““CEOs go to their vacation homes just after companies report favorable news, and CEOs return to headquarters right before subsequent news is released. More good news is released when CEOs are back at work, and CEOs appear not to leave headquarters at all if a firm has adverse news to disclose. When CEOs are away from the office, stock prices behave quietly with sharply lower volatility. Volatility increases immediately when CEOs return to work.” —David Yermack, a New York University finance professor, whose recently released study shows a correlation between when CEOs take their private jets on vacation and movements in their companies’ stock price ”
Is the fractional business model broken?
Not long ago, the idea of selling fractional shares in business jets looked like a winner. Industry pioneer NetJets-which Warren Buffett had acquired for Berkshire Hathaway in 1998-appeared prosperous, and so did the several other companies that had formed to take advantage of the business model. Flexjet started in 1995, PlaneSense launched a year later, Flight Options debuted in 1998 and CitationAir by Cessna (then called CitationShares) opened its doors in 2000. Avantair-which, like PlaneSense, focuses on turboprops-came along in 2003. There was, it seemed, business enough for all of them.
Today, though, the news about the fractional-share industry doesn't concern the startup of companies-at least not national ones with ambitious plans. With the Great Recession having taken a toll on business jet travel and residual aircraft values, the news these days at the major U.S. fractional providers largely concerns red ink and efforts to stop its flow. NetJets, for example, had accumulated a staggering $1.9 billion in debt as of April 2009 and has since cut staff, moved its headquarters from New Jersey to Ohio and replaced its CEO, industry founder Richard Santulli. Avantair and PlaneSense appear to be doing at least relatively well on a much smaller scale, but CitationAir, Flexjet and Flight Options have all struggled to varying degrees. We've seen furloughs, layoffs, reorganizations and downsizings.
Increasingly, the question being asked is whether the fractional business model even makes sense anymore. And if it does, what do the providers need to do to survive? To address these questions, we talked with industry consultants as well as CEOs at the leading fractional providers. (NetJets CEO David Sokol declined our request for an interview for this article.) None of them predicted the business model's demise but most suggested that significant changes lie ahead.
A key problem for the industry is that providers have relied on share sales rather than on operations for their profits, said New Jersey-based business aviation analyst Brian Foley. "Until recently, they could make all their money on the front end by buying aircraft at deep discount from the manufacturers," he commented. "They were buying in fleets and then divvying up the aircraft at list price to their clients. So you could almost be unprofitable on the operational side because you'd make it up on the front end.
"With the economic change in 2008," Foley continued, "the number of fractional shareowners went down, so suddenly the cash flow made on the front end of the sale went away and the providers had only the operational income to fall back on, and that was apparently a money loser."
Avantair CEO Steve Santo echoed these comments. The traditional business model for fractional operators involved making "a lot of profits on the sale of the aircraft...and not on the operations side," he said. "If you bought a share in a Hawker 400, you were paying considerably more [on a proportional basis] than a person who bought a full aircraft from Hawker. So you've already taken a depreciation hit on the day you sign the contract. And I think those days are really over. The consumer has become so educated on the residual values of the aircraft."
Another problem, said Foley, is that the market simply isn't as big as the providers apparently hoped. "Even before the '08 collapse," he noted, "it was clear that fractional owner growth wasn't logarithmic anymore and it appeared to plateau. The providers discovered that there was a limit to that market and maybe there were even too many players out there to support it."
CitationAir CEO Steve O'Neill commented similarly and went further, saying he dismissed the traditional fractional business model two years ago as being "irrational." Added O'Neill: "There are essentially no new sales of fractional contracts taking place, meaning that there is no new money coming into the fractional business. We give the customers the right to sell us back a share anytime they want and don't get paid for that option. We give them the right to have the aircraft any day of the year and don't get paid for that. It's just not a business model that has proven effective. There's too much risk in it and too much cost for both the provider and the customer."
His solution? "Our current business model has us owning no airplanes," O'Neill said. "We have no core fleet to speak of-I think we have two core airplanes." Instead, he explained, CitationAir sells fractional shares in aircraft that it merely manages. "We've got as much lift as we need-we just don't own it. So we don't have the balance-sheet risk and the exposure to falling aircraft prices that our competitors have.
"Fractional is slightly more than 50 percent of our business and it'll probably not get any bigger than that," O'Neill added. "From my perspective, it'd be fine if it got smaller."
Still, there will continue to be a place for fractional aircraft shares, believes James Butler, who is CEO of the private aviation consulting firm Shaircraft Solutions. "There will always be those who want the convenience of being able to call one number and have a single fleet managed by a company that hires and trains their own pilots and has aircraft available and you don't have to do any research or bid out your flight," Butler said. "There will be people who are willing to pay for that as opposed to a block-charter program where the aircraft come from a menu and there may be some you like and some you don't like and pilots with different experience and training."
Flight Options CEO Kenn Ricci agreed, commenting, "I really don't think the model is broken. When I see the bad press that's been put on corporate ownership [of aircraft], I say, 'Wow, that really does bring us to more to a fractional model.' Of course, if I thought that [the model was broken], we never would have made the investment to be in the marketplace. It's just becoming more and more onerous to be on the airlines. I see only a bright future for [the fractional field]."
