Month: November 2005
What are Frequent Flyer Programs Really Worth?
The market certainly thinks so. When Air Canada exited bankruptcy it spun off its own loyalty program into a separate, publicly traded entity. Based on the price paid for a 12.5% stake in June 2005, Aeroplan has a market value of CAD$2 billion.
These programs have their own independent revenue streams. Airlines sell miles, and then buy seats redeemed with those miles (or merchandise, etc.) at a discount, earning money on the spread. The sale of miles alone currently generates US$3 billion in revenue annually.
According to the cover story of July’s Inside Flyer magazine, Air Canada isn’t the first airline to spin off its frequent flyer program, although it’s the first to become publicly traded. United spun off Mileage Plus into a wholly-owned subsidiary in 2002 in a $1.4 billion transaction.
In 2003, ULS accounted for 5 percent of UAL’s 2003 revenues. In 2004, United recognized more than $400 million in revenues related to ULS, which would not reflect the entire business revenue of ULS for that year. In 2000, revenue for third-party mileage sales reached $220 million during the first six months alone.
But American AAdvantage is clearly the king of frequent flyer programs, with annual revenue related to third-party sales of miles exceeding $1 billion annually.
United’s Mileage Plus program is estimated to be worth between $2.5 billion and $15 billion. (The $15 billion estimate is hugely flawed. It takes the per-member market value of the Air Canada Aeroplan program and multiplies that by the number of United Mileage Plus members. But US consumers participate in more frequent flyer programs than Canadian consumers do, so Mileage Plus occupies far less mindspace than Aeroplan.)
United’s bankruptcy is likely the reason that Mileage Plus has not yet been brought public. Air Canada was ready to spin off Aeroplan a couple of years back but put those plans on hold when it entered bankruptcy. The questionable status of the underlying airline would have been a drag on the value of its frequent flyer program. With United’s exit from bankruptcy I expect an IPO of Mileage Plus to follow (within two years).
While airlines lose money, their loyalty programs are engines of wealth creation that have yet to be fully exploited. I don’t have a fully formed method of valuing these operations, but I do expect the market to develop one.
A not unreasonable point is that these programs are tied directly to airlines with questionable futures. I’m not sure that matters for their viability as going concerns. A frequent flyer program redeeming miles for 5 – 10 million seats per year would be the single largest customer of any airline. It’s not unreasonable to believe that they could negotiate major discounts with another carrier or group of carriers, and continue to both sell miles and redeem them for flights at a profit. That will certainly take some business vision, but could go a long way in supporting market valuations in the billions.
Bohemians of times past
By February, Michelle realized she was pregnant. With Sartre, as with Boris, she became pregnant the very first time she slept with him. Sartre could not believe it at first. He had practiced his usual method of contraception, coitus interruptus, and thought it foolproof. "Of course, it wasn’t safe at all," says Michelle Vian. "Sartre would withdraw, and ten minutes later, he would make love again. We [TC: who?] didn’t know it back then, but it takes only a drop of semen…"
Were any of these sex lives any good? And does this help explain Sartre’s blindness toward Stalin? Was he simply pigheaded when it came to his perceived self-interest?
The quotation is from Hazel Rowley’s excellent Tete-a-Tete: Simone de Beauvoir and Jean-Paul Sartre.
Not Enough Togetherness
I’m teaching urban economics now for the first time. There is still a lot I don’t know, but it seems clear to me that there is one big overall market failure in urban economics, one that the textbooks don’t seem to make clear.
Land in populated areas is valuable mostly because other people live nearby; people with whom one can have social, job, and shopping relationships. While our neighbors often hurt us, their net (and marginal) effect is on average positive, and huge.
This externality, however, mainly comes from the people on nearby land, and not from their gardens. So when we consider how much land to use for our homes or offices, we do not consider the gains to others from our using less land, and so allowing more people to be nearby. We also neglect the benefits we provide others when choosing to live at the edge of the populated area, versus living in an unpopulated area.
These neglects suggest a big market failure, wherein housing and office density, and the size of the populated areas, are too small. It might perhaps be countered by a status externality, wherein people gained status by living closer to an urban center. But I doubt status effects fully compensate.
