Military Aircraft
Observations on the Air Force's Plan to Lease Aerial Refueling Aircraft Gao ID: GAO-03-1143T September 3, 2003At 543 aircraft, the KC-135 is the mainstay of U.S. aerial refueling capability. Recapitalizing this fleet is crucial to maintaining this capability and, ultimately, maintaining the mobility of U.S. forces. In the fiscal year 2002 defense appropriations act, the Congress authorized the Air Force to lease up to 100 aerial refueling aircraft after the Air Force reported its plans to the Senate and House Armed Services Committees and Defense Appropriations Subcommittees. The Air Force sent Congress on July 10 its report containing a business case analysis of its proposed lease. The Air Force plans to lease 100 KC-767A aircraft for 6 years each from a special purpose entity (SPE) that will order the aircraft from the Boeing Company. GAO was asked to (1) summarize the Air Force's report for leasing KC-767A aircraft, (2) present its observations on the report and justification for the lease, and (3) identify related issues and costs to assist the Congress as it considers the Air Force's proposal.
The Air Force report indicates the following: (1) leasing costs more than buying by $150 million (net present value); (2) replacing the KC-135 is urgent because of aging and corrosion; (3) the Air Force will pay 89.9 percent of aircraft's fair market value--$138.4 million--complying with the Office of Management and Budget's (OMB's) requirement that the price not exceed 90 percent; and (4) the Air Force may return the planes or buy them for about $44 million per aircraft (if authorized by the Congress) at the end of the lease. GAO has the following observations about the lease report: (1) purchasing could be up to $1.9 billion cheaper (net present value), if multi-year procurement authority were granted; (2) the Air Force believes that replacement is urgent because of decreased availability, increased maintenance costs, and the risk of fleet wide grounding for the KC-135, although until recently, recapitalization had not been a high enough priority to successfully compete for funding; and (3) the lease payments comply with OMB requirements only if $7.4 million in construction financing is added to the $131 million-per-aircraft purchase price, for a total of $138.4 million per aircraft. Otherwise, the lease payments represent about 93 percent of the value of the aircraft. Other issues the Congress may wish to examine include the following: (1) Boeing will maintain the aircraft for between $5 billion and $5.7 billion during the lease period; KC-135 total operating and support costs were about $4.3 million to $4.5 million per year per aircraft in fiscal year 2002; (2) Boeing's profit is limited to 15 percent on the KC-767As compared to about 6 percent on commercial 767s, according to one financial analysis; and (3) leasing delays payments for the first 100 aircraft so acquiring 100 more tankers will significantly increase outlays in the 2012-17 time frame.
GAO-03-1143T, Military Aircraft: Observations on the Air Force's Plan to Lease Aerial Refueling Aircraft
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United States General Accounting Office:
GAO:
Testimony before the Committee on Commerce, Science, and
Transportation, United States Senate:
For Release on Delivery Expected at 2:30 p.m., EDT:
Wednesday: September 3, 2003:
MILITARY AIRCRAFT:
Observations on the Air Force's Plan to Lease Aerial Refueling
Aircraft:
Statement of Neal P. Curtin, Director:
Defense Capabilities and Management:
GAO-03-1143T:
GAO Highlights:
Highlights of GAO-03-1143T, a testimony before the Senate Committee on
Commerce, Science, and Transportation
Why GAO Did This Study:
At 543 aircraft, the KC-135 is the mainstay of U.S. aerial refueling
capability. Recapitalizing this fleet is crucial to maintaining this
capability and, ultimately, maintaining the mobility of U.S. forces.
In the fiscal year 2002 defense appropriations act, the Congress
authorized the Air Force to lease up to 100 aerial refueling aircraft
after the Air Force reported its plans to the Senate and House Armed
Services Committees and Defense Appropriations Subcommittees. The Air
Force sent Congress on July 10 its report containing a business case
analysis of its proposed lease. The Air Force plans to lease 100 KC-
767A aircraft for 6 years each from a special purpose entity (SPE)
that will order the aircraft from the Boeing Company.
GAO was asked to (1) summarize the Air Force‘s report for leasing
KC-767A aircraft, (2) present its observations on the report and
justification for the lease, and (3) identify related issues and costs
to assist the Congress as it considers the Air Force‘s proposal.
What GAO Found:
The Air Force report indicates the following:
* Leasing costs more than buying by $150 million (net present value).
* Replacing the KC-135 is urgent because of aging and corrosion.
* The Air Force will pay 89.9 percent of aircraft‘s fair market value”
$138.4 million”complying with the Office of Management and Budget‘s
(OMB‘s) requirement that the price not exceed 90 percent.
* The Air Force may return the planes or buy them for about $44
million per aircraft (if authorized by the Congress) at the end of the
lease.
GAO has the following observations about the lease report:
* Purchasing could be up to $1.9 billion cheaper (net present value),
if multi-year procurement authority were granted.
* The Air Force believes that replacement is urgent because of
decreased availability, increased maintenance costs, and the risk of
fleet wide grounding for the KC-135, although until recently,
recapitalization had not been a high enough priority to successfully
compete for funding.
* The lease payments comply with OMB requirements only if $7.4 million
in construction financing is added to the $131 million-per-aircraft
purchase price, for a total of $138.4 million per aircraft. Otherwise,
the lease payments represent about 93 percent of the value of the
aircraft.
