OEMs reeling from frax airplane order retreat

 - October 15, 2007, 11:15 AM

When Richard Santulli sold three fractional shares in a business aircraft in 1986, people snickered. Ten years later, NetJets had sold 1,551 shares and Santulli was the one left laughing. Today, NetJets has company in the fractional-ownership industry, an industry that now represents 5,827 fractional shares. Even with the current economic slump, last year’s new share sales were up by 17 percent over the tally for 2001.

So why the gloom that appears to be spreading over the fractional-ownership industry in the early months of this year? It may be reaction to an announcement earlier this year by the head of NetJets’ parent company, Berkshire Hathaway, that last year the fractional provider lost money for the second year in a row, despite record revenues. Berkshire Hathaway CEO Warren Buffett further pronounced that “overall, the fractional-ownership industry lost significant sums last year, and that is almost certain to be the outcome in 2003 as well.”

The despondency might also stem from more recent news that NetJets, by far the world’s largest fractional-ownership provider, has canceled some $350 million in business jet orders with Cessna Aircraft.

Also not particularly inspiring was news from Raytheon that Raytheon Aircraft sees Hawker Horizon orders at risk. The NetJets order for the new super-midsize accounts for slightly more than 80 aircraft. And although neither Gulfstream nor NetJets will comment, it’s possible that Gulfstream’s recent delay of the G150 development program by nearly a year is related to NetJets’ order for 50 of the model.

Under the “no news is good news” category is the Flight Options situation. As of the middle of last month, there had been “no change” in the uncertain status of the Cleveland-based fractional provider, which had been unsuccessfully seeking additional outside financing. Flight Options had absorbed fractional operator Raytheon Travel Air last year, leaving Raytheon with a 49.9-percent interest. Now, based on terms agreed to late last year and in the absence of additional outside financing, Raytheon Co. would become the majority shareholder and take over operations after converting to equity some $30 million in debt that Flight Options owes Raytheon.

As of December 31, Raytheon’s investment in, and other assets related to, the joint venture totaled $107 million, including losses Raytheon has recorded since formation of the joint venture. The recent Raytheon Company 10-K annual report to the Securities and Exchange Commission was revealing. “Flight Options LLC,” said the report, “has been unprofitable to date and has not been generating adequate cash flow to finance current operations.”

If Raytheon consolidates Flight Options, as it is soon expected to do, Raytheon executives do not expect the fractional operation to have a material effect on the company’s financial position or results of operations, even though in doing so the company would reduce its reported aircraft backlog by approximately $850 million because of an order received from Flight Options last year. (The order still stands, but it can’t be included in the backlog per accounting rules.)

The merger had included orders by Flight Options for a mix of 115 aircraft from Raytheon, including Premier Is, Beechjets and Hawker 800XPs, with deliveries to begin in 2007. It was also reported at that time that an order for up to 50 Hawker Horizons was pending.

In the wake of the turmoil, Flight Options founder Kenn Ricci stepped down in February as its chairman and CEO and was replaced by John Nahill, former v-p of corporate strategy and development at Raytheon Co. The end result has been a number of unresolved questions, including how committed Raytheon is to a company it had divested only a year earlier. More important, how will Flight Options share owners and the market perceive the company’s stability?

NetJets and Flight Options Face Off
A tight economy and the emergence of Flight Options as the second-largest fractional provider in the market prompted a battle with NetJets for the hearts and minds of potential customers. The skirmish spilled across the ad pages of The Wall Street Journal throughout much of 2001, with each shamelessly sniping at the other and reaching a low when Ricci gave reporters a copy of a letter from an Executive Jet (NetJets) v-p to a prospective NetJets buyer who was known to have committed verbally to Flight Options. Warning the buyer not to purchase a share at that time, the writer added, “Both Flight Options and Raytheon Travel Air are in dire straits. By purchasing from either program you are putting a significant amount of capital at risk.”

To exacerbate matters, Flight Options, soon after the merger of Travel Air assets into its operation, found itself embroiled in a court action brought by six pilots who were employed by Raytheon Travel Air before the merger, all alleging wrongful discharge from their jobs. Eric Miller said he was fired while employed by Travel Air following a refusal to perform “illegal acts” while operating an aircraft. Thomas Bowden, William Brunet, Thomas Jeter, William Tumlin and David Yeager filed suit against Flight Options, claiming they were wrongfully terminated by Flight Options because of their union-organizing activities at Travel Air before the merger. Ricci denied all allegations by the six men.

