Yves here. Hubert does his usual detailed job of explaining what it would take to “save” the US airlines and why the approach the US is using instead, of saving their investors, is fundamentally at odds with taking the required operational measures. But the part I find staggering is that anyone with an operating brain cell would buy the airlines’ effort to depict their frequent flyer programs as an asset separable from the airline proper that can be pledged as collateral.
And on top of that, the value of those frequent flyer perks has diminished in the eyes of their main market, business travelers. As the Financial Times pointed out:
Frequent flyers grounded by the growing number of corporate travel bans are unable to collect the number of loyalty points they would expect from premium airfares and hotel stays — not to mention linked points deals on the credit cards used to pay for these.
Access to different “tiers” of membership depends on how much money is spent within a set period, leading some airlines to reassure customers that they will not lose their coveted perks as a result of coronavirus disruption….
However, other US, European and British carriers such as Delta, Lufthansa and British Airways are yet to follow suit, which has angered some business customers who fear their membership to elite flying clubs that offer free upgrades and lounge access will expire in 2020.
Note that no US carrier was mentioned as making accommodations.
By Hubert Horan, who has 40 years of experience in the management and regulation of transportation companies (primarily airlines). Horan currently has no financial links with any airlines or other industry participants
The biggest issue in the airline industry at the moment is how the largest carriers can survive the coronavirus-induced catastrophic collapse in demand. As discussed in last month’s post[1] there is no apparent way for airlines to shrink their cost structure fast enough to avoid ruinous cash flow drains. The taxpayer subsidies provided in the US ($50 billion to date, through the CARES Act) and certain other countries appeared to be based on the false assumption that the industry’s liquidity problems were temporary and that revenue would largely recover by the year end.
All of the problems described in last month’s post have gotten worse. It is now obvious that a V-shaped recovery is not in the cards. The large post-Memorial Day spike in coronavirus dashed previous hopes that international travel could restart, and that domestic traffic would begin a steady rebound. Coronavirus has obliterated most of the corporate business travel that is the most important driver of airline revenue, and a large chunk of this revenue loss may be permanent.[2] Mass layoffs are expected at US carriers once CARES no-layoff rules expire in October.[3] Airlines outside the US have either begun filing for bankruptcy in countries that did not provide CARES-magnitude bailout money (Aeromexico, LATAM, Avianca), propose draconian staffing and service cuts (Air Canada), or partially renationalize their carriers.
Due to various combinations of bad luck and bad management, some airlines are much more vulnerable to short-term liquidity problems than others. Coronavirus has especially hurt the carriers (Delta and United in the US) with the greatest focus on international markets, while Southwest, an almost exclusively domestic carrier with strong service in leisure markets is relatively better positioned. United and (especially) American entered the crisis with the greatest debt and the fewest assets that could be used to raise cash. In recent years the large US carriers (again, especially American) had irresponsibly spent $50 billion on stock buybacks, leaving them vulnerable to recessions much smaller than the one they are currently facing.
What Are the Goals of Current Airline Bailout Efforts?
The moves required to rebalance longer-term capacity and revenue will be painful and enormously expensive. It is critical to understand the objectives of current efforts to “save” the industry, and how those efforts will distribute the pain and offsetting subsidies.
An enormous amount of economic activity depends on having the most economically sustainable airline service possible at the lowest possible prices. If Washington’s objective was to maximize the economy-wide benefits while minimizing the pain and costs, the process would focus on accelerating the needed restructuring and providing direct financial support to affected workers and airports. The restructuring would need to only operate the capacity that the reduced revenue base could support, ensure that industry resources were quickly reallocated to their most efficient uses, and that unsustainable capacity and assets were quickly shed. It would also need to maximize the future the industry competitiveness needed to drive ongoing innovation and efficiency improvements.
Instead, all of the actions taken and proposed so far are designed to protect the interests of capital accumulators. A simple one-time bailout of current owners might have been justified if there had been actual evidence that a V-shaped revenue recovery was likely. Even though the evidence is overwhelming that this hope is not materializing and that major restructuring is needed, Washington remains exclusively focused on the needs of capital.
