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By MisterBe
July 3, 2003

Posts selected for this feature rarely stand alone. They are usually a part of an ongoing thread, and are out of context when presented here. The material should be read in that light. How are these posts selected? Click here to find out and nominate a post yourself!

The NetJets moat

Flying may not be all plain sailing, but the fun of it is worth the price.
-Amelia Earhart (1897 - 1937)

What does NetJets' moat look like? I have been trying to figure it out, but haven't had much success. So I had to do the only thing that has worked for me in the past. I assiduously trawled through everything I could find on NetJets. The Sandman's website was particularly helpful as a starting point. A condensed version of the info on his website can be found here. Here are my thoughts on the above info and bits and pieces I collected elsewhere.

The business jet industry is relatively new. It only really took off when Bill Lear popularized the private jet with the introduction of the Learjet 23 in 1964. In 2001 it was estimated that 11,525 business jets were ever delivered. As far as I can tell this number was compiled at the beginning of 2001 and therefore does not include the 783 jets that were manufactured in 2001. Add to that the 682 jets manufactured in 2002 and you have 12,990 business jets ever delivered. How many are left? The global business jet fleet stood at 12,581 at the end of last year. 98 were delivered in the first quarter of 2003, which brings the current total to 12,679. Just over 5,000 of those jets were delivered in the last 10 years, which alludes to the recent good fortune of the business jet manufacturing industry.

In the sixties global business jet sales, in 2001 dollars, were around $2bn with a high of $2.7bn in '68. Sales in the seventies averaged around $2bn and the eighties were really when things started to change. This happens to be the time that the US economy started it steady climb. 85% of the global business jet fleet resides in the US and explains the business jet market's strong correlation to the health of the US economy. 1981 delivered sales of $3bn and '82 $4bn. $4bn was pretty much where things stayed for more than a decade. Then in '97 the industry produced sales of $6.1bn, which marked the start of the best years for the manufacturing industry. 1999 produced sales of $9.8bn, 2000 $10.7bn, 2001 $11.9bn and 2002 $13.9.
It is not only the expansion of the US economy that was an important driver of the business jet market, but also the spectacular expansion of the frax (fractional or fractional ownership) market in recent years. Rich Santulli started the frax business jet market with 3 shares in 1986 and at the end of 2002 the market was made up of 5,827 shares. NetJets/The market was launched in 1986 with 8 Citation S/II's and at the end of 2002 business jets operating in the frax market came to a whopping 776!

The market's compounded annual growth rate, as measured in frax shares, is as follows,

1986-1996      68%
1996-2000      58%
2000-2001      27%
2001-2002      20%

One cannot help to think whether you should read anything into the drop of the growth rate. Here are a couple of things I considered.
� Initial growth rates were high, because the market came of a low base.
� Although 20% is low compared to 50% and 60% plus growth rates, it is still very high.
� Out of a global business jet market of 12,581 the frax market's 776 planes still only make up 6.2% of that market. So there is plenty of room in which to expand. It also make up only 4% of the business aircraft market (jets/turbo props/helicopters), but I doubt NetJets would expand beyond the jet market.
� The global business jet market is expected to expand at a rate of about 5% per annum over the next five years. Although I won't dwell on the exact percentage of growth, I am convinced it will grow. Most long-term estimates come in at just over 6,000 aircraft, valued at $90bn, for the next decade. That also translates to a 4% annual growth rate. Let's not forget that estimates are only that...estimates.
� 80% of frax owners never owned a plane or share in a plane before. As a result it is not only a case of the frax market cannibalizing the existing business jet market share. It is actually doing its fair bit to grow the larger market in which it operates.
� The Citation Excel's and Citation Ultra's, read lower end of the market, is the fastest growing section of the global frax fleet. Light jets make up 5,843 (46%) and medium jets 3,812 (30%) of the global jet fleet of 12,581, with heavy jets obviously making up the remainder. The following list is a breakdown of the various sized jets on offer at NetJets,


Cessna Citation Ultra
Cessna Citation Encore
Cessna Citation Excel

Cessna Citation VII
Raytheon Hawker 800XP
Cessna Citation Sovereign (Available 2004)
Raytheon Hawker 1000
Raytheon Hawker Horizon (Available 2004)
Cessna Citation X
Gulfstream 200

