The airline frequent flyer programme: for love and money

IF YOU'RE RUNNING AN AIRLINE, YOU'RE PROBABLY IN THE WRONG BUSINESS. Not just for the obvious reasons. You should be marketing your brand, not selling tickets. One is unique and valuable, the other is a commodity. One can be monetised, the other mostly creates jobs for others. And the truly remarkable feature with the brand business – leveraged through a frequent flyer programme (FFP) – is that while someone else willingly collects the money for you (and pays for the privilege of doing so), your customers will love you more for it, just as your partners bring along their own customers for you as well.

All you have to do is recognise and exploit the value of your airline’s brand. It sounds so simple, but how is it that so many very smart airlines have failed to leverage their income in this way? Certainly it is an undertaking that requires skill and capital. As Groupe Aeroplan (GA) noted, many of the early programmes were unable to exploit the potential of the customer data they were collecting because they neither had the necessary database design or functionality nor the expertise to effectively mine and analyse that data. A key ingredient was to possess the budget necessary to make use of the data.

But the expertise now exists and the evidence of revenue potential is clear – if it is done well.

Loyalty programmes began long before the first airline frequent flyer programme, generally ascribed to United Airlines in 1981, although more basic models had previously appeared. Until the benefits of the airlines’ programmes could be understood (and leveraged through more advanced IT systems), there was a strong belief through the 1980s that the US airlines had forced everyone into a costly and worthless exercise which left everyone back on equal terms – but spending a great deal managing their systems. Improvements in IT capabilities and general business sophistication have changed that.

Today, most major international airlines have a loyalty programme of one kind or another – even though most of them underperform drastically as an additional revenue source. For the most successful, hundreds of millions of dollars in payments from third party-points issuers are the pot of gold. This has led some to describe the business no longer as frequent flyer programmes but as frequent buyer programmes. Qantas, for example, reported more than USD1.1 billion in billings in the 12 months to 30-Jun-2011, nearly a tenth of gross revenues. And a handy spinoff, with several months between these receipts and accounting their redemptions, is that an airline gains access to large banks of cash in the meantime.

The flood of non-flyer points can, however, raise internal conflicts: the basic concept of the loyalty programme is to reward customers and encourage them to prefer the particular airline brand, but as more points are sold to third parties, the supply-demand balance shifts, reducing the number of redemption seats available to actual flyers. In a successful FFP, many of the travellers redeeming points may not even have previously bought a ticket on the airline. All of their points could have been earned from using their credit card.

The FFP equation is more complex for low-cost carriers, operating exclusively short haul, even where they possess powerful brands. Here the value that can be delivered internally to FFP members is constrained; the frequent flyer reward for a fifty-dollar air fare isn’t going to have a magnetic attraction.

But, as LCCs look to integrate their systems with long-haul, usually international, partners, the equation changes. The benefits in growing mutual loyalty programmes are extensive – and therefore are there for the taking. This report looks at the big picture of FFPs, the alternative of outsourcing and considers some of the specifics at the interface between low-cost airlines and full service airlines.

There is no industry template for reporting revenues from airline frequent flyer programmes

Partly this is because the concept and the way the programmes are implemented is still evolving. Also, there are so many different facets to the income and liability aspects that the various elements tend to be reported separately. But some airlines patently make very large revenues from their FFPs. That is just the benefit that shows up on the ledger; then there is the less accountable, but undoubtedly substantial, incremental revenue gained from the loyalty the programme drives – those additional tickets sold because travellers are captured by the attraction of winning points or higher status. After all, these are still loyalty programmes beneath all the partner dollars – and they work.

The more successful programmes have progressed far beyond awarding points for miles flown, as airlines add new partners to their lists. Now the FFPs are typically integrated with large external companies, including banks, credit cards, retailers (especially food sellers, sales outlets that no consumer can avoid), as well as car rentals, petrol companies, hotels and other travel- related operators. In all of these cases, a cobweb of loyalties develops which entraps the willing consumer; for example using an airline branded credit card to buy groceries. And that’s where the money comes from.

The airline is simply the gleaming light that attracts the moths. Redeeming points on a set of wine glasses or a gift voucher does not generate the same attraction as a flight on the magic carpet – or an upgrade towards the front of the aircraft. Dependent on where those dollars are being spent too, the frequent flyer family can be grown substantially, in a virtuous spiral. Staple product retailers, such as utilities, telcos and retail chains, are sound partners. Major food conglomerates are the most valuable.

The credit card company – there’s usually a bank involved too – pays the airline for every dollar, euro, pound, yuan, yen or riyal spent on food; the food store also pays the airline in a similar way, while the airline merely prepares to issue seats, or perhaps goods, at some distant time in the future when the happy consumer accumulates enough points. If the points are then redeemed for travel on the airline, there is another wrinkle: there will almost invariably be built-in redemption charges too and a top-up (in hard cash) to ensure the customer gets the ticket(s) he or she wants.

