Friction in fractionals to spark big changes

 - January 10, 2008, 9:33 AM

Like the shifting of continental plates beneath the earth’s crust, changes in the fractional-aircraft industry are under way. And while only a few cracks are now visible on the surface, underground rumblings signal greater turmoil to come. By mid-year, if not sooner, according to industry observers, the fractional landscape is going to look very different from the way it does today.

Changes are occurring in Cleveland at Flight Options and in Dallas at Bombardier Flexjet, respectively the second- and third-largest fractional providers. And Woodbridge, N.J.-headquartered NetJets, the largest provider, is already seeing increased interest because of these providers’ problems, according to Kevin Russell, executive senior vice president.

In Cleveland, Raytheon Co. officials are negotiating details of an agreement with Flight Options that will result in Raytheon becoming the largest shareholder in the fractional provider. At this time last year the two companies were negotiating a joint-venture merger of Raytheon’s fractional arm, Raytheon Travel Air, with Flight Options. The merger, completed last March, gave Raytheon 49.9 percent of the new entity, Flight Options LLC, with Raytheon also contributing a $20 million loan. As of September 29 last year, according to Raytheon’s third-quarter report to the Securities and Exchange Commission, Raytheon’s “investment in and other assets related to the joint venture totaled $83 million.”

Since the merger, Flight Options has been attempting to raise additional capital both to pay back the loan and to buy out Raytheon’s equity. As the report to the SEC explained, “In light of current capital market conditions, there can be no assurance that Flight Options will ultimately be successful in attracting additional outside funding. If Flight Options is not successful in this regard, the company may offer to exchange the Flight Options debt it currently holds for additional equity in the joint venture, whereby the company could be responsible for its operations, own a majority of Flight Options and consolidate Flight Options in its financial statements.”

In a weekly voice-mail message to employees early last month, Flight Options chairman and CEO Kenn Ricci said he has spent much time looking for the right solution to the company’s financial difficulties and that now “Raytheon has become that solution.” He said that as Flight Options’ largest shareholder, “Raytheon will have significant input on how we do things,” but added that “we’re not moving to Wichita” and “we can’t be spooked by who’s in the head office or change of command.” He encouraged employees not to “let anxieties about the future compromise the job we do.”

Neither Raytheon nor Flight Options has revealed publicly what will happen after negotiations are completed. Some observers see Raytheon’s takeover as positive, while others are not so sure.

Robert Pinkas, a Flight Options board member, told Crain’s Business Cleveland, “Raytheon stepping up is a plus. Raytheon is a major shareholder. They have the capital, they have the resources and they have their viewpoint…they want to build the business. They see a terrific opportunity.” Pinkas is managing general partner of Ohio-based Brantley Partners, an investment firm that has also invested in Flight Options.

Mike Riegel, president and CEO of Fractional Insider, also views the takeover as positive: “With the backing of a multibillion-dollar company, customers will have confidence that Flight Options is well funded.”

On the other hand, some observers who spoke with AIN believe that Raytheon is not particularly happy about having to bail out Flight Options. “Raytheon wanted to get out of the fractional business,” said Steve O’Neill, CEO of fractional provider CitationShares. “Why else would they have formed the joint venture with Flight Options in the first place?” Others, who wished to remain off the record, also expressed this view.

Ricci’s position in the reorganized company, if he’ll get one, is another subject of much speculation. Ricci told AIN in late November that he planned to stay on in a leadership role, but other people have heard him say he does not want to be a Raytheon employee.

Will fractional-aircraft shareowners necessarily care which company has ownership? Attorney Kitt Narodick thinks not. Narodick’s firm, Lane Powell Spears and Lubersky of Seattle, has handled more than 600 fractional deals for shareowners. “We have a lot of former Raytheon Travel Air clients and heard no service complaints from them after Flight Options took over in March. So far, our client base has been very quiet about the current Raytheon takeover. You have to realize that these folks buy a membership ticket in a limo service in the sky. Most don’t really care who pays the pilots, dispatchers and mechanics.”