Successful past approaches (bankruptcy, federally supervised industry restructuring) are off the table because they would give voice to consumer and broader economic interests and require equity and holders of current financial obligations to take substantial losses. Policies and legislation are based on the fantasy that the best way to solve this catastrophic demand collapse is to let “capital markets” act without restrictions or supervision. Capital markets have never solved an industry-wide crisis of this magnitude, and capital market participants have no incentive to maximize local service, employment levels or competition, or to share the pain of restructuring.
The short-term focus is on protecting current equity holders. If they can maintain control of these companies they could realize most (if not all) of the gains from an eventual profit recovery. But this requires misallocating tens of billions in taxpayer subsidies to funding prior debt obligations and aircraft commitments that are supporting unsustainable capacity. Washington has not made current owners make any of the major sacrifices that other governments imposed (at carriers including Lufthansa) in return for major bailout funding, or made them bear any of the costs of stock repurchases or any other recent management failures.
Despite these efforts, the crisis is likely to overwhelm some current equity holders and investments but there will still be a powerful political bias to favor capital over all other interests. Competition in the US industry has been massively reduced in the last 15 years and the especially lucrative international markets have been cartelized.[4] Airline profit improvements in the 21stCentury have overwhelmingly come from reducing competition in order to increase artificial power over prices, suppliers and labor, and these will undoubtedly be the primary way airline owners respond to the current crisis.
If one (or more) carriers collapses, the current relative balance between the four large US carriers would also collapse, allowing an overwhelmingly dominant carrier to emerge. Washington might search for a way to restore the vague appearance of competition, but investors would have little incentive to prop up structurally weak airlines unless given even greater power to collude and to limit service levels and wages.
Carriers Announce Major New Initiatives to Raise Cash in June
In the past two weeks United and American, the two US carriers with the greatest liquidity challenges, announced plans for major new borrowings. United wants to secure its final $4.5 billion CARES loan with aircraft, route rights, airport slots, while separately raising $5.0 billion from capital markets using its Mileage Plus frequent flyer program as collateral. If completed, United would have raised $20 billion in new funding since the crisis began, half via the federal CARES facilities. American announced plans for $3.5 billion in private funding ($2 billion in new shares and $2 billion in junk bonds with an 11.75% coupon) and a $4.7 billion CARES loan using its AAdvantage frequent flyer program as collateral.[5] American will have over $40 billion in debt when these announced transactions are finalized. Without new taxpayer guarantees (or dramatic coronavirus case declines), American and United seem to be very close to the limit of the money they can raise to plug their financial hemorrhaging.
Right now, it appears that the markets and Washington will provide the desired funding. US airline stock prices doubled in the three weeks after May 15thand rose 50% in the first week of June alone, even though traffic was 88% below 2019 levels. One explanation is that this is just the latest of many examples that capital markets have lost all ability to evaluate risk or corporate profit potential. Another explanation is that capital markets believe that Washington will continue to provide whatever funding is required to protect current airline equity and debt holders.
Investors with an unusually strong appetite for risk might want to take a flyer on paper issued by American and United, even though bankruptcy filings could seriously impair (or totally wipe out) their investment. Perhaps a vaccine will suddenly be found, or perhaps new legislation will authorize unlimited taxpayer funding to protect current airline owners. But the idea that pledging frequent flyer programs as collateral would materially reduce investment risk makes absolutely no sense.
United claims a standalone value of $21.9 billion (12X EBITDA) for Mileage Plus while American claims AAdvantage should be valued between $18-30 billion. [6] These claims are economically meaningless. Both programs generate “value” as an integral part of the airline, but neither has any standalone value. More importantly, if the airlines fail to meet the covenants of these loans, attempts by lenders to seize total control of the collateral (or its cash flows) would accelerate the parent airline’s collapse. United has restructured Mileage Plus around what it claims would be a “bankruptcy-remote intellectual property special purpose vehicle” but it is hard to imagine how these protections could survive an actual bankruptcy filing.