This is all a very nice position for the airline to be in, as a virtual banker, holding points which almost have the status of currency. Hived-off Air Canada FFP, Groupe Aeroplan, reports that the average elapsed time between earning and redeeming (“burning”) frequent flyer points is 30 months; and some 17% of points are never redeemed. This, as Aeroplan explains, ensures that, “a significant portion of our profitability is based on estimates of the number of GA Loyalty Units that will never be redeemed by the member base.”

These numbers are higher than airline FFPs would concede today, perhaps by as much as a factor of three. “Engagement” with their members is more intense. Nonetheless, with such large numbers in the pipeline, there is a significant business line there alone.

FFP partners are almost like unpaid tax collectors. And who are the airlines’ best friends? – the credit cards, by a country mile. Because consumers – even surprisingly sophisticated professionals – get a bit silly and irrational about frequent flyer points, they take less care in assessing the costs around the edges when they know they are going to receive awards. Even buying a hotel room, where only a few hundred points are at stake, frequently influences decisions. That is especially true when the employer is paying the bill.

As a result, for the credit cards – mostly American Express and Mastercard, but also Visa and Diners Club – the airline associations are the most profitable products the cards operate. Many small businesses too put all of their company expenses on a branded credit card, often accumulating millions of points a year in this way. And, when every dollar spent by the consumer receives a point or two on an airline’s plan, that means another few cents paid by the card company to the airline.

In its Amadeus 2011 Yearbook of Ancillary Revenues, IdeaWorks estimates for example that a combined United and Continental Airlines generated approximately USD3 billion in 2010, purely from miles sold through its third party card “partners”. This sets the benchmark for airline FFP revenue streams and far exceeded the measly USD2 billion or so that United generated from such high profile ancillary sources as baggage charges, upgrades and other sales.

The report also suggests that Southwest underperforms in this area. The low-cost, and short-haul, carrier hopes in future to be able to exploit its Chase Rapid Rewards Credit Card – Chase is making a big push in the FFP area in the US – and IdeaWorks reports a potential upside of “hundreds of millions of dollars” that Southwest is currently leaving on the table – perhaps a case of too much love and not enough money for the redoubtable LCC.

But the same is probably true of most airlines around the world – and especially LCCs. It is hard to imagine a brand in the US that would attract more positive attention than Southwest’s, yet a focus on flying appears to have blinded management to the near-painless fortune that is there to be made through financial partnerships – with someone else collecting revenues for you and paying for the privilege of doing so. If that sounds like airline heaven, well it wouldn’t be far from reality.

The actual levels of per-point payment by credit cards and other partners to their airline partners are carefully guarded secrets and they vary depending on volumes of business delivered, as well as the nature of the relationship. For cards, the level tends to be in the region of 1.2-1.5 cents, but others, such as hotels and car rentals, can be as high as 4 or even 5 cents a point. It is not hard to see why the volumes now put through on cards are so vast that they can deliver far more FF points to consumers than the airline issues for travelling on its services.

It’s difficult to know who owns whom in the credit card-airline partnerships. Although the airlines rarely make a return on capital, they are the processing centre for billions of dollars in sales, so are a magnet for the cards. The dollar-surrogate points that move between them can become real cash when, as happened with United’s and Delta’s Chapter 11 bankruptcies, Chase and American Express respectively helped them through with financial support, relying on the neo-cash value of their frequent flyer points. American Airlines, the only US major not to undergo the cleansing impact of Chapter 11 bankruptcy, would probably also not have avoided it without support from Citi, which effectively purchased points from the airline when it was in trouble.

In this respect the miraculous thing about an airline’s partners is that they generate both income and “loyalty” from the extended families that they deliver.

The days are long past of joking that FFPs are more valuable than the airline they belong to. Or at least, if the programmes are leveraged effectively they should be. And there is a further value in that, if not completely bullet proof, FFPs are to some extent countercyclical. When airline revenues slow, their partners’ fortunes often improve. Choosing the right partners, for example food chains, is important; consumers have to eat.

The connections are most clearly illustrated where an independent loyalty programme links into an airline, such as Britain’s easyJet, which had no FFP of its own and signed up to a professional group in the UK, Nectar.

Nectar is the UK’s largest loyalty system, founded by the massive retail group, Sainsbury’s. It is now a subsidiary of Groupe Aeroplan. The arrangement allows any of Nectar’s 17 million members to redeem points on easyJet flights, with the option to make cash top-ups. The highly symbiotic airline-FFP relationship created by the easyJet-Nectar-Sainsbury’s linkage is emphasised by the terms used by Sainsbury’s CEO Justin King in announcing the easyJet tie-up: “Sainsbury’s will be supporting the easyJet addition to Nectar through in-store promotional activity as well as other direct marketing initiatives.”