Dassault Falcon 2000
Dassault Falcon 2000EX (Available 2004)
Gulfstream IV
Gulfstream V
Gulfstream V-SP (Available 2004)
Boeing Business Jet

� The frax market holds 45% of the current aircraft order backlog. Clearly it is a main driver of the growth in the business jet (manufacturing) market.
� Airlines lost 8% of 1st and business class passengers to frax operators in 2002. I think airlines are adding to their misery by shelving plans for corporate jet services (Virgin and BA in particular), thereby just giving up on the passengers lost to the frax operators. Thanks, anyway.
� 20% of NetJets' frax shareholders are wealthy individuals, 30% are public companies and 50% are private companies. In light of the fact that NetJets make up 75% of the frax market it can be safely assumed that the above is a good proxy for the whole market. When I think business jet, I either think rich guy or big company. Yet, the numbers paint a different picture. This is important, because when I think private companies, 80% new frax owners that never owned a plane, airlines that are loosing 1st and B-class passengers and thatthe lower end of the frax market is the fastest growing then a very powerful concept springs to mind. The market is becoming more and more accessible. You only have to look at the development of the automobile industry, the airline industry and the PC industry to realize what powerful growth driver increased accessibility to a market is.
� I already mentioned that 85% of business jets reside in North America. Europe needs to start flying seriously and so does Asia. Why aren't they keen on business jets? Your guess is as good as mine. However, I don't see any reason why those markets cannot be developed. Although NetJets is finding it tough in Europe it is forging ahead. Berkshire Hathaway shareholders are keenly aware of this, because they are paying for it. NetJets' European expansion started in 1996 and as far as I can tell produced losses all the way. Over the last two years the European losses pushed the whole of NetJets into the red. Bombardier's Flexjet unit was also helpful in developing the European market, but only up until 2001 when it pulled out. Now it maintains a presence only through its block charter programme SkyJet. Marquis Jet, another block charter operator, which sells time on the NetJets fleet, is also making significant progress in Europe. On the Asian front NetJets is steadily making progress and so is Flexjet. Flexjet Asia was started in Dec, 2001, but I could not establish how successful they have been. For what its worth, NetJets undertakes more flights into Asia than all the other frax operators put together.
� Rich Santulli thinks the market in the US alone is worth at least 20,000 frax owners. At the end of 2002 frax owners totaled 4,098.

When considering the above, I don't feel as if one needs to take a huge leap of faith when expecting a 10% plus revenue growth rate at NetJets over the next 10 years. NetJets produced a compounded revenue growth rate over the last 6 years of 67%. Anyway, I am totally comfortable settling for the following,


Frax operators.

"Aerodynamically, the bumble bee shouldn't be able to fly, but the bumble bee doesn't know it so it goes on flying anyway."
-Mary Kay Ash

� NetJets (75% of the market),
� Flight Options/Travel Air (25%). Flight Options differentiates itself by only using refurbished jets. That means it can sell frax shares cheaper. Other frax operators will be quick to point out that when you are in need of a brain surgeon, you don't shop around for the cheapest one. They will argue that it holds true for the jet market as well. I would argue that the above is true only to a limited extent. The business jet industry has the best safety record in general aviation, which means they are literally the safest planes to fly. To me this means that the old adage is being overplayed. I do believe the strategy of focusing on refurbished jets is worth an alligator or two in the moat around the Flight Options castle.
� Flexjet (13%)
� Citationsshares- (one tends to ignore this little fella, because it holds just 4% of the market). It has only 32 (2002) aircraft. I think CEO Steve O'Neil is quite clever in focussing the company on small aircraft and staying small in general. The company's average flight is 1.4 hrs and the average load is 2.6 passengers. It looks like Citationshares is working itself into a nice little niche.

Block charter operators

No flying machine will ever fly from New York to Paris ... [because] no known motor can run at the requisite speed for four days without stopping.

-Orville Wright

What is a block charter operator? If you don't want to own a share of a plane you can just buy 25 hours of flying time on the fleet. You get all the perks without the capital investment in a frax share, which starts at $375,000. In most cases you buy a card, which entitles you to 25, 50 or 100 hours, usually per annum, on a certain type of aircraft. Still it doesn't come cheap. It will cost you around $100,000, $250,000 and $500,000 for 25, 50, and 100 hours respectively. Block charter operators buy frax shares on fleets or make block bookings with charter companies. It is then repackaged and sold as travel time on a card, very much the same as you would buy pre-paid airtime on a mobile phone card.
� Sentient is independent and claims to have completed more flights in 2002 than NetJets.
� Marquis Jets sells time on the NetJets fleet.
� Platinum Travel sells time on the Citationshares fleet.
� Bombardier's Flexjet backs Skyjet. Skyjet has access to 1,300 planes and 235 charter operators.
� Delta AirElite.

