Fractionals: Evolution in action

 - September 14, 2006, 11:21 AM

Twenty years after its birth, the fractional concept is finally a mainstream part of the business aviation industry. It didn’t start out that way, and one need only look at the current chorus of very light jet air-limo naysayers to get an idea of how the business aviation community reacted to fractional aircraft ownership in 1986. But Richard Santulli, NetJets chairman and the father of the fractional concept, just held his chin high and maintained a steady course.

Eventually the naysayers quieted as NetJets began to gain traction in the early 1990s. By the middle of the decade, the fractional provider was doing well–so much so that it caught the attention of several would-be competitors. First to challenge NetJets was Bombardier Flexjet in 1995, then Raytheon Travel Air in 1996, Flight Options in 1998 and CitationShares in 2001, not to mention a host of local and regional fractional providers–including Avantair and PlaneSense–between the mid-1990s and the present. (Raytheon Travel Air and Flight Options merged in 2001 as Flight Options LLC.)

The fractional industry rode the wave to success as the stock market skyrocketed in the late 1990s and early 2000s. Fractional providers added airplanes and shareowners in record numbers, and it seemed there was no end in sight to annual double-digit percentage growth.

But what goes up must eventually come down, and as the stock market deflated in late 2001, the fractionals began to experience more modest growth. At the same time, shareowners–feeling the financial squeeze–began to cut back on using their fractional airplanes.

This challenged the fractionals, which rely on share sales, monthly management fees and hourly occupied charges to cover their costs, and profits remained elusive. In an effort to help spur growth, the fractionals began to offer jet cards–25-hour blocks of time in a fractional aircraft–that came without the requirement of buying a share and paying monthly management fees.

First on the jet-card market was Marquis Jet, which has been selling block-hour time in NetJets aircraft since 2001. Marquis Jet is not owned by NetJets; instead, it’s an outside party that buys shares in NetJets aircraft and parses them out by the hour to its jet-card customers.

It didn’t take long for the other major fractional providers to notice Marquis Jet’s success and launch competing jet-card programs. However, these programs– Flight Options’ JetPass, CitationShares’ Vector Jet Card and Flexjet’s Flexjet 25 card–are administered by their respective fractional provider program.

Jet Cards: Good or Bad?

Despite the premium pricing of jet cards, sales took off and brought much-needed cash to providers that were bleeding red ink. But then the economy started to rebound in 2004 and with it renewed enthusiasm by shareowners to fly.

The double whammy of surging jet-card usage and a 30-percent increase in shareowner flying put so much strain on the fractional fleet that service began to suffer and charter outsourcing climbed. This angered many shareowners, who began to question why non-shareowners had equal access to “their” fractional aircraft. (It should be noted that safety does not appear to have been affected at the fractionals, especially given their fatal accident rate, which remains at zero.)

Over the past year, the fractionals have reacted to the increased flying demand by placing limits on the jet cards. Besides adding core aircraft in the past 12 months, NetJets last summer issued blackout dates for jet-card users during the 10 holiday peak travel days per year. CitationShares took a different approach by limiting the number of jet cards it will sell, and last month both Flight Options and Flexjet took a new tack by offering new jet-card programs that, as Jet Advisors’ Kevin O’Leary said, “shape demand with pricing incentives."

While the fractionals are starting to pay attention to managing jet-card demand and providing better service, it might be too little, too late for some shareowners who are up for renewal this year. Industry watchers say that between 20 percent and 30 percent of shareowners are in that group, depending on the specific fractional provider.

According to the fractional consultants contacted for this article, aircraft resale values at three of the four major providers are at “acceptable” blue-book market values. The consultants were quick to praise Flexjet for improving markedly in this area but were equally quick to label Flight Options as less than fair when it comes to resale values. In fact, they all said departing Flight Options shareowners would be lucky to get half of their original investment back, as most have seen valuations in the “30 and 40 [percent range].”

The consultants also said shareowners continue to be much more educated about business aviation, and they routinely
examine all of their lift options–charter
(including block charter), jet cards (from both charter brokers and the fractionals), other fractional programs and whole ownership–before renewing with their exis-
ting provider.