Mr King continued: “Our customers often ask for new ways to spend their Nectar points and flights are one of the most popular requests [italics added]. easyJet joining Nectar now means that many families will be able to book flights in time for their summer holidays with the points they have collected through simply doing their weekly shop at Sainsbury’s.” The attraction for Nectar is the magic drawcard of “free flights”. For easyJet, the benefits are added revenues and a greatly expanded target group. The shortcoming? This does little for easyJet’s loyalty; they remain Nectar customers.

Establishing a balanced programme

A sound loyalty programme requires a balance of accumulation partners – to generate the points income – and redemption partners – where the points earned can be redeemed or “burnt”. The loyalty programme sits nicely in the middle, earning from both ends.

The accumulation contracts are ideally long term – generally at least two years in length – include annual minimum financial commitments and have annual, consumer price-indexed linked programme support fees.

The preferred redemption profiles include in-store discounts, entertainment and gifts such as theme parks, concerts, video rental and cinema tickets, and travel and leisure. And, as leading independent loyalty programme Groupe Aeroplan succinctly puts it, “Air travel rewards remain the most desirable reward for consumers under the Aeroplan Programme.”

But starting from the airline’s position, already in possession of this desirable feature, exploiting the financial opportunities means generating a good spread of accumulation partners.

Question: How much does your frequent flyer programme earn?

Answer: “How much do you want it to earn?” - CFO of a major airline

It is relatively straightforward to account FFP income from external partners who pay the airline’s programme for the right to issue points on the airline. Those partners will pay the airline an amount, on average about 1.3 cents, for each point they issue to their own customers. With several large partners, those cents can add up to hundreds of millions of dollars.

For various accounting reasons it is not quite as simple as it may seem and, for example it is typically many months before the points are redeemed, so allocating where income and expenditure occur involves some discretion, even within the increasingly global accounting principles that now exist.

But, once the programme starts to negotiate a price for buying seats from the airline, then the fun starts. This is not an arm’s length transaction, even if airline-established principles apply. The FFP may pay anything from marginal cost (a few dollars) to an inflated price – or even simply the “published” fare. This leaves enormous scope for variation. When the FFP is “buying”, say, a billion dollars worth of travel on its airline, it is not improbable that the amount charged for a certain amount of seats can vary by as much as half of that – in other words, whether that variable $250 million is shown as income to the airline or to the FFP is little more than a matter of internal discretion.

Then there are the numerous ways of accounting the value (and booked liability) of points earned the old fashioned way – by flying the airline, or its partners.

As for reporting to stock exchanges or investors, the practices are uneven at best. Qantas for example, which claims to be “building the world’s best loyalty business”, reports “billings”, as well as “underlying EBIT”, while making clear that “no profit is derived from transfer pricing between Qantas Frequent Flyer and Qantas Group Airlines”. Lufthansa, meanwhile, reports only income from its Miles and More programme. United Continental reports both.

Qantas, with 8 million members, took AUD1.04 billion (USD1.1 billion) in billings in the year to 30-Jun-2011, reporting an EBIT of AUD342 million; Lufthansa’s 20 million-plus members delivered EUR121 (USD176 million) in the year to 31-Dec-2010. For the same year United reported USD2.2 billion in cash proceeds from miles sold in its United Mileage Plus, which included a fourth quarter contribution of USD293 million from merger partner Continental’s OnePass – leading a May-2011 IdeaWorks/Amadeus report on ancillary revenues to conclude a combined annualised total of USD3 billion. In comparison, the report noted, Delta’s SkyMiles generated USD1.6 billion and American’s AAdvantage issued “approximately 185 billion miles, of which approximately 62% were sold to programme participants”.

Note: Standard accounting principles must be applied, but the income and expenditure variables in an FFP are so extensive that, however detailed those principles, they are wide open to interpretation. However, an airline must generally show some internal consistency in the way the pricing regime works, as this also relates to the accounting of assets and liabilities for reporting purposes.

Loyalty is still important

Differentiating points from “status” is an increasingly valuable art. As a basic principle, frequent flyers typically want status, while less-frequent flyers want redemptions. Thus, as the programmes evolve, their airline operators are wise to the need to distinguish more carefully between awarding flyer points and status points.

So, for example, where a passenger flies often but always manages to get the cheapest fares – which may not attract redeemable flyer points – he or she will generally be much more interested in receiving better treatment along the way, through access to airline lounges for example. This type of “Up in the Air” flyer is much more likely to be captured by gaining status access than by acquiring the low number of award points that would come with a low-priced seat.

Loyalty has different faces

Not all loyalty programmes are the same, by any means. Indeed, the evolving model has more about revenue earning than loyalty, even if the outcome is win-win-win. It remains to be seen whether a focus on loyalty per se will generate a better outcome for an airline – or whether the lure of the bottom line will prevail, no matter what. The following are some contrasting examples involving major airlines:

Skywards (Emirates)

The UAE carrier’s programme concentrates mainly on airline miles accumulation and redemptions, applying significant status levels. Revenue is part of Emirates’ strategy, but while its financial reporting talks of the methodology used, it does not actually split it out: “Revenue is recognised in the consolidated income statement only when Emirates fulfils its obligations by supplying free or discounted goods or services on redemption of the miles accrued.”

