take advantage of this opportunity. With a track record for success in difficult circumstances and our strategic relationships, BCI has strong deal flow and the benefit of substantial financial support of bank and capital markets. BCI is in the top 25 leasing companies worldwide and top 5 privately held. BCI is one of the most active players in the second hand markets and the leading leasing company to offer this product to third party equity investors.

Values are a function of supply and demand. For aircraft, demand is the number of travelers. This has grown consistently since 1945 and has a correlation of 0.99 to gross national product. This correlation was first breached by the events of September 11. Traffic is still 10% below 2001 levels despite two years of economic growth. Buying aircraft is very difficult because of lack of capital. Start-ups, who usually enter the market with low fares and stimulate traffic, have been virtually non-existent. So demand is depressed. Supply is glutted by the structurally slow response of manufacturers to the drop in traffic. The drop in traffic rendered 10% of the fleet surplus. This was compounded by manufacturers building the equivalent of another 10% of the world’s fleet in 2 years. Aircraft break ups for parts have not kept pace. As a result, there is gross oversupply and prices are dictated by buyers.

Aircraft follow predictable business cycles

The airline industry is the industry of prediction. Months in advance each airline commits to its flight schedule. It allocates its airplane, human and real estate resources to support that schedule. Schedule changes are expensive, disruptive and difficult. An overshoot in traffic results in lost passengers. An undershot results in heavy discounting. Each empty seat is an opportunity to earn revenue lost forever. Commitment to aircraft is even more long term. Modern aircraft have useful lives of 25 or more years. Typically the first 20 will be with the same airline. British Airways today is operating aircraft initially ordered and committed to in 1980. As a result, the ability of airlines to respond to changes in traffic is limited. Variance of traffic from projections is very painful. What happened to traffic in the past two years has been unprecedented and worse than any airline’s plans. Airlines are suffering.

Most of every dollar in airline expense is fixed. The aircraft cost, fuel, staffing, gates, landing fees and other costs are set when the aircraft leaves the gate, whether it empty or full. This makes the airlines highly sensitive to small changes in revenue. A relatively small drop in revenue results in huge losses. Similarly, growing revenue goes to the bottom line and creates impressive profits. Given enough time, airlines can reduce their fleets and staffing. However, their short-term ability to respond to variances between their anticipated and actual traffic is limited. So, unable to cut costs quickly, they discount all remaining available seats to maximize revenue. Airline losses in the past two years have been stunning. But recovery in revenues will also create large profits.

Fleet changes take a long time to feed through. In down times, a drop in demand can be partly offset by parking aircraft. But that is expensive, because the obligation to pay rent remains until enough leases expires. Airlines park the aircraft that have the lowest rent. These are usually the ones with the highest maintenance and fuel costs, normally their oldest aircraft. And although these have economics comparable to those of new aircraft (lower rent offsetting higher fuel and maintenance), they are cheaper to remove from the fleet. This gives the incorrect impression that these aircraft are not competitive. With respect to orders in the pipeline, the manufacturer collects progress payments of 30% of the aircraft cost. Canceling orders on short notice is expensive. If an airline decided to cancel orders on September 12, 2001, the first no-cost cancellations would have been deliveries after September 2003. The airline would have been forced to accept 2 years worth of new aircraft it did not want. While there are always some airlines looking to grow and manufacturers can shift some deliveries, it would be fair to say that a large majority of the aircraft delivered in the past two years were not wanted and exacerbated the oversupply problem.

This sequence of events reverses itself in an improving market. Airlines initially raise fares, spilling the lowest fare customers. This results in improving revenues and, at some point, profits. Eventually, they make plans to grow their fleets. First, used aircraft are taken out of the desert. Eventually, new orders are placed. It takes 3-5 months and a lot of cash for deposits for an evaluation and order of new aircraft. Then it takes 18-24 months before the first aircraft can arrive to accommodate suppliers and subcontractors. And the rate of additions is low, no faster than 1 per week for even the largest carriers. For a 500 aircraft airline, it takes 1 year of deliveries to add 10% to its capacity. By the time new deliveries arrive airlines are very short on aircraft. And values are bid up. Eventually, absent a bubble, values reach the level of discounted profits from the aircraft.

