Military Aircraft: Considerations in Reviewing the Air Force Proposal to Lease Aerial Refueling Aircraft
Published: 2003-07-23T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: This testimony discusses the Air Force's report on the planned lease of 100 Boeing 767 aircraft modified for aerial refueling. These aircraft would be known by a new designation, KC-767A. Section 8159 of the Department of Defense Appropriations Act for fiscal year 2002 authorizes the Air Force to lease up to 100 KC-767A aircraft. We received the report required by section 8159 when it was sent to the Congress on July 10. We subsequently received a briefing from the Air Force and some of the data needed to review the draft lease and lease versus purchase analysis. However, we were permitted to read the lease for the first time on July 18 but were not allowed to make a copy and so have not had time to fully review and analyze the terms of the draft lease. As a result, this testimony today will be based on very preliminary work. It will (1) describe the condition of the current aerial refueling fleet, (2) summarize the proposed lease as presented in the Air Force's recent report, (3) present our preliminary observations on the Air Force lease report, and (4) identify related issues that we believe deserve further scrutiny.
section_title: What GAO Found
paragraphs: The KC-10 aircraft are relatively young, averaging about 20 years in age. Consequently, much of the focus on modernization of the tanker fleet is centered on the KC-135s, which were built in the 1950s and 1960s, and now average about 43 years in age. While the KC-135 fleet averages more than 40 years in age, the aircraft have relatively low levels of flying hours. The Air Force projects that E and R models have lifetime flying hours limits of 36,000 and 39,000 hours, respectively. According to the Air Force, only a few KC-135s would reach these limits before 2040, but at that time some of the aircraft would be about 80 years old. Flying hours for the KC-135s averaged about 300 hours per year between 1995 and September 2001. Since then, utilization is averaging about 435 hours per year. The Air Force eventually plans to replace all 543 KC-135 aircraft over the next 30 years and considered lease and purchase alternatives to acquire the first 100 aircraft. Office of Management and Budget Circular A-94 directs a comparison of the present value of lease versus purchase before executing a lease. In its report, the Air Force estimated that purchasing would be about $150 million less than leasing on a net present value basis. The Air Force plans to award a contract to a special purpose entity created to issue bonds needed to raise sufficient capital to purchase the new aircraft from Boeing and to lease them to the Air Force. The lease will be a three-party contract between the government, Boeing, and the special purpose entity. Office of Management and Budget Circular A-11 requires that an operating lease meet certain terms and conditions including a prohibition on paying for more than 90 percent of the fair market value of the asset over the life of the lease at the time that the lease is initiated. According to the report, if the government were to terminate the lease, it must do so for all of the delivered aircraft and may terminate any planned aircraft for which construction has not begun, must give 12-months advance notification prior to termination, return the aircraft, and pay an amount equal to one 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. At the expiration of the lease, the Air Force will return the aircraft to the special purpose entity after removing, at government expense, any Air Force unique configurations. The contractor will warrant that each aircraft will be free from defects in materials and workmanship, and 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. Because we have only had the Air Force report for a few days, we do not have any definitive analytical results. However, we do have a number of questions and observations about the report that we believe are important for the Congress to explore in reaching a decision on the Air Force proposal.

section_title: Letter
paragraphs: 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. These aircraft would be known by a new designation,   KC-767A. Section 8159 of the Department of Defense Appropriations Act  for fiscal year 2002 authorizes the Air Force to lease up to 100 KC- 767A  aircraft. We received the report required by section 8159 when it was sent  to the Congress on July 10. We subsequently received a briefing from the  Air Force and some of the data needed to review the draft lease and lease  versus purchase analysis. However, we were permitted to read the lease  for the first time on July 18 but were not allowed to make a copy and so  have not had time to fully review and analyze the terms of the draft lease.  As a result, my testimony today will be based on very preliminary work. I  will (1) describe the condition of the current aerial refueling fleet,   (2) summarize the proposed lease as presented in the Air Force’s recent  report, (3) present our preliminary observations on the Air Force lease  report, and (4) identify related issues that we believe deserve further  scrutiny.
