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Frequent Flyer Program Collateral · Acedra
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0:00
last year for the first time ever the public got a glimpse into the financials of airline frequent flyer programs what they saw was truly astonishing during the early days of the covet 19 pandemic airlines were hemorrhaging money and so naturally they looked for a loan united for example sought 5 billion to tie the company over until travel came back but like with any loan they needed to put up collateral they needed to offer something to the bank that it would acquire if the company failed to
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pay the loan back the problem was united wasn't worth much at the time since of course it was hemorrhaging money meaning it would have had to offer a huge chunk of itself as collateral rather they decided to offer one of their subsidiaries as collateral mileageplus holdings llc essentially their loyalty program of course given that united is a publicly traded company they have various financial reporting requirements including the obligation to file a form 8k with the securities and exchange
1:03
commission whenever a major business event takes place such as taking out a multi-billion dollar loan of thousands one line on this document stood out quote multiplying mileageplus holdings 2019 ebitda by a factor of 12 equates to a mileage plus valuation of approximately 21.9 billion dollars 21.9 billion dollars that's the value of united's loyalty program according to the company and this loan similar financial disclosures from delta and american airlines pegged the value of
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their loyalty programs at 26 billion and and a half to 31.5 billion dollars respectively so not withstanding their size why did these numbers turn heads well because of these the airlines is market caps these figures equal the total value of all the shares in each company it's essentially a real-time indicator of what wall street considers a company worth given the ebbs and flows in stock prices at the time united's was 10 billion dollars delta's 20 billion
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dollars and americans 6 billion dollars so the value of each airline is less than the value of their loyalty programs which is interesting in and of itself but the airlines own their loyalty programs therefore at least according to wall street airlines themselves are worthless in fact they're more than worthless they have negative value they're lost leaders and the only thing imparting each airline with value is its loyalty program this is a less absurd proposition than
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it might initially seem in 2018 well before the covet-induced travel downturn american airlines earned about 14.42 in passenger revenue per seat per mile flown but simultaneously it cost them 14.85 cents to operate a given seat one mile so the airline actually lost about half a cent for each mile it flew each seat the company however earned 1.9 billion dollars in pre-tax profits thanks exclusively to their 4.2 billion dollars in frequent flyer program revenue in the
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u.s airports are plastered with ads for co-branded airline credit cards touting free checked bags and other benefits they're stuffed with lounges accessible to frequent flyers but not even first class passengers they're littered with priority lanes reserved for getting elite status members through security and onto planes more quickly airlines even have their flight attendants acting as salespeople reciting credit card pitches at 30 000 feet in exchange for the chance of a commission on a
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passenger sign up the reason why the entire flying process in the u.s and increasingly other countries seems like a carefully manicured experience nudging you to sign up for credit cards and frequent flyer programs is because of these numbers airlines are hardly transportation companies anymore over the past 40 years they have crafted a system so effective so unbelievably advantageous to their own interests that they are now willing to lose money flying to prop up their frequent flyer
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businesses businesses whose core proposition is giving away free flights today airlines are basically banks this all snowballed from a concept no different than the loyalty punch card at your favorite sandwich place you fly a certain number of times you get a free flight while airlines had already started tracking the activity of individual flyers formal frequent flyer programs became technically and legally possible with the deregulation of the american airline industry in 1978. the
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first program was set up by a small airline called texas international which later merged with continental but the first major long-haul airline to do so was american airlines in 1981. what the airline observed was not surprising american advantage members were more likely to choose to fly with american so that they could accumulate enough miles to get a free flight in fact they were even willing to pay slightly more some five percent extra for an american flight rather than an equivalent united
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flight for example since that united flight wouldn't get them any closer to a free american flight it's all sunk cost fallacy if someone's earned 10 000 advantage miles they'd prefer to fly american and get to the 12 and a half thousandth for free flights rather than starting from zero with united even if they'd earn the same number of miles overall the program certainly did have an expense for the airline but it quickly became clear that the expense was far eclipsed by the additional
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revenue it brought in but more significant that the program's launch was its first evolution beyond the sandwich shop punch card in 1982 american partnered with hertz and holland america to allow its members to earn points when renting cars or booking cruises but the concept of earning points with partners was not what was revolutionary about this rather it was the behind-the-scenes mechanics that made that possible american wasn't going to give miles away for free when people
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spent money at another company because the redemption of miles did have a cost for the airline beyond small variable costs like food fuel insurance and more there is potentially significant opportunity cost from offering a seat in exchange for points if that seat might have otherwise been booked by a paying passenger therefore america needed to be compensated for the miles he gave to hertz and holland america and so for the first time it put a real monetary price
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on its imaginary points while the actual numbers are closely guarded secrets american airlines would for example sell one point to hertz for one cent which hertz would then reward to its customers in order to incentivize them to rent at hertz rather than another rental car company that did not reward airline points now if hertz paid that one cent per mile which is within the range of educated estimates and if a customer redeemed 25 000 miles for domestic flight which was a typical redemption
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rate at the time that means american would have earned 250 dollars for a domestic flight considering the typical variable cost for a domestic flight was about 15 american airlines quickly recognized just how incredible the profit opportunities could be they started to realize them in 1987 when american teamed up with citibank to offer a co-branded credit card that way for every dollar spent on the card the member would earn a point this dramatically increased the volume
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at which american and other airlines sold points to external partners and shifted these programs from ways to incentivize more spending on airfare to profit centers in and of themselves today part of the strength of these multi-billion dollar programs is based on the fact that despite their strength government and businesses essentially treat them the same as that sandwich shop punch card to start with almost universally points are not taxed despite the fact that one can accumulate points
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like income and redeem them for something worth money governments consider it a rebate or cash back on your purchase because to get that reward you had to spend money and you can't exchange that reward for money at least officially just as you don't pay tax on the amount saved when bananas are 25 off at the grocery store you don't pay tax when the airline awards you points you can use for free flights in this case the savings just happened further away from purchase however unlike with