In 1999 Boeing built 631 commercial jets. In 2002, the year after the terrorist attacks, the number was 398. Airbus delivered 325 in 2001 and was planning 380 deliveries for 2003. Instead, this year each manufacturer is expected to deliver fewer than 300. In 2004 and 2005 Boeing and Airbus anticipate 265- 275 deliveries each. Considering a world fleet of large jets of 15,000 and a 25-year average retirement age, it takes 600 deliveries per year to keep the fleet constant. There is unlikely to be any material production growth before 2007, at the earliest.

In short, today airlines are planning future operations with the expectation that traffic will continue to shrink indefinitely. This is no different than what they were doing at this point in the cycle in past recessions. They do this to a great extent out of necessity, for lack of funds to finance growth. Once again, they will be proven wrong as a rising economy feeds through to traffic. Ultimately, richer people fly more. When they finally have enough resources to finance growth with few aircraft to be had in short order, aircraft values will pick up strongly.

Current Values

The drop in traffic has devastated the industry. Unable to sustain massive losses, many airlines have shut down, filed for bankruptcy, or restructured out of bankruptcy to reduce costs. Nearly half the fleet has seen major impairment through these restructurings or through lease expirations and new leases at new low market rents. This has affected in some negative way almost all lessors, lenders, and other providers of liquidity in the industry. All have curtailed their activities drastically and most have exited the market or suspended new business. Cash to buy aircraft is very scarce. With no liquidity, any demand that might have existed has evaporated. Manufacturers have become lenders of last resort to support their deliveries.

As a direct consequence, between 2001 and 2003 aircraft values have fallen by over a third. New bellwether aircraft are down 10%-15%, with values supported by manufacturer financing. Ten-year-old aircraft that were previously considered the best in that age group are down 45%. Less attractive 10 year olds are down 60%. Investment quality 18-year-old aircraft are down 80% and less desirable aircraft of the same age are down 90%. Older aircraft have fallen by much more. Never before have quality new aircraft been worth 50% of their original cost at the age of 5. There are now 2400 large jets parked, out of a total fleet of 15,000. Older aircraft are more represented in the desert than newer ones. Values bear no resemblance to the economic utility of these assets. Nothing fundamental changed to make aircraft inherently worth less. Southwest and Easyjet have seen virtually no erosion in their yields. Their costs have not gone up materially. They are just as profitable operating 737-300s costing $250,000 a month as they were in 2001. When excess supply is mopped up by rising demand, they would still theoretically be willing to pay $250,000 for that same aircraft and still recognize healthy profits from operating that aircraft. Bidding up of rents and return of liquidity will boost values. Any quality aircraft acquired in today’s market are likely to experience strong value appreciation as the industry turns around.

Leading Indicator of Recovery – GNP

Traffic is tied to growth in GDP with a historical correlation of 0.99. The US has officially been growing since November 2001. Much of Europe is emerging from recession. Japan is experiencing recovery. The long-term fundamentals for the global economy are good. This will eventually translate into higher demand for travel.

Traffic is always slower to respond to growth in GNP after a recession. This time it has taken much longer, partly because of events that affected travel disproportionately, like war, SARS, and intrusive security. But airlines and governments have come a long way towards making security less obtrusive. Airport lines are not as bad as they had been. Random searches seem a thing of the past. Technology is allowing for a more hassle free travel experience. Airlines are working hard to make the flight experience better where it counts, with lower fares and more punctual service. Ultimately this news will filter down to consumers. It is just a matter of time before pent up demand materializes.

Globally, one thing is certain, there is a massive amount of pent up demand for air travel. In no country do people fly as much as Americans. There is no reason why as people in other countries grow as rich as Americans they should not fly as much as Americans.