To determine the condition of the current fleet, we used data from an  ongoing study of tanker requirements being done for this committee’s  Subcommittee on Readiness. Specifically, we obtained and analyzed   KC-135 and KC-10 mission capable rates, fleet inventory records,  utilization records, maintenance records, and other documents; and we  met with knowledgeable officials at the Air Force’s KC-135 Systems  Program Directorate at Tinker Air Force Base in Oklahoma and the Air  Mobility Command at Scott Air Force Base in Illinois, among other  officials. To summarize and analyze the report of the proposed lease, we  reviewed the report, initiated our analysis of the draft lease, and received a  briefing from the Office of the Assistant Secretary of the Air Force  (Acquisitions), Air Mobility Programs. To identify key issues for further  scrutiny, we identified issues raised by the Air Force in the report of the  proposed lease, but we believe the Air Force did not explain fully. We also  identified additional costs the Air Force expects to incur to field the new  aircraft.
subsections: section_title: Background
paragraphs: While numerous military aircraft provide refueling services, the bulk of  U.S. refueling capability lies in the Air Force fleet of 59 KC-10 and 543   KC-135 aircraft. These are large, long-range aircraft that have counterparts  in the commercial airlines, but which 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-135s are the mainstay of the refueling fleet, and successfully carrying  out the refueling mission depends on the continued performance of the  KC-135s. Thus, recapitalizing this 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 have been re-fitted with  modern engines and other upgrades that give them an advantage over the  E models. The E-model aircraft on average are about 2 years older than  the R models, and the R models provide more than 20 percent greater  refueling capacity per aircraft. The E models are located in the Air  National Guard and Air Force Reserve. Active forces have only R models.  Over half the KC-135 fleet is located in the reserve components.
The rest of the DOD refueling fleet consists of Air Force HC- 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  and Navy aircraft comes from the Air Force KC-10s and KC-135s. 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-10s and KC-135s are equipped to do this.
section_title: Condition of Aerial Refueling Fleet
paragraphs: The KC-10 aircraft are relatively young, averaging about 20 years in age.  Consequently, much of the focus on modernization of the tanker fleet is  centered on the KC-135s, which were built in the 1950s and 1960s, and now  average about 43 years in age.
While the KC-135 fleet averages more than 40 years in age, the aircraft  have relatively low levels of flying hours. The Air Force projects that E and  R models have lifetime flying hours limits of 36,000 and 39,000 hours,  respectively. According to the Air Force, only a few KC-135s would reach  these limits before 2040, but at that time some of the aircraft would be  about 80 years old. Flying hours for the KC-135s averaged about 300 hours  per year between 1995 and September 2001. Since then, utilization is  averaging about 435 hours per year.
According to Air Force data, the KC-135 fleet had a total operation and  support cost in fiscal year 2001 of about $2.2 billion. The older E model  aircraft averaged total costs of about $4.6 million per aircraft, while the   R models averaged about $3.7 million per aircraft. Those costs include  personnel, fuel, maintenance, modifications, and spare parts.
The Air Force has a goal of an 85 percent mission capable rate. Mission  capable rates measure the percent of time on average that an aircraft is  available to perform its assigned mission. KC-135s in the active duty forces  are generally meeting the 85 percent goal for mission capable rates. Data  on the mission capable rates for the KC-135 fleet are shown in   table 1.
Mission capable rate  (percent)
For comparison purposes, the KC-10 fleet is entirely in the active  component, and the 59 KC-10s had an average mission capable rate during  the same period of 81.2 percent.
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-135s 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. Additional aircraft provided “air bridge” support for movement  of fighter and transport aircraft to the combat theater, for some long-range  bomber operations from the United States, and, at the same time, to help  maintain combat air patrols over major U.S. cities since September 11,  2001.
section_title: The Air Force Report on The KC-767A Aircraft Lease
paragraphs: Section 8159 of the Department of Defense Appropriations Act for fiscal  year 2002, which authorized the Air Force to lease the KC-767A aircraft,  also 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 (1) outlining  implementation plans and (2) describing the terms and conditions of the  lease and any expected savings. The Air Force has stated that it will not  proceed with the lease until it receives approval from all of the committees  of the New Start Notification. The Air Force also submitted the report of  the proposed lease to the committees as required by section 8159. I will  now summarize the key points that the Air Force made in this report to the  committees:    The Air Force pointed out that aerial refueling helps to support our  nation’s ability to respond quickly to operational demands anywhere  around the world. This is possible because aerial refueling permits other  aircraft to fly farther, stay aloft longer, and carry more weapons,  equipment, or supplies.
