Reinforcing the value of frequent flyer miles

How non-flight rewards drive mileage currency and frequent flyer program value.

Dominic HoferCEO Loylogic Inc.

August 2008

White Paper

Airline frequent flyer programs earn billions by selling miles to program partners, but invest little to make redemption options attractive to program members. As a result, miles currencies have become devalued and frequent flyers have started to re-direct their affiliations towards other loyalty programs. Airlines may soon miss out on billions of dollars.

It’s no news that the airline industry has accumulated a liability of more than twenty trillion frequent flyer miles (that’s 20,000,000,000,000). It’s also a fact that frequent flyers face difficulties redeeming their hard-earned miles for flight tickets.

What is new is that frequent flyers are moving their card spending to credit card and hotel programs, where they find value for their currency and loyalty. This trend may be devastat-ing at a time when leading airlines consider spinning-off their most valuable asset (i.e. their frequent flyer program) to fund airline growth.

If frequent flyer programs don’t invest in reinforcing the value of their miles, they face decreasing revenues from credit cards. The airline spin-off buzz will disappear as fast as it hit the industry last year.

The Theory:Rewards define the value of loyalty currencies

Amongst all success factors in a loyalty program, rewards are the most important market-ing tool available to loyalty managers. The core mechanism of any loyalty program is the process of consumer spending consolidation: putting their business with one company or program in return for a reward (and not to receive miles or points). The more attractive the reward, therefore, the more control program managers have over steering members towards a desired behavior.

The same theory applies to frequent flyer programs (FFPs). No matter how simple the program concept, how diverse the partner network, how advanced the consumer insight, how targeted the campaigns or how friendly the call center staff: if members can’t book their flight reward tickets or get an attractive reward alternative, then the mileage currency and the program itself become simply a waste of time and effort all round.

The Situation:The value of frequent flyer miles is declining

Over the last couple of months, a lot has been written about the availability of flight rewards and the declining value of frequent flyer miles. A number of facts underline the devaluation:

From 1981 to 2005, the number of miles issued grew 10 times faster (CAGR 42.4%) than airline capacity (CAGR ASK 4.4%). Over the same period, airline load factors increased 14%. Today, over 20 trillion miles are on frequent flyer accounts or USD 400 billion worth of airline tickets. In addition, most US airlines have already announced 2-4% capacity cuts for 2008 due to increased fuel costs.

Exhibit A:Global FFP Miles vs. Airline Capacity 1981-2005

Source: Aeroplan, WebFlyer.com, World Airline Traffic, ATA

“The reward is a crucial part of any loyalty programme.

It has to be desirable enough to change the behaviour of

the customer.”

(Robin Clark, The Loyalty Guide)

According to Aeroplan’s Global FFP Benchmarking Survey 2006, the average flight reward demand satisfied for FFPs with over 3 million members is around 45%.

According to Bain & Co., the value of 1 mile has decreased by 56% (USD 0.025 to 0.011) over the last 8 years due to declining mileage redemption rates, increasing miles required for a flight reward and declining overall ticket prices on reward routes.

In a survey performed by USA Today in April 2008, over 64% of frequent flyers said: “Frequent flyer miles are less valuable than 5 years ago.”

In an article published by the International Herald Tribune in April 2008, Jeff Robertson from Delta said: “We at Delta and as an industry cannot continue to have customers earn a significantly greater number of miles year after year without providing customers some flexibility in ways to use those miles.”

The Challenge:To keep the extremely profitable miles selling business going

About thirty years ago, FFPs were developed as a marketing tool for the airline. Over time, FFPs developed communication channels to millions of affluent consumers. By selling miles to program partners (e.g., credit card companies, hotels, retailers), FFPs have given marketers access to their frequent flyer community. Today, leading FFPs earn billions of dollars and have become their airlines’ most valuable asset.

However, the decreasing miles value puts the very profitable miles-selling business at risk. Why should frequent flyers keep earning miles on program partners if they don’t get relevant rewards?

