In that same year, Robert Miles published “The Warren Buffett CEO,” which I mentioned in my most recent article (here); as would be expected in any book with a focus on the managers of Berkshire’s wholly owned operating companies, Mr. Miles took it upon himself to uncover the most likely candidate for the top job (operational successor). His conclusion? Rick Santulli.
Some readers may not be familiar with Mr. Santulli, so let’s start with one pretty important tidbit of information: He hasn’t been an employee of Berkshire Hathaway for nearly four years. Mr. Santulli is the man behind Executive Jet – which changed its name to NetJets in the early 2000s; he came into the Berkshire fold when the company was acquired for $725 million ($350 million was paid in cash, with the remainder coming from Berkshire stock) on July 23, 1998.
Anybody who has read Miles' book knows that he thought quite highly of NetJet’s future (comparing it to that of FedEx multiple times), with Warren Buffett sharing similar (albeit decidedly more reserved) thoughts in the 1998 shareholder letter:
“To understand the huge potential at Executive Jet Aviation (EJA), you need some understanding of its business, which is selling fractional shares of jets and operating the fleet for its many owners. Rich Santulli, CEO of EJA, created the fractional ownership industry in 1986, by visualizing an important new way of using planes. Then he combined guts and talent to turn his idea into a major business.
In a fractional ownership plan, you purchase a portion — say 1/8th — of any of a wide variety of jets that EJA offers. That purchase entitles you to 100 hours of flying time annually. (“Dead-head” hours don’t count against your allotment, and you are also allowed to average your hours over five years.) In addition, you pay both a monthly management fee and a fee for hours actually flown. Then, on a few hours’ notice, EJA makes your plane, or another at least as good, available to you at your choice of the 5500 airports in the U.S. In effect, calling up your plane is like phoning for a taxi.
I first heard about the NetJets program, as it is called, about four years ago from Frank Rooney, our manager at H.H. Brown. Frank had used and been delighted with the service and suggested that I meet Rich to investigate signing up for my family’s use. It took Rich about 15 minutes to sell me a quarter (200 hours annually) of a Hawker 1000. Since then, my family has learned firsthand — through flying 900 hours on 300 trips — what a friendly, efficient, and safe operation EJA runs. Quite simply, they love this service. In fact, they quickly grew so enthusiastic that I did a testimonial ad for EJA long before I knew there was any possibility of our purchasing the business. I did, however, ask Rich to give me a call if he ever got interested in selling. Luckily, he phoned me last May, and we quickly made a $725 million deal, paying equal amounts of cash and stock.
EJA, which is by far the largest operator in its industry, has more than 1,000 customers and 163 aircraft (including 23 “core” aircraft that are owned or leased by EJA itself, so that it can make sure that service is first-class even during the times when demand is heaviest). Safety, of course, is the paramount issue in any flight operation, and Rich’s pilots — now numbering about 650 — receive extensive training at least twice a year from FlightSafety International, another Berkshire subsidiary and the world leader in pilot training. The bottom line on our pilots: I’ve sold the Berkshire plane and will now do all of my business flying, as well as my personal flying, with NetJets’ crews.
Being the leader in this industry is a major advantage for all concerned. Our customers gain because we have an armada of planes positioned throughout the country at all times, a blanketing that allows us to provide unmatched service. Meanwhile, we gain from the blanketing because it reduces dead-head costs. Another compelling attraction for our clients is that we offer products from Boeing, Gulfstream, Falcon, Cessna, and Raytheon, whereas our two competitors are owned by manufacturers that offer only their own planes. In effect, NetJets is like a physician who can recommend whatever medicine best fits the needs of each patient; our competitors, in contrast, are producers of a “house” brand that they must prescribe for one and all.
In many cases our clients, both corporate and individual, own fractions of several different planes and can therefore match specific planes to specific missions. For example, a client might own 1/16th of three different jets (each giving it 50 hours of flying time), which in total give it a virtual fleet, obtained for a small fraction of the cost of a single plane.
Significantly, it is not only small businesses that can benefit from fractional ownership. Already, some of America’s largest companies use NetJets as a supplement to their own fleet. This saves them big money in both meeting peak requirements and in flying missions that would require their wholly-owned planes to log a disproportionate amount of dead-head hours.
When a plane is slated for personal use, the clinching argument is that either the client signs up now or his children likely will later. That’s an equation I explained to my wonderful Aunt Alice 40 years ago when she asked me whether she could afford a fur coat. My reply settled the issue: ‘Alice, you aren’t buying it; your heirs are.’
EJA’s growth has been explosive: In 1997, it accounted for 31% of all corporate jets ordered in the world. Nonetheless, Rich and I believe that the potential of fractional ownership has barely been scratched. If many thousands of owners find it sensible to own 100% of a plane — which must be used 350-400 hours annually if it’s to make economic sense — there must be a large multiple of that number for whom fractional ownership works.
In addition to being a terrific executive, Rich is fun. Like most of our managers, he has no economic need whatsoever to work. Rich spends his time at EJA because it’s his baby — and he wants to see how far he can take it. We both already know the answer, both literally and figuratively: to the ends of the earth.”
