The Points Guy
Inside the Business of Air Miles
“People are willing to pay anything for a free ticket.” — Apocryphal airline executive.
When it comes to frequent flyer points, I’m more of a saver. It’s daft: Points devalue over time like any currency and they don’t even pay interest. But the thrill of refreshing a balance that currently exceeds 2 million miles makes up for it. This holiday season I added to my haul, flying to Vietnam via Qatar while also spending liberally on my British Airways co-branded credit card. The allure of oneworld Gold status for life, which I am 85% of the way to securing, keeps me motivated. A retirement of free champagne, flat bed seats and exclusive lounge access awaits.
Frequent flyer programs are big business. Introduced by American Airlines in 1981, they were launched to bolster customer retention in an industry growing increasingly competitive following the US Airline Deregulation Act of 1978. “Using incentives was hardly new,” Bob Crandall, American Airlines’ CEO said later. Supermarkets were giving out S&H Green Stamps, buying customers’ loyalty with free toasters and vacuum cleaners. As long ago as 1793, a merchant in Sudbury, New Hampshire is recorded to have awarded copper tokens to his customers for them to redeem later for goods.
But airlines are almost uniquely positioned to maximize the economic features of loyalty schemes:
They cater to both business and leisure customers, exploiting the fuzzy space between them. Most of my miles were funded by my employer, yet they sit in my account long after I handed back my key pass. Could I have flown Delta rather than American on that work trip to New York? Perhaps, but those warm nuts…
They offer a perishable product. Planes take off whether they are full or not. By filling unsold seats with loyal customers, airlines turn distressed inventory into an asset, getting paid back via repeat business.
They offer a range of price tiers and service levels at similar marginal cost (the warm nuts retail at $8.60 a ramekin, a fraction of the price differential to attain them). Points-based upgrades can be offered to boost utilization in higher price tiers without significantly impairing pricing power.
More than a million people signed up for American Airlines’ frequent flyer program in its first three months of launch, and other airlines quickly followed. Within a few years, an estimated 75% of business travelers had joined at least one program.
Initially, the schemes allowed members to claim the occasional free flight (usually to Hawaii) in the course of their regular business travel. Then, in 1988, Delta introduced a Triple Mileage scheme which allowed travelers to clock up points at a turbo-charged rate. It led to a frequent-flying frenzy, as the industry’s first “points guys” emerged to play the game the programs spawned. Flying back and forth between two short-leg cities, a rewards ticket to Hawaii could be earned in just eight continuous hours of flying. “One of the most popular ones was Dallas to Austin,” an early points maven told the New York Times. “People would do that eight, nine, 10 times in a day.”1
At around the same time, another innovation opened up airline programs to a broader market than just frequent flyers. In 1987, American partnered with Citi to launch a co-branded credit card. Now, consumers could collect points simply by spending on their card, whether that was on American Airlines flights or not.
As a marketing strategy, it was genius. By offering rewards, card issuers provided card holders with an incentive to use their card. Meanwhile, the rewards themselves created loyalty towards the airline. Because the airline can adjust the redemption rate to encourage the use of rewards in ways that reduce their marginal cost, it is able to offer rewards to card issuers at a discount.2 In this way, reward programs can generate profits for both issuers and airlines while generating loyalty to both, a significant positive sum outcome. With points in the mix, airlines, consumers and banks all end up as winners: Airlines make money selling rewards; consumers enjoy the indulgence of free travel; banks recruit new customers and profit from more spend on their card.
Today, the largest programs have over 100 million members each. The three big ones – American’s AAdvantage, Delta’s SkyMiles and United’s MileagePlus – generated $15.6 billion of revenue in 2022, equivalent to 11% of their parent companies’ total revenue. Because it is typically a more stable income stream, loyalty revenue helps insulate airlines from fluctuations in the business cycle and can be used to secure cheaper funding. During the pandemic, all three used their programs as collateral to issue bonds at more favorable rates than the airlines themselves would have received.
The schemes anchor issuers’ credit card businesses, too. American’s co-branded card accounts for around 16% of Citi’s card loans, while the partnership American Express forged with Delta in 1996 makes up 14% of Amex card loans. “We’ve had record acquisition with…Delta in recent quarters,” said the Vice Chairman of American Express last year. “And I think there is a ton more that we can do together to create value and customer experiences… It unlocks a whole bunch of distribution reach that would be difficult to do without a really powerful partner.”