The Air Force indicated that KC-135 aircraft are aging and becoming  increasingly costly to operate due 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.
The Air Force considered maintaining the current fleet until about 2040  but concluded that the risk of a “fleet-grounding” event made continued  operation of the fleet unacceptable, unless it began its re-capitalization  immediately. The Air Force considered replacing the KC-135 (E model)  engines with new engines but rejected this changeover since it would not  address the key concern of aircraft corrosion and other age-related  concerns.
The Air Force eventually plans to replace all 543 KC-135 aircraft over the  next 30 years and considered lease and purchase alternatives to acquire  the first 100 aircraft. The Air Force added traditional procurement funding  to the fiscal year 2004-2009 Future Years Defense Program in order that  100 tankers would be delivered between fiscal years 2009 and 2016.  Conversely, the report states that under the lease option, all 100 aircraft  could be delivered from fiscal years 2006 to 2011. To match that delivery  schedule under a purchase option, the Air Force stated that it would have  to reprogram billions of dollars already committed to other uses.
Office of Management and Budget Circular A-94 directs a comparison of  the present value of lease versus purchase before executing a lease. In its  report, the Air Force estimated that purchasing would be about   $150 million less than leasing on a net present value basis.
The Air Force plans to award a contract to a special purpose entity created  to issue bonds needed to raise sufficient capital to purchase the new  aircraft from Boeing and to lease them to the Air Force. The lease will be  a three-party contract between the government, Boeing, and the special  purpose entity. The entity is to issue bonds on the commercial market  based on the strength of the lease and not the creditworthiness of Boeing.
Office of Management and Budget Circular A-11 requires that an  operating lease meet certain terms and conditions including a prohibition  on paying for more than 90 percent of the fair market value of the asset  over the life of the lease at the time that the lease is initiated. The report to  Congress states that the Defense Department believes the proposed lease  meets those criteria.
If Boeing sells 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, with  any return on sales exceeding 15 percent reimbursed to the government.
According to the report, if the government were to terminate the lease, it  must do so for all of the delivered aircraft and may terminate any planned  aircraft for which construction has not begun, must give 12-months  advance notification prior to termination, return the aircraft, and 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 will return the aircraft to the  special purpose entity after removing, at government expense, any Air  Force unique configurations.
The contractor will warrant that each aircraft will be free from defects in  materials and workmanship, and 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.
section_title: Considerations in Reviewing the Proposed Lease
paragraphs: Because we have only had the Air Force report for a few days, we do not  have any definitive analytical results. However, we do have a number of  questions and observations about the report that we believe are important  for the Congress to explore in reaching a decision on the Air Force  proposal.  1.  What is the full cost to acquire and field the KC767A aircraft  under the proposed lease (and assuming the exercising of an  option to purchase at the conclusion of the lease)?
While the report includes the cost of leasing, the report does not  include the costs of buying the tankers at the end of the lease. The  report shows a present value of the lease payments of $11.4 billion and  a present value of other costs, such as military construction and  operation and support costs of $5.8 billion. This totals to $17.2 billion.
If the option to purchase were exercised, the present value of those  payments would be $2.7 billion. Adding these costs to the present  value of the lease payments and other costs, this would total $19.9  billion in present value terms.
The costs of the leasing plan have also been presented as $131 million  per plane for the purchase price, with $7.4 million in financing costs  per plane, both amounts in calendar year 2002 dollars. If the option to  purchase were exercised, the price paid would be $35.1 million per  plane in calendar year 2002 dollars. Adding all of these costs together,  the cost of leasing plus buying the planes at the end of the lease would  total $173.5 million per plane in calendar 2002 dollars or $17.4 billion  for the 100 aircraft.  2.  How strong is the Air Force’s case for the urgency of this  proposal?
