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When's the last time you flew somewhere? Yesterday, last week, last month? After you settled into your seat, buckled up, checked for the nearest emergency exit, and determined what movie was being shown, did you also inquire as to whether the aircraft you were sitting on was owned outright by the airline or was instead under lease from a third party?

Probably not, but if you're interested in business processes and the management and financing of capital equipment, the buy-versus-lease question related to the aircraft you were sitting on would have made for a pretty fascinating conversation. So, let's imagine that you happen to have a seat on your flight that's right next to the CEO of the airline itself – in first class, of course. What could you learn?

First off, if you yourself are in the semiconductor business, you would find you have a lot in common with the folks who run airlines. The airline business is a tricky one; there's lots of money to be made and lots of money to be lost as well. It's an industry with a high barrier for entry with facilities and equipment that are costly to own and operate, and it's an industry that needs lots of customer traffic to stay viable – characteristics that the airline business most definitely shares with the semiconductor business.

As your discussion with the CEO unfolds, you learn that the decision to buy or lease an aircraft is a pivotal one with a potentially profound impact on the long-term success of an airline. This issue you understand, because the financing of capital equipment for semiconductor manufacturing has a profound impact on success or failure for chipmakers as well. You want to discuss these things further, but before the conversation drills down into the details of financing options, you ask something you've always wanted to know.

Two wings and a fuselage

You admit that you don't really know how much an aircraft actually costs. Your CEO companion tells you that it's not billions, but you're definitely talking millions when it comes to the price tag for two wings, some engines, and a fuselage. For a narrow-body aircraft these days, the prices range from $35 million to $45 million – sometimes even $50 million. But for the larger, wide-body aircraft, prices start at around $80 million and go up from there, sometimes to as much as $120 million.

No matter the size of the aircraft, however, the CEO tells you that there are always expenses associated with outfitting the plane – tenant upgrades, if you will. The aircraft needs seats, in-flight entertainment systems, a galley, and other on-board features installed in order to make it a fully operational commercial vehicle. Those costs are born by the airline no matter who owns the aircraft and run in the neighborhood of $2 million to $3 million per aircraft. Not big numbers in comparison to the tens of millions for the aircraft itself, but large nonetheless.

On rare occasions, those costs are bundled into the debt or lease financing, but that would be the exception not the rule according to your new friend, the CEO. Usually seats, entertainment systems, and so forth are expensed by an airline. They belong to the airline, not to the aircraft, and are reflected in the costs of doing business. If a newer aircraft is brought on-line and an older aircraft swapped out, on-board equipment from the old aircraft can be installed on the newer vehicle and the lifetime of those materials extended. The airline owns that equipment, even if they don't own the aircraft it's sitting on.

You tell the CEO that there are comparable circumstances with regards to expensed equipment in the semiconductor industry. Then you work to get the discussion back around to capital equipment, and the decision-making process involved in whether the aircraft you're riding in is acquired or leased.

Frequent flier miles

The CEO leans back, takes a look out the window briefly, and continues. Whether you decide to buy or lease, you need to determine first if you need a new aircraft or if you should be considering used equipment instead. To answer that question, an airline needs to look at anticipated levels of utilization – what's the mission for the aircraft? Will it be flying shorter routes or longer routes? Is the aircraft going to be flown 3000 hours a year, or closer to 5000 hours?

The utilization issues have to be examined and understood, because there's a crossover point in these metrics that drives the decision whether to go with a new aircraft or used. When utilization is very high – in hours or miles – you may need to go with new equipment. Used equipment, if highly utilized, may present servicing requirements that reduce or eliminate any cost savings associated with the lower purchase or leasing price of re-marketed aircraft. Highly utilized equipment probably needs to be new equipment.

You tell the CEO that there's a comparable situation with regards to semiconductor equipment. Equipment in a semiconductor fab that's being used to make next-generation products with on-chip features sizes at 90 or 65-nanometers probably is probably new and frequently custom-built. Older equipment is usually earmarked for semiconductor manufacturers meeting the demands of customers involved in more mature technologies. There's certainly a place and a market for older equipment in the industry, but not if you're addressing the needs of cutting-edge customers – the "high-end utilization" players in your customer base.

At this point, you decide not to ask your traveling companion if the plane you're buckled into was new or used when it was brought into the airline's fleet. You'd rather not know, even if he does. You turn instead and ask in greater detail about leasing.