State of the Industry

According to the latest figures from Utica, N.Y.-based JetNet subsidiary AvData, between last May 31 and early November, the four major fractionals’ fleets shrank from 814 to 809 aircraft (down 0.61 percent) though the number of shareowners increased from 4,547 to 5,219 (up 14.8 percent). In the most recent six-month period ending May 31, AvData said the major providers added 11 aircraft to their fleets (a 1.4-percent increase) and welcomed 250 shareholders to the fold.

Again led by Avantair and PlaneSense, the 24 regional/local fractional providers AvData tracks posted much healthier growth numbers. Between last May and November, these “minor” players boosted their fleets by 40 aircraft (a 56.8-percent increase) and added 124 shareholders (up 38.6 percent). Over the past six months, they added 16 aircraft fleetwide (an increase of 13.8 percent) and attracted 88 more shareholders (up 25.5 percent).

Due to a change in AvData’s reporting methods, AIN was unable to determine how many fractional shares were sold between May and November last year. Previously, AvData reported shares sold simply as the number of share-sale transactions. This meant that a provider that sold four quarter shares had the same number of “shares sold” as a provider that sold four one-sixteenth shares, though the former sold one whole aircraft and the latter sold only a quarter of an aircraft. Now AvData provides the number of aircraft sold into service, reflecting the true cumulative number of aircraft sold.

Under this new reporting structure, AvData said the Big Four providers saw the number of aircraft sold into service decline 2.4 percent during the past six months, falling from 537.1 to 524.34 aircraft. The local/regional fractionals trended positive in aircraft sold into service, from 45.19 to 47.66 aircraft (a 5.5-percent rise).

In the past six months, the fractional industry recorded a gain of 27 aircraft (up 2.9 percent), a 338-shareholder increase (a 6.1-percent rise) and a 1.8-percent loss of aircraft sold into service (about 10 aircraft), according to AvData. Interestingly, the industry would have posted larger gains in aircraft and shareholders and would have trended positive in aircraft sold into service if not for the erosion at Flight Options.

Regarding market share, NetJets remains the big dog on the porch with a 52.4-percent piece of the pie, up 1.2 percent from last November. (Market share is derived from the number of aircraft sold into service, meaning a 12-month comparison is not possible as explained previously.) According to AvData, next is Flight Options at 19.7 percent (down 2.5 percent); Flexjet, 10.6 percent (no change); CitationShares, 9 percent (up 0.7 percent); Avantair, 3.1 percent (up 0.6 percent); PlaneSense, 2.4 percent (up 0.1 percent); and the remaining 22 local/regionals, 2.8 percent (down 0.1 percent).

Focus on Profitability

Talk to any of the fractional provider executives, and it won’t take long before they mention the “p” word–profitability. After posting large losses year after year, management teams at the fractionals now appear to be under the financial microscopes of their respective parent companies.

Though Berkshire Hathaway subsidiary NetJets had net profitability of $10 million in 2004, it lost some $80 million (pre-tax) last year. Noted Berkshire CEO Warren Buffett, “I said last year that [NetJets] would earn money in 2005–and I was dead wrong. Our European operation, it should be noted, showed both excellent growth and a reduced loss. Despite a large increase in customers, however, our U.S. operation dipped far into the red.”

But it seems that NetJets is again on the right track with regards to profitability. According to Berkshire’s first-quarter report, “Pre-tax losses from the [NetJets] fractional ownership business declined $12 million in 2006 as compared with 2005. The decline in the fractional ownership pre-tax loss was primarily due to a comparative decline in losses from subcontracted flights, which are necessary to meet peak customer demand and increased rates, somewhat offset by higher interest, depreciation and payroll expenses.”

Meanwhile, Flexjet v-p of sales Bob Knebel told AIN that his company was operationally profitable last year, meaning that the monthly management fees and occupied hourly fees covered aircraft operations but not sales and general staff overhead. But Knebel said Flexjet achieved “net profitability” in the first quarter.

“What’s driving our profit is better efficiency–we have low outsource charter rates, we’ve improved our fleet optimization software, we have a young fleet and we have the highest sold-into-service ratio,” he said.