Other issues the Congress may wish to examine include the following:
* Boeing will maintain the aircraft for between $5 billion and $5.7
billion during the lease period; KC-135 total operating and support
costs were about $4.3 million to $4.5 million per year per aircraft in
fiscal year 2002.
* Boeing‘s profit is limited to 15 percent on the KC-767As compared to
about 6 percent on commercial 767s, according to one financial
analysis.
Leasing delays payments for the first 100 aircraft so acquiring 100
more tankers will significantly increase outlays in the 2012 –17 time
frame.
www.gao.gov/cgi-bin/getrpt?GAO-03-1143T.
To view the full product, including the scope and methodology, click
on the link above. For more information, contact Neal P. Curtin, (202)
512-4914, curtinn@gao.gov.
[End of section]
Mr. Chairman and Members of the Committee:
I appreciate the opportunity to appear before you today to discuss the
Air Force's report on the planned lease of 100 Boeing 767 aircraft
modified for aerial refueling. Aerial refueling is a key capability
that is essential to the mobility of U.S. forces. Section 8159 of the
Department of Defense Appropriations Act for fiscal year 2002
authorizes the Air Force to lease up to 100 Boeing 767 aircraft; the
leased aircraft would be known by a new designation, KC-767A. The act
also requires the Air Force to report to the Congress with a
description of the proposed lease terms and conditions and any expected
savings before proceeding. The Air Force sent its report to the
Congress on July 10.
You asked for our analysis of the Air Force's business case and our
views on the proposed lease arrangement. In my statement today, I will
(1) summarize the proposed lease as presented in the Air Force's recent
report to the Congress, (2) present our observations on the Air Force's
lease report and its justification for the lease, and (3) identify
related issues and costs that we believe the Congress will want to
consider as it assesses the Air Force's proposal.
To summarize and analyze the report of the proposed lease, we reviewed
the report to the Congress, examined the draft lease (which is still in
negotiation and is subject to change), and reviewed documents and
briefings from the Office of the Assistant Secretary of the Air Force
for Acquisitions, Air Mobility Programs, to identify issues and costs
that are material to the contract. We also reviewed the Air Force's
analysis and data used in its analysis of the lease versus buy
comparison as required by Office of Management and Budget (OMB)
Circular A-94. Finally, we used data gathered for our ongoing review of
tanker requirements being conducted for the House Armed Services
Committee's, Subcommittee on Readiness.
BACKGROUND:
Aerial refueling is critical to carrying out our national security
strategy because it allows other aircraft to fly further, stay airborne
longer, and carry more weapons, equipment, and supplies. While numerous
military aircraft provide refueling services, the bulk of U.S.
refueling capability lies with the Air Force's fleet of 59 KC-10 and
543 KC-135 aircraft. These are large, long-range aircraft that have
counterparts in the commercial airlines but have been modified to turn
them into tankers. The KC-10 is based on the DC-10 aircraft, and the
KC-135 is similar to the Boeing-707 airliner. Because of their large
numbers, the KC-135 is the mainstay of the refueling fleet, and
successfully carrying out the refueling mission depends on the
continued performance of the KC-135. Thus, recapitalizing the fleet of
KC-135s will be crucial to maintaining aerial-refueling capability, and
it will be a very expensive undertaking.
There are two basic versions of the KC-135 aircraft, designated the KC-
135E and KC-135R. The R model aircraft has been refitted with modern
engines and other upgrades that give it an advantage over the E model.
The E model aircraft on average is about 2 years older than the R
model, and the R model provides more than 20 percent greater refueling
capacity per aircraft. The E model is located in the Air National Guard
and Air Force Reserve. Active forces have only the R model. Over half
the KC-135 fleet is located in the reserve components.
The rest of the Department of Defense's (DOD) refueling fleet consists
of Air Force HC-130 and MC-130 aircraft used by special operations
forces, Marine Corps KC-130 aircraft, and Navy F-18 and S-3 aircraft.
However, the bulk of refueling for Marine Corps and Navy aircraft comes
from the Air Force KC-10 and KC-135. These aircraft are capable of
refueling Air Force and Navy/Marine aircraft, as well as some allied
aircraft, although there are differences in the way the KC-10 and KC-
135 are equipped to do this.
The Air Force's Report on the KC-767A Aircraft Lease:
Section 8159 of the Department of Defense Appropriations Act for fiscal
year 2002,[Footnote 1] which authorized the Air Force to lease the KC-
767A aircraft, specified that the Air Force could not commence lease
arrangements until 30 calendar days after submitting a report to the
House and Senate Armed Services and Appropriations Committees that
would (1) outline implementation plans and (2) describe the terms and
conditions of the lease and any expected savings. At about the same
time that the Air Force submitted the required report (on July 10,
2003), it submitted a New Start Notification[Footnote 2] and stated
that it would not proceed with the lease until it received approval
from all of the committees. The House and Senate Appropriations
Committees and the House Armed Services Committee approved the new
start in July. We previously testified before the House Armed Services
Committee and its Subcommittee on Projection Forces, and we issued a
briefing report in 2002 on the status of the proposed lease to date
(see our Related GAO Products page for a complete list of products to
date related to refueling requirements and the proposed lease).
