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Business Jets: Fractional ownership in the post September 11 world December 2002 Download PDF

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Proponents of the Business Jet (BJ) fractional ownership concept argued that September 11 would boost their business as top business flyers and high net worth individuals increasingly switched from scheduled airlines to BJs. While the demand is undoubtedly there, finding a profitable business model for this sector is proving difficult.

An early indication of the problems facing this sector was United’s decision in March 2002 to shelve its BJ fractional ownership subsidiary, Avolar, having given up the search for external investors in the venture, which had ordered or optioned 306 new BJs.

Avolar’s failure came as a profound disappointment.

Airline fractional BJ operations were supposed to be the next growth opportunity for the private aviation industry.

The end of the airline BJ model, coupled with questions about profitability at the fractional ownership concerns, raises concern about the future of the BJ market. Explosive growth in recent years seems to have stalled, the market’s long–term direction is unclear.

The original fractional BJ ownership company was Executive Jet , created in 1986 and re–branded as NetJets in 2002. NetJets is now owned by Berkshire Hathaway, the venture capital enterprise run by Warren Buffett.

It has, according to Aviation Research Group/US (ARG/US), a 49% share of the US fractional ownership market.

The two other key payers are FlexJet, 18%, and Flight Options, 33%. FlexJet was established in the mid 90s by Bombardier as a vehicle for leasing out its own BJs; it may now be up for sale as part of the manufacturer’s restructuring process. Flight Options was the most important of the independent providers, and doubled its size in December 2001 when it merged with Travel Air, a subsidiary of Raytheon Aircraft. Over the past seven years some 57 fractional operations were set up in the US, but they almost all failed.

The number of fractional owners was estimated by ARG/US at around 4,500 in 2002, a total it expects to soar to 13,500 by 2006.

However, there has been as yet no firm evidence of a post–September 11 surge in business.

The fractional message

Fractional companies proudly state that 70–80% of their client bases have had no experience with private plane ownership. And most of these newcomers came from first and business class sections, which provide a disproportionate amount of airline profits. By some estimates, 8–12% of these sections have moved to private aviation (these are the passengers who pay full price, not those upgrading by using FFP benefits).

This development in aviation mirrors a broader economic trend. As for instance with retail stores, customers are splitting into a large cost–sensitive element (scheduled air service, which is becoming more Spartan than ever), and a small, price–inelastic element (private aviation). There is less and less of a middle market.

So, the departure of these very high–yield passengers had a strong negative impact on airline finances. Inevitably but belatedly, the airlines took the defensive move of co–opting the trend towards private aviation. This led to Avolar, the most ambitious example of the numerous airline fractional concepts. Actually, Avolar’s demise was presaged by the decision by British Airways to drop their plans for corporate jet services. This leaves just Lufthansa’s experimental Dusseldorf–New York BBJ service and Air Canada’s planned Elite operation.

Fractional profitability

When Avolar died, Warren Buffet admitted that NetJets lost money in 2001. Thecosts of European expansion in 2001 outweighing the small profit earned in the US during that year. He also doubted that the other fractional players made any money at all.

Naturally, this statement was quickly refuted. Flight Options stated that it had made its first quarterly profit in the last quarter of 2001. However, around the same time, Bombardier admitted that FlexJet did not make money in 2001, and could only hope to break even on operations in 2002.

Obviously, making money with fractional operations is difficult. Unless a provider has a tremendous market presence (in terms of bases and planes), it will need to fly a large number of non–revenue producing flights. After all, planes will often need to fly empty somewhere to pick up a customer; they might also need to fly empty after dropping off a customer.

Airlines are occasionally hobbled by Airplanes On Ground (AOGs, planes that produce no revenue but still have a capital cost attached). Fractional companies are hobbled by something much worse, planes that produce no revenue but still have capital and operating costs attached.

Fractional companies are also extremely sensitive to demand surges: the fleet must be sized to meet the highest demand surge requirements. If it is not, customers will need to be paid for any violation of timing and availability guarantees. To avoid this, the fractionals need to supplement their fleets by chartering in other aircraft, which is an expensive proposition.

Despite the difficulties inherent in making money with this business model, the fractional players all have big plans. They currently operate over 650 BJs, with about 1,500 more on order. Yet if they continue to lose money, their financial backers may decide to cut their losses, the way Raytheon did with Travel Air and United did with Avolar.