If there are fewer new share owners entering the fractional-ownership industry, the difficulty is further compounded by the exit from programs by existing customers. According to Mike Riegel, president and CEO of Fractional Insider, “In 2001, about 1,000 new owners bought shares and some 110 left, leaving a net gain of 890 owners industry-wide. In 2002, as of December 7, there were 760 new owners, but 210 had left the industry, leaving a net gain of only 550.”

It also did little to burnish the industry image when fractional owners who were assured five years ago–when business aviation was booming–that their shares would retain 75 to 80 percent of their value discovered that the shares had in some cases retained as little as 50 percent of their original worth. According to Riegel, shareowners opting to leave a program and sell back their shares to the operator before expiration of the contract were seeing resale fees ranging from 4 to 12 percent. And some operators were including a “liquidated damage fee” as high as 20 percent of the value of what the operator deemed to be the current share value.

Fractionals Dominate Order Books
The fractional market might be politely described as in a state of flux. And that makes no one more nervous than the original equipment manufacturers, whose order books are heavy with orders from the fractional providers. According to London-based Airclaims, order backlogs for major business jet manufacturers–Boeing, Bombardier, Cessna, Dassault, Gulfstream and Raytheon– totaled 987 aircraft late last year. Of those, 749, about 75.8 percent, were destined for fractional providers. Raytheon topped the backorder list with 86.5 percent of its 304 aircraft on order headed to fractional programs.

Over the years, OEMs have grown fat on orders from the fractional operators and were looking forward to more of the same. Before recent cancellations, if all the orders were fulfilled, the top-four fractional providers would have taken delivery of 455 aircraft over the next two years. Just two years earlier the entire fractional fleet totaled only 452 airplanes. Now, fractional providers have begun adjusting to an economy in which pentup demand is not translating into contracts. And, worse still, in which orders are being canceled and buyers are deferring delivery dates.

Included in the Raytheon backlog is about $900 million related to an order for the Hawker Horizon, which the company noted, “due to current market conditions and development and certification delays, could be restructured or canceled.”

Despite this news in Raytheon’s 10-K first-quarter report, Flight Options said early last month that it expected to add 15 more airplanes to the fleet over the next 30 to 60 days. Valued at about $100 million, the additional jets–three Beechjets, four CitationJets, two Citation IIIs, two Citation Vs, two Citation Xs and two Hawker 800XPs–include a mix of new and used aircraft. It will bring the fractional’s fleet total to 220 airplanes.

Also, Lewis Campbell, chairman, president and CEO of Cessna parent Textron, last month projected a reduction in Citation deliveries from 195 last year to 180 this year. “Most significantly, one of Cessna’s largest customers [NetJets] recently informed the company of a significant reduction in the number of jets it plans to purchase in 2003.” The news accompanied a decision to realign the workforce to meet a reduced production schedule, including a seven-week furlough that will affect 6,000 workers and permanent layoff notices for more than 1,200 employees.

Dassault Falcon Jet, whose only fractional buyer is NetJets, has had no order cancellations. The company has delivered 38 aircraft to NetJets and has 39 more remaining on firm order. That firm order includes 25 new Falcon 2000EXs, with the first deliveries to begin in 2006. Although there have been no cancellations, a Dassault spokesman did say that of the 14 other Falcons going to NetJets, there have been some delivery date deferrals, “going back about 12 months.”

So What’s the Good News?
That’s the bad news. Is there any good news?

“Yes,” said Steve Phillips, a spokesman for Bombardier Flexjet, who notes that despite the economy, aircraft deliveries to fractional operators last year were up 11 percent over the previous year. “A lot of industry segments today would consider that a very healthy increase.”

In the long term, the fractional business is a solid business, he said, pointing out that Bombardier stands by its commitment to Flexjet and continues to project a growth rate of 10 to 15 percent a year.

