It is rare to read about boardroom drama and controversy within the diverse group of Berkshire Hathaway subsidiaries. Warren Buffett routinely makes a point of his preference to purchase businesses that are already well run and to then leave management alone to continue running the business. Acquisitions almost always meet expectations, but no one bats 1.000 and mistakes are sometimes made. This was certainly the case with Berkshire’s 1998 purchase of NetJets in a $725 million stock and cash transaction. At the time, there were high hopes for the long term profitability of the business.
Fast forward eleven years. In Mr. Buffett’s 2009 letter to shareholders (pdf), he reported that NetJets had posted aggregate pre-tax losses of $157 million during Berkshire’s period of ownership while debt ballooned from $102 million at the time of purchase to a peak of $1.9 billion in April 2009. Furthermore, without Berkshire’s backing in 2009, Mr. Buffett stated that NetJets would have been out of business. Mr. Buffett credits David Sokol with engineering a turnaround that returned NetJets to profitability in the first quarter of 2010. Mr. Sokol replaced NetJets founder Richard Santulli as Chairman and CEO in August 2009.
NetJets Status Quo: Not Pleased and Unsatisfied
We have previously reported on Mr. Sokol’s efforts to address the serious situation at NetJets (click on this link for an archive of our past coverage). The impression one gets from reading about the turnaround is that Mr. Sokol is a no nonsense hands on executive who took quick action to address what he considered to be lax management practices that had been tolerated under Mr. Santulli’s leadership. The actions taken seem very consistent with the principles laid out in Mr. Sokol’s book, Pleased But Not Satisfied, which we reviewed last year.
Drastic Action Required
Fortune Magazine published an extensive account of Mr. Sokol’s career today (thanks to Jacob Wolinsky of ValueWalk.com for bringing the article to our attention). The article includes interviews with Mr. Sokol as well as several other executives and former executives of NetJets who agreed to discuss the changes that were made over the past year.
The article goes into detail regarding the main problem facing NetJets in early to mid 2009: Many NetJets owners were exercising their contractual rights to sell back their fractional interest in jets due to liquidity problems. Financial assets were depressed and real estate could be illiquid, but affluent customers had the option of obtaining liquidity by exercising the option to sell back their shares to NetJets. Private aviation was also being demonized at the time as a display of wretched excess in the midst of the worst economic downturn since the Great Depression. At the same time, NetJets was burdened with high debt levels due to buying too many planes.
Fixing the Corporate Culture
Mr. Santulli was a very popular leader at NetJets and had the personal loyalty of many executives and rank and file employees. When Mr. Sokol put in place cost cuts and proposed selling planes, many executives were frustrated and several resigned or were fired. The cost cutting also included significant layoffs. Most disturbing of all was the lack of internal controls and inability to properly measure performance and compensate executives accordingly:
Sokol argues that the company was long overdue for a shakeup. “One thing that can be very nice in a dysfunctional management is that it’s very hard to measure people,” he says. “So you have managers who are patting themselves on the back, saying they’re doing great, while the reality is that there’s no way to measure what they’re doing.” One NetJets executive whose sales region was losing money still received multimillion-dollar bonuses.
It is not surprising that the wrong type of executive may prefer this type of culture since there is limited accountability when progress cannot be measured. This has been corrected:
Sokol has trained his team to measure every single thing the company does, from on-schedule service to bill collection to the quality of catering. “When we make a mistake,” he says, “we analyze why we made the mistake, and if there’s a way to fix it, we fix it by putting a system in place that solves the problem.”
A company in a fast growing industry with many tailwinds can sometimes survive the chaotic picture painted by the Fortune article, but when adversity strikes, it can lead to financial disaster as we can see at NetJets. This brings to mind Warren Buffett’s frequent saying that you cannot tell who is swimming naked until the tide goes out.
Sokol Harshly Criticized
Perhaps not surprisingly, those who were impacted by Mr. Sokol’s actions may feel some bitterness regarding the situation. What is surprising is the degree to which the critics are going public with their grievances. While Mr. Santulli has not commented, Jim Jacobs, the co-founder of NetJets is quoted as follows:
Jim Jacobs, the co-founder of NetJets, is one of the harshest critics. Jacobs, who left his post as vice chairman in January, argues that Sokol’s cost cutting is sacrificing service and that owners are complaining and many are leaving. He also claims that canceling orders for new planes is a big mistake. Says he: “We were protecting the franchise value and the ability of the golden goose to keep laying eggs. We didn’t panic and lay off pilots who cost a fortune to bring back on. We didn’t cancel new planes to let our fleet get older and thus more expensive to run. We didn’t shut down our influencer network. No one at NetJets now has a clue how to run it.”
Mr. Sokol counters that he has never seen this level of unprofessional public criticism at any other point in his career:
“In all the acquisitions and business turnarounds I’ve done, I’ve never seen senior people leave a company who then go out and try to spread rumors and call customers and try to be harmful to the business. It’s a horrible thing to see, because the only people they are hurting are themselves and the employees of the company.”
Who should external observers believe? Everyone can come up with their own reactions, but Mr. Buffett has delivered his verdict. He strongly praises Mr. Sokol’s role in the turnaround and expresses confidence in his leadership going forward:
“Dave is now making very good money, and not from selling planes,” Buffett says. “It looks like NetJets will earn $200 million pretax this year. It’s as remarkable a managerial achievement as I have ever seen. When aviation picks up, it could be a company that could earn $500 million a year.”
Sokol May Succeed Buffett as CEO But Employs Different Style
We have speculated many times in the past regarding David Sokol’s prospects for replacing Warren Buffett as CEO once Mr. Buffett decides to retire. Mr. Sokol has demonstrated strong leadership and a track record that should make Berkshire Hathaway shareholders confident if he is the next CEO. However, his management style is quite different from Mr. Buffett’s. What does this mean for Berkshire Hathaway’s corporate culture?
The Fortune article discusses Mr. Sokol’s punishing travel schedule and his management style in some detail. One cannot paint any picture other than a very hands on manager. While Mr. Buffett is known to be available to his managers and likes to review detailed reports from some subsidiaries, he rarely takes a hands on role. Indeed, when NetJets ran into trouble, Mr. Buffett delegated the task of fixing the business to Mr. Sokol rather than taking on the responsibility himself. The most famous example of Mr. Buffett taking a very hands on role in a crisis was his involvement with Salomon Brothers in the early 1990s, an experience that he has often said he would never like to repeat even though his leadership was very effective.
Can Mr. Sokol take a more hands off approach similar to how Mr. Buffett has run Berkshire Hathaway in the past? Would he want to take a more hands off role? If he takes a more hands on and assertive role, will this change the culture of the company? These are interesting questions to ponder when thinking about Berkshire Hathaway succession. Our observation is that Mr. Sokol takes a hands on role when necessary to address a problem rather than simply for the sake of micromanagement. This seems to be corroborated by the lack of any stories of past micromanagement as well as the principles in Mr. Sokol’s book.
Disclosure: The author of this article owns shares of Berkshire Hathaway.