I would argue that the block charter operators are largely complimentary to the frax market. Currently the economics of the business dictate that you charter or use a block charter company when you fly less than 50 hrs/annum. For 50 hrs to 400 hrs you use frax operators and if you fly more than 400 then you buy the plane. If you fly in excess of 1,500 hrs per annum then your name is Mark Mobius.

The relationship between frax operators and block charter companies seems to be very good. NetJets will gladly direct you to Marquis Jets if they feel that it the best option for you. Why not? It makes business sense. You still end up as their client and once you grow up, financially speaking, you can seamlessly migrate to NetJets. Marquis opened for business in 2001 and sold 500 cards in its first year, which produced turnover of $105m. If you feel you might have a need for their services then don't hesitate to visit them on

Charter companies

If God had really intended men to fly, he'd make it easier to get to the airport.

-George Winters

There are some 500 charter companies with around 3,000 planes at their disposal. The business aviation industry will say I am doing this backwards, because it lumps the block charter operators with the charter companies and therefore includes it in the above figure of 500.
However, I am looking at the industry from a NetJets point of view. I find it more logical to separate the block charter operators from the charter companies and treat them as somewhere in between the frax operators and the pure charter companies. So my way is not the most popular way of doing it. Then again I always tell my shareholders; you pay me for being right...not popular.
The charter market itself is growing very fast (30% in 2001). This is probably mostly due to the activity of the block charter operators. If Sentient is correct in its claim of completing more flights than NetJet's in 2002 then it must be doing more than 250,000 flights per annum. This kind of activity is a strong driver of growth in the charter market. The frax operators influence this market more directly in that it uses charter companies to fly the 'overflow' flights that it cannot accommodate on its own fleet. The growth in the 'overflow' market or business between frax operators and charter companies will be directly linked to growth in the frax market. It is also interesting to note that although the number of aircraft in the charter market dropped, the business jets in that market increased substantially, which also supports the notion that the block charter operators and 'overflow' market are behind the growth in the charter market.

However, I wish to focus on a much more pressing issue, namely ...REGULATION! Charter companies operate under Part 135 of the Federal Aviation Regulations and frax operators under Part 91. The FAA's job is to regulate the industry, with its main focus on the safety of all participants. It has different rules for flying clubs as apposed to airlines for obvious reasons. Generally the FAA does not concern itself with an issue that does not involve some aspect of safety. However, it seems that in the case of the frax operators this has changed. My suspicion is that it is due to the lobbying efforts on behalf of the charter companies.
At the risk of over simplifying, if you have your own plane then your safety is pretty much up to you. It is not a case of the FAA not caring, but I think it is correct to observe that they care less. If you want to fly your plane in a state of disrepair or in dodgy weather and kill yourself in the process then go ahead. What is important to note specifically with regards to the frax operators is that the regulations are more lax when it comes to specifications of airports you are allowed to fly to and in what kind of weather you are allowed to take off.
On the other hand if you are going to be making money out of chartering your plane then you are regulated more to ensure that you don't fly the public around in an excuse for a plane and that you take off in specified conditions.

It all gets blurred in the case of the frax operators. If I own a share in a plane then my buddies and me can still decide how we look after our plane and in which conditions we take off. Now this shouldn't be any different when I outsource the management of my plane to a professional company like NetJets. In fact I am doing it, because I think they can do a better job of maintaining and flying the plane than me. It is important to note that business aviation haven't been doing a bad job of 'flying safe' to start off with. In fact, as I mentioned before, they have the best safety record in general aviation and in 2002 they established one of the best records ever. There were 0.116 accidents and 0.029 fatal accidents for every 100,000 professional flight hours in 2002. To put it differently, in 2002 all business flights (piston and jet planes plus helicopters) flying under Part 91 regulation produced only 8 accidents and two fatal accidents in which 6 people died.