Other insiders also spoke optimistically about the business model. "Not only do I think it is viable-I think there's plenty of objective proof that shows it's viable," said Flexjet CEO Fred Reid. "Sure, the number of jets in fractional service has dropped, but we're seeing a modest increase in new business. What you've got to keep track of is the exit rate, but it's pretty normal right now."
While declining to provide numbers, Reid claimed that Flexjet has more net customers than it had a year ago and that "by disposing of a small number of airplanes and rightsizing the staffing," his company returned to profitability in November 2009. "Since the beginning of the downturn in the fourth quarter of 2008," Reid said, "we've already seen people get out of fractional, buy a card, the card expires and they come back to fractional. So we've seen movement down and back up the food chain."
Flight Options' Ricci did concede that jet cards could wind up being more popular than fractional shares. "It all depends on the price that companies in the aircraft financing business put on residual-value risk," he remarked. "If they price it based on what happened in 2008, the cost of leasing aircraft will push jet card prices so high that it may drive people back to the fractional model. Once you tell me what my financing costs are going to be...I can tell you where cards will be priced versus fractional. When we know that, we can decide what model's better."
Regardless of what happens with financing and residual values, however, Butler foresees shrinkage in at least one segment of the fractional market. "What's going to be more and more difficult to sell to nonbusiness travelers is the idea of using their capital to purchase the aircraft," he said. "Fractional will continue to work for businesses that can use the depreciation and that otherwise might be looking at purchasing an aircraft and having to manage it and have a flight department. But I think a lot of people who fly for leisure purposes will look more at other options, having been burned on the way out [when providers repurchased shares]."
To survive, Butler added, fractional companies "will have to be well managed and provide what customers are looking for in a cost-effective and profitable way. Or else they will have to be airplane manufacturers that are selling their aircraft into their [own] programs-they make their profit that way.
"I think what will bring more buyers to the table is more of what the industry started out with," Butler continued. "The main selling point was that your costs were known-you'll pay this much for the share, this much per month, this much when you fly, and the costs could go up X percent. And they would guarantee you a floor on the value of your share. So you could run the numbers and know your costs.
"Over time," Butler continued, "the companies have moved toward more of a traditional management model where they'll manage the aircraft for a fee but the variable-cost risk is yours. I've also been surprised that some of the fractional companies have simply changed the rules in the middle of the game. They say, 'We're not gonna buy back your share like we said we would-we're gonna wait a while and we'll let you know.' Or, 'We're a little worried about our salary structure, so here's a new surcharge.'
"I think there needs to be a new transparency and level of trust between the programs and their customers. [The relationship] has been strained as the economy has soured and owners have seen the cost of their flying become much more variable."
Not surprisingly, all the fractional CEOs we interviewed predicted or implied that their own firm would survive the current economic downturn. Several CEOs and analysts also commented that NetJets would endure because of its impressively sized fleet of large-cabin aircraft and because, as Reid noted, "they have a committed investor [in Berkshire Hathaway] and a very committed management team."
However, a few interviewees suggested that some firms might not be so lucky. "I think there's a little more volatility among one or two of the players," is the way Reid put it. "I honestly don't know [which will survive] and wouldn't care to speculate." Added Santo: "I think we'll see some merger-and-acquisition activity going on. It has to happen."
Still, he noted that some NetJets competitors could have an easier time going forward. A few years ago, Santo commented, NetJets could charge a premium by claiming to be the safest operator and "people bought into that marketing perception. Now people have realized, hey, everybody flies under the same regulations, everybody's training at FlightSafety, everybody's paying their pilots pretty much the same amount and getting the same type of talent. So that element of branding kind of disappeared. People aren't willing to pay more now."
Two observers suggested that more fractional operators would follow NetJets' lead and expand internationally. "There's less room for domestic providers and perhaps more room for international ones," said Foley. And, commented Flight Options' Ricci: "I think you'll see us go more into the international market. The market is becoming more and more global. We have to start thinking about what products we want to use to access the international market."
On the other hand, Reid noted that FlexJet has no such plans, "because the market is going to be at its current low levels for a good time to come." O'Neill also said "absolutely not" to the idea of international expansion for CitationAir. "The cost is prohibitive in this economic environment," he explained. "I do not have any interest in expanding into Europe or Asia at this time."
That doesn't mean O'Neill sees no room for expansion-he just has his eye on new products rather than new places. "I believe that a pure 100-percent fractional operator will struggle in this market for a long time," O'Neill said. "It's the complementary products that we offer that allow us to become more effective in the marketplace-jet cards and the jet-management product that gives us the lift we need that we only have to pay for on a variable-cost basis."
Butler echoed that comment. "You'll see a lot of firms going back into standard aircraft management and certainly the cards and charter and those sorts of things," he said.