CitationShares executive v-p of sales, marketing and contracts Patrick Dunlavy was not shy about this topic: “CitationShares has not yet made a profit, but we’re getting closer.” He said the fractional provider late last year raised its management and occupied charges to the highest in the industry, becoming the “price leader.” Dunlavy hopes others will follow, “because the industry isn’t sustainable in the long term by continuing to operate at a loss.” As a result, he expects his company to be operationally profitable next year.

Raytheon’s Flight Options subsidiary was the most unprofitable in the fractional industry. According to Raytheon’s annual report, its “other segment had an operating loss of $117 million in 2005 versus $40 million in 2004 and $34 million in 2003. The increase in operating loss in 2005 was primarily due to the operating results of [Flight Options].”

“We are on track for our profitability plan with Raytheon corporate,” noted a Flight Options spokesman. However, he claimed he could not disclose the timeline for this plan since Raytheon is a publicly traded company.

Avantair CEO Steve Santo told AIN that operations money at his company is “at least break-even, if not making a small profit. With every aircraft we add to our fleet, our repositioning costs go down a half percent, which helps us profitability-wise.”

According to Fractional Insider president Mike Riegel, shareowners are indeed concerned about the operational profitability of their providers. “Shareowners know that their provider needs to make a reasonable profit to stay in business,” he said. “They don’t mind paying enough to cover expenses and then some, but they want the pricing to be more transparent,” alluding to the fuel, pilot salary increase and other surcharges commonly found on customers’ bills.

Shaircraft president James Butler echoed Riegel: “Owners are willing to pay a fair price for service, but they don’t like the lack of cost transparency–the hidden costs. They want providers to be more straightforward and they want to be treated like owners, not passengers. Ultimately, the owners want the providers to be sustainable.”

Fleet Rationalization

A continuing dominant theme among the fractionals is fleet rationalization.
In February last year, Flight Options announced that it would consolidate its available fleet types by 2010 to simplify operations, increase fleet reliability and reduce overall costs. The Cleveland-based provider is reducing its fleet from 11 types to four jets–the Beechjet 400A/Hawker 400XP (light); Hawker 800XP (midsize); Citation X (super-midsize); and Legacy (large-cabin). This amounts to one type per aircraft class and lays the foundation for an eventual fleet of younger aircraft, versus the current mixture of new and older pre-owned airplanes.

Asked about the progress of the transition, the Flight Options spokesman said, “We’re almost two years into our Go Forward fleet modernization. Right now we’re a little bit ahead of schedule, with 75 percent of the fleet already transitioned to the Go Forward types. By year-end, we’ll be at 85 percent.”

Flexjet is nearly done replacing its Learjet 31As with Learjet 40XRs. Once its last remaining Learjet 31A is sold, Flexjet will have five fleet types–the Learjet 40XR, 45 and 60 and Challenger 300 and 604.

Greenwich, Conn.-based CitationShares is phasing out its Citation CJ1s and Bravos in favor of the CJ3, which is now the entry-level aircraft at the fractional provider. Going forward, CitationShares will have three fleet types–the Citation CJ3, XLS and Sovereign.

NetJets still bucks the trend with 22 current fleet offerings. Fractional Insider’s Riegel believes this course is a mistake. “NetJets badly needs to rationalize its fleet–it has way too many fleet types. Also, it should stop focusing on manufacturer discounts when buying aircraft; instead, NetJets needs to pay better attention to operating and reliability characteristics.”

Further, Riegel is disappointed that the fractionals haven’t used their clout to force business aircraft manufacturers
to make products that are better suited for the fractional environment. “The fractionals need to inject themselves into an aircraft’s development stage. If they did, the resulting aircraft would be paradigm shifters,” he noted.

However, Riegel did praise Embraer for its Phenom 300, which he believes will be a great fractional airplane due to its performance and expected regional-airliner reliability. “Embraer’s approach to the market is good for fractional operators. It is targeting interesting segments, and the Phenom 300 will set the standard for fractional aircraft. This should be a real wake-up call for the established business aircraft OEMs.”

The Labor Equation

A big story in the fractional industry is the rise, and influence, of International Brotherhood of Teamsters Local 1108. At NetJets, the pilot union fought for a new contract; at Flight Options, it fought to organize the pilot workforce and won. Local 1108’s long-term goal is to unionize the pilot groups at all of the major fractionals.

