UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-Q
(Mark One)
For the quarterly period ended SeptemberJune 30, 20172018
For the transition period from ____________ to ____________
Commission File Number:001-13387
AeroCentury Corp.
(Exact Name of Registrant as Specified in Its Charter)
| Delaware | 94-3263974 | |
| (State or Other Jurisdiction of Incorporation or Organization) | (I.R.S. Employer Identification No.) |
1440 Chapin Avenue, Suite 310
Burlingame, California 94010
(Address of Principal Executive Offices)
(650) 340-1888
(Registrant's Telephone Number Including Area Code)
None
(Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report)
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 ☒ No ☐
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes☒No ☐ No ☒
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company, or an emerging growth company. See the definitions of "large accelerated filer," "accelerated filer," and "smaller reporting company,"company" and emerging"emerging growth companycompany" in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer ☐ Accelerated filer ☐
Non-accelerated filer ☐
Smaller reporting company ☒
Emerging growth company ☐
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes ☐ No ☒
The number of shares of the Registrant's Common Stock outstanding asas of November 9, 2017August 10, 2018 was 1,416,699.1,416,699.
1
PART I
FINANCIAL INFORMATION
Forward-Looking Statements
As used in this report, unless the context indicates otherwise, the "Company" and "AeroCentury" refer to AeroCentury Corp. together with its consolidated subsidiaries.
Forward-Looking Statements
This Quarterly Report on Form 10-Q includes "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended (the "Securities Act"), and Section 21E of the Securities Exchange Act of 1934, as amended ("the Exchange(the "Exchange Act"). All statements in this Reportreport other than statements of historical fact are "forward-looking statements"forward-looking statements for purposes of these provisions, including any statements of the Company's plans and objectives for future operations, the Company's future financial or economic performance (including known or anticipated trends), and any statements ofthe assumptions underlying any ofor related to the foregoing. Statements that include the use of terminology such as "may," "will," "expects," "plans," "anticipates," "estimates," "potential," or "continue," or the negative thereof, or other comparable terminology, are forward-looking statements.
Forward-looking statements in this report include these statements: (i) in Item 1, "Notes to Financial Statements," thatstatements about the Company has determined that adoption of Topic 606 willfollowing matters, although this list is not have a material effect on its consolidated financial statements; that the Company does not expect to adopt ASU 2016-02 early, and expects to elect practical expedients in connection with its adoption, including not re-evaluating lease classification or capitalized initial direct costs on existing leases; that the outcome of any existing or known threatened proceedings, even if determined adversely, should not have a material adverse effect on the Company's business, financial condition, liquidity or results of operations; that the Company expects to account for the acquisition of JHC using the acquisition method of accounting; and that the Company will be required, for accounting purposes, to record, at the time of acquisition, a substantial portion of the Merger consideration paid for JHC as a settlement loss; (ii) in Item 2, "Management's Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources," that the proposed acquisition of JHC by the Company may result in one-time expenses that will have a negative impact on the Company's credit facility covenants; and that the Company will have adequate cash flow to meet its ongoing operational needs, including any required repayments under the Credit Facility due to borrowing base limitations; (iii) in Item 2, Management's Discussion and Analysis of Financial Condition and Results of Operations – Outlook," that the acquisition of JHC is anticipated to be consummated in the first quarter of 2018; that the combination of the management function performed by JMC and the portfolio held by the Company will be accretive to the Company and will create shareholder value for the shareholders of the combined post-Merger company; that the elimination of the outside management company structure removes a key impediment to capital raising by the Company; that the Company will incur certain non-recurring merger expenses in the periods leading up to the Merger with JHC, and immediately following, as well as having to record, for accounting purposes, a settlement loss at the time of consummation of the Merger; that the Company anticipates the trend toward downward pressure on lease rates, resulting in lower margins, and fewer acquisition opportunities for the Company will continue for the short- to medium-term, until yields on alternative investments return to a more normal historical range; and that the Company may experience delays in re-leasing or selling its off-lease aircraft; (iv) in Item 2, "Management's Discussion and Analysis of Financial Condition and Results of Operations – Factors that May Affect Future Results," that the Company believes it will continue to be in compliance with all of the covenants under its debt agreements; that the Company intends to acquire JHC; that the Company will be required to record a substantial portion of the consideration paid for JHC as a settlement loss if the Merger is consummated; that the Company will likely need to obtain waivers or modifications of certain covenants from its Credit Facility lenders for post-Merger periods in order to avoid a default under certain Credit Facility agreement financial covenants; that the Company typically acquires used aircraft; that as competition increases, the competition will likely continue to create upward pressure on acquisition prices for many of the aircraft types that the Company has targeted to buy and, at the same time, create downward pressure on lease rates, resulting in lower margins for the Company and, therefore, fewer acceptable acquisition opportunities for the Company; that the Company will have sufficient cash funds to make any required principal repayment that arises due to any borrowing limitations; that the Company does not anticipate any worsening of the financial condition of its overall customer base, but believes that there may be further shakeouts of weaker carriers in economically troubled regions;exhaustive:
| · | The Company's business plans and strategies, including its continued focus on acquiring used regional aircraft, any potential for acquiring and managing new types and models of regional aircraft, and its expectation that most of its future growth will be outside of North America; |
| · | Matters related to the Company's proposed merger with JetFleet Holding Corp. ("JHC"), including: the Company's ability to obtain the approval of its stockholders to issue shares of its common stock as partial merger consideration; the ability to complete, and the timing of, the closing of the merger; and the anticipated impact of the merger (if completed) on the Company and its performance, including the amount and nature of merger expenses payable by the Company, certain losses and other accounting effects of the merger, any changes to the Company's risk profile after the Company internalizes the management services presently performed for the Company by JetFleet Management Corp. ("JMC"), a subsidiary of JHC, and the expectation that the combination effected by the merger could be accretive to the Company and create value for the stockholders of the combined post-merger company; |
| · | Certain industry trends and their impact on the Company and its performance, including: increasing competition that results in higher acquisition prices for many of the aircraft types that the Company has targeted to buy and, at the same time, downward pressure on lease rates for these aircraft; relatively lower market demand for older aircraft types that are no longer in production, which could cause certain of the Company's aircraft to remain off lease for significant periods of time; and expectations of shakeouts of weaker carriers in economically troubled regions, which could impact the financial condition and viability of certain of the Company's customers, and as a result, their demand for the Company's aircraft and their ability to fulfill their lease commitments and other obligations to the Company under existing leases; |
| · | Expectations about the Company's future liquidity, cash flow and capital requirements; |
| · | The Company's continued compliance with its existing credit facility and other outstanding debt instruments, including making payments of principal and interest thereunder as and when required and complying with the financial and other covenants included in the credit facility; |
| · | The expected impact of existing or known threatened legal proceedings; |
| · | The effect on the Company and its customers of complying with applicable government and regulatory requirements in the numerous jurisdictions in which the Company and its customers operate; |
| · | The Company's cyber vulnerabilities and the anticipated effects on the Company if a cybersecurity threat or incident were to materialize; |
| · | General economic, market, political and regulatory conditions, including anticipated changes in these conditions and the impact of such changes on customer demand and other facets of the Company's business; and |
| · | The impact of the foregoing on the prevailing market price and trading volume of the Company's common stock. |
All of the Company's expected growth will be outside of North America; that the Company intends to continue to focus solely on regional aircraft; that the overall industry experience of JMC's personnel and its technical resources should permit the Company to effectively manage new aircraft types; that effective mitigating factors exist against undue compensation-incented risk-taking by JMC; that the burden and cost of complying with environmental regulatory requirements will fall primarily upon lessees of equipment or the Company as owner of the equipment; that the costs of complying with environmental regulations will not have a material adverse effect on the Company; that the Company's main vulnerability would be interruption to email communication, internally and with third parties, loss of customer and lease archives, and loss of document sharing between the Company's offices and remote workers; that sufficient replacement mechanisms exist such that there would not be a material adverse financial impact on the Company's business; and that while the Company believes that it has sufficient cyber-security measures and backup mechanisms in place commensurate with the risks to the Company of a successful cyber-attack or breach of its data security, its resources and technical sophistication may not be adequate to prevent all types of cyber-attacks.
This cautionary statements made in this Reportstatement should be read as being applicable toqualifying all related forward-looking statements included in this report, wherever they appear herein.appear. All forward-looking statements and risk factorsdescriptions of risks included in this documentreport are made as of the date hereof based on information available to the Company as of the date hereof, and except as required by applicable law, the Company assumes no obligation to update any such forward-looking statement or risk factor.for any reason. You should, however, consult the risk factors listedrisks and other disclosures described in the reports the Company files from time to time in the Company's filings with the Securities and Exchange Commission.Commission after the date of this report for updated information.
2
Item 1.Financial Statements.
AeroCentury Corp.
Condensed Consolidated Balance Sheets
(Unaudited)
| ASSETS | ASSETS | ASSETS | ||||||||||||||
| September 30, | December 31, | June 30, | December 31, | |||||||||||||
| 2017 | 2016 | 2018 | 2017 | |||||||||||||
| Assets: | ||||||||||||||||
| Cash and cash equivalents | $ | 6,529,200 | $ | 2,194,400 | $ | 4,378,000 | $ | 8,657,800 | ||||||||
Accounts receivable, including deferred rent of $2,600 and $604,800 at September 30, 2017 and December 31, 2016, respectively | 4,004,200 | 4,046,100 | ||||||||||||||
Accounts receivable, including deferred rent of $228,100 and $707,300 at June 30, 2018 and December 31, 2017, respectively | 3,151,600 | 3,825,100 | ||||||||||||||
| Finance leases receivable | 24,470,600 | 17,468,300 | 22,066,100 | 23,561,000 | ||||||||||||
Aircraft and aircraft engines held for lease, net of accumulated depreciation of $38,790,800 and $32,639,600 at September 30, 2017 and December 31, 2016, respectively | 204,967,100 | 192,799,800 | ||||||||||||||
Aircraft and aircraft engines held for lease, net of accumulated depreciation of $38,219,000 and $33,234,200 at June 30, 2018 and December 31, 2017, respectively | 210,592,000 | 195,098,200 | ||||||||||||||
| Assets held for sale | 7,412,400 | 1,998,100 | 4,736,100 | 4,966,500 | ||||||||||||
| Prepaid expenses and other | 371,900 | 229,400 | 312,700 | 301,300 | ||||||||||||
| Total assets | $ | 247,755,400 | $ | 218,736,100 | $ | 245,236,500 | $ | 236,409,900 | ||||||||
| LIABILITIES AND STOCKHOLDERS' EQUITY | LIABILITIES AND STOCKHOLDERS' EQUITY | LIABILITIES AND STOCKHOLDERS' EQUITY | ||||||||||||||
| Liabilities: | ||||||||||||||||
| Accounts payable and accrued expenses | $ | 1,402,100 | $ | 1,218,100 | $ | 2,277,900 | $ | 645,200 | ||||||||
Notes payable and accrued interest, net of unamortized debt issuance costs of $1,826,000 and $1,999,900 at September 30, 2017 and December 31, 2016, respectively | 154,201,500 | 125,837,900 | ||||||||||||||
Notes payable and accrued interest, net of unamortized debt issuance costs of $1,483,500 and $2,216,000 at June 30, 2018 and December 31, 2017, respectively | 147,642,500 | 145,598,200 | ||||||||||||||
| Maintenance reserves | 29,451,000 | 29,424,100 | 30,342,000 | 26,942,800 | ||||||||||||
| Accrued maintenance costs | 332,500 | 965,000 | 359,800 | 1,275,300 | ||||||||||||
| Security deposits | 3,818,300 | 3,933,200 | 3,434,800 | 3,147,900 | ||||||||||||
| Unearned revenues | 3,353,900 | 1,903,900 | 4,764,200 | 2,447,500 | ||||||||||||
| Deferred income taxes | 13,489,400 | 12,830,500 | 8,503,000 | 8,533,700 | ||||||||||||
| Income taxes payable | 357,500 | 123,200 | 309,400 | 452,600 | ||||||||||||
| Total liabilities | 206,406,200 | 176,235,900 | 197,633,600 | 189,043,200 | ||||||||||||
| Commitments and contingencies | ||||||||||||||||
Commitments and contingencies (Note 5) | ||||||||||||||||
| Stockholders' equity: | ||||||||||||||||
Preferred stock, $0.001 par value, 2,000,000 shares authorized, no shares issued and outstanding | - | - | - | - | ||||||||||||
Common stock, $0.001 par value, 10,000,000 shares authorized, 1,629,999 shares issued, 1,416,699 and 1,566,699 shares outstanding at September 30, 2017 and December 31, 2016, respectively | 1,600 | 1,600 | ||||||||||||||
Common stock, $0.001 par value, 10,000,000 shares authorized, 1,629,999 shares issued, 1,416,699 shares outstanding | 1,600 | 1,600 | ||||||||||||||
| Paid-in capital | 14,780,100 | 14,780,100 | 14,780,100 | 14,780,100 | ||||||||||||
| Retained earnings | 29,604,300 | 28,222,600 | 35,858,000 | 35,621,800 | ||||||||||||
| 44,386,000 | 43,004,300 | 50,639,700 | 50,403,500 | |||||||||||||
Treasury stock at cost, 213,300 and 63,300 shares at September 30, 2017 and December 31, 2016, respectively | (3,036,800 | ) | (504,100 | ) | ||||||||||||
| Treasury stock at cost, 213,300 shares | (3,036,800 | ) | (3,036,800 | ) | ||||||||||||
| Total stockholders' equity | 41,349,200 | 42,500,200 | 47,602,900 | 47,366,700 | ||||||||||||
| Total liabilities and stockholders' equity | $ | 247,755,400 | $ | 218,736,100 | $ | 245,236,500 | $ | 236,409,900 | ||||||||
The accompanying notes are an integral part of these consolidated financial statements.
3
AeroCentury Corp.
