[h=1]Airlines make more money
selling miles than seats[/h][h=3]Analyst Joseph DeNardi says investors have undervalued the US’ five biggest airlines, whose mileage credit-card programs are a high-margin business[/h] By Justin Bachman / Bloomberg
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 Co, 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 US$0.015 to US$0.025, 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 has 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 Corp.
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, Maryland.
Since August last year, he has issued a steady stream of client notes arguing that the market has undervalued the five largest airlines.
DeNardi has repeatedly stated 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.
In many ways, the Big Three US airlines have organized themselves into two distinct businesses. There is 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, the world’s largest.
“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 by US$30, raising his outlook for Southwest Airlines by US$15 and adding US$10 for Delta Air Lines shares.
He cited the likelihood that airlines will begin disclosing more information over the next year or two.
Stifel also upgraded his share price target for Alaska Airlines’ parent to US$145. That stock traded at US$93.66 on Thursday last week.
DeNardi said that more transparency about loyalty plans would also pressure airline executives to further improve profits in their core business — namely flying.
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 is 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 is separate from the “airline economy,” American chief executive officer 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.
Parker said US executives are interested in providing greater detail, as did Alaska Air CEO Brad Tilden on Wednesday last week. “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 underappreciated by investors,” United chief financial officer Andrew Levy said on a January earnings call. Still, the airline is not ready to disclose its Mileage Plus numbers.
Delta, the world’s second-largest carrier, said it expects its American Express partnership will yield US$4 billion in revenue per year by 2021, rising by more than US$300 million annually until then.
Those sums translate to a very high margin of profit, Delta executives have acknowledged, but they have declined to provide specifics.
At an investor presentation on Wednesday, Alaska Air Group Inc said its Mileage Plan relationship with Bank of America would account for US$900 million in annual cash flow, once the airline has fully combined with Virgin America Inc.
So while there is agreement from some chief executives that more transparency is needed, that is about as far as it goes.
American, Delta and United declined to comment, as did a spokesman for Barclays PLC, which issues cards for American, JetBlue Airways Corp, and Frontier Airlines Holdings.
A spokeswoman for Bank of America said she did not “have anything to add.”
Cash pouring in from the big banks is not 100 percent profit — airlines are still on the hook for seats obtained with those miles, as well as merchandise offered in their catalogs. Fly the family to Bali, Indonesia, 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.
However, 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 canceled, 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 is 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 Airline Weekly.
For the purpose of valuation, that might lower a loyalty program’s value if an airline wants to spin it off.
“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 favorable financial terms with Aimia Inc, the program’s Montreal-based owner, when the current contract ends in 2020.
For his part, DeNardi does not 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 are not 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] 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 last year.
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?
“Given the sheer size of American’s program and the fact that Doug [Parker] gets paid all in stock, he’s pretty well incentivized to have the stock adequately reflect the valuations,” DeNardi said.