The key elements of the Air Force's proposal, as presented in the
report to the Congress, are summarized below:
The Air Force proposes to lease 100 KC-767A aircraft for 6 years each;
the first aircraft would be delivered in August 2006 and the final ones
by the end of 2011. Leases on the final group of aircraft would
terminate in 2017. The report indicates that the total program for the
leased aircraft would cost about $17.2 billion in net present value
over the lease period.[Footnote 3]
The Air Force's report includes an analysis required by OMB Circular A-
94 comparing the net present value of the lease approach against that
of purchasing the aircraft. The Air Force acknowledges that its
analysis indicated that purchase would be cheaper than leasing by about
$150 million in net present value terms. Nevertheless, it proposes to
use the leasing approach because it allows the Air Force to take
delivery of the aircraft more quickly than it could through purchase
(and avoid creating major disruptions to other procurement programs for
which funding has already been identified in the Future Years Defense
Program). Specifically, the Air Force said that if the aircraft were
purchased at the same rate as planned under the lease, it would need $5
billion more funding through fiscal year 2006 and more than $14 billion
more for the 6 years reflected in the Future Years Defense Program.
Under the procurement budget plan that the lease would replace, the Air
Force would not begin acquiring new tankers until fiscal year 2009 and
would not have 100 new tankers until 2016, 5 years later than planned
through the lease.
The key justification for the lease, according to the Air Force, is an
urgent need to replace the current fleet of KC-135 aircraft. The Air
Force has stated that the KC-135 is aging and becoming increasingly
costly to operate owing to corrosion, the need for major structural
repair, and increasing rates of inspection to ensure air safety.
Moreover, the report indicates that the Air Force believes it is
incurring a significant risk by having 90 percent of its aerial-
refueling capability in a single, aging airframe and that a "fleet
grounding" event could jeopardize the tanker's mission.[Footnote 4]
The Air Force plans to award a contract to a special purpose entity
(SPE), a trust to be created under the laws of Delaware, that will
issue bonds to raise sufficient capital to purchase the new aircraft
from Boeing and lease them to the Air Force.[Footnote 5] The entity is
to issue bonds on the commercial market based on the strength of the
lease and not the creditworthiness of Boeing. The lease is part of a
three-party contract between the Air Force, Boeing, and the SPE. Figure
1 depicts the relationships of the three parties to the contract and
the transactions that are to take place under the contract, once it is
signed.
Figure 1: Diagram of the Relationships of the Parties to the Contract
and the Transactions That Are to Take Place Under the Contract:
[See PDF for image]
[End of figure]
Office of Management and Budget Circular A-11 requires that an
operating lease meet certain terms and conditions, including a
criterion that the net present value of the lease payments not exceed
90 percent of the fair market value of the asset at the time that the
lease is initiated. The report to the Congress states that DOD believes
the proposed lease meets those criteria and that payments over the life
of the lease will be equal to 89.9 percent of the fair market value of
the aircraft. At the same time, the report points out that the
percentage is based on the cost to buy the aircraft --$131 million plus
the cost of construction financing of $7.4 million, for a total of
$138.4 million. If the fair market value is assumed to be the cost to
buy the aircraft, then the lease payments represent about 93 percent of
the fair market value and would not meet the requirement.
If Boeing sells up to 100 comparable aircraft during the term of the
contract to another customer for a lower price than that agreed to by
the Air Force, the government would receive an "equitable adjustment."
The report also states that Boeing has agreed to a return-on-sales cap
of 15 percent and that an audit of its internal cost structure will be
conducted in 2011, and that any return on sales exceeding 15 percent
would be reimbursed to the government.
According to the report, if the government were to terminate the lease,
it must (1) do so for all of the delivered aircraft, and any aircraft
for which construction has not begun, (2) give 12 months advance
notification prior to termination, (3) return the aircraft, and (4) pay
an amount equal to 1 year's lease payment for each aircraft terminated.
If termination occurs before all aircraft have been delivered, the
price for the remaining aircraft would be increased to include
unamortized costs incurred by the contractor that would have been
amortized over the terminated aircraft and a reasonable profit on those
costs.
The government will pay for and the contractor will obtain commercial
insurance to cover aircraft loss and third-party liability as part of
the lease agreement. Aircraft loss insurance is to be in the amount of
$138.4 million per aircraft in calendar year 2002 dollars. Liability
insurance will be in the amount of $1 billion per occurrence per
aircraft. If any claim is not covered by insurance, the Air Force will
indemnify the special purpose entity for any claims from third parties
arising out of the use, operation, or maintenance of the aircraft under
the contract.
At the expiration of the lease, the Air Force can return the aircraft
to the SPE after removing, at government expense, any Air Force-unique
configurations added by the Air Force after delivery of the aircraft
from the SPE. Alternatively, the Air Force also has the option to
purchase the aircraft at residual value (the estimated value of the
aircraft after the lease term ends). However, the purchase can take
place only if it is authorized and funded by the Congress at or before
the expiration of the lease.
The contractor will warrant that each aircraft will be free from
defects in materials and workmanship and that the warranty will be of
36 months' duration and will commence after construction of the
commercial Boeing 767 aircraft but before they have been converted into
aerial-refueling aircraft. Upon delivery to the Air Force, each KC-767A
aircraft will carry a 6-month design warranty, 12-month material and
workmanship warranty on the tanker modification, and the remainder of
the original warranty on the commercial components of the aircraft,
estimated to be about 2 years.
