What happened to airline miles? I read an article today where the author mentions that in 2013 he was able to fly from New York to Frankfurt and then on to Bangkok all first class for 70,000 United MileagePlus miles. The ticket would normally cost about $10,000. It would still cost $10,000 today but the same flight in miles would be double the price to 140,000 miles. What produced this airlines miles inflation?
Bad Investment to Goldmine
Airlines had for a long time had a reputation as losing stocks. Their biggest costs are labor and fuel. As fuel prices swung wildly or climbed, it would eat into the profits of the airlines. Pilots were usually unionized and periodically went on strike. Add to that competition and a highly government regulated sector and you had the recipe for financial underperformance. Indeed this was the case for many decades. It was a regular occurrence in the US for airlines to go bankrupt to save themselves from creditors, spend a number of years in turn around and then re-emerge only to go bankrupt again a few years later.
At the turn in the millenium though, slow moving consolidation started with the large network carriers in the US. At the same time, competition from low cost start ups like JetBlue started bringing down costs for domestic routes. For a time, it looked as if some of the large carriers would not make it. Indeed some didn’t. Names like Continental and US Airways were folded into United and American respectively. This allowed the network carriers to take advantage of economies of scale when it came to cost. At the same time, the low cost airlines like Southwest continued to grow their organic market share based on price.
This is essentially where we are today in terms of the airline industry in the US. There are primarily 3 segments: the bottom basement fares from airlines like Frontier, the low cost carriers with a bit more perks and service like JetBlue and Southwest, and the network carriers that do domestic and transatlantic flights. The network carriers consist of the big three: American, Delta and United. Below is their domestic market share in 2018.
Source: Upgraded Points
Margins have improved since the bad old days pre-merger for these names but net profit margins across the industry still tend to fall somewhere around 5% as a whole.
Source: Aviation Outlook
If the airlines were to just base their business on cutting costs and trying to tack on fees, it would remain a tough business to grow profits.
The Airlines Print Railroad Money
I will get into the new stealth profit generator for the airlines in a moment, but first I want to give you a short history of private money in the US inspired by my recent visit to the Federal Reserve Bank in Cleveland this week.
Throughout much of the 19th century, the US did not have a central bank. Twice Congress created the Bank of the United States and twice its charter was either revoked or not renewed. Essentially this was because populist politicians like Andrew Jackson derided it as a tool for a small elite of bankers to control the country, sound familiar? The current central bank (the Fed) is the only entity allowed to print money in the US so if there was no central bank in the 19th century who printed the money?
The answer was banks and private companies. Most economies were on some form of the gold standard in those days. You could deposit your gold in a bank which would hold it safely for you and then issue you a note redeemable for the gold. You then didn’t have to carry around the gold, you could simply carry around the note (the dollar bill) and trade it for goods and services.
Soon people realized these notes didn’t need to be for gold. They could be notes issued by companies that were redeemable for services later on as well. For example railroads issued money that could be redeemable for rides.
Source: The Ohio Channel
The problem was, the issuers of these currencies had to be responsible in order for them not to print too many dollars and reduce the value of their railroad currency in the market through inflation.
When miles were created, they were like currency but not necessarily like railroad dollars. If you flew 2,000 miles, you received a credit of 2,000 miles and you would build up your miles by distance. The pricing of the seats you wanted to buy with your miles was therefore linked to the distance you had flown in total. In 2009 however, JetBlue teamed up with Virgin and started awarding miles based on the cost of the ticket purchased. This started the trend of dynamic miles that spread to the other airlines. Now miles weren’t really “miles” anymore, they were just points being created which loosely were tied to dollars.
Miles Now Dominating Profit?
However the miles didn’t grow at the same slow rate as the dollars you and I know, which grow at about 2% a year. Instead, when airlines began co-branding with credit cards, the number of miles issued to the public grew quickly. This was because the credit card companies would buy miles up front to be able to offer to consumers for those sign up bonuses. This is money in the bank right off the bat for airlines.
Then the airlines are earning part of the merchant fees from every time you use your card. Merchant fees tend to be 1-2.5% of the transaction, the credit card companies would just take those fees and buy more miles with them. This essentially created a new consistent revenue stream for the airlines. One when they renewed contracts with credit card companies and two for the ongoing merchant fees when credit card holders do their daily spending.
Of course this isn’t just free money. The airlines generate a liability on their balance sheet in terms of the future cost of redeeming those points but since so many people are sitting on miles to save them up, there is no risk of a massive redemption at any one time. In addition, remember this is like a currency issued by the airlines. If too many people start redeeming miles and the cost to airlines suddenly increase, they can just raise the price in terms of miles. This effectively works like a devaluation of your airline currency and is what started the trend of airline miles inflation.
The airlines have been reluctant to reveal data on the profitability of their miles programs but some equity analysts estimate that profits are in the 70%-80% range. If this is true, this would mean that some airlines are earning 50% or more of their profits from the purchase of airline miles from credit card companies through co-branding miles purchases and daily credit card transactions we all make.
To get an idea of how this looks, take a look at the revenue to Delta from the Delta-Amex partnership versus their overall revenue and profit.
Source: Delta
Credit cards accounted for about 8% of revenue in 2018 or $3.4 billion out of revenues of $44.4 billion.
Source: Delta
Source: Delta 10-K
If we take 80% as the profit margin figure, that means that credit cards account for about 70% of profits for Delta.
This was just a back of the envelope computation but the airlines are in no hurry to disclose this. The theory is if they do then they may start to be put under pressure to reduce their costs further on the operations side which would likely impact customer satisfaction and their market share. Nobody wants to risk market share just because equity analysts want more disclosure.
The analysts at Stifel did an estimate in 2017 of the value of the credit card programs for each airline and compared that to their market caps to show that some of the credit card programs were in fact more valuable than the airlines themselves.
Source: Bloomberg
The market may have picked up on this, which also may be one reason that if you start at the 2015 water mark, Delta has since outperformed the S&P by leaps and bounds.
Source: Yahoo
Airlines have seemed to hone in on their cash cow and have ramped up the offers and the miles. They have essentially printed a bunch of railroad dollars in order to feed real dollars into the company through the credit cards. The co-brand spend has increased 12.5% annually since 2013 which would essentially have reduced the value of the miles out there by about 50%, which brings us back to the beginning of the post where the price of a trip with miles seems to have doubled.
Conclusion
Credit card miles have seemingly become the number one profit generator for many airlines which makes to you start to wonder, are these just credit card companies that have the ability to fly you around at this point?
The danger for this revenue stream for airlines is in the devaluation of their miles. If airlines devalue their miles too much, say to a point where I mile is worth less than 1 cent, consumers may reach an inflection point where they realize that a cash back card would pay them more than an airline card even for travel on that airline. I believe we will still see high miles inflation but the rate of dilution will start to slow as it becomes ubiquitous. These initial gains for airlines will go to the first and largest movers in this space like the big network carriers.
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