Local governments are in a position to reduce this externality, but they seem to mostly make matters worse. Minimum lot sizes, maximum building heights, maximum densities, and barriers to development at the populated edge are far more common than their opposites.
Now why don’t the urban economics textbooks make this point clear?
What Credit Card Should I Choose?
It’s free the first year and $30 thereafter, comes with a signup bonus of 6,000 points with your first purchase and up to 6,000 more for hotel stays, and offers points which can be used for hotel nights or converted 1:1 into most airline programs (it’s not a good option for accumulating United miles, since the ratio is 1:2 – BankOne, which provided a plurality of United’s debtor-in-possession financing, didn’t like competition from this card).
When you covert 20,000 points at a time into airline miles Starwood gives you 5,000 bonus miles — which means you’re really earning 1.25 miles per dollar on most every carrier, better earning than most airlines’ own co-branded offerings. The flexibility, though, is the best benefit. With, say, an American Airlines Mastercard you’re stuck with American Airlines miles. With the Starwood American Express you earn whatever miles you want and you don’t have to decide until later.
An example of the power of this card — spend $50,000 on the United Visa or American Mastercard, and you have enough miles for a coach ticket to Europe. Spend $50,000 on the Starwood American Express, and you can transfer those 50,000 points to Cathay Pacific in exchange for 60,000 Asia Miles which are enough for a business class ticket on British Airways from the East Coast of the U.S. to most destinations in Europe.
My own personal solution involves also carrying a Diners Club card and a Hilton American Express. This combination won’t work out as well for everyone, however.
The Diners Club card is now a Mastercard, so it’s accepted universally. I use the card with merchants that don’t take American Express. Their points program offers transfers into most airline and hotel programs. I can even launder United or American miles into other programs through this program (with some devaluation).
Since Diners Club became a Mastercard, it lost some of its unique features — such as two billing cycles to pay and a lower than usual foreign currency conversion charge. But it maintains its primary insurance coverage on rental cars (in many cases if you wreck a rental car paid for with this card your own insurance doesn’t need to know, in contrast most cards provide only secondary rental insurance), and since it’s a Mastercard it’s useful for airline and hotel promotions that require payments with that brand of card (such as Hyatt’s outstanding Faster Free Nights promo).
Downsides to the card are a charge for transferring points to airline miles (95 cents per 1000 miles) and a $90 annual fee. I rent cars enough to make this worthwhile.
I use the free Hilton American Express only for things where I earn bonus points (5 Hilton points per dollar instead of the standard 3). I use it at the grocery store and at restaurants and my cell phone bill is automatically charged to the card. I run no more than $1000 or $1500 a month on this card. If I ever run out of Gold status with Hilton, I’ll probably notch up the spending to reach $20,000 in a year which will requalify me for that level in the Hilton HHonors program.
One of the most important pieces of advice is to stay away from proprietary rewards programs, like the CapitalOne GoMiles card.
Proprietary miles programs have marketing appeal, offering "any seat on any airline" and tapping into the frustration that some feel trying to redeem their miles. But these programs turn the value proposition of miles on their head. Miles are most useful for tickets that would have been too expensive to purchase — international business or first class tickets, or even last minute cross-country flights (which aren’t as expensive as they used to be). Proprietary programs generally offer coach seats, which have to be purchased a few weeks in advance, and the amount of airfare that they’ll pay is usually capped.
Furthermore, proprietary miles can be earned only through credit card spending so it may be harder to earn enough points for a free ticket than it is with a traditional frequent flyer program. Airline and hotel points can be earned through a variety of partnerships, whether it’s telephone or internet or mortgage financing, let alone actually flying or spending the night somewhere.
Proprietary programs amount to a cash rebate card where you can only spend the rebate on specific travel offerings.
So What’s In Your Wallet? Comments are open.
The Oracle At Delphi Worked, When Independent
A student and a colleague of mine, Colleen Berndt and Larry Iannaccone, have an interesting paper on the Oracle at Delphi. It turns out that the Oracle’s prophecies tended to be pretty accurate:
The long journey some made to reach Delphi, combined with the long waits for a consultation, indicate a greater opportunity for information to make its way to the priests and pythias. In addition to the information circulated at the local watering holes, the priestesses were able to aggregate information gleaned from petitioner.