Condensed Consolidated Statements of Operations
(Unaudited)
For the Nine Months Ended September 30, | For the Three Months Ended September 30, | For the Six Months Ended June 30, | For the Three Months Ended June 30, | |||||||||||||||||||||||||||||
| 2017 | 2016 | 2017 | 2016 | 2018 | 2017 | 2018 | 2017 | |||||||||||||||||||||||||
| Revenues and other income: | ||||||||||||||||||||||||||||||||
| Operating lease revenue | $ | 21,995,600 | $ | 17,054,100 | $ | 7,568,500 | $ | 6,074,600 | $ | 13,286,800 | $ | 14,427,000 | $ | 6,823,900 | $ | 7,110,100 | ||||||||||||||||
| Finance lease revenue | 1,173,400 | 571,900 | 415,700 | 199,800 | 740,400 | 757,700 | 361,300 | 432,300 | ||||||||||||||||||||||||
| Maintenance reserves revenue | 1,035,800 | - | 349,800 | - | - | 686,000 | - | 686,000 | ||||||||||||||||||||||||
| Net gain on sales-type finance leases | 297,400 | 1,213,600 | - | 1,166,100 | - | 297,400 | - | - | ||||||||||||||||||||||||
| Net (loss)/gain on disposal of assets | (130,400 | ) | 2,149,200 | 3,500 | 2,800 | |||||||||||||||||||||||||||
| Net gain/(loss) on disposal of assets | 9,900 | (133,900 | ) | 18,100 | (147,700 | ) | ||||||||||||||||||||||||||
| Other income | 2,300 | 2,200 | 1,700 | 500 | 1,631,600 | 600 | 580,200 | 400 | ||||||||||||||||||||||||
| 24,374,100 | 20,991,000 | 8,339,200 | 7,443,800 | 15,668,700 | 16,034,800 | 7,783,500 | 8,081,100 | |||||||||||||||||||||||||
| Expenses: | ||||||||||||||||||||||||||||||||
| Depreciation | 9,037,700 | 6,283,100 | 3,158,600 | 2,332,600 | 6,092,300 | 5,879,100 | 3,150,400 | 2,943,000 | ||||||||||||||||||||||||
| Interest | 5,496,400 | 3,766,400 | 2,143,400 | 1,338,500 | 4,619,400 | 3,353,000 | 2,365,100 | 1,742,800 | ||||||||||||||||||||||||
| Management fees | 4,588,700 | 3,685,600 | 1,583,700 | 1,249,100 | 2,948,800 | 3,005,100 | 1,502,100 | 1,498,300 | ||||||||||||||||||||||||
Professional fees, general and administrative and other | 1,621,800 | 1,563,800 | 521,500 | 385,900 | 954,000 | 924,100 | 376,900 | 418,000 | ||||||||||||||||||||||||
| Maintenance | 830,600 | 2,571,600 | 169,200 | 750,700 | 160,200 | 661,400 | 68,900 | 405,300 | ||||||||||||||||||||||||
| Provision for impairment in value of aircraft | 523,100 | 321,200 | 68,800 | - | 298,200 | 454,300 | 298,200 | 454,300 | ||||||||||||||||||||||||
| Bad debt expense | - | 835,800 | - | 572,900 | ||||||||||||||||||||||||||||
| Insurance | 157,700 | 130,900 | 78,000 | 57,700 | ||||||||||||||||||||||||||||
| Other taxes | 45,100 | 45,200 | 22,500 | 22,500 | ||||||||||||||||||||||||||||
| 22,098,300 | 19,027,500 | 7,645,200 | 6,629,700 | 15,275,700 | 14,453,100 | 7,862,100 | 7,541,900 | |||||||||||||||||||||||||
| Income before income tax provision | 2,275,800 | 1,963,500 | 694,000 | 814,100 | ||||||||||||||||||||||||||||
Income/(loss) before income tax provision | 393,000 | 1,581,700 | (78,600 | ) | 539,200 | |||||||||||||||||||||||||||
| Income tax provision | 894,100 | 701,500 | 309,500 | 284,400 | 156,800 | 584,500 | 2,500 | 183,500 | ||||||||||||||||||||||||
| Net income | $ | 1,381,700 | $ | 1,262,000 | $ | 384,500 | $ | 529,700 | ||||||||||||||||||||||||
| Earnings per share: | ||||||||||||||||||||||||||||||||
Net income/(loss) | $ | 236,200 | $ | 997,200 | $ | (81,100 | ) | $ | 355,700 | |||||||||||||||||||||||
Earnings/(loss) per share: | ||||||||||||||||||||||||||||||||
| Basic | $ | 0.95 | $ | 0.81 | $ | 0.27 | $ | 0.34 | $ | 0.17 | $ | 0.67 | $ | (0.06 | ) | $ | 0.25 | |||||||||||||||
| Diluted | $ | 0.95 | $ | 0.81 | $ | 0.27 | $ | 0.34 | $ | 0.17 | $ | 0.67 | $ | (0.06 | ) | $ | 0.25 | |||||||||||||||
Weighted average shares used in earnings per share computations: | ||||||||||||||||||||||||||||||||
Weighted average shares used in earnings/(loss) per share computations: | ||||||||||||||||||||||||||||||||
| Basic | 1,460,655 | 1,566,699 | 1,416,699 | 1,566,699 | 1,416,699 | 1,482,997 | 1,416,699 | 1,416,699 | ||||||||||||||||||||||||
| Diluted | 1,460,655 | 1,566,699 | 1,416,699 | 1,566,699 | 1,416,699 | 1,482,997 | 1,416,699 | 1,416,699 | ||||||||||||||||||||||||
The accompanying notes are an integral part of these consolidated financial statements.
4
AeroCentury Corp.
Condensed Consolidated Statements of Cash Flows
(Unaudited)
For the Nine Months Ended September 30, | For the Six Months Ended June 30, | |||||||||||||||
| 2017 | 2016 | 2018 | 2017 | |||||||||||||
| Net cash provided by operating activities | $ | 13,363,000 | $ | 10,816,200 | $ | 11,191,500 | $ | 8,706,500 | ||||||||
| Investing activities: | ||||||||||||||||
Proceeds from sale of aircraft and aircraft engines held for lease, net of re-sale fees | 2,980,000 | 3,332,600 | 3,186,800 | 1,397,300 | ||||||||||||
| Proceeds from sale of assets held for sale, net of re-sale fees | 160,100 | 2,675,200 | 2,644,900 | 112,600 | ||||||||||||
| Proceeds from insurance | - | 18,886,700 | ||||||||||||||
| Investment in direct financing leases | (7,614,200 | ) | - | - | (7,614,200 | ) | ||||||||||
| Purchases of aircraft | (32,063,100 | ) | (53,109,100 | ) | ||||||||||||
| Investment in aircraft parts and acquisition costs | (22,606,000 | ) | (21,735,900 | ) | ||||||||||||
| Net cash used in investing activities | (36,537,200 | ) | (28,214,600 | ) | (16,774,300 | ) | (27,840,200 | ) | ||||||||
| Financing activities: | ||||||||||||||||
| Issuance of notes payable – Credit Facility | 35,900,000 | 31,300,000 | 21,000,000 | 26,000,000 | ||||||||||||
| Repayment of notes payable – Credit Facility | (4,800,000 | ) | (31,600,000 | ) | (17,500,000 | ) | (2,800,000 | ) | ||||||||
| Repayment of notes payable – special purpose financing | (2,127,000 | ) | (2,033,900 | ) | ||||||||||||
| Debt issuance costs | (525,000 | ) | (65,000 | ) | (70,000 | ) | (65,000 | ) | ||||||||
| Issuance of notes payable – special purpose financing | - | 19,609,900 | ||||||||||||||
| Repayment of notes payable – special purpose financing | (3,066,000 | ) | (986,400 | ) | ||||||||||||
| Net cash provided by financing activities | 27,509,000 | 18,258,500 | 1,303,000 | 21,101,100 | ||||||||||||
| Net increase in cash and cash equivalents | 4,334,800 | 860,100 | ||||||||||||||
| Net (decrease)/increase in cash and cash equivalents | (4,279,800 | ) | 1,967,400 | |||||||||||||
| Cash and cash equivalents, beginning of period | 2,194,400 | 2,721,000 | 8,657,800 | 2,194,400 | ||||||||||||
| Cash and cash equivalents, end of period | $ | 6,529,200 | $ | 3,581,100 | $ | 4,378,000 | $ | 4,161,800 | ||||||||
During the ninesix months ended SeptemberJune 30, 20172018 and 2016,2017, the Company paid interest totaling $4,697,000$3,942,500 and $3,211,100,$2,890,700, respectively. The Company paid income taxes of $1,600 and $800 during each of the nine-month periodssix months ended SeptemberJune 30, 20172018 and 2016.2017.
The accompanying notes are an integral part of these consolidated financial statements.
5
AeroCentury Corp.
Notes to Condensed Consolidated Financial Statements (Unaudited)
1. Organization and Summary of Significant Accounting Policies
(a) The Company and Basis of Presentation
AeroCentury Corp., a Delaware corporation incorporated in 1997, typically acquires used regional aircraft and engines for lease to foreign and domestic regional carriers.
In August 2016, AeroCentury Corp. formed two wholly-owned subsidiaries, ACY SN 19002 Limited ("ACY 19002") and ACY SN 19003 Limited ("ACY 19003") for the purpose of acquiring aircraft using a combination of cash and financing ("SPE Financing" or "special purpose financing") separate from the parent's credit facility. Financial information for AeroCentury Corp., ACY 19002 and ACY 19003 (collectively, the "Company") is presented on a consolidated basis in accordance with accounting principles generally accepted in the United States of America ("GAAP") for interim financial information, the instructions to Form 10-Q and Article 108 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three- and nine-monthsix-month periods ended SeptemberJune 30, 20172018 are not necessarily indicative of the results that may be expected for the year ending December 31, 2017 and future periods. 2018. All intercompany balances and transactions have been eliminated in consolidation.
For further information, refer to the financial statements and footnotes thereto included in the Company's annual report on Form 10-K for the year ended December 31, 2016.2017.
(b) Use of Estimates
The Company's condensed consolidated financial statements have been prepared in accordance with GAAP. The preparation of consolidated financial statements in conformity with GAAP 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 consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable for making judgments that are not readily apparent from other sources.
The most significant estimates with regard to these condensed consolidated financial statements are the residual values and useful lives of the Company's long livedlong-lived assets, the amount and timing of future cash flows associated with each asset that are used to evaluate whether assets are impaired, accrued maintenance costs, accounting for income taxes, and the amounts recorded as allowances for doubtful accounts.
(c) Fair Value Measurements
Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Valuation techniques used to measure fair value must maximize the use of observable inputs and minimize the use of unobservable inputs, to the extent possible. The fair value hierarchy under GAAP is based on three levels of inputs.
Level 1 - Quoted prices in active markets for identical assets or liabilities.
Level 2 - Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.
Level 3 - Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.
Assets and Liabilities Measured and Recorded at Fair Value on a Recurring Basis
The carrying amount of the Company's money market funds included in cash and cash equivalents was $5,150,400$2,154,400 and $1,348,100$6,151,900 at SeptemberJune 30, 20172018 and December 31, 2016,2017, respectively. The fair value of the Company's money market funds is categorized as Level 1 under the GAAP fair value hierarchy.
As of SeptemberJune 30, 20172018 and December 31, 2016,2017, there were no liabilities that were required to be measured and recorded at fair value on a recurring basis.
Assets Measured and Recorded at Fair Value on a Nonrecurring Basis
The Company determines fair value of long-lived assets held and used, such as aircraft and aircraft engines held for lease and assets held for sale, by reference to independent appraisals, quoted market prices (e.g., offers to purchase) and other factors. An impairment charge is recorded when the Company believes that the carrying value of an asset will not be recovered through future net cash flows and that the asset's carrying value exceeds its fair value.
The Company recorded an impairment charge of $68,800$298,200 on one of its aircraft held for lease in the three months ended June 30, 2018. The Company recorded an impairment charge of $454,300 on one of its assets held for lease in the quarter ended September 30, 2017, based on expected sales proceeds. The aircraft was sold in October 2017. The Company also recorded an impairment charge of $454,300 on one of its assets in the quarter ended June 30, 2017, based on its appraised value. The Company recorded no impairment charges on its aircraft held for lease in the quarter or nine months ended September 30, 2016.
Fair Value of Other Financial Instruments
The Company's financial instruments, other than cash and cash equivalents, consist principally of finance leases receivable, amounts borrowed under its credit facility (the "Credit Facility") and notes payable under special purpose financing. The fair value of accounts receivable, finance leases receivable, accounts payable and the Company's maintenance reserves and accrued maintenance costs approximates the carrying value of these financial instruments.instruments because of their short-term maturities. The fair value of finance lease receivables approximates the carrying value as discussed in (d) below.
Borrowings under the Company's Credit Facility bear floating rates of interest that reset periodically to a market benchmark rate plus a credit margin. The Company believes that the effective interest rate under the Credit Facility approximates current market rates for such indebtedness at the balance sheet date, and therefore that the outstanding principal and accrued interest of $141,446,500$137,723,000 and $110,183,600$134,278,900 at SeptemberJune 30 2017, 2018 and December 31, 2016,2017, respectively, approximate their fair values on such dates. The fair value of the Company's outstanding balance of its Credit Facility would be categorized as Level 3 under the GAAP fair value hierarchy.
The amounts payable under the Company's SPE Financing are payable through the fourth quarter of 2020 and bear a fixed rate of interest, as described in Note 4(b) to the condensed consolidated financial statements. The Company believes that the effective interest rate under the SPE Financingspecial purpose financing approximates current market rates for such indebtedness at the balance sheet date, and therefore that the outstanding principal and accrued interest of $14,581,000$11,403,000 and $17,654,200 approximate$13,535,300 approximates their fair valuesvalue at SeptemberJune 30 2017, 2018 and December 31, 2016,2017, respectively. Such fair value would be categorized as Level 3 under the GAAP fair value hierarchy.
(d) Finance Leases
As of SeptemberJune 30 2017,, 2018, the Company had six aircraft subject to sales-type finance leases and three aircraft subject to direct financing leases. All nine leases contain lessee bargain purchase options at prices substantially below the subject assets' estimated residual values at the exercise date for the options. Consequently, the Company has classified each of these nine leases as finance leases for financial accounting purposes. For such finance leases, the Company reports the discounted present value of (i) future minimum lease payments (including the bargain purchase option) and (ii) any residual value not subject to a bargain purchase option as a finance lease receivable on its balance sheet and accrues interest on the balance of the finance lease receivable based on the interest rate inherent in the applicable lease over the term of the lease. For each of the six sales-type finance leases, the Company recognized as a gain or loss the amount equal to (i) the net investment in the sales-type finance lease plus any initial direct costs and lease incentives less (ii) the net book value of the subject aircraft at inception of the applicable lease.
The Company recognized revenue from interest earned on finance leases in the amount of $415,700$361,300 and $199,800$432,300 in the quarters ended SeptemberJune 30, 20172018 and 2016,2017, respectively and $1,173,400$740,400 and $571,900$757,700 in the nine monthsix-month periods ended September June 30, 2018 and 2017, and 2016, respectively.
