Summer Travel and the Changing Landscape of Airline Loyalty Programs
It’s summer, and for many, that means it’s time for travel.
In fact, I’m writing this article while on the road (albeit on a business trip).
As I’m sure, many of you are preparing for vacation, and I hope (or assume) that many of you will cash in your hard-earned airline loyalty points for flights. However, the landscape of frequent-flyer programs is constantly shifting, and travelers may find themselves caught “in transit.”
Several months ago, the U.S. Transportation Department scrutinized the frequent-flyer programs of the major airlines for potential deceptive or unfair practices. This increased attention from regulators comes at a time when many airlines have been reducing the value of their loyalty points, making it harder for consumers to redeem their rewards.
As highlighted in the Reuters report, one key issue under investigation is the devaluation of frequent-flyer miles over time, which makes booking tickets through loyalty points increasingly tricky:
Looking at the graph, it’s not clear if this holds throughout the industry. It seems true for Delta, but less so for United.
But the Department of Transportation (DOT) is not alone. At the beginning of the year, Senators Dick Durbin and Roger Marshall raised concerns about airlines “changing point systems in ways that are unfair to consumers, including by devaluing points, meaning it takes more points than initially marketed to achieve the promised rewards.”
As regulators investigate these practices, consumers may see changes in how loyalty programs operate.
However, given the significant role these programs play in airlines’ business models—Delta reported over 100 million frequent-flyer members in 2020 and added 8.5 million more in 2022—any changes are likely to be carefully considered and hotly debated.
It’s clear that the value of these programs extends beyond ticket sales. For example, Delta Air Lines is predicted to earn roughly $7 billion from its program with American Express in 2023. This revenue stream explains why airlines resist legislation that might affect their ability to offer rewards credit cards.
Two questions are worth exploring today:
How should regulators consider loyalty programs and their impact on the financial health of the airline industry, given airlines’ dependency?
How should regulators think about these loyalty programs in terms of consumer rights?
Both questions are more complex than they seem.
The Surprising Value of Airline Loyalty Programs: A Hidden Goldmine
The data reveal a peculiar phenomenon in the airline industry: For the major carriers, the value of loyalty programs far exceeds their market capitalization.
For example, in 2021, United Airlines, with a market cap of $10 billion, boasted a loyalty program valued at an astonishing $21.9 billion —more than double the airline’s overall market value. Delta Air Lines presented a similar picture, with its loyalty program worth $26 billion against a market cap of $20 billion. Perhaps the most striking case is American Airlines, whose $25.5 billion loyalty program dwarfed its modest $6 billion market cap by over four times.
The situation in 2023 was slightly better. Delta Air Lines’ SkyMiles was valued at an impressive $30.5 billion, United Airlines’ MileagePlus was estimated at $24.5 billion, and American Airlines’ AAdvantage at $23.6 billion. Interestingly, as of the latest market data, market capitalization for each airline is still well below the loyalty program value. Delta Air Lines has a market cap of $28.99 billion, United Airlines $15.25 billion, and American Airlines $6.98 billion.
These figures raise questions regarding the true nature of airline business models: Are these companies primarily in the business of airborne travel, or have they evolved into sophisticated marketing entities running financial instruments with planes attached?
Loyalty programs have become increasingly central to airlines’ strategies, offering a steady stream of revenue through partnerships with credit card companies and other businesses. These programs not only encourage customer retention but also provide valuable data on consumer behavior.
The outsized value of these loyalty schemes may explain airlines’ reluctance to make significant changes to their programs despite the recent scrutiny regarding fairness and transparency.
It also highlights the delicate balance they must strike between maximizing the value of these programs and maintaining customer satisfaction. I’m sure you go through the annual drill of trying to book a vacation using miles, only to realize that the points are worth less than before and the options to redeem them are slimmer. It ends with telling yourself that maybe you should switch to a competing airline (nothing screams privilege more than being annoyed at not being able to redeem miles for a family vacation, but if you follow this newsletter, you’re no stranger to privilege.)
