NetJets Ascendant

NetJets, the original and by far the largest fractional aircraft operation, was founded by Richard Santulli in 1986 and acquired by Warren Buffett’s Berkshire Hathaway conglomerate in 1998 for $725 million. A decade later, the company operated some 800 business jets in the United States and Europe for thousands of share owners. However, once the global recession struck, new share sales slowed dramatically, existing owners began cashing in their shares and the company began hemorrhaging money — Buffett put its 2009 losses at a “staggering” $711 million.

Santulli resigned and in August 2009 Buffett installed as CEO David Sokol, a favorite problem solver who also heads Mid American Energy, another Berkshire company. Sokol quickly canceled orders for all new aircraft, a move that eliminated billions of dollars from OEM order books; oversaw sweeping changes in the executive suites; consolidated operations; sold off dozens of aircraft into an already flooded market; and furloughed 1,000 employees including nearly 500 pilots.

Then last year, the company acquired Marquis Jet, which sold “jet cards” using the NetJets fleet, and in October announced it was purchasing as many as 125 Phenom 300 jets from Embraer, an OEM new to NetJets. Those moves created hard feelings, worry and controversy, but seem to have had a positive effect on the bottom line. NetJets operations were predicted to end 2010 with a comfortable profit, and to continue in the black.

Long the subject of speculation and controversy within the business aviation community, NetJets has grown to be largest single business jet operator and a significant force within the industry. Its course impacts many.

Consequently, we traveled to NetJets headquarters in Columbus, Ohio, in mid-January to interview Sokol and get his assessment of the state and future of his company.

BCA: Was this assignment a surprise?

Sokol: When Warren called and said, “David, can I get you to handle a couple of things at NetJets?” I asked, “What are my qualifications?” And he said, “You’ve been an owner for 10 years.” And actually, it’s been very useful.

BCA: You must have had some sense of what was wrong.

Sokol: The thing about NetJets that was becoming somewhat obvious was that it was a great concept, but oftentimes entrepreneurs struggle to transition to the professional management side, and that was really the case here.

BCA: Buffett told shareholders, “I failed you in letting NetJets descend into this condition.” But what could he have done differently? Nobody saw a downturn of this magnitude coming.

Sokol: At Berkshire, we let the management team run the business. But that means sometimes when that team doesn’t make the transitions it should, we will be slower to step in.

Starting in late 2006, 2007, you could see that the capital being expended was exceeding the returns coming with it. There were commitments to acquire too many airplanes when you’d already seen a leveling off in the industry — things that a pure entrepreneur often won’t see, because they tend to want to grow the business forever no matter what.

I think Warren saw those things, but wanted to give them a chance to figure it out. Then the fall of ’08 happened, and there still wasn’t enough reaction to that, and I think he felt: Time.

Of Berkshire’s 40 acquisitions in the last 20 years, 38 have outperformed any expectations, and two have stumbled a little bit. That’s a pretty good track record.

You want to err on the side of giving the management team the opportunity, and I think he meant he probably gave it more than he should.

BCA: So NetJets didn’t pull back quickly enough?

Sokol: That’s right.

BCA: What was the other business that stumbled?

Sokol: Dexter Shoes.

BCA: NetJets has been operating since 1986. How many of those years have been profitable?

Sokol: Berkshire’s owned it for 11 years and through 2009, cumulatively it lost about $150 million. Of that 11-year period, six were profitable and five were not.

BCA: And that does not include the purchase price?

Sokol: Right. That is just operating profit.

BCA: If Berkshire had it to do again, would it buy NetJets?

Sokol: I think so. Obviously, you would grow it differently. But I think it’s a business that Warren believes has a real place, particularly for Berkshire.

Our 4,000 customers are among the most important, wealthiest, most powerful people in the world. And that’s a group of people Berkshire does a lot of work with in different ways. Secondly, there’s not room for very many in the business. It doesn’t lend itself to that. There are only so many people who can afford the product.

Berkshire spent a lot of money to be where it is, and this is not a hugely profitable business. We make money, but our after-tax margin on revenues, steady state, long term, I believe will be between 4% and 5%. He probably would have paid less for the company had he known that. It’s very expensive to provide the level of service that the owners deserve and want.

But I think fractional aviation is going to demonstrate itself as a more important product long term than it was even perceived to be before the downturn. It’s so much more efficient.

BCA: NetJets had a reputation of almost being a family-run kind of business. But it’s been through a downturn, had 1,000 layoffs, and you came in with more of a corporate bent. How’s morale?

Sokol: I think it’s good. It went through a difficult period for exactly the reasons cited.

NetJets at the time was 7,500 employees. That’s not a family. And I don’t mean you shouldn’t treat people properly. But Warren said it well in his annual statement last year that had Berkshire not been here, this company would be bankrupt. It was spending money faster than it made it by a large proportion, and Berkshire stood behind it. Now that’s family.

On the other hand, the business has to be run properly. And so when I sat down with employees I said my job is to bring balance. Berkshire is not entitled to an unfairly high return, and 4% and 5% on revenues is not a huge return. But we’ve got to run the business in the most efficient method we can. That means buying airplanes and fuel at the right price, and doing everything to run the business so that the owner is getting exactly everything he paid for and hopefully a little more, and we properly pay and provide benefits to our employees, and Berkshire makes a fair return.