(e) Recent Accounting Pronouncements
In May 2014, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2014-09 that created the new Topic 606 ("Topic 606") in the Accounting Standards Codification ("ASC"). Topic 606 also included numerous conforming additions and amendments to other Topics within the ASC. Topic 606 established new rules that affect the amount and timing of revenue recognition for contracts with customers, but does not affect lease accounting and reporting. As such, adoption of these provisions will not affect the Company's lease revenues but may affect the reporting of the Company's non-lease revenues. On August 12, 2015, the FASB deferred the effective date of the provisions included in Topic 606 to years commencing after December 15, 2017, although early adoption was permitted for the year ended December 31, 2017. As such, the Company has adopted Topic 606 can be adopted early for years commencing after December 15, 2016, andas of January 1, 2018. Adoption may be reflected using either a full retrospective method, applying the standard to all periods presented, or a simplified method that does not recast prior periods but does disclose the effect of the adoption on the current period consolidated financial statements. The Company has determined that Since most of the Company's revenues arise from its lease contracts, which are not affected by the new standard, and since the Company's revenue recognition for other sources of revenue is generally the same as it was under previous accounting standards, adoption of Topic 606 will not have a materialin the current year, using the modified retrospective approach, has had no effect on its consolidated financial statements.
In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842) ("ASU 2016-02"). ASU 2016-02 is effective for public companies for years beginning after December 15, 2018, although early adoption is permitted. ASU 2016-02 substantially modifies lessee accounting for leases, requiring that lessees recognize lease assets and liabilities for leases extending beyond one year. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement.
The new standard requires a lessor to classify leases as sales-type, finance, or operating. A lease will be treated as a salesales-type if it transfers all of the risks and rewards, as well as control of the underlying asset, to the lessee. If risks and rewards are conveyed without the transfer of control, the lease is treated as a financing. If the lessor does not convey risks and rewards or control, an operating lease results. A modified retrospective transition approach is required for lessors for sales-type, finance, and operating leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements, with certain practical expedients available.
The Company is reviewing those agreements under which it is the lessor and is evaluating the impact of the adoption of ASU 2016-02 on its consolidated financial statements and related disclosures. The Company does not expect to adopt ASU 2016-02 early, and expects to elect practical expedients in connection with its adoption, including not re-evaluating lease classification or capitalized initial direct costs on existing leases.
The Company is not a lessee under any agreements that would be considered leases under ASU 2016-02, and so would be unaffected with respect to its adoption with respect to lessee accounting.
In January 2017, the FASB issued ASU 2017-01, Business Combinations (Topic 805) ("ASU 2017-01"). ASU 2017-01 is effective for public companies for years beginning after December 15, 2017, although early adoption is permitted. ASU 2017-01 clarifies the definition of a business with the objective of adding guidance to assist entities with evaluating whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses. The Company has early adopted ASU 2017-01 effective beginning the first quarter ended March 31, 2017 and has determined that none of its acquired assets qualifies as a business, such that no gain, loss or adjustment to the carrying value of assets was required in connection with such adoption.
In January 2017, the FASB issued ASU 2017-04, Intangibles -- Goodwill and Other (Topic 350) ("ASU 2017-04"), which provides for simplification of the test for goodwill impairment. Under the revised standard, "step 2" of the test under the previous standard is eliminated and (i) the fair value of the reporting unit is compared to its carrying value, with (ii) an impairment charge up to the amount of goodwill recognized for the excess of carrying value over fair value (considering the income tax effects of deductible goodwill, if applicable). The new provisions are required to be adopted for fiscal years beginning after December 15, 2019, although the Company has elected to early adopt the new provisions beginning with its quarter ended March 31, 2017. Adoption of ASU 2017-04 has had no effect on the financial results or position of the Company.
In December of 2017, the United States enacted the Tax Cuts and Jobs Act of 2017 (the "Tax Act"), which had numerous effects on U.S. corporate taxation, including reducing the federal corporate tax rate to 21%, substantially modifying the U.S. taxation of international investments and transactions, and repealing the alternative minimum tax. In December of 2017, the Staff of the SEC issued Staff Accounting Bulletin No. 118 ("SAB 118"), which provides that companies should reflect in their financial statements the effects of the change in tax law in which the accounting is complete, as such completion occurs; provisional amounts for such effects for which the company can determine a reasonable estimate, as such estimates can be made; and continued accounting under the provisions of the law as it existed before enactment of the Tax Act for such effects for which no reasonable estimate under the new law can be made, until such a reasonable estimate is available and a provisional amount can be reported. Under SAB 118, in no event should the period during which a company is obtaining, preparing, and analyzing the information needed to complete the accounting for the effects of the change in tax law exceed one year from enactment (the "measurement period"), the fourth quarter of 2018. The Company has included the effects of the Tax Act in its financial statements and does not expect that further analysis will be required.
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2. Finance Leases Receivable
At SeptemberJune 30, 20172018 and December 31, 2016,2017, the net investment included in sales-type finance leases and direct financing leases receivable were as follows:
September 30, 2017 | December 31, 2016 | June 30, 2018 | December 31, 2017 | |||||||||||||
| Gross minimum lease payments receivable | $ | 28,382,000 | $ | 20,829,200 | $ | 24,839,100 | $ | 27,074,400 | ||||||||
| Less unearned interest | (3,911,400 | ) | (3,360,900 | ) | (2,773,000 | ) | (3,513,400 | ) | ||||||||
| Finance leases receivable | $ | 24,470,600 | $ | 17,468,300 | $ | 22,066,100 | $ | 23,561,000 | ||||||||
As of SeptemberJune 30, 2017,2018, minimum future payments receivable under finance leases were as follows:
| Years ending | ||||||||
| Remainder of 2017 | $ | 1,758,200 | ||||||
| 2018 | 5,811,600 | |||||||
| Remainder of 2018 | $ | 4,026,900 | ||||||
| 2019 | 7,087,600 | 7,087,600 | ||||||
| 2020 | 5,036,600 | 5,036,600 | ||||||
| 2021 | 5,381,000 | 5,381,000 | ||||||
| Thereafter | 3,307,000 | |||||||
| 2022 | 3,307,000 | |||||||
| $ | 28,382,000 | $ | 24,839,100 | |||||
3. Aircraft and Aircraft Engines Held for Lease or Sale
(a) Assets Held for Lease
At SeptemberJune 30, 20172018 and December 31, 2016,2017, the Company's aircraft and aircraft engines held for lease consisted of the following. following:
| September 30, 2017 | December 31, 2016 | June 30, 2018 | December 31, 2017 | |||||||||||||||||||||||||||||
| Type | Number owned | % of net book value | Number owned | % of net book value | Number Owned | % of net book value | Number owned | % of net book value | ||||||||||||||||||||||||
| Regional jet aircraft | 15 | 81 | % | 12 | 73 | % | 13 | 73 | % | 13 | 82 | % | ||||||||||||||||||||
| Turboprop aircraft | 10 | 17 | % | 12 | 23 | % | 10 | 26 | % | 10 | 17 | % | ||||||||||||||||||||
| Engines | 2 | 2 | % | 4 | 4 | % | 1 | 1 | % | 1 | 1 | % | ||||||||||||||||||||
During the thirdsecond quarter of 2018, the Company used cash of $22,606,000 for the acquisition of two Dash 8-400 aircraft on lease to a customer in Croatia, as well as equipment added to an aircraft.
During the second quarter of 2017, the Company used $10,557,400$21,172,700 for the acquisition of a regional jettwo Embraer 175 aircraft on lease to a customer in the United States and acquisition costs related toStates. The Company also paid a $500,000 deposit for a third Embraer 175 aircraft which was acquired earlier in the year.
The Company sold no aircraft during the second quarter of 2018. During the second quarter of 2017, the Company used cashsold two spare turboprop engines and recorded a loss of $52,138,000 for acquisition of four aircraft and related costs. At the time of purchase, the Company received $17,179,300 of maintenance reserves related to two of the aircraft; such reserves are reflected as a deduction in the amount of cash used for purchases and related acquisition costs in the investing activities section of the Company's statement of cash flows for the nine months ended September 30, 2016.$173,700.
As of SeptemberJune 30, 2017,2018, minimum future lease revenue payments receivable under non-cancelablenoncancelable operating leases were as follows:
| Years ending | ||||||||
| Remainder of 2017 | $ | 6,955,100 | ||||||
| 2018 | 25,882,900 | |||||||
| Remainder of 2018 | $ | 13,858,100 | ||||||
| 2019 | 25,455,200 | 27,460,200 | ||||||
| 2020 | 23,003,000 | 25,821,900 | ||||||
| 2021 | 15,901,600 | 18,720,500 | ||||||
| 2022 | 16,762,900 | |||||||
| Thereafter | 43,391,400 | 34,732,900 | ||||||
| $ | 140,589,200 | $ | 137,356,500 | |||||
(b)Assets Held for Sale
Assets held for sale at SeptemberJune 30, 20172018 consist of a turboprop aircraft and turboprop airframe parts from threetwo aircraft.
During the three months ended September 30, 2017 and 2016,second quarter of 2018, the Company received $47,500$73,400 in cash and $41,400, respectively, fromaccrued $41,000 in receivables for parts sales. These amounts were accounted for as follows: $10,600 reduced accounts receivable for parts sales accrued in the salefirst quarter of parts. Of such amounts, $44,000 and $38,600, respectively,2018, $85,700 reduced the carrying value of the parts. In the same periods, the Company received amountsparts, and $18,100 was recorded as gains in excess of the carrying value for parts from two of the airframes,parts. During the second quarter of 2017, the Company received $96,300 from the sale of parts, of which $70,400 reduced the carrying value of the parts and $25,900 was recorded gains totaling $3,500 and $2,800, respectively.as a gain.
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4. Notes Payable and Accrued Interest
At SeptemberJune 30, 20172018 and December 31, 2016,2017, the Company's notes payable and accrued interest consisted of the following:
September 30, 2017 | December 31, 2016 | June 30, 2018 | December 31, 2017 | |||||||||||||
| Credit Facility: | ||||||||||||||||
| Principal | $ | 141,200,000 | $ | 110,100,000 | $ | 137,500,000 | $ | 134,000,000 | ||||||||
| Unamortized debt issuance costs | (1,826,000 | ) | (1,999,900 | ) | (1,483,500 | ) | (2,216,000 | ) | ||||||||
| Accrued interest | 246,500 | 83,600 | 223,000 | 278,900 | ||||||||||||
| SPE Financing: | ||||||||||||||||
| Special purpose financing: | ||||||||||||||||
| Principal | 14,557,600 | 17,623,600 | 11,384,800 | 13,511,900 | ||||||||||||
| Accrued interest | 23,400 | 30,600 | 18,200 | 23,400 | ||||||||||||
| $ | 154,201,500 | $ | 125,837,900 | $ | 147,642,500 | $ | 145,598,200 | |||||||||
(a) Credit Facilityfacility
The Company's $170 million Credit Facility is provided by a syndicate of banks and is secured by all of the assets of the Company, including its aircraft and engine portfolio. In July 2017, the Credit Facility was amended to increase the total amount available for borrowing from $150 million to $170 million. Covenants regarding a debt to equity ratio and customer concentration were also modified.
The Credit Facility, which expires on May 31, 2019, can be expanded to a maximum of $180 million. The Company was in compliance with all covenants under the Credit Facility at SeptemberJune 30, 20172018 and December 31, 2016.2017.
The unused amount of the Credit Facility was $28,800,000$32,500,000 and $39,900,000$36,000,000 as of SeptemberJune 30, 20172018 and December 31, 2016,2017, respectively.
The weighted average interest rate on the Credit Facility was 4.65%5.51% and 4.15%5.21% at SeptemberJune 30, 2018 and December 31, 2017, and December 31, 2016, respectively.
(b)SPE Financing
In August 2016, the Company acquired two regional jet aircraft using cash and financing separate from its Credit Facility. The separate SPE Financing resulted in note obligations totaling $19,609,900,of $9,805,600 and $9,804,300, which are being paid from a portion of the rent payments on the related aircraft leases through October 3, 2020 and November 7, 2020, respectively, and which bear interest at the rate of 4.455%. per annum. The borrower under each note obligation is the special purpose entity that owns each aircraft. The notes are collateralized by the aircraft and are recourse only to the special purpose entity borrower and its aircraft asset, subject to standard exceptions for this type of financing. Payments due under the notes consist of quarterly principal and interest. The combined balance of the notes payable and accrued interest on these notes at SeptemberJune 30, 20172018 and December 31, 20162017 was $14,581,000$11,403,000 and $17,654,200,$13,535,300, respectively.
5. Acquisition Costs
In the ordinary conduct of the Company's business, the Company is subject to lawsuits, arbitrations and administrative proceedings from time to time. The Company believes that the outcome of any existing or known threatened proceedings, even if determined adversely, should not have a material adverse effect on the Company's business, financial condition, liquidity or results of operations.
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6. Computation of Earnings Per Share
Basic and diluted earnings per share are calculated as follows:
For the Nine Months Ended September 30, | For the Three Months Ended September 30, | |||||||||||||||
| 2017 | 2016 | 2017 | 2016 | |||||||||||||
| Net income | $ | 1,381,700 | $ | 1,262,000 | $ | 384,500 | $ | 529,700 | ||||||||
| Weighted average shares outstanding for the period | 1,460,655 | 1,566,699 | 1,416,699 | 1,566,699 | ||||||||||||
| Basic earnings per share | $ | 0.95 | $ | 0.81 | $ | 0.27 | $ | 0.34 | ||||||||
| Diluted earnings per share | $ | 0.95 | $ | 0.81 | $ | 0.27 | $ | 0.34 | ||||||||
For the Six Months Ended June 30, | For the Three Months Ended June 30, | |||||||||||||||
| 2018 | 2017 | 2018 | 2017 | |||||||||||||
| Net income/(loss) | $ | 236,200 | $ | 997,200 | $ | (81,100 | ) | $ | 355,700 | |||||||
| Weighted average shares outstanding for the period | 1,416,699 | 1,482,997 | 1,416,699 | 1,416,699 | ||||||||||||
| Basic earnings/(loss) per share | $ | 0.17 | $ | 0.67 | $ | (0.06 | ) | $ | 0.25 | |||||||
| Diluted earnings/(loss) per share | $ | 0.17 | $ | 0.67 | $ | (0.06 | ) | $ | 0.25 | |||||||
Basic earnings per common share is computed using net income and the weighted average number of common shares outstanding during the period. Diluted earnings per common share are computed using net income and the weighted average number of common shares outstanding, assuming dilution. Weighted average common shares outstanding, assuming dilution, include potentially dilutive common shares outstanding during the period,period.
7. Acquisition of whichManagement Company
In October 2017, the Company had none duringand JetFleet Holding Corp. ("JHC") entered into an Agreement and Plan of Merger (the "Merger Agreement") for the three monthsacquisition of JHC by the Company in a reverse triangular merger ("Merger") for consideration of $3.5 million in cash and nine129,286 shares of common stock of the Company, subject to adjustment as provided in the Merger Agreement. The Company submitted an application to the State of California Department of Business Oversight (the "DBO") for a permit ("Permit") to issue securities to JHC's shareholders in the Merger, which Permit was issued on February 22, 2018 after a hearing with the DBO. JHC has received the requisite consent of its shareholders to the Merger. The Company intends to hold a special meeting of the Company's shareholders in order to approve the Merger and the issuance of AeroCentury Common Stock in connection with the Merger as required under the applicable listing rules of the NYSE American exchange on which AeroCentury's common stock is traded. Approval of the Merger is not required under Delaware or California corporate law, or under the Merger Agreement. If the AeroCentury shareholders approve the issuance of AeroCentury Common Stock, the Merger is anticipated to be consummated in the third quarter of 2018 or shortly thereafter, but there can be no assurance that such closing will occur, or that it will occur in the anticipated time frame.
