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.
The point about hedging is based on the first paper I mentioned.
To address this question, it's important to understand how the deferred revenue associated with loyalty programs can act as a hedge for an airline's cash flows, beyond just being an accounting treatment.
The paper provides several key insights that help explain this:
1. Buffer against uncertainty: The paper shows that the deferred revenue associated with loyalty points can act as a buffer against poor financial performance and can be used to smoothen a firm's earnings (Theorem 2). This means that in times of strong performance, more revenue is deferred, while in times of weak performance, deferred revenue can be recognized to boost current earnings.
2. Real operational decisions: The paper emphasizes that the value of loyalty points is not just an accounting construct, but a real operational decision that affects customer behavior and cash flows. The optimal point value is set based on the firm's profit potential, which includes both realized cash flows and deferred revenue (Theorem 1).
3. Impact on future cash flows: While the paper doesn't explicitly model the detailed cash flow dynamics you mentioned (like higher ticket prices for miles-earning flights or opportunity costs of redemptions), it does capture that the value of loyalty points affects future cash flows. This is represented in the model by κt+1, which depends on the loyalty program value Lt+1 (see equation 6).
4. Hedging tool: The paper argues that loyalty programs can act as hedging tools against uncertainty in future operating performance (Section 4.2). By adjusting the value of points, firms can influence future cash flows and mitigate the impact of volatility.
5. Long-term perspective: The model takes a multi-period view, showing that decisions about point values today affect not just current accounting treatment but also future cash flows and operational decisions.
Regarding your specific concerns:
- Indirect cash flow impacts: While the paper doesn't model the specific mechanisms you mentioned (higher prices for miles-earning tickets, opportunity costs of redemptions), these effects could be captured in the aggregate cash flow function κt used in the model.
- Partner redemptions: The paper doesn't specifically address partner redemptions, but the model is flexible enough to incorporate such dynamics. The shorter hold times for partner points could be reflected in the model parameters.
- Market response: The paper doesn't directly address market responses to non-cash deferred revenue. However, it argues that the loyalty program's value is a real operational decision that affects future cash flows, which should be relevant to the market.
It's important to note that this paper provides a theoretical framework and doesn't empirically test these effects in real-world airline data. The actual hedging utility of loyalty programs may indeed be more limited in practice than the model suggests, especially given the complexities you've highlighted. However, the paper's key contribution is to show how loyalty programs could potentially be used as a tool for managing financial performance and risk, beyond just being an accounting treatment.
As always, thanks for the careful read of the article and for the great feedback!
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.
The point about hedging is based on the first paper I mentioned.
To address this question, it's important to understand how the deferred revenue associated with loyalty programs can act as a hedge for an airline's cash flows, beyond just being an accounting treatment.
The paper provides several key insights that help explain this:
1. Buffer against uncertainty: The paper shows that the deferred revenue associated with loyalty points can act as a buffer against poor financial performance and can be used to smoothen a firm's earnings (Theorem 2). This means that in times of strong performance, more revenue is deferred, while in times of weak performance, deferred revenue can be recognized to boost current earnings.
2. Real operational decisions: The paper emphasizes that the value of loyalty points is not just an accounting construct, but a real operational decision that affects customer behavior and cash flows. The optimal point value is set based on the firm's profit potential, which includes both realized cash flows and deferred revenue (Theorem 1).
3. Impact on future cash flows: While the paper doesn't explicitly model the detailed cash flow dynamics you mentioned (like higher ticket prices for miles-earning flights or opportunity costs of redemptions), it does capture that the value of loyalty points affects future cash flows. This is represented in the model by κt+1, which depends on the loyalty program value Lt+1 (see equation 6).
4. Hedging tool: The paper argues that loyalty programs can act as hedging tools against uncertainty in future operating performance (Section 4.2). By adjusting the value of points, firms can influence future cash flows and mitigate the impact of volatility.
5. Long-term perspective: The model takes a multi-period view, showing that decisions about point values today affect not just current accounting treatment but also future cash flows and operational decisions.
Regarding your specific concerns:
- Indirect cash flow impacts: While the paper doesn't model the specific mechanisms you mentioned (higher prices for miles-earning tickets, opportunity costs of redemptions), these effects could be captured in the aggregate cash flow function κt used in the model.
- Partner redemptions: The paper doesn't specifically address partner redemptions, but the model is flexible enough to incorporate such dynamics. The shorter hold times for partner points could be reflected in the model parameters.
- Market response: The paper doesn't directly address market responses to non-cash deferred revenue. However, it argues that the loyalty program's value is a real operational decision that affects future cash flows, which should be relevant to the market.
It's important to note that this paper provides a theoretical framework and doesn't empirically test these effects in real-world airline data. The actual hedging utility of loyalty programs may indeed be more limited in practice than the model suggests, especially given the complexities you've highlighted. However, the paper's key contribution is to show how loyalty programs could potentially be used as a tool for managing financial performance and risk, beyond just being an accounting treatment.
As always, thanks for the careful read of the article and for the great feedback!