Boeing Capital Corporation

Business Environment and Trends

Historically, BCC has acted as a captive finance subsidiary by providing market-based lease and loan financing for commercial aircraft as well as commercial equipment. In November 2003, we announced a significant change in BCC's strategic direction, moving from a focus on growing the portfolio to a focus on supporting our major operating units and managing overall corporate exposures. For our commercial aircraft market, BCC will facilitate, arrange and selectively provide financing to Commercial Airplanes' customers. For our defense and space markets, BCC will primarily arrange and structure financing solutions for IDS's government customers. In addition, BCC will enhance its risk management activities to reduce exposures associated with the current portfolio. BCC expects to satisfy any external funding needs through access to traditional market funding sources.

BCC competes in the commercial equipment leasing and finance markets, primarily in the United States, against a number of competitors, mainly larger leasing companies and banks. BCC's Commercial Financial Services' portfolio encompasses multiple industries and a wide range of equipment, including corporate aircraft, machine tools and production equipment, containers and marine equipment, chemical, oil and gas equipment and other equipment types. Historically, approximately 20% of BCC's portfolio was related to commercial equipment leasing and financing activities. In January 2004, we announced that we are exploring strategic alternatives for the future of BCC's Commercial Financial Services business. The alternatives being examined include a sale of the operation itself, sale of the portfolio or a phased wind-down of the existing portfolio. We have no fixed timetable for determining the future of this business.

Refer to discussion of the airline industry environment in the Commercial Airplanes Business Environments and Trends. The downturn in the airline industry has resulted in reduced collateral values for aircraft, declines in airline credit ratings and bankruptcy filings by certain of our airline customers. These events have resulted in our recognition of non-cash charges in 2003 and 2002 in order to strengthen our allowance for losses on receivables and to recognize impairments on certain assets. Any additional impact that we may incur is dependent upon the duration of the current airline industry decline and the related defaults, repossessions or restructurings that may occur. Aircraft valuations could decline materially if significant numbers of aircraft are removed from service due to additional airline bankruptcies or restructurings.

Aircraft values and lease rates are also being impacted by the number and type of aircraft that are currently out of service due to overcapacity. Slightly over 2,000 aircraft (12% of world fleet) have been out of service for most of 2003, including aircraft types in production. In years prior to 2001, the out of service fleet was approximately 4% to 6% of the world fleet, which was mainly comprised of aircraft that were out of production. Aircraft values and lease rates should improve as aircraft are returned to service.

In October 2003, Commercial Airplanes announced the decision to end production of the 757 program in late 2004; however, we will continue to support the aircraft. While we continue to believe in the utility and marketability of the 757, we are unable to predict how the end of production, as well as overall market conditions, may impact 757 collateral values. At December 31, 2003, $1.4 billion of BCC's portfolio was collateralized by 757 aircraft of various vintages and variants. Should the 757 suffer a significant decline in utility and market acceptance, the aircraft's collateral values may decline which could result in an increase to the allowance for losses on receivables. Also, BCC may experience a decline in rental rates, which could result in additional impairment charges on operating lease aircraft. While BCC is unable to determine the likelihood of these impacts occuring, such impacts could result in a potential material adverse effect on BCC's earnings and/or financial position.

Due to ongoing market uncertainty for 717 aircraft, possible material exposures exist related to the 717 program. (See Commercial Airplanes segment discussion.) At December 31, 2003, $2.2 billion of BCC's portfolio was collateralized by 717 aircraft. We are unable to predict how the possible end of production, as well as overall market conditions, would impact 717 collateral values. In the event of a program termination decision, the aircraft's collateral values may decline resulting in an increase to the allowance for losses on receivables. This could lead to a potential material adverse effect on BCC's earnings and/or financial position.

As of December 31, 2003, there were $278 million of assets, principally commercial aircraft that were held for sale or re-lease at BCC, of which $122 million had a firm contract to sell or place on lease. Additionally, approximately $332 million of BCC's assets are currently scheduled to come off lease in 2004 and become subject to replacement into the market. The inability of BCC to sell or place these assets into a revenue-generating service could pose a potential risk to results of operations.

Airlines regularly utilize a special purpose entity (SPE) known as a Pass Through Trust. The Pass Through Trust enables the airline to aggregate a large number of aircraft secured notes into one trust vehicle, facilitating the issuance of larger bonds called Pass Through Certificates (PTCs). The most common form of PTCs issued by airlines is the EETC. EETCs provide investors with tranched rights to cash flows from a financial instrument, as well as stratified collateral positions in the related asset. While the underlying classes of equipment notes vary by maturity and/or coupon depending upon tenor or level of subordination of the specific equipment notes and their corresponding claim on the aircraft, the basic function of the Pass Through Trust in an EETC remains: to passively hold separate debt investments to enhance liquidity for investors, whom in turn pass this liquidity benefit directly to the airline in the form of lower coupon and/or greater debt capacity. BCC participates in several EETCs as an investor typically in the last-position tranche. The EETC investments are related to customers we believe to have less than investment-grade credit.

