Frequent flyer programs create tremendous value for airlines. They’re highly profitable, and have been for years. When United filed for bankruptcy it was said to have to continue flying to support the underlying credit card business. The airline’s first call after seeing the judge each time was to Jamie Dimon.

The issuer of the United co-brand credit card provided debtor-in-possession financing to United, and co-led bankruptcy exit financing. As with other airlines, United received hundreds of millions of dollars in loans backed by future mileage sales to provide liquidity during the financial crisis.

That said, it’s possible to overvalue frequent flyer programs. Stifel analyst Joe DeNardi continues to push the idea of spinning off programs into separate companies, suggesting that the programs would be more highly valued than the airlines who own them today. Airlines push back at that notion. DeNardi rests his belief on unrealistic assumptions about future profit growth.

Nonetheless Brian Sumers talks to Joe about the data he’s compiled on frequent flyer program profitability during the first half of 2018, and the data is interesting.

It’s back of the envelope stuff, based on some reasonable assumptions, since airlines don’t disclose very much detail about their programs.

• Two years ago American Airlines stopped disclosing very much at all (they used to be the most forthcoming).

• United doesn’t want to make it easy to figure out that MileagePlus revenue growth is largely coming from Chase Ultimate Rewards points transfers rather than engagement in their own program.

DeNardi estimates the ‘marketing component’ of frequent flyer program revenue from the first half of 2018 so far and equates that with profit. It’s not quite accurate to call those two the same thing, though it’s a high margin component of revenue.

Here’s how American Airlines described the different elements of frequent flyer program revenue from their bank deals in their 10-K filed at the start of 2016 (prior to adoption of new revenue recognition standard ‘ASC 606, Revenue From Contracts With Customers’).

Under the relative selling price approach, we identified five revenue elements for the co-branded credit card agreements with Citibank and Barclays: the transportation component; use of the American brand including access to loyalty program member lists; advertising; lounge access; and baggage services (together excluding the transportation component, the marketing component).

…The marketing component represents services provided to our business partners and relates primarily to the use of the American brand including access to loyalty program member lists.

At American Airlines marketing revenue was defined to include free checked bags, Admirals Club membership, as well as advertising revenue.

Airline		Marketing Revenue Jan-June 2018		Year-Over-Year Increase
American Airlines		$1.15 billion		10%
United Airlines		$962 million		12%
Delta Air Lines		$805 million		12%
Southwest Airlines		$563 million		14%
Alaska Airlines		$215 million		3%
JetBlue Airways		$80 million		23%
Hawaiian Airlines		$34 million		53%

These programs do make money but there are several reasons why spinning off a frequent flyer program is a bad idea, from a financial perspective.

• Air Canada’s split from Aeroplan makes this a bad environment for a spin-off. Aimia, the company that owns Aeroplan, saw its shares plummet after Air Canada announced it wouldn’t renew their exclusive agreement with Aeroplan. Investors will be skeptical of frequent flyer spinoffs.

  

  DeNardi suggests that an airline could retain majority ownership of a frequent flyer program, still control it, and they’d retain an ongoing relationship. However minority public ownership could be even less attractive, and doesn’t guarantee that the majority owner won’t sell further shares in the future (Air Canada itself initially spun off only a minority of shares).

• Many of the high value spin-offs have been intentionally overvalued. I spent a couple of hours one time working with a hedge fund manager to help him understand why publicly traded frequent flyer programs had been such bad investments relative to their initial sale price. The trick here is that part of Etihad’s tool kit for investing in foreign airlines was spinning of their frequent flyer programs. They were limited in how much of a foreign airline they could own, but they could buy a stake in the frequent flyer program too for additional control. And overpaying allowed them to funnel additional cash into the carrier. Indeed air berlin’s topbonus is out of business now even.

• A public company has different incentives even if the airline retains majority ownership. Public companies have new bureaucratic requirements, they’re also pressured to manage to short-term results. They’ll have a fiduciary duty to their shareholders to maximize their own returns versus the combined returns of the loyalty program and the airline, or at least will be pressured to move in that direction over time.

• The market isn’t undervaluing frequent flyer programs. DeNardi sees a market failure. He believes that since frequent flyer programs generate so much cash, if you value them separately they’re worth more than the entire airline. That may underscore how little the airlines are worth. More likely frequent flyer programs aren’t as valuable as he thinks. While they’re earning tremendous revenue now, that’s largely contingent on sales of miles to banks, which in turn is dependent on current levels of interchange (merchant swipe fees).

  Banks pay to incentivize consumers to use their products, but will no longer pay or pay as much if and when interchange falls — as a result of competition from new payment technologies (ApplePay, Samsung Pay, bitcoin, etc0, government regulation (as we’ve seen in Europe and Australia), and competition (Amex is lowering its rates, Costco pays almost nothing to process credit cards). Revenue from mileage sales is likely lower in the future than it is today whereas the market will place a premium on businesses with greater potential for growth.

Always be skeptical of people claiming publicly that the market doesn’t understand the world it’s investing in. There are good reasons we haven’t seen any of the US airlines spin off their frequent flyer programs into public companies. The airlines that have done it have largely done so out of desperation, a source of cash. It may have even been a good business a decade ago, and indeed credit card revenue has grown tremendously in that time.

The argument now for selling off a frequent flyer program is that the airline would be ‘selling at the top’ that they’ll get more money now for the program than they will in the future. But that even depends on a belief that the market won’t realize it and will overvalue the future income streams of these programs, not that the market today undervalues it.