SkyMiles (Delta)

Making loyal customers feel “valued” is a large part of the sticky features of Delta’s SkyMiles Programme. The programme, into which Northwest’s WorldPerks folded when the carriers merged, focuses on priority treatment – reservations, check-in, security, boarding and baggage charge exemptions – “Hello Mr Bingham”. It does not leverage the airline’s financial upside; its 2010 financial report, for example, noted that “other revenue” increased USD241 million primarily due to new or increased baggage handling fees and higher SkyMiles programme revenue”. That is, the FFP component of this would have been only 10s of millions of dollars, not hundreds. Delta has also, uniquely, established codeshare and FFP linkages with two of the more aggressive domestic LCC/hybrids, Gol and Virgin Australia.

Executive Club (British Airways)

Although the US airlines began FFPs in 1980, and the UK was home to one of the first major loyalty programmes in the 1960s and 1970s, British Airways has typically taken a lower key approach to its FFP. Its Executive Club, while attaching numerous partners, in addition to other airlines, makes no mention of FFP revenues in its financial reporting, presumably including any added income under “passenger revenues”. The programme’s longstanding Tesco link delivers revenue – but without loyalty.

Mileage Plus (United)

The carrier has the oldest surviving airline programme. Its self-described “world’s most rewarding loyalty programme”, Mileage Plus, will continue in the “new United”, as Continental’s OnePass is folded into it. Global Traveler magazine has also awarded the carrier the “Best FFP” for seven years in a row. Mileage Plus has a long list of predominantly hotel and car rental partners, along with some retail. The card partner in the US is Visa, with variously American Express and Mastercard as well in other countries. And, particularly important in the US, elite members qualify automatically for the privileges of the carrier’s airport service, Premier Access, which offers priority lanes at check-in, security and boarding.

Flying Blue (Air France-KLM)

The two airlines have a joint Flying Blue programme that is highly focused on loyalty. Monetisation has yet to be a large motivator in this programme. Apart from the range of partners and an American Express branded card, Flying Blue caters very effectively for the elite traveller, with dedicated “Clubs”, including “Flying Blue Golf”, as well as business-related information/support clubs for business travellers to Africa and China. It even boasts “Flying Blue Petroleum”, “an exclusive Air France and KLM service for oil and gas industry professionals”, giving priority treatment for the obviously important segment of its market – including the resource-rich former French colonies which the group serves in Africa.

JAL Mileage Bank (Japan Airlines)

The Asian carriers came late to the FFP party and, as JAL’s FFP name suggests, its JMB is, typically, mostly about loyalty and rewards. Status is an important part of the programmes. JAL’s financial reporting makes no mention of its FFP, other than revenue from credit card relationships.

The counter-cyclical nature of FFPs and airline stocks

The airline industry is subject to constant shocks, natural and otherwise, meaning that it is always volatile. One of the arguments Aeroplan has used to support the role of an independent loyalty programme – although this should also work where the entity remains within a group function – is that an FFP will tend to support the airline in times where the operational activity turns down, a sadly frequent occurrence.

As airline stocks have dived this year in the face of declining consumer sentiment, Groupe Aeroplan’s share price has held steady. Where the loyalty programme had confirmed an expected EBITDA in excess of CAD355 million (USD363 million), its former parent, Air Canada, lost CAD20 million in 1Q2011 – albeit better than the CAD116 million it lost in the first quarter of 2010 – and its share price is down 50% this year. The two are no longer under the same ownership, but come from the same stable and remain joined at the hip.

Due to its multiple streams, incorporating a selected range of partners, the loyalty programme can act as a consistent revenue source. It can, in other words, become a form of risk management.

Thus, as part of an airline’s strategy, a wide profile FFP can occupy multiple roles. An FFP which embraces extensive non-airline partners can greatly reshape the risk profile of an airline, actually providing stability, rather than counter-cyclicality.

FFPs have become a valuable constituent of the glue that binds global alliances

When it comes to loyalty, the big three alliances are powerful. By achieving elevated status in any one member airline’s programme, a regular flyer can gain access to airport lounges and often (although this remains far from seamless) to additional baggage allowances and preferred check-in of any other member.

Although the basis of cooperation among membership of the three large branded alliances is bilateral – for example, codesharing is entirely an optional activity, determined by each pair of partners – common frequent flyer principles bind them all. Each member airline retains its own independent FFP, which then participates with the other alliance partners’ programmes. Earning points on the programme of any one of the constituent members means that these points can generally also be burnt on each of the others (although not always for upgrades, a popular demand). This adds a whole dimension to the “stickiness” of the multilateral alliance strategy.

The expansionist Gulf carriers here suffer from not being able to participate multilaterally in comprehensive global programmes that the alliances are beginning to achieve. They can establish bilaterally the right for their passengers to earn and burn, but only the carrier at the centre of the operation – say, Emirates Airline – can grant that right to all of its FFP members. A member cannot do the same as between other bilateral airline partners.