So why increase regulation? Maybe the FAA has a long-term outlook and sees trouble down the road. I think it is mainly due to pressure from charter companies. They use the added regulation as a means of eroding the frax industry's competitive advantage and to increase their own in the process. Business jets can fly to around 5,300 airports in the US. Airlines and other commercial operators, including charter companies, can fly to only 558 and most passengers actually fly to or from just 30 major hubs. What's more, consider the fact that at these 30 hubs passenger operations make up only 8% of total operations. Therefore if you want to move people for whom it is a priority to get where they are going as quickly and efficiently as possible then the number of airports you can fly to is critical. Passengers are not the main priority at the major 'congested' hubs so the number of 'alternative' airports you can fly to is even more important. As any pilot will tell you the only other significant factor hindering you getting from A to B is the weather.
Let's look at the proposed changes in detail, in light of the above.
Part 135 (charter operators) has a 60% rule that says you can only land a plane on a strip where you can bring your plane (if fully loaded) to halt in 60% of the distance. Charter operators want this to be increased to 85% for various reasons. Also, you can only fly to an airport that has certain specified weather reporting facilities. Charter operators want to include airports that do not have the specified facilities, but which has an airport close by with the required facilities. None of the above applies to frax operators, which means they can fly to more airports and in worse weather conditions. The number of airports and the kind of weather you can take off in, are very important elements of the frax operator's competitive advantage.
Subpart K (frax operators) is to be added to the existing Part 91 regulation. It will regulate all frax operators in which the programme allows you to fly in an aircraft that you don't own a part in. This includes NetJets who usually only provides you with the same type of aircraft, but not the actually one you own a share in. Subpart K has a host of added restrictions covering drug test requirements for maintenance personnel, pilots, equipment, manuals, inspection facilities and of course the inevitable extra taxes. Taxes are of particular importance, since frax operators are not considered 'commercial operators'. Just consider the following federal taxes. Commercial operators are subject to a 7.5% passenger transportation tax, a 6.25% property transportation tax, a $3 segment charge for flights into all non-rural airports and a $13.40 'head tax' for all flights out of the US. Consider that NetJets will fly some 300,000 flights this year and you can see that this is a substantial sum we are talking about.

It does seem that the proposed regulations will for the most part become part of the Federal Aviation Regulations. All the above makes it quite obvious that frax operators are going to get more competition from charter operators, it is going to increase operating costs relative to charter operators and absolutely. Will it succeed in making the safest section in general aviation even safer? Maybe, but that was not the real driver behind all this in my opinion now was it? Still this is what the playing field will look like in future.


Thank God men cannot as yet fly and lay waste the sky as well as the earth!

-Henry David Thoreau (1817 - 1862)

From a supply point of view the frax operators are in a good position. The notable manufacturers are,
� Cessna, part of Textron Inc,
� Gulfstream, part of General Dynamics,
� Raytheon,
� Dassault
� Boeing, and
� Bombardier
In 2002 billings for the general aviation (excl military planes) manufacturing industry fell from $13.9bn to $11.9bn or some 14.4%. This is the first time sales have declined for almost a decade. Of the 2,994 planes manufactured in 2002 683 were business jets. The number of business jets manufactured declined by 12.7% from 2001. The dramatic increase in the resale market is party to blame for the decline in sales. Of the 12,581 jets in the global fleet some 2,500 are currently on sale. The historical average is more like 1,500. I can't help to think that this must be a good thing for block charter operator Flight Options, which only sells frax shares in refurbished planes. Then again this is a buyers market in general and all frax operators are buying. Although the downturn in the market is quite dramatic it does not even rank in the top five of the worst industry downturns the aircraft manufacturing industry ever experienced. Manufacturing companies still produced after tax return on equity of 13.4% in 2002. Leverage is about 17%-18% of total equity.
Cessna with Citation and Learjets is the main player in the light and medium jet segment with Raytheon's Hawker and Beechjets the other notable player. Gulfstream, Dassault and Bombardier populate the heavy jet segment. The Boeing business jet is really more an airline type jet. Teal Group estimates that the market share of the manufactures will look roughly as follows in 10 years time.

