The Economics of Frequent Flyer Programs: How Airlines Monetize Loyalty
Last Updated : 09 Sep 2024
In the cutthroat world of commercial aviation, where profit margins are razor-thin, frequent flyer programs (FFPs) have become invaluable profit generators for airlines. What started as a simple loyalty scheme has evolved into a complex financial ecosystem spanning banks, credit card companies, and retailers. These programs generate billions of dollars for airlines, often surpassing the profits from core flight operations.
Frequent flyer programs are more than just customer retention tools — they are sophisticated financial assets that generate revenue by selling miles to partners, managing redemptions, and fostering customer loyalty. However, not all airlines have adopted this model, with low-cost carriers (LCCs) opting to keep their operations lean and avoiding the complexity of FFPs.
In this detailed exploration, we’ll examine how airlines monetize their frequent flyer programs, break down the unit economics behind frequent flyer miles, and dive into specific examples like Delta SkyMiles and United MileagePlus, whose valuation has sometimes exceeded the value of the airline itself. We’ll also take a closer look at why low-cost carriers often choose to avoid FFPs and the economics that underpin these decisions.
The Rise of Frequent Flyer Programs
The frequent flyer program (FFP) as we know it began in 1981, when American Airlines launched AAdvantage. Its goal was to encourage loyalty by rewarding frequent fliers with free flights and other perks. The concept proved so popular that other airlines quickly followed suit, and frequent flyer programs became a standard part of airline offerings by the 1990s.
However, it wasn’t long before airlines realized the full potential of these programs. What started as a way to boost loyalty evolved into an intricate ecosystem of partnerships, particularly with credit card companies and banks. By selling miles to financial institutions, airlines could generate substantial revenue without even flying passengers. Frequent flyer programs became financial assets with significant standalone value, sometimes even greater than the value of the airline itself.
Today, frequent flyer miles can be earned and redeemed for far more than flights — from hotel stays and car rentals to retail products and exclusive experiences. The evolution of frequent flyer programs has transformed them into multi-billion-dollar businesses that serve as key revenue streams for airlines.
How Airlines Monetize Frequent Flyer Programs
Airlines generate revenue from frequent flyer programs in several ways. While the specifics vary from airline to airline, the basic business model revolves around selling miles, leveraging partnerships, and managing redemption costs effectively. Let's dive into the economics behind these programs:
1. Selling Miles to Partners
The primary way airlines monetize their frequent flyer programs is by selling miles to partners, especially credit card companies and banks. Financial institutions purchase miles in bulk, offering them as rewards for customer spending. For example, when a customer signs up for a co-branded credit card, they receive bonus miles. As they continue to use the card, they earn more miles, which the bank purchases from the airline.
For airlines, selling miles is a highly lucrative business. According to a 2019 report by Skift, more than 60% of frequent flyer miles are now earned through non-flight activities, primarily through credit card spending. Airlines sell miles to credit card companies at a markup, generating significant profits.
To understand just how lucrative this is, Delta’s SkyMiles program generated nearly $3 billion from the sale of miles to partners like American Express in 2019. The relationship between Delta and Amex has proven so profitable that the companies signed a 10-year extension of their partnership, which runs through 2029. Similarly, American Airlines’ AAdvantage program brought in over $4 billion from partnerships with Citi and Barclays.
This is where unit economics play a significant role. The cost to the airline for creating a mile is typically less than 0.5 cents, while it can sell miles to partners for between 2 and 3 cents per mile. This high margin allows airlines to generate billions in revenue from selling miles alone. The value of frequent flyer miles isn't tied to actual flights; it’s a currency created by airlines that financial partners are willing to buy.
2. Co-Branded Credit Cards
Co-branded credit cards are a cornerstone of frequent flyer programs. They allow customers to earn miles for everyday purchases, not just for flights. Airlines benefit from these partnerships in several ways:
- 1
Interchange Fees: Every time a customer uses a co-branded credit card, the merchant pays an interchange fee, part of which goes to the airline. These fees can range from 1-3% of the transaction amount.
- 2
Sign-Up Bonuses: Banks often pay airlines a commission when a new customer signs up for a co-branded card. These commissions range from $50 to $200 per new cardholder, depending on the agreement.