And, as the alliances occupy more and more space geographically, even the bilateral avenues are beginning to be closed off for the Gulf carriers. Emirates has lost its earlier codeshare with United and, more recently Continental has slipped off the list; in Asia it retains codeshares with Japan Airlines and Korean Air, neither of which is especially threatened (yet) by the UAE carrier’s expansion.

Lufthansa has substantially limited its partnership with Qatar Airways. Etihad has, however, been able to consummate a partnership between its Etihad Guest programme and American Airlines, although for the time being at least this only applies to accrual of points. And, although it has concluded a useful partnership with Virgin Australia, in Europe, Etihad is limited to minor players. No majors are prepared to encourage competition from these highly challenging operators.

Despite being a considerable force in passenger decision-making, competition authorities have so far been relatively tolerant in their oversight of this aspect of multilateral cooperation.

Low-cost airlines are finally beginning to leverage their enormous brand value into FFPs

Many of the non-legacy airlines that started up in the past 15 years have developed extraordinarily high brand profiles. Yet few have anything more than an embryonic loyalty scheme, often as simple as offering a free coffee-style programme, of buy-10-get-one-free.

The fundamental of the LCC model is to strip out all the non-essential activities and focus on keeping costs at a bare minimum. Consequently, when it comes to FFPs as a strategy, they find themselves in the position the legacy airlines were a decade ago: many still see this sort of activity as a cost centre and one which diverts a lot of management attention while the programme is establishing. And indeed it took a while for most legacy airlines to comprehend the upside of the FFP – and it did take time and add to costs, at least initially.

Where LCCs have adopted more than the most rudimentary programme, the preference is now to apply an expenditure-based earnings system – one that grants rewards based on the amount of money spent on the carrier – more like the basic loyalty retail model. It allows other partner expenditure to accrue in a logical way. WestJet did this in its Frequent Guest Program, as did Southwest with its Rapid Rewards. Southwest has a Visa-linked credit card, along with a still-relatively basic list of partners, including hotels, car rentals and the like. WestJet has only a credit card link, with a branded Mastercard and no other partners; this is still pretty much a basic loyalty programme.

JetBlue has developed perhaps the most sophisticated system of any of the LCCs. It had taken until Nov-2009 to launch its own in-house TrueBlue loyalty programme. When the carrier evolved from its Navitaire Open Skies distribution system to Sabre the following year, it effectively outsourced its loyalty programme upgrade to Comarch, a Europe-based specialist loyalty IT provider.

This entailed, among other things, a change from the mileage-based to an expenditure-based system, an important add-on where some 13% of the carrier’s total revenue is non-ticket. When it took on Comarch, JetBlue had begun to outgrow its ability to exploit effectively the numbers in its system, but also had enough on its hands making the switch over to Sabre to be able simultaneously to handle a transformation of its FFP. And, as interfacing with international airlines became more central to its strategy, so a flexible programme became core to its operations.

Thus for example, following JetBlue’s codeshare arrangements with American Airlines services in 2010 which link into New York JFK and Boston Logan, the TrueBlue programme now allows members to earn points on American’s international services. Meanwhile, although JetBlue’s 16% shareholder Lufthansa has 235 loyalty partners, of which 48 are airlines, their respective programmes do not cooperate – yet.

In a Feb-2010 media release Comarch sheds some light on the IT complexities that can be involved in establishing an efficient programme for an LCC: “JetBlue and Comarch agreed not only to replace the existing in-house (FFP) solution but also fundamentally restructure the TrueBlue program. The process involved custom development of the Comarch CLM-FFP system to interface with JetBlue’s existing IT systems, including both the Navitaire and Sabre reservation systems. Over the past nine months, Comarch has been working to implement and support the new TrueBlue loyalty program which was launched in November of 2009.”

The upshot of this considerable venture is that JetBlue has created a platform for interacting effectively with its partners, implying a potential upside for the TrueBlue programme. The rewards will take time to show, but they should be there in both inter-airline connectivity (and loyalty) and in generating added revenues.

One solution is to follow the standard LCC strategy and effectively “outsource” the activity, as several have done. As mentioned above, easyJet has signed up for the UK’s Nectar, a subsidiary of Groupe Aeroplan (and perhaps by association has now become a distant cousin of Air Canada!). The carrier’s branding challenges have made exploitation of the easyJet brand difficult, so this agreement appears a useful alternative.

Another LCC, Germanwings, a wholly-owned subsidiary of Lufthansa, also shifted this year to the expenditure-based style. The carrier still performs all of its FFP functions in-house, while its Boomerang Club offers full reciprocity with Lufthansa’s Miles & More programme.