�      Gulfstream       25%
�      Bombardier       25%
�      Cessna       20%
�      Dassault      20%
�      Raytheon      10%

What I found particularly interesting is that various manufacturing sources are of the opinion that a foothold is being established in China. The Chinese are reorganizing their civil aviation regulatory environment, which is making it easier for the business jet market to establish itself. Also, where in 1996 10% of global jet production went to Europe it is now 17%. This is all good news, because where there are jets there is business for NetJets.

We cannot move onto the next point without addressing the manufacturers involvement in the frax market. The following manufacturer frax/charter relationships exist.
� Raytheon - Flight Options/Travel Air.
� Bombardier - Flexjet and Skyjet
� Cessna � Citationshares.
What should one make of this? First of all it is mostly more difficult for a diversified company (manufacturers + frax + block charter) to compete against a company that specialises (NetJets). It is important to note that the manufacturers/frax operators only fly their own make of plane. On the other hand, NetJets fly almost the full range with 13 different types of planes, which includes Cessna, Raytheon and Bombardier. That is the position to be in when you are buying. The worst think you can do is to tie yourself to one supplier. That is the worst bargaining position to be in and all the notable players apart from NetJets are in that position. All indications are that all frax operators are currently loosing money. That makes it more likely that the manufacturers, which are making good money would want to get out of the frax/charter business. Raytheon is apparently a very reluctant participant in the frax market and many industry players think it really wants to do only one thing and that is to get out.

The problem I see is that the exit barriers in the frax industry are quite high, especially for the manufacturers, which would flood the market with their own planes if they were to get out. It makes me as a NetJets owner rather uncomfortable to have competitors for whom it is very difficult to get out of the market even if they wanted to. Yet, out of all this comes a very exhilarating idea. If either Raytheon or Bombardier wants to get out then whom can they possibly sell to? Who has both the financial muscle, know how and market share incentive to buy these two companies? Only NetJets. However, whether the competition guys, especially the European bunch would allow this is another story. Still it is a point worth thinking about. With the current difficult times in the frax industry I won't be surprised to see Raytheon throwing in the towel. In fact I am waiting for it.

Last but not least on the manufacturing point is the very light jet manufactures like Eclipse Aviation. Whether the jet will ever fly is open for discussion, but the vast majority of reports I have seen are very positive. For around $1m you will be able to buy a small six-seat jet. Numerous see this as a threat to the frax industry, but I don't. In fact I hope it happens. Cheaper jets mean more jets and more jet owners that want the use and not the hassle. How can this possibly be bad for NetJets?

Let's quickly recap.
� The global business jet industry is growing at a steady pace.
� The frax industry is growing very fast.
� NetJets has 75% market share.
� Europe is moving forward and China is in its infancy, but it is definitely growing.
� The entry price for frax shareholders is steadily reducing and will drop like a stone if light jets ever see the light of day on a commercially viable basis.
� Manufactures are doing well. However NetJets is in a superior negotiating position.
� Regulation is a pain in the butt and will add to current operating costs. Yet it is here to stay and will just have to be passed on to the frax shareholders. Naturally this is easier said than done, but current margins or rather lack of it means it has to happen.


It is possible to fly without motors, but not without knowledge and skill.

-Wilbur Wright

� Dick Lassiter founded Executive Jet Aviation in 1964.
� Rich Santulli bought it in 1984 for $2m.
� 1986-NetJets launched with 8 Citation S/II's
� 1995-Buffett bought first share for Suzie
� 1995-Sold 25% to Goldman Sachs
� 1996-Launched in Europe 4 Citation S/II
� 1998 (Aug 7)-Berkshire purchased 100% of NetJets. Price $725m ($350m cash and $375m A&B shares. Price BRK A shares 7 Aug 1998 $69,800 which translates to 5,372 A shares). Buffett � [the question] "I always ask it to myself on every deal, was whether Rich Santulli would take the money and go sit on a beach or stay and run the company."
� Current (26 June 2003) BRK price $73,700. 1.1% compounded growth for Rich Santulli, since 1998. However, the 'in pocket' return is higher, because there were significant tax benefits in selling for stock rather than cash. Rich Santulli paid $2m for the company in 1984 and by 1990 lost around $40m. I am not sure whether it was the bank's money or his own that he lost, but let us presume it was the latter. That means by 1990 he invested $42m in the company, which means his return compounded by 43% when he sold it in 1998 for $725m. He might have lost more money after 1990, but my guess is that no matter how you slice it, it remains a very good deal for Rich Santulli. No wonder Buffett had to ask whether he was heading for the beach. Rich Santulli, which has a PhD in maths, surely knows how to do his sums.
� 1999-Launched in Middle East.
� 2002-Changed name from Executive Jet Inc to NetJets Inc and added a new tagline Everything else is just a plane.
� Currently 6 largest airline in the world measured by the number of planes.

