Hidden Assets?

Hidden Assets?

Over the years, we’ve written extensively about the value that frequent flyer programs have in building customer loyalty, and on a monthly basis trump the bonuses and promotional offerings that continue to make these programs as popular as ever. During the dot.com craze, we even ventured to propose that several programs were poised to take advantage of the red-hot public market for anything — including frequent flyer programs. When that red-hot market fizzled, so did the loyalty programs’ ability to capitalize on the hidden assets that they have become for their sponsors — airlines, hotels and credit cards alike. And with the airline industry still in search of funding for its future, we believe that these programs can provide one of several keys to survival. We take a look at the interest in and the possible result of your frequent flyer miles as public companies.

First of all, frequent flyer programs are highly profitable and operate at a relatively low cost. To date, they have all provided a more than ample cushion to airlines seeking every bit of positive revenue. And arguably, they haven’t damaged their relationship with their members in the process. Sure, there’s continued grousing about award availability — but that existed when airlines were making money as well, and changes that have occurred over the past four years have been primarily based on the fact that these programs have become victims of their own success. Frankly, we all want our particular frequent flyer program to be what we want it to be without sacrifice or change.

Some months ago, we speculated that Air Canada would be the first, and would spin off its Aeroplan division (which has for some time operated independently from Air Canada itself) into a financial gain. With the Aeroplan Income Trust now being touted on the market at an estimated $10 a share, could you soon be a member who has shares in the miles you have earned?

And what value might we be talking about? We estimate that the Aeroplan program will land at a valuation of nearly $1.2 billion, and that a program such as American’s (which we pick along with Mileage Plus as the logical first candidates for the stock market among U.S.-based programs) could fetch a valuation greater than $2.5 billion.

Frankly, we’re surprised that this topic has not been mentioned by the airlines, as they continue to seek ways to raise capital. Granted, the trend seems to be in cutting costs, and we think the industry might be a little too narrow-minded for such consideration. We called several airline industry analysts and were even more surprised that the topic hasn’t even been considered by the likes of JP Morgan and others. American and United have for some time treated their frequent flyer programs as separate business units, so to spin them off would be no major concession and would undoubtably lead to a better prospects of raising even more capital.

Money Makers
Some of our readers might wonder how can this be — that a frequent flyer program would provide such value to the stock market, let alone the airline sponsoring the program. Beyond being one of the most recognizable assets of an airline in terms of driving passenger choice, as well as operating as a weapon used against low-cost carriers and new entrants into various markets, they serve as cash cows. The incremental revenue brought in from the growing stable of partners has changed these programs from solely being about the “frequent flyer” to being more about the “frequent buyer.” Take for instance the new partner for AAdvantage and SkyMiles: LoanToLearn.com.

Investor interest started to sprout just as the dot.com frenzy was dying out, no doubt because of the implementation of the SEC staff accounting bulletin No. 101 in December 1999. This new accounting standard required airlines to recognize frequent flyer program revenues on an accrual basis rather than as cash. This resulted in an increase in reported passenger revenue while lowering other types of revenue, since on an accrual basis, this partner revenue is recognized over a period of time. For instance, in the prospectus for the Aeroplan Income Trust, it is noted that there is a 30-month average lag time between Aeroplan selling its miles to partners and members redeeming those miles for awards. Since airlines and other loyalty programs are paid for partner participation, the pennies per mile add up in significant amounts. InsideFlyer has estimated in the past that more than $3 billion of miles are sold annually by programs in North America to their partners. The miles bought by partners are really a form of advertising and incentives to their customers.

We asked Fadi Chamoun, airline analyst, UBS Securities Canada about the Income Trust (a tax-efficient offer) for Aeroplan, and he noted “It is somewhat unique to Air Canada and Aeroplan. The main reason is that over the years, Aeroplan has become less reliant on Air Canada for its revenues then you would see in other propriety loyalty programs.” He went on to say that the interest is in high-yielding income and that “Aeroplan does provide a more sustainable and less risky business model than the airline.” At this time, not many would argue that point.

Would it be such a jump? As it is, many airlines already have collective bargaining agreements for employees of their frequent flyer programs. In the case of United, those CBA’s were represented by the International Association of Machinists and Aerospace Workers and any new contract would have to be ratified as all other types of contracts.

Standing Alone, Standing Tall
To get a glimpse of what United’s Mileage Plus program might be worth, we can take a look at the first quarter of 2002, when United made changes to its corporate structure and marketing programs. The changes were designed to increase the overall value of United’s loyalty businesses and to allow the airline to focus on enhancing the range of products and services for Mileage Plus members and its partners. Unfortunately, all has not gone as smoothly as planned, with the hiring and departure of several marketing executives and the challenge of convincing potential partners that the Mileage Plus mile as a marketing currency was stable. Nonetheless, United “sold” all of its stock in Mileage Plus, Inc. and Mileage Plus Holdings, Inc., to the new subsidiary, UAL Loyalty Services (ULS) for a $900 million unsecured promissory note payable over 12 years and bearing an interest rate of seven percent, plus the assumption of approximately $500 million of outstanding liability on miles previously sold. That $1.4 billion transaction was three years ago, before the IPO market started to heat up again, and in a time when everything was still reeling from the effects of 9/11. But the value at that time properly represented the value of net future cash flows.

Worth it? In 2003, ULS accounted for 5 percent of UAL’s 2003 revenues. In 2004, United recognized more than $400 million in revenues related to ULS, which would not reflect the entire business revenue of ULS for that year. In 2000, revenue for third-party mileage sales reached $220 million during the first six months alone.