Our Analysis of the Air Force's Report and Lease Proposal:
I will now present our observations on the Air Force's lease report to
the Congress and on some of the details of the lease proposal. We
believe there are a number of aspects of the report and lease that the
Congress needs to be aware of in considering the Air Force's proposal,
including the following:
The cost differential between leasing and purchasing was presented by
the Air Force as about $150 million favoring purchase in net present
value terms, although the differential can rise to $1.9 billion
favoring purchase, depending upon the assumptions used. For example,
according to the Air Force report to the Congress, had the Congress
provided multiyear procurement authority and had DOD been able to
accommodate that while preserving "program stability," the net present
value could favor purchase by up to $1.9 billion.
The Air Force report states that there is an urgent need to begin
tanker replacement 3 years earlier than previously planned, but until
recently, recapitalization of the fleet has not been a high enough
priority in the Air Force budget to successfully compete for funding.
The Air Force proposal may not meet all the criteria specified by OMB
to qualify as an operating lease since the Air Force would pay 93
percent of the fair market value of the aircraft if construction
financing were not assumed to be included in the fair market value of
the aircraft.
As required by section 8159 of the fiscal year 2002 defense
authorization act, the Air Force report to the Congress was limited to
the costs of leasing the aircraft. However, the report does not present
the total costs of this program, including the costs to acquire the
aircraft at the expiration of the lease or to maintain the aircraft
during the period of the lease.
Net Present Value Analysis:
OMB Circular A-94 specifies that whenever a federal agency needs to
acquire the use of a capital asset, it should do so in the way that is
least expensive to the government as a whole and further specifies how
a lease versus purchase analysis should be conducted. Specifically, the
circular directs a net present value comparison between the proposed
lease and a hypothetical purchase on the basis of the same delivery and
return profile. This approach permits an accounting for the time-value
of money.
In its report to the Congress, the Air Force's net present value
calculations between the proposed multiyear lease and a hypothetical
purchase indicate that purchasing the aircraft would be cheaper than
leasing by about $150 million; however, the report contains a footnote
indicating that the net present value could favor purchase by an
additional $1.7 billion (for a total of $1.9 billion less in costs
compared with leasing). The $1.7 billion is based on four assumptions
(all in net present value terms). First, the Air Force assumes that
using a multiyear contract[Footnote 6] for purchasing the aircraft
would lead to $900 million in savings. Second, the Air Force assumes
that using a shorter span of time for the period when progress
payments[Footnote 7] are made would lead to another $200 million in
savings. Third, it assumes that if a shorter span of time for
calculating inflation for progress payments is used, then savings of
$500 million will occur. Fourth, it assumes that if a 30 percent
discount on the imputed cost of insurance is included (since the
government self-insures), savings of $100 million will occur.
The net present value analysis is also sensitive to the appropriate
discount rate and other expected inflation. The Air Force followed OMB
guidance contained in Circular A-94 in doing its analysis, to include
using the discount rate of 4.1 percent. Our analysis shows that a 1-
percentage point change in the discount rate can cause a change of over
$660 million in the net present value results. Table 1 shows the
sensitivity of the net present value analysis to different discount
rates, including the discount rate of 4.2 percent that we would use on
the basis of the July 10, 2003, date on which the report to the
Congress was issued.[Footnote 8]
Table 1: Sensitivity Analysis of Discount Rates for the A-94 Analysis:
Dollars in millions:
Discount rates in percentages: 3.5; Net present value of leasing minus
purchase: $567.6.
Discount rates in percentages: 4.1 (Air Force discount rate); Net
present value of leasing minus purchase: 154.7.
Discount rates in percentages: 4.2 (GAO discount rate); Net present
value of leasing minus purchase: 89.5.
Discount rates in percentages: 4.5; Net present value of leasing minus
purchase: -100.4.
Sources: Air Force (data); GAO (analysis).
[End of table]
The assumptions being used for the analysis regarding rates of expected
inflation for construction of the aircraft, for military construction
for facilities, and for operation and maintenance are reasonable;
however, if the actual cost increases for the construction of the
aircraft are higher than the assumed cost increases in the Air Force
analysis, the cost of leasing will be higher than the cost presented in
the report to the Congress. The reverse could also be true.
Urgency of Tanker Replacement:
In its report to the Congress, the Air Force stated that "our National
Security Strategy is unexecutable without air refueling tankers" and
that "the risks involved with indefinitely operating a fleet of aging
aircraft are unacceptable." These statements indicate that tankers are,
or should be, a very high priority; however, the Air Force has for many
years faced the issue of an aging KC-135 fleet and yet has not planned,
until recently, to begin replacing them.
After reviewing a wide variety of Air Force reports and documents as
well other documents, we have concluded that neither the Air Force nor
DOD have been willing to make the difficult decision to reallocate
procurement funds from other programs in the near term. For example,
the Air Force put a replacement tanker program (known as the "KC-X") in
its submission for the President's fiscal year 2004 budget. But in view
of "affordability constraints" in the near term, the program would not
begin to be funded until fiscal year 2006, and the first aircraft would
be delivered in fiscal year 2009.