Asia’s largest independent emerging airline brand is AirAsia. Although it has been very active in ancillary sales generally, the carrier has done little to leverage its brand for loyalty and revenue purposes. Shortly after it began flying, the carrier established a branded credit card with Singapore’s DBS Bank, which “effectively doubled as a frequent flyer programme”, as card users earned “AA$”s for redemption on the airline’s flights. The wrinkle was that the real credit card dollars spent at “affiliated merchants” received a much higher redemption value. But, other than some muted suggestions, notably from long-haul subsidiary AirAsia X, like many other LCCs there is as yet no AirAsia frequent flyer programme.

Domestic-international LCC-full service airline interfaces: a vital part of the new partnerships - but it’s not simple

When creating a domestic-international airline partnership that connects a long-haul international airline into a domestic system, an important part of the relationship is leveraging off each other’s FFP. Creating loyalty – and, for the LCC in particular, also new revenue streams – can depend greatly on linking different flyer programmes.

Apart from the (highly complex) need for their respective IT systems to communicate effectively, a big issue in connecting an LCC’s programme into an international partner’s is how to account between the two (or more) airlines. This has two aspects: (1) rewarding the passenger and (2) reconciling payments and redemptions between partner airlines.

Accruing in dollars or miles? For low-cost point-to-point airlines offering very low fares, accumulating enough points to generate real loyalty makes an FFP unattractive. Simple “buy 10, get one free” systems can work, but they offer little potential for extrapolating into a more valuable programme.

Moving to a higher level, the next decision is whether to account customer earnings based on dollars paid or miles flown. Domestically, rewarding passengers for their dollar spend is the ideal way to work; there is a clean payback, and passengers who pay more for their fare on a particular flight are rewarded proportionately. These are the customers who are usually most valuable and the airline’s income is directly scaled to the reward. For valued regular travellers who use low fares, a parallel system of providing status points can help capture their loyalty, by accumulating non-point privileges such as airport lounge access. Higher status members also usually receive more points per dollar/mile.

Many older programmes offered a mileage-based reward, regardless of whether the passenger was paying $50 or $500 for a flight. And, even where the mileage system did discriminate in favour of the bigger spender, it would not be anywhere near the 10:1 that a dollar-based system offered. This also integrates more coherently with the dollar spends of loyalty members on third party retailers, or credit cards, where FF points are also awarded.

Most LCCs took a while to adapt to this approach, having been weaned on the bigger, mixed domestic/international systems that the likes of United Airlines had used from the start. But now most have moved to the dollar-based proposition of “the more you pay, the more you get”.

However, that happened just as the likes of JetBlue, Southwest and WestJet in North America, and such widely dispersed airlines as Vueling and Virgin Australia are seeking to link their operations into international partners’ systems.

Although ideally the same formula would apply to both domestic and international operations, there is a host of reasons why the dollar formula does not work outside domestic markets. International airline pricing is arcane to say the least – particularly when interline deals are involved – and total transparency of pricing is near impossible. Add in the fact that prices and exchange rates constantly change, so that although a dollar system may be preferable, there is no realistic alternative to accounting in miles.

That doesn’t mean an airline can’t use both systems internally – just that when reconciling with offshore partners, the basis has to be mileage.

Reconciling partner payments and negotiating terms between airlines on which points are redeemed/burned on each other’s flights is necessarily a highly important part of the inter-airline transaction. The smaller airline has to avoid being swamped by mileage points generated by the large FFPs of its partners, yet at the same time provide seats at somewhere near lead-in prices, in order to be attractive.

The transaction works both ways. The smaller carrier wants to ensure that its own FFP customers receive a good deal from the other airlines – at the same time ensuring it keeps enough seats to sell for a profit and providing adequate redemption possibilities to keep its own members happy. So a happy medium must be found with each bilateral partner. There is no simple formula for trading points between airlines – and skilled staff who fully understand the mechanics and implications of negotiating are rare. Yet the real dollars involved in the trading process are potentially massive.

For example, it is always possible simply to establish blackout periods to block excess consumption (and reduce the cost to the airline). But over-use of blackouts will be unpopular with the airline partner’s programme members, leading to downgrading of the mutual relationship. A further refinement that helps ease pricing concerns is the “any-seat” solution, where a combination of points and dollars can be used, so that the full value of the seat can be recouped, without requiring outrageous numbers of points. However, this comes with its own IT complexities.

To spin off the programme – or not: the Groupe Aeroplan model as a guide

Where today it has become clear just how valuable a FFP can be to an airline’s bottom line, another question can arise: to separate out the FFP or to keep the operation in-house. Most airlines keep their programmes very much in-house; of the main carriers, only Qantas and Virgin Australia have a separate arm and Air Canada was, until TAM recently sold down its Multiplus programme, the only full service carrier to have wholly outsourced its FFP, Aeroplan. And as previously mentioned, easyJet has recently linked with Groupe Aeroplan subsidiary Nectar.