NetJets’ 24-hr. operations center at Port Columbus International Airport

If we can’t do those things, if Berkshire went 11 years without a return, how much longer are they going to go? Berkshire will never walk away from a business — we still redeem Green Stamps, we still print World Books, we don’t walk away from commitments. On the other hand, we would just start shrinking the business. You certainly wouldn’t grow a business that has no return.

And so my job was to really explain to the employees, you don’t have to like me, but respect the equation here. Because if I tried to continue what was going on for another year, then it was going to get much uglier.

I’ve been out and met with more than 600 of our pilots, and I think they feel great about things. I think the morale around here is actually quite good. People feel very accomplished at what they’ve done. And we’re back growing again.

BCA: Your pilots are key in customer contact and caused some upset during the last contract negotiations. What’s the pilot contract status now?

Sokol: Our contract is due in 2016. I was not here when they had a problem in ’06 and ’07. I think there was not an appreciation for some of the issues that mattered to the pilots. I think that got worked through. I think the contract we have for the quality of pilots we have is great. We’ve got the finest pilots in the world. They’re well treated, as they should be. They’re the tip of our sword. They are the single most important asset we have.

BCA: Will those furloughed be the first hired again?

Sokol: Yes, if they choose to be.

BCA: How have the cuts affected your customers?

Sokol: What’s important to recognize is that virtually all those layoffs were people who had been added to the company on the anticipation of the growth levels of ’06 and ’07 continuing into the future. So those reductions were on balance just taking the excess out of the system.

Initially we had owners who said, “Gee, is this going to affect service?” A fair question. But the data shows that in 2010 in any way you want to measure — on time, number of complaints — we had the best service ever. Those were from the same owner surveys we always used.

I made the commitment that we would never reduce the safety standards, and in fact we increased them, but we also raised service standards beyond expectations.

BCA: The original NetJets business model had four shares per aircraft, but now you’re down to 32nds.

Sokol: Actually, a 1/32 is the equivalent of a 25-hr. card. The smallest share we sell is 1/16. I think there is some reasonable question as to whether the smallest incoming share shouldn’t be 1/8, but 1/16 is currently our smallest.

BCA: Including cardholders, how many people have claim to an aircraft?

Sokol: In total we have just under 4,000 customers including cards, and I’m talking about unique owners. So it averages out to just under eight owners or users per aircraft.

BCA: Is that the right ratio, a profitable ratio.

Sokol: Yes.

BCA: Can you still deliver on the 4-hr. response promise?

Sokol: The response time varies with the product. Depending on the size of your share, you can have as little as four hours. If you own a 1/16, you don’t have 4 hr. from notification, you’ve got between eight and 10, depending the size of your aircraft. And with cards you have restrictions during peak periods. There is an appropriate differentiation between the products, both in price and in what flexibility that product has. And we will probably expand that more.

BCA: NetJets businesses now include charter, aircraft management, jet cards and fractional ownership. What will their percentages look like in five years?

Sokol: I think you’ll see the card program range from 15-25% of our total flight volume. It’s an entry point for people who haven’t used private aviation and want the safety and the service of NetJets. They pay a premium. And may of our share owners also buy cards.

We manage 160 aircraft at EJM, but almost all of those customers are also fractional or card owners. In many cases they want us to sell the airplanes we manage for them and buy NetJets shares. It’s a great mechanism. We rotate through almost 20 aircraft a year in that business.

In terms of flight hours, if you add them all up, you would have about 18% cards, about 8% EJM, and then 74% fractional.

Now, share ownership is certainly not an inexpensive product, but what we’re finding is that the late 2008 shock that corporate America took when survival was in question caused boards to look at every line item in their budgets. And that’s been a real positive for us. The boards want the CEO to continue flying privately, but want it done efficiently, and safely. So in 2010 our strongest segment was corporate share sales. I think it’s going to be true going forward.

BCA: You’re pretty bullish on the fractional market coming back.

Sokol: I think it is coming back. We added 100 net fractional share owners last year.

BCA: What was your net in 2009?

Sokol: It was down 82.

BCA: So you made all that back?

Sokol: And then some.

BCA: You canceled a lot of airplanes with Hawker, Cessna and Dassault. What was the thinking in the purchase deal with Embraer?

Sokol: When you have a major economic shift such as in the fall of 2008, you have to reinvent yourself. Well, when I came in I asked why do we have so many different types of airplanes? The answer was back in the early ’90s, we weren’t big enough to tell anybody how we wanted an airplane. We bought what they sold. Well, I recognized that a bunch of those airplanes had to be canceled, but also a lot of those airplanes were last generation.

We honored every contract and paid damages to cancel those airplanes in significant numbers. But to me that was an investment in allowing us to go out and get the business stabilized and profitable and then buy aircraft for the future.

We need airplanes that are highly reliable, highly maintainable, extremely environmental and energy efficient, and designed to not be outdated.

