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Insight: How profitable are airline loyalty programs?

There's been a lot of buzz this week about a recent Bloomberg news story revealing that the major US airlines generate up to half of their profits through their loyalty programs. Specifically, they do so by selling program miles to their program partners - and by "program partners," we mean specifically their co-branded credit card partners. The story seems to be generating a lot of surprise - a reaction which is in itself surprising, given that it's been this way for years. The news does beg the question - if airline loyalty programs are so profitable, why don't more carriers consider spinning them off into separate businesses?
 
By Rick Ferguson
 
Some key insights from the Bloomberg article reveal just how lucrative airline loyalty programs have become. Some key stats from the article:
 
  • According to research from the Stifel Financial Corp, each airline mile sold grosses an airline between 1.5 cents to 2.5 cents.
  • Delta Air Lines recently revealed that its American Express partnership will yield $4 billion in revenue per year by 2021, at a growth rate of over $300 million per year.
  • A March 29 Alaska Air Group investor presentation revealed that the airline's Mileage Plan partnership with Bank of America will soon generate more than $900 million in annual cash flow.
So profitable have the airline loyalty programs become that analysts have begun to rethink airline valuations. Money quote from Bloomberg:
 
"Investors have failed to appreciate how crucial these programs are to airline profitability amid the stability consolidation brought, said Joseph DeNardi, a senior airline analyst with Stifel Financial Corp. in Baltimore. Since August, he's issued a steady stream of client notes arguing that the market has undervalued the five largest airlines...DeNardi [boosted] his target prices on American and United Continental Holdings Inc. by $30, [raised] his outlook for Southwest Airlines Inc. by $15, and [added] $10 for Delta Air Lines Inc. shares. He cited the likelihood that airlines will begin disclosing more information over the next year or two. Stifel also upgraded its target share price for Alaska Airlines' parent to $145. That stock traded at $93.66 on March 30."
If DeNardi's numbers are on the money, then airlines are significantly undervalued - and what you, or your financial advisor, should do with that information, I'm in no position to say. DeNardi's argument that airlines should provide more transparency into loyalty program profitability makes sense from an investor standpoint.
 
DeNardi may, however, not be taking into account the ostensible purpose of these programs, which is to build profitable customer relationships that drive loyalty. As the Boarding Area's Ian Snyder points out, running these programs as profit centers can lead airlines to make decisions that run counter to the programs' original purpose. Money quote:
 
"Airlines used to run loyalty programs. If you flew with them more, they would reward you with both perks and miles. It was a cost center, not a revenue source. Now they are a business of their own...You still get your coveted miles and elite status. Airlines have just figured out how to monetize this. Rather than treating loyalty programs as a cost of doing business, they have turned them into a revenue stream...
 
"But wait! What happens when an airline raises redemption prices on its award chart? Frequent fliers (and credit card churners) tend to take these devaluations in stride, accepting them as part of 'the way things are.' But there is more that goes on under the hood. When an airline raises award prices (thus devaluing its miles), it is effectively writing off a portion of its liability, which effectively yields them a profit. And it's completely fine because they set the rules of the program!"
Therein lies the rub - airlines may be reluctant to reveal just how profitable these programs are because by doing so, they may damage their ability to leverage these programs to build profitable and loyal behavior among their best customer segments. Frequent flyers are savvy and knowledgable about these programs - if they weren't, sites like the Boarding Area wouldn't exist. All it would take is a whiff of knowledge that airlines run these programs to benefit shareholders, rather than flyers, for the golden goose to wind up dead. Airlines must walk a tightrope between maximizing program profitability and and rewarding their best customers.
 
One solution to mazimizing program value would be to follow the Aeroplan model - in 2005, Aeroplan spun off its Aeroplan program into a separate company. That company became Groupe Aeroplan, which rebranded as Aimia Inc. in 2011. Since the spinoff, Aeroplan has positioned itself as a coalition loyalty program in semi-competition with Air Miles in Canada. Since then, many airlines have flirted with spinning off their programs, including Qantas, Lufthansa, and even American Airlines in 2007. British Airways' Avios program is managed by the rebranded Air Miles UK, and Aimia owns 49 percent of AeroMexico's Club Premiere program, which has been rumored to be considering an IPO.
 
So why don't the airlines spin off their programs into separate companies and IPO them? The cash flow from an IPO would be immense, allowing the new companies to fuel partnership expansion and turn the programs into full-blown loyalty coalitions in the Aeroplan model. According to Joseph DeNardi, one reason the airlines won't consider spin-offs is that they value the programs as a way to hedge against recessionary forces that dampen air travel. Money quote #2 from Bloomberg:
 
"Beyond the cash, carriers reap something else from the cards: These deals remain lucrative in both good times and bad, as they are immune to economic cycles. That’s because of the addictive nature of miles, a dubious commodity that tens of millions of Americans, particularly those who fly for their jobs, will probably never quit. 'In a recession, that [bank] business will go down, but it should provide a very high cushion to the airline,' DeNardi said... 'That's the real benefit here: It speaks to downside protection for the industry better than anything else."
There may be another reason for the lack of spinoffs, as well - DeNardi may be overstating the value of these programs to airlines. That's the opinion of the Boarding Area's Gary Leff:

"In general analysts likely undervalue the free cash flow provided by loyalty programs, because they don’t understand the programs, but it sure seems the cheerleading goes well beyond anything supported by the numbers. And it may well be that the market understands something that the Stifel analyst doesn’t — precisely that the airlines have been killing their golden goose. Rarely in history have companies had marketing programs which aren’t costs, but profit centers. And while they’re very profitable now, parent airline valuations which are lower than a financial analyst thinks mileage programs ought to be worth based on current performance suggest that the mileage program profits may not be sustainable over time."
We may yet see airlines spin off their programs - the most likely candidates are low-cost carriers who don't sell as many miles as the big guns, and would therefore likely benefit from third-party management with expertise in partner development and liability management. In the meantime, the big carriers will continue to walk the tightrope between building loyalty with their best customers - and cashing them in for profit.
 
Rick Ferguson is CEO and Editor in Chief of the Wise Marketer Group.