Where airlines make their money

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Published Mar 31, 2017

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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.”

BLOOMBERG

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