The total Flexjet fleet of 104 aircraft includes 16 Learjet 31As, 31 Learjet 45s, 36 Learjet 60s and 21 Challenger 604s. While additions to the fleet suffered a “serious decline” in recent years (22 aircraft in 2001 and 12 last year), Phillips said Flexjet expects to add another 12 airplanes this year–two Learjet 40s, three Learjet 60s, four Challenger 300s and three Challenger 604s. “And that’s a conservative estimate,” he added.

Phillips also said the next couple of years are likely to see a greater evolution of fractional programs industry wide. “They will become more tailored and more customized than ever to fit customer needs and desires; not as special offers and incentives, but as significant program changes.”

But incentives are good, too. Flexjet has just announced a new share structure for its Challenger 604 fleet. It has increased the flight time purchased by new one-sixteenth share owners from the industry standard of 50 hours to 60 hours “at no additional cost in terms of variable rate, maintenance fees or capital investment.”
Phillips further said that Flexjet has focused more closely on creating a more efficient operation rather than cost-cutting measures. As an example, he offers Flexjet’s new “optimizer” scheduling program as a key to allowing the company to offer the additional flight time in its 604 fleet. “It reduced costs by improving scheduling aircraft and crews and reducing the empty legs and deadhead flights.”

Flight Options v-p of sales and marketing Richard Heckman sees an advantage in its broad range of aircraft types, which allows share-package bundling. “We go to whatever length is necessary to create a unique package to fit the customer’s needs.”

It was with this in mind that Flight Options recently announced its “75/25” pricing option. The program, requiring a minimum purchase of an eighth share, allows customers to purchase combined 75/25 fraction shares in a Beechjet and Hawker, respectively.

To improve product support, Flight Options has also announced that the Raytheon Aircraft Services chain is now its “preferred partner” for airframe maintenance. The partnership will allow Flight Options access to more than 20 Raytheon Aircraft Services maintenance facilities in the U.S., including six regional maintenance centers. It will also provide easier access to both parts and factory-approved maintenance technicians.

A Changing Customer Profile
Phillips from Flexjet also notes that, for good or bad, the customer profile appears to be changing. When the company was in its infancy, much of the customer base came from the “dot-com” industry. Now, said Phillips, most of the customers seem to be more established companies, and the people are more corporate rather than wealthy individuals who want the convenience of business aircraft travel for personal use.

CitationShares also has an optimistic outlook, despite having been launched in 2000, at a time when the economy was about to head south and 9/11 was still a year away.

According to CitationShares CEO Steven O’Neill, the Greenwich, Conn.-based company plans to introduce 17 more aircraft into its program this year, “a 40-percent increase over last year.” The company also expects to add 25 Citation CJ3s to the fleet, starting next year. The CitationShares fleet currently consists of 32 airplanes–seven CJ1s, nine Citation Excels and 16 Bravos.

O’Neill said CitationShares has neither canceled nor deferred deliveries of any of its order for 50 aircraft. At the same time he defends the fractional industry as a whole. It is a mistake, he said, to assume that because there have been cancellations and deferrals that the fractional industry is as weak as the business aircraft market as a whole. “It’s weaker than I’d like, but it is steady,” he added.

Both O’Neill and Heckman see changes in customer demographics driving some of the changes in the fractional industry.

Both noted that while demand for shares in the larger business jets has dropped, demand has actually increased for shares in small and midsize aircraft.

According to Heckman, it is not by accident that of the 15 business jets scheduled for delivery to Flight Options in the next couple of months, 13 are in the small to midsize category. Heckman said customers driving demand for small and midsize jets are for the most part either new to business aviation or fractional owners downsizing from a larger jet.

With Flight Options’ fleet of King Airs, Beechjets, Citation and Hawkers, said Heckman, “We are in the sweet part of the market.”

Heckman also noted that the relationship with Raytheon has changed its customer demographics. “With Raytheon’s involvement, we’ve been pleasantly surprised by increased activity with Fortune 500 companies. Before that a major part of our customer base was individual entrepreneurs from small to midsize companies.”

Terrorism Causes Temporary Spike in Interest

After 9/11 there was a sharp spike in interest in business aviation as an alternative to scheduled airline service, driven primarily by perceptions that airline travel was less safe, cancellations of flights and some routes and the frustrations caused by new security measures. In some cases, the spike in interest turned into contracts.