Foley, meanwhile, envisions opportunity for fractional firms in traditional charter. "Charter really doesn't have a [company with a] national presence yet," he said. "I think some of the fractional providers could have a national charter presence because they have the airplanes and can cover Seattle to Miami without having to do costly deadheads. No one's really cracked that space yet. And probably the only folks in a position to do something like that are the fractional providers. You could brand yourself the American Airlines of business aviation. That's probably a missed opportunity right now."
How Fractional Offerings Might Change
What changes might customers see in the years ahead as fractional providers tweak their business model? Here are some of the predictions we heard:
Fewer aircraft models. Some providers, such as Flight Options, have already cut back on the number of models they offer. "I'm not sure there needs to be anything more than a small, a medium and a large offering by a company," commented consultant Brian Foley. "If you have a dozen models, you have the associated costs-different pilot training and maintenance-for each."
Avantair CEO Steve Santo agreed. "We're not going to see companies that have 15 types of airplanes anymore," said Santo, whose company already limits itself to one aircraft, the Piaggio Avanti twin turboprop. "Before, if you were owned by a manufacturer, you were going to try to offer everything the manufacturer sells to help it sell airplanes. From an efficiency standpoint, that doesn't work."
Higher prices. "I think prices will escalate modestly as jet prices escalate," commented Flexjet CEO Fred Reid. Santo, meanwhile, said, "Operating costs are definitely going to go up," and Foley predicted, "They'll all raise rates and monthly management fees. In the past, if one tried to raise prices, the others didn't have to follow but everyone's in the same boat now and if you see price-increase leadership, the others will be happy to follow."
CitationAir CEO Steve O'Neill, however, said, "I think we should actually see lower prices on operating rates. If we get our cost structure in line, that can happen."
No buyback guarantees. A promise to buy back shares from customers at a given rate "caused a lot of money to go out the door for fractional providers," Foley said. "Avantair doesn't have that provision and we suspect the others could be following suit." But, said Reid, "The buyback guarantee is one of the selling points of the product. I wouldn't want to speculate that that is going to disappear."
More product types. "There won't just be pure fractional like there was in the past," Foley predicted. "For example, we'll see more flavors of fractional jet cards. The cheaper ones might have more restrictions and blackout days; the premium ones will be more flexible. We'll also see more companies like XOJet, which isn't really a fractional provider and isn't really a charter provider-they're somewhere in between."
Added Reid: "I think the menu is broadening. Perhaps [there will be] easier movement between aircraft types. That's not brand new but we're seeing more of it." Reid also cited his company's five-year-old Versatility Plus program, which allows users who under-fly their hours to sell what they don't use to other owners. "That's an example of adapting to the marketplace," he said. "Also, you can have a Walkaway Lease [another Flexjet product], which conveys all the benefits of fractional, costs ever so slightly more because you don't have the capital investment but also provides some flexibility because you don't have the capital investment."
Smaller service areas. For competitive reasons, Santo said, everybody kept expanding their service areas, which led to more repositioning. People were flying deep into the islands and we didn't have any chance of somebody flying back. So we were positioning the airplane at our cost. I think we're going to see shrinking of the service areas."
New alliances with airlines. Fractional providers are starting to cut deals with airlines, making it easier for shareowners to arrange and make trips that involve both private flights in the U.S. and airline flights internationally. Two recent examples: Flexjet's collaboration with Korean Air and CitationAir's alliance with British Airways.
More variable pricing. Butler said providers will need to more closely match services with costs. "For
example," he explained, "I see a company like CitationAir basically saying, 'Look, if you want to have first right [to aircraft] on 340 days, it costs this and if you want 350 days, it costs that.' [We'll see] those kinds of things, where people can choose the level of service they want and the cost that goes with it."
Said O'Neill: "Most of our customers choose the nonpeak-day options and enjoy the savings of not having to pay a premium to fly any day of the year. I think it's likely in the future that we'll also see differentiated pricing on locales. So, for example, if you fly routinely from Teterboro to Palm Beach, you should not pay as much as the person who flies from North Dakota to Oklahoma."
And, said Santo: "I think you'll see a business-usage plan where the guy is gonna fly Monday to Thursday. And then you'll see a higher-priced program for people who are flying on the busier days. So you'll see more of an airline approach, I think, to a lot of the programs."
More light-jet and turboprop shares. Flight Options has ordered 100 of Embraer's Phenom 300 light jets, hoping that the model's relatively low operating costs will appeal to customers. Meanwhile, Butler predicts more interest in turboprops. "I see people taking a very sharp pencil to the cost side and looking to see whether much of their flights can be serviced by the turboprops," he said. "Especially people flying up and down the East Coast or Texas to California, Texas to Colorado, those kind of flights.
"One company that I think is doing sort of well is Avantair," Butler added. "They're offering a slightly slower aircraft that people like very much, and the cost structure is attractive. I hear people who have been in cards or with the major fractionals saying, 'I can accomplish much of what I want to do at Avantair and the other stuff I can figure out with charter or something like that.'" Avantair's statistics appear to back that up, as it claims that 80 percent of its recent new business has come from customers who previously owned shares with one of the four largest providers.