Until the authority to lease tanker aircraft was established by section
8159 of the fiscal year 2002 Department of Defense Appropriations Act,
we did not perceive that concern within the Air Force about the
condition of its KC-135 fleet was serious enough to successfully
compete with other programs for funding. Instead, the Air Force has
expressed belief in the necessity of continuing to operate and sustain
the 540-plus aircraft fleet for several more decades, and it has also
expressed confidence it its ability to do so, as illustrated in the
following:
* In our 1996 report on aging tanker aircraft,[Footnote 9] we stated
that procurement of a commercial-derivative aircraft could take as long
as 4 to 6 years and that development of a new aircraft could take up to
12 years. Therefore, we stated, the Air Force will need to quickly
initiate studies to develop a replacement strategy for mobility
aircraft and should consider a multirole aircraft that could be used
for air mobility as well as aerial refueling. In response, DOD stated
that "while the KC-135 is an average of 35 years old, its airframe
hours and cycles are relatively low. With proper maintenance and
upgrades, we believe the aircraft may be sustainable for another 35
years." Thus in 1996, the Air Force was planning to continue to rely on
the KC-135 aircraft until about 2030. The Air Force's comments
notwithstanding, we pointed out at the time of our report that the
long-term serviceability of the aircraft was questionable and we
continue to believe it.
The KC-135 Aircraft Sustainment Master Plan (1997), an Air Force
strategic guide for investment, repair, and modification decisions,
concluded that "with continued aggressive maintenance, the KC-135 will
fly safely well beyond the FY 97-02 time frame." The report added that
the aircraft can continue to be a safe and affordable weapon system
that will meet the operational requirements well into the next century
"if there is a consistent investment in maintenance and the aging
aircraft programs.":
The Air Mobility Command's Air Mobility Strategic Plan for 2002
(October 2001) established a time frame of fiscal year 2008-2013 to
begin fielding an updated fleet of refueling aircraft. However, the
report also identified additional problems hampering operations,
including tanker aircraft and aircrew shortfalls, an increase in the
number of KC-135 aircraft in the depot, and a decrease in mission
capable rates. The strategic plan acknowledged that the KC-135
Programmed Depot Maintenance Improvement Plan had been developed to
reduce the number of aircraft in the depot. In addition, the strategic
plan indicated that an Analysis of Alternatives would be conducted over
the next two years to determine the most effective solution set to meet
the nation's future air-refueling requirements, although, to our
knowledge, the analysis has not been done yet.
In the Mission Need Statement: Future Air Refueling Aircraft (AMC 004-
01, November 2001), the commander of the Air Mobility Command (AMC)
stated that the "Air Mobility Command's priority is to continue with C-
17 acquisition and C-5 modernization in the near term. As the airlift
priority is met, AMC will begin to shift resources to address the next
air refueling platform in the mid-to-long-term. Air Mobility Strategic
Plan 2000 envisions KC-135 aircraft retirement beginning in 2013 with
the concurrent fielding of a replacement air refueling platform." The
mission need statement also stated that "definition of future air
refueling mission needs and examination of opportunities for technology
enhancement must begin in the near-term.":
In a May 2002 response to our briefing on our preliminary analysis to
the Senate Armed Services Committee of the planned tanker lease, the
Air Force stated that while it had programmed funds for a traditional
replacement tanker since 2001, the first new aircraft would not enter
the fleet until fiscal year 2009. The Air Force maintains an aggressive
program of inspection and repair to keep the KC-135 fleet operational
and to meet mission requirements. Consequently, while the KC-135 fleet
was built from 1957 through 1965, significant portions of the aircraft
have been upgraded or modified in the intervening years.
From 1975 through 1988, the Air Force replaced about 1,500 square feet
of the aluminum skin on the underside of the wings of most KC-135
aircraft with an improved aluminum alloy that was less susceptible to
fatigue. In addition, engine strut fittings were replaced.
Beginning in the mid-1980s, the Air Force began to replace the engines
of the original KC-135A aircraft. Over 410 KC-135 aircraft have been
converted to the R model by installation of fuel-efficient, quiet F108
(CFM-56) engines that enhanced the aircraft's performance and
capability. In addition to new engines, this modification includes 25
other changes per plane, including reinforced floors, new and
strengthened landing gear, reinforced wing structures, new engine
struts, and over 12 miles of wiring.
The Air Force modernized the cockpits on all of its KC-135 tankers
through a program called PACER CRAG (compass, radar, and Global
Positioning System receiver) to enhance reliability, maintainability,
and capability.
In addition to specific large-scale, fleet wide upgrade programs such
as those that I described above, most aircraft have had major
structural components replaced as necessary. Moreover, if--as KC-135
aircraft undergo their periodic programmed depot maintenance--trend
analyses indicate the potential for fleet wide problems, some major
components may be replaced on all aircraft. Examples of some of these
major structural repairs include segments of fuselage skins, floor
beams, fuselage bulkheads, and upper wing skins. As components such as
these are replaced, the use of new and improved materials, fabrication,
and corrosion prevention techniques are designed to solve problems and
to last for the remaining life of the aircraft. In the case of the
upper wing skins, for example, the Air Force reported, "as we work
through the fleet, this level of replacement will decrease as most of
the bad skins have been or shortly will be replaced. Replaced skins are
installed with attention to corrosion prevention and should last more
than 40 years.":
Despite the Air Force's aggressive maintenance and upgrade programs to
keep the KC-135 mission capable, since 2001, the Air Force has come to
believe that the condition of the fleet has deteriorated to the point
where replacement has become more urgent. For example, Air Force
officials have cited the Air Force's Economic Service Life Study, which
showed that program depot maintenance has become increasingly costly on
the KC-135. Air Force officials told us that the E-model of the KC-135
is currently operating under flight restrictions owing to corrosion.