These airlines understand the economics of frequent flyer programs. In 2017 American CEO Doug Parker publicly rejected the idea that the frequent flyer program might be worth $30 billion or more as a standalone company. “…that’s greater than the value of the American Airlines in total as we sit here today…I find it odd that simply separating something that is inside the airline today and putting it into a separate entity with the exact same cash flows would somehow generate that much incremental value.”[7]
These airlines are only pledging their frequent flyer programs as collateral because they understand that they are facing an imminent existential threat. This desperation is also reflected in other recent moves such as the open acknowledgement that they will need to ignore health risks and fill every possible seat, their refusal to refund payments for cancelled flights, and new efforts to gut basic consumer protections.[8] If dumb investors perceive value that doesn’t really exist, these executives know they need to exploit those perceptions.
Frequent Flyer Credit Cards—More Valuable Than the Rest of the Airline Business?
Airline frequent flyer programs were one of the greatest marketing innovations of the 20thCentury. Airline seats were a commodity product when the mileage programs began in 1981, but they gave airlines new ability to establish brand loyalty among frequent business travelers. They also made huge profit contributions since the award tickets issued in those days had close to zero cost. Given 65% load factors most award travel filled otherwise empty seats, and high-volume frequent fliers ignored competitive options and often paid higher fares.
The economics of frequent flyer programs were further transformed once the major credit-card issuing banks developed airline affinity cards. The banks suddenly discovered a wealthy, high-spending customer base that would not only ignore competing cards but would pay high annual fees. The banks had tried dozens of customer incentives, but frequent flyer miles were the only one that drove higher fees, higher spend rates and strong loyalty.
Cards that were already lucrative for the banks (thanks to Visa/Mastercard’s enormous market power) now became a license to print money. The airlines developed a massive new revenue stream from charging the banks for the miles accumulated through non-airline purchases.
The economic power of frequent flyer credit cards became so great that one can argue that the airline industry had become a secondary appendage to this portion of the banking industry. Margins from these deals (earned mostly by the banks) were not disclosed publicly but they appeared to dwarf the returns the airlines had traditionally earned from transporting passengers and cargo.
When 70% of US airline capacity fell into bankruptcy starting in 2004, the reorganization process was effectively controlled by the credit card issuing banks. Since the cards were so profitable, they happily provided all the debtor-in-possession financing needed to sustain operations. Had the Courts and the bankrupt carriers obeyed the bankruptcy laws, these contracts would have been cancelled so that competitive bidding between banks would have produced new, more airline friendly contracts that would have maximized creditor recovery. Instead, the incumbent airline executives (who had driven their companies bankrupt) worked to protect the credit card deals that strongly favored the banks. In return the banks fought to ensure that the incumbent managers maintained full control and would personally profit from the bankruptcy.
In United’s case, JPMorgan Chase blocked all efforts by other creditors to challenge management’s control of the reorganization process, even though they could not produce a credible plan after four years. This allowed United CEO Glen Tilton to personally pocket $30 million. While in Chapter 11, American’s management similarly blew off its legal obligation to provide its creditors with financial information about its Citibank arrangements.[9]
Frequent Flyer Cards Had Become Vulnerable Before Coronavirus
The airline credit card business had matured prior to coronavirus, and while still extremely profitable, appeared to have begun declining. The market of people who accumulated large numbers of airline miles every year and were willing to pay $100 or more for a credit card that would allow them to earn award travel faster had been saturated years ago. Despite major effort, US banks have had little success expanding reward incentive cards beyond airlines and travel directly tied to airline trips (e.g. hotels).
More importantly, changes in ways that airlines managed revenue hugely reduced the value that frequent flyer credit cards originally offered. Airlines that could now fill 85-90% of their seats drastically reduced the seats available for award travel, especially to the destinations frequent flyers were most interested in such as Hawaii. That business class seat to Europe, which once required 50,000 miles, often now requires over 200,000 miles.