Points schemes are a business inside a business, sitting at the intersection of airlines and banks. To understand how they work, where points come from and where they go, read on…
A quick review of my British Airways Executive Club account reveals that around 70% of the points I was awarded over the past 12 months come from card spend; the rest from flights. That’s not too far off the average. The industry trade group representing US carriers estimates that 63% of total frequent flyer points earned in 2022 by consumers were generated through credit card use.3 They are a critical part of the overall landscape.
There are two ways points schemes generate money. When a scheme member buys a regular ticket, they are not just buying air travel on a scheduled flight, they are also buying mileage credit they can redeem in the future. Airlines allocate the ticket price between the air transportation and the mileage credits earned. Because customers don’t get the benefit of the mileage credit immediately, airlines defer it, recognising the revenue when points are redeemed and the transportation is provided.
At the end of September, American Airlines had $9.3 billion of deferred mileage credits on its balance sheet. Its points don’t expire as long as there is some account activity over a 24-month period, so that liability has a long shelf life. In the first nine months of 2023, the company issued $2.9 billion credits while recognizing $2.7 billion worth of redemptions.
Of course, not everyone is like me; most members like to spend their points quickly. The company estimates that $3.5 billion out of the $9.3 billion will be recognized over the next 12 months. At Delta, utilization is even more front-loaded. It estimates $3.9 billion out of its total liability of $8.4 billion will be recognized over the next 12 months.
Neither of these companies disclose the number of points they issue or redeem each year any longer (American Airlines stopped in 2016) but Avios Group, which operates my scheme, the British Airways Executive Club, as well as those run by Iberia, Aer Lingus and others, does. In 2022, it issued 105 billion Avios points, up from the pandemic years but still tracking below the 119 billion it issued in 2019. Over the past five years it has issued 444 billion points and redeemed 325 billion. At the end of 2022, it had £2.3 billion ($2.8 billion) deferred revenue sitting on its balance sheet.
The second way schemes earn money is through payments from card companies and other partners. There are various income streams here. Card companies purchase mileage credit, typically at a discount, to allocate to their cardholders; they pay for marketing services, allowing them to send promotional materials to the airlines’ lists of members; and they pay for ancillary services such as lounge access for some cardholders.
In my scheme, operator Avios Group has disclosed that 80% of billed revenue comes from external partners. To raise cash in the grip of the pandemic in 2020, it pre-sold a bunch of points to American Express for £750 million.
A key question in the whole points dynamic is how much partners pay for miles. Avios Group deferred revenue at a rate of 0.62 pence per point on the stock it issued in 2022. That’s down from 0.76 pence per point over the two years of the pandemic and 0.66 pence per point in the two years prior. The consumer value of points varies widely according to how they are used, but The Points Guy puts the value of Avios at around 1.2 pence per point, so the benefit to the consumer is clear.
In the US, Bask Bank, an online-only subsidiary of Texas Capital Bank, offers a novel savings account that pays interest in American Airlines AAdvantage miles rather than cash (2.5 miles for every $1 saved annually). For tax purposes, it discloses the value of the miles, which it pegs at 0.42 cents each. According to The Points Guy, their value to consumers is 1.5 cents each, so, again, the discount is apparent.
By minting points, airline companies are able to lock in substantial cash flows. American Airlines earned $5.9 billion in cash from mileage sales in 2019, the last full year before the pandemic (65% of which was from non-air partners). The value of redemption activity was only $2.6 billion and after other operating expenses of $130 million, that left $3.1 billion of operating cash flow, for a 53% cash margin. The company put the margin of the other two large programs at 41%.
But what about the credit card companies? American Express was estimated to have paid Delta over $6.5 billion in 2023, a payment that is expected to grow to $10 billion by the time the partnership contract is up for renewal in 2030.4 What kind of return does Amex get on that investment?
For Amex, Delta’s SkyMiles members represent a profitable customer segment. The firm currently has around 7.5 million people holding its co-branded card, representing 30% of SkyMiles’ active members. And they typically steer more of the spend to that card. According to Delta’s CEO, “co-brand spend on the American Express Card is approaching 1% of total US GDP.”
