Frequent Fliers: Will Plans Bump Airline Profits?

Anthony M. Tedeschi, a Roslyn, N.Y., free-lance writer, travels quite a bit and has accumulated more than 100,000 miles on the OnePass frequent-flier program of Eastern Airlines and Continental Airlines. But he has used none of it yet, hoping to earn enough credits so that he and his wife can take a free first-class trip to Europe.

“It’s like putting away a little nest egg,” he said. “It’s like cash. You put it in the bank and you watch it grow. You don’t want to take any of it out. The more you pile up, the better the reward.”

Like Tedeschi, many travelers have hoarded their mileage. Some have been doing it, in fact, since the frequent-flier programs began about seven years ago. And that makes airline executives shudder.

Frequent fliers join programs through which they earn free flights, upgrades in class or other premiums for specified numbers of paid miles flown. And every day, the airlines’ liability for unredeemed mileage grows. If there is ever a run on the “bank,” it could spell big trouble for the carriers, which might have to turn paying passengers away in order to accommodate their frequent fliers cashing in travel awards.

As if such mileage were not being doled out fast enough already, Delta Airlines, in a bid to lure traffic, recently began to offer three times the normal bonus mileage to members of its frequent-flier program. Overnight, all of its competitors had to follow suit.

Adding to the rush, the move came at time when the carriers had already reinstituted low discount fares--first offered last year--that encourage people to fly even more than they normally would.

So now it is even easier for Tedeschi and other frequent-flier “players,” as the airlines call them, to increase their “savings.” Under terms of most airlines’ current offers, the players have until March 31 to make one paid round-trip flight (or two one-way trips) to earn the triple-mileage credit. And if they do so, they will earn such triple mileage for all flights they take during 1988.

On top of that, many of the carriers have expanded their programs to allow free mileage to be accrued by holders of certain credit cards. Members are allowed to charge anything from dinners to fur coats on the cards, with each dollar spent earning the frequent flier a bonus mile.

Some people who usually do not buy on credit nevertheless filter all of their purchases through their credit cards. They pay their bills immediately and still accrue the added frequent-flier mileage.

The triple-bonus programs pose the danger that thousands of passengers will suddenly become eligible for free travel awards and will begin to use them.

It is estimated that only about 3% of all passenger tickets are “bought” with redeemed mileage at present. But Helane Becker, airline analyst with the investment firm of Shearson Lehman Hutton Inc., predicts that the rate could soar to 9% or even 15% this summer, a peak travel period when it will hurt the airlines most.

“Frequent fliers don’t really know what they want,” said Michael A. Ribero, Eastern’s vice president of marketing services, who runs the OnePass program. “When they reach a threshold, they target the next threshold. The ultimate threshold is a trip around the world for two.”

When the airlines’ unredeemed liability climbed in the past, they had simple solutions: increasing the amount of mileage needed to buy free trips or greatly limiting the number of seats available to frequent-flier program members. But some lawsuits and a set of guidelines issued last December by the National Assn. of Attorneys General greatly limited such actions.

The airlines consequently rolled back their boosts in requirements for some awards and also gave players a grace period after the announcement of an award level change so that they can have time to accumulate enough mileage for a particular trip they had been planning.

Nationwide, there are about 30 million members of the various frequent-flier programs. But since many belong to more than one program, the number of people involved is only about 8 million. Of these, about 2.7 million have accumulated enough mileage to be eligible for free travel, upgrades or some kind of discount fares.

And they have accumulated enough, according to Julius Maldutis, airline analyst with the New York brokerage of Salomon Bros., to represent total lost sales of about $300 million for all of the carriers. The new triple-mileage program, he calculated, will boost this potential for lost sales by about $940 million. Thus, the potential total for all U.S. airlines is $1.24 billion.

While there are concerns about what an avalanche of redemptions could do to the airlines, the carriers say the programs still generate more revenue than they cost. Indeed, they consider the programs the best marketing tool the airlines have ever had.

But accountants are beginning to rethink the ways that airlines enter the frequent-flier mileage on their books. One accounting regulatory group has suggested that $1 of every $10 worth of travel earned should be shown as a liability for future redemption of free travel.

The added cost of the industry’s triple-mileage programs alone will total $150 million annually, according to David G. Sylvester, airline analyst with the New York financial firm of Kidder, Peabody & Co.--equal to 15% of the industry’s net income in 1987.