Leading hotel and credit card loyalty programs have identified the opportunity and give their members better value for miles. Hotel programs, for example, let members book any available hotel room with points. Credit card programs started to cooperate with lead-ing travel web sites to offer flexible travel options without blackout dates. As a result, in a recent survey, 18% of frequent flyers indicated that they had switched from an airline co-branded credit card to a stand-alone credit card program and 42% responded that they are thinking about doing so.

Exhibit B: Frequent flyers are ready to switch card spending

Have you ever thought of switching from your co-branded airline credit card to a credit card program?

Already done that

Thinking about it

Not an option

40%

18%

42%

Source: Loylogic Freddie Award Survey, 2008

In a recent report published by Oliver Wyman, the New York-based consultancy clearly stated its view on the future of FFPs: “With credit card companies increasing more earn and burn options, customers are learning to bypass the traditional airline loyalty program, putting the viability of this model in question.”The facts are on the table, but the airlines miss out on the action. Why is this? First of all, they lack the cash to invest into more flexible reward solutions. Second, they clearly don’t feel the need to change (yet). As Jeff Robertson from Delta said, the FFPs still grow the miles selling business every year. In addition, not many airline CFOs are willing to dedicate time to challenge the one growing and profitable business they have in their portfolio.

Nevertheless, the above mentioned facts prove that the miles selling business is not where it could be. The real challenge is to stop losing share in frequent flyers’ credit card spending to the more attractive hotel and credit card programs.

“Every dollar a program spends on members that

are not redeeming is wasted money.”

(Kelly Hlavinka, Colloquy)

At this point in time, the hot discussion topic is about the first signs of slowing growth - very soon, we might be writing articles about decreasing miles sales of airline FFPs to program partners. When this happens, airlines will have to deal with a far greater impact on their business: They will lose the chance to sell their FFPs to investors. The FFP spin-off case is primarily based on two value drivers: member growth and miles sales growth. With a decreasing miles-selling business, one of these drivers will be gone and with it the high valuation of the FFP – the only reason why airlines might consider spinning-off their super asset.

The Solution:Airlines need to offer attractive non-flight rewards

It’s a marketing truism that every challenge is an opportunity for differentiation and future growth; the observation rings as true as ever in this case. To reinforce the value of frequent flyer miles, FFPs have two areas they can focus on; flight rewards or non-flight rewards.

1) Flight Rewards: Increasing the number of flight rewards remains a difficult task. Airline load factors are high and most airlines are expected to cut capacity even further in 2008. This means that offering more reward seats on an airplane will heavily impact airline displacement cost (i.e., revenue lost when a reward traveler preempts a paid ticket holder). It goes without saying that airlines should do whatever they can to increase the number of reward seats. How-ever, this approach will not substantially decrease frequent flyer reward demand. Rather than offering more reward seats, airlines could increase the overall seat capacity. In theory, the airline could pool the commercial with the reward demand and adjust capacity accord-ingly. Considering the fact that 20 trillion miles equate to a capacity of 1.04 million filled A340-300s, and that the airline business comes at 70% fixed cost, no airline will follow this approach. In a spin-off constellation, however, where the FFP purchases reward seats from the airline, such capacity increase could develop over time.

2) Non-Flight Rewards:The only smart option for airlines to reinforce the value of frequent flyer miles is to offer at-tractive non-flight rewards. Non-flight rewards provide the following advantages over flight rewards:

• FFPs can define the cost per mile redeemed• They are easy to integrate, manage and scale• They are attractive for any member profile• They come at low or no fixed costs• They free demand on flight rewards• They drive program member growth• FFPs can steer redemptions to recognise deferred revenues (IFRIC 13)

While there is no doubt that flight rewards are the number one reward option, 16% of frequent flyers prefer non-flight rewards and 35% consider them as a valid alternative to flight rewards.

Exhibit C: Non-flight rewards are an important alternative

How important are non-flight rewards for you?

More important than flight rewards

An alternative to flight rewards

A nice to have

Not important

36%

13%

35%

16%

Source: Loylogic Freddie Award Survey, 2008

“Over 64% think frequent flyer miles are less valuable

than 5 years ago”

This is not surprising as ‘Mileage Millionaires’ who travel most of their time might see more value in a bike for their kid or a new suitcase than in another flight. And FFP members who do not earn enough miles for a free flight might get the required ‘motivator’ to stay in the program and continue to collect miles with program partners.

