You've Got Miles!

Carriers boost profits by linking up with marketers like AOL

In the late '80s, when U.S. airlines wooed passengers by tripling frequent-flier miles, Wall Street cringed. Investors worried that the giveaways would result in crushing future liabilities. Today, as American Airlines Inc. prepares to join America Online Inc. to give away miles to people who use AOL services, airline analysts are cheering.

What has changed is that the airlines have figured out how to turn their frequent-flier programs into profit centers. They've fashioned them into marketing tools for credit-card issuers, telephone companies, and even supermarkets. Under a deal announced Feb. 9, shoppers at 1,300 Safeway Inc. stores are earning miles on United Airlines Inc. when they buy their groceries.

On average, marketing partners pay the airlines about 2 cents a mile. Randy Petersen, editor of InsideFlyer, a magazine that tracks the business, estimates that in 1999, that amounted to at least $2 billion. Bruce T. Chemel, head of American's AAdvantage program, thinks Petersen's estimate is low but declines to make one himself. "We're selling those miles at very good prices," he says.

American, which created the first program 19 years ago, says more than half the miles its members earn now come from nonflying activities. And the revenue for each trip from those passengers works out to a nice bit of change. Most airlines charge 25,000 miles for a round-trip, advance-purchase domestic ticket, and for miles that were sold to marketing partners, that's the equivalent of $500--which is higher than discounted fares paid by many travelers.

The airlines won't reveal how much money they make selling miles or their profit margins on this business. American, which manages the biggest frequent-flier program, with 38 million members, will only say that it's raking in "hundreds of millions" of dollars each year from the sale of miles to more than 1,000 marketing partners. The incremental cost of providing the travel is small. Airlines figure these are seats that would otherwise go empty, so they calculate their costs based on such direct expenses as food, extra fuel, and ticketing, but not airline overhead.

And thanks to improved computer systems for managing pricing and inventory, the airlines can better handle this surge in frequent-flier miles. They're making more seats available to frequent fliers while minimizing the displacement of higher-paying passengers.

NEW AWARDS. At the same time, the airlines are encouraging members to use miles for less popular routes by reducing the number of miles needed for such tickets. The airlines say that even while abolishing the expiration date on miles earned--which American and United did last year--they've improved their ability to manage the programs. One reason: Generally, people postpone flying. "They tend to use things when they think they're expiring," says Lawrence W. Kellner, chief financial officer of Continental Airlines Inc., which has never had expiring miles.

Even when most carriers did set expiration dates, nearly 70% of miles were never redeemed, says Petersen. American figures passengers using travel awards represented 11% of its traffic last year, up from 9% in 1998. United's awards comprised 9% of traffic, compared with about 7% earlier in the decade, while Continental had 7%. "They're doing a good job controlling" frequent-flier programs, says analyst Raymond Neidl of ING Barings, who once predicted the programs would crash under their own weight.

LIMITED LIABILITY. With the AOL deal, American is also creating new ways to redeem miles for something other than air travel. Members will soon be able to use miles for some AOL services or for such goodies as videos, magazines, and music downloads. This program and similar ones that are sure to follow "take some of the pressure off the airlines to deliver airline seats," says Petersen. Right now, only a "relatively small percentage" of members redeem miles for something other than flying, but it's growing, says American's Chemel. "This is not a program where a single award is going to satisfy millions of people."

With the increase in marketing programs, the Securities & Exchange Commission is now requiring most airlines to change how they account for the sale of miles. Except for American and Northwest Airlines Corp., the airlines have been immediately booking most of the revenue while counting the incremental cost of providing the travel as a liability. Now, they'll have to defer much of the revenue until a time that they estimate the travel will occur and calculate the liability based on the market value of the ticket. Airline analyst Samuel C. Buttrick of PaineWebber Inc. notes that such changes could lower earnings modestly in the short term but will not affect cash flow.

You've Got Miles!

American, which has always used the more conservative accounting approach, calculates its frequent-flier liabilities at $827 million last year, up 19% from 1998. Continental puts its liability from miles sold to its marketing partners at about $80 million. It won't reveal the figure for miles given to its own fliers. But these liabilities are "not something we have felt is a big credit factor," says Philip A. Baggaley, senior airline bond analyst at Standard & Poor's Corp. For American, he notes, its frequent-flier liability is dwarfed by the nearly $14 billion in total funded debt and off-balance-sheet leases. "The airlines do have a lot of control over how these miles are used up," he says, "as anyone who's tried to book a flight knows."

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