We started at about this time last year a competitive process to acquire a small-cabin aircraft for the future. We’ve been sitting down with manufacturers and saying here’s what we need. We want to make sure the avionics are upgradeable. We want much greater reliability and long-term guarantees on major parts of these airplanes. Embraer really embraced that and ended up winning the contest.

And now we’re doing that with large cabin and hope to make a decision in three months, and we’ll be doing it with mid-cabin with a decision on that this fall. The goal is to take the number of different types down and to buy new generation aircraft that we specify versus just what the manufacturers have.

Embraer President and CEO Frederico Curado (left) and NetJets CEO David Sokol announced the Phenom 300 agreement at the NBAA convention in October 2010.

Five years from now I’ll wager all of us will look back at 2008 and say it was the best thing that ever happened to the aviation industry because it’s forcing innovation that wasn’t going to happen.

If you can manufacture something that’s 30 years old and put a new price tag on it and paint it a little differently and somebody’s still paying that new price, it’s kind of hard to tell yourself to stop doing that and spend money to build a better one. Well, in September 2008 reality showed up. So, it will be great for our business.

BCA: Is Bombardier a possible aircraft supplier?

Sokol: We have an obligation to put the best, most efficient, most effective aircraft in front of our owners. That’s what we do. And so in my view we can’t ban any manufacturer.

BCA: You have 800 jets, including EJM’s 160. Do you need them all?

Sokol: We sold 47 airplanes last year. One part of our model that the former team wasn’t following properly — we only keep small-cabin airplanes up to 12 years and mid-cabin and large up to 15. They should have been selling our airplanes faster back in 2006 and 2007. By the end of 2011 we will be where we need to be. That’s why we have orders for airplanes starting in 2012. We will need new aircraft.

BCA: Wasn’t aircraft retention to be for five years?

Sokol: No. The contracts with owners are for five years, but then they re-up typically.

BCA: So what’s the fleet age?

Sokol: Our average fleet is about 7.3 years when you subtract the 47 we just sold because obviously we sell the oldest aircraft. With 800 airplanes, 7.3 years is not an old fleet.

BCA: Is 800 airplanes the right number, or have you too many still?

Sokol: We will dispose of probably 40 more aircraft this year. Then we start taking new aircraft next year.

BCA: Are deadheads a significant part of your flight hours?

Sokol: Positioning flights represent 20-25%.

BCA: That means 75% is revenue flying?

Sokol: On an annual basis, yes.

BCA: When will we see the fractional comeback in Europe?

Sokol: The European market has always been slower than the U.S. market. Total flight hours in our company were up 7.5% year to year in 2010. Of that the United States is more than twice Europe on a per-airplane basis. But Europe on a share basis had a better fourth quarter than the United States.

BCA: How is NetJets Europe constructed?

Sokol: We own half of it directly and then we have essentially a franchise agreement on top of that. And so from an economic standpoint, we probably own more like 90%.

BCA: Same arrangement in the Middle East?

Sokol: We have a pure franchise agreement there. We oversee the safety and operations side and provide a number of systems. They operate through a company called NAS, which is owned by a consortium of individuals in Saudi Arabia. They have 19 aircraft, four of which are managed. And it seems to work well. We have our people there. They reimburse us, plus a fee.

And then in China we have begun filing for certification to set up a fractional operation there. It probably will take somewhere between 12 and 16 months to finish that. NetJets people actually helped the Chinese write their private aviation rules back in the early 2000s. But it hasn’t been until the last two years that the opportunity to get really involved in private aviation has made sense. We’re being driven there by our customers who do a lot of work in China.

BCA: So you’ll have a NetJets fractional operation in China in 2013?

Sokol: I would hope to have it up and operating in late 2012.

BCA: Is China a big growth market?

Sokol: Having done business there for a long time, I think you always have to look at China as a very significant potential that will grow at its own time. It is a society and a government that does things on a schedule that they don’t always tell everybody about.

There’s no question that they’re very encouraging to us. But whether it’s a 20-airplane business or a 500-airplane business 10 years from now, I don’t know.

Our primary business is to satisfy the demand of our U.S. and European customers, and then assume some growth of actual domestic Chinese customers over time. I’ve been around China long enough to know it will happen at the right pace, but I don’t know what the pace is yet.

BCA: You were brought in to fix things. When will that be done and when will you leave?

Sokol: The way Warren has done this in the past is each time I’ve been involved in a company, ultimately I stay as chairman. Here I looked for the managers who really get it and now we have a senior team running the business. I brought in Jordan Hansell as general counsel because he’s a genius and an excellent manager. I promoted him in November to president. Some time in the future the CEO’s title will transfer and I’ll stay as chairman.

BCA: Some time in the future.

Sokol: It could be in the first quarter or it could be a year and a half from now. I’ve done this enough times now to know when it’s time. You can see it; you can feel it. I won’t keep it a day longer.

BCA: What’s your overall employee count now?

Sokol: It’s 6,360 globally.

BCA: What are your profits going to be in 2010?

Sokol: What I said earlier last year was we were targeting to make $200 million pre tax. I’m comfortable that we will make that.

BCA: And profitable henceforth?

Sokol: Yes. This business should always be profitable. BCA

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