Last fall, NetJets finally closed the chapter on its long-running, and often acrimonious, contract negotiations with its pilot group. Things became heated
in the spring last year when Local 1108 decided to make its fight for a better contract more public.

The union’s assault began with roadside billboards near Teterboro Airport and at Columbus, Ohio, where NetJets’ operations base and day-to-day management are located. Then came informational picketing at busy business aviation airports, the Berkshire Hathaway annual meeting in Omaha, Neb., and several NetJets-sponsored events. This put pressure on the company to acquiesce–or at least come closer–to some of the pilots’ demands.

Four years after their contract became “amendable” in October 2001, the unionized NetJets pilots finally reached a new work agreement. Pilot pay, one of the biggest sticking points in the negotiations, in the new contract increased by an average of between 40 and 60 percent. This made the NetJets pilots the highest-paid in the fractional industry until CitationShares exceeded the raise for its pilots last November.

The NetJets pilots also got a “signing bonus” calculated at $833 per month worked since Oct. 1, 2001 (the day the existing contract became amendable). Quality-of-life improvements–notably scheduling and home basing–were also a union priority. Here, the pilots largely
got what they wanted–a seven-and-seven schedule for most and home basing (meaning no gateways) for at least 70 percent of the pilot workforce.

According to a union spokeswoman, the best part of the contract is its strong scope-clause provision, which contains merger language, successorship protections and future flying protections. It also addresses NetJets International (NJI)–the company’s nonunion fractional arm that flies Gulfstreams–which Local 1108 wants merged with NetJets Aviation (NJA), the unionized division.

Specifically, the contract allows the IBT to petition the National Mediation Board (NMB) for single-carrier status in November 2008. If the NMB approves the petition, NJI would merge with NJA, creating a single pilot workforce that is represented by Local 1108.

Under the contract, one third of the open captain positions and half of the open first-officer slots at NJI will be filled by pilots from the NJA seniority list. This is creating a mix of union and nonunion pilots at NJI, which the union said will all but guarantee that the NMB approves the single-carrier petition.

In March, the Flight Options pilots overwhelmingly voted for union representation under Local 1108. A previous union drive in January 2002 failed at fractional provider Raytheon Travel Air, which merged with Flight Options one month later.

After the results were announced on March 2, the Flight Options organizing committee said it “seeks a contract with wages, benefits and working conditions comparable to industry standards, along with enhancements to existing job security and workers’ protections.” Contract negotiations between the company and union began early last month and could take months or years to conclude.

In late March, the IBT Local 1108 executive board voted to recognize the interim leadership for the Flight Options pilots–Bill Hart, Mat Slinghoff, Mike Groner, Rick Maluda and Rick Kata. They are the legal union representatives for Flight Options pilots until permanent leadership elections can take place this fall.

Problems and Solutions

According to Riegel, “The fractional industry is healthy, but it needs a shake out.” Specifically, he called for the fractionals to change their ways–get rid of the hidden fees, stop objectionable practices and find more efficiency instead of automatically raising fees–or “they should just cease doing business.”

Riegel also believes that the fractionals should distance themselves from the OEMs–obviously a message not intended for NetJets. “OEMs need to get out of the business,” he said. “Boeing and Airbus don’t run airlines, so it makes no sense for manufacturers, or their parent companies, to run a fractional provider.”

He continued, “Providers need enough independence, otherwise one provider will continue to [out]perform the rest of the industry,” a not-so-subtle nod to NetJets. “Now is a good time for these airlines to be spun off from the OEMs.”

Another problem is the fractional model, observed CitationShares’ Dunlavy. “The basic fractional model was designed to be a quarter-share market. But today the industry is selling sixteenth shares, and really with the jet cards it’s more like one-thirty-second shares. The model is broken– something needs to be done to fix it.”

He said that pricing with Flexjet’s and Flight Options’ new incentive-based jet cards is a step in the right direction. In fact, Dunlavy commented that CitationShares is working on a similar jet-card program that would shape demand by offering discounts for travel on nonpeak days.

But he suggested that just confining it to jet-card programs might not be enough. “Incentive-based pricing will likely move from jet cards to the fractional share side,” he concluded.