On political subjects, it was especially important for Delphi to be independent of political influence:
When Delphi gained its independence from the Phocians, it began to benefit greatly from a perception of fairness. Lack of control by any one state meant that Delphi could operate free from any political pressure.
Since the Oracle charged by the question, it was important to think carefully about the questions one asked. This is also good advice for those creating prediction markets today. The cost of creating a market is largely independent of the topic, while the value varies greatly by topic. So for the best cost-benefit, ask the biggest questions.
Why is social science so late to the science party?
Our ancestors thousands of years ago knew that if they really wanted to understand the heavens, they would have to sit down and carefully count some things. By a few centuries ago, such painstaking efforts had yielded an impressive understanding of dozens of other subjects. By the twentieth century, the virtues of counting to understand would seem to have long been established.
Ordinary people are far more interested in the social world around them than they are in most of the arcane topics to which counting was first applied. And yet, social science didn’t really start to count in ernest until the twentieth century. Why? Here are some possible theories:
- We thought we already understood the social world as well as we needed.
- Social science is just very hard – simple counting yields far fewer
useful insights than in other fields. So social counting had to wait
until we could do it on a massive scale. - The subject was taboo because we thought that a better social science would mainly just let some people take more advantage of others – there were few net benefits.
- We held strong opinions on social topics, but at some level knew many of them to be false. Social science was taboo for fear of confronting our self-deceptions about the social world.
I lean toward #4. Comments are open.
Markets in Everything
Organic cigarettes. Henry Sicignano, American Spirit’s vice president of marketing, explains his purpose succintly:
"Our company’s greatest challenge – also
our greatest opportunity – is to expose smokers to our chemical-free,
all-natural tobacco products…"
I also liked this classic bit of statistical illusion:
With a market share of less than 1 percent
of the total U.S. cigarette business, Santa Fe is undaunted by the
behemoths that are their competition. "Natural American Spirit
cigarettes are the fastest growing brand in the United States,"
Sicignano reports.
(Groups which are small are often the fastest growing, also the fastest declining.)
The Rise and Fall of Regional Jets.. and the disastrous dilemma facing Independence Air
Though they were touted as a customer favorite, the real value in regional jets was that these aircraft were bigger and flew farther than turboprops, so regional carriers could fly these planes on routes that major carriers used to fly. (While the planes were advertised as preferable to turboprops, in reality they replaced larger jets.) The major airlines could outsource flying to their lower cost regional affiliates.
Fifty-seat regional sets were at the heart of this revolution, because in general airline pilot contracts allowed the majors to pay smaller regional airlines to fly the planes. Anything larger and the majors would run into contract problems with their pilots union (since they’d be contracting out flying of aircraft close to the size that their own pilots flew, something often verboten under collective bargaining agreements).
Over 1000 of Bombardier’s 50 seat Canadair Regional Jets are now in operation, with 152 having been delivered in Bombardier’s fiscal year 2004. Now, though, they’re all out of orders and they’ve announced layoffs of 660 employees.
[S]ome analysts warned it could be a long time before the company books another order for a 50-seat RJ. “The market is glutted,” Canaccord Capital analyst Bob Fay said.
There’s several reasons for that. RJs, introduced by Bombardier in 1992, caught on primarily in the U.S., and by early this decade the market was getting saturated. Then, major carriers were hit by plunging traffic (after the Sept. 11, 2001 attacks) and growing competition from discount airlines. That pushed some into bankruptcy; more followed after fuel prices soared. With fewer passengers, cheaper tickets and higher costs, 50-seat RJs became less economical on some routes.
The industry-wide restructuring also forced unionized pilots to give up concessions, freeing airlines to add more large regional jets to their non-unionized feeder networks. They were previously limited to RJs with 50 seats or less, which weren’t always optimally-sized for some routes.
After predicting demand would gradually shift to larger RJs, Bombardier and rival Embraer had to throw out their earlier projections, as demand accelerated for the larger planes, and fell off for 50-seaters.