The Groupe Aeroplan model is useful both in viewing the potential scope of the FFP and the opportunities for spinning off a programme. The model for independent Groupe Aeroplan’s IPO and its spinoff from Air Canada, as the flag carrier cleared a way through its bankruptcy turmoil in the early part of the new century, generated widespread popularity for the loyalty concept as a means of making not only new friends but also large quantities of new revenues. Budding knowledge of the new forms of loyalty meant that most airlines now understood enough about the earning potential of the programmes to recognise an exciting new strategy. And that included spinning off the entire programme into a self-standing company. For some time, the architect of Aeroplan, Air Canada’s Robert Milton, was held up as the airline loyalty icon.

As Mr Milton elaborated, the complex business of running an airline, with all its different, but integrated functions, meant that financial analysts – and consequently the stock market – supposedly could not appreciate the powerful underlying ingredients of the operation, most notably the loyalty programme.

Each of the functions was submerged in a whole that was too complicated for the market to understand; airlines simply did not conform to the core activity principles of other prominent companies. As a result the company was undervalued, debt and equity raising was more complicated – and, not unimportantly – share price-linked executive bonuses were harder to achieve.

So, went the logic, separating the different activities out into discrete entities meant that their respective values were brought out. The sum of the parts would be worth more than the whole, by “unlocking the value”.

That much turned out to be pretty much accurate. However, the downside was that this form of transparency also tends to expose the basic reality: once you strip out the profitable self standing parts of an airline, the flying operation is exposed for what it is: a poorly performing economic entity in its own right, dominated by a unionised workforce and often ineffective work practices.

As Air Canada emerged from bankruptcy in 2004, its new profile was under a holding company, ACE Aviation Holdings Inc, with 10 subsidiary operations. Mr Milton, the airline’s CEO at the time, went ahead over the next couple of years and separated out the airline’s regional division, Jazz, its maintenance activity and, most significantly, the frequent flyer programme. At that time, explaining the concept to investors was a real struggle, partly because it was so new and there were so many areas where the investor benefits were not immediately transparent. Aeroplan’s first battle was to convince the doubters and the successful float was evidence of this success.

But even as the theory was being put into practice it was already clear that the airline as a standalone was a negative earner. The hope was that this would improve when it could get on with the business of flying.

As Aeroplan split off, a crucial negotiation was guaranteeing access to the airline’s seat inventory, the part of the programme that attracted new members. Given the subsequent troubled history of Air Canada, the relatively generous terms under which 8% of Air Canada’s and Jazz Air’s seats were guaranteed to Aeroplan until 2020 are unlikely to be repeated. It is difficult to establish the precise terms of this agreement, but the price paid to the airline for this 8% is reputedly somewhere between the airline’s marginal seat cost and its direct cost. Aeroplan has described the price it pays for these seats as “a fixed low redemption cost”. A subsequent agreement expanding the number of seats available in response to demand for more redemptions had Aeroplan paying the “fully allocated cost” of the seats. These were for the ClassicPlus Flight Rewards.

The agreement gives Aeroplan indirect access to the programmes of all Star Alliance members for redemption purposes, although these are only redeemable for “certain other air carriers under the ‘AC’ code”. Its 2010 report stated: “The airline (redemption) category is comprised of 33 partners, most notably Air Canada, Jazz Air LP and other Star Alliance member airlines.” This relies on access via Air Canada’s programme, as the other airlines do not feature in the report’s discussion on minimising risk, were the Canadian carrier to fail.

Getting the right management mentality was an additional value in segregating the FFP – an important consideration, whether it is a separate division in the airline or a spinoff. Thinking airline-first is less likely to create the right sort of role for the FFP. As a Yale School of Management report, Air Canada. Selling the Company by the Slice, stated: “The carve-out also shifted Aeroplan’s corporate mindset. Management focused on both the cost of an Aeroplan point and its value to consumers.”

This segmentation of management psyche is an important part of the process – one illustration being the many disputes between programme managers and the airline’s yield management teams in the early days of FFPs, as airlines were learning how to generate positive results on both ledgers.

There is one charming twist to the evolution of Groupe Aeroplan. The former Air Canada FFP company now owns 60% of Rewards Management Middle East, the operator of the Air Miles loyalty programme in that region. According to Aeroplan’s website, more than 1.7 million members have enrolled from more than 700,000 households in the UAE, Qatar and Bahrain and, tantalisingly, the programme “offers a wealth of rewards and experiences to members such as electronics, jewellery, family days out, adventure experiences, hotel and flight bookings” – perhaps on that same Air Canada and its Star Alliance partners.

Robert Milton, now ACE chairman, president and CEO, fiercely opposes the entry of the Gulf airlines into Canada in order to protect Air Canada. But it is important for an independent loyalty plan to spread its risk, especially in terms of over-reliance on the notoriously hazard-ridden airline business. ACE is progressively helping Aeroplan evolve away from its reliance on Air Canada and although it has significantly diluted its reliance on the airline elements of the loyalty programme, the group still counts heavily on the airline to deliver the invaluable flight rewards. As the company’s 2009 annual report noted: “In 2008, Groupe Aeroplan purchased approximately $490 million in rewards tickets.”

