Military Aircraft: Considerations in Reviewing the Air Force	 
Proposal to Lease Aerial Refueling Aircraft (23-JUL-03, 	 
GAO-03-1048T).							 
                                                                 
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.
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-03-1048T					        
    ACCNO:   A07676						        
  TITLE:     Military Aircraft: Considerations in Reviewing the Air   
Force Proposal to Lease Aerial Refueling Aircraft		 
     DATE:   07/23/2003 
  SUBJECT:   Inventory control systems				 
	     Military aircraft					 
	     Leases						 
	     Air Force procurement				 
	     Cost effectiveness analysis			 
	     Boeing 767 Aircraft				 
	     KC-10 Aircraft					 
	     KC-135 Aircraft					 
	     Boeing 707 Aircraft				 

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GAO-03-1048T

Testimony Before the Committee on Armed Services, House of Representatives

United States General Accounting Office

GAO For Release on Delivery Expected at 10: 00 a. m., EDT Wednesday, July
23, 2003 MILITARY AIRCRAFT

Considerations in Reviewing the Air Force Proposal to Lease Aerial
Refueling Aircraft

Statement of Neal P. Curtin, Director Defense Capabilities and Management

GAO- 03- 1048T

Page 1 GAO- 03- 1048T 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. 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.

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 Background

Page 2 GAO- 03- 1048T 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.

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 Condition of Aerial Refueling Fleet

Page 3 GAO- 03- 1048T 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.

Table 1. Mission Capable Rates for KC- 135 Aircraft in May 2003 Component
Number of aircraft Mission capable rate

(percent)

Active 245 85 Reserve R models 52 82 National Guard R models 115 75
Reserve E models 16 75 National Guard E models 115 79 Source: Air Force
data. 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.

Page 4 GAO- 03- 1048T Section 8159 of the Department of Defense
Appropriations Act for fiscal year 2002, 1 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. 2 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.

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, S: 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, S: 133, 116 Stat. 2458, 2477 (2002). The Air Force
Report

on The KC- 767A Aircraft Lease

Page 5 GAO- 03- 1048T  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. 3 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

3 The Air Force would pay the interest on the bonds through its lease
payments.

Page 6 GAO- 03- 1048T 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.

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. Considerations in

Reviewing the Proposed Lease

Page 7 GAO- 03- 1048T 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?

Page 8 GAO- 03- 1048T 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.

Page 9 GAO- 03- 1048T 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.

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 Other Issues
Related

to the Lease Proposal

Page 10 GAO- 03- 1048T 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.

Page 11 GAO- 03- 1048T  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.

Page 12 GAO- 03- 1048T 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. Related
GAO Products

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