Banking on the
While revenues have disappeared in the Covid-19 crisis, airlines have been on the hunt for emergency liquidity, and some of the largest have found innovative assets to act as security for the vast loans they need.
In June, American announced that it would pledge its AAdvantage frequent flyer loyalty programme as collateral for a $4.75bn loan from the US government as part of the CARES Act measures, citing third-party appraisals of the FFP of between $19.5bn and $31.5bn.
In the same month, United raised $6.8bn in an “innovative” financing structure secured on its own MileagePlus loyalty programme. It cited a report from On Point Loyalty (see table) suggesting that MileagePlus was the third most valuable FFP out of the 150 surveyed at over $20bn — just short of United’s total market capitalisation at the end of 2019 (and more than twice the current market cap half a year later).
|Loyalty Plan||Airline||Value ($bn)||% Market Cap end 2019|
|Miles & More||Lufthansa Group||7,418||85%|
|Flying Blue||Air France-KLM||6,675||140%|
|Asia Miles||Cathay Pacific||4,701||81%|
|JAL Mileage Bank||Japan Airlines||4,228||40%|
|ANA Mileage Club||All Nippon||4,197||37%|
|Qantas Frequent Flyer||Qantas||4,104||45%|
And then in July, IAG announced that it had signed a multi-year renewal agreement extending its global partnership with American Express. Under this agreement Amex will make an up-front payment to IAG Loyalty of £750m, primarily relating to pre-purchase of Avios points for use in the British Airways co-branded cards and its Membership Rewards Programme in the UK.
But in United’s presentation on the transaction, it gave some interesting data on the performance of MileagePlus, splitting out some of its financial performance for the first time. In the last five years the FFP has been consistently profitable, generating cashflow margins of 35%: and in the last four years — which have been the most profitable in United’s history — has accounted for an average 25% of the group’s total earnings before interest, tax depreciation and rentals (see chart).
How is it possible for an airline’s frequent flyer programme to attract such high returns and such a high valuation?
The credit (or the blame) for the first frequent flyer programme (FFP) — as with many of the developments of the industry in the deregulated era — has been laid at the door of Bob Crandall, former President and CEO of AMR Corp. American’s programme AAdvantage was indeed established in 1981, and swiftly followed by United’s MileagePlus and Delta’s Frequent Flyer (since renamed SkyMiles) — although the now long-forgotten Texas International had introduced a mileage scheme in 1979. The FFP virus spread round the world in the following decade.
At the start the FFPs were relatively simple marketing tools designed to encourage and reward loyalty to a brand — for a product (a seat from A to B) that is essentially a commodity. Passengers were awarded credit for the miles flown on the airline and rewarded with the ability to use this credit to book “free” flights or upgrade class of service. For the airline the cost of providing the “reward” was in effect a very modest discount to the original fare — in the early 1980s the industry was operating on load factors of 65%, and the marginal cost of carrying a passenger in a seat that would otherwise be unfilled is minuscule — while for the passenger the benefit of the reward fulfilled aspirational goals.
The airline could keep track of its most treasured customers, the frequent flyers, and added status levels to the FFP with incremental additional personal benefits, depending on the total number of flights or miles flown, such as lounge access, pre-boarding and free upgrades, to add further cachet to the plan.
A brilliant marketing concept: it worked. And it did so because it plays on basic concepts of human psychological behaviour:
- Operant conditioning: offering and providing a reward to an individual for a certain type of behaviour reinforces that behaviour, especially when that reward is perceived as desirable. And the airline frequent flyer rewards created a sufficiently desirable currency out of miles attractive enough to influence members to adjust where they shop in order to accumulate more.
- Social identity theory: consumers do not just feel emotional connections to preferred brands, but they adopt them as part of their identity; and a frequent flyer plan which serves to make the member feel a sense of exclusivity and belonging can play a central role in the member adopting the brand (sub-consciously or otherwise) as an element of their own self-definition. Status tiers reinforce this and can also act to engender “stickiness” between the member and the loyalty scheme. A member who has achieved a status tier for a specific company is much more likely to continue spending with that company, as the switching costs include losing access to those desired benefits. This even happens when the company is charging a higher price than a competitor. Members also provide significantly higher net promotion scores.