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sandwich punch cards or banana discounts in this case the people paying for the flights are often different than those receiving the reward almost all of airline's most frequent flyers travel on business in which case their employers pay the airfare despite that frequent flyer programs award points to the individual flying not the individual paying in addition if the employee books the trip on their company card they also get the credit card points from that
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spend the companies paying don't really have a problem with this because it essentially acts as a free tax free benefit for their employees business travel isn't anywhere as glamorous as it used to be so companies are happy to allow their employees to earn points they can eventually use for leisure travel in exchange for them getting out on the road and making money of course this potentially creates a scenario in which the individual is incentivized to fly or pay more on the company's dime
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but most don't seem too worried about this so both tax law and company policy or the lack of it works in favor of the airline the way in which frequent flyer programs were set up wasn't perfect though there was potential for exploits namely as airline revenue management systems became more complex price and travel distance became less and less correlated nowadays it's rather intuitive to us that the 400 mile flight from dc to nantucket a high-end vacation destination is going to cost more than
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the 400-mile flight from dc to boston in fact american's lowest price for that nantucket flight is 98 while its flights to boston start at just 49 so it's double the price for the same distance simply because the more wealthy travelers headed to nantucket are more likely to pay for the convenience of a non-stop flight meanwhile based on the traditional one mile one point system the member would still gain just 400 points for each of those flights despite the difference in price therefore if
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someone found an itinerary that was low cost but long distance their mileage earning could be so high that the miles earned would be worth more than the cost of the flights for example if one found an itinerary from los angeles to san francisco via chicago the traveler would earn 10 times the point than if they flew direct and more complex revenue management systems would likely price that long circuitous connecting itinerary lower than the non-stop one since it was less convenient all around
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this was bad for airlines it was incentivizing people to take longer multi-stop itineraries which cost the airline more to operate and it forced them to give out more miles which cost the airline more in redemptions in short they were incentivizing against their own interests this was a rare element of the system that did not work in their favor so they changed it over the past decade nearly every major program has pivoted to a system where passengers are rewarded points based on how many
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dollars they spend rather than how many miles they fly among the big three american airlines it's simple you spend one dollar you earn five points this shifted the system from one where the airline wins overall but might lose out from time to time to one where the airline quite literally cannot lose at least on the earnings side revenue based systems cannot be exploited but airlines quickly figured out how to restructure the redemption side in their favor too it used to be that any economy class
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flight within the continental us cost 12 and a half thousand points on united regardless of whether it was a tuesday in february or the sunday after thanksgiving that's despite the fact that cash rates were undoubtedly far higher on the sunday after thanksgiving one of the highest demand travel days of the year while availability of point seats differed that meant that someone who did manage to score thanksgiving sunday booking on points got a deal the cost for the airline to offer that seat
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on points was greater than what the airline earned that's since the opportunity cost on those highest demand days is huge as almost every available seat is likely to be sold for cash even if it all worked out in the end in the airline's favor they didn't like these losses so they switched the way redemptions works too now nearly every major airline has dynamic award charts just like how cash fares rise for high demand days so too do point redemption rates for example in october 2022 united
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is charging 114 dollars for non-stop newark to denver flights on low demand tuesdays and 254 on high demand sundays meanwhile mile redemption rates rise from 8 300 to 22 200 points that roughly two and a half times rise for each means that mile rates are now correlated to cash rates and so arbitrage between what airlines charge in miles and cash is no longer possible so they've now closed loopholes on both ends of the equation you can't exploit the accumulation of miles or the
13:00
redemption of miles essentially the only factor placing a check on airlines is power is the exchange rate considering how much of their profit comes from selling points to credit card companies and other marketing partners airlines do care tremendously about how much those companies are willing to pay for points and how much those companies are willing to pay is loosely based on what the general public believes those points are worth various travel and finance websites
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publish their estimated point valuations to help inform consumers of whether they're getting a good deal with a given redemption and there is a good amount of variability aggregating 5 estimates the average value of 1 point is 1.218 cents for delta sky miles 1.226 for united mileage plus and 1.416 for american advantage what this means is that if all else were to be equal consumers would be more incentivized to fly american flights use american co-branded credit
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cards transfer points to american and more which means credit card companies and other marketing partners are likely to run out of american points sooner and need to buy more that being said power is still in the hands of airlines as there are only three major long-haul airlines in the u.s but far more credit card companies united has partnered with chase american with citibank and delta with american express but if any of these credit card companies refused to
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agree to a higher mile purchase price when contract negotiations came around the airline could dump them and switch to bank of america barclay capital one discover each of which would be delighted to score a major airline partner so why is it that the value of these frequent flyer programs has eclipsed the value of the airlines themselves well it's because what's happening here is that airlines are essentially acting as the central banks for their own virtual
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currencies they're acting like the us treasury or the bank of england or the european central bank and that they control the supply of their currency but airlines power actually goes far beyond that of these central banks not only do they control the flow of the currency but they also control the availability of goods to spend it on then on top of that it's as if these all-powerful central banks are operating as private for-profit companies that can just create more of their currency for the
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purposes of selling it at any given time airlines have nearly complete unchecked control over a currency with which they are the only entity that can convert it to cash that is the key to their power frequent flyer programs are genius financial instruments because it's nearly impossible for airlines to lose alright so think about all the times in your day when you're not using your ears maybe while you get ready for the day make dinner do laundry or drive to work
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audible.comwendover or texting wendover to 500 500.
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