BCC also routinely utilizes SPEs to isolate individual transactions for legal liability, perfect its security interest and that of third-party lenders in certain leveraged transactions, and to realize certain income and sales tax benefits. These SPEs are fully consolidated in BCC's and our financial statements.

Significant Customer Contingencies

A substantial portion of BCC's portfolio is concentrated among commercial airline customers. Certain customers have filed for bankruptcy protection or requested lease or loan restructurings; these negotiations were in various stages as of December 31, 2003. These bankruptcies or restructurings could have a material adverse effect on BCC's earnings, cash flows or financial position.

United Airlines (United) accounted for $1.2 billion (9.5% and 10.1%) of BCC's total portfolio at December 31, 2003 and 2002. At December 31, 2003, the United portfolio was secured by security interests in two 767s and 13 777s and by an ownership and security interest in five 757s. As of December 31, 2003, United was BCC's second largest customer. United filed for Chapter 11 bankruptcy protection on December 9, 2002. During 2003, BCC completed a restructuring of United's aircraft loans and leases. The receivables associated with a security interest in the two 767s and 13 777s were restructured with terms that did not necessitate a troubled debt restructuring charge to the allowance for losses on receivables. The lease terms attributable to the five 757s in which BCC holds an ownership and security interest were revised in a manner that reclassified these leases as operating leases. Additionally, BCC previously assigned to a third party the rights to a portion of the lease payments on these five 757s. As a result of this lease restructuring, as of December 31, 2003, BCC recorded operating lease equipment with a value of $84 million and non-recourse debt of $42 million (representing the obligation attributable to the assignment of future lease proceeds). As of December 31, 2003, United is current on all of its obligations related to these 20 aircraft.

United retains certain rights by virtue of operating under Chapter 11 bankruptcy protection, including the right to reject the restructuring terms with its creditors and return aircraft, including our aircraft. The terms of BCC's restructuring with United, which were approved by the federal bankruptcy court, set forth the terms under which all 20 aircraft BCC financed are expected to remain in service upon United's emergence from Chapter 11 protection. If United exercises its right to reject the agreed upon restructuring terms, the terms of all of the leases and loans revert to the original terms, which terms are generally less favorable to United. United would retain its right under Chapter 11 to return the aircraft in the event of a reversion to the original lease and loan terms.

American Trans Air Holdings Corp. (ATA) accounted for $743 million and $611 million (6.1% and 5.2%) of BCC's total portfolio at December 31, 2003 and 2002. At December 31, 2003, the ATA portfolio included 12 757s and an investment in preferred stock. In November 2002, ATA received a loan of $168 million administered by the Airline Transportation Stabilization Board. During 2003, BCC agreed to restructure certain outstanding leases by extending their terms and deferring a portion of ATA's rent payments for a limited period of time. The terms of the restructured leases did not result in a charge to the allowance for losses on receivables. ATA must meet certain requirements for the terms of the restructured leases to remain in effect. These requirements included the completion of an exchange offering on its publicly traded debt, which would result in a deferral of the principal debt maturity date. ATA satisfied those requirements on January 30, 2004.

Hawaiian Holdings, Inc. (Hawaiian) accounted for $509 million and $479 million (4.2% and 4.1%) of BCC's total portfolio at December 31, 2003 and 2002. At December 31, 2003, the Hawaiian portfolio primarily consisted of 12 717s and three 767s. Hawaiian filed for Chapter 11 bankruptcy protection on March 21, 2003. With bankruptcy court approval, BCC has reached an agreement releasing Hawaiian from its obligation to take delivery of a new 767 that was scheduled for delivery to Hawaiian in April 2003. This aircraft was sold to a third party in October 2003. Similarly, BCC agreed to permit Hawaiian to return two 717s it leased from BCC. BCC has arranged for these 717s to be leased to a third party. On February 11, 2004, we announced BCC's support for a plan to restructure Hawaiian. The restructuring would include among other things, a revision of BCC's lease terms and result in a substantial decrease in rental receipts from Hawaiian. This plan is subject to approval by the bankruptcy court and Hawaiian's creditors. Taking into account the specific reserves for the Hawaiian receivables, BCC does not expect that the transactions with Hawaiian will have a material adverse effect on its earnings and/or financial position. In the event that future negotiations or proceedings result in the return of a substantial number of aircraft, there could be a material adverse effect on BCC's earnings, cash flows or financial position, at least until such time as the aircraft are sold or redeployed for adequate consideration.