During the quarter and six months ended SeptemberJune 30, 2018, the Company accrued $64,300 and $264,200 of expenses related to the proposed Merger transaction. During the quarter and six months ended June 30, 2017, the Company accrued $24,100 and 2016.$125,900 of expenses related to the proposed Merger transaction. Such expenses are included in professional fees, general and administrative and other in the Company's consolidated statements of operations.
The Company's portfolio of leased aircraft assets is managed and administered under the terms of a management agreement (the "Management Agreement") with JetFleet Management Corp. ("JMC"), which is an integrated aircraft management, marketing and financing business and a subsidiary of JetFleet Holding Corp. ("JHC").JHC. Certain officers of the Company are also officers of JHC and JMC and hold significant ownership positions in both JHC and the Company.
Under the management agreement,Management Agreement, JMC receives a monthly management fee based on the net asset value of the assets under management. JMC also receives an acquisition fee for locating assets for the Company. Acquisition fees are included in the cost basis of the asset purchased. JMC may receive a remarketing fee in connection with the re-lease or sale of the Company's assets. Remarketing fees are amortized over the applicable lease term or included in the gain or loss on sale.
See the description of the Merger Agreement between the Company and JHC in Note 7 above.
In April 2018, subsequent to the execution of the Merger Agreement for the acquisition of JHC, JHC agreed to waive its right to receive management and acquisition fees ("Contract Fees") otherwise owed by the Company to JHC pursuant to the Management Agreement for all periods after March 31, 2018 and until the earlier of the consummation of the Merger or August 15, 2018. In return, the Company agreed to reimburse JMC for expenses ("Management Expense") incurred in providing management services set forth under the Management Agreement. In July 2018, JHC agreed to extend the expiration of this agreement (the "Waiver and Reimbursement Agreement") through October 15, 2018. Thus, if the Merger Agreement is terminated on or before October 15, 2018 or the Merger otherwise does not close by October 15, 2018, the Company would become obligated to JMC pay any excess (the "JMC Margin") of (i) the Contract Fees that would have been paid to JMC since April 1, 2018 in the absence of the Waiver and Reimbursement Agreement over (ii) the Management Expenses actually paid by the Company to JMC since April 1, 2018. For the quarter and six months ended June 30, 2018, contractual fees exceeded the reimbursed management fees by $497,200 of management fees and $494,400 of acquisition fees. Notwithstanding the Waiver and Reimbursement Agreement, until the closing or termination of the Merger Agreement, the Company will accrue as an expense the total Contract Fees that would have been due under the Management Agreement. If the Merger closes on or before October 15, 2018, the Waiver and Reimbursement Agreement for the period beginning on April 1, 2018, and ending on the consummation of the Merger will be considered in the acquisition accounting for the calculation of the settlement loss recognized by the Company when the Merger is consummated.
Fees incurred during the three months and ninesix months ended SeptemberJune 30, 20172018 and 20162017 were as follows:
| For the Nine Months Ended September 30, | For the Three Months Ended September 30, | For the Six Months Ended June 30, | For the Three Months Ended June 30, | |||||||||||||||||||||||||||||
| 2017 | 2016 | 2017 | 2016 | 2018 | 2017 | 2018 | 2017 | |||||||||||||||||||||||||
| Management fees | $ | 4,588,700 | $ | 3,685,600 | $ | 1,583,700 | $ | 1,249,100 | $ | 2,948,800 | $ | 3,005,100 | $ | 1,502,100 | $ | 1,498,300 | ||||||||||||||||
| Acquisition fees | 850,500 | 1,124,200 | 208,600 | 1,124,200 | 494,400 | 641,900 | 494,400 | 421,400 | ||||||||||||||||||||||||
| Remarketing fees | 51,100 | 284,500 | - | 225,700 | - | 51,100 | - | - | ||||||||||||||||||||||||
9. Subsequent Events
In October 2017, the Company sold a turboprop aircraft that was written down to its sales value at September 30, 2017.
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Item 2.Management's Discussion and Analysis of Financial Condition and Results of Operations.
The following discussion should be read in conjunction with the Company's Form 10-K for the year ended December 31, 20162017 and the unaudited financial statements and related notes that appear elsewhere in this report.Pursuant to Instruction 2 to Item 303(b) of Regulation S-K promulgated by the Securities and Exchange Commission, in preparing this discussion, the Company has presumed that readers have access to and have read the discussion under the same heading that appears in the Company's Form 10-K for the year ended December 31, 2017. The following discussion contains forward-looking statements. Please see the cautionary note regarding these statements at the beginning of this report.
Overview
AeroCentury provides leasing and finance services to regional airlines worldwide. The Company is principally engaged in providing leasing services of mid-life regional aircraft to carriers, including operating leases and finance leases. In addition to leasing activities, the Company sells aircraft from its operating lease portfolio to third parties, including other leasing companies, financial services companies, and airlines. Its operating performance is driven by the growth of its aircraft portfolio, the terms of its leases, the interest rate of its debt, as well as asset sales.
During the first nine monthssecond quarter of 2017,2018, the Company purchased three aircraft subject to operating leases. During the same period, the Company sold two engines for cash, exchanged one of its spare engines for 150,000 shares of the Company's common stock held by a stockholder, and reclassified an airframe and one of its engines at lease termination during the third quarter to held for sale for parts. The second engine from the returned aircraft remains held for lease.aircraft. The Company ended the period with a total of twenty-fivetwenty-three aircraft and two enginesone engine held for lease, with a net book value of approximately $205$210 million. This represents a 6%an 8% increase compared to the net book value at December 31, 2016.2017, as a result of the aircraft purchases, as well as two asset sales during the first quarter of 2018 and depreciation on its remaining assets held for lease. The Company also owns nine aircraft subject to finance leases, three of which were acquired in 2017, and one aircraft that is held for sale.2017.
The Company has a globally diversified customer base of eleven airlines in tennine countries. Average portfolio utilization was approximately 91% during the second quarter of 2018 compared with approximately 94% during the same period in 2017, and approximately 90% during the first ninesix months of 20172018 compared with approximately 93%95% during the first ninesix months of 2016.
In July 2017, the Company expanded its revolving credit facility (referred to as the "Credit Facility" or the "credit facility") from $150 million to $170 million. The unused amount of the Credit Facility was $28,800,000$32,500,000 as of SeptemberJune 30, 2017.2018. The weighted average interest rate on the Credit Facility was 4.65%5.51% at SeptemberJune 30, 2017.2018.
The Company has agreed to acquire, by way of merger (the "Merger"), JetFleet Holding Corp. ("JHC"). JHC is the owner of JetFleet Management Corp. ("JMC"), an integrated aircraft management, marketing and financing business that manages and administers the Company's portfolio of leased aircraft assets under the terms of a management agreement (the "Management Agreement"). If the Merger is completed, these management and administration services will be internalized and performed by the Company following completion.
Total revenues and other income for the quarter ended SeptemberJune 30, 2017 increased2018 decreased by $0.9$0.3 million compared to the thirdsecond quarter of 2016,2017, and total revenues and other income for the six months ended June 30, 2018 decreased by $0.4 million compared to the first six months of 2017, primarily as a result of increaseddecreased operating lease finance leaserevenues and maintenance reserves revenues, the effects of which were significantly offset by decreasedincreased other income and gains from asset dispositions.on sales of aircraft parts in the 2018 period versus net losses on sales of assets in the 2017 period.
Net incomeloss for the quarter ended SeptemberJune 30, 20172018 was $0.4$0.1 million, compared to net income of $0.5$0.4 million in the same period of 2016,2017, resulting in basic and diluted earnings per share of $0.27$(0.06) and $0.34$0.25 respectively. Net income for the six months ended June 30, 2018 was $0.2 million, compared to net income of $1.0 million in the same period of 2017, resulting in basic and diluted earnings per share of $0.17 and $0.67, respectively. Pre-tax profit margin (which the Company calculates as its income before income tax provision as a percentage of its revenues and other income) for the quarter ended SeptemberJune 30, 20172018 was 8%(1%) compared to 11%7% for the third quarter of 2016. The thirdsecond quarter of 2017, and pre-tax profit margin for the six months ended June 30, 2018 was 3% compared to 10% for the same period of 2017 . The second quarters and first six months of 2018 and 2017 included $161,800$64,300 and $24,100 and $264,200 and $125,900, respectively, of expenses incurred in connection with the proposed acquisition of JHC by the Company.
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Fleet Summary – Assets Held for Lease
Portfolio metrics of the Company's aircraft held for lease as of SeptemberJune 30, 20172018 and December 31, 20162017 were as follows.
| September 30, 2017 | December 31, 2016 | June 30, 2018 | December 31, 2017 | |||||||||||||
| Number of aircraft held for lease | 25 | 24 | ||||||||||||||
| Number of aircraft and engines held for lease | 24 | 24 | ||||||||||||||
| Weighted average fleet age | 11.3 years | 11.3 years | 11.5 years | 11.4 years | ||||||||||||
| Weighted average remaining lease term | 60 months | 59 months | 57 months | 58 months | ||||||||||||
| Aggregate fleet net book value | $ | 204,967,100 | $ | 192,799,800 | $ | 210,592,000 | $ | 195,098,200 | ||||||||
| For the Nine Months Ended September 30, | For the Three Months Ended September 30, | |||||||||||||||
| 2017 | 2016 | 2017 | 2016 | |||||||||||||
Average portfolio utilization | 94 | % | 93 | % | 93 | % | 93 | % | ||||||||
For the Six Months Ended June 30, | For the Three Months Ended June 30, | |||||||||||||||
| 2018 | 2017 | 2018 | 2017 | |||||||||||||
Average portfolio utilization | 90 | % | 95 | % | 91 | % | 94 | % | ||||||||
The following table sets forth the net book value and percentage of the net book value, by type, of the Company's assets that were held for lease at SeptemberJune 30, 20172018 and December 31, 2016.2017.
| September 30, 2017 | December 31, 2016 | June 30, 2018 | December 31, 2017 | |||||||||||||||||||||||||||||
| Type | Number owned | % of net book value | Number owned | % of net book value | Number owned | % of net book value | Number owned | % of net book value | ||||||||||||||||||||||||
| Turboprop aircraft: | ||||||||||||||||||||||||||||||||
| Bombardier Dash-8-400 | 2 | 7 | % | 3 | 11 | % | 4 | 18 | % | 2 | 7 | % | ||||||||||||||||||||
| Bombardier Dash-8-300 | 3 | 6 | % | 3 | 6 | % | 3 | 5 | % | 3 | 6 | % | ||||||||||||||||||||
| Saab 340B Plus | 5 | 4 | % | 5 | 5 | % | 2 | 2 | % | 4 | 3 | % | ||||||||||||||||||||
| Fokker 50 | - | - | 1 | 1 | % | |||||||||||||||||||||||||||
| Saab 340B | 1 | 1 | % | 1 | 1 | % | ||||||||||||||||||||||||||
| Regional jet aircraft: | ||||||||||||||||||||||||||||||||
| Canadair 900 | 4 | 30 | % | 4 | 33 | % | ||||||||||||||||||||||||||
| Canadair 900 (*) | 5 | 35 | % | 5 | 38 | % | ||||||||||||||||||||||||||
| Embraer 175 | 3 | 15 | % | - | - | 3 | 14 | % | 3 | 16 | % | |||||||||||||||||||||
| Canadair 1000 | 2 | 14 | % | 2 | 16 | % | 2 | 13 | % | 2 | 15 | % | ||||||||||||||||||||
| Canadair 700 | 3 | 12 | % | 3 | 14 | % | 3 | 11 | % | 3 | 13 | % | ||||||||||||||||||||
| Canadair 705 | 1 | 7 | % | 1 | 8 | % | ||||||||||||||||||||||||||
| Fokker 100 | 2 | 2 | % | 2 | 2 | % | ||||||||||||||||||||||||||
| Engines: | ||||||||||||||||||||||||||||||||
| General Electric CF34-8E5A1 | 1 | 2 | % | 2 | 3 | % | ||||||||||||||||||||||||||
| Pratt & Whitney 150A | 1 | 1 | % | - | - | 1 | 1 | % | 1 | 1 | % | |||||||||||||||||||||
| General Electric CT7-9B | - | - | 2 | 1 | % | |||||||||||||||||||||||||||
(*) December 31, 2017 includes a Canadair 705 that was converted to a Canadair 900 in 2018.
At SeptemberJune 30, 20172018 and December 31, 2016,2017, the Company also had nine aircraft and five aircraft, respectively, subject to finance leases.
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The following table sets forth the net book value and percentage of the net book value of the Company's assets that were held for lease at SeptemberJune 30, 20172018 and December 31, 20162017 in the indicated regions:regions (based on the domicile of the lessee):
| September 30, 2017 | December 31, 2016 | June 30, 2018 | December 31, 2017 | |||||||||||||||||||||||||||||
| Region | Net book value | % of net book value | Net book value | % of net book value | Net book value | % of net book value | Net book value | % of net book value | ||||||||||||||||||||||||
| Europe | $ | 93,625,700 | 46 | % | $ | 105,088,300 | 55 | % | $ | 113,905,000 | 54 | % | $ | 92,108,500 | 47 | % | ||||||||||||||||
| North America | 71,832,200 | 35 | % | 42,824,300 | 22 | % | 70,378,100 | 33 | % | 72,270,700 | 37 | % | ||||||||||||||||||||
| Africa | 13,519,300 | 7 | % | 21,724,400 | 11 | % | ||||||||||||||||||||||||||
| Asia | 6,177,500 | 3 | % | 6,463,700 | 3 | % | 5,854,400 | 3 | % | 6,082,100 | 3 | % | ||||||||||||||||||||
| Australia | 3,007,700 | 1 | % | 3,585,900 | 2 | % | ||||||||||||||||||||||||||
| Off lease | 16,804,700 | 8 | % | 13,113,200 | 7 | % | 20,454,500 | 10 | % | 24,636,900 | 13 | % | ||||||||||||||||||||
| $ | 204,967,100 | 100 | % | $ | 192,799,800 | 100 | % | $ | 210,592,000 | 100 | % | $ | 195,098,200 | 100 | % | |||||||||||||||||
For the quarter ended SeptemberJune 30, 2017,2018, approximately 27%30%, 25%28%, 19% and 11%21% of the Company's operating lease revenue was derived from customers in Slovenia, the United States Spain and Mozambique,Spain, respectively. Operating lease revenue does not include interest income from the Company's finance leases. The following table sets forth geographic information about the Company's operating lease revenue for leased aircraft and aircraft equipment, grouped by domicile of the lessee:
| For the Three Months Ended June 30, | ||||||||||||||||||||||||
| 2018 | 2017 | |||||||||||||||||||||||
| Region | Number of lessees | % of operating lease revenue | Number of lessees | % of operating lease revenue | Number of lessees | % of operating lease revenue | ||||||||||||||||||
| Europe | 3 | 48 | % | 4 | 58 | % | 4 | 53 | % | |||||||||||||||
| North America | 4 | 33 | % | 4 | 37 | % | 4 | 24 | % | |||||||||||||||
| Africa | 1 | 11 | % | - | - | 1 | 15 | % | ||||||||||||||||
| Asia | 1 | 4 | % | 1 | 5 | % | 1 | 4 | % | |||||||||||||||
| Australia | 1 | 4 | % | - | - | 1 | 4 | % | ||||||||||||||||
For the quarter ended SeptemberJune 30, 2017,2018, approximately 70% and 30% of the Company's finance lease revenue was derived from customers in Africa and Europe, respectively.