The independent loyalty programme cannot afford to be burdened by the possible demise of the troubled flag carrier, so, in 2008 alone, Aeroplan had “reduced exposure to Air Canada with gross billings representing 17% in 2008 (down) from 25% in 2007”, according to the annual report. In other words, Air Canada only provides the plan with some 17% of direct revenue. Under the formula applied between the parties, Air Canada’s “estimated minimum requirement for 2011 is [to pay Aeroplan] CAD215.3 million”.

On the redemption side of the ledger however, the carrier still remains a vital ingredient, even though that reliance is diminishing. Aeroplan’s 2010 report noted: “Air Canada, including other Star Alliance partners, is Groupe Aeroplan’s largest Redemption Partner. The cost of rewards provided by Air Canada (and other Star Alliance Partners) as a percentage of total rewards and direct costs represented 37% for the year ended December 31, 2010 compared to 56% for the year ended December 31, 2009.”

What Aeroplan calls its “coalition loyalty business” is thus based on two major streams of activity:

(i) The sale of Aeroplan Loyalty Units and related marketing services to Accumulation Partners; and

(ii) Delivering rewards to members through the purchase of rewards or shopping discounts from its Redemption Partners. Today, Aeroplan’s roster of non-flight rewards includes “more than 800 existing specialty, merchandise, gift card and experiential rewards, as well as hotel and car rental rewards”.

This two-directional dealing is illustrated in the diagram below, with cash payments flowing from left to right.

The Qantas FFP: piling on the profits

As the IdeaWorks/Amadeus report noted, among the world’s airlines, “it is the Qantas frequent flyer programme that really piles on the profits.”

The publicly listed Qantas in fact came within a hair’s breadth of complete privatisation in 2007, shortly before the world’s economy melted down. The FFP played an important role in the board’s decision to take the company into private equity hands, supported no doubt by senior Qantas staff, in line for substantial payouts. As it happened, an error of timing by a large shareholder meant that the necessary majority was not achieved and Qantas remained listed.

The sale would have involved floating off several of the airline’s varied assets, including the FFP, in the process seeking to expose the underlying value of each of the different activities by disaggregating them.

Despite today remaining within the group, Qantas’ FFP, although a separate division, has adopted many of the features of the Aeroplan model, to the extent that it is now pushing out feelers into such areas as marketing the group’s IP in the area. Management has undoubtedly studied the Aeroplan experience in some detail.

In the year to 30-Jun-2011, Qantas’ billed income was up 9% year on year. The “profit from external billings” alone – that is, ignoring any internal value enhancement – was up 22% to AUD202 million (USD212 million).

Following its brush with being hived off, Qantas has established partnerships with several major retailers, notably Woolworths, which owns more than half of Australia’s food and liquor markets, as well as deals with a petrol company, a major telco and utilities, along with the usual list of travel items.

Qantas has recently signalled a new direction, buying into the online retail market. One online retailer it recently acquired, Wishlist, manages reward programmes for more than 80 companies, as well as generating a healthy return in its own right.

Meanwhile, Qantas’ excursions into data analytics and “operating other airlines’ programmes” open up countless new areas of revenue. This is a programme which has proven highly profitable, but without sacrificing loyalty goals – indeed, the leverage into new markets provided by its retail partners genuinely appears to be part of a highly virtuous cycle.

This could also underpin the reason for the carrier’s “any seat” redemptions growing by 20% year on year – that is, would-be passengers who don’t have enough points to pay for a trip, topping up with real cash.

Future directions for loyalty programmes

Despite the one or two real success stories, surprisingly few airlines have exploited their FFPs for direct financial reward, let alone disaggregate the activity or farm it out to a third party. Several, notably the large US airlines, see the activity as too important to their loyalty management to risk degrading it by commercialisation.

Add to this the highly competitive nature of the loyalty market, and market entry becomes increasingly complex. Where the cornerstone requirements are an extensive “domestic” market presence (extending perhaps to a transnationally branded presence) and partnerships with major retailers, telcos, utilities and similar staples, there can only be so many strong players.

But the airline seat is far and away the most attractive redemption item that any programme can offer. Consequently, it is hard to avoid the conclusion that most airlines simply do not recognise the inherent value they are sitting on, nor the market potential they have for negotiating favourable positions. The airlines’ failure to exercise their market presence in the FFP area is probably simply due to a lack of appropriate skills in the airline and the failure at board level to look enquiringly at the state of play with market leaders.

One further intriguing possibility for future directions in the loyalty area is how social media might play a part. A few airlines have adopted these outlets effectively for various roles, such as crisis management and sales and distribution; but there have also been elements of loyalty introduced in these dialogues. As social media itself becomes more commercial, new opportunities for innovative loyalty directions will surely emerge.

Whatever future directions loyalty programmes follow, they are generally still under-developed in most economies. As the airline industry becomes more outward looking and as liberalisation and emerging market growth drives change, this will surely become a much more vibrant playground for airline treasuries.

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