Industry searches for its footing

 - October 4, 2006, 11:12 AM

Although it is approaching its 20th birthday, the fractional aircraft industry is still very much mired in adolescence. It’s come a long way since NetJets chairman Richard Santulli invented the concept of fractional ownership and launched his program in 1986, but the industry still has a long uphill road ahead.

That’s not to say the road already traveled wasn’t long and uphill, especially since NetJets didn’t really gain momentum until the mid-1990s. And just as it gained traction, serious competitors started to emerge–first Bombardier Flexjet in 1995, then Raytheon Travel Air in 1996, Flight Options in 1998 and CitationShares in 2001. (Flight Options and Raytheon Travel Air merged in April 2002.)

The major fractional providers experienced rapid growth in the late 1990s and early
2000s, adding airplanes and shareowners in record numbers. Life was good, even though many fractionals experienced significant growing pains during this period.

Then the U.S. economy began to slow in mid-2001 and, feeling the financial squeeze, shareowners started to curtail their use of fractional aircraft. Providers eventually found themselves with large fleets of underutilized business jets, at least by fractional operating standards of about 1,000 flight hours per aircraft per year; lower operating revenues due to fewer billed occupied hours; rising fuel prices; and high overhead costs.

They had to do something to take up this extra slack or else face financial ruin. Fortunately, jet cards–25-hour blocks of “occupied time” in a fractional aircraft without the cash-laden requirement to actually buy an aircraft share–in part helped save the day.

First on the fractional jet-card market was Marquis Jet in March 2001, and–with customers free from the burden of having to purchase an expensive aircraft share–sales quickly took off for the NetJets affiliate program. The other fractional providers took notice and eventually started their own competing jet-card programs.

Life was good again–that is, oddly, until the economy started to pick up last year. What followed, and continues, could be described as the perfect storm.

Robust sales of jet cards joined forces with a 30-percent increase in shareowner baseline flying to swing the aircraft-utilization pendulum the other way. In other words, demand for aircraft exceeded the available supply at many of the fractionals. As a result, according to several industry sources, service levels have deteriorated to unacceptable levels and charter outsourcing has surged, angering many fractional shareowners.

This also comes at a time when providers are imposing fuel surcharges that add between $400 and $1,000 per occupied flight hour, leaving many shareowners feeling ripped off. In addition, the fractional flights operated under Part 135, versus Part 91K, come with a 7.5-percent federal excise tax, adding yet another layer of cost.

Many shareowners who signed up in 2000 are now up for renewal of their five-year fractional aircraft sales contracts and discovering that aircraft resale values aren’t nearly living up to the promises some fractional aircraft salesmen made five years ago, even though the pre-owned aircraft market is now on the rebound.

Adding further uncertainty, NetJets management and its unionized pilot workforce, represented by Local 1108, are involved in a contentious labor dispute that could end in a strike. NetJets shareholders are taking note and, according to Fractional Insider president Mike Riegel, many are “diversifying share buys” in the event of a work stoppage.

So it’s no wonder that many shareowners up for renewal are evaluating all of their options–other fractional programs, charter (including block charter) and jet cards. The irony is that those opting for a fractional provider’s jet-card program are only further straining aircraft supply.

Current Market

According to every fractional consultant AIN contacted, fractional customers are much more informed than they were several years ago. They are well schooled about the industry and want to buy only what they need, not what the fractional provider is pushing. And they aren’t afraid to shop around before finally committing to an aircraft lift solution.

The term “lift solution” is important here because fractionals must now compete in a larger environment. A few years ago many prospective fractional clients didn’t know what other alternatives existed; now they can cite every option down to the minutiae.

Shareowners are also a highly networked group; they talk frequently about their lift solution, including the good, bad and downright ugly details. If a fractional provider spurns a customer, word quickly spreads through the shareowner community, which is now happening all too frequently given the strains in the industry these days.
“This industry was built on networking,” Riegel notes. “Negative networking, which is going on right now, is bad for business.”

This has greatly affected the fractional industry’s share sales growth in the last two years. Over most of the past 10 years the major fractional providers have experienced double-digit growth, but certainly not last year and, especially, this year.

According to the latest figures from AvData of Utica, N.Y., in the one-year period ending May 31 the four major providers added 37 aircraft to their fleets (a 4.8-percent increase), gained a net of 156 shares (up 2.5 percent) and signed 123 new shareowners (a 2.8-percent increase). (Some shareowners bought multiple shares, accounting for a higher increase in shares sold compared with new customer intake.) Hardly a banner year for an industry that admittedly makes most of its profits by selling airplanes, not by operating them.