The flight plan

The CEO agrees to talk about leasing. To frame those comments, he first talks about buying. He says there are plusses and minuses to buying an aircraft. From an accounting point of view, equipment that's owned can either be capitalized – it's an asset on the balance sheet that can depreciated over time – or the equipment can be expensed. Each and every company establishes a policy such that below a certain cost threshold, equipment is expensed. About that threshold, equipment's capitalized and therefore a candidate for depreciation.

As the CEO has explained to you already, the equipment on-board the aircraft is usually expensed; the aircraft itself is capitalized. Therefore, buying an aircraft gives the airline the opportunity to depreciate that piece of equipment. This can be very important from an accounting and tax standpoint, not to mention the fact that ownership also gives you total control over the life cycle of the equipment. When you're ready to trade up, if there's resale value to the equipment – and with aircraft, there almost always is – the airline has access to the cash-back advantages of selling their used equipment into a secondary market.

Ultimately you're told, it comes down to strategies related to the balance sheet. Ownership of the aircraft gives the airline the ability to add that equipment to the assets of the company, to enhance the financial profile of the company by listing the aircraft in the plus column, even if there is also a companion item in the liabilities column reflecting the debt incurred in buying the aircraft in the first place. The benefits of showing the asset outweighs the downsides of the debt liability and, assuming you've got the up-front funding to enter into the purchase in the first place, owning the aircraft outright is definitely a positive move for the airline.

By now, the CEO is enjoying the role of tutor. You already know most of what you're hearing, but the storytelling is good and it's making the flight go quickly, so you continue to listen. The CEO says the pros and cons of ownership already described must be contrasted with the pros and cons of leasing.

Why does an airline lease an aircraft, rather than buy? For several reasons, you're told. Sometimes there's a desire to do off-balance-sheet financing – to take the asset and the liability off the balance sheet. Sometimes, as in the case of a start-up airline, there's insufficient cash to buy and leasing is the only choice. If a young airline is unable to come up with the down payment, the up-front capital needed to purchase a multi-million dollar aircraft, the airline has no choice but to lease.

Holding pattern

The CEO explains that if and when equipment is leased, you can structure the deal in an infinite number of ways by allocating the elements of ownership between the financing entity and the user of the equipment. One consideration in that structuring might include the risk of technical obsolescence. In the face of typical equipment that ages, if a lease can be structured like a rental you're probably better off. However, aircraft are not "typical" – aircraft aren't rented, they're leased even though they do become obsolete. So airlines, and the companies that lease to them, need to have a strategy to deal with that.

You tell the CEO, who may or may not be listening, that semiconductor equipment can become obsolete as well. It's also never really rented; it's purchased or sometimes it's leased, so semiconductor companies and their financing partners also have strategies to deal with those issues. The CEO continues the tutorial.

You're told that another consideration in leasing is the responsibility for maintenance and repair. Again a lease can be better than a purchase here, but that's reflected in the terms and cost of the lease. In the airline industry, the airline always shoulders the maintenance and repair costs for the aircraft. That responsibility does not fall to the leasing agent, and so the costs of upkeep add complexities to the financial landscape of aircraft leasing.

Also with leasing, the CEO continues, there are issues with regards to insuring the equipment. In the airline industry, this is not negotiable. The airline always carries the responsibility for insuring the aircraft – owned or leased – and that insurance doesn't come cheap. It can run $700,000 to $800,000 or more per aircraft per year to cover the hull, passenger liability, and acts of war. In some cases, the insurance payments can go even higher.

For instance, the CEO tells you that they once leased an aircraft that was valued at $42 million. Because of the circumstances of the anticipated utilization pattern, the leasing agent insisted that the value of the policy be bumped all the way up to $50 million. The lessor felt that the replacement value of the aircraft was above the $42 million market price, so if the CEO's airline wanted to have access to that aircraft, they had no choice but to meet the demand. A $42 million piece of capital equipment was insured for $50 million.

You tell the CEO that with respect to insurance issues in the semiconductor industry, there can be huge insurance premiums on multi-billion dollar fab facilities and the capital equipment housed inside as well. The CEO nods briefly and moves on.

With regards to leasing an aircraft, he says you also have to look closely at what happens at the end of the lease. Who's going to end up owning the aircraft at the end of its useful life?