Most of the impact of the triple-mileage bonuses will not be felt by the airlines until next year, when the vastly expanded free travel earned in 1988 is likely to be used. Sylvester figures that the cost of triple mileage is likely to keep the airlines’ profits down during the next 18 months.

So what may be a good deal for Tedeschi could mean big problems for the airlines, worsening a situation--the huge unused backlog of frequent flier bonus mileage--that has already grown to dangerous proportions.

And although the carriers so far have been able to accommodate most frequent fliers, financial danger looms. For one thing, the triple mileage deals will add significant cost to the programs. It is estimated that the cost of a free trip averages $60, divided equally between lost potential revenue and direct costs, such as food, ticketing and baggage-handling.

In addition, as time goes on and more mileage is accrued, more of the revenue derived from paid discretionary travel will be lost as frequent fliers use their accumulated rewards.

“One day, the piper will have to be paid,” said Morton S. Beyer, chairman and president of Avmark, an aviation management and marketing service based in Arlington, Va. “And airlines will rue the decision to start down the yellow brick road of frequent flier-ism to Never-Never Land.”

A. B. Magary, executive vice president of marketing for Northwest Airlines, complained that the new promotions are “definitely going to result in too many travel awards being issued.” He added that the new mileage bonus programs will result in at least 50% more free tickets being issued over the next 16 months than Northwest had originally anticipated.

Since every free ticket results in what he says is “a zero yield for Northwest, it will lower our average yield.” (The “yield” is the average amount of revenue received for carrying one passenger one mile, expressed in cents.)

Hard to Find Details

Delta’s Matt Guilfoyle, director of consumer marketing, said as the “accrual of mileage is faster and the redemption is slower, it becomes self-defeating (for the airlines). . . . Are we there yet? If not, I would say we are homing in on it.”

Specific figures are difficult to come by. The airlines do not like to talk about their frequent-flier liabilities, saying that their reticence is for competitive reasons. It is also probably because they are more overextended than they want the public to know.

But there are some clues. Delta’s Frequent Flyer program alone is a good example of the impact of such programs. Delta gives away an average of 1,200 travel awards daily. Of that total, about 400, are actual free tickets. The rest are upgrades or “companion ticket” discounts.

A few more hints came from a case brought to trial two years ago when several of the airlines sued a coupon broker who was selling frequent-flier mileage.

According to Harold E. Shenton, director of market analysis for Avmark, American Airlines said in court in 1986 that as of March of that year members of its frequent-flier program had flown 44.3 billion miles on paid trips to earn awards.

On the average, frequent fliers receive one mile in awards for every five miles they have paid to fly. That means that American in 1986 was liable for about 9 billion passenger miles worth of frequent-flier premiums, including low-level awards that pay off in discounts or upgrades. American said in its testimony that the 9 billion miles would represent about 800,000 free tickets, which would, at that time, have equaled a staggering full month’s traffic for the airline.

Trans World Airlines testified in the same court case that if it dropped its program while others continued theirs, it would lose 10% of its revenues. That would have accounted for $309 million at that time

A number of factors could set off a stampede by passengers to redeem their awards. And if that ever happened, it could cause serious sales and profit problems for the carriers.

For instance, the Internal Revenue Service has considered almost since the inception of the programs whether to tax frequent-flier awards. Should the IRS announce such a ruling, it is expected that frequent fliers would rush to cash in their mileage while it was still tax free.

A recession would also dramatically step up the rate of frequent fliers using their awards, severely affecting airline profits. At a time when they could least afford it, the carriers would be giving free travel to passengers whose saved up frequent-flier miles might be the only way they could afford their trips.

Worse Loss Than Expected

If an airline suffers well publicized financial difficulty--a prospect not unlikely, given the industry’s experience in recent years--its frequent flier members, rather than lose their awards, would probably redeem them in a hurry.

The likely consequences are illustrated by what occurred a few years ago when Pan American World Airways put a deadline on its WorldPass. It provided that miles earned in 1983 had to be used by the end of the second quarter of 1984.

The result was a 90% redemption of awards in the second quarter. Free travel accounted for 14% of all of Pan Am’s traffic that June and for 11% during the second quarter. As a result, Pan Am’s losses for the second quarter were $50 million worse than expected.

However, the airlines scoff at assertions that they will one day go broke because of the growing backlog of unredeemed frequent-flier mileage.