However, there is much more behind these numbers. Mirroring the previous year’s results, NetJets and CitationShares experienced positive growth while Flight Options and Flexjet continued on a downward trend. “The number of sellbacks at Flight Options and Flexjet is surprising,” noted Riegel.

Led by PlaneSense and Avantair, the 16 “minor” fractional players grew more rapidly than the majors. AvData said these regional programs added 17 aircraft, sold 149 shares net and signed 129 new share customers, which equates to 29.8, 64.5 and 67.2 percent year-over-year growth, respectively. The minors nearly outpaced the majors in share sales.

Overall, the AvData numbers show that the entire fractional industry added 54 aircraft (up 6.5 percent), sold 305 shares net (a 4.8-percent increase) and attracted 252 new shareowners (a 5.5-percent rise).

In terms of overall market share, AvData shows NetJets continues to lead the industry at 47.7 percent. Next is Flight Options at 26.5 percent, Flexjet at 11.1 percent, CitationShares at 9.0 percent, Avantair at 1.9 percent and PlaneSense at 1.4 percent. The remaining 14 minor providers have a combined market share of 2.3 percent.

Notably, Flight Options, Flexjet and one minor player lost market share, according to AvData. Flight Options lost a whopping 4.2 points while Flexjet lost only one point. Leading the trend upward in market share was CitationShares with a 2.1-point gain. Meanwhile, NetJets and Avantair were each up by 1.1 point.

According to Berkshire Hathaway CEO Warren Buffett, “Last year NetJets again gained about 70 percent of the net new business (measured by dollar value) going to the four companies [NetJets, Flight Options, Flexjet and CitationShares] that dominate the [fractional aircraft] industry.” NetJets is a division of Berkshire Hathaway.

Show Me the Money

It’s no secret that the fractional providers are struggling to make money in operations. After all, it’s quite easy to make a profit selling shares in aircraft, especially when the fractional providers get bulk discounts from the aircraft manufacturers. Ordering 40 or 50 new aircraft at a time yields healthy discounts for the fractionals, which then resell shares in the aircraft at its sticker price.

But operations are the bane of fractionals, at least in terms of profitability. Flexjet president Michael McQuay pointed out, “Fractionals operate on very thin margins, and every day is a battle to maintain profitability.”

The problem is that most providers aren’t charging enough in monthly and occupied hourly fees to stem losses, say industry consultants. But none of the providers admit experiencing losses; all claim they’re profitable, though it’s hard to prove this since limited financial information about the providers exists in the public domain.

Berkshire Hathaway has been perhaps the most open about the financial records of its fractional arm, NetJets. In the investment company’s annual report, Buffett said earnings improved last year at Berkshire’s flight services division, which includes Net-Jets and flight-training provider FlightSafety International. Last year the unit saw its pre-tax profits rise to $191 million on revenues of $3.24 billion.

Buffett attributed more than 90 percent of the $810 million year-over-year revenue increase at the division to NetJets. The fractional provider’s flight operations revenue rose by nearly $400 million and revenues from aircraft sales jumped about $360 million, he said. Even with this frank financial disclosure, it’s uncertain how much of the profit at Berkshire’s flight division actually belongs to NetJets.

It appears the fractional provider made an overall, if slim, profit last year. According to Buffett, “NetJets earned a modest amount in the U.S. last year. But what we earned domestically was largely offset by losses in Europe.” It’s possible that the investment mogul tempered his statement on NetJets’ profitability given the ongoing labor negotiations with its pilot group.

Of the other three major fractionals, industry consultants believe CitationShares is turning a profit, while Flight Options and Flexjet are thought to be in the red. However, there isn’t enough detailed public financial information to support these assertions, as the financial results are hidden in their parent companies’ annual reports–CitationShares in Textron’s report, Flight Options in Raytheon’s statement and Flexjet in Bombardier’s financials.

However, industry consultants agree that Flight Options is in the direst straits. “From what I understand, the finances at Flight Options may soon deteriorate significantly,” noted Riegel, adding that the provider’s parent, Raytheon, might soon be forced to buy back shares from other investors due to a rough management transition.

Interestingly, at press time it appeared that Brantley Capital was positioning to sell its investment in Flight Options, most likely to Raytheon. This would give Raytheon more control over Flight Options’ future, whether that be status quo, divestiture or anything in between.

Another industry consultant, who asked not to be named, told AIN that he is certain that Flight Options is on the block. “At this point,” he said, “Raytheon [which is a majority owner in Flight Options] most likely just wants to cut its losses.”

