Economics of Loyalty under Pressure

Almost weekly I am asked by about the economic levers of a loyalty program. This week was no exception particularly with the recent news from Air Canada surrounding the launch of a proprietary loyalty program starting in 2020.

As my cassette of this conversation has seen a lot of use, I thought it best to publish the basic economics and to refer everyone to my digital explanation instead.

The Basics

Let’s first start by how a loyalty program makes money. It’s not rocket science, and looks something like this:

Revenues:    

• Miles/Points are sold at a price including a profit margin

Costs:           

• Rewards are purchased for redeemed miles
• The rest of the cost of running the program are incurred including but not limited to marketing, operations, administration, etc.

The above constitute the direct cash flows of running a loyalty program.

There are subsequently other additional elements that can grow the economic profit of the program; in the context of a traditional loyalty program, one element is Working Capital. Of all the miles that are issued, a certain percentage is never redeemed. In addition, not all miles can be redeemed the moment they are earned and therefore, both of these situations result in a substantial amount of funds being available to the firm to invest as they await redemption or expiry.

Finally, there is Shareholder Value. If you haven’t read between the lines, loyalty programs are serious cash flow generators that come with a very high financial multiple. Unlike the organizations that they partner with that typically face more market risk, loyalty program typically bear a somewhat lower risk allowing investor to be more certain about a financial performance that is less volatile or slightly more insulated from market conditions.

In cases where organizations elect to retain their loyalty program in-house, it is thus not surprising to see them publish the financial results of programs in hopes of convincing investors to provide them a higher multiple given the value created by their loyalty program. An example of this is Qantas Loyalty that consistently publishes its results in the Qantas Annual Report.

Big Financial Levers

Let’s get down to the nuts and bolts of it all. Where does all the money come from and what are some of the hidden costs?

One industry contributes disproportionately to the revenue generation of major loyalty programs: Financial Services; and most importantly Credit Cards. In many cases, when one digs into the results of major loyalty programs, it is not surprising to see the contribution of FS firms to be north of 50% of the revenues generated by the programs. That’s right, all those Gold, Platinum and even Entry level cards create a huge amount of value (and in case you are holding equity in some of these FS firms, don’t worry, they make money on the deal too).

Behind the financial service mammoths come the other core partners of loyalty programs, the airlines if the program is an airline based program, retail partners in the case of coalition programs, etc…

Hidden Costs or Opportunity Costs

As an airline, there are numerous hidden costs to running a program and/or leaving the levers of redemptions to a 3rd party loyalty program. These costs are largely dependent on the contracts between the airline and the purchasing loyalty program. In cases where airlines simply pass along retail pricing with a negotiated discount, there is limited opportunity cost; however any moment a contracted or fixed amount of seat inventory is allocated by the airline, this causes a potential opportunity cost, particularly when passenger load factors (avg. % of seats sold on the total available seats) are progressively getting higher. This means that revenue seats that could be sold at increasingly higher values are contractually released at a lower value. This is both true for internally or externally managed programs.

A second lost opportunity is Working Capital. As the airline purchases miles from the loyalty program; if the said program is not owned by the airline, all the earlier mentioned benefits of expiry and float are not realized by the airline.

What Levers to Pull?

So based on the above observations, in case an organization (in this case an airline) is looking to repatriate its loyalty program, the levers of value creation are the following:

1. Acquire a greater share of the economics of the credit card and FS relationships. Gabriel Dechaine, a stock analyst with National Bank Financial, went so far as to state that the move may imply a “gradual erosion of a significant cards portfolio for each (partner) bank over the next three years,” and predicted Air Canada’s move "will touch off a new round of competition among the banks for credit card customers"
2. Better manage the dynamic relationship between the available product (seat) inventory and reward pricing; reduce the opportunity cost related to displacing full revenue tickets and allocate availability of rewards more efficiently. Analysts at AltaCorp Capital highlighted this in a client note, stating that the change would "greatly improves" the airline's ability to manage revenues
3. Directly leverage the working capital benefits instead of seeing them realized by a third party.
4. Reduce the program’s relative operating costs by leveraging your existing marketing and operational investments instead of layering them on top of it all.
5. By having full control on the accumulation, redemption and FFF benefit value propositions, allow the airline design a stronger, better-aligned and personalized customer experience that better contributes to the joint entity’s profitability and customer lifetime value.

"The move may imply a gradual erosion of a significant cards portfolio for each (partner) bank over the next three years,” and "will touch off a new round of competition among the banks for credit card customers".

The full value creation of repatriation can only be fully realized in a vacuum of critical assumptions, namely:

1. The loyalty program (and its FS partners) in question does nothing and let’s the repatriation occur; it does not adopt a substitution strategy.
2. The mileage redemption options and volumes from the loyalty program continue to be directed to the airline and maintain a market share status quo
3. The value proposition of a new program under the airline is equally compelling and at a minimum customers’ reaction is neutral and they transfer seamlessly to the new program instead of transferring to other airline programs or other airlines under the original program
4. The repatriated program marketing costs can be managed down and don’t need to be significantly increased due to unforeseen competition

It is safe to assume that investors will not allow repatriation to occur in such a vacuum and that the aforementioned assumptions will be strongly challenged. As reported in the Globe and Mail, Cameron Doerksen, a stock analyst at National Bank of Canada, "called Air Canada’s move “hugely positive” for the airline, but said there will be associated startup costs and the risk that not all Aeroplan members will become customers of Air Canada’s new program".

Cameron Doerksen, a stock analyst at National Bank of Canada, "called Air Canada’s move “hugely positive” for the airline, but said there will be associated startup costs and the risk that not all Aeroplan members will become customers of Air Canada’s new program".

Given there are still 3 years to go; it will be quite the soap opera for the airline, the loyalty program, investors and customers alike.

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