Results of Operations
(a) Quarter ended SeptemberJune 30, 20172018 compared to the quarter ended SeptemberJune 30, 20162017
Operating lease revenue increased 25%decreased 4% to $7.6$6.8 million in the thirdsecond quarter of 2018 from $7.1 million in the second quarter of 2017, from $6.1 million in the third quarter of 2016, primarily due to revenue from assets that were purchased during the third quarter of 2016 and first nine months of 2017, the effect of which was partially offset by(i) the loss of revenue from assets that were on lease during the 20162017 quarter, but off lease in 2018 and (ii) the loss of revenue from aircraft that were sold during 2017. Such decreases were partially offset by revenue from assets purchased in mid-2017 and in the 2018 quarter.
Average portfolio utilization wasdecreased to approximately 93%91% during the third quarterssecond quarter of 2018 from approximately 94% during the second quarter of 2017. The decrease was due to asset sales during late 2017 and 2016.2018, as well as the return of several aircraft at lease end in 2017.
Maintenance reserves that are retained by the Company at lease end are recorded as revenue at that time. The Company recorded no such revenue during the second quarter of 2018. During the thirdsecond quarter of 2017, the Company recorded maintenance reserves revenue of $0.3$0.4 million related to an economic adjustment when an aircraft was returned at lease expiration and $0.3 million of retained reserves when two aircraft were returned prior to lease expiration.
The Company sold no aircraft during the second quarter of 2018. During the second quarter of 2017, the Company sold two of its spare engines and recorded a loss of $0.2 million.
During the second quarter of 2018, the Company recorded $0.6 million in other income resulting from cash received from the previous lessee of three aircraft that were returned to the Company during 2017. Such payments were for unpaid maintenance reserves, as well as amounts due pursuant to the return conditions of the applicable leases. The Company did not accrue unpaid reserves or return condition amounts at the time of lease termination based on management's evaluation of the creditworthiness of the lessee. Therefore, the Company is accounting for two aircraft. The Company did not record any maintenance reserves revenuepayments as they are received and recorded the amount in the third quarter of 2016.other income.
The Company did not sell any assets during the third quarter of 2017. During the third quarter of 2016, the Company recorded gains of $1.2 million on the sale ofpurchased two aircraft pursuant to sales-type finance leases.
The average net book value of assets held for lease during the thirdsecond quarters of 20172018 and 20162017 was approximately $207.9$203.3 million and $165.0$190.9 million, respectively. Management fees, which are based on the net book value of the Company's aircraft and engines as well as finance lease receivable balances, were 27% higher for the third quarter of 2017 as compared toapproximately the same periodin the second quarters of 2016.2018 and 2017.
The Company's interest expense increased by 60%36% to $2.1$2.4 million in the thirdsecond quarter of 20172018 from $1.3$1.7 million in the same period of 2016,2017, primarily as a result of both a higher average debt balance and a higher average interest rate on the Company's Credit Facility, reflecting increases in LIBOR rates, in the 2017 period.2018 period, as well as higher fee amortization.
The Company's professional fees, general and administrative and other expenses increasedmaintenance expense decreased by 35%83% to $0.5$0.1 million in the thirdsecond quarter of 20172018 from $0.4 million in the same period of 2016,2017 primarily as a result of an increase in expenses related to the acquisition of JHC by the Company.
During each of the third quarter ofquarters ended June 30, 2018 and 2017, the Company recorded an impairment provision of $0.1$0.3 million and $0.5 million, respectively, for one of its turboprop aircraftan asset held for lease, based on its expected sales value. The aircraft was sold in October 2017. The Company recorded no such impairments during the third quarter of 2016.
Professional fees, general and administrative and other expenses infor the third quarter ofquarters ended June 30, 2018 and 2017 included $161,800$64,300 and $24,100, respectively, incurred in connection with the proposed acquisition of JHC byJHC.
(b) Six months ended June 30, 2018 compared to the Company.six months ended June 30, 2017
The Company recorded net income of $0.4$0.2 million for the quartersix months ended SeptemberJune 30, 2017,2018, compared to net income of $0.5$1.0 million in the same period of 2016.
Operating lease revenue increased 29%decreased 8% to $22.0$13.3 million in the ninefirst six months ended September 30, 2017of 2018 from $17.1$14.4 million in the same periodsecond quarter of 2016,2017, primarily due to revenue from assets that were purchased during the third quarter of 2016 and the first nine months of 2017, the effect of which was partially offset by: (i) the loss of revenue from assets that were on lease during the 2016 period,2017 quarter, but off lease in 20172018 and (ii) the loss of revenue from an aircraft that was involvedwere sold during 2017. Such decreases were partially offset by revenue from assets purchased in an accidentmid-2017 and in April 2016 and was declared a total loss.2018.
Average portfolio utilization increaseddecreased to approximately 94%90% during the first ninesix months of 20172018 from approximately 93%95% during the first ninesix months of 2016.2017. The decrease was due to asset sales during late 2017 and 2018, as well as the return of several aircraft at lease end in 2017.
During the first ninesix months of 2017,ended June 30, 2018, the Company recorded maintenance reserves revenuenet gains of $0.4 million related to an economic adjustment due from the lessee when an aircraft was returned at lease expiration and $0.6 million of retained reserves when four aircraft were returned at or prior to lease expiration. The Company did not record any maintenance reserves revenue in the first nine months of 2016.
parts. During the ninesix months ended SeptemberJune 30, 2017, the Company recorded a gain of $297,400 on the sale of an aircraft pursuant to a sales-type finance lease. DuringIn the nine months ended September 30, 20162017 period, the Company recorded gains totaling $1.2 million on the sale of three aircraft pursuant to sales-type finance leases.
During the ninesix months ended SeptemberJune 30, 2016,2018, the Company recorded a $2.1$1.6 million gain on insurance proceeds related to anin other income resulting from cash received from the previous lessee of three aircraft that was involvedwere returned to the Company during 2017. Such payments were for unpaid maintenance reserves, as well as amounts due pursuant to the return conditions of the applicable leases. The Company did not accrue unpaid reserves or return condition amounts at the time of lease termination based on management's evaluation of the creditworthiness of the lessee. Therefore, the Company is accounting for payments as they are received and recorded the amount in an accident in April 2016 and was declared a total loss.other income.
The Company purchased two aircraft subject to operating leases during the first six months of 2018. During the first ninesix months of 2017, the Company acquired threetwo aircraft that are subject to operating leases, as well as three aircraft that the Company leased pursuant to direct financing leases to the seller of such aircraft. During the first nine months of 2016, the Company acquired four aircraft that are subject to operating leases.
The average net book value of assets held for lease during the ninesix months ended SeptemberJune 30, 20172018 and 20162017 was approximately $195.8$196.8 million and $153.0$189.8 million, respectively. Management fees, which are based on the net book value of the Company's aircraft and engines as well as finance lease receivable balances, were 25% higher for2% lower in the first ninesix months of 20172018 as compared to the same period of 2016. 2017.
The Company's interest expense increased by 46%38% to $5.5$4.6 million in the first ninesix months of 2017ended June 30, 2018 from $3.8$3.4 million in the same period of 2016,2017, primarily as a result of both a higher average debt balance and a higher average interest rate on the Company's Credit Facility in the 2017 period.2018 period, as well as higher fee amortization.
The Company's maintenance expense decreased by 68%76% to $0.8$0.2 million in the first nine monthshalf of 20172018 from $2.6$0.7 million in the same period of 2016,2017, as a result of a decrease in maintenance performed by the Company on off-lease aircraft to prepare them for sale or re-lease.
During each of the first ninesix months ofended June 30, 2018 and 2017, the Company recorded impairment provisions of $0.4 million for one of its aircraft held for lease, based on its appraised value, and $0.1 million on another aircraft, which was sold in October 2017, based on the net sales value agreed with the buyer during the third quarter. The aircraft was sold in October 2017. During the first nine months of 2016, the Company recorded an impairment provision of $0.2$0.3 million and $0.5 million, respectively, for one of its spare engines that was sold in July 2017,an asset held for lease, based on the net salesappraised value. The Company also recorded $75,000 of impairment charges on two aircraft that had been held for sale and were sold during the second quarter of 2016.
Professional fees, general and administrative and other expenses infor the first ninesix months ofended June 30, 2018 and 2017 included $287,700$264,200 and $125,900, respectively, incurred in connection with the proposed acquisition of JHC by the Company.JHC.
The Company recorded netCompany's provision for income taxes decreased by 73% to $0.2 million in the first six months of $1.4 million for the nine months ended September 30, 2017, compared to net income of $1.32018 from $0.6 million in the same period of 2016.2017 as a result of lower pre-tax income in 2018, as well as lower tax rates provided in the Tax Act of 2017.
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Liquidity and Capital Resources
The Company is currently financing its assets primarily through debt financing and excess cash flows.
(a) Credit Facility
ratios. The Company was in compliance with all covenants at SeptemberJune 30, 20172018 and December 31, 2016.2017.
If the Company were to become out of compliance with any of its Credit Facility covenants at future calculation dates, the Company would need to request waivers or amendment of applicable covenants from its lenders if such compliance failure is not timely cured. The Company is currently negotiating new financing terms with its current lenders and other financing sources.
Although the Company believes that the assumptions it has made in forecasting its compliance with the Credit Facility covenants are reasonable in light of experience, actual results could deviate from such assumptions and there can be no assurance that the Company's beliefs will prove to be correct. Among the more significant factors that could have an impact on the accuracy of the Company's future covenant compliance forecasts are (i) unanticipated decreases in the market value of the Company's assets, or in the rental rates deemed achievable for such assets that cause the Company to record an impairment charge against earnings, (ii) lessee non-compliance with lease obligations, (iii) inability to locate new lessees for returned equipment within a reasonable remarketing period, or at a rent level consistent with projected rates, (iv) an inability to locate and acquire a sufficient volume of additional assets at prices that will produce acceptable net returns, (v) increases in interest rates, or (vi) an inability to timely dispose of off-lease assets at prices commensurate with their market value.
Any default under the Credit Facility, if not cured in the time permitted under the facility or waived by the lenders, could result in the Company's inability to borrow any further amounts under the Credit Facility, the acceleration of the Company's obligation to repay amounts borrowed under the Credit Facility, or foreclosure upon any or all of the assets of the Company.
(b) Special purpose financings
In August 2016, the Company acquired, using wholly-owned special purpose entities, two regional jet aircraft, using cash and third-party financing (referred to as "special purpose financing or "SPE Financing") separate from its Credit Facility, as described in Note 4(b) to the Company's condensed consolidated financial statements in Item 1 of this Quarterly Report on Form 10-Q.
(c) Cash flow
The Company's primary sources of cash are payments due under the Company's operating and finance leases, maintenance reserves, which are billed monthly to lessees based on asset usage, and proceeds from the sale of aircraft and engines.
The Company's primary uses of cash are for (i) purchasepurchases of assets, (ii) Credit Facility and special purpose financing interest and principal payments, (iii) maintenance expense and reimbursement to lessees from collected maintenance reserves, (iv) management fees and expense reimbursement owed to JMC, and (v) professional fees, including legal, accounting and accounting.directors' fees costs.
The Company's payments for maintenance consist of reimbursements to lessees for eligible maintenance costs under their leases and maintenance incurred directly by the Company for preparation of off-lease assets for re-lease to new customers. The timing and amount of such payments may vary widely between quarterly and annual periods, as the required maintenance events can vary greatly in magnitude and cost, and the performance of the required maintenance events by the lessee or the Company, as applicable, are not regularly scheduled calendar events and do not occur at uniform intervals throughout any calendar period. The Company's maintenance payments typically constitute a large portion of its cash needs, and the Company may from time to time borrow additional funds under the Credit Facility to provide funding for such payments.
Management fees paid by the Company are relatively predictable because they are based on the net asset value of the Company's portfolio and finance lease receivable balances. As discussed above in Results of Operations, the Company and JHC agreed to the waiver of certain fees beginning April 1, 2018, in exchange for reimbursement of certain expenses by the Company to JMC. Because of this, the risk of increased costs for employee salaries and benefits, worldwide travel related to the management of the Company's aircraft portfolio, office rent, outside technical experts and other overhead expenses is entirely placed on JMC. If, pursuant tobecame the Merger, the Company acquires JHC causing JMC to become an indirect wholly-owned subsidiaryresponsibility of the Company rather than JMC beginning with the second quarter of 2018. The shift in responsibility for these expenses is expected to continue if and after the Merger is completed, since the management and administrative services currently performed by JMC will be internalized and the Company will assume this riskno longer pay a management fee to an unconsolidated third party in exchange for the performance of increased costs.these services. As a result, the Company expects the types, timing and amounts of, and patterns and trends with respect to, its recorded expenses to change as a result of the Merger, but the manner and extent of these changes remains uncertain until the Company begins to internally perform and control these functions.
The amount of interest paid by the Company depends primarily on the outstanding balance of its Credit Facility, which carries a floating interest rate as well as an interest rate margin, and is therefore also dependent on changes in prevailing interest rates. Interest related to the Company's special purpose financings is payable at a fixed rate.