In any case, the lack of public financial knowledge is causing shareowners to question the motives of their fractional providers when it comes to trip billing. Shareowners generally believe that many of the fractionals are losing money on the operational side of the business and will do anything to stem losses.

This speaks to the level of shareowner distrust directed at their fractional providers. In fact, many shareowners carry stopwatches to time their trips aloft to ensure they’re not overcharged.

Not only are they watching trip times–shareowners are also keeping a close eye on all extra charges, including catering, landing fees, federal excise taxes and, last but certainly not least, fuel surcharges.

Riegel contends that share customers are, in fact, being “tricked” by low fuel basis prices that average $1.60 to $1.80 per gallon. To be fair, the fuel basis is disclosed in fractional contracts: caveat emptor.

The surcharge is the difference between current fuel prices– as determined by the fractional providers–and the basis, meaning the lower the basis the higher the fuel surcharge. With today’s higher prices at the pump, “Fuel surcharges now amount to an extra $400 to $1,000 an hour,” Riegel said. However, he is convinced that “surcharges have become a profit source” because they are calculated using a too-low basis and retail fuel prices, even though the fractionals never pay retail since they receive substantial volume discounts on fuel.

Of the four majors, only Flight Options offers fuel hedging through its Fuel Club. Available for owners of 1997 or newer Beechjet 400As/Hawker 400XPs, Hawker 800XPs, Citation Xs or Legacys, this program allows owners to pre-purchase fuel at a discounted, locked-in rate for up to 12 months. Flight Options said the fuel surcharge rate is discounted 20 percent from the previous three-month average fuel price published by ARG/US.

Another issue is double taxation in Part 135 fractional flights. In this case, providers must charge a 7.5-percent federal excise tax on flight costs. However, these flights are exempt from the fuel tax of about 21 cents per gallon, which in most cases isn’t being refunded to the shareowners or jet-card customers.

According to Shaircraft CEO James Butler, “With these cost increases and surcharges the fractional route is not so much a known cost factor any more. Customers want price stability; they don’t want to feel like they’re being ripped off at every available opportunity.”

Emerging Trends

One thing that all fractional providers interviewed for this story say they are doing is focusing on providing top-notch customer service. Flexjet’s McQuay put it succinctly: “Service in the fractional industry is often overlooked because of aircraft issues. Our customers expect service above and beyond what they get in first class at an airline.”

CitationShares president Steven O’Neill explained, “Customer service is what the fractionals are all about. I’d much rather choose a slow-growth strategy during which good customer service is maintained than skyrocketing growth coupled with compromised service.”

Flight Options and NetJets also know the virtues of customer service, though they have both struggled somewhat in this area due to the negative side effects of jet cards. Both maintain, however, that they are committed to providing exceptional customer service.

Other market trends include eliminating out-of-service-area repositioning fees, though most come with caveats. These repositioning fees can add thousands to a trip’s costs just for crossing an imaginary line, so no doubt customers are happy to see some, if not all, go.

Dallas-based Flexjet started the trend earlier this year when it announced it would waive ferry fees to and from the Caribbean. In February it launched a new secondary service area for Flexjet owners who fly to and from the region, including the Greater, Lesser and Netherlands Antilles, Trinidad and Tobago and Bermuda. Last month it dropped ferry fees to and from Europe and Hawaii for Challenger 300 and 604 shareowners. However, shareowners must agree to bring their contracts to current (read higher) rates to take advantage of these extended areas.

In early May, Cleveland-based Flight Options began offering customers an extended service area that includes all of Mexico, the Caribbean and Bermuda. Flight Options customers who opt to pay the annual access fee for this feature have unlimited access to these regions without ever having to worry about repositioning fees.

CitationShares in late June eliminated repositioning fees for Saturday trips to and from the Caribbean–the most popular day to travel to/from the region, the company said. However, eligible flights must fall within four-hour windows designated by CitationShares, though the benefit comes at no additional cost.

A dominant theme among the fractionals is fleet rationalization. Flight Options made the biggest move in this regard with its February announcement that it will heavily consolidate its available fleet types over the next three to five years to simplify operations, increase fleet reliability and reduce overall costs.

The provider said it will gradually pare its fleet from 11 types to four–the Beechjet 400A/ Hawker 400XP (light category); Hawker 800XP (midsize); Citation X (super-midsize); and Legacy (large). This amounts to one type per aircraft class and effectively lays the foundation for an eventual fleet of younger aircraft, versus the current mixture of new and older pre-owned airplanes.