It’s Not Just the Economy
There’s no doubt that the economic downturn has hurt sales of both new and used aircraft throughout the industry. (General Aviation Manufacturers Association figures for the first nine months of 2002 show new business jet sales down 12 percent and turboprop sales down 40 percent.) This has hurt the fractionals–some more than others–because sales of new airplane shares have always accounted for most of their revenue. The operational side of the business (flight hours and monthly management fees) has not been nearly as profitable as new share sales. In fact, for most frax providers, according to Riegel, it has not been profitable at all. “Before about 18 months ago,”  he said, “volume sales of aircraft up front were offsetting losses from operations. Now they’re not.”

Exacerbating the situation is that the number of shareowners leaving the fractional business has increased while the number of new owners entering the business has decreased. So although the total number of shareowners showed an increase last year, it was at a lower rate than in previous years. Explained Riegel: “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. However, because December is historically a good month for fractional sales, the actual net increase was probably between 600 and 650. Still, it’s quite a bit less than the year before.”

But the change has not been equal across the board, according to statistics compiled by Fractional Insider. “NetJets took in more new business and lost less of the old,” said Riegel. “Flight Options lost customers to NetJets, and Flexjet lost a higher percentage of existing owners than the others.”

A NetJets salesman, speaking off the record, claimed that some other providers are now feeling the effects of “concessions” they made to close sales with shareowners. “Giving away extra flight hours to sell a contract or the ‘tenths’ [a tenth of an hour to cover taxi time] on each end of a leg are coming back to haunt them,” he claimed.

Also reducing revenue on the operational side, according to Riegel, is that shareowners are generally under-flying their shares, to the point that some are selling back a portion of their shares (if not the whole share). He said, “People tend to put their flying into two categories: essential flying, which is mainly by the principal share owner, and nonessential flying, which could be by family and more junior personnel. The principal may still be using the share, but the second category is being reduced.”

But when owners decide to sell their fractional shares, they’re finding that the residual value, based on fair market value of the aircraft, has decreased much more than expected. Flight Options owners, said Riegel, have been hit particularly hard, because their used airplanes were bought and valued during a bull market. “Some owners have lost up to 50 percent of the value of their shares in the last two years,”

he said. Ricci told employees in his weekly message on January 17 that the higher-priced used aircraft have lost value, while the entry-level jets are holding their value. “The marketplace,” he said, “is very much an entry-level marketplace.”

Some Flexjet owners have also seen lower-than-expected valuations. And although valuations of NetJets aircraft have also followed the market, the drop in value has not been as significant. One observer attributed this to NetJets’ philosophy of buying the best airplane in each category, so that when a NetJets airplane does enter the used market, its residual value holds up better than that of the less popular models.

Will Frax Prices Go Up?

Actually, fractional prices normally increase every January 1. Although fractional contracts are set for five years, providers increase the management fee by 3.75 percent or the Consumer Price Index, which-ever is greater, and the hourly fee by the Consumer Price Index. (The CPI increased 2.4 percent from December 2001 to December 2002.) Prices for new contracts–covering shares, management fees and hourly rates– are generally raised as well.

But the question implies greater increases than those in past, with the idea that a 10- to 15-percent increase in management and hourly fees would be enough to make the operational side of the business profitable, or at least break even. There’s also the thought that NetJets may be holding these rates down until the competition crumbles. Both of these ideas are no more than rumblings under the surface.

More substantially, the requirements of Subpart K, RVSM, TAWS and other equipment or procedural mandates will add costs to fractionals that they will be able to recover only by increasing rates.

Riegel discounts the notion that NetJets is guilty of predatory pricing or even that it could do it. “There will be changes in the fractional landscape, but I expect to see multiple providers in the future,” he said.

CitationShares’ O’Neill said his company is taking the long view, which is similar to that of NetJets CEO Richard Santulli and owner Warren Buffett. “We’ve not trying to become big fast,” O’Neill told AIN. “We’re looking for the long term and growing slowly. Flight Options tried to go after NetJets in a short period of time, slashing prices, giving away hours and engaging in negative ad campaigns. It’s better to take the time to grow slowly.”

Fractionals aren’t dead or dying. Far from it. The industry is still growing, albeit at a slower rate than two years ago. But the industry is definitely changing, so much so that some observers say it’s in turmoil and that only the strong will survive.