American Express pays for the rewards out of merchant fees. Over the past 12 months it has paid out $15.2 billion of rewards (in addition to what it pays over to Delta and other partners) but has earned $33.0 billion in so-called discount revenue and $58.9 billion in total revenue, once interest income and card and other fees are included.
The only problem is that competition has been driving up the rate at which card companies pay rewards. Over the last 12 months, American Express has paid out 1.07% of purchase volume in rewards, up from 0.80% ten years ago. Other card issuers have seen similar reward inflation. Capital One paid out 1.29% of purchase volume in 2022, up from 0.80% in 2013. And Discover paid out 1.43%, up from 0.94%.
For now, there is enough headroom in the merchant discount rate to absorb rewards inflation. What could cause the model to unravel, though, is a regulatory assault on merchant fees (interchange). One of the reasons points are much more prevalent in the US compared with other countries is that interchange rates are wide enough to sustain them. Not so in other countries:
In Australia, policymakers placed price controls on credit card interchange fees in 2003; in the eight years that followed, rewards fell from $0.81 to $0.54 per $100 spent.
And in the European Union, controls in 2015 capped credit card interchange fees at 0.30% (compared with ~2% in the US). Rewards mostly fell.
American Express was initially exempt from the EU rules, so my British Airways co-branded card remained unaffected. In 2018, though, the courts brought Amex into line. Fortunately, American Express agreed to eat the cost. My BA Premium Plus card continues to pay 1.5 Avios points for every £1 spent, equivalent to around 1.8% on the basis of The Points Guy’s 1.2 pence per Avios valuation. I guess I do pay £250 per year for the privilege, and Amex likely bought the points at a steep discount (in particular the batch they acquired in 2020 to help the airline out of a liquidity squeeze).
What it does show, though, is that there are clear subsidies at play. Someone, somewhere is subsidizing my points habit – no longer the merchant, it is now other BA or Amex customers. Indeed, such subsidies are the most controversial aspect to the model. A 2022 Federal Reserve paper estimates that in the US, credit card rewards induce an aggregate annual redistribution of $15.1 billion “from less to more educated, poorer to richer, and high to low minority areas.” Cardholders with superprime scores typically earn money with the use of reward cards while subprime and near-prime cardholders lose out.
In reality, though, there are subsidies hidden in any business as costs are distributed between the heavy users and the light. With so many stakeholders aligned in the points system – consumers, airlines, banks – it’s unlikely anything will change soon. And as long as there’s enough fuel in the tank to get me to Gold-for-life, I’ll retire happy.
One of the most famous mileage grabs was the LatinPass Run. “Start the millennium off right,” teased the marketing materials of the LatinPass scheme that served a group of Latin American airlines. “One Million Miles Bonus will be earned by any member who flies at least one international segment on each of the ten (10) LatinPass member airlines; flies at least three (3) partner segments on any of our partner airlines (KLM, US Airways, TWA); stays at least three (3) nights in at least any two of our partner hotels; and rents a car for at least five (5) days from any of our Car Rental partners. From January 1 – July 1, 2000.” The promotion was closed early in March 2000 after around 250 people earned the million-mile bonus at a cost of around $1,100 per person and a long weekend spent continuously in the air. One of them: “The Pudding Guy”.
American Airlines talks about the “cash displacement risk” of a customer paying for a flight with points. It “manages the cost of fulfilling these awards by leveraging member elasticity to steer reward demand to optimal flights based on cash displacement risk.” By integrating its points system with its inventory systems, the airline can vary award prices based on factors such as travel date, routing and time until departure. Thus, an unpopular 6am flight from Dallas-Fort Worth to Las Vegas may cost 10,000 miles, a 9am flight with higher displacement risk would cost 12,000 miles and a popular 5pm flight, where displacement risk is highest, would cost 18,000 miles.
This is consistent with data from Avios Group which manages the Avios reward currency used by British Airways, Iberia, Aer Lingus and Vueling. In 2022, the company issued 105 billion Avios, of which 65 billion (62%) was issued to non-air partners, the biggest being American Express.
In 2022, American Airlines received $4.5 billion in cash from co-branded credit card and other partners, principally Citi and Barclays, up from $3.4 billion in 2021.