As far back as our 1996 report, we said that the Air Force needed to  start planning to replace the KC-135 fleet, but until the past year and a  half, the Air Force had not placed high priority on replacement in its  procurement budget. While the KC-135 fleet is old and is increasingly  costly to maintain due mainly to age-related corrosion, there has been  no indication that mission capable rates are falling or that the aircraft  cannot be operated safely. By having 90 percent of its refueling fleet in  one aircraft type, the Air Force for some years now has been accepting  the risk of fleet wide problems that could ground the entire fleet; it is  really a question of how much risk and how long the Air Force and the  Congress are willing to accept that risk.  3.  How will the special purpose entity work?
Under the Air Force proposal, the 767 aircraft would be owned by a  special purpose entity and leased to the Air Force. This is a new  concept for the Air Force, and the details of the workings of this entity  have not been presented in detail. It is important for the Congress to  understand how this concept will work and how the government’s  interests are protected under such an arrangement. For example, what  audit rights does the government have? Will financial records be  available for public scrutiny?  4.  What process did the AF follow to assure itself that it obtained  a reasonable price?
Because this aircraft is being acquired under the Federal Acquisition  Regulations, the Air Force is required to assure itself through market  analysis and other means that the price it is paying is reasonable and  fair. To assess this issue, we would need to know how much of the  $131 million purchase price is comprised of the basic 767 commercial  aircraft and how much represents the cost of modifications to convert  it to a tanker. There is an ample market for commercial 767s, and the  Air Force should have some basis for comparison to assess the  reasonableness of that part of the price. The cost of the modifications  is more difficult to assess, and the Air Force has not provided us the  data to analyze this cost. It would be useful for the Congress to  understand the process the Air Force followed.  5.  Does the proposed lease comply with the OMB criteria for an  operating lease?
Office of Management and Budget Circular A-11 provides criteria  that must be met for an operating lease. The Air Force report says that  the proposal complies with the criteria, but the report points out that  one of the criteria is troublesome for this lease. This criterion, in  particular, provides that in order for an agreement to be considered an  operating lease, the present value of the minimum lease payments over  the life of the lease cannot exceed 90 percent of the fair market value  of the asset at the inception of the lease. Depending on the fair market  value used, the net present value of the lease payments in this case  may exceed 90 percent of initial value. Specifically, if the fair market  value is considered to include the cost of construction financing, then  the lease payments would represent 89.9 percent. If the fair market  value were taken as $131 million per aircraft, which is the price the  special purpose entity will pay to Boeing, then the lease payments  would represent 93 percent. We do not have a position at this time on  which is the more valid approach, but we believe the Air Force was  forthright in presenting both figures in its report. Congress will need to  consider whether this is an important issue and which figure is most  appropriate for this operating lease.  6.  Did the Air Force comply with OMB guidelines for lease versus  purchase analysis in its report?
A-94 specifies how lease versus purchase analysis should be  conducted. Our preliminary analysis indicates that the Air Force  followed the prescribed procedures, but we have not yet had time to  validate the Air Force’s analysis or the reasonableness of the  assumptions. The Air Force reported that under all assumptions and  scenarios considered, leasing is more expensive than purchasing, but  by only about $150 million under its chosen assumptions. In a footnote,  however, the report points out that if the comparison were to a  multiyear procurement, the difference in net present value would be   $1.9 billion favoring purchase.  7.  Why does the proposal provide for as much as a 15 percent  profit on the aircraft?
The Air Force report indicates that Boeing could make up to 15  percent profit on the 767 aircraft. However, since this aircraft is  basically a commercial 767 with modifications to make it a military  tanker, a question arises about why the 15 percent profit should apply  to the full cost. One financial analysis published recently said that  Boeing’s profit on commercial 767s is in the range of 6 percent. Did the  Air Force consider having a lower profit margin on that portion of the  cost, with the 15 percent profit applying to the military-specific  portion? This could lower the cost by several million dollars per  aircraft.
section_title: Other Issues Related to the Lease Proposal
paragraphs: In addition to the questions and observations presented above on the Air  Force report to the Congress, we believe there are a number of additional  considerations that Congress may want to explore, including the  following:    What is the status of the lease negotiations? The Air Force has  informed us that the lease is still in draft and under negotiation. We  believe it is important for the Congress to have all details of the lease  finalized and available to assure that there are no provisions that might be  disadvantageous to the government. Just last Friday, the Air Force let us  read the draft lease in the Pentagon but has not provided us with a copy of  it, so we have not had time to review it in detail.