Flight Options’ current fleet of 208 aircraft includes King Airs, Beechjet 400As/Hawker 400XPs, Hawker 800s, CitationJets, Citation Vs, Citation 650s (III, VI, VII), Falcon 50s, Citation Xs, Challenger 601s, Legacys and Gulfstream IVs.

With lesser fanfare, Flexjet last year began phasing out Learjet 31As, with the light jet being superseded by the Learjet 40. Flexjet’s McQuay isn’t shedding any tears: “We never made a penny with the Learjet 31As.”

At the same time, Greenwich, Conn.-based CitationShares took delivery this spring of its last Citation CJ1s and Bravos. The two aircraft types will eventually be replaced by the CJ3, which was expected to join the provider’s fleet late last month.

Going forward, CitationShares will have three fleet types–the Citation CJ3, XLS and Sovereign. O’Neill explained the move: “For us, a narrower fleet focus is more efficient and will lead to higher levels of service. Customers care much more about service than they do about greater aircraft choice.”

Here, NetJets bucks the trend with 19 current fleet offerings, although Riegel believes this course is a mistake. “NetJets desperately needs to rationalize its fleet with the focus on aircraft capabilities, not manufacturer discounts. I really don’t know why it opted last year for Hawker 400XPs when the Citation CJ3 is clearly better in the fractional environment.”

Last year the industry was preparing for the transition to the new Part 91K fractional rules. Fortunately, it emerged relatively unscathed by the transition to the new regulations in February.

But what lies ahead for the industry could be considerably more challenging–fixing service issues, rationalizing fleets and returning to profitability.

“To see real growth again, the fractional industry needs to stabilize and focus on service issues,” according to Riegel. “The industry is too volatile, which is reflected by flat growth over the past year.”

Basically, this means adding core aircraft to diffuse shareowner resentment over jet cards. Doing so, Riegel said, would increase aircraft supply to meet fractional flying demand, thereby improving service and reducing flight hours in shareowners’ aircraft.

Fleet rationalization is also essential to the profitability of the fractional industry, consultants say. It’s the Southwest Airlines approach: narrow the fleet types and you also lower operating, training and maintenance costs.

“The fractionals need to simplify their fleets to three types–small, medium and large,” notes Docherty Aviation president Brendon Docherty. “If they can rationalize their fleets then fractionals can compete on service and brand.”

Riegel also believes that fleet rationalization will help the fractionals’ bottom line. However, he is concerned about some of the aircraft the fractionals are choosing during the fleet reorganizations.

He specifically singled out the Embraer Legacy, which is Flight Options’ “large” aircraft choice in its fleet renewal plans. The aircraft might have a cabin equivalent in size to that of a Gulfstream IV, but Riegel says its Mach 0.80 max cruise speed is way too slow for fractional operations.

The industry consultant would like to see a sea change in how fractional aircraft are selected. “The fractionals are generally not doing a good job of working with aircraft manufacturers to design aircraft that meet the specific needs of the industry– high utilization rates, high reliability and easy maintainability,” Riegel told AIN. “They have to stop buying warmed-over ‘new’ designs that are meant to be flown 400 to 500 hours a year. Fractional aircraft need to be more like airliners, in terms of reliability, utilization and maintenance.

“The Challenger 300 is the exception to this rule. Flexjet outlined its specifications and performance requirements for the aircraft to Bombardier, which then designed and built the jet to those specs.”

No doubt fleet rationalization is a step toward profitability, but more must be done. All of the industry consultants indicated that all the fractional providers need to charge more in monthly and hourly fees to make money in operations.

It seems that this trend is already starting. Last month CitationShares did in fact raise its monthly management fees by about 10 percent. Avantair’s Santo also told AIN that his company recently increased monthly fees for new customers. (The provider bills customers non-fluctuating monthly fees that cover both management fees and occupied charges.)

Despite these challenges, industry watchers say the fractionals are poised for significant growth in the next five years. How much? Many say a return to double-digit growth is highly probable.

Docherty pointed out, “The fractionals have done an unbelievable job of bringing in new people to business aviation. There’s no reason why they won’t continue to do this, especially given their 100-percent safety record. This contrasts with the recent spate of high-profile accidents involving [Part 135] charter aircraft.”

As for the industry’s future, Riegel told AIN, “I expect the past three months’ upward share sales trend to continue since the market has a lot of growth potential. The fractional industry is still a young industry, and with more engineering work it should see much growth.”