Frequent Flyer Miles, the Hidden Lynchpin of Airline Sector

Rising fuel and labor costs, together with surging competition from budget carriers, led many of the nation’s major airlines to cut their revenue guidance last month, sparking fears that this volatile market, once described by Warren Buffett as a “death trap for investors”, has once again lost its shine. Following several years of startling profit growth, driven in part by a series of megamergers that served to wipe out competition, investors have begun to question whether the sector’s share price rally has now run out of steam. (See also: Is the Airline Industry Becoming a Cartel?)

These fears have been compounded by dwindling revenue per available seat mile (RASM) figures. RASM, a key indicator used to gage how much revenues airlines make per seat, is carefully watched by investors to establish industry efficiency and profitability.  

Worryingly, of the nation’s four biggest airlines, only American Airlines (AAL) is guiding for an improvement in the amount of revenue it generates from each seat. Delta Airlines (DAL) forecasts no growth, while United Continental (UAL) and Southwest Airlines (LUV) both expect RASM to fall in the first quarter of 2017. (See also: What does the term 'revenue passenger mile' mean for an airline?)

These observations indicate that surging capacity, driven mainly by the rising popularity of low-cost carriers, is weakening the industry's pricing power. Many credit years of successfully restricting the number of available seats as the key reason why fares and profit margins across the major airlines remained high.

Morgan Stanley (MS) reacted to a recent wave of underwhelming forecasts by downgrading its view on the sector, adding that rising supply ought to see the amount of profit that airlines squeeze out of their services shift downwards. Judging by the performance of the U.S. Airlines index over the past month, investors appear to agree with this assessment.

Analysts at Stifel (SF) presented an altogether different view. Although mindful that increased capacity is far from ideal, the Missouri-based financial services company is confident that those issues can be easily offset by a revenue stream that the stock market has yet to fully recognize: the easy money airlines pull in from their frequent flier programs. (See also: How do frequent flier mile programs affect the profitability of an airline?)

According to analysts Joseph DeNardi and Matthew Rachal, these addictive programs, which are used by millions of wealthy Americans every year, provide a reliable source of income that is immune from the issues that have previously dogged the cyclical sector. Strikingly, they add that the business of selling miles has become so big that it now accounts for roughly half of airline profits.

“Airlines are earning upwards of 50 percent of [income] from selling miles to a credit card company,” Stifel analysts wrote in a note circulated to investors. “Airlines are selling miles to credit card companies for much more than they will cost the airline when those miles are redeemed — and they are doing it hundreds of billions of times a year.”

American Airlines currently offers the largest frequent flier program. What’s more, Stifel claims that the Texas-based company sells each mile to Citigroup (C) and Barclays (BCS) at roughly three times its cost at redemption. Based on these estimates, Stifel analysts believe that American Airlines’ AAdvantage program could generate about $2.7 billion in 2018.

American Airlines is not the only company set to prosper from this trend. According to reports highlighted by Bloomberg, Delta Airlines’ partnership with American Express (AXP) will generate $4 billion in revenue per year by 2021, while Alaska Air’s (ALK) contract with Bank of America (BAC) will soon account for $900 million in annual cash flow. Bank of America also has partnerships with low-cost carriers Spirit Airlines (SAVE) and Allegiant (ALGT), while United Continental and SouthWest sell air miles to JP Morgan Chase (JPM). (See also: Alaska Airlines Acquisition of Virgin America Close to Closing.)

The revelation that banks are forking our billions of dollars to affiliate themselves with airlines will come as welcome news to investors. Until now, the market was largely unaware of the lucrative scale of these partnerships, mainly because airlines have been burying financial details in their income statements to satisfy confidentiality clauses and stop competitors from finding out just how profitable their reward programs are.

“We know it exists. American Airlines knows it exists. But the vast majority of the investment community does not or, at this point, is skeptical that it does,” said Stifel. “We attribute this to a lack of information supplied by the companies for investors to properly assess the size and profitability of airline loyalty programs.”

Stifel reckons that this method of concealing frequent flier profits will change within the next 12 to 18 months. Once it does, share prices across the airline sector are expected to surge.

Other developments that could benefit the sector in the future include rising consumer prices, which make it easier for airlines to raise fares, and President Donald Trump’s proposed tax reform, which are likely to favor companies with domestic income bases and heavy capital investment​ commitments. (See also: Donald Trump's Tax Plan: Who Will Love It.)