What other costs are associated with this lease agreement? In  addition to the lease payments, the Air Force has proposed about $600  million in military construction, and it has negotiated with Boeing for  training costs and maintenance costs related to the lease agreement that  could total about $6.8 billion over the course of the lease. In addition, AF  documents indicate that there are other costs for things like insurance  premiums (estimated to be about $266 million) and government  contracting costs.
Given the cost of the maintenance agreement, how has the Air  Force assured itself that it received a good price? 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 an  agreement with Boeing as part of the lease negotiations, covering all  maintenance except flight-line maintenance to be done by Air Force  mechanics. This represents an average of about $50 million per aircraft,  with each aircraft being leased for 6 years, or over $8 million per year. We  do not know how the Air Force determined that this was a reasonable  price or whether competition might have yielded a better value. A number  of commercial airlines and maintenance contractors already maintain the  basic 767 commercial aircraft.
What happens when the lease expires? At the end of each 6-year lease,  the aircraft are supposed to be returned to the owner, the special purpose  entity, or be purchased by the Air Force for their residual value, estimated  at about $44 million each in then-year dollars. If the aircraft were returned,  the Air Force tanker fleet would be reduced, and the Air Force would have  to find some way to replace the lost capability even though lease payments  would have paid almost the full cost of the aircraft. In addition, the Air  Force would have to pay an additional estimated $778 million if the entire  100 aircraft were returned; this provision is intended to cover the cost of  removing military-specific items. For these reasons, returning the aircraft  would probably make little sense, and the Congress would almost  certainly be asked to fund the purchase of the aircraft at their residual  value when the leases expire.
How is termination liability being handled? If the lease is terminated  prematurely, the Air Force must pay Boeing 1 year’s lease payment.  Ordinarily, under budget scoring rules, the cost of the termination liability  would have to be obligated when the lease is signed. Because this could  amount to $1 billion to $2 billion for which the Air Force would have to  have budget authority, this requirement was essentially waived by Section  8117 of the Fiscal Year 2003 Department of Defense Appropriation Act.  This means that if the lease were terminated, the Air Force would have to  find the money in its budget to pay the termination amount or come to  Congress for the appropriation.
If the purpose of the lease is to “kick-start” replacement of the  KC-135 fleet—as the Air Force has stated—why are 100 aircraft  necessary, as stipulated under this lease arrangement? The main  advantage of the lease, as pointed out by the Air Force, is that it would  provide aircraft earlier than purchasing the aircraft and without disrupting  other budget priorities. It is not clear, however, why 100 aircraft is the  right number to do this. Section 8159 authorized up to 100 aircraft to be  leased for up to 10 years. The Air Force has negotiated a shorter lease  period, but stayed with the full 100 aircraft to be acquired from fiscal years  2006 to 2011. The “kick-start” occurs in the early years, and by fiscal year  2008 the Air Force would have 40 new aircraft delivered. We do not know  to what extent the Air Force (1) considered using the lease for some  smaller number of aircraft and then (2) planned to use the intervening  time to adjust its procurement budget to begin purchasing rather than  leasing. Such an approach would provide a few years to conduct the  Tanker Requirements Study and the analysis of alternatives that the Air  Force has said it will begin soon.
In the coming weeks, we will continue to look into these questions in  anticipation of future hearings by the Senate Armed Services Committee  and the Senate Commerce Committee.
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 include Kenneth W. Newell, Tim F. Stone,  Joseph J. Faley, Steve Marrin, Kenneth Patton, Charles W. Perdue, and  Susan K. Woodward.
section_title: Related GAO Products
paragraphs: 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.: Aug. 8, 1996.
This is a work of the U.S. government and is not subject to copyright protection in the  United States. It may be reproduced and distributed in its entirety without further  permission from GAO. However, because this work may contain copyrighted images or  other material, permission from the copyright holder may be necessary if you wish to  reproduce this material separately.