At first glance, it's the lessor. But a lease could be structured so that the airline has a right to purchase the capital equipment at the then-going rate, so that they can then resell the equipment and have access to the capital gains. Also – perhaps the airline doesn't want to let go of the aircraft at the end of the lease. Provisions need to be in the contract to cover that eventuality as well.

You tell the CEO that's there also a market for used equipment in the semiconductor industry; financing can be structured to reflect that reality just as the CEO has suggested is true for airlines. Some companies that provide lease financing for semiconductor equipment, for instance, also act as re-marketing agents for used semiconductor equipment. As manufacturing equipment ages, it can be re-deployed via these agents to other owners in other locations who are interested in mature markets and access to capital equipment they perhaps otherwise could not afford. Again the CEO listens to you, and then moves on with his story.

Landing gear

There are tax implications with aircraft. If an aircraft spends time on the ground in a municipality, the airline frequently has to pay property taxes on that equipment. Sometimes, if the aircraft spends measurable amounts of time on the ground in two different municipalities, property taxes are incurred in both locations. Sometimes, property taxes are also incurred in the city where the airline is headquartered, whether the aircraft is on the ground there for long periods of time or not. The CEO is clearly frustrated by all of this.

You respond with concerns from the semiconductor industry. Those manufacturers who operate outside of North America complain about a tax structure in the U.S. that makes it very unattractive to do business there. The CEO is unimpressed. He responds that at least your capital equipment isn't getting taxed in two different locations. Whatever your tax liabilities are, at least they're not transient.

The CEO now distinguishes between capitalized leases and leveraged leases with regards to aircraft capital equipment. This is a level of detail he had overlooked earlier and it has to do with depreciation. In a capitalized lease, the lessee – the airline in the CEO's case – gets access to the tax benefits of the equipment as it depreciates over time. Normally, these advantages are only associated with ownership, but there are actually lease agreements that arrange for the airline to be able to depreciate the asset.

You're happy to see that the flight is drawing to a close because the CEO now wants to tell you about operating leases. Capitalized leases and leveraged leases for aircraft are usually set at 12 to 18 years. Operating leases usually are set at 7 years. These are particularly attractive to young, cash-strapped airlines that hope to be able to re-negotiate the lease later on as their financials improve.

The downside of an operating lease has to do with the age of the aircraft involved. Older aircraft may be facing a "heavy check" 5 years into the lease – an expensive and time- consuming maintenance overhaul – and hence having to address that requirement prior to the end the 7-year operating lease is not attractive. Still, for young airlines, an operating lease is the least expensive option and usually best suited to their financial position.

Arrival time

You tell the CEO as the plane circles in for its final approach, that there are a variety of financing options – terms, lengths, and conditions – available to semiconductor equipment manufacturers as well. The decision on how to structure financing is one that's made in concert with the senior management at the manufacturing company, the investors, and the financing partner, along with input from the fab managers who understand the trade-offs between the advantages of using newer equipment and the challenges of bringing equipment operators up to speed on next-generation machinery.

You tell the airline guy that there are costs associated with swapping out older equipment in a manufacturing setting, but those costs are often unavoidable in light of the increased efficiencies and improved product yields that come with upgraded equipment. You also tell him that the semiconductor industry is very past-paced; if you don't keep moving, you may get left behind.

The CEO is listening carefully at last and as the aircraft pulls up to the gate he tells you that he's really enjoyed this conversation. He tells you that he's very impressed with your knowledge of business issues and asks if you've ever considered a career in the airline industry. He says you might have a career path there because of your grasp of the complexities related to financing capital equipment.

As you stand up to reach for your carry-on in the overhead compartment, you tell the CEO that as much as you might enjoy that opportunity, you're already pretty far along in your current career in semiconductors. You give him your business card and for the first time he realizes you're a CEO as well. He laughs, shakes his head, and tells you to look him up next time you're in town. You assure him you will. You take out your cell phone and call back to office as you walk up the ramp.

By the time you get to the luggage carousel, you're deep in conversation with your CFO. You want to review how your property tax liabilities are structured across multiple geographies.

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June 30, 2005

Peggy Aycinena owns and operates EDA Confidential. She can be reached at peggy@aycinena.com

Copyright (c) 2005, Peggy Aycinena. All rights reserved.