- Endowed progress effect: the frequent flyer plans tap into another psychological phenomenon — individuals provided with artificial advancement toward a goal exhibit greater persistence toward reaching the goal. In other words, when consumers feel that they have started on the journey towards a reward, they feel compelled to complete the journey to claim the reward. Earning miles serves to drive repeat purchase because the member is accumulating with each transaction, giving them a sense they are progressing towards a goal.
FFPs take advantage of this drive in a variety of ways: by providing bonus points to new members to get them started on the journey, by communicating to members their progress towards their goal and by promoting the desirable reward they will earn if they complete the journey.
- Goal gradient effect: based on a 1934 study showing that rats run progressively faster the closer they get to the food bowl, this phenomenon is seen also in airline FFPs status programmes where members will increase their consumption (more flights, more stays, more rentals) as they approach the next status tier in order to achieve it sooner.
There is even a concept of a “status run”: booking a trip that maximises the number of status credits earned while minimising the cost of the flights. According to The Australian Frequent Flyer (which provides a list of such runs), status runners typically aim to keep the cost per status credit below A$5.
- Size heuristics relates to the theory that the man-in-the-street does not have the capacity, time or motivation to evaluate all available information, but will rely on heuristics — mental short-cuts — to deal with complexity. When consumers are deciding on the “size” of a thing they will typically look for something to tell them how big that thing is. In doing this, they will typically mistake “lots” for “big”. The quantity of things can seem like a lot. For example, a pile of two hundred 5 penny coins can somehow seem much more than a ten pound note. FFPs exploit this psychological effect. The award of 15,000 miles in return for spending $3,000 on a flight seems like a lot, but has a net real value (which the member never knows) of next to nothing.
Frequent flyers enhance revenues
Plan members do go out of their way to pay that bit more than necessary to make sure they earn their miles and retain their tier status, significantly increasing their value to the airline. United pointed out in its recent presentation that, in the past five years, passenger yields from MileagePlus members had grown 18% faster than non-members. Moreover, passengers who were members of the MileagePlus plan provided yields (in terms of revenue per mile flown) some 50% higher than non-members; new members provided 35% more revenue in their first year of membership; members who had been in the plan for more than five years generated four times as much as newer members; premier members generated 14 times as much revenue as non-premier members.
But in the 40 years of existence, the FFP has evolved. Other partners have been brought in to allow the members to “earn” and “burn” their miles: initially this involved other travel companies such as other partner airlines, car hire (eg Avis and Hertz) and hotels (eg Hilton and Marriott) — who then found it such a good idea that they set up their own loyalty schemes — but has also expanded into other segments of the economy. MileagePlus for example boasts 39 aviation partners, 20 hotel and “other” travel partners, but 31 non-air partners including 15 retail, six lifestyle, six “in home”, two entertainment and two financial.
Of more importance was the development of co-branded credit cards. Here, usually for an annual fee, the FFP members can earn miles on all plastic purchases and not just air travel. These have proved immensely popular and have become an increasingly important source of cashflow to the FFP and the airline (and the issuing banks). So much so that United highlights that 71% of its frequent flyer programme’s cash flow comes from third party accrual partners — suggesting that half the miles (or points) issued to a plan’s member come from non-airline consumer activity. United states that premier “partner-engaged” members provide 25 times the average revenues than non-premier, non-engaged programme members. This is no doubt similar in other FFPs.
For example, Qantas (one of the few airlines that separately discloses the financial results of its frequent flyer programme) has a bewilderingly large array of over 40 different Frequent Flyer credit cards co-branded with 17 different institutions (including its own Qantas Money) with a wide variety of annual fees and benefits. Last year it promoted a new ultra-premium Titanium Mastercard, which provided, amongst other things, First Class lounge access, 20% bonus status credits, 10% discount on flights, double Qantas Points on spending overseas and “extra points” when spent with Qantas — all for an annual A$1,200 fee.