I find the structure of NetJets rather confusing, but here is how I understand it. What used to be Executive Jet Aviation (EJA) and is now called NetJets consists of three companies,
� Executive Jet Management (EJM),
� Executive Jet International Inc, and
� Boeing NetJets.
EJM manages the charter operations and all aircraft in the NetJets programme, which is not, managed by the latter two. Executive Jet International Inc manages the Gulfstream IV SP and the Gulfstream V aircraft. Boeing NetJets manages the Boeing business aircraft. I am waiting on NetJets' response on how this all fist together. I also asked them to explain how Europe and the Middle East fit in. Will let you know once they responded.

EJM currently employs 510 personnel. I don't know where the 2,600 NetJets pilots fit in. EJM anticipates turning a year-end total of 19,300 flight segments. Of this 4,920 will be charter segments, which will include 726 international segments and the rest will be 14,500 owner flight segments. They will be flying close to 300,000 flights. To me this means that a segment can contain several flights. Can the pilots please explain? EJM currently owns 109 planes, yet manages 513. This ratio remains at roughly 20% of the total managed fleet. It is needed to support the fractional ownership programme. This is where the majority of the capital investment goes. However, NetJets is NOT a capital-intensive business. Capital investment ($m) over the last six years at Berkshire Hathaway's flight services business (NetJets and FlightSafety International [FSI]) was as follows,


In 1997 we owned only FSI. NetJets was included in Berkshire Hathaway's books only from August 1998. It gives you a fairly rough idea of which operation needs the most ongoing investment. In 1999 the fleet managed by EJM increased by 100. We know it will need to own 20 of the same type of planes to support the increase in the programme planes. The cheapest plane in the fleet costs $6m so NetJets capex must have been at least $120m. This leaves around $200m for FSI, which looks about right if you compare it to previous years. The point is that an increase of 100 planes will call for an increase of 20% of its value in capex, not 100%. The 100 planes must have cost at least $600m. Who came up with the $600m? The frax shareholders. Remember they own the planes and EJM only manages it for them. Sure there will be other needs such as increase infrastructure costs such as a new operational centre. Currently there are three,

�      Columbus, Ohio
�      Lisbon, Portugal, and
�      Jeddah, Saudi Arabia.

When will we have one in China?

NetJets is currently managing 513 planes worldwide of which 404 is owned by frax shareholders. NetJets generates revenues from mainly two sources,

� Aircraft sales, and
� Programme management fees.

In the case of the former it simply acts like a broker. If you multiply the price for a share in a plane by the number of shares in that plane you will usually end up with the list price for that particular aircraft. NetJets doesn't seem to add anything above the list price. However, it does buy in bulk. NetJets repeatedly breaks records in terms of order size, such as placing the world's largest order in 1993. This means it can negotiate the best discounts in the industry and not all of it will be passed on to frax owners.

The programme management fees are where the real money lies. However, we have seen little of the real money to date. Warren Buffett is of the opinion that margins can get to between 5% and 10%. 1998 produced a margin of 5.4%, 1999 2.2%, 2000 0.7% and for the last two years NetJets only produced losses. For calculations of these figures I refer you to the following post by Lleweilun Smith.

