It turns out frequent flyer programs are worth more than the airlines themselves
More than six months after the World Health Organization first declared Covid-19 a pandemic, airlines are barely limping along. The TSA’s daily passenger count tracker currently shows that air travel is down about a staggering 70% from last year. Demand for air travel is better than it was during the depths of the crisis in mid-April, when travel was down 95%, but it’s still far from a level that would keep airlines operating sustainably. Thanks to the federal government, airlines received a $25 billion bailout in April, which allowed them to keep employees on staff at current pay rates through the end of September. And major airline CEOs have been in talks with the White House and policymakers to discuss passing another coronavirus relief package that would extend payroll assistance and avert job cuts.
September 30 seemed impossibly distant back in April, but now that bailout money is quickly running out, and airline executives have a critical decision to make, with some 35,000 jobs hanging in the balance: Do they take an additional round of financial aid from the government, giving up more equity but keeping their labor-heavy, high-scale cost structure in place for longer? Or do they radically scale back their business and accept that it will take several years or longer for travel volume to recover and for prices to stabilize and return to pre-pandemic levels? The latter could prove extremely difficult for airlines, especially considering how heavily they have been relying on their frequent flyer programs to prop up their businesses — and make the economics work.
To remain solvent during the pandemic, airlines have raised cash by putting up for collateral typical aviation assets, including aircraft and landing slots or the rights to use a particular flight route (for example, Delta could borrow against a given route and, if it defaulted, the lender could sell that route to United). But perhaps more interesting, airlines have also collateralized their loyalty programs, popularized by frequent flyer miles and travel points accumulated with credit card purchases. A recent analysis of these loyalty and rewards programs by the Financial Times reveals significant data about just how big and profitable those programs are as a stand-alone business — and how dependent major airlines have become on them as a core revenue generator.
The Financial Times pegs the value of Delta’s loyalty program at a whopping $26 billion, American Airlines at $24 billion, and United at $20 billion. All of these valuations are comfortably above the market capitalization of the airlines themselves — Delta is worth $19 billion, American $6 billion, and United $10 billion. In other words, if you take away the loyalty program, Delta’s real-world airline operation — with hundreds of planes, a world-beating maintenance operation, landing rights, brand recognition, and experienced executives — is worth roughly negative $7 billion. But economics of the loyalty program don’t work without a robust airline operation.
When airlines decide which routes to expand and which to cut, they’re not just thinking about ticket prices — they’re also thinking about their loyalty members. Abandoning a major city, or even reducing routes to it, is a good way to permanently lose those lucrative customers.
The mechanics of a loyalty program are simple: Flyers earn rewards, generally by flying or using branded credit cards. They redeem those rewards for flights. Loyalty programs in general take advantage of an odd quirk of consumer psychology: Spending money on a Delta-branded American Express card to earn points feels like getting free money, and redeeming it feels like getting a free flight. Since consumers mentally double count their points, they’re willing to accumulate them, which means banks and other counterparties have found it valuable to offer those points to consumers.
Typically, the airline will sell points to banks, who then offer those points to cardholders in exchange for spending. Once someone has picked out a loyalty program, they’re incentivized to be loyal and rack up points, so the bank knows they’ve acquired a credit card customer for the long haul. Exclusive partnerships between airlines and credit card issuers can be quite lucrative: Delta’s deal for American Express to be the sole issuer of its SkyMiles credit card was worth $3.4 billion in 2018, and the contract has since been extended to 2029. It’s a classic fintech play: provide a novel way to help exchange money now for money later at favorable rates. Since the loyalty rewards business is asset-light, grows fast, and is not as sensitive to economic cycles as the core airline business — United revealed that loyalty revenues dropped just 2% in 2009 — it raises the question: Why not just spin them off? That’s harder than it looks, and it gets to the crux of the airline industry’s problems.
Loyalty programs acquire customers because those customers want to earn and spend points with a particular airline that has flight routes optimized for their needs. That means they’re ultimately dependent on an airline’s route network. For example, if you do a lot of business in Atlanta, Delta’s your go-to airline; if work takes you up and down the West Coast, you’ll probably choose Alaska. When airlines decide which routes to expand and which to cut, they’re not just thinking about ticket prices — they’re also thinking about their loyalty members. Abandoning a major city, or even reducing routes to it, is a good way to permanently lose those lucrative customers.
That problem is especially hard because people like to earn miles on business trips and spend them on vacation. So an airline that cuts a route to the Bahamas or Vail might lose business in New York and Chicago. The big carriers are already a network effects–driven business, where part of the value they create is using their hub cities to create connections between city pairs that can’t support direct flights. But loyalty programs make them even more of a network effects–driven business, since the value of the network is not at the level of individual routes but at the level of every travel decision their best customers will make: Adding a new route to a hub means connecting that city to every other city the hub serves, and cutting a new route means losing all that connecting traffic, too.
Marc Andreessen once pointed out, when discussing network effects in another context, that they’re not all they’re cracked up to be:
The problem with network effects is they unwind just as fast. And so they’re great while they last, but when they reverse, they reverse viciously. Go ask the MySpace guys how their network effect is going. Network effects can create a very strong position, for obvious reasons. But in another sense, it’s a very weak position to be in. Because if it cracks, you just unravel.
And so when airlines cut cities to save costs, they’re not only hurting their revenue because they’re selling fewer tickets — they’re also threatening the more lucrative business of selling loyalty programs.
Loyalty programs aren’t a great business paired with a terrible one, they’re the part of a single unified business that makes it viable. An airline without its highly profitable loyalty program is a company that faces high labor costs, volatile fuel prices, and a rapidly changing demand environment. With loyalty programs, that’s offset by a high-margin, high-growth side business.
The airline business was perfectly optimized for the economics of 2019, offering a mix of cheap-but-uncomfortable seats, lucrative last-minute business-class tickets, and, of course, a durable fintech business. Today, the fintech business is the only part of the airlines that investors are excited about, but if airlines dramatically scale back their flights and routes, those loyalty programs could become worthless, too.