Management believes that the Company will have adequate cash flow to meet its ongoing operational needs, including any required repayments under the Credit Facility based upon its estimates of future revenues and expenditures, which include assumptions regarding (i) revenues for assets to be re-leased, (ii) cost and anticipated timing of maintenance to be performed, (iii) required debt payments, (iv) timely use of proceeds of unused debt capacity for additional acquisitions of income producing assets, and (v) interest rates. rates and (vi) the amount, timing and patterns of management and administrative expenses to be borne by the Company after completion of the Merger. Although the Company believes that the assumptions it has made in forecasting its cash flow are reasonable in light of experience, actual results could deviate from such assumptions. As discussed above, in "Liquidity and Capital Resources – (a) Credit Facility," and below in Outlook and Factors that May Affect Future Results and Liquidity, there are a number of factors that may cause actual results to deviate from such forecasts. If these assumptions turn out to be incorrect and the Company's cash requirements exceed its cash flows, the Company would need to pursue additional sources of financing to satisfy these requirements, which may not be available when needed, on acceptable terms, or at all. See Factors that May Affect Future Results and Liquidity below for more information about financing risks and limitations.
(i) Operating activities
The Company's cash flow from operations increased by $2.8$2.5 million in the first nine monthshalf of 20172018 compared to the same period in 2016.2017. As discussed below, the decreaseincrease in cash flow was primarily a result of increases in payments received for other income and operating lease revenue, and maintenance reserves.as well as a decrease in payments for management fees. This positive effect was partially offset by increases in payments for interest and management fees.maintenance and a decrease in payments received for security deposits.
| (A) | Payments for other income |
During the first half of 2018, the Company recorded $1.6 million in other income resulting from cash received from the previous lessee of three aircraft that were returned to the Company during 2017. Such payments were for operatingunpaid maintenance reserves, as well as amounts due pursuant to the return conditions of the applicable leases. The Company did not accrue unpaid reserves or return condition amounts at the time of lease revenuetermination based on management's evaluation of the creditworthiness of the lessee. Therefore, the Company is accounting for payments as they are received and recorded the amount in other income.
| (B) | Payments for operating lease revenue |
Rent receipts from lessees increased by $2.7$0.6 million in the first nine monthshalf of 20172018 compared to the same period in 2016,2017, primarily due to additionalhigher rent from assets purchased and leased to customers during the third quarter of 20162017 and the first nine months of 2017.2018.
As of the date of this filing, the Company is receiving no lease revenue for six aircraft and one engine held for lease that are off lease. The total book value of these assets is $21.0$20.4 million, representing 10% of the Company's total assets held for lease. In addition, an off-lease turboprop aircraft, with a book value of $1.5 million, is being held for sale and is not generating lease revenue.
| (C) | Payments for management fees |
| (D) | Payments for interest |
Payments for interest increased by $1.5$1.0 million in the first nine monthshalf of 20172018 compared to the first nine monthsquarter of 20162017 as a result of a higher average debt balance and higher rates during the 20172018 period.
| (E) | Payments for maintenance |
Payments for ma
13
(ii) Investing activities
During the first ninesix months ofended June 30, 2018 and 2017, and 2016, the Company received net cash of $3.1$5.8 million and $6.0$1.5 million, respectively, from the sale of assets. During the 2016 period, the Company also received $18.9 millionfirst six months of insurance proceeds related to the total loss of an aircraft during the period2018 and for damage to an aircraft in 2015.
(iii) Financing activities
During the first ninesix months of 20172018 and 2016,2017, the Company's special purpose entities repaid $3.1$2.1 million and $1.0$2.0 million, respectively, of SPE Financing principal. The special purpose entities borrowed $19.6 million during the 2016 period.
Outlook
The Company has identified three principal factors that it believes may materially affect the Company's growth and operating results:results in the near term. These and other factors that could impact the Company's business, performance and liquidity are described in more detail under Factors that May Affect Future Results and Liquidity below.
• The Company entered into an Agreement and Plan of Merger to acquire JHC on October 26, 2017. There are numerousseveral conditions to the closing of the mergerMerger between the Company and JHC, (the "Merger"), most of which are out of the control of the Company. On February 22, 2018, the State of California Department of Business Oversight ("DBO") held a hearing regarding the Merger pursuant to Section 25142 of the California Corporations Code, to determine whether the terms and conditions of the issuance of AeroCentury's shares of Common Stock in the Merger to JHC's shareholders are fair. Following the hearing, a permit was issued by the DBO, which will allow the issuance of the Company's common stock in the Merger transaction to be exempt from federal securities registration under Section 3(a)(10) of the Securities Act. The Company has received the consent of JHC's shareholders to the Merger. The Company intends to hold a special meeting of the Company's stockholders on August 31, 2018 in order to approve the issuance of AeroCentury Common Stock in connection with the Merger as required under the applicable listing rules of the NYSE American exchange on which AeroCentury's common stock is traded. Approval of the Merger is not required under Delaware or California corporate law. If the AeroCentury shareholders approve the issuance of AeroCentury Common Stock, the Merger is anticipated to be consummated in the firstthird quarter of 2018 or shortly thereafter, but there iscan be no assurance that such closing will occur, or that it will occur in the anticipated time frame. The conditions to the Merger include the issuance of a securities permit for the merger transaction from the California securities regulatory authority following a fairness hearing conducted by such authority, which will allow the Company's securities to be issued without registration under the Securities Exchange Act pursuant to the exemption provided by Section 3(a)(10) thereof and the consent of the JHC shareholders to the Merger.
The Company believes that the combination of the management function performed by JMC and the portfolio held by the Company will be accretive to the Company and will create shareholder value for the shareholders of the combined post-Merger company, but such accretion may not be realized until after transaction and integration costs in connection with the Merger have been paid and/incurred or subside. The Company also believes that the elimination of the outside management company structure removes a key impediment to capital raising by the Company.at all. The Company, however, will incur certain non-recurring, non-tax deductible Merger expenses in the periods leading up to the Merger, and immediately following, as well as having to record, for accounting purposes, a settlement loss at the time of consummation of the Merger (See Item 1 - Financial Statements, Footnote 9), which could negatively affect the Company's results for those periods.
• NotwithstandingIncreased production of aircraft types in the Company's market niche has resulted in some manufacturers offering competitive pricing for new aircraft to regional aircraft customers. In addition, notwithstanding recent interest rate increases in the U.S., new acquisition and leasing market entrants have increased competition for the Company for assets in itsthe Company's market niche of worldwide regional aircraft.aircraft has continued to increase. Some of the Company's newnewer competitors are funded by investment banks and private equity firms seeking higher yields on investment assets than are currently available from traditional income investment types. The increased competition has resulted in higher acquisition prices for many of the aircraft types that the Company has targeted to buy and, at the same time, continues to put downward pressure on lease rates, resulting in lower margins and, therefore, fewer acceptable acquisition opportunities for the Company. The Company anticipates this trend will continue for the short- to medium-term, untilbut could change if and when yields on alternative investments return to a more normal historical range.
• The Company has not identified re-lease or sale customers for six turboprop aircraft that are currently off lease. These aircraft are types for which the Company has observed decreased market demand and, therefore, the Company may experience significant delays in re-leasing or selling the aircraft. The Company is analyzing the amount and timing of maintenance required to remarket these assets, the amount of which may differ significantly if the assets are sold rather than re-leased. These aircraft are older types that are no longer in production, so it is not unusual that market demand for them is weak and, therefore, they may remain off lease for significant periods of time.
• The Company also owns a turboprop aircraft that is held for sale, for whichcurrently negotiating new financing terms with its current lenders and other financing sources. If the Company is seeking sales opportunities.not successful, the Company's ability to grow and remain in compliance with its current debt covenants would be negatively affected. In the event of any non-compliance, the Company would need to request waivers or amendment of applicable covenants from its lenders if such compliance failure is not timely cured.
Critical Accounting Policies, Judgments and Estimates
The Company's discussion and analysis of its financial condition and results of operations are based upon the financial statements included in this report, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets and liabilities, revenues and expenses, and the related disclosure of contingent assets and liabilities at the date of the financial statements.statements or during the applicable reporting period. In the event that actual results differ from these estimates or the Company adjusts these estimates in future periods, the Company's operating results and financial position could be materially affected. For a discussion of Critical Accounting Policies, Judgments and Estimates, refer to Note 1 to the Company's financial statements in Item 1 of this Quarterly Report on Form 10-Q.
14
Factors that May Affect Future Results and Liquidity
The Company's business, financial condition, results of operations, prospects and reputation could be affected by a number of factors. In addition to matters discussed elsewhere in this discussion, the Company believes the following are the most significant factors that may impact the Company; however, additional or other factors not presently known to the Company or that management deems immaterial could also impact the Company and its performance.
Availability of Financing. The Company's credit facility expires on May 31, 2019. The Company's continued growth will depend on its ability to continue to obtain capital, either through debt or equity financings. The Company is currently negotiating new financing terms with its current lenders and other financing sources. There can be no assurance that the Company's belief regarding the availability of financing under the current credit facility will prove to be correct, or that the Company will succeed in finding additional financing, and if such financing is found, it may be on terms less favorable than the Company's current debt financing. One of the current primary limiters on the Company's ability to draw under the current credit facility or incur any other additional debt is the covenant limitation on the Company's maximum debt to equity ratio. Under the current terms, even if the credit facility limit were increased, in order to utilize the higher limit, the Company would need to source additional equity capital in order to remain in compliance with the debt to equity ratio covenant to utilize the higher limit. Thus, the Company would need to raise additional equity capital to accompany any increase in the current credit facility, or, in the alternative, would need to refinance its credit facility debt with a new lender with more favorable financial covenants not limited by the Company's current equity capitalization. One of the motivations for the Company to acquire JHC was to remove the outside management structure of the Company which was believed to be an impediment to attracting capital sources. Even if the Merger is consummated, there can be no assurance that the Company will obtain such additional equity capital in the future or that it will be successful in obtaining more favorable credit facility financing, as a successful capital raising transaction depends on many factors, some of which are outside the Company's control.
Noncompliance with Debt Financial Covenants. The Company's use of debt as the primary form of acquisition financing subjects the Company to increased risks associated with leverage. In addition to payment obligations, the Company's debt agreements include financial covenants, including some requiring the Company to have positive earnings, meet minimum net worth standards and be in compliance with certain other financial ratios.
Consummation of Merger May Subject the Company to Additional Risks. TheIn October 2017, the Company recently announced its agreement to acquire JHC, the parent of the Company's management company, for the Company, JMC, by way of a reverse triangular merger ("Merger").merger. There iscan be no assurance that the Merger will eventually be consummated as there are numerous closing conditions that must be satisfied, before the Merger is closed, some of which are out of the control of the Company. The entry into the Agreement and Plan of Merger Agreement subjects the Company to additional risks, including the following:
• Merger Expenses. The Company entered into an Agreement and Plan of Merger with JHC. In addition to legal, accounting and financial advisory fees incurred prior to the execution of the Agreement and Plan of Merger, in order to consummate the Merger, the Company will need to incur significant additional expenses, including legal and third partythird-party consulting fees, which will be payable whether or not the Merger eventually occurs.
• Settlement Loss Effect on Covenant Compliance. The Company believes that if the Mergeracquisition by merger of JHC is consummated, the Company will be required toit may record a substantial portion of the consideration paid for JHC as a settlement loss related to the extinguishment of the Company's futureits existing obligations to JMC as a third party under the management agreement with JMC (since any payments post-Merger byon the Companyclosing date of the Merger in an amount equal to JMC undera substantial portion of the management agreement willpurchase consideration to be treated as intercompany transfers).paid in the Merger. The amount of the loss cannot be ascertained exactly until the Merger closes, as it depends on several variables, including final adjustments to the agreed purchase price, and the quoted market price of AeroCentury Common Stock on the Merger closing date. While consent todate and the total difference between the accrued aggregate Contract Fees for the period between April 2018 and the Merger AgreementClosing, and the expenses paid by the Company to JMC under the waiver and reimbursement agreement, as discussed in Results of Operations. In December 2017, the Company obtained the consent of the Credit Facility lenders is a condition to consummation of the Merger, underand modifications to the Merger Agreement, once the Merger is consummated, because of the recognition of such settlement loss, the Company will likely need to obtain waivers or modifications of certain covenants from its Credit Facility lenders for post-Merger periods in order to avoidprevent certain expense items arising from the Merger causing a default under certain Credit Facility agreement financial covenants. There is no assurance that the Company will be able to obtain such waivers from its Credit Facility lenders and the failure to obtain such waivers may result in the inability of the Company to borrow any additional amounts under the Credit Facility and/oragreement covenants. The modifications impose a limit on the accelerated maturityamount of all amounts currently owingsettlement loss and merger costs that will be disregarded for covenant purposes, but the Company believes that they are sufficient to avoid these from causing a default under the Credit Facility.Facility financial covenants.
• Assumption of Expenses Covered under Management Agreement.Agreement; Interim Waiver of Management Fee. Under the Management Agreement, the Company pays a management fee to JMC based upon the book value of the Company's aircraft assets, an acquisition fee for each asset purchased by the Company, and a remarketing/re-lease fee for each sale or re-lease transaction entered into with respect to the Company's aircraft. In return, JMC provides the Company with comprehensive management services, under which JMC has full responsibility for payment of all employee salaries and benefits, outside technical services, worldwide travel needed to promote the Company's business, office space, utilities, IT and communications, furniture and fixtures, and other general administrative and overhead costs. Under the Management Agreement, if the fees collected are not enough to cover JMC's expenses in managing the Company's portfolio, such losses are borne entirely by JMC.
In April 2018, subsequent to the execution of the Merger Agreement for the acquisition of JHC, JHC agreed to waive its right to receive management and acquisition fees ("Contract Fees") otherwise owed by the Company to JHC pursuant to the Management Agreement for all periods after March 31, 2018 and until the earlier of the consummation of the Merger or August 15, 2018. In return, the Company agreed to reimburse JMC for expenses ("Management Expense") incurred in providing management services set forth under the Management Agreement. In July 2018, JHC agreed to extend the expiration of this agreement (the "Waiver and Reimbursement Agreement") through October 15, 2018. Thus, if the Merger Agreement is terminated on or before October 15, 2018 or the Merger otherwise does not close by October 15, 2018, the Company would become obligated to JMC pay any excess (the "JMC Margin") of (i) the Contract Fees that would have been paid to JMC since April 1, 2018 in the absence of the Waiver and Reimbursement Agreement over (ii) the Management Expenses actually paid by the Company to JMC since April 1, 2018. For the quarter and six months ended June 30, 2018, contractual fees exceeded the reimbursed management fees by $497,200 of management fees and $494,400 of acquisition fees. Notwithstanding the Waiver and Reimbursement Agreement, until the closing or termination of the Merger Agreement, the Company will accrue as an expense the total Contract Fees that would have been due under the Management Agreement. If the Merger closes on or before October 15, 2018, the Waiver and Reimbursement Agreement for the period beginning on April 1, 2018, and ending on the consummation of the Merger will be considered in the acquisition accounting for the calculation of the settlement loss recognized by the Company when the Merger is consummated.