Airline bankruptcies have another financial consequence for Bombardier, a function of their aggressive sales agreements:
Some of Bombardier’s largest customers are expected to unleash dozens of 50-seaters onto the used market. That will whipsaw back at Bombardier: the company guarantees part of the resale value of its planes, and faces a maximum exposure of US$2.6-billion in the worst case scenario over the next 20 years or so.
Meanwhile, production of Bombardier’s turboprops (e.g. Dash-8s) – the very planes that regional jets were supposed to send to the dustbin of history – are on the rise. Offering fewer seats, they were less attractive to major airlines and their regional partners who sought to replace mainline flying.
But the world has turned upside down. Major airlines have brought down their labor costs, so the cost advantages to outsourcing flying are lower. Major carrier bankruptcies have meant renegotiating down pilot and pension costs. Meanwhile, the cost of fuel has risen markedly and turboprops are more fuel efficient. Those two factors have the pendulum swinging back towards the ‘old’ prop planes.
Fast forward and we have a window into a key driver of the financial disaster that is Washington Dulles-based low fare carrier Independence Air.
Independence Air is the airline formerly known as Atlantic Coast, a long-time regional affiliate of United Airlines. When United entered bankruptcy it sought to reduce its payments to United Express carriers. Atlantic Coast wouldn’t take lower fees, and threatened to go off on its own and start a new airline. Everyone, myself included, thought this was a bluff. It wasn’t.
The airline owned planes and leased its own gates at Dulles, where it was already the largest carrier. It didn’t have the luxury of starting slowly and building up markets. It had to fully utilize these assets on day one. Hence eight flights a day between DC and Lansing, Michigan. (At the time I thought they should at least split their fleet and operate half as a regional feeder for a major airline and only half as a startup low-fare carrier, allowing them to offer fewer flights at least until they built a customer base).
They had planes to fill, and while they advertised heavily in Washington, DC they didn’t want to pay fees to the computer reservation systems like Sabre and Galileo. If customers booked direct on the Southwest website, they’d book direct at flyi.com too! Only not too many customers in Lansing thought of doing so. Even when Independence had the lowest price, Orbitz or Expedia didn’t display it, and customers didn’t book it. $39 fares to Pittsburgh without any advance purchase or minimum stay requirements weren’t enough to fill planes.
Independence Air finally gave back aircraft and started paying for displays in CRS systems. But that only put the lie to their fundamental business model – which is that you can’t be a low cost carrier if you have high costs, and your costs won’t be low if you operate primarily a fleet of regional jets. (While a 50-seat regional jet costs less to fly than a 737, there are also a whole bunch fewer seats to amortize your fixed costs across.)
Only one carrier had tried the low-fare regional jet model before. Midway Airlines, in its second incarnation (when it no longer even flew to Chicago’s Midway airport), operated primarily RJs (along with some Fokkers and a single Airbus). It survived for awhile through its marketing partnership with American, essentially operating as a feeder carrier, since American had scaled back its once near-hub operations at Midway’s hub of Raleigh. When that partnership ended, so did Midway’s revenue stream. The airline shut down operations in the days after 9/11, but was given enough cash to make once last failed attempt when the government paid out cash subsidies to all commercial carriers post-9/11 based on prior year traffic.
Insiders tell me Independence would love to scrap their whole business model, get rid of all the regional jets, and go for an all-Airbus fleet. But when they entered the third quarter of 2005 with less cash than they lost in the second quarter, they had to give up several Airbus orders, raising cash by getting deposits back.
The future appears to be a convergence between mainline aircraft and regional jets, with the most successful RJs being larger than in the past. Here’s the latest move by United:
United Airlines is slowly rolling out its latest weapon in its battle to fight off low-cost carriers and win over business travelers: new 70-seat regional jets.
Unlike most small jets, these aircraft for short-haul flights of up to three hours on United Express have three seating sections — first class, “economy plus” and coach. In first class, the Embraer 170 twin-engine planes also have extra legroom (38 inches) and meals (a cold sandwich). Coach passengers get a soft drink and a snack.
Bombardier is a fairly diversified company, making smaller turboprops, larger regional jets, and even firefighting aircraft. But it’s not clear how in the world Independence Air can possibly survive…
How to make this year’s NBA season interesting
The standard fantasy is that Antoine Walker is better than his reputation, Jason Williams will fly straight, Shaq isn’t finished, and Miami will flourish. A more ridiculous fantasy involves Denver, a team with too many green or broken-down players. When it comes to Houston, Tracy McGrady and Yao Ming will fail coordinate their styles.