The Success Factors:Recipe for a great reward experience

Today, only few FFPs offer a full blown non-flight reward web shop, where frequent flyers can redeem miles for a wide variety of merchandise and experiences. The following fac-tors guarantee a great reward experience for the frequent flyer and success for the FFP manager:

1) Reward Value:52% of frequent flyers favor ‘value’ over ‘selection’ and ‘top brands’ when redeeming for non-flight rewards.

Exhibit D: Frequent flyers seek value from non-flight rewards

What is most important to you in non-flight rewards?

Top brands

Huge selection

Great value

52%

19%

29%

Source: Loylogic Freddie Award Survey, 2008

Therefore, reward prices should be benchmarked with those of key competitors. A comparison from August 2008 shows that the Apple iPod nano 160GB can be redeemed for 115,400 miles (Emirates Skywards), 51,000 miles (Aeroplan) or 41,294 miles (Etihad Guest). Prices often vary according to the business model selected between the FFP and the reward solution provider or incentive house. In some cases FFP managers finance the reward solution through a ‘kickback’ from products sold on the reward shop. Such models lead to higher reward prices for the member and do not consistently reinforce the value of miles for non-flight rewards.

Exhibit E: Non-flight reward prices vary over 100%

Source: Loylogic desk research, May 2008

Another option to add value to non-flight (and flight) rewards is to offer miles-plus-cash reward payment. 94% of frequent flyers state that they “would really like” a flexible pay-ment option.

Exhibit F: Miles-plus-cash reward payment is a must

How would fully flexible miles-plus-cash reward payment increase the value of your FFP miles?

Would change my world

I would really like it

Not at all68%

6%

26%

Source: Loylogic Freddie Award Survey, 2008

Such an option may lead to a decline in miles breakage rates (i.e., miles expired), but is compensated by a more active program member base which leads to increased revenues from flight tickets and miles sold.

2) Reward Mix:Reward Mix: Non-flight rewards give FFP managers the chance to make their programs relevant to each and every member profile in their database. Many members seek free travel for the family holiday in Hawaii, but others prefer to spend their miles on the simple toaster, the once-in-a-lifetime Formula 1 experience, the latest Gucci handbag or a car-diac health check or, alternatively, find satisfaction in donating the fruits of their loyalty to charity. Everything that can be bought with cash should be available against miles. The broader the non-flight reward offering, the bigger the chance that every member finds the one reward that motivates him/her to stay loyal to the airline and its program partners.

3) Reward Access:As already mentioned, some FFPs offer non-flight rewards. To find the offering, however, frequent flyers often need to login and sometimes register with other platforms and web shops or browse through many different reward categories to find paradise. That’s defi-nitely not a fun shopping experience. If an FFP invests in reinforcing the value of its miles, it must make sure the extensive reward offering gets promoted and found. In an ideal sce-nario, members find one ‘reward’ tab where miles can be easily redeemed against flight as well as non-flight rewards.

In addition, FFP managers should opt for latest reward technologies that provide strong personalization capabilities; based on member country, miles balance, tier-level, age, gender or past reward shopping behavior.

4) Reward Thrill:Miles are not more than a little something for a frequent flyer’s loyalty. If suddenly those miles can provide some thrill, some adrenaline-rush then they actually become a currency which makes it possible to enter a world of excitement. Therefore leading reward shops feature not only buying, exchange and donation options, but also auctions, raffles and gambling possibilities for redeeming miles.

The Business Case:Where there is a case there is a budget

The airline CFO will definitely challenge any FFP managers’ initiative to set up or expand a non-flight reward shop. The CFO fears the cash out as well as a lower breakage rates. However, he/she will understand that the FFP manager is asking for an investment into a very profitable business (i.e., the most valuable in the airlines’ books). An investment into reinforcing the miles value will transfer into more flights sold to frequent flyers as well as more miles sold to program partners at better rates.