In that year, according to the annual report, Executive Jet had roughly $380 million in revenues, and about $21 million in operating income; over the next few years, however, the business struggled to get much better, at least in terms of profitability. For example, Buffett estimated in the 2002 Letter that NetJet’s accounted for an astounding 75% share of the fractional ownership business, per FAA records; even with such a commanding lead, the financials were quite poor:
“Though NetJets revenues set a record in 2002, the company again lost money. A small profit in the U.S. was more than offset by losses in Europe. Overall, the fractional-ownership industry lost significant sums last year, and that is almost certain to be the outcome in 2003 as well. The bald fact is that airplanes are costly to operate.”
While we don’t have the exact figures (due to the fact that NetJets is part of the broader “Flight Services” segment at this time), we have the following description of the operating results in the annual report: “NetJet's pre-tax earnings in 2002 were relatively unchanged from 2001 as each year’s results reflect losses related to expansion into Europe somewhat offset by small profits from its domestic operations.”
In 2006, Warren updated investors on NetJets results; while revenues had increased nearly 600% since the company had been purchased eight years earlier (a compounded annual growth rate north of 25%), earnings had been a bit more erratic for one continuing reason – Europe:
“Our move to Europe, which began in 1996, was particularly expensive. After five years of operation there, we had acquired only 80 customers. And by mid-year 2006 our cumulative pre- tax loss had risen to $212 million. But European demand has now exploded, with a net of 589 customers having been added in 2005-2006. Under Mark Booth’s brilliant leadership, NetJets is now operating profitably in Europe, and we expect the positive trend to continue.”
At that point, it looked like a bonanza was near; as we saw a few years later (2009), this was far from the case:
“The major problem for Berkshire last year was NetJets, an aviation operation that offers fractional ownership of jets. Over the years, it has been enormously successful in establishing itself as the premier company in its industry, with the value of its fleet far exceeding that of its three major competitors combined. Overall, our dominance in the field remains unchallenged.
NetJets’ business operation, however, has been another story. In the eleven years that we have owned the company, it has recorded an aggregate pre-tax loss of $157 million. Moreover, the company’s debt has soared from $102 million at the time of purchase to $1.9 billion in April of last year. Without Berkshire’s guarantee of this debt, NetJets would have been out of business. It’s clear that I failed you in letting NetJets descend into this condition. But, luckily, I have been bailed out.
Dave Sokol, the enormously talented builder and operator of MidAmerican Energy, became CEO of NetJets in August. His leadership has been transforming: Debt has already been reduced to $1.4 billion, and, after suffering a staggering loss of $711 million in 2009, the company is now solidly profitable.”
At this point, you might think that this article is a review of NetJet’s history as a subsidiary of Berkshire Hathaway; while that’s an interesting case study on its own, I think this story serves as a broader lesson into why Berkshire – and more specifically Buffett – has chosen to follow the current path in regards to succession.
Publicly naming a successor in advance is nonsensical, particularly when the current CEO is at the top of his game, in good health, and has made no indication that he plans to step down; just as Coca-Cola (KO), American Express (AXP) and Wells Fargo (WFC) haven’t named their future officer’s years (and possibly more than a decade) in advance of the current CEO’s departure, it simply does not make sense for Berkshire to deviate from this model. On the other hand, privately updating the board’s search as time goes on is critical in case something unexpectedly happened to the CEO; as Warren’s noted many times, this is the primary focus at every board meeting, and has been for years.
Secondly, and more importantly, things change over time; as shows in the case of NetJets, both Mr. Santulli and Mr. Sokol proved to be out of the race well before Buffett’s tenure ended, despite the fact that they were both frequently cited as potential successors. Ironically, many have pulled Matt Rose from Burlington Northern into the hunt as of late – despite the fact that if Berkshire had announced the successor a few years prior, he wouldn’t have even been a potential candidate (a deal to acquire BNSF was announced in November 2009).
Finally, the NetJets story reveals an often overlooked component of the search: Buffett is human, and the potential for error – albeit small – is a real risk that must be considered. When reading “The Warren Buffett CEO,” the importance of Berkshire’s operating model (namely decentralized wholly owned operating subsidiaries, with occasional help from the home office and financial incentives to ensure sound capital allocation at the subsidiary level) is front and center; the next person who fills that seat will be responsible for ensuring that this culture doesn’t slowly fade away. Howard Buffett will become non-executive chairman, as a sort of backstop in case Buffett (and collectively, the board) err in their succession planning. As Buffett noted in a “60 Minutes” interview a few years ago, “The odds of that happening are very, very, very low - but having Howie there adds just one extra layer of protection.”
All in all, succession will continue to be top of mind; while investors may be queasy about the uncertainty, it will continue to be the case (here’s to hoping for many, many years to come). For those who have thought about why it’s that way, take solace in realizing that there’s no other logical way to approach the issue; such is the uncertainty of change. Take comfort in knowing that the future of Berkshire is in the hands of a well-informed board, and will be largely determined by the two men who have made it into the unparalleled success that it has become.
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About the author:
I hope to own a collection of great businesses; to ever sell one, I demand a substantial premium to the average market valuation due to what I believe are the understated benefits to the long term investor of superior fundamentals and time on intrinsic value. I don't have a target when I purchase a stock; my goal is to replicate the underlying returns of the business in question - which if I've done my job properly, should be very attractive over many years.