Airlines could devalue frequent flyer points at will; industry insiders sometimes compare these miles to Zimbabwean dollars. They could sell as many miles to the banks as they wanted, but they never had to provide comparable increases in award seat availability. Using standard industry rules-of-thumb for valuing miles, the (indirect) cost consumers pay for “free” award tickets is often higher than the price of buying a regular ticket, and “redemption fees” can make that tradeoff even worse.
Airlines also converted from straightforward mileage-based schemes to highly opaque systems based on ticket prices paid. This was entirely rational in terms of maximizing short-term airline revenue but it meant that holders of frequent flyer credit cards hoping to redeem miles for a trip had no way of knowing what it would take to collect the miles, or whether any seats would be available when they were ready to travel. Despite heavily promoting the value of their international frequent flyer partners, the actual availability of international partner award seats has been massively reduced.
Frequent flyer credit cards remain popular because the idea that frequent flyer miles are worth collecting has been ingrained into consumers for 40 years. They remained useful to the small percentage of “road warriors” who fly hundreds of thousands of miles year-in and year-out, but most casual travelers have been getting ripped-off for years.
Frequent Flyer Programs Do Not Have Any Independent Standalone Value
Somewhat perversely, the airlines worked strenuously to conceal evidence about their most profitable activity. The Wall Street analysts regularly demanded detailed data about the frequent flyer business, arguing it would convince investors to give airlines higher equity values. But until this month, the airlines treated this information as extraordinarily confidential, and there was no way to glean any useful insights from SEC filings. Some of this helped hide failures to negotiate better deals with the big banks. Some of the secrecy was demanded by the banks who wanted to limit public awareness of how incredibly lucrative these credit cards were.
To their credit, all of the US airlines and most airlines elsewhere understood that their frequent flyer programs were an integral part of their core business.[10] These programs provided critical customer data, were the most important driver of customer loyalty and were inseparable from their pricing and revenue management functions. These airlines understood that Wall Street’s demands for data was so they could pressure them to spin off frequent flyer programs into a separate company and capture big investment banking fees.
Air Canada succumbed to Wall Street demands to “unleash the shareholder value” in frequent flyer programs and raised $250 million when it spun off its Aeroplan program in 2002. The independent company failed to expand the business, but Air Canada needed to pay $450 million to buy it back in 2018 after realizing the folly of surrendering control of their most powerful marketing tool. Aeroplan’s actual 2018 valuation should also raise serious red flags about 2020 United and American valuation claims that are 45 to 65 times larger.
United’s 15 June “Mileage Plus Investor Presentation” [11] was the first major public disclosure of frequent flyer financial data and confirms both their historic strength and current vulnerability.
- Frequent flyers are only interested in travel rewards; 97% of United Mileage Plus mileage is redeemed on travel, and 80% is redeemed for travel on United
- Mileage Plus economics are largely artificial. United established an arbitrary internal transfer price that guarantees Mileage Plus a 20% margin on miles awarded directly by United.
- Price and the availability of rewards can be changed at will, thus historic Mileage Plus economics do not reflect the economics of a standalone business
- The big money (71% of all Mileage Plus revenue at a 50% margin) comes from the bank credit cards as the banks pay twice the rate United pays for mileage redemptions
- Mileage Plus (based on these arbitrary economics) accounts for 24% of United’s total EBITDAR however Mileage Plus EBITDAR has been flat since 2016
Coronavirus Will Likely Devastate Frequent Flyer Economics
Frequent Flyer economics depend on a small but powerful base of frequent business travelers, and the ability of banks to sell especially high-margin credit cards to travelers actively collecting miles. Business travel has been decimated by the virus, especially the international travel where miles are most easily accumulated. Airlines have radically reduced the capacity and network scope that allowed customers to concentrate their travel on a single airline. Airline prices will inevitably increase (perhaps quite steeply) which will force even relatively price-insensitive business travelers to reduce total travel and to increasingly forego mileage collecting itineraries in favor of lower priced alternatives.
The greater risk is that these marketplace changes force the broader credit card market to finally recognize that high-fee frequent flyer cards are a terrible value for most people. Even if travel demand somehow completely recovers the broader perception that it is worthwhile for most people on the plane to pay high prices and fees in order to maximize mileage collection miles might totally burst.
