oversight

Military Aircraft: Observations on the Air Force's Plan to Lease Aerial Refueling Aircraft

Published by the Government Accountability Office on 2003-09-03.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                          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
                          MILITARY AIRCRAFT
September 3, 2003

                          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
                                                September 3, 2003


                                                MILITARY AIRCRAFT

                                                Observations on the Air Force’s Plan to
Highlights of GAO-03-1143T, a testimony         Lease Aerial Refueling Aircraft
before the Senate Committee on
Commerce, Science, and Transportation




At 543 aircraft, the KC-135 is the              The Air Force report indicates the following:
mainstay of U.S. aerial refueling               • Leasing costs more than buying by $150 million (net present value).
capability. Recapitalizing this fleet           • Replacing the KC-135 is urgent because of aging and corrosion.
is crucial to maintaining this
capability and, ultimately,                     • The Air Force will pay 89.9 percent of aircraft’s fair market value—
maintaining the mobility of U.S.                   $138.4 million—complying with the Office of Management and Budget’s
forces. In the fiscal year 2002                    (OMB’s) requirement that the price not exceed 90 percent.
defense appropriations act, the                 • The Air Force may return the planes or buy them for about $44 million
Congress authorized the Air Force                  per aircraft (if authorized by the Congress) at the end of the lease.
to lease up to 100 aerial refueling
aircraft after the Air Force reported           GAO has the following observations about the lease report:
its plans to the Senate and House               • Purchasing could be up to $1.9 billion cheaper (net present value), if
Armed Services Committees and                     multi-year procurement authority were granted.
Defense Appropriations
                                                • The Air Force believes that replacement is urgent because of decreased
Subcommittees. The Air Force
sent Congress on July 10 its report               availability, increased maintenance costs, and the risk of fleet wide
containing a business case analysis               grounding for the KC-135, although until recently, recapitalization had
of its proposed lease. The Air                    not been a high enough priority to successfully compete for funding.
Force plans to lease 100 KC-767A                • The lease payments comply with OMB requirements only if $7.4 million in
aircraft for 6 years each from a                  construction financing is added to the $131 million-per-aircraft purchase
special purpose entity (SPE) that                 price, for a total of $138.4 million per aircraft. Otherwise, the lease payments
will order the aircraft from the                  represent about 93 percent of the value of the aircraft.
Boeing Company.
                                                Other issues the Congress may wish to examine include the following:
GAO was asked to (1) summarize
                                                • Boeing will maintain the aircraft for between $5 billion and $5.7 billion
the Air Force’s report for leasing
KC-767A aircraft, (2) present its                  during the lease period; KC-135 total operating and support costs were
observations on the report and                     about $4.3 million to $4.5 million per year per aircraft in fiscal year 2002.
justification for the lease, and (3)            • Boeing’s profit is limited to 15 percent on the KC-767As compared to
identify related issues and costs to               about 6 percent on commercial 767s, according to one financial analysis.
assist the Congress as it considers             • Leasing delays payments for the first 100 aircraft so acquiring 100 more
the Air Force’s proposal.                          tankers will significantly increase outlays in the 2012 –17 time frame.

                                                Estimated Outlays to Lease and Buy 100 Aircraft and to Acquire 100 More




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.
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,


                                              1
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

                                                                                                           1
Section 8159 of the Department of Defense Appropriations Act for fiscal year 2002,
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

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
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 Notification2 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.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
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.”


                                                         3
        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.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.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.




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.


                                                        4
Figure 1: Diagram of the Relationships of the Parties to the Contract and the Transactions That Are to Take
Place Under the Contract




    •   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


                                                      5
    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


                                           6
       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.



                                                7
       •   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
                                             6
Force assumes that using a multiyear contract 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 payments7 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.

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 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
                8
was issued.


Table 1: Sensitivity Analysis of Discount Rates for the A-94 Analysis
Dollars in millions
Discount rates in percentages                Net present value of leasing minus purchase
3.5                                                                               $567.6
4.1 (Air Force discount rate)                                                       154.7
4.2 (GAO discount rate)                                                              89.5
4.5                                                                                -100.4

Sources: Air Force (data); GAO (analysis).



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

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
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,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

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
    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



                                          11
    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


                                          12
       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



                                            13
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)




Note: Fiscal year 2003 includes data through July 2003.



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.10 Additional KC-135 aircraft provided “air bridge” support for the movement
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.


                                                          14
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.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.
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.


                                                    15
     •   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),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.


12
  Construction financing will be raised by the special purpose entity through borrowing in order to make
progress payments.


                                                      16
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.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.14




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.”



                                                       17
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                                     Net present value   Constant fiscal year 2002   Then-year dollars
                                                                                   dollars
Lease payments with aircraft return                     $11.4                        $12.3              $16.3
Aircraft purchase and other costs                         3.1                          3.4                5.2
Subtotal                                                 14.5                         15.7               21.5
Operations and Support                                    4.6                          5.7                6.8
Military construction and other costs                     1.2                          1.3                1.5
Lease-buy Total                                         $20.3                        $22.7              $29.8


Sources: Air Force (data). GAO (analysis).



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


                                                           18
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
                                            15
aircraft is in the range of 6 percent.           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




15
     See Morgan-Stanley, Does 767 Tanker Equate to 700+ Comml Orders?, (May 30, 2003).


                                                       19
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




                                                   ----


Mr. Chairman, this concludes my prepared statement. I would be happy to answer any
questions that you or Members of the committee may have.




                                                    20
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.




                                           21
                            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.




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