The pedal was really put to the metal, since 1998 in terms of expansion. Although NetJets currently enjoys a 75% market share it is important in terms of the business model to have scale. One of the elements at work is illustrated by the following.
I need one plane to support 4 frax owners (ratio 4/1). I need two planes to support 10 (ratio 5/1) and 3 to support 20 (6.7/1). See how the ratio is increasing? So the more planes I have the higher the ratio of frax owners to planes. The following shows the concept at work in practice. The frax industry had 633 business jets at the end of 2000, which supported 3,834 frax shares for a ratio of 6.1 shares per plane. At the end of 2002 the industry had 776 planes, which supported 5,827 shares for a ratio of 7.5 shares per plane. Another example of the business model enjoying more leverage with scale would be Rich Santulli's experience. He said that when he developed the concept and put it into practice in 1986 he needed to own 5.25 planes for every 20 sold. This means that he could support 3.8 planes for everyone owned. Currently EJM owns 109 planes and there are 513 in total. Therefore it is currently supporting 4.7 planes with every one plane owned. This is a simple illustration of assets being leveraged. Now I know that we don't own around 80% of the assets, but we do generate revenues from those assets. If you consider that this is a low margin business then the leverage can have a dramatic affect. We know NetJets USA is profitable and that NetJets Europe is not only unprofitable, but that the losses are so big that it produces an overall loss for NetJets. The latest total for planes at NetJets I have seen was 513 of which 44 was in Europe. Therefore operating costs for those 44 planes outweighed the profits of the 469 planes in the US. (Please note that the Middle Eastern operations are included in one of the above, but I don't know which).

The above argument looks suspiciously like the revenue model that was touted in the ere. We didn't believe it then, so why should we believe it now? I think the main difference is that the model has proven that it can make money. In 1998 NetJets did produce an operating/pre tax margin of 5.4%. At the time it had about 12 planes operating in Europe out of a total 163. Therefore Europe was 7.4% of the total. However, on average, those 12 planes was much more expensive to run than the current 44. As I have argued above, there exists an economy of scale in this model. Currently Europe's jets make up 8.6% of the total. Out of this follows that we must be close to break even. My calculations (see Lleweilun's post above) show that last year the negative margin was �1.4%. It is not a train smash, but a reasonable short-term sacrifice.

I do believe the landscape is changing in Europe. As mentioned before, 10% of the global business jet output went to Europe in 1996 and in 2002 it was 17%. Mark Booth (NetJets Europe) said last year, "we're seeing a lot of interest in GVs [Gulfstream V's] and BBJs [Boeing Business Jets]," he said-while smaller aircraft are in heavy demand. "Bravos are back ordered. Those and Excels are basically selling out as soon as we get them." The London financial community is a heavy user of the Bravo as it can operate into London City Airport near their offices at Canary Wharf. On the one hand the fact that Flexjet switched from frax to block charter indicates that they are finding it difficult in Europe. On the other hand it means there are one less competitor to contend with. I don't know what the current numbers are, but in 1999 40% of US customers interchanged with Europe and 100% of European customers interchanged with the US. Therefore it is a case of the US market spilling over into Europe rather than the European market being developed in isolation. I believe it is preferable to enter a new market, by extending an existing one than establishing a remote market.

NetJets said that they believe the European programme will turn profitable in 2004. A 28 May 2003 press release from EJM stated the following, Executive Jet Management, Inc. (EJM), the leading provider of aircraft management and charter services worldwide, reported that March 2003 was the company's best month every in charter sales activity since the company was founded in 1964. The company also reported an 11-percent increase in charter activity during the first quarter of 2003 compared to the same period a year earlier. EJM's charter activity is used to take care of the overflow in the NetJets frax owner fleet. Therefore charter activity is an indicator of the activity in the frax owner fleet.

It might be a case of NetJets pausing to take a breath in the expansion race to let profitability catch up. I say this, because an increase in the charter operations means there is a decrease in the relative capacity of the frax owner fleet compared with the charter fleet. We know NetJets recently cancelled a number of orders or reduced it. Moreover, Air Inc, recently reported, NetJets, Flight Options, Bombardier Flexjet and Citation Shares�hired 92 pilots in the first five months of this year, compared with 559 in the same period last year. In May alone, these fractional operators added just 22 pilots, compared with 100 in May last year.

One cannot fly a plane without a pilot so it does logically translate in a significant slowdown of expansion. If business are still increasing, but the growth in capacity is being curtailed then it logically follows that asset utilization increases. That is the way to profitability.

In the meantime the severe drop in the resale values of planes does impact the industry. Up until 7 December 2002 the industry signed on 760 new frax owners and lost 210 for a net gain of 550. Yet those must be a very unhappy bunch of customers, because they would have seen a dramatic drop in the value of their capital investment. The same will happen in 2003. It cannot be good for the industry, but I am not able to assess the damage. While at NetJets around 70% of new customers come from referrals from existing clients. At least they seem to be happy.