- 3
Annual Fees: Most co-branded cards charge annual fees, which can range from $95 to over $450 for premium cards. A portion of these fees goes to the airline, adding another revenue stream.
For example, Delta's SkyMiles co-branded credit card partnership with American Express is highly lucrative. In fact, it was reported that 30% of Delta’s total revenue in 2019 came from its co-branded credit card relationship, amounting to $4 billion. American Airlines similarly relies heavily on its partnerships with Citi and Barclays, which contribute over 30% of the airline's revenue through its co-branded credit card offerings.
3. Mileage Redemptions and Redemption Management
While airlines make substantial profits from selling miles, they also have to manage the costs associated with mileage redemptions. However, this is another area where airlines have fine-tuned their unit economics to maximize profitability.
Airlines limit the number of seats available for award redemptions, particularly on high-demand routes or during peak travel seasons. This allows them to control their redemption costs and ensure that award flights don’t eat into revenue from paying passengers. Airlines can also adjust their award charts, periodically increasing the number of miles required for a flight (often called devaluations), which effectively reduces the value of miles without explicitly changing their price.
Many airlines now use dynamic pricing for redemptions, meaning that the number of miles required for a flight is tied to the cash price of the ticket. This allows airlines to extract more value during peak times, ensuring that they don’t lose out on revenue. For example, Delta and United have both shifted to dynamic pricing, allowing the cost of redemptions to vary based on demand.
Non-flight redemptions, such as for hotel stays or car rentals, are often less costly for airlines, making them a more profitable way for customers to redeem their miles. For instance, Singapore Airlines’ KrisFlyer program allows members to redeem miles for luxury hotels and exclusive experiences, driving additional revenue through partnerships with premium service providers.
4. Expiration of Miles
Although many frequent flyer programs have moved away from strict expiration policies, some miles still expire if an account remains inactive for a certain period. When miles expire without being redeemed, airlines enjoy a 100% profit margin, as they no longer need to provide any rewards for those miles.
According to The Points Guy, an estimated 10-20% of frequent flyer miles go unredeemed, either because they expire or because customers fail to use them. This results in millions of dollars in profit for airlines each year.
Valuing Frequent Flyer Programs: Delta SkyMiles and United MileagePlus
Frequent flyer programs have become so valuable that they often eclipse the value of the airline itself. This was especially evident during the COVID-19 pandemic, when airline stocks plummeted, but the value of their loyalty programs remained strong.
In 2020, Delta Air Lines revealed that its SkyMiles program was valued at $26 billion—more than the market capitalization of the airline itself at the time. Similarly, United Airlines’ MileagePlus program was valued at $22 billion, compared to the airline’s market cap of $10 billion during the same period.
This phenomenon highlights the disconnect between the core business of flying and the financial value of frequent flyer programs. Loyalty programs have become financial assets that generate steady revenue from non-flight activities, particularly credit card partnerships, even during periods of reduced flight operations.
The ability of these programs to generate consistent revenue through mileage sales and credit card partnerships allows airlines to weather economic downturns. During the pandemic, United Airlines used its MileagePlus program as collateral to raise $6.8 billion in financing, underscoring how valuable these programs are as standalone entities.
The Unit Economics of Frequent Flyer Miles
To truly understand the economics of frequent flyer programs, it's important to break down the unit economics behind miles:
1. Cost of Creating a Mile
For airlines, the cost of creating a frequent flyer mile is remarkably low, typically around 0.5 cents. Since miles are a form of currency that airlines generate themselves, the marginal cost of creating additional miles is minimal. The real cost comes when those miles are redeemed for flights or other rewards.
2. Revenue from Selling a Mile
Airlines typically sell miles to partners at rates between 2 and 3 cents per mile, resulting in a gross margin of 300-500%. This is one of the reasons why frequent flyer programs are so profitable—airlines can sell miles at a significant markup, while the cost of providing rewards is carefully controlled.
For example, if Delta sells a million SkyMiles to American Express at **2.5
cents per mile**, it generates $25,000 in revenue. Meanwhile, the cost of redeeming those miles might only be $5,000, resulting in a $20,000 profit.