For investors, these numbers suggest that traditional metrics for valuing airlines may need reconsideration. The hidden value in loyalty programs could represent an untapped resource for airlines facing financial pressures.
As the industry continues to evolve, it's clear that loyalty programs are no longer just perks for frequent flyers, but have become the lifeblood of modern airlines, potentially worth more than the flights themselves. But as with any lifeblood, it comes with risks.
Miles and Points as Financial Liabilities
Just like any sophisticated financial instrument, questions need to be raised regarding the impact these loyalty programs may have on airlines’ financial health. What if all passengers tried to cash their miles simultaneously? Airlines already limit this by blocking dates and seats on planes. What about cashing in on other ancillary services, such as hotel rooms? Are airlines fully prepared?
The paper “Loyalty Program Liabilities and Point Values” by So Yeon Chun, Dan Iancu, and Nikolaos Trichakis studies the value of these points. The authors ask how firms should value and account for loyalty program liabilities and how these accounting practices affect firms’ operational decisions and customer welfare.
The paper’s motivation is exactly the point I’m making above: Loyalty programs represent significant liabilities for firms, especially airlines. However, there’s considerable debate and inconsistency in how these liabilities are valued and reported, a fact which can affect both firm behavior and customer welfare.
The authors developed an analytical model of a firm’s loyalty program and analyzed it using game theory and dynamic programming. Their results show that the current accounting practices often undervalue loyalty program liabilities, and even more worrying, that firms have incentives to manipulate point values to strategically reduce their reported liabilities.
The authors suggest a more accurate valuation method based on expected redemption values, which can lead to better operational decisions and increased customer welfare. In particular, the paper proposes a novel way to estimate point values based on the opportunity cost to the firm. The study introduces the concept of “profit potential,” defined as the sum of a firm’s realized cash flows and outstanding deferred revenue.
The authors make an interesting point about loyalty programs as buffers: Loyalty programs can act as hedging tools against uncertainties in future operating performance. When performance is strong, the value of points should increase, deferring more revenue to future periods. Conversely, when performance is weak, the value of points should decrease to recognize more deferred revenue immediately.
In fact, this explains what we see in the 2021 data above. During the peak of the Covid pandemic and the airline crises around it, the value of these points far exceeded the value of the airline.
This is a feature. Not a bug.
The authors argue that firms facing higher variability in cash flows should increase the value of loyalty points to create a larger pool of deferred revenue, serving as a financial buffer. The study highlights how loyalty programs can be used to smooth out earnings. By adjusting the value of loyalty points, firms can manage their reported earnings in response to fluctuations in operating performance.
Consumers and Loyalty Programs
What about passengers?
One fundamental assumption regulators are making is that consumers are being manipulated.
The paper “Strategic Consumers, Revenue Management, and the Design of Loyalty Programs” by So Yeon Chun and Anton Ovchinnikovasks studies how loyalty programs affect consumer behavior, firm profitability, and social welfare. The authors developed a game-theoretic model of strategic consumer behavior in the presence of loyalty programs and solved it analytically and numerically.
The authors first show an effect that is obvious but still interesting: Loyalty programs can increase firm profitability by inducing consumers to purchase tickets earlier and at higher prices.
Furthermore, these programs can sometimes lead to higher average prices in the market, as they reduce the pressure to compete on prices, and act as a form of price discrimination, allowing airlines to charge different prices to different customer segments based on their willingness to pay. Additionally, they serve as a lock-in mechanism (i.e., increase consumer switching costs), making customers less likely to choose competing airlines.
However, loyalty programs can sometimes increase consumer surplus despite higher prices, thus providing additional value.
In other words, the study shows that loyalty programs have complex effects on both airlines and consumers. While they can lead to higher prices, they also provide value to consumers, making the assessment of “fairness” less straightforward.
In fact, there’s potential for win-win outcomes, with loyalty programs sometimes benefiting both airlines and consumers. This implies that regulators should be cautious with overly restrictive policies that may eliminate these mutual benefits.