Conclusion (on moat)

The easiest way invariably is the best way. -Charlie Munger

Although I have focused a lot on the industry it mostly translates directly for NetJets. This is simply because NetJets make up 75% of the industry. I believe it is reasonable to argue that it will be profitable in the long run, in light of the above. The barriers to entry are huge, mainly because the margins are so thin and because NetJets have such a significant first mover advantage. There are a lot of similarities between the business model for Coca Cola, Fedex and Amazon. Of particular importance is the scale of the operations. When your distribution system is very big and you have razor thin margins to add then a first mover advantage builds an insurmountable barrier. It is a moat you just cannot cross. It is impossible to breach the difference in value with a difference in price when you want to compete with Coca Cola. Their product is desired and their system is super-efficient. You cannot make it cheap enough for the consumer to switch, because the economics of the business does not allow it. Neither can you make it desirable to switch, because the economics does not allow you to spend the required money to build a brand of equal value to the consumer. Amazon has the same power. The production and distribution system has become so efficient that it does not allow you enough leverage in price to get the customer to switch. Consumers will pay the dollar or two above the competitor's price, because it knows and trusts Amazon. NetJets has the same economics at work at the heart of its business model. Yet, it not only has a product that is desired, it is needed, has to be trusted and be reliable. Those are huge competitive advantages if you get it right and we know NetJets is getting all of it right in spades. However, the most important element, which I left for last is that it is one of the very few products in this world that literally buys you time. Not only does NetJets sell time, it sells it to the section of the global community for whom it is worth the most. Time has a very high price for the typical NetJets frax shareholder. Moreover, the value of time will only increase in future for the globe's wealthiest individuals. You call that a moat? You bet.

As they say,


NetJets's value

Surely there comes a time when counting the cost and paying the price aren't things to think about any more. All that matters is value - the ultimate value of what one does.

-James Hilton (1900 - 1954)

Back of the envelope calculation:
� Full year turnover for 1998 was about $950m and pre-tax profit about $50m.
� On a purchase price of $725m this is a pre-tax yield of 7%. Not bad considering the growth expectations.
� In 2003 turnover was around $2.2bn. If we stopped growing now and Rich Santulli and his team can get margins back to 5.4% then we are looking at pre-tax profits of $119m. On $725 this is a pre-tax yield of 16%. However we invested money in the meantime. My guess is anywhere between $500m-$1bn in current value terms. Capex I could establish is as follows,

o 1999-Control centre in Jeddah.
o 1999-100 Hawker Horizons were purchased for a total cost of $2bn. Roughly 20% would have been for EJM itself, which comes to $400m for that year alone.
o 2000-$25m 200,000 ft operation head quarters at Port Columbus Ohio
o 2001-Takes delivery of first of 29 Boeing Business Jets ($46m plane in 2001).
o 2001-Takes deliver of first of 32 Gulfstream V's ($30m plane in 2001)

� EJM purchased around 80 planes for its own use, between 1998 and the end of 2002. With the cheapest plane at $6m, the planes cost at least $480m. However, the 1999 jets alone were $400m. I could not establish exactly which type of planes were taken delivery of, but in light of all the above a capex figure for 1998-2002 of between $500m - $1bn still looks acceptable. This translates to a pre-tax yield of between 7% and 9% when we use these amounts for capex ($119m/[$725+$500m] and $119m/[$725+$1bn]). Applying the 1998 ratios to current figures means the company is worth $1.7bn ($119/7%) or what we put in.
� I believe we are not close to full capacity in terms of revenue that the current fleet can produce. Average revenue per owner was around $950,000 in 1999 and in 2002 it was $626,000 or 34% lower. Therefore revenues will be $3.3bn if we were running at 1999 capacity, which I doubt was at full capacity. That translates to a pre-tax return of around $180m and the commensurate yield will be between 10% and 15%. That is more like what we are used to. If NetJets is in fact capable of margins closer to 10%, as Buffett believes, then those return figures would double to 20% and 30% respectively.
� Apart from the last part of the previous point, I believe the above calculations are very conservative. In fact I am probably erring in being over conservative. All I want to see is whether I get a satisfactory yield when I am being a bit ridiculous in my assumptions at the lower end. I am satisfied that this is the case. I do feel the odds are much more in favour of me erring on the lower end than the other way around. In light of the above I would say we would be stupid to let NetJets go for anywhere close to $2bn.

Whatever you are up to, I hope it is profitable and ethical!

Mr. B

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