Furthermore, the industry is liberalizing, which always spurs growth. Governments are allowing airlines increasingly to set their own fares and fly where customers want them to. Europe is liberalizing the fastest with low fares and higher service, which should spur growth. There are moves to liberalize North Atlantic traffic, which should bring down fares and result in impressive growth. Asia is becoming richer and travels more. Airlines are poised for growth well into the next 20 years. How soon it happens and how strong the growth is the subject of debate. Barring further shocks to the system, 2004 should be a year of improving yields and reasonable traffic growth. 2005 is likely to be even better on both counts. By the summer of 2005 North American carriers should be posting reasonable profits.

Impact on Values

No major US carrier, other than the low cost operators, is making any fleet plans to accommodate this growth. Almost all are still shrinking as of the fall of 2003. Continental has often said publicly that it will not order any aircraft until it can make money with the ones it has. With 2004 being likely a break-even year, they are likely to be on the prowl for new aircraft in 2005, for delivery starting in 2007. Any necessary growth between 2003 and 2007 will have to be accommodated by the second hand market. In that regard Continental will be bidding against other US majors who are in a similar position, start-ups and certain European carriers. Prices will most certainly be bid up, just like they have in every other recession in the past. Lessees will be likely to want to extend their leases rather than replace aircraft in their fleet with other used aircraft, a costly proposition. Renewal rents will no longer be at today’s depressed levels, but at future market prices. These could easily be 50%-100% higher than today’s rents, particularly for mid-life aircraft. High revenue generating aircraft will be more valuable to financial investors, pushing up resale values.

The chart plots inflation adjusted values since 1975 relative to base values adjusted for economic conditions. A broad measure of aircraft values typically lost 30% from peak to trough. In this recession the impact was almost 40%. Similarly, the gain in values in previous recoveries was in the order of 30%-40% from the low point numbers. Based on the level of the drop, broad values for used aircraft will have torise by 50%-80% to reach previous equilibrium with older quality models doubling or more in price. In the previous recession the midlife sector of the market was represented by 10-15 year old 727s and 737-200s.

These traded as low $1MM in 1993 and 1994 with typical prices in the $2MM-$3MM range before surging to $8MM-$9MM in 1999.

BCI expects this to happen and is investing heavily on that expectation. The only question relates to the timing and strength of the recovery. Extraneous shocks will only delay the recovery, not cancel it.

Where are we in the cycle?

The last time the market was in balance was in the late 1990s. There was no excessive liquidity or artificial demand, no bubble in values. The peak in values was in 1999. Initially after 2001, the drop in values was slow, as the market was trying to absorb the impact of what had happened. The drop accelerated in late 2002 and continued heavily in 2003. The summer of 2003 saw some of the lowest prices ever recorded, particularly in the liquidation of Ansett, and US Airways that were subject to foreclosure sales. Since then the market has recovered somewhat at the lowest end, though few would predict immediate recovery. Although the unused fleet of United has not yet hit the market and several other carriers are at risk of failing, it does appear that the cyclical drop in values is now over. Values are likely to remain at these low levels and depreciate to reflecting the ageing of aircraft for another year. Eventually, late next year or in 2005 values should start rising again. This assumes that the summer 2004 turns out well for airlines and they start recalling their aircraft from the desert. On the basis of that assessment BCI believes that values are now at the bottom of their cyclical low. As such, this period represents the best buying opportunity in the history of jet aircraft.

Why do Aircraft retain value?