Why Would Anyone Think That Frequent Flyer Collateralized Investments Make Sense?
If airlines like United and American somehow survive the current crisis without facing major bankruptcy risk, then no one will have to address the quality of the collateral backing these loans. But it is hard to imagine how these frequent flyer programs could provide much value to lenders if covenants are violated or the airlines find themselves on the verge of bankruptcy. The collateral should be irrelevant to investors gambling that current owners get unlimited future bailout money. While lenders may have the nominal right to seize control of these programs if airline finances collapse, they could not survive as an independent business, and there are no other loyalty marketing companies that would be interested in buying them.[12]
The weaknesses of this collateral reflect serious problems with the core business that the frequent flyer programs support. Overall airline economics depend enormously on the very high yields and margins of corporate business and international travel, which will remain badly depressed even if domestic leisure travel begins to recover. The industry needs to reduce capacity to what the depressed revenue base can support, but no one is doing this. These borrowings reflect the dire straits these airlines are facing, but investors don’t seem to notice either the desperation, or how coronavirus has dramatically changed industry economics.
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[1] Hubert Horan: What Will it Take to Save the Airlines? Naked Capitalism 3 June 2020.
[2] The small recent traffic increases are attributed entirely to pent-up demand from individuals. In 2015 United CEO Scott Kirby (then President of American) pointed out that 87% of all US airline passengers flew only once a year and the other 13% provided 50% of all airline revenue. Dennis Schaal, American Airlines President on the Problem of the Infrequent Flyer, Skift, 23 Oct 2015.
[3] Mary Schlangenstein, American Air Says It Will Have 20,000 More Employees Than Needed, Bloomberg 2 July 2020. American has ample incentive to be understating its excess capacity problem at this point.
[4] The industry consolidation process is described in detail in my recent four part series at ProMarket (including “The Airline Industry’s Post-2004 Consolidation Reversed 30 Years of Successful Pro-Consumer Policies” and “How Alliances Carriers Established a Permanent Cartel” promarkethttps://promarket.org/category/reading-list/aviation/) and in “Double Marginalization and the Counter-Revolution Against Liberal Airline Competition”, Transportation Law Journal, v.37 n.1, Fall 2010.
[5] Claire Bushey, US airlines raise $10bn in a week, Financial Times 24 June 2020; Ben Goldstein, U.S. Carriers Seek $10B In New Financing This Week, Aviation Week, 23 June 2020
[6] AAdvantage valuation claimed by American CFO Derek Kerr at the 13th Annual Wolfe Research Global Transportation and Industrials Conference, 19 May 2020. Mileage Plus valuation claimed by United in an 8-K filing on 12 June 2020.
[7] Will Horton, AAdvantage Miles Will Soon Be Government Collateral as American Airlines Pledges Frequent Flyer Program for Coronavirus Loan, Forbes 20 May 2020
[8] Matt Stoller, The Plan to Make Post-Pandemic Flying Miserable, Big 16 June 2020
[9] the author worked on behalf of creditors in four US airline bankruptcy cases, including United and American, and helped Northwest, Swissair and Sabena prepare for bankruptcy filings.
[10] Doug Parker: “I’ve never really considered as a particularly good idea to spin out…” [AAdvantage] “is part and parcel of the airline and part of running the airline and part of inventory management.” Horton supra note 7 United’s Mileage Plus presentation (cited below in note 11) correctly states in multiple places that “Mileage Plus is critical to its core business” and is critical to customer loyalty and revenue maximization
[11] United’s presentation is available at https://ir.united.com/news-and-events/events-and-presentations. American has not yet published comparable data supporting the use of its AAdvantage program as collateral for a CARES Act loan.
[12] Hypothetically, the current credit card banks (JPMorgan Chase at United, Citibank at American) could step in to purchase these programs in a distress scenario. But this would likely be requiring transferring even more of the frequent flyer cash generation from the airline (and its other creditors) to the bank(s).