Olivia Wirth, Qantas Loyalty CEO said: "we started our loyalty program for frequent flyers, but as the number of partners has grown it’s actually frequent buyers who are now earning the most points. In the past 12 months, one member earned more than 30 million Qantas Points on credit card spend. That’s equivalent of over 100 round-the-world trips in business class.”
Australia is a relatively small country, and has a domestic airline duopoly, but astoundingly Qantas can boast that 35% of all credit card spend in Australia is on a Qantas or Qantas Frequent Flyer co-branded credit card.
However, as currencies go, miles and frequent flyer points have particularly opaque values: the issuing airline determines the exchange rate. Industry load factors have risen from the 65% seen in the 1980s to well over 80%, making it harder to justify allocating reward redemption flights on a marginal cost basis, and in some cases reducing the availability of attractive reward capacity.
But the FFP has significant power to influence demand, and is increasingly seen as a revenue generating adjunct to an airline’s revenue management tools.
In its MileagePlus presentation, United highlights the steps the plan can take to reduce the programme expense and preserve margins.
For redemptions that include air travel, it operates a dynamic pricing engine to balance award availability with demand, similar to the traditional yield management models: increasing award pricing for peak days and weeks; adjusting award pricing based on estimated revenue fare displacement at United; segmenting the offering to its members depending on programme tier and cardholder status.
For non-air redemptions it can vary the number of miles required for any reward; increase or decrease marketing promotion of non-air rewards to influence demand; offers different non-air awards at differing redemption values to different members based on behaviour and status.
But one of the consequences of the high load factors and success of the programmes (and possibly of the consolidation of the industry with the USA) all the three US legacy carriers' FFPs have moved to allocate tier status on the basis of dollars spent rather than just miles flown.
Accounting for miles
Marketing departments come up with brilliant ideas... and then accountants get involved. Issuing miles (or points) under an FFP generates a potential liability to provide a flight at some point in the future, and the accounting profession loves to ensure that liabilities are shown on the balance sheet. And over the years there has been much controversy over how to account for this intangible potential liability with virtually no value.
Until the mid 2000s there were two choices: the incremental cost basis and the deferred revenue basis.
Under the Incremental-cost basis, the liability represented by the miles issued is put into the deferred revenue account on the balance sheet at a value based on the estimated marginal cost of an estimated flight tempered with an estimate of the amount of miles that would not be redeemed or would expire (the breakage rate). This amount is allocated to revenues when the reward is redeemed.
Under the deferred revenue basis, when a frequent flyer accumulates miles for a flight taken on the airline, a portion of the ticket price is recognised as revenue on the date of travel, a portion representing an estimate of the value of the miles issued is deferred. Each portion is treated as if they had been sold separately. The value of the miles is estimated on the basis of an estimated market cost of the flight (or other goods) for which those miles might be redeemed, adjusted by an estimate of the breakage rate.
Where the miles are issued through an affiliate programme such as a co-branded credit card, the revenues are also apportioned into two components, one representing an estimated “fair” value of marketing or advertising (recognised in revenues when the points or miles are issued), the other the estimated value of the miles (deferred to be recognised as revenues when redeemed). Where points are redeemed for non-air products and services, the airlines is deemed to be acting as agent and the net margin is recorded in revenues when the obligation is satisfied.
The deferred revenue method has been mandatory under IFRS since 2008, but the USA’s FASB did not insist on it until 2014. But all the major US carriers had moved to the deferred method when they emerged from their respective bankruptcies of the last fifteen years on the basis of fresh start accounting — also referred to as “bath” accounting because you can throw everything bad you have into the bath for a good wash.
An example of the transparency under which these deferred revenues are calculated comes from one of United’s annual filings: "The objective of using the estimated selling price based methodology is to determine the price at which we would transact a sale if the product or service were sold on a stand-alone basis. Accordingly, we determine our best estimate of selling price by considering multiple inputs and methods including, but not limited to, discounted cash flows, brand value, volume discounts, published selling prices, number of miles awarded and number of miles redeemed." But then accountancy is an art form.