In any event, if and when the Merger closes, the financial arrangement created by the waiver and reimbursement agreement will become permanent, as the third-party outside management structure will be eliminated by the Merger. As a result, the Company's expenses in connection with management of its assets will be solely the Company's liability, and will no longer be limited to the amount of the management fee, as was the case under the third party management structure with JMC. Consequently, the risk of any unexpected post-Merger cost overruns or unanticipated expenses in asset management will be borne solely by the Company and no longer shifted to a third party management company.
• AeroCentury's Management Will Become Internalized. If the Merger is consummated, then the obligation to pay JMC management feesJHC will cease, but the costs previously borne by JMC in managing the Company's assets will be borne bybecome a wholly-owned subsidiary of the Company and sole responsibility for management of the combined company will notfall upon its management. If the Company is dissatisfied with management services following consummation of the Merger, the Company would have to address the shortcomings internally, and if they cannot be limited, as wasresolved with the case whenexisting management and personnel, the Management Agreement wasCompany may be required to reorganize its management structure and replace personnel or seek new third party management services, either of which could result in place.the Company incurring significant expense and use of resources.
• Assumption of JHC Liabilities. By acquiring JHC in a reverse triangular merger, JHC will become a wholly-owned subsidiary of the Company. To the extent that JHC or any of its subsidiaries have liabilities, these will become liabilities of the Company on a consolidated basis. While the Merger Agreement provides for limited indemnification by JHC shareholders for certain liabilities of JHC or its subsidiaries that arise from pre-Merger occurrences, and the Company has performed due diligence reviews of the liabilities of JHC and its subsidiaries, the indemnification is limited to the consideration paid by the Company to JHC.
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Credit Facility Debt Limitations. The amount available to be borrowed under the Credit Facility is limited by asset-specific advance rates. Lease arrearages or off-lease periods for a particular asset that is collateral under the Credit Facility may reduce the loan advance rate permitted with respect to that asset and, therefore, reduce the permitted borrowing under the facility or require repayments. Amounts subject to payment deferral agreements also reduce the amount of permitted borrowing. The Company believes it will have sufficient borrowing availability under the Credit Facility to meet its anticipated capital needs in the near term in spite of these limitations and it will have sufficient cash funds to make any required principal repayment that arises due to any such borrowing limitations, but actual cash levels could deviate from these assumptions.
Ownership Risks. The Company's leases typically are for a period shorter than the entire, anticipated, remaining useful life of the leased assets. As a result, the Company's recovery of its investment and realization of its expected yield in such a leased asset is dependent upon the Company's ability to profitably re-lease or sell the asset following the expiration of the lease. This ability is affected by worldwide economic conditions, general aircraft market conditions, regulatory changes, changes in the supply or cost of aircraft equipment, and technological developments that may cause the asset to become obsolete. If the Company is unable to remarket its assets on favorable terms when the leases for such assets expire, the Company's financial condition, cash flow, ability to service debt, and results of operations could be adversely affected.
The Company typically acquires used aircraft equipment. The market for used aircraft equipment has been cyclical, and generally reflects economic conditions and the strength of the travel and transportation industry. The demand for and value of many types of used aircraft in the recent past has been depressed by such factors as airline financial difficulties, airline consolidations, the number of new aircraft on order, an excess supply of newly manufactured aircraft or used aircraft coming off lease, as well as introduction of new aircraft models and types that may be more technologically advanced, more fuel efficient and/or less costly to maintain and operate. Values may also increase or decrease for certain aircraft types that become more or less desirable based on market conditions and changing airline capacity. Because the Company's ability to borrow under its credit facility is subject to a covenant setting forth a minimuman upper limit on the ratio of (i) the outstanding debt under the facility to (ii) the appraised value of the collateral base of aircraft assets securing the credit facility, a significant drop in the appraised market value of the portfolio could require the Company to make a substantial prepayment of outstanding principal under the credit facility in order to avoid a default under the credit facility.facility and limit the utility of the credit facility as a source of future funding.
In addition, a successful investment in an asset subject to aan operating lease depends in part upon having the asset returned by the lessee in the condition as required under the lease. Each operating lease typically obligates a customer to return an asset to the Company in a specified condition, generally in equal a condition that will allow the aircraft to be readily re-leased to a new lessee, and/or better condition than at delivery to the lessee.pay an economic settlement for redelivery that is not in compliance with such specified conditions. The Company strives to ensure this result through onsite management during the return process. However, if the lessee were to become insolvent during the term of its lease and the Company had to repossess the asset, it is unlikely that the lessee would have the financial ability to meet these return obligations. In addition, if the lessee filed for bankruptcy and rejected the aircraft lease, the lessee would be required to return the aircraft but would be relieved from further lease obligations, including return conditions specified in the lease. In either case, it is likely that the Company would be required to expend funds in excess of any maintenance reserves collected to return the asset to a remarketable condition.
Several of the Company's leases with financially strong lessees do not require payment of monthly maintenance reserves, which serve as the lessee's advance payment for its future repair and maintenance obligations. If repossession due to lessee default or bankruptcy occurred under such a lease, the Company would be left with the costs of unperformed repair and maintenance under the applicable lease and the Company would likely incur an unanticipated expense in order to re-lease or sell the asset.
Furthermore, the occurrence of unexpected adverse changes that impact the Company's estimates of expected cash flows generated from an asset could result in an asset impairment charge against the Company's earnings. The Company periodically reviews long-term assets for impairment, particularly when events or changes in circumstances indicate the carrying value of an asset may not be recoverable. An impairment charge is recorded when the carrying amount of an asset is estimated to be not recoverable and exceeds its fair value. The Company recorded impairment charges for some of its aircraft in 20152016 and 2016,2017, and may be required to record asset impairment charges in the future as a result of a prolonged weak economic environment, challenging market conditions in the airline industry, events related to particular lessees, assets or asset types or other factors affecting the value of aircraft or engines.
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Interest Rate Risk. The Credit Facility carries a floating interest rate based upon short-term interest rate indices. Lease rates typically, but not always, move over time with interest rates, but market demand and numerous other asset-specific factors also affect lease rates. Because the Company's typical lease rates are fixed at lease origination, interest rate changes during the lease term have no effect on existing lease rental payments. Therefore, if interest rates rise significantly and there is relatively little lease origination by the Company following such rate increases, the Company could experience decreased net income as additional interest expense outpaces revenue growth. Further, even if significant lease origination occurs following such rate increases, other contemporaneous aircraft market forces may result in lower or flat rental rates, thereby decreasing net income.
Lessee Credit Risk. The Company carefully evaluates the credit risk of each customer and attempts to obtain a third party guaranty, letters of credit or other credit enhancements, if it deems them necessary, in addition to customary security deposits. There can be no assurance, however, that such enhancements will be available, or that, if obtained, will fully protect the Company from losses resulting from a lessee default or bankruptcy.
If a lessee that is a certified U.S. airline were in default under a lease and sought protection under Chapter 11 of the United States Bankruptcy Code, Section 1110 of the Bankruptcy Code would automatically prevent the Company from exercising any remedies against such lessee for a period of 60 days. After the 60-day period had passed, the lessee would have to agree to perform the lease obligations and cure any defaults, or the Company would have the right to repossess the equipment. However, this procedure under the Bankruptcy Code has been subject to significant litigation, and it is possible that the Company's enforcement rights would be further adversely affected by a bankruptcy filing by a defaulting lessee.
Lessees located in low-growth or no-growth areas of the world carry heightened risk of an unanticipated lessee default. The Company has had customers that have experienced significant financial difficulties, become insolvent, or have been declared or have filed for bankruptcy.entered bankruptcy proceedings. An insolvency or bankruptcy of a customer usually results in a total loss of the receivables from that customer, as well as the Company incurring additional costs in order to repossess and, in some cases, repair the aircraft. The Company closely monitors the performance of all of its lessees and its risk exposure to any lessee that may be facing financial difficulties, in order to guide decisions with respect to such lessee that would mitigate losses in the event the lessee is unable to meet or rejects its lease obligations. There can be no assurance that additional customers will not become insolvent or file for bankruptcy or that the Company will be able to mitigate any of the resultant losses.
It is possible that the Company may enter into deferral agreements for overdue lessee obligations. When a customer requests a deferral of lease obligations, the Company evaluates the lessee's financial plan, the likelihood that the lessee can remain a viable carrier, and whether the deferral will be repaid according to the agreed schedule. The Company may elect to record the deferred rent and reserves payments from the lessee on a cash basis, which could have a material effect on the Company's financial results in the applicable periods. Deferral agreements with lessees also reduce the Company's borrowing capacity under its Credit Facility.
Concentration of Lessees and Aircraft Type. For the month ended June 30, 2018, the Company's four largest customers accounted for a total of approximately 77% of the Company's monthly operating lease revenue. A lease default by or collection problem with one or a combination of any of these significant customers could have a disproportionate negative impact on the Company's financial results and borrowing base under the Credit Facility, and, therefore, the Company's operating results are especially sensitive to any negative developments with respect to these customers in terms of lease compliance or collection. In addition, if the Company's revenues become overly concentrated in a small number of lessees, the Company could fail to comply with certain financial covenants in its Credit Facility related to customer concentration. In the event of any non-compliance that is not cured in the time permitted under the Credit Facility, the Company would need to seek waivers or amendment of the applicable covenants if such compliance failure is not timely cured. Any default under the Credit Facility, if not cured in the time permitted under the Credit Facility or waived by the lenders, could result in foreclosure upon any or all of the assets of the Company.
The Company's aircraft portfolio is currently focused on a small number of aircraft types and models compared to the variety of aircraft used in the commercial air carrier market. A change in the desirability and availability of any of the particular types and models of aircraft owned by the Company could affect valuations and future rental revenues of such aircraft, and would have a disproportionately significant impact on the Company's portfolio value. In addition, the Company is dependent on the third-party companies that manufacture and provide service for the aircraft types in the Company's portfolio. The Company has no control over these companies, and they could decide to curtail or discontinue production of or service for these aircraft types at any time or significantly increase their costs, which could negatively impact the Company's prospects and performance. These effects would diminish if the Company acquires assets of other types. Conversely, acquisition of additional aircraft of types currently owned by the Company will increase the Company's risks related to its concentration of those aircraft types.
Competition. The aircraft leasing industry is highly competitive. The Company competes with aircraft manufacturers, distributors, airlines and aircraft operators, equipment managers, leasing companies, equipment leasing programs, financial institutions and other parties engaged in leasing, managing or remarketing aircraft, many of which have significantly greater financial resources. Competition in the Company's market niche of regional aircraft, however, has increased significantly recently as a result of new entrants to the acquisition and leasing market and consolidation of certain competitors. As competition increases, it has and will likely continue to create upward pressure on acquisition prices for many of the aircraft types that the Company has targeted to buy and, at the same time, create downward pressure on lease rates, resulting in lower margins for the Company and, therefore, fewer acceptable acquisition opportunities for the Company.
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Risks Related to Regional Air Carriers. The Company's continued focus on its customer base of regional air carriers subjects the Company to additional risks. Many regional airlines rely heavily or even exclusively on a code-share or other contractual relationship with a major carrier for revenue, and can face financial difficulty or failure if the major carrier terminates the relationship or if the major carrier files for bankruptcy or becomes insolvent. Some regional carriers may depend on contractual arrangements with industrial customers such as mining or oil companies, or franchises from governmental agencies that provide subsidies for operating essential air routes, which may be subject to termination or cancellation on short notice. Furthermore, many lessees in the regional air carrier market are start-up, low-capital, and/or low-margin operators. A current concern for regional air carriers is the supply of qualified pilots. Due to recently imposed FAA regulations requiring a higher minimum number of hours to qualify as a commercial passenger pilot, many regional airlines have had difficulty meeting their business plans for expansion. This could in turn affect demand for aircraft and the Company's business.
General Economic Conditions and Lowered Demand for Travel. While the United States economy has seen substantial improvement since its most recent global recession, not all global regions are experiencing growth, and some remain in recession. The Company does not anticipate any worsening of the financial condition of its overall customer base, but believes that there may be further shakeouts of weaker carriers in economically troubled regions. Any such shakeouts or any continued or new economic recession or downturn in the regions in which the Company's lessees operate could negatively impact the financial condition and viability of certain of the Company's customers and, in turn, the Company's performance.
A growing concern arises from the fact that much of the recent growth in demand for regional aircraft in developing countries has arisen from mining or other resource extraction operations by Chinese enterprises in these countries. A future, sustained major downturn in the Chinese domestic economy that reduces demand for imported raw materials could have a significant negative impact on the demand for business and regional aircraft in these developing countries, including in some of the markets in which the Company does, or seeks to do, business.
Furthermore, any further upheavals due to instability in Europe due to newly imposed U.S. sanctions against Russia, and the Russian and European reaction to such sanctions, or due to other factors, could have a negative impact on intra-European carriers with which the Company does business. Also, Brexit and any further departures from the European Union ("EU") could threaten "open-sky" policies under which EU based carriers operate freely within the EU. Losing open-sky flight rights could have a significant negative impact on the health of the Company's European lessees and, as a result, the financial performance and condition of the Company.
If international conflicts erupt into military hostilities, heightened visa requirements make international travel more difficult, or terrorist attacks involving aircraft or airports occur, or a major flu outbreak occurs, passengers may avoid air travel altogether, and global air travel worldwide could be significantly affected. This would have an adverse impact on many of the Company's customers.
Airline reductions in capacity in response to lower passenger loads can result in reduced demand for aircraft and aircraft engines and a corresponding decrease in market lease rental rates and aircraft values. This reduced market value could affect the Company's results if the market value of an asset or assets in the Company's portfolio falls below carrying value, and the Company determines that a write-down of the value on its balance sheet is appropriate. Furthermore, if older, expiring leases are replaced with leases at decreased lease rates, the lease revenue from the Company's existing portfolio is likely to decline, with the magnitude of the decline dependent on the length of the downturn and the depth of the decline in market rents.
Economic downturns can affect certain regions of the world more than others. As the Company's portfolio is not entirely globally diversified, a localized downturn in one of the key regions in which the Company leases assets could have a significant adverse impact on the Company. The Company's significant sources of operating lease revenue by region are summarized in "Outlook - Operating Segments,"Fleet Summary – Assets Held for Lease, above.
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International Risks. The Company leases assets in overseas markets. Leases with foreign lessees, however, may present different risks than those with domestic lessees. Most of the Company's expected growth is outside of North America.
A lease with a foreign lessee is subject to risks related to the economy of the country or region in which such lessee is located, which may be weaker than the U.S. economy. An economic downturn in a particular country or region may impact a foreign lessee's ability to make lease payments, even if the U.S. and other foreign economies remain stable.
