Dallas - Does your wallet contain an airline-branded
credit card? If so, your daily Starbucks visits, iTunes selections, and dining
habits serve a critical role in keeping the US airline industry fat and
happy.
For carriers such as American Airlines riding Citigroup
plastic, or Delta on American Express, these programs are a cash cow, a golden
goose, or any other fiscal livestock you care to conjure. Each mile fetches an
airline anywhere from 1.5 cents to 2.5 cents, and the big banks amass those
miles by the billions, doling them out to cardholders each month.
For the banks, people who pay annual fees for those
cards to accumulate miles are the closest thing to a sure bet. These consumers
typically have higher-than-average incomes and spend more on their cards, which
generates merchant fees for the banks. They also tend to maintain high credit
scores, which means they pay their bills on time and banks experience fewer
defaults.
The airline-miles business, formally known as loyalty
programs, has become a high-margin enterprise that’s grown in size and
value amid airline consolidation, with carriers keen to expand credit-card
rolls and see loyalty members spend more. This year, Alaska Airlines began
tying a small percentage of its 19 000 employees’ performance pay to the
market growth of its card with Bank of America.
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 has repeatedly explained that investors have
little insight into the billions of dollars large banks pay for these
affiliations. At each airline investor call or conference, DeNardi has
steadfastly prodded executives for greater reporting detail.
Organised
In many ways, the Big Three US airlines have organised
themselves into two distinct businesses. There’s the traditional activity—the
one with jets—which involves pricing seats for as much as possible,
collecting a bag fee, and selling some food and drinks while keeping a close
eye on costs. The other business is the sale of miles—mostly to the big banks,
but also to companies that range from car rental firms to hotels to
magazine peddlers.
The latter has expanded so much that it accounts for more
than half of all profits for some airlines, including American Airlines Group
Inc., the world’s largest.
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“Airlines are earning upwards of 50 percent of [income]
from selling miles to a credit card company, which we believe is a great
business to be in,” DeNardi wrote on March 20, boosting his target prices on
American and United Continental Holdings Inc. by $30, raising his outlook for
Southwest Airlines by $15, and adding $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. DeNardi
argues that more transparency about loyalty plans would also pressure airline
executives to further improve profits in their core business—namely flying.
Benefits
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 in an
interview. “That’s the real benefit here: It speaks to downside protection for
the industry better than anything else.”
The credit-card revenues are tied to spending that’s
separate from the “airline economy,” American CEO Doug Parker told DeNardi in
January, on the company’s most recent earnings call. “So I think you’re
right to suggest that investors should do their best to look through and
understand the level of those cash flows and the certainty of them.” Parker
said American executives are interested in providing greater detail, as did
Alaska Air CEO Brad Tilden on March 29. “Why don’t we take that as a
challenge?” Tilden said. “There might be some things we can do.”
“We do agree it’s a really important part of our
business, and we share your view that it is perhaps under-appreciated by
investors,” Andrew Levy, United’s finance chief, told DeNardi on a January
earnings call. Still, the airline isn’t ready to disclose its Mileage Plus
numbers.
Picture: Reuters Delta Air Lines, the world’s second-largest carrier,
said it expects that its American Express partnership will yield $4 billion in
revenue per year by 2021, rising by more than $300 million annually until then.
Those sums translate to a very high margin of profit, Delta executives have
acknowledged, but they’ve decline to specify further. At an investor presentation
on March 29, Alaska Air Group Inc. said its Mileage Plan relationship with Bank
of America will account for $900 million in annual cash flow, once the airline
has fully combined with Virgin America Inc.
So while there’s agreement from some CEOs that more
transparency is needed, that’s about as far as it goes.
American, Delta, and United declined to comment, as did a
spokesman for Barclays, which issues cards for American, JetBlue Airways, and
Frontier Airlines Holdings. A spokeswoman for Bank of America said she didn’t
“have anything to add.”
Not all profit
Cash pouring in from the big banks isn’t 100 percent
profit—airlines are still on the hook for seats obtained with those miles,
as well as merchandise offered in their catalogues. Fly the family to Bali on
reward tickets or cash in miles for a new laptop, and the airline incurs a
redemption cost. The loyalty programs’ outstanding mileage balances also count
as a liability under accounting rules, giving airlines a powerful incentive to
prod you to use them.
But redemption expense is largely incidental to these
bank partnerships, given the wide spread between what a bank pays an airline
for a mile and its future cost to the airline. At American, which has the
largest program, Stifel estimates a mile’s sale price is about three times its
cost at redemption. (Naturally, any miles that are cancelled, expire, or are
otherwise never redeemed flow to airline coffers at a 100 percent margin.)
“Fundamentally, airlines are selling miles to credit card companies for much
more than they will cost the airline when those miles are redeemed—and they are
doing it hundreds of billions of times a year,” Stifel wrote in a February
client note.
It’s difficult to quantify how much investors focus on
the value of loyalty programs when assessing an airline’s prospects. Stifel’s
“sum-of-the-parts” valuation approach may overlook one aspect of how airline
loyalty programs operate: They are intimately tied to the core business, since
most members prefer to use their miles for air travel, said Seth Kaplan, a
managing partner at industry journal Aviation Weekly. For the purpose of
valuation, that might lower a loyalty program’s value if an airline wants to
spin it off.
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“It’s still highly dependent on the airline,” Kaplan
said. “So would somebody pay retail for that company or … would they apply some
kind of discount to it?”
Several airlines have sold their loyalty programs, mostly
in times of financial distress. Air Canada’s then-parent company did so in
2008. In that transaction, it jettisoned its remaining stake in Aeroplan three
years after spinning off its program. Earlier this month, Air Canada’s chief
executive said the airline expects to gain more favourable financial terms with
Aimia, the program’s Montreal-based owner, when the current contract ends in
2020.
Don’t spin off
For his part, DeNardi doesn’t believe the US airlines
should spin off their loyalty programs.
He points to the loyalty program disclosure United made
for 2002 through 2005 during its bankruptcy, calling it a “perfect” model for
how airlines could report this income. While United was unprofitable at the
time, the mileage program, United Loyalty Services, posted margins as high as
45 percent. United ended those disclosures in 2006 when it emerged from court
protection.
Airlines have been reluctant to reveal more details
about these figures, which usually run through their “other” income lines,
because the bank deals typically carry confidentiality clauses. Moreover,
carriers aren’t keen to show competitors detailed information about their
loyalty profits. The banks, however, probably have a good sense of what their
rivals are paying, DeNardi said.
“If I know that the margin on this business is 60 percent
or 70 percent, with a very limited level of disclosure, then [JPMorgan Chase
Bank, N.A.] and Citi and AmEx—the guys negotiating these agreements—they must
know what the margin is,” he said.
The banks are making out pretty well in these
partnerships, too. AmEx said in securities filings that Delta SkyMiles, its
“largest airline co-brand portfolio,” accounted for approximately 7 percent of
its worldwide billed business in 2016. The loyalty program is also responsible
for approximately 20 percent of worldwide card-member loans as of Dec. 31.
If airlines do come around to DeNardi’s call for greater
transparency, maybe as a way to boost share prices, which one will take the
plunge first?
Said DeNardi: “Given the sheer size of American’s program
and the fact that Doug [Parker] gets paid all in stock, he’s pretty well
incentivised to have the stock adequately reflect the valuations.”