My fantasy is that Detroit is underrated. Hardly anyone is picking them and they are running only seven to eight percent in www.tradesports.com. Two years ago they won the title and last year they took the Spurs down to the wire. All their key pieces are in place, no one should be worse, and unlike all the other top teams, they do not appear to have potential chemistry problems. They are more offense-oriented than before, and the defensive influence of Larry Brown will linger for at least the rest of the year. Why not?
My second fantasy is that Larry Hughes (and not Lamar Odom) is the Scottie Pippen-in-waiting. LeBron James will continue his path to being the next Michael Jordan. Donyell Marshall will hold up and they will trade their stiff and slow center (don’t expect me to spell his name) for a dynamic front court player. Offer up your own NBA fantasy in the comments, if you wish…
The Next Pudding Guy?
The type of thing I usually write about on my frequent flyer blog is a deal like the one that came across in today’s MilesLink Newsletter: Airtran and Wendy’s have partnered to give away credits in the Airtran frequent flyer program when you buy drinks or combo meals.
You earn a quarter of a rewards credit for each combo, 20 or 32 ounce drink purchased at participating Wendys through December 31st.
An Airtran coupon will be printed on the cup. You can only buy five drinks per transaction, so you may need to go stand in line a few times or circle ’round the drivethrough driveway in order to really load up on coupons.
After you have consumed your beverage, carefully cut out the Proof of Purchase/AirTran Flight Coupon along the dotted line. Fill out a 3×5 card with your complete name, street address (no P.O. Boxes) and AirTran Airways A+ Rewards account number and mail in a handwritten business size (#10) envelope along with at least four (4) but no more than one hundred and twenty-eight (128) Proofs of Purchase/AirTran Flight Coupons per stamped envelope to Wendy’s/AirTran Airways Promotion, AirTran Airways Special Services, 1224 Bob Harmon Road, Savannah, GA 31408 to be received by 2/13/06. Extra postage may be required.
Since there’s a cap of 32 Airtran A+ Rewards credits (enough for two roundtrip coach tickets on Airtran, or if you prefer Airtran will buy you a single roundtrip ticket on another airline) you can’t become the next Pudding Guy (and you won’t get a movie made about your mileage exploits). Of course Pudding Guy gave his pudding away to charity and took a tax deduction. In all likelihood, you’ll just wind up eating this.
Frequent Flyer Miles as Currency, the Coming Devaluation, and What You Should Do About It
Even if mileage values held constant, I’d rather spend miles now instead of money to get my tickets… and invest the money I saved for retirement (or something else). Money earns a rate of return when properly invested. Airlines have never paid a return on miles held in an account.
But mileage values won’t hold constant. All we need to see that is a basic monetarist formulation, the very mv=pq that college freshman learn, without any other fancy tools.
If the quantity of airline award seats remains the same (because airlines aren’t growing capacity) or quantity is even going down (because airlines are selling the seats) while new miles are printed faster than they’re redeemed, prices rise.
Airline bankruptcies have sped up the rate at which awards are being redeemed. When loyalty program members are uncertain about the future of their points you get a run on awards — United and USAirways both experienced this when their frequent flyer members believed they needed to cash in their points while the airline was still around. Both lasted in the end, in USAirways’ case in spite of near-universal pundit predictions. But many frequent flyer program members didn’t wait — they wanted to travel for fear of winding up with nothing.
On the whole, though, 8% of airline seats go to award redemption (over time and across programs), and this has remained fairly stable. But while the quantity of award seats being redeemed stays fairly constant, the quantity of miles outstanding rises.
Unfortunately, additional award seats aren’t made available and consumers simply experience more miles chasing a fixed pie of seats.
That’s why prices of awards do and will rise.
But airlines, especially in financial jeopardy, are loathe to alienate their best customers (the ones most likely to be earning mileage) through price increases, so we see some selective increases and also award seat shortages. Instead of achieving a new equilibrium by raising prices, airlines frustrate customers in a different way, turning them away when they look for awards.