Summary Financial Information

Revenues BCC segment revenues consist principally of interest from financing receivables and notes, lease income from operating lease equipment, investment income, gains on disposals of investments and gains/losses on revaluation of derivatives. The overall growth in revenues for BCC over the past three years was principally driven by a larger portfolio, resulting from new business volume and portfolio transfers from other segments in 2002 and 2001. While the numbers above demonstrate revenue growth of approximately 23% in 2003 and 22% in 2002, BCC does not expect such growth in the future due to the change in its business strategy described in the Business Environment and Trends section above.

In addition, during 2003, BCC's net gain on disposal was $49 million as compared to $8 million in 2002 and $34 million in 2001. The increase was due to the sale of an investment in a single SPE arrangement in 2003. These gains are sporadic in nature and depend in part on market conditions at the time of disposal. There can be no assurance that BCC will recognize such gains in the future.

Operating earnings BCC's earnings are presented net of interest expense, valuation allowance adjustments, asset impairment expense, depreciation on leased equipment and other operating expenses. The increase in 2003 operating earnings was primarily attributable to the increase in revenues discussed above, partially offset by increased interest expense, valuation allowance and impairment charges. Financing related interest expense increased to $442 million for 2003 when compared to $410 million for 2002 and $324 million for 2001.

As summarized in the following table, during the year ended December 31, 2003, we recognized pre-tax expenses of $320 million in response to the deterioration in the credit worthiness of BCC's airline customers, airline bankruptcy filings and the continued decline in the commercial aircraft and general equipment asset values, of which $254 million related to BCC. For the same period in 2002, we recognized pre-tax expenses of $426 million, of which $200 million related to BCC.

In light of the decline in the creditworthiness of its customers over the past two years, BCC has substantially increased the valuation allowance. BCC recorded a $130 million charge to earnings in 2003 compared to $100 million in 2002 to increase the valuation allowance. The Other segment recorded a $61 million charge to earnings in 2003 compared to $80 million in 2002. The valuation allowance did not increase significantly in 2001.

Additionally, because aircraft equipment values have dropped significantly over the past few years, BCC recognized asset impairment-related charges of $124 million, of which $21 million was due to the write-off of forward-starting interest rate swaps related to Hawaiian, in 2003. During 2002, BCC recognized charges of $100 million, which consist of $13 million related to investments in ETCs, charges of $48 million due to impairments of joint venture aircraft and charges of $39 million related to other assets in the portfolio. Additionally, the Other segment recognized charges of $5 million in 2003. During 2002, the Other segment recognized charges of $146 million, which consist of $66 million related to investments in ETCs and charges of $80 million related to other assets in the portfolio, of which $66 million related to the return of 24 717s by AMR Corporation. BCC carefully monitors the relative value of aircraft equipment since we remain at substantial economic risk to significant decreases in the value of aircraft equipment and their associated lease rates. While equipment risk is inherent in our business, this risk has been magnified over the past few years by the lingering weakness in the airline industry and the resulting oversupply of aircraft equipment. Total impairment charges were not significant in 2001.

Other Segment

The increase in Other segment operating losses in 2003 reflects higher investments in Connexion by Boeing^SM, decreased revenues in Boeing Technology, lower customer financing revenues and lower pension income. Connexion by Boeing^SM continues to prepare for launch of commercial service in early 2004. Connexion by Boeing^SM signed initial service agreements with Japan Airlines and All Nippon Airways for 10 aircraft each bringing the total number of aircraft under contract for its service to 119. Boeing Technology experienced decreased revenues due to the transfer of certain programs to IDS. Lower customer financing earnings also contributed to the increase in Other segment operating losses. Additionally, we recognized lower pension income as a result of declining interest rates and negative pension asset returns in 2001 and 2002, the impact of which is amortized into earnings in future periods.

During the years 2003, 2002 and 2001, operating earnings of $69 million, $69 million and $36 million, respectively, were attributable to four C-17 transport aircraft on lease to the United Kingdom Royal Air Force, which began in 2001. Offsetting the 2002 and 2001 operating earnings of the C-17 leases were increases in losses primarily due to increases in intracompany guarantees and asset impairments, lease accounting differences and other subsidies related to BCC.

Research and development activities in the Other segment relate primarily to Connexion by Boeing^SM and, to a lesser extent, Air Traffic Management. Research and development activities in the Other segment remained constant in 2003.

Astro Ltd., a wholly-owned subsidiary, operates as a captive insurance company. This subsidiary enables certain of our exposures to be insured at the lowest possible cost to us. In addition, it provides flexibility to us in structuring our insurance and risk management programs and provides access to the reinsurance markets. Currently, Astro Ltd. insures a portion of our aviation liability, workers compensation, general liability, property, as well as various smaller risk liability insurances.