1) Non-Flight Reward Case:The following chart is based on a ‘Current Case’, simulating FFP profits without offering non-flight rewards and slightly decreasing revenues from the miles selling business:

Exhibit G: Non-flight rewards ‘Current Case’ (illustrative)

‘Current Case’: Without non-flight rewards and decreasing co-brand credit card miles sales (illustrative)

Source: Loylogic, 2008

The chart illustrates that the FFP has no cost for offering non-flight rewards but faces lower miles sales and lower profits compared to the previous year.

The second chart is based on an ‘Opportunity Case’, simulating FFP profits after imple-menting a non-flight reward web shop, resulting in an increase of miles sold to program partners:

Exhibit H: Non-flight rewards ‘Opportunity Case’ (illustrative)

‘Opportunity’ Case: With non-flight rewards and growing co-brand credit card miles sales (illustrative)

Source: Loylogic, 2008

This chart adds the cost for offering non-flight rewards with the benefit of generating higher growth on the miles selling side. FFP profits that are lower in Year 1, compared to the ‘Current’ case, are substantially higher in Year 2. The red box compares both cases in terms of profits after Year 2 and indicates the opportunity the FFP is missing. NOTE: The ‘Opportunity’ case only applies a FFP view, i.e., additional revenues from flight tickets sold due to a more valuable miles currency are NOT included.

2) Non-Flight Reward Budget:Many FFP managers are sold on the idea of non-flight rewards. What they lack is a budget for buying the iPods, suitcases, toasters, experiences and other rewards. Here are two ideas on how to finance a non-flight reward solution:

Airline/FFP: Airlines calculate a cost per mile redeemed for a free flight. This miles liability cost is typically based on the variable cost (i.e., the cash-out) attributed to such free flight. The figure varies from airline to airline but typically is between USD 0.002 and USD 0.008 (NOTE: The new accounting standard IFRIC 13 pursues a different method for calculating miles liability prices). If CFOs believe in the accuracy of this figure they have no downside in attributing the same cost per mile to non-flight reward redemptions. The airline’s costs will look the same, since the costs for non-flight rewards are compensated by saved displacement, fuel, food or other expenses associated with a flight reward. The only additional task for airline CFOs to solve is to collect money from those departments that account for flight reward costs (i.e., charge their budgets). Credit Card Partner: Credit cards earn a lot of money from their FFP co-branded credit card portfolios and are, next to the FFP, the key beneficiary from a stronger mile currency. They might consider financing the reward solution on behalf of the FFP (i.e., do the up-front investment) deducting the number of miles burned on behalf of the FFP from the number of miles they buy from the FFP. The model becomes particularly attractive for the card-issuing bank, and most probably also for the FFP, when the non-flight reward solution is only available to FFP co-brand cardholders.

The Conclusion:Attractive ‘Non-flight rewards’ are FFPs future growth driver

Non-flight rewards effectively reinforce the value of frequent flyer miles. The following reasons help FFP managers argue for developing non-flight reward solutions: Aeroplan, Miles & More, Etihad Guest and a few other FFPs have successfully implemented non-flight reward solutions. Today, they lead the industry in terms of member and partner growth, profitability, and program attractiveness and innovation.

• Rewards define the value of loyalty currencies• Frequent flyer mile currencies are losing value• Credit card and hotel programs gain momentum• Non-flight rewards are a smart way of reinforcing miles value• Airline CFO’s can choose among two options: Accept the non-flight rewards cash-out

(at same cost) or accept decreasing FFP profits; The financing options are at hand

Contact Dominic Hofer directly at dominic.hofer@loylogic.com

More Information:Loylogic Inc.Freihofstrasse 22CH-8700 Kuesnacht/ZurichPhone: +41 (0)43 500 51 55Fax: +41 (0)43 500 51 56Email: press@loylogic.com

About Loylogic:Loylogic is a leading reward solutions provider, helping clients worldwide to differentiate their loyalty programs by combining loyalty expertise with state-of-the-art technology and a fast-growing reward merchant network. The company’s aim is stated as: Making Miles & Points More Valuable than Money™. Loylogic Inc. was founded in 2005 and is a global, independent company with headquarters in Zurich, Switzerland and an office in Dubai, United Arab Emirates. For more information, visit www.loylogic.com.

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