The KC-135 fleet averages over 40 years in age, but the aircraft have
relatively low levels of flying hours. Flying hours for the KC-135
averaged about 300 hours per year from 1995 through September 2001.
Since then, utilization is averaging about 435 hours per year. The Air
Force projects that E and R models have lifetime flying hour limits of
36,000 and 39,000 hours, respectively--according to the Air Force, only
a few KC-135 aircraft would reach these limits before 2040, at which
time some of the aircraft would be about 80 years old.
The KC-135 fleet has not been meeting its mission capable rate goal.
Mission capable rates measure the percentage of time on average that
the aircraft are available to perform their assigned mission. The Air
Force has a goal of an 85 percent mission capable rate for the KC-135
fleet. As shown in figure 2, KC-135 aircraft have not met the 85
percent mission capable rate in any of the last 3 fiscal years,
although aircraft in the active component have consistently reached a
mission capable rate of over 80 percent.
Figure 2: Average Annual Mission Capable Rates for KC-135 Aircraft by
Service Component and Aircraft Type, Fiscal Year 2001 - Fiscal Year
2003 (July):
[See PDF for image]
Note: Fiscal year 2003 includes data through July 2003.
[End of figure]
By most indications, the fleet has performed very well during the past
few years of high operational tempo. Operations in Kosovo, Afghanistan,
Iraq, and here in the United States in support of Operation Noble Eagle
were demanding, but the current fleet was able to meet the mission
requirements. Approximately 150 KC-135 aircraft were deployed to the
combat theater for Operation Allied Force in Kosovo, about 60 for
Operation Enduring Freedom in Afghanistan, and about 150 for Operation
Iraqi Freedom.[Footnote 10] Additional KC-135 aircraft provided "air
bridge" support for the movement of fighter and transport aircraft to
the combat theater, for some long-range bomber operations from the
United States, and to help maintain combat air patrols over major U.S.
cities since September 11, 2001.
According to Air Force projections, the KC-135 operating and support
costs will increase substantially in the coming years. The costs for
the current fleet totaled about $2.4 billion in fiscal year 2002 (2002
dollars). The Air Force projects that the cost will total about $3.5
billion (2002 dollars) in fiscal year 2012 for a fleet of 510 aircraft.
According to Air Force officials, increased programmed depot
maintenance costs were a significant cause of the increase. The
officials said that, based on historical experience, programmed depot
maintenance costs are expected to increase about 18 percent per
aircraft per year. By the same projections, the operating and support
costs for the fleet of 100 KC-767A aircraft will total about $808
million.[Footnote 11]
The concept of an aging KC-135 fleet, and the problems and costs
associated with operating and sustaining old aircraft, is not a sudden
manifestation, but rather a fact of life that the KC-135 support
infrastructure has had to deal with for years. Many of the problems
currently being reported as reasons to begin tanker recapitalization
immediately--including corrosion, increasing operating and support
costs, and reduced aircraft availability--are not new and were issues
that the Air Force was addressing in the mid-1990s, when we last
examined aerial-refueling matters and when the Air Force concluded that
recapitalization was not urgent.
Operating Lease Requirements:
OMB Circular A-11 provides certain criteria that must be met for an
operating lease:
Ownership must remain with the lessor throughout the term of the lease
and is not to transfer at or shortly after the end of the lease period.
No bargain price purchase option is allowed.
The lease term may not exceed 75 percent of the asset's economic
lifetime.
The present value of the minimum lease payments cannot exceed 90
percent of the fair market value of the asset at the beginning of the
lease term.
The asset must be a general-purpose asset and not government-unique.
The asset must have a private-sector market.
The Air Force report says that the proposal complies with all of the
criteria.
However, the report also points out that, depending on the fair market
value used, the net present value of the lease payments in the case of
the KC-767A may exceed the 90 percent of initial value threshold. On
the one hand, if the fair market value is considered to include the
cost of construction financing of $7.4 million per aircraft (or $740
million for all 100 aircraft),[Footnote 12] then the lease payments are
estimated to represent 89.9 percent. This is the formula that the Air
Force used to document compliance with the circular and which the Air
Force cited in its report to the Congress; it results in a cost of
$138.4 million per aircraft. On the other hand, if the fair market
value excludes construction financing, it totals $131 million per
aircraft, and the lease payments represent 93 percent, thus exceeding
the 90 percent threshold. According to the Air Force report,
construction financing, however, must be included to meet the OMB
Circular A-11 requirement.
However, it is not clear that including the construction financing
represents the fair market value of the aircraft. The SPE will borrow
money on the commercial market to raise funds to pay Boeing to finance
construction of the aircraft and will repay the banks up to $7.4
million in interest on the loans per aircraft. Once constructed, the
aircraft will be delivered to the SPE, and the SPE will pay Boeing $131
million less the amount of financing already paid to Boeing for the
aircraft. The Air Force will then lease the aircraft for up to $138.4
million per aircraft over the life of the lease. Consequently, the $7.4
million (reported by the Air Force as construction financing)
represents interest on the loans to the SPE, and it is not clear that
interest should be included in the fair market value of the aircraft.
