Sir Richard Branson was once asked for advice on how to quickly become a millionaire. Simple, he replied: “just start with a billion dollars and then buy an airline.” Airlines are terrible businesses. Between high equipment and labor costs, high fuel prices, and cutthroat competition, they’re almost perfectly designed to go bankrupt. Back in 2002, when United Airlines took its most recent trip to the bankruptcy court, its financial books were opened to the examiners, and they were not pretty. Amazingly, there was just one part of United’s business that made money. Not flying passengers, not shipping cargo – it was their MileagePlus frequent flyer program.
Wait – how in blazes do you make a profit handing out free seats? Well, that’s actually the wrong question. Let’s step back, and consider the larger, more important question: what exactly is a frequent flyer program? Anyone? Bueller? Bueller? Yes, in the back?
Uh… it’s a promotional tool to generate customer loyalty? By giving away free seats to Fort Lauderdale?
Wrong. Or, at least, incomplete answer.
It makes more sense to think of a frequent flyer program as an alternate currency. Amazingly, if you counted up all of the miles that have ever been issued by the world’s airlines, you come up with something on the order of 15 trillion miles. Valued at two cents apiece, that would make frequent flyer miles the second most widely-circulated currency in the world, after the U.S. Dollar. From the airline’s perspective, though, there are several major built-in advantages to their currency over the ordinary sawbuck. The Federal Reserve chairman would be green with envy. (Ha! Because money is gree … eh, never mind.) Remember, airlines not only issue this “currency,” they also arbitrarily decide how much of it to create, have total control over how it can be spent, and they can sell it – for a big profit. Let’s examine just how much.
I previously wrote about how credit card companies routinely hand out tons of frequent flyer miles, but just think of all the other ways that you can earn frequent flyer miles: hotel stays, car rentals, flower deliveries, Netflix signups… where’d those companies get all those miles? They bought them from the airline, and not for face value. While the exact price is something the airlines keep pretty close to their chest, an excellent estimate of a FF mile’s “sale price” (based on the airlines’ own annual financial reports) is somewhere around two cents per mile. In other words, when the bank gives you 25,000 bonus miles for hitting that minimum credit card spend, they probably paid the airline around $500 for those 25,000 miles. Hey, not bad, Mr. Airline Marketing Guy! 25,000 miles is a common price for a saver-level domestic roundtrip ticket in Cattle Class, and those usually don’t sell for more than $500. So the airline generated $500 by giving away a free seat …
Hold on, nobody’s actually getting that seat yet. Now we consider another important feature of the frequent flyer mile…it’s perishable. It expires. For as hard as most Mileage Junkies here on the blog chase after miles, to the great majority of the flying public, they’re an afterthought. Somewhere between 17% and 25% of all issued miles are simply forgotten, and disintegrate into nothingness, year after year. Imagine getting paid in $20 bills that had “good until December 2013” printed under Andrew Jackson’s picture. Mile spoilage is predictable enough that an airline can sell a billion frequent flyer miles, and safely assume that around 200 million of them will never get used. The other 800 million will eventually be redeemed – with considerable difficulty.
Ask anyone who’s ever tried to book the family to Disneyland at Christmas, airlines make it pretty challenging to spend those hard-earned miles. You can’t redeem them for just any empty seat on the plane – only the ones that are made available. And when low-cost award seats are available, they’re likely to be on flights that are leaving at inconvenient times in the middle of the week, on flights that usually don’t fill up. Yes, the airlines are selling mileage awards to fill seats that would have gone empty otherwise. Oh, they may release additional seats on more convenient flights – at twice the mileage price or more (I’m looking at you, Delta).
By the airline’s own estimates (as of 2008), when they figure out the total liability of their outstanding frequent flyer miles, they use a valuation of – wait for it – 40 cents per one thousand miles. Yes, that award in the heavenly lie-flat business class seat to Paris, that you shelled out 100,000 miles for, costs the airline a grand total of forty bucks. Well, the price of fuel has gone up in the past four years; it might cost them fifty, now.
So the next time you feel guilty for collecting all those “free” miles, remember that the airlines are making a five thousand percent profit on them. Whoa. Running an airline may be a terrible way to turn a profit, but running a frequent flyer program is a license to print money.