Aircraft are revenue-generating assets that have inherent value. Their value is a function of their revenue generating ability less the costs of operation and capital at market discount rates. Aircraft are superior to other fixed assets for the following reasons:

1. Obsolescence - Commercial aircraft are a mature product. There has been little technological development since the early 1980s. After producing initially large leaps in economics, performance, reliability and productivity, by the 1970s development of aircraft was generating only small incremental gains. Rapid obsolescence became a thing of the past as life cycles became extended. Many large airlines today still find older models designed in the 1960s to be fully competitive economically in today’s environment alongside their newer deliveries. The world fleet currently includes large numbers of Boeing 727 and first generation 737-200s, which were designed in the 1960s. Many of the world’s most profitable airlines operate them still in large numbers profitably, 40 years after they were introduced. Large users include Southwest, Delta, Westjet, Ryannair, Northwest and others. Improved engines were featured on designs introduced in the early 1980s. These, nevertheless, were acquired as incremental fleet and in many cases did not replace the previous generation aircraft. The current generation, introduced in the late 1980s through mid 1990s, made marginal improvements in the previous designs, such as single-digit improvements in fuel burn, and application of technology to simplify maintenance, systems and reliability. BCI is only investing in second and third generation aircraft, those introduced in the 1980s or later.

2. Worldwide market – Unlike real estate, aircraft can be moved from one market to another worldwide to meet demand.

3. Few standard types – There are a handful of designs used by everyone around the world. Boeing builds 6 designs and Airbus another 4. These come in a small number of sub-types. This results in large pools of aircraft of every type and improves liquidity.

4. Government oversight – Maintenance is an important consideration in aircraft values. Governments worldwide provide a critical oversight role ensuring aircraft are maintained to standards agreed by the manufacturers and their direct authorities. Other governments typically follow the guidelines of the US FAA or European JAA for Boeing and Airbus designs, respectively. This helps to preserve value.

What characteristics Determine Aircraft Values?

BCI looks for aircraft that are liquid. That is, those that is likely to be easy to sell. These have the following characteristics:

1. Aircraft sold in large numbers – The more economically productive an aircraft is the more airlines prefer it to its competitors. The two best selling aircraft families are the Boeing 737 and the Airbus A320 families. Between them they account for 36% of all large passenger jets now in service.

2. Smaller aircraft – Smaller narrowbody aircraft are more popular. Nearly three quarters of all flights are short haul. This favors smaller aircraft. This segment of the market is the deepest, most vibrant and most liquid. Most new start up carriers also tend to start with short haul flights. All airlines fly short haul. Less than a quarter have long haul operations, and fewer still operations able to support jumbos.

3. Used aircraft – Typically, numerically few airlines order new aircraft. Most others rely on retirements from the world leaders for their fleets. As a result, the number of users for aircraft grows significantly as an aircraft program matures. Deep market supports values.

4. Inexpensive aircraft – BCI is purchasing every aircraft for one purpose only, eventual sale at a profit. In absolute terms, less expensive aircraft are more affordable to likely buyers and as such more liquid.

5. Quality lessees – Aircraft with leases to quality credits are more liquid and easier to sell to third parties, who rely on lessee credit for part of their financing. BCI therefore focuses on leases to stronger credits.

6. Currently active programs – BCI avoids aircraft that have been discontinued, including the McDonnell Douglas and Lockheed lines. Although the DC-9/MD-80 has been sold in excess of 2,000, making it one of the most successful aircraft ever, the disappearance of the manufacturer bodes ill for the aircraft. Few airlines are likely to take the risk of introducing it into their fleets in the future.

The Aircraft Investment Market - Segments

The market can be viewed and analyzed in several distinct segments. While there is some overlap, most players tend to focus on one segment only.