“We saw a definite increase in share sales after 9/11,” said Heckman, “for about three to six months.” But, he added, a combination of the economic downturn and speculation concerning the war in Iraq saw share sales at Flight Options drop from 40-percent growth to about 16-percent growth.

While most of the fractional operators admit to slower growth in share sales in recent years, as well as greater numbers of customers leaving programs at the expiration of their contracts, NetJets and CitationShares both launched block-charter variations to stem losses. And both claim these programs have been extraordinarily successful.

In simplest terms, the programs are a form of block charter that allows customers/members to purchase a defined number of flight hours. As customers use flight hours, the charges are deducted from their account.

One of the first was Marquis Jet, formed in fall 2001 in partnership with NetJets. The exclusive agreement allows Marquis Jet to lease fractional shares from NetJets, which are then made available in the form of Marquis Private Jet Cards good for a certain number of flight hours in NetJets aircraft.

CitationShares offers its similar Platinum Traveler Program, which it describes as a program “for travelers who are not ready to commit to a fractional jet ownership plan, but who would like to take advantage of the flexibility, convenience, time savings and security that other forms of standard air transportation cannot offer.” A more important advantage perhaps is that it requires no long-term commitment and allows participants to exit the program at any time without additional costs or penalties.

Both Marquis and Platinum sell flight time in 25- and 50-hour blocks.

Sentient, an independent company not associated with any of the fractional providers, may have provided the initial model for the Marquis and CitationShares programs. It was launched four years ago and now claims that, after near triple-digit growth annually, last year it operated more flights through its approved business jet providers than NetJets.

Sentient offers a three-tier program, with silver, gold and platinum TravelCards valued at $100,000, $250,000 and $500,000, respectively. Cards are debited at the appropriate hourly rate for the class of business aircraft selected–small, midsize or large.

The company has done well enough that it was recently purchased by TH Lee Putnam Ventures, a respected New York-based private equity firm.

Another recent entrant in this particular form of business aviation travel is Delta AirElite. Rather than launch a fractional-ownership program, the Cincinnati-based charter operator chose to create its Fleet Membership Program in February. And like Sentient, it offers silver, gold and platinum levels of “membership” good for 25, 50 and 100 flight hours.

Bill Allard, president and CEO of Marquis Jet, sees the association with NetJets as a mutually beneficial partnership. Allard said he does not view his customer as someone leaving NetJets, or a customer new to business aviation who might have purchased a NetJets share. “In a sense, it is a revenue-sharing partnership, and they’re all still flying the ‘QS’ tail,” said Allard, referring to the QS suffix on each NetJets N-number.

Is it working? According to Allard, business was up 130 percent in the first three months over the same period last year. In its first year of operation, Allard said the company sold about 500 Marquis Private Jet Cards at an average price of about $150,000 per card. “We did that in the first year, and this year we expect to sell more than double that.”

Both NetJets and CitationShares see the block-charter membership programs as a way to continue making business aviation travel available and attractive to new customers, and as an option to fractional share owners who are exiting those programs during tough economic times. Both NetJets and CitationShares expect that when the economy improves, many of those who exited a fractional program for block-charter membership will return, and those who entered business aviation travel through block charter will move up to a fractional program.

So are times tough for the fractional providers? Without a doubt, said Riegel, whose company keeps a sharp eye on industry trends. But he also notes that there is a lot
of pent-up customer demand as a result of the economy, and he added, “Fractional providers who have managed their owners’ programs effectively will be in a position to gain the most when the economy improves.

“In 22 years in the business, I’ve never seen such an economic effect on the business aviation industry,” said Riegel. But he added, “When the economy improves and the concerns of the war in Iraq are laid to rest, the fractionals are going to be the first to feel the effects of renewed customer confidence.”

Heckman noted that one of the primary drivers of growth in the fractional market is going to be the continued struggle of the airlines. It may or may not be their fault, he said, but the fact remains that airline travelers are going to continue to be frustrated by long lines, canceled flights and delays. That, he said, is good news for business aviation and for the fractional industry, which traditionally has great appeal to customers new to business aviation.

O’Neill suggests that the block-charter membership programs are likely to have an effect on the shape of fractional programs. In particular, he believes they are likely to push average share sizes down further, nothing that the average share in terms of flight time is now about 70 hours. “I think that may get down to as little as 50 hours.”