(By the way, the Capital One ‘mileage cards’ are about the worst credit card decision you could make outside of earning no reward at all, that will be the subject of another post in the next few days).
Here’s where I part company with the rest of the pundits: this inflationary future does not mean you should walk away from mileage programs. It just means that you should earn and burn miles in the same period to the extent you possibly can. Don’t save for retirement, spend your miles just as quickly as you earn them before prices rise.
As for me I do have a seven figure mileage balance but I also spent 675,000 miles on a single three week vacation this summer.
This advice won’t change until Alan Greenspan decides that for a retirement job he’ll become the head of Mileage Plus (and Paul Volcker takes over AAdvantage).
Airline ‘Outsourcing’
First off, thanks to Tyler for the generous introduction and to both Tyler and Alex for inviting me to guest blog. It’s a great honor, since I read Marginal Revolution each morning with my coffee. Hopefully I’ll have some interesting things to pass along, and I look forward to reader comments (gleff -at- yahoo.com).
Moving call centers to India is nothing new. On the whole, Americans seem to have a visceral distaste for it (though they may still opt for it if given the choice). So criticizing outsourcing, an effective rhetorical tool, has spread in its uses. In the battle between Northwest Airlines and its flight attendants, the Wall Street Journal uncritically picked up on the language. This Susan Carey piece (link is to a reprint of the Wall Street Journal article) offers a rather odd definition of outsourcing:
Those intra-Asia flights are mostly staffed by nearly 700 Asian attendants from bases in Japan, China, South Korea, the Philippines and other countries. They operate under different pay and work rules but have language skills for Asian destinations as well as English. The current union contract allows this limited but longstanding outsourcing.
(Emphasis mine.)
According to Susan Carey (and the PR voice of the Northwest flight attendants union), staffing planes flying within Asia with flight attendants from Asia is outsourcing.
Northwest has significant operations in Asia, and operates a mini-hub at Tokyo’s Narita airport. The airline was formerly known as Northwest Orient Airlines. They maintain local crew bases for their Asian flights for several reasons, only one of which is wages. The airline saves on per diem and hotel costs. But mostly American union members don’t possess the language skills that local residents do.
The practice isn’t unique to Northwest and stretches back decades. Pan Am had a contingent of flight attendants from Kenya 50 years ago. And it works both ways – non-U.S. carriers generally outsource their US government relations function to Americans….
Guest blogger Gary Leff
We have another guest blogger this week, namely Gary Leff. Gary is CFO at the Institute for Humane Studies and Mercatus Center. When it comes to aviation, luxury travel, and loyalty marketing, he is without peer. Inside Flyer magazine called him "one of five experts to listen to" on business travel. The Financial Times, San Francisco Chronicle, Washington Post, and The New York Times all have promoted his work. And he’s Senior Moderator at airline megasite Flyertalk.com.
Gary usually blogs at View from the Wing (http://blogs.flyertalk.com/blogs/viewwing/), which Gridskipper advises "true fanatics" to consult when seeking an airline upgrade. He tells me that until a short Sydney-Melbourne segment in June, he hadn’t flown coach in
over two years.
Why I am in Lockhart, Texas
Many of you have asked, here is the answer. My manuscript-in-progress on the economics of food will have a chapter on barbecue. Eating it three times a day, as I now must do, is not easy. Eating it no times a day, as is the case living in Fairfax, isn’t easy either.
The economics of textbook revision
…the economists Austan Goolsbee and Judith Chevalier, in a study of more than a thousand colleges, found that the year before a textbook is revised new-book sales drop sharply. That’s because a textbook in its final year is significantly less valuable, since you won’t be able to resell it. In other words, before nineteen-year-olds decide to buy a textbook, they consider not just the use they’ll get from it but also its current price, the probable future demand for it, and perhaps whether they can blow off the reading entirely. Funnily enough, they’re acting in what economists would call textbook fashion. And that serves as a check on publishers, who know that if they revise too frequently they could end up losing sales.
That is James Surowiecki, thanks to Chris F. Masse for the pointer.
By the way, Pizzatola’s, Shepherd and Rt.10, is superb Houston barbecue. "You look like you’ve never been here before," was the first thing they said to me.