Total Cost of the Program:
While the Air Force report includes the cost of leasing and other
government costs such as training, as well as operations and support,
the report does not include the costs of buying the tankers at the end
of the lease.[Footnote 13] At the end of each 6-year lease, the
aircraft are to be returned to the owner, the SPE, or they can be
purchased by the Air Force for their residual value, estimated at about
$44 million each in then-year dollars. If the aircraft are returned,
the Air Force tanker fleet will be reduced, and the Air Force will have
to find some way to replace the lost capability. In other words, the
lease payments will have paid almost the full cost of the aircraft, and
then the capability would be lost. Thus, the total cost of this 100-
aircraft program should include the eventual acquisition cost. In
addition to the cost to lease and subsequently purchase the aircraft,
Air Force operations and support costs range from $4.6 billion to $6.8
billion, depending on which dollar calculation is used. The Air Force
also plans to construct new facilities and would incur other costs
ranging from $1.2 billion to $1.5 billion. Table 2 summarizes total
cost in three different dollar calculations--then-year (or current)
dollars, constant fiscal year 2002 dollars, and net present
value.[Footnote 14]
Table 2: Estimated Cost of the Contract to Lease, Maintain, and
Purchase 100 KC-767A Aircraft Under Three Different Types of Analysis:
Dollars in billions:
Category: Lease payments with aircraft return; Net present value:
$11.4; Constant fiscal year 2002 dollars: $12.3; Then-year dollars:
$16.3.
Category: Aircraft purchase and other costs; Net present value: 3.1;
Constant fiscal year 2002 dollars: 3.4; Then-year dollars: 5.2.
Subtotal; Net present value: 14.5; Constant fiscal year 2002 dollars:
15.7; Then-year dollars: 21.5.
Category: Operations and Support; Net present value: 4.6; Constant
fiscal year 2002 dollars: 5.7; Then-year dollars: 6.8.
Category: Military construction and other costs; Net present value:
1.2; Constant fiscal year 2002 dollars: 1.3; Then-year dollars: 1.5.
Lease-buy Total; Net present value: $20.3; Constant fiscal year 2002
dollars: $22.7; Then-year dollars: $29.8.
Sources: Air Force (data). GAO (analysis).
[End of table]
In addition, the Air Force will have to pay an additional estimated
$778 million if the entire 100 aircraft are returned, to ensure that
the aircraft are returned in the maintenance condition specified in the
lease. For these reasons, returning the aircraft would probably make
little sense, and the Congress will almost certainly be asked to fund
the purchase of the aircraft at their residual value as the lease
expires.
Related Issues and Concerns:
Our preliminary analysis indicates that certain other costs associated
with the lease may deserve further examination by the Congress.
Specifically, we have concerns related to contractor logistics support,
the extent of Boeing's profit margin, and the impact of the lease on
follow-on tanker acquisitions.
Contractor Logistics Support:
The Air Force estimates that the maintenance agreement with Boeing will
cost between $5 billion and $5.7 billion during the lease period. It
has negotiated a non competitive agreement with Boeing as part of the
lease negotiations, covering all maintenance except flight-line
maintenance, which is to be done by Air Force mechanics. This
represents an average of about $6.4 million per aircraft per year in
fiscal year 2002 dollars. We do not know how the Air Force determined
that this was a reasonable price or whether competition might have
yielded savings because the Air Force did not provide sufficient
documents on a timely basis for us to evaluate its price analysis. A
number of commercial airlines and maintenance contractors already
maintain the basic 767 commercial aircraft and could possibly do some
of the required maintenance if given the opportunity to compete for the
contract.
Profit Margin:
The Air Force report indicates that Boeing can earn no more than a 15
percent profit on the Boeing 767 aircraft and that an audit will be
conducted after the final planes are delivered to ensure that the
company's profit does not exceed that amount. However, since this
aircraft is basically a commercial 767 with modifications to make it a
military tanker, it is not clear why the 15 percent profit should apply
to the full cost. One financial analysis published recently states that
Boeing's profit on commercial 767 aircraft is in the range of 6
percent.[Footnote 15] If the Air Force negotiated a lower profit margin
on that portion of the cost, with the 15 percent profit applying only
to the military-specific portion, this could lower the cost by several
million dollars per aircraft. For example, assuming the commercial
tanker portion of the cost is about $80 million, the difference between
profits of 6 percent and 15 percent would be about $7 million per
aircraft, or $700 million for all 100 aircraft.