Most airline groups are extremely secretive about the financial returns they achieve from their loyalty plans (and indeed the details of the agreements with credit card companies), despite pressure from financial analysts eager to find a sum-of-the-parts valuation to justify a buy recommendation on the shares and investment bankers eager for the transaction fees. IAG for example is not alone in stating in its annual report that its programme, IAG Loyalty (formerly Avios), does not exceed the quantitative thresholds to be reportable and management has concluded that there are currently no other reasons why they should be separately disclosed. But it did state at the Group’s 2019 Capital Markets' Day that it assumes long term operating margins of over 20%, profits growing at 10% a year, and that the c£400m net cash generated by Avios in 2019 could grow to c£600m by 2022.
One of the few that does report separately is Qantas. Here the returns have been strongly consistent (see graph) generating operating margins of over 20% and providing a meaningful proportion of group operating profits. (Unusually, and possibly uniquely, Qantas Loyalty only recognises a profit margin on non-air reward points). At one point the Australian flag carrier had been considering an IPO in Qantas Loyalty. (The other Australian airline, Virgin Australia, made substantially all its profits through its programme Velocity — see Aviation Strategy, Dec 2019).
Smiles Felididade meanwhile, which operates GOL’s FFP, is separately quoted having gone through a minority IPO in 2013 (GOL retains a 53% stake). The company highlights the very simple operating business model (see chart) in which there are three basic sources of profitability: the spread (miles are issued for cash and, when redeemed on average around seven months later the rewards — mostly flights — are bought in for about half the cost) provides 60% of their net income; the float (interest earnings on the seven months' use of the money) provides 20%; and breakage (and in this programme the miles expire if unused after 3-12 years) creates the last 20%.
But if United’s presentation of MileagePlus is anything to go by, these high operating margins are some sophisticated sleight of hand. Most tellingly, the airline determines the price of the miles its “sells” to the FFP to guarantee a 20%+ operating margin.
Another airline who succumbed to the idea of extracting value from its FFP was Air Canada. After it emerged from bankruptcy protection in 2004 it sold a 12.5% stake in Aeroplan for C$250m through an IPO (subsequently changing its name to Aimia), disposing of its remaining stake in 2008 for a further C$349m.
Ten years later, Air Canada no doubt realised that the disposal of the marketing tool had severely hampered its ability to control its customer base. It announced plans to close the Aeroplan frequent flyer plan and start a new one, effectively bullying Aimia into selling the programme back to Air Canada. At the beginning of 2019 the Canadian flag carrier forked out a modest C$500m to bring the plan back in house (plus the re-assumption of deferred revenue liabilities of C$2.8bn, which in reality would have been its own anyway).
Even generously assuming a total deal value for Air Canada’s re-acquisition of Aeroplan at US$2.2bn this falls well short of the estimated value of $6.3bn ascribed by consultancy On Point Loyalty in February this year (see table), and should raise eyebrows of those looking at the value of the proposed security offered by American’s AAdvantage and United’s MileagePlus.
Frequent flyer programmes are a core element of the airline business. United, in its presentation, emphasises that MileagePlus is a critical driver of enhanced revenue generation.
But it is a mistake to assume that they are valid standalone businesses away from their parent airlines.
Although the FFPs have diversified their income streams to allow members to earn miles through everyday spending, members still essentially want to use their miles on travel, and specifically free flights on the airline. And those who fly often want the feeling of exclusivity — being treated as an individual — provided by the tier status. United points out that 97% of all redemptions at MileagePlus are for travel and travel related products, and that 80% of travel rewards are for flights on United (see chart).
In 2017 American CEO Doug Parker publicly rejected the idea that the frequent flyer program might be worth $30bn or more as a standalone company, saying: “…that’s greater than the value of the American Airlines in total as we sit here today… I find it odd that simply separating something that is inside the airline today and putting it into a separate entity with the exact same cash flows would somehow generate that much incremental value.”
And that was long before the arrival of the Covid-19 pandemic.