While the research focuses on economic outcomes, the complexity of the programs highlighted in the study aligns with concerns raised in the current scrutiny regarding transparency. This suggests that regulators might focus on improving program clarity and disclosure, rather than eliminating the programs altogether.
Implications
Together, these two papers provide interesting insights both for consumers and regulators.
Over the years, more airlines have shifted to revenue-based point systems rather than mileage-based. This shift aligns with the papers’ findings. By tying points directly to dollars spent, airlines can more accurately value their liabilities and potentially reduce the undervaluation problem identified in the research. So, while customers may not like this change (it prioritizes spending over flying, and awards more points to those who buy tickets early and at higher prices), it’s better for the industry as a whole.
The DOT is investigating the need for more transparency in these programs. The opacity observed in many loyalty programs may partly be driven by airlines’ desire to manage their reported liabilities as better price discrimination and to lock-in customers. Airlines might resist full transparency, even as regulators push for it.
For consumers, the actual value of loyalty points may be higher than what firms currently report. This underscores the potential value of these programs for consumers who use them strategically. However, it also highlights the complexity and potential for manipulation in these programs, emphasizing the need for consumers to be vigilant and informed.
In conclusion, both papers provide strong theoretical and empirical support for the current regulatory scrutiny of airline loyalty programs, and suggest that improved accounting practices and transparency could benefit both firms and consumers. On the other hand, the research highlights the complex incentives that have led to the current state of these programs, and the findings imply that regulators may need to focus on consumer-facing practices and the underlying accounting and valuation methods used by airlines in managing these programs.
Long time readers of this newsletter know that I’m always on the fence when it comes to regulation, but this is one more example where regulators must add transparency.
Bottom Line
As airlines, regulators, and passengers navigate this complex and changing landscape, the future of airline loyalty programs may look quite different from what we’re accustomed to.
As summer travelers cash in their points, they should keep an eye on the evolving value of their miles.
But, don't worry! This article isn’t meant to stress you out about travel.
But if you find yourself bleary-eyed at 3 AM, frantically searching for award flights, remember this: You’re not suffering from insomnia…You’re simply a savvy financier experiencing jet lag from all those imaginary trips.
To confirm your take, in 2004 I saw a talk by the head of United MileagePlus in which he explicitly stated that they saw themselves as a loyalty program that happens to have an airline attached.
Could you explain how the deferred revenue is an actual hedge that applies to an airline’s cash flows and not just non-cash accounting treatment? I’m having trouble seeing it. The cash flow impact of miles earned from flying is largely indirect and would be the opposite of deferred: higher prices as customers buy tickets to earn miles followed by a negative impact due to the opportunity cost of not selling a seat. For partner redemptions, wouldn’t the difference be a larger up-front cash flow (e.g. Amex pays Delta when someone converts Amex points to skymiles) and the same opportunity cost when used. But with partners, I’d guess that the hold time is much shorter, also making any hedge of limited utility. In any case, I have a hard time seeing the market respond to non-cash deferred revenue in a meaningful way.
With regard to transparency to shareholders, do you think the understatement of liabilities is harming shareholders? In principle, I’m in favor of avoiding accounting games with regard to liabilities, but it’s hard to perceive the market not seeing through that. In particular, because the airlines can heavily manipulate the rate of redemptions by adjusting program rules, the risk seems limited.
I wonder if the actual hedge that loyalty programs provide is a hedge against disclosure of underlying demand. Award availability should negatively correlate with operational performance: when demand falls, there are more seats available for miles and they’re available at lower redemption rates. Given the extreme transparency of airline operating metrics, loyalty programs could artificially boost load factors. But they wouldn’t affect RASM and CASM.
all of this makes me think that airline executives might be devoting inordinate time to accounting gimmicks that have nothing to do with fundamental value. And they’re doing this despite having created a very impressive value stream with their loyalty programs.