AIRLINES: NOT SO FUNNY MONEY

The mania began in 1981, when American Airlines launched AAdvantage, the world's first mileage-based frequent-flyer program, to encourage customer loyalty. Today more than 130 airlines issue miles and 163 million people around the globe collect miles of some sort. Indeed, by some calculations the total stock of unredeemed miles was worth more than all the dollar bills in circulation. The record for the biggest individual account is 25 million miles, reputedly belonging to a publishing executive who charged his firm's postage bill to his own credit card.

The biggest collectors of miles today are not frequent flyers but frequent buyers. More than half of all miles are earned on the ground, notably on credit cards linked to airlines' programs or on telephone calls. Hotels, car-rental firms, retailers, real-estate agents and mortgage brokers all dole out miles. In America, if you pay by credit card you can earn miles for hospital surgery, income-tax payments and funerals. Some airlines even award miles to pets that fly with their owner.

On most airlines, one mile is earned for every mile flown. But what is a mile worth? Airlines sell them to credit card firms at a rate of between one and two cents a mile. Yet if you make the best use of your miles, such as flying business class across the Atlantic, the market value can be up to 10 cents per mile. In 2004, over 20 million free tickets were issued, and on a typical flight 7-8% of passengers were traveling on such tickets. You can also use miles for hotel rooms, car rental, holidays, restaurants, CDs and magazines, but these account for a small fraction of miles spent.

As with any form of “money”, frequent-flyer miles have bred crime, corruption and crafty scams. A Singapore Airlines employee in Australia was jailed for fraudulently awarding himself 17.6 million miles. In 2002, two German politicians were forced to resign when it was discovered that they had broken the rules by using miles earned on official trips for personal tickets. In America, by contrast, miles earned by federal employees can now be used for personal trips. But sadly one of the best scams to earn lots of miles ended in 2003, when the American Treasury stopped accepting credit cards for online bond purchases.

Frequent-flyer programs are no longer just a marketing gimmick; they have become a lucrative earner for airlines, through their sale of miles to partners, such as credit-card companies. When United Airlines filed for bankruptcy in 2002, it said that its frequent-flyer program was the only part of its business that was making money. The economics is certainly attractive. Charging partners for each mile earned on a credit card, say, by a member of a frequent-flyer program, brings in estimated annual revenue of more than $10 billion for the industry worldwide. Better still, the airlines get this revenue upfront, while the miles are not redeemed until well into the future—if ever.

Airlines have to include a contingent liability in their accounts, to cover the future cost of unredeemed miles, but they try to make this as small as possible. American airlines ignore all miles in individual accounts until they reach blocks of 25,000 miles (the minimum required for a domestic ticket). Then, for each 25,000-mile block of unredeemed miles, they enter a liability of only $20-25. They also assume, on average, that one third of miles will never be redeemed. Taking all this into account, in 2004 the 14 biggest American airlines posted a total liability of only $3.9 billion to allow for future frequent-flyer mileage redemptions, according to IdeaWorks, a consulting firm.

Just as passengers are addicted to earning miles, so airlines have become habituated to the profits from selling miles to partner firms. As a result, the stock of miles has soared. The snag is that the stock of seats available for awards is limited. With too many miles chasing too few seats, there are growing complaints from consumers who cannot book the flight they want, or have been forced to redeem twice as many miles to get a seat. Most American airlines have a two-tier system: a limited number of seats are on offer at the basic rate of 25,000 miles for a domestic ticket; but if you pay up to double this, you can buy any available seat. This is a form of devaluation.

It is one thing for frequent-flyer miles to be devalued, but what is the risk they might become worthless? Never before have so many airlines been in such trouble. And now the International Accounting Standards Board’s new rules on such programs threaten to wipe hundreds of millions of dollars off airline balance sheets. Qantas’s review of whether to spin off its frequent flyer division – which has 5 million members – and sell up to 40% to outside shareholders could be the first in a series of restructurings and sales to result from the IASB’s new rules, which came into force on Tuesday.

Traditionally, the liability of unused flyer miles was recorded on the airlines’ balance sheet at the (relatively low) marginal cost of a delighted regular customer sitting in an otherwise empty seat. But the IASB, seeking a more rigorous analysis of the opportunity cost of frequent flyer rewards, now wants the liability to be valued at “the amount for which the award credits could be sold separately”. At its most conservative, that means basing the value on the cost of a full price ticket.

The new regulations have their logic, no doubt. But their timing is awful, given that airlines are struggling for survival amid surging oil prices. When Qantas voluntarily adopted the new standards this year, it took a hit of A$508.4 million ($490 million) to its retained earnings. Spinning off its loyalty program could raise between A$2 billion and A$3.5 billion. Keeping control would make strategic sense as the Qantas brand is at stake. And acting quickly might produce a better price than waiting for other airlines to crowd the market and depress demand.

Run well, these can be embarrassingly successful standalone businesses. One danger is that the semi-independent reward program outshines the parent airline. Air Canada spun off its rewards program, Aeroplan, in 2002. It is now worth four times more than the airline itself. That would come in handy, but in the long run, airlines that sell off their loyalty programs risk killing the goose that lays the golden (or perhaps platinum?) eggs.