But American AAdvantage is clearly the king of frequent flyer programs, with annual revenue related to third-party sales of miles exceeding $1 billion annually.

How might it work? A stand-alone public company would retain the gross proceeds and liability from selling miles. As members of a particular frequent flyer program use the miles earned through means other than air travel, then redeem a travel award on the airline or its partners, the stand-alone company would be obligated to compensate the airline for the value of this award travel. Likewise, the airline would be obligated to pay the stand-alone company for miles earned through air travel if they are redeemed for any non-air travel award. The price of a mile sold between the two entities as a result of these arrangements would always be expected to be contractually mandated and fixed. Terms would be updated on market factors and conditions such as alliances. The spin-off benefits from the so-called margin or spread between how much it charges to sell miles to the program partners and how much it costs to purchase a product or service from those partners, whether it be airline travel or merchandise.

The strength of such a public spin-off would be that it would make miles safer for program members, since with the huge cash reserves for liability, it could easily arrange to purchase free air travel from other surviving airlines or new entrants should the airline become a victim of a bad economy. This sense of security would go a long way toward soothing some of the highs and lows of members’ emotions regarding the safety of their miles, if an airline is in bankruptcy.

But even that might be secondary to the amount of cash that could be raised to help airlines today. For instance, Air Canada is selling off just 18 percent of Aeroplan, but that is likely to put more than $200 million in the coffers of Air Canada, which just recently came out of bankruptcy. Since these programs could become stand-alones, it’s conceivable they would turn their attention to acquisitions and actually running loyalty programs for many other industries and businesses — something most would assume that frequent flyer programs are good at anyway.

Partners Pay Off
But the concept is not for every airlines’ program. One needs innovative, entrepreneurial and accounting-minded top management without direct ties to the airline itself to make this work. Much like United, of course, it would still require airline personnel to actually run the airlines’ frequent flyer bonuses, elite levels and benefits. We’re just talking about the revenue engine. Growth in mileage sales used to be in the 18-percent annual average, and has slowed down quite a bit following 9/11, but recently we’ve seen an uptick in the types of partners coming into the programs, as well as the promotional efforts of key partners such as credit cards. It is interesting to note in the Aeroplan prospectus that financial services account for nearly 63 percent of the annual revenue the program produces, with Air Canada at 27 percent, other travel services 8 percent and consumer product partners contributing 2 percent. That’s more than $340 million from financial partners. The U.S. market is even more robust with credit card and other financial partners. This is witnessed by the advance of $500 million to Delta SkyMiles from American Express, and the recent pledge of $350 million to the new America West/US Airways entity from their frequent flyer credit card sponsors.

Among international programs, Lufthansa Miles & More, Cathay Pacific Asia Miles and Qantas Frequent Flyer would make excellent candidates for a public float.

Currently, partner revenue is growing at a rate of around 14 percent, which is respectable as the economy continues to rebound. Some programs have even seen years where partner revenue has grown by nearly 30 percent, but that is usually the smaller programs just adding an array of partners for the first time. These are very respectable numbers, coming eleven years after the introduction of American AAdvantage Incentive Miles and United Mileage Plus Reward Miles; programs which ushered in the idea of adding partners that were not inherent to the airline business itself. Hotels and car rental partners are natural, but car loans and realtors?

The plus to all this is the fact that partner miles now outnumber miles earned by flying, and the percentage has been growing every year. In fact, last year we noted that the total of miles earned by credit card spending was greater than miles earned by flight activity (bonuses not included). The average award being redeemed these days measures 31,113 miles — a blend of business/first class awards as well as the popularity of international awards with airline alliances accounting for much of the growth. Assuming that 54 percent of the miles for this award will come from partner activity and the industry might be averaging 1.33 cents per mile (remember, financial partners buy the most but pay the least), the business model for this might show a gross revenue of $223.45. Good for the airline, the spin-off, the investor and if these programs can make better use of revenue management; better for members. You might say that these spin-off programs could become a modern-day version of a ticket consolidator who can purchase inventory at a discount based on volume. In 2004, several of the larger programs redeemed two million free award seats (this does not include partner airline redemption). Imagine the buying power of two million seats!

We don’t believe that members of frequent flyer programs will be harmed if the industry follows through with public spin-offs. As noted, the best policy would be to spin off a portion of the business to raise much needed cash, and then take more out of it as the stock rises (as would be expected in a rebounding economy with the acquisitions of additional partners and leveraging the expertise these programs have in managing customer loyalty). We accept that if adopted by the industry, some will not perform, but that would likely be due to stewardship rather than the business model itself. Given how airline stocks have been languishing for some time, this could benefit the airline in two ways: provide instant cash infusion to convince employees and others that the airline is indeed doing all it can to maximize its potential to weather the current crisis, and bolster the actual stock price of the airline for equity and borrowing purposes. While the long term might be a full spin-off. Taking Aeroplan’s lead of around a 20 percent float would do well for airlines right now. While one could argue that this is risky given that these programs are a core value to most major airlines, the move to capitalize this asset would not interfere with the airlines’ current mode of operating the program for their own passengers.

And finally, while all this may be interesting speculation on the behalf of this magazine, let’s also look at what an investment in AAdvantage or Mileage Plus might bring to a prospective shareholder. Seems likely that IPO costs would be driven far down, in that the membership base of these programs is the market maker; no boiler rooms touting the stock to unsuspecting investors. Various analysts in Canada have pegged the yield of the Aeroplan Income Trust to be nearly 8.75 percent. Healthy by most regards.

Leave a Reply

Your email address will not be published. Required fields are marked *