Foreign lessees are subject to risks related to currency conversion fluctuations. Although the Company's current leases are allThe Company currently has one customer with rent obligations payable in U.S. dollars,Euros, and the Company may, from time to time, agree in the future to additional leases that permit payment in foreign currency, which would subject such lease revenue to monetary risk due to currency fluctuations. During the periods covered by this report, the Company considers the estimated effect on its revenues of foreign currency exchange rate fluctuations to be immaterial; however, the impact of these fluctuations may increase in future periods if additional rent obligations become payable in foreign currencies.
Even with U.S. dollar-denominated lease payment provisions, the Company could still be affected by a devaluation of the lessee's local currency and a stronger U.S. dollar that would make it more difficult for a lessee to meet its U.S. dollar-denominated payments, increasing the risk of default of that lessee, particularly if its revenue is primarily derived in the local currency.
Foreign lessees that operate internationally may also face restrictions on repatriating foreign revenue to their home country. This could create a cash flow crisis for an otherwise profitable carrier, affecting its ability to meet its lease obligations. Foreign lessees may also face restrictions on payment of obligations to foreign vendors, including the Company, which may affect their ability to timely meet lease obligations to the Company.
Foreign lessees are not subject to U.S. bankruptcy laws, although there may be debtor protection similar to U.S. bankruptcy laws available in some jurisdictions. Certain countries do not have a central registration or recording system which can be used to locally record the Company's interest in equipment and related leases. This could make it more difficult for the Company to recover an aircraft in the event of a default by a foreign lessee. In any event, collection and enforcement may be more difficult and complicated in foreign countries.
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Investment in New Aircraft Types. The Company intends to continue to focus solely on regional aircraft. Although the Company has traditionally invested in a limited number of types of turboprop aircraft types in the past, including two in its most recently completed quarter, the Company has also acquired several types of regional jet aircraft types, which now comprise a larger percentage of the Company's portfolio based on number of aircraft and net book value. The Company may continue to seek acquisition opportunities for new types and models of aircraft used in the Company's targeted customer base of regional air carriers. Acquisition of aircraft types not previously acquired by the Company entails greater ownership risk due to the Company's lack of experience managing those assets. The Company believes, however, that theits overall industry expertise of JMC's personnel and its technical resources shouldmay permit the Company to effectively manage such new aircraft types. Further, the broadening of the asset types in the aircraft portfolio may have a benefit of diversifying the Company's portfolio (see "FactorsFactors That May Affect Future Results and Liquidity – Concentration of Lessees and Aircraft Type", above).
Reliance on JMC. All management of the Company is currently performed by JMC under a Management Agreement between the Company and JMC that expires in August of 2025 and provides for an asset-based management fee. JMC is not a fiduciary of the Company or its stockholders. The Company's board of directors (the "Board") has ultimate control and supervisory responsibility over all aspects of the Company and owes fiduciary duties to the Company and its stockholders. The Board has no control over the internal operations of JMC, but the Board does have the ability and responsibility to manage the Company's relationship with JMC and the performance of JMC's obligations to the Company under the Management Agreement, as it would have for any third-party service provider to the Company. While JMC may not owe any fiduciary duties to the Company by virtue of the Management Agreement, all of the officers of JMC are also officers of the Company, and, in that capacity, owe fiduciary duties to the Company and its stockholders. In addition, an officer of the Company holds significant ownership positions in the Company and JHC, the parent company of JMC, and JHC is the Company's largest shareholder. Therefore, the economic interests of the Company should be aligned with the interests of JHC and JMC, and JMC should have substantial incentive to make financial decisions as the management company for the Company that are in the best interests of the Company. These assumptions, however, could prove to be incorrect, in which case JMC may act in a manner that is in its interest but is not in the interest of the Company or its stockholders.
The Management Agreement may be terminated if JMC defaults on its obligations to the Company. However, the agreement provides for liquidated damages in the event of its wrongful termination by the Company. A director of the Company is also a director of JMC and, as discussed above, the officers of the Company are also officers of JMC, and one such officer holds significant ownership positions in both the Company and JHC, the holding company for JMC. Consequently, the director and officers of JMC may have a conflict of interest in the event of a dispute between the Company and JMC. Although the Company has taken steps to prevent conflicts of interest arising from such dual roles, such conflicts may still occur.
Management Fee Structure. All decisions regarding acquisitions and disposal of aircraft from the Company's portfolio are currently made by JMC. JMC is paid a management fee based on the net asset value of the Company's portfolio. It may also receive a one-time asset acquisition fee upon purchase of an asset by the Company, and a one-time remarketing fee in connection with the sale or re-lease of an asset. Optimization of the results of the Company depends on timing of the acquisition, lease yield on the acquired assets, and re-lease or sale of its portfolio assets. Under the current management fee structure, a larger volume of acquisitions generates acquisition fees and also increases the periodic management fee by increasing the size of the aircraft portfolio. Since the Company's current business strategy involves continued growth of its portfolio, with the intention to buy and hold assets until the appropriate time to sell them, a compensation structure that results in greater compensation with an increased portfolio size is consistent with that strategy. The compensation structure does, nonetheless, create a situation where a decision by JMC for the Company to forego an asset transaction deemed to be an unacceptable business risk due to the lessee or the aircraft type or other factors is in conflict with JMC's own short-term pecuniary interest. As a result, the compensation structure could act to incent greater risk-taking by JMC in asset acquisition decision-making. However, because JMC's sole business and source of revenue arises from and is expected to continue arising from acting as the management company for the Company, the long-term financial health and viability of the Company are important to JMC's own long-term health and viability. Therefore, in assessing risk-taking in the Company's acquisition transactions, JMC's and the Company's motivations are closely aligned, as JMC is incented to make asset acquisitions that are expected to contribute to the long-term viability of the Company. In addition, the Company has established objective target guidelines for yields on acquired assets and the Company's Board, including a majority of the outside independent directors, must approve any acquisition that involves a new asset type. While the Company currently believes the foregoing are effective mitigating factors against undue compensation-incented risk-taking by JMC, there iscan be no assurance that such mechanisms can entirely and effectively eliminate such risk.
Government Regulation. There are a number of areas in which government regulation may result in costs to the Company. These include aircraft registration safety requirements, required equipment modifications, maximum aircraft age, and aircraft noise requirements. Although it is contemplated that the burden and cost of complying with such requirements will fall primarily upon lessees, there can be no assurance that the cost will not fall on the Company. Furthermore, future government regulations could cause the value of any non-complying equipment owned by the Company to decline substantially. Moreover, any failure by the Company to comply with the government regulations applicable to it could result in sanctions, fines or other penalties, which could harm the Company's reputation and performance.
Casualties, Insurance Coverage. The Company, as an owner of transportation equipment, may be named in a suit claiming damages for injuries or damage to property caused by its assets. As a triple-net lessor, the Company is generally protected against such claims, since the lessee would be responsible for, insure against and indemnify the Company for such claims. A "triple net lease" is a lease under which, in addition to monthly rental payments, the lessee is generally responsible for the taxes, insurance and maintenance and repair of the aircraft arising from the use and operation of the aircraft during the term of the lease. Although the United States Aviation Act may provide some protection with respect to the Company's aircraft assets, it is unclear to what extent such statutory protection would be available to the Company with respect to its assets that are operated in foreign countries where such provisions of the United States Aviation Act may not apply.
The Company's leases generally require a lessee to insure against likely risks of loss or damage to the leased asset, and liability to passengers and third parties pursuant to industry standard insurance policies and require lessees to provide insurance certificates documenting the policy periods and coverage amounts. The Company tracks receipt of the certificates and calendars their expiration dates. Prior to the expiration of an insurance certificate, if a replacement certificate has not been received, the Company reminds the lessee of its obligation to provide current insurance certificates to avoid a default under the lease.
Despite these requirements and procedures, there may be certain cases where the loss is not entirely covered by the lessee or its insurance. The Company believes the possibility of such an event is remote, but any such uninsured loss with respect to the equipment or insured loss for which insurance proceeds are inadequate might result in a loss of invested capital in and any profits anticipated from, such equipment, as well as a potential claim directly against the Company.
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Compliance with Future Environmental Regulations. Compliance with future environmental regulations may harm the Company's business. Many aspects of aircraft operations are subject to increasingly stringent environmental regulations, and growing concerns about climate change may result in the imposition by the U.S and foreign governments of additional regulation of carbon emissions, aimed at either requiring adoption of technology to reduce the amount of carbon emissions or putting in place a fee or tax system on carbon emitters. It is likely that any such regulation will be directed at the Company's customers, as operators of aircraft, or at the Company, as ownersowner of aircraft. Under the Company's triple-net lease arrangements, the Company would likely shift responsibility for compliance to its lessees, but there might be some costs of regulationcomplying with these regulations that the Company could not shift and would itself have to bear. Although it is not expected that the costs of complying with current environmental regulations will have a material adverse effect on the Company's financial position, results of operations, or cash flows, no assurance can be given that the costs of complying with environmental regulations adopted in the future will not have such an effect.
Cyber-Security Risks. The Company believes that its main vulnerability to a cyber-attack would be interruption of the Company's email communications internally and with third parties, loss of customer and lease archives, and loss of document sharing between the Company's offices and remote workers. Such an attack could temporarily impede the efficiency of the Company's operations; however, the Company believes that sufficient replacement and backup mechanisms exist in the event of such an interruption such that there would not be a material adverse financial impact on the Company's business. A cyber-hacker could also gain access to and release proprietary information of the Company, its customers, suppliers and employees stored on the Company's data network. Such a breach could harm the Company's reputation and result in competitive disadvantages, litigation, lost revenues, additional costs, or liability to third parties. While the Company believes that it has sufficient cyber-security measures in place commensurate with the risks to the Company of a successful cyber-attack or breach of its data security, its resources and technical sophistication may not be adequate to prevent all types of cyber-attacks.
Possible Volatility of Stock Price. The market price of the Company's common stock is subject to fluctuations following developments relating to the Company's operating results, changes in general conditions in the economy, the financial markets, the airline industry, changes in accounting principles or tax laws applicable to the Company or its lessees, or other developments affecting the Company, its customers or its competitors, or arising from other investor sentiment unknown to the Company. Because the Company has a relatively small capitalization of approximately 1.4 million shares outstanding, there is a correspondingly limited amount of trading and float of the Company's shares. Consequently, the Company's stock price is more sensitive to a single large trade or a small number of simultaneous trades along the same trend than a company with larger capitalization and higher trading volume and float. This stock price and trading volume volatility could limit the Company's ability to use its capital stock to raise capital, if and when needed or desired, or as consideration for other types of transactions, including strategic collaborations, investments or acquisitions. Any such limitation could negatively affect the Company's performance and liquidity.
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Item 3.Quantitative and Qualitative Disclosures About Market Risk.
This report does not include information described under Item 305 of Regulation S-K pursuant to the rules of the Securities and Exchange Commission that permit "smaller reporting companies" to omit such information.
Item 4. Controls and Procedures.
CEO and CFO Certifications.Attached as exhibits to this Quarterly Report on Form 10-Q (the "Report"“Report”) are certifications of the Company'sCompany’s Chief Executive Officer (the "CEO"“CEO”) and the Company'sCompany’s Chief Financial Officer (the "CFO"Officer(the “CFO”), which are required pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (the "Section“Section 302 Certifications"Certifications”). This section of the Report includes information concerning the evaluation of disclosure controls and procedures referred to in the Section 302 Certifications and this should be read in conjunction with the Section 302 Certifications for a more complete understanding of the topics presented.
Evaluation of the Company'sCompany’s Disclosure Controls and Procedures.Disclosure controls and procedures ("(“Disclosure Controls"Controls”) are controls and other procedures that are designed to ensure that information required to be disclosed in the Company'sCompany’s reports filed or submitted under the Securities Exchange Act of 1934, such as this Report, is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission and that such information is accumulated and communicated to the Company'sCompany’s management, including the CEO and CFO, as appropriate, to allow timely decisions regarding required disclosure.
In the course of the review of the consolidated financial results of the Company for the three months and six months ended June 30, 2018, we identified a material weakness in our internal control over financial reporting at June 30, 2018 related to the Company’s incorrect accounting for management fees and acquisition fees associated with the management agreement between JetFleet Holding Corp (“JHC”) and the Company.
Management has determined that this deficiency constitutes a material weakness as of June 30, 2018. Management is in the process of conducting the controls related to the acquisition accounting over the JHC Merger as the transaction has not been consummated and therefore the control has not been finalized. Management believes that it will operate effectively once the Merger is finalized and the material weakness relating to the recognition of expenses subject to the Waiver Agreement is included in management’s internal controls over the final acquisition accounting in future periods.
The Company'sCompany’s management, with the participation of the CEO and CFO, evaluated the effectiveness of the design and operation of the Company'sCompany’s Disclosure Controls and concluded that the Company'sCompany’s Disclosure Controls were not effective as of SeptemberJune 30, 2017.2018 due to the material weakness described above.
Changes in Internal Control Over Financial Reporting. NoExcept for the material weakness note above, no change in the Company'sCompany’s internal control over financial reporting occurred during the fiscal quarter ended SeptemberJune 30, 20172018 that has materially affected, or is reasonably likely to materially affect, the Company'sCompany’s internal control over financial reporting.
Inherent Limitations of Disclosure Controls and Internal Control Over Financial Reporting. In designing its Disclosure Controls and internal control over financial reporting, the Company’s management recognizes that any controls and procedures, no matter how well-designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of the Company’s controls and procedures must reflect the fact that there are resource constraints, and management necessarily applies its judgment in evaluating the benefits of possible controls and procedures relative to their costs. Because of these inherent limitations, the Company’s Disclosure Controls and internal control over financial reporting may not prevent or detect all instances of fraud, misstatements or other control issues. In addition, projections of any evaluation of the effectiveness of disclosure or internal controls to future periods are subject to risks, including, among others, that controls may become inadequate because of changes in conditions or that compliance with policies or procedures may deteriorate.
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PART II
OTHER INFORMATION
Item 6. Exhibits
Exhibit Number | Description |
| 31.1 | Certification of Michael G. Magnusson, |
| 31.2 | Certification of Toni M. Perazzo, |
| 32.1* | Certification of Michael G. Magnusson, |
| 32.2* | Certification of Toni M. Perazzo, Section 906 of the Sarbanes-Oxley Act of 2002 |
| 101.INS | XBRL Instance Document |
| 101.SCH | XBRL Schema Document |
| 101.CAL | XBRL Calculation Linkbase Document |
| 101.LAB | XBRL Label Linkbase Document |
| 101.PRE | XBRL Presentation Linkbase Document |
| 101.DEF | XBRL Definition Linkbase Document |
* These certificates are furnished to, but shall not be deemed to be filed with, the Securities and Exchange Commission.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
| AEROCENTURY CORP. | ||
| Date: | By: | /s/ Toni M. Perazzo |
| Name: Toni M. Perazzo | ||
| Title: Senior Vice President-Finance and | ||
| Chief Financial Officer | ||
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