In a recent interview with Aviation Week, NetJets Chairman and CEO David Sokol stated that he is “comfortable” with his previous prediction that the company will post pre-tax profits of $200 million for 2010 and that “the business should always be profitable” in the future. However, Mr. Sokol also indicated that NetJets is likely to evolve into a fundamentally low margin business that may deliver 4 to 5 percent net profit margins in a “steady state, long term” environment. Berkshire Hathaway paid $725 million to acquire NetJets in 1998 and incurred cumulative pre-tax losses of $157 million from the time of the acquisition through the end of 2009.
Without Berkshire’s backing during the recession, NetJets would have likely been “out of business” according to Warren Buffett’s 2009 annual letter to shareholders. Mr. Sokol was brought in to restructure the business in August 2009. Although NetJets is now profitable, Mr. Sokol’s management has been controversial. We provided an update on NetJets after Berkshire posted Q3 2010 results which included background information on the various controversies.
“Berkshire Will Never Walk Away From a Business”
In the interview, Mr. Sokol made some interesting statements regarding Berkshire’s reputation for never walking away from a business even when financial results fail to meet the expectations that existed at the time of acquisition. Berkshire’s refusal to abandon ailing businesses is a key competitive advantage in the market for acquisitions particularly when the seller is the founder of the company and is primarily interested in securing a stable future for employees and customers:
Berkshire is not entitled to an unfairly high return, and 4% and 5% on revenues is not a huge return. But we’ve got to run the business in the most efficient method we can. That means buying airplanes and fuel at the right price, and doing everything to run the business so that the owner is getting exactly everything he paid for and hopefully a little more, and we properly pay and provide benefits to our employees, and Berkshire makes a fair return.
If we can’t do those things, if Berkshire went 11 years without a return, how much longer are they going to go? Berkshire will never walk away from a business — we still redeem Green Stamps, we still print World Books, we don’t walk away from commitments. On the other hand, we would just start shrinking the business. You certainly wouldn’t grow a business that has no return.
And so my job was to really explain to the employees, you don’t have to like me, but respect the equation here. Because if I tried to continue what was going on for another year, then it was going to get much uglier.
In August, David Sokol wrote a letter to NetJets staff in which he complained about “rumor mongering, deceit, and other forms of unethical behavior” that threatened to damage the brand. Mr. Sokol indicated that NetJets would be “forced to redirect our plans” if the situation persisted. From his statement to Aviation Week, it appears that he was referring to shrinking the business rather than selling it or winding down operations immediately.
Sounding More Like Buffett’s Successor …
We have stated in the past that David Sokol appears to be the most likely candidate to assume the CEO role at Berkshire Hathaway when Warren Buffett eventually steps down. In the interview, it is notable that Mr. Sokol seems to speak with a broader mandate than one would expect from the head of a Berkshire subsidiary. The quote provided above is one example since it has to do with Berkshire’s overall acquisition strategy and how the company chooses to behave when expectations are not met. The following quote is another example:
At Berkshire, we let the management team run the business. But that means sometimes when that team doesn’t make the transitions it should, we will be slower to step in.
Starting in late 2006, 2007, you could see that the capital being expended was exceeding the returns coming with it. There were commitments to acquire too many airplanes when you’d already seen a leveling off in the industry — things that a pure entrepreneur often won’t see, because they tend to want to grow the business forever no matter what.
I think Warren saw those things, but wanted to give them a chance to figure it out. Then the fall of ’08 happened, and there still wasn’t enough reaction to that, and I think he felt: Time.
Of Berkshire’s 40 acquisitions in the last 20 years, 38 have outperformed any expectations, and two have stumbled a little bit. That’s a pretty good track record. You want to err on the side of giving the management team the opportunity, and I think he meant he probably gave it more than he should.
As Berkshire Hathaway shareholders know, David Sokol is also Chairman of MidAmerican Energy Holdings and Johns Manville. He serves as a non-executive Director at BYD, the Chinese automaker in which MidAmerican holds a 10 percent ownership stake. While there are other viable candidates to serve as a future Berkshire Hathaway CEO, it is fair to say that none have been involved in as many Berkshire subsidiaries as David Sokol.
The Rational Walk’s upcoming report on Berkshire, In Search of The Buffett Premium, will discuss NetJets in more detail. The report focuses on succession issues at Berkshire and attempts to estimate the extent to which Berkshire’s current valuation reflects a “Buffett Premium”.
Disclosure: Long Berkshire Hathaway.