Loyalty program operators are similar to insurance operations in the sense that they issue a claim “stamps” or “air miles” in exchange for cash upfront “float” (industry term “billings”). This cash or “float” can then be invested while the clients slowly (or never, see breakage) redeem their points or miles (industry term “redemptions”).

Earning streams

Ordered by increasing amount of uncertainty, money is earned through

  1. taking a margins on a mile billed minus a mile redeemed
  2. selling customer habit analytics to companies
  3. breakage: this can be a significant ~20-50% of billings, with ~100% pre-tax margin
  4. investment income and capital gains from investing the float (other people’s money)
  5. point devaluations: this comes at the expense of the loyalty program’s reputation if done visibly, but remains largely unregulated. Companies should take an example from central banks and slowly but steadily devalue (as in “the optimal inflation target is 2% p.a.”)

Float from customers and the government (other people’s money²)

From day one the “billings” cash comes in with most of the revenue still unrecognized (except for a conservative breakage estimate), and offsetting “deferred liabilities” on the balance sheet. This means that almost no cash taxes are paid upfront.

In other words, this business uses other people’s money (clients) to earn extra money on the investment side, while deferring the cash taxes due on real loyalty earnings far into the future (after accounting for real breakage and devaluations down the road).

Powerful psychological biases working in favor of loyalty operator

I think there are some powerful psychological biases working in a loyalty card issuer’s advantage:

  • small amount of miles in every purchase “feels” like it was earned for free, or an “extra” (this is far from the truth, as loyalty programs get paid cash on day one for these points and an alternative to miles is cash back credit cards)
    • people do not value things they got for free as much as things they “worked” for
      • Result n1.: neglect of points that leads to slow devaluation of redemption liability and breakage
  • because the points are not expressed in usual fiat money terms, and they feel for free, the urge to buy unnecessary goods is bigger (perfume, hotel upgrades etc), this is similar to buying presents for friends.
    • see Dan Ariely’s The Perfect