New Aircraft

This is the domain primarily of the largest institutionally backed leasing companies such as GECAS, ILFC, GATX, SALE, Boullioun, CIT and others. Most of them have placed speculative orders for new aircraft with the manufacturers. They acquire aircraft new from the manufacturers and lease them to carriers. Also, they often take over new deliveries ordered by airlines that do not have the financial resources to purchase the aircraft they ordered. These large companies have the lowest cost of funds among all lessors. They borrow mostly unsecured supported by their own credit or that of their parent. Equity is usually relatively plentiful and from the parent and is compensated with after tax returns barely in the double digits. Moreover, because in many countries aircraft are tax-advantaged investments creating tax losses that can be used to offset other income, many of these companies count tax savings in their total return. The aircraft are depreciated little. Lease factors typically range from 55 -80 bp of aircraft cost per month. This translates into 6.5%-9.6% all-in cash. This is required to pay overhead, and service the debt. Equity rarely receives cash returns or dividends. Excessive “investment” type purchase prices are also common. BCI is not in a position to compete in this market. Neither has BCI been able to package such transactions to provide reasonable returns on investment. These investments do not stand alone in the capital markets except in times when the markets are hot. Most such transactions booked in the past are now materially under-water.

Midlife Aircraft

This is the area BCI has selected to compete. This includes aircraft built between 1985 and 1997. Fellow competitors are mostly private companies, though occasionally larger companies such as GECAS will compete on one-off deals. Transaction are smaller, a disincentive to the large players. Debt is usually on a transaction by transaction basis, non-recourse, more expensive, and secured by the aircraft. Because smaller companies have to access retail equity, these transactions are priced with higher rent factors of 100- 150 bp, or 12% - 18% per year of aircraft price. After paying interest on the loan and cash flow to the equity, there is still sufficient cash to accomplish large amortization of the loan and consequent risk reduction over time. BCI believes that this market provides the best risk/reward combination for investors. Furthermore, this market is not currently competitive with a handful of players being active. Smaller companies are unable to raise debt and equity capital. In good times these players fund themselves with close to 100% debt and virtually none has developed an equity raising capability. BCI has long recognized the critical importance of debt and equity availability. It maintains the largest equity sales force of any leasing company. It is staffed with ex-bankers with long experience in aircraft financing.

Old Aircraft

Of aircraft built before 1985, there are few models that would be considered viable investments. Most are not economically competitive. The exception is older versions of the 737 family. Other models have too many engines and too many pilots, two very expensive items for airlines. Regulations required any aircraft over the 737-200 size to fly with 3 pilots. Pilots costs are the lion’s share of direct labor costs. Engine maintenance is by far the largest component of total maintenance. Lower output engines meant that it took more engines to create the same thrust. The early 1980s brought higher thrust more efficient engines. Trijets like the L1011 and DC-10 were replaced by twins like the 767 and A330 with the same capacity yet longer range and superior economics. The smaller trijet 727 was replaced by A320, 757 and larger 737s, all twins. The 757 also replaced the 707 and DC-8, each with four engines.

Old aircraft are parked in large numbers. The idle fleet as a portion of total fleet ranges from 26% for the 737-200 to 65% for the L1011, 43% for the 727, and 30% for each of the DC-8, DC-9 and DC-10. Such aircraft are likely to be leased in Latin America, East Asia or Africa. Rent factors are well over 2% per month. Debt financing is virtually impossible because of banks’ aversion to older aircraft, weak credits and difficult countries. BCI is not typically a player in this market. Yet BCI will occasionally consider investing in such aircraft provided either 1) the price is low enough and there is a ready lessee, or 2) irrespective of price, there is a strong lessee. In each case, investment in residual position will be nominal or zero. The aircraft still have some value as break up candidates for spare parts and spare engines.

How does BCI target what aircraft to acquire?

All aircraft have some value. There are no bad aircraft, only bad prices. At some price, any aircraft is a good investment after considering the lessee risk. BCI analyzes and seeks to balance the following risks:

1. Lessee risk – This is the risk that the lessee will not make payment, will not return the aircraft voluntarily after a default, or is in a country where the legal system is not as efficient as in many Western countries. With a strong lessee such as Air France, BCI can assess the residual risk only at lease end. A weaker lessee necessitates that the residual risk be assessed at all times during the transaction because we cannot know when we will have to redeploy the aircraft.