Effect on Follow-on Tanker Acquisitions:
One of the key advantages of leasing is that it enables the Air Force
to take delivery of aircraft without the large, up-front obligation of
funds required for purchase; thus by the end of fiscal year 2011, the
Air Force will have received 100 new tankers. The flip side of this,
however, is that payments are spread out over many years and represent
an obligation that must be met throughout the term of the lease. The
Air Force will be making lease payments on the leased aircraft through
fiscal year 2017, and will likely pay
about $4.4 billion (in then-year dollars) in fiscal years 2012-17 to
purchase the aircraft at the expiration of the lease. Funds spent
during those years on these 100 aircraft are therefore funds that are
not available for the procurement of additional tanker aircraft that
will be needed to replace the remaining 400-plus aircraft in the KC-135
fleet. If the Air Force wants to procure additional tankers starting in
this 2012-17 period, it will need an even larger budget during those
years to accommodate both the continuing lease payments and new
procurement. Figure 3 illustrates the annual outlays that would be
required to lease the aircraft as proposed and the additional outlays
needed to purchase an additional block of 100 aircraft. This assumes
that delivery of the additional aircraft would begin after the first
100 had been delivered. If additional aircraft are to be obtained
before the planned end of delivery of the first 100 leased aircraft in
2011, then the additional funds for the second block of aircraft would
be needed even sooner.
Figure 3: Outlays Required to Lease 100 Aircraft and to Subsequently
Purchase an Additional 100 Aircraft:
[See PDF for image]
[End of figure]
Mr. Chairman, this concludes my prepared statement. I would be happy to
answer any questions that you or Members of the committee may have.
Contacts and Staff Acknowledgments:
For future questions about this statement, please contact me at (757)
552-8111 or Brian J. Lepore at (202) 512-4523. Individuals making key
contributions to this statement included Kenneth W. Newell, Tim F.
Stone, Joseph J. Faley, Stephen Marrin, Kenneth Patton, Charles W.
Perdue, and Susan K. Woodward.
RELATED GAO PRODUCTS:
Military Aircraft: Considerations in Reviewing the Air Force Proposal
to Lease Aerial Refueling Aircraft. GAO-03-1048T. Washington, D.C.:
July 23, 2003.
Military Aircraft: Information on Air Force Aerial Refueling Tankers.
GAO-03-938T. Washington, D.C.: June 24, 2003.
Air Force Aircraft: Preliminary Information on Air Force Tanker
Leasing. GAO-02-724R. Washington, D.C.: May 15, 2002.
U.S. Combat Air Power: Aging Refueling Aircraft Are Costly to Maintain
and Operate. GAO/NSIAD-96-160. Washington, D.C.: August 8, 1996.
(350432):
FOOTNOTES
[1] Department of Defense and Emergency Supplemental Appropriations for
Recovery from and Response to Terrorist Attacks on the United States
Act, 2002, Pub. L. No. 107-117, § 8159, 115 Stat. 2230, 2284-85 (2002).
[2] The New Start Notification, submitted to the Armed Services and
Appropriations Committees on July 11, 2003, was required by section 133
of the Bob Stump National Defense Authorization Act for Fiscal Year
2003, and is being used by the Air Force as the trigger for executing
the lease. Pub. L. No. 107-314, § 133, 116 Stat. 2458, 2477 (2002).
[3] When costs and benefits are evaluated over time, a net present
value calculation is used to account for the time value of money
through an interest rate called a "discount rate."
[4] A fleet grounding event would involve some systemic problem or
equipment failure affecting all aircraft of the same type and would be
serious enough to require replacement before the aircraft could resume
normal operations.
[5] The special purpose entity would pay the interest on the bonds
using lease payments it receives from the Air Force and would pay off
all the bonds at the conclusion of the lease term.
[6] In multiyear procurement, all items are bought under one contract
as opposed to a series of annual contracts.
[7] Progress payments, which are made to contractors before they
deliver items, reduce contractors' financing costs and in turn result
in a lower purchase price for the government.
[8] The Air Force used a 9-year discount rate from Appendix C of
Circular A-94, which is revised annually. The date of the revision used
by the Air Force was January 2003. GAO policy for determining a
discount rate is that it should be the interest rate for marketable U.
S. Treasury debt with maturity comparable to the term of the project
being evaluated. On the basis of the date the report was issued, the
discount rate that we would use would be 4.2 percent.
[9] U.S. Combat Air Power: Aging Refueling Aircraft Are Costly to
Maintain and Operate, GAO/NSIAD-96-160 (Washington, D.C.: August 8,
1996).
[10] Air Force officials told us that combat commanders refused to
permit the E-model of the KC-135 to be deployed to recent combat
theaters.
[11] The projections assume that the KC-135Es and KC-135Rs will fly 308
and 368 hours per year while the KC-767A will fly 750 hours per year.
[12] Construction financing will be raised by the special purpose
entity through borrowing in order to make progress payments.
[13] The Department of Defense and Emergency Supplemental
Appropriations for Recovery from and Response to Terrorist Attacks on
the United States Act, 2002, Pub. L. No. 107-117, § 8159, 115 Stat.
2230, 2284-85 (2002) required that the Air Force report on the costs to
purchase or lease the aircraft but did not require that other costs be
reported.
[14] Current dollars or then year dollars are the dollar value of a
good or service in terms of prices at the time the good or service is
sold. These contrast with constant dollars, which measure the value of
purchased goods or services at price levels that are the same as those
for the base year. Constant dollars do not contain any adjustments for
inflationary changes that have occurred or are forecasted to occur
outside the base year. When costs and benefits are evaluated over time,
a net present value calculation is used to account for the time value
of money through an interest rate called a "discount rate."
[15] See Morgan-Stanley, Does 767 Tanker Equate to 700+ Comml Orders?,
(May 30, 2003).