3. Redemption Costs
When customers redeem miles, the cost to the airline varies depending on the type of redemption. For award flights, the cost is typically the opportunity cost of not selling that seat to a paying customer. If the seat would have otherwise gone unsold, the redemption cost is close to zero. If the flight is in high demand, however, the cost may be substantial.
Non-flight redemptions, such as hotel stays or merchandise, generally cost airlines less than award flights. Airlines negotiate bulk pricing with partners, allowing them to offer these rewards at a lower cost while still providing perceived value to the customer.
4. Breakage Rate
The breakage rate refers to the percentage of miles that are issued but never redeemed. Airlines benefit when customers fail to redeem their miles, as the cost of those miles is effectively zero. The breakage rate for most frequent flyer programs ranges from 10-20%, depending on the airline and its redemption policies.
High breakage rates can significantly boost the profitability of frequent flyer programs, as airlines collect revenue from selling miles without having to provide any rewards in return.
Why Low-Cost Carriers Avoid Frequent Flyer Programs
While frequent flyer programs have proven to be highly profitable for full-service airlines, low-cost carriers (LCCs) have largely opted out of this model. LCCs like Ryanair, easyJet, and SpiceJet focus on keeping costs low and maximizing efficiency, and they view frequent flyer programs as unnecessary complexity.
1. The Low-Cost Business Model
The business model of low-cost carriers revolves around high seat utilization, fast turnaround times, and ancillary revenue from services like baggage fees, seat selection, and in-flight purchases. LCCs prioritize simplicity and cost control, which allows them to offer ultra-low fares that attract price-sensitive travelers.
For LCCs, managing a frequent flyer program introduces administrative costs, including IT infrastructure, marketing, and customer service, which run counter to their low-cost ethos. Instead of building loyalty programs, LCCs focus on offering the lowest possible fares to drive customer retention.
Ryanair, Europe’s largest low-cost carrier, has explicitly avoided frequent flyer programs. CEO Michael O'Leary has consistently stated that Ryanair’s goal is to provide the lowest fares, not to build loyalty through complex reward schemes. In 2019, Ryanair generated 45% of its total revenue from ancillary services, highlighting the airline’s reliance on additional fees rather than loyalty programs.
2. Price Sensitivity of LCC Customers
The typical LCC customer is more price-sensitive than the average full-service airline passenger. Frequent flyer programs are designed to reward customer loyalty, but in the low-cost carrier market, price often trumps loyalty. A CAPA - Centre for Aviation study found that 75% of LCC customers prioritize price over other factors when booking flights.
In this context, introducing a frequent flyer program could backfire for LCCs, as customers may expect rewards that undermine the airline’s low-cost structure. Additionally, the lower average ticket prices of LCCs limit the potential revenue from selling miles to partners. Full-service airlines can sell miles to financial institutions at a premium because of their brand value, but LCCs often lack the cachet to command similar pricing.
The Role of Frequent Flyer Programs in Airline Profitability
Frequent flyer programs have become essential profit centers for full-service airlines, generating billions of dollars in revenue through the sale of miles, credit card partnerships, and carefully managed redemptions. Programs like Delta SkyMiles and United MileagePlus have become so valuable that their standalone valuations have exceeded the market capitalization of the airlines themselves. With unit economics that allow airlines to sell miles at a significant markup, frequent flyer programs provide a steady stream of income that is largely independent of flight operations.
However, frequent flyer programs are not a universal solution for all airlines. Low-cost carriers, which prioritize simplicity and efficiency, have largely opted out of the frequent flyer model. Instead, they focus on ancillary revenue and low fares to attract price-sensitive travelers. The economics of frequent flyer programs, while highly profitable for full-service airlines, do not align with the low-cost carrier business model.
As the airline industry continues to evolve, frequent flyer programs will remain a key tool for driving loyalty, generating revenue, and competing in an increasingly crowded market. However, their relevance will continue to vary based on the business model, customer base, and strategic goals of each airline.
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- Current Version
09 Sep 2024
Written By:
Mohak Nahta
Edited By:
Mohak Nahta