It is possible that this industry will follow the traditional pattern of new technology market development: a new idea leads to many players, who suddenly discover that they need to make money. The industry then experiences a painful shakeout, followed by a mature market, which is often a duopoly.

This industry may have a lot in common with the dotcoms.

If fractional companies need to raise their prices to bolster their profitability, their relative competitiveness may diminish. They would be less able to attract scheduled airline service customers. Indeed, some recent converts might switch back to airlines.

Currently, fractional companies account for 17–18% of new BJ deliveries. Their orders, however, account for well over half the stated industry backlog (alarmingly, the rest of the backlog is completely opaque and non–verifiable). Fractional aircraft account for 6% of the worldwide BJ fleet. According the Honeywell’s annual BJ survey, this figure will rise to 15–17% by 2011.

Clearly, the future of the BJ manufacturing industry is closely linked to the success or failure of fractional ownership. There is also certain to be a cost to manufacturers from fractional ownership itself. Any kind of concentration of market power in buyers increases their ability to negotiate lower prices, which affects manufacturer profit margins. Also, if competition among fractional ownership firms grows, possibly with the emergence of discount fractional players, price competition would result. This would further increase pressure on manufacturer margins as the fractional players try to pass down their cost–cutting efforts.

Another related problem might be the flexibility that fractional companies have when ordering aircraft. If a company buys one or two jets, the manufacturer will enforce the sales conditions and schedule, making deferrals difficult. But fractional companies, with their greater market power, will be able to demand deferrals (and possibly even cancellations) based on prevailing market conditions.

So, sales to fractional firms may be somewhat less "firm" than sales to traditional BJ end–users. This is particularly true if fractionals fail to raise their prices and need to cut their costs instead. The one profitable fractional company, Flight Options, has only purchased used BJs, at much lower prices.

The company it absorbed, Raytheon’s unprofitable Travel Air, only purchased new jets. The Flight Options model might be the right one. This would be good for the fractional business (higher residual values), but not as good for manufacturers (fewer direct new sales).

Fractional ownership will also have an impact on market cyclicality. We don’t know enough about how the mature industry will behave during inevitable market cycles. But looking to the commercial jetliner industry for a parallel, there are roughly two alternatives. If fractional companies behave like jetliner lessor GPA did in the 1988–1990 market upturn, placing large block orders in anticipation of continued market growth, fractionals may exacerbate market cyclicality.

However, if they behave a bit more rationally, like ILFC, they will place large block orders when the market is down and the buyer has the advantage over the manufacturer. While this ILFC–type model would further increase pressures on manufacturer margins, it implies a strong and welcome counter–cyclical impact on the market.

Finally, because fractional ownership companies emphasise greater utilisation of aircraft, residual values may suffer. If a fractional firm uses a given plane twice as many hours per year as the current norm, values for the entire fleet of those planes may decline somewhat. And because fractional companies place large block orders for new BJs, they are more likely to dump large fleets of earlier models on the market, which would also depress prices.

              Market price
Units Produced 2002 2003 2004 2005 2006 2007 New 2002 ($m)
Raytheon Beechjet/Premier 55 70 52 38 42 43 5.4
Raytheon Hawker 800 40 34 22 24 24 29 12.0
Raytheon Hawker Horizon 3 0 26 30 33 24 16.8
Bombardier Continental Jet 2 24 33 31 23 21 16.3
Bombardier Challenger 29 25 22 17 20 19 23.2
Bombardier Global 5000 0 0 1 12 14 12 33.0
Bombardier Global Express 24 22 17 12 14 14 41.7
Cessna CitationJet 80 60 50 46 55 60 4.5
Cessna Citation (other) 144 124 110 100 110 145 8.0
Cessna Citation X 29 20 15 15 14 20 18.6
Dassault Falcon 900 25 21 17 14 11 7 31.0
Dassault F.50/2000 48 52 56 38 32 30 21.6
Dassault Falcon 7X 0 0 0 1 6 23 36.0
GD Gulfstream IV 31 24 25 23 26 31 32.0
GD Gulfstream V 28 26 23 25 26 27 41.9
GD G100 13 12 12 12 12 16 12.4
GD G200 29 28 22 18 16 22 18.8
Bombardier Learjet 81 55 44 45 65 91 8.9
New Very Light Models 0 0 0 12 40 80 1.4
Swearingen SJ30 0 14 22 23 16 18 4.9
Total Units 661 611 569 536 599 732  

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