2. Liquidity risk – All investments are made to be sold for a profit. BCI assesses how marketable a transaction will be when the market returns to equilibrium and how much up side potential there is in a hot market. Different classes of aircraft experience larger swings in values both up and down. This is typically true of larger aircraft and older aircraft. The most saleable transactions are those that involve reasonably good lessees and aircraft that are in favor. Good larger aircraft such as the 757 and 747, which today are completely out of favor because they are too big for this low traffic environment will nonetheless be attractive to airlines and, consequently, to lessors, because of their good overall economics. Difficult aircraft like the A340 and BAE RJ100 are unlikely ever to be liquid.

3. Aircraft lease appeal – All aircraft subject to operating lease will at some point need to be leased to another carrier. BCI assesses how attractive aircraft are as lease candidates, likely lease rates, and for what markets they are suited.

4. Residual risk – this is the biggest risk of loss, compounded by the use of leverage. Typically, aircraft debt has a balloon that comes due at the end of the lease or upon lease default. Foreclosure wipes out the equity. BCI considers the balloon amount and assesses how the maturing debt can be serviced or paid off. This consideration is the single biggest component in the pricing of transactions. Where the airline credit is strong, the residual risk matters only at lease end. BCI could take above market exposure so long as the rent was high enough to amortize the investment to the desired residual. For a weak credit, however, the above market rent will not be able to be replicated after a default. So the residual risk is assessed throughout the term.

The discipline of debt

BCI has to rely on debt to fund a portion of all of its transactions. BCI has never failed to close a transaction for inability to raise debt. Its staff includes ex-commercial bankers. The bank credit approval process serves to add discipline to the transaction.

Banks are typically more risk averse than equity investors and receive a lower return. They are eager to avoid a loss and want to ensure that the loan will remain performing for its entire term and that their balloon will be paid off. They therefore scrutinize the credit of the lessee to a high level. They also restrict the level of balloons to a number that is a fraction of the projected future value. This serves to create discipline in pricing transactions. It also prevents financing of shaky airlines.

What BCI uses as future values?

Predicting the future is a hazardous undertaking. Travel and aviation are susceptible to world events. Since 1945 the world has experienced a level of peace and prosperity, punctuated by recessions of ever decreasing frequency and world events of smaller and regional magnitude. This steady state has allowed industry analysts to study the behavior of values and make predictions on the basis of steady state assumptions. These tend to be too rosy in good times and too grim in bad, like today. A number of appraisal companies employ statisticians, Ph.D. economists and an army of analysts to study the past and predict the future.

Base valuation is relatively simple. Inputs are revenue generating ability of the assets and operating costs, which are known to a science and readily available from government reports of airlines (Form 41) and manufacturers in overwhelming detail and precision. Average ticket prices across the industry fluctuate less than might be imagined. The value of the aircraft is some function of its discounted future economic benefit. Statistical models then project market values using base values and future projected economic conditions as inputs.

The industry has an organization that accredits appraisers called ISTAT (www.istat.org). Like most other industries, the quality and integrity of appraisers varies significantly, often in proportion to their size. Smaller firms with 1-2 people do not do statistical analysis and are more susceptible to client pressures to win incremental business and fees. Larger firms are more concerned about their reputations and are unlikely to be responsive to client pressures for desired values. They also collect and analyze much larger amounts of price and economic data, which results in the best appraisals and future value projections possible.

Future values always have a component of interpretation. Some appraisers consistently take more optimistic views while others tend to see a bleaker future picture across the board.

BCI consults with most large appraisal firms but generally uses the services of Avitas (www.avitas.com). This is one of the largest appraisal firms in the world specializing in commercial aircraft. Although not typically the lowest, their values tend to be among the most conservative.

In pricing residuals for transactions, BCI uses future Avitas base values discounted by a factor which is dependent on the quality and age of the aircraft to protect against downward volatility. The investment should be protected at those numbers. Realistic profit potential is assessed at Avitas future values and also at these values, adjusted for what BCI believes will be market prices relative to bases prices as the industry recovers.