[0:00]Last year, for the first time ever, the public got a glimpse into the financials of airline frequent flyer programs.
[0:08]What they saw was truly astonishing. During the early days of the COVID-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 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. Mileage Plus 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 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 Mileage Plus Holdings 2019 EBITDA by a factor of 12 equates to a Mileage Plus valuation of approximately $21.9 billion. $21.9 billion. 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 their loyalty programs at $26 billion and 19 and a half to $31 and a half billion respectively. So, notwithstanding their size, why did these numbers turn heads? Well, because of these, the airlines' 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 abs and flows in stock prices. At the time, United's was $10 billion, Delta's $20 billion, and American's $6 billion. 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 loss leaders, and the only thing imparting each airline with value is its loyalty program. This is a less absurd proposition than it might initially seem. In 2018, well before the COVID-induced travel downturn, American Airlines earned about 14.42 cents in passenger revenue per seat per mile flown. But, simultaneously, it cost them 14.85 cents to operate a given seat 1 mile. So, the airline actually lost about half a cent for each mile it flew each seat. The company, however, earned $1.9 billion in pre-tax profits, thanks exclusively to their $4.2 billion in frequent flyer program revenue. In the US, 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 sales people, reciting credit card pitches at 30,000 ft in exchange for the chance of a commission on a passenger sign up. The reason why the entire flying process in the US 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 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 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 5% extra for an American flight rather than an equivalent United 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 12.5 thousandth for a free flight, rather than starting from zero with United, even if they'd earned 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 revenue it brought in. But more significant than 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 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, American needed to be compensated for the miles it gave to Hertz and Holland America, and so, for the first time, it put a real monetary price on its imaginary points. While the actual numbers are closely guarded secrets, American Airlines would, for example, sell one point to Hertz for 1 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 1 cent per mile, which is within the range of educated estimates, and if a customer redeemed 25,000 miles for a domestic flight, which was a typical redemption rate at the time, that means American would have earned $250 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 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 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 from bananas or 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 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 airlines' 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 spend. The company's 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, but most don't seem to worry 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 D.C. to Nantucket, a high-end vacation destination, is going to cost more than the 400-mile flight from D.C. 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 nonstop flight. Meanwhile, based on the traditional 1 mile, 1 point system, the member would still gain just 400 points for each of those flights despite the difference in price. Therefore, if 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 flight. For example, if one found an itinerary from Los Angeles to San Francisco via Chicago, the traveler would earn 10 times the points than if they flew direct. And more complex revenue management systems would likely price that long circuitous connecting itinerary lower than the nonstop one, since it was less convenient. All around 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 dollars they spend, rather than how many miles they fly. Among the big three American airlines, it's simple: you spend $1, you earn 5 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 earning 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 flight within the Continental US cost 12.5 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 on points was greater than what the airline earned. That's since the opportunity costs of 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 worked, 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 is charging $114 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 2 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 redemption of miles. Essentially, the only factor placing a check on airlines' 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 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 five estimates, the average value of one point is 1.218 cents for Delta SkyMiles, 1.226 for United MileagePlus, 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 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 US, but far more credit card companies. United is partnered with Chase, American with Citibank, and Delta with American Express, but if any of these credit card companies refused to 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 will 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 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 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. All right, 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. All that time, you could be entertaining and educating yourself by listening to Audible. Audible is the place to get spoken word entertainment. They have a massive streaming catalog of podcasts, audiobooks, guided fitness, sleep tracks, and so much more. Then, on top of that, for anything not already included, you get one credit per month that you can use to get any audiobook in their premium library, which includes pretty much every major title. For example, I recently listened to The Ride of a Lifetime, which is a memoir retelling Bob Iger's rise from low-level production assistant at ABC to legendary Disney CEO, especially focusing on the two-decade process of developing Shanghai Disneyland. I absolutely love listening to audiobooks on Audible, and if you don't already, I think you will. Right now, for a limited time, you can save 60% on your first three months of Audible. That's only $5.95 a month, so give yourself the gift of Audible by clicking the button on screen, heading to audible.com/wendover, or texting Wendover to 500,500.