For one thing, they contend that 50% of their total liability consists of so-called “breakage” mileage that is never redeemed and mileage that is used for upgrades in class, which costs the airlines very little. Airlines also figure that only about one-third of their frequent-flier plan members will take the round trips required in the first quarter of this year to qualify for triple mileage awards for the entire year. Additionally, except for a few isolated times and on favorite routes (such as those to Hawaii), the carriers have more than enough room to accommodate frequent fliers.

Michael W. Gunn, senior vice president of marketing for American Airlines, which started the first frequent-flier program in 1981, said his airline’s average load factor for all of 1987 was 65%. That, he added, “leaves 35% to 40% of our inventory that goes to waste on a daily basis.”

Between 40% and 50% of the members of American Airlines’ AAdvantage program are not active players, Gunn said. Nevertheless, the mileage they have accrued--but will probably not use--must be counted as a liability by the airline.

The problem of free-riding frequent-flier award users displacing fare-paying passengers has not been a major one so far, the airlines say.

Gunn said that, in a few “isolated” cases in a couple of markets, paying passengers have been pushed aside by AAdvantage members. The favorite prizes sought by American’s members, he said, are upgrades to first class.

United Airlines concedes that “on certain flights, the demand from members of the Mileage Plus (frequent-flier program) outstrips the capacity at certain times of the year,” according to spokesman Matt M. Gonring. “It happens on first-class travel to Hawaii, a favorite destination.”

But even if their contention is true that they can easily accommodate all passengers who are redeeming frequent-flier mileage, the airlines are, nevertheless, working hard to avoid problems by encouraging fliers to shave off their mileage incrementally with such enticements as non-flight premiums and off-peak and off-season travel for fewer mileage credits than usual. This tactic has been dubbed the “burn off.”

On OnePass, the Eastern-Continental program, a trip to the Caribbean in an off-peak period is marked down to 20% of its normal redemption price. Likewise, last fall, Delta offered two off-season coach tickets to Hawaii for 40,000 miles, half the normal redemption level. In July, American’s frequent fliers can get two tickets to Europe for 90,000 miles; in April the two tickets go for 60,000 miles.

“People are willing to make the sacrifice,” American’s Gunn said. “Every time we run a special, we burn off hundreds of millions of miles.”

Premiums for Mileage

Midway Airlines, a regional carrier based in Chicago, is already offering a substitute for free trips: money. At the top end of its program, it will give $2,000 in cash or the payment of $2,500 on a member’s Citicorp Diners Club International.

Members of Trans World Airlines’ Frequent Flight Bonus program might soon be able to get valuable premiums for the mileage, according to Timothy G. Brier, vice president for passenger marketing. He said these awards might include cruises or such premiums as television sets.

Clearly, though, free travel remains the top attraction. Barry McCabe, president of De Anza Assets, a Los Angeles real estate investment and management company, travels 15,000 to 20,000 miles on business every month on Delta. And for pleasure, cashing in his frequent-flier miles, he has taken three trips to Europe, one to Australia and several to Hawaii. “In the last three years, I have had a heyday. I make use of my frequent-flier mileage to make trips that I might otherwise not take,” he said.

And he will probably take even more such trips now that he can earn three times the mileage he got in the past. He is pleased about that but realizes that it presents a danger for the airlines.

“Triple mileage makes it that much easier for me to accumulate those bonuses. But, while it’s good for us, if the airlines continue this foolishness into next year, it could come back and slap them in the face.”

Thomas Wills, director of management analysis for Whittaker Corp., a Los Angeles-based diversified manufacturing and services firm, has accumulated 1.3 million miles on Delta, some of which he has already cashed in. He thinks that the idea of getting gifts instead of free trips in exchange for frequent-flier mileage may not be such a bad idea.

“My family uses my frequent-flier mileage more than I do,” he said. “The last thing I want to is get on another airplane.”

THE AIRLINES’ EXPOSURE

Potential 1988 Revenue Loss Membership Airline (Millions of $) (Millions) United 215 6.0 American 190 6.3 Continental/Eastern 170 3.0 Delta 140 4.0 Northwest 90 3.0 USAir/Piedmont 90 3.0 Pan Am 30 1.0 TWA 15 4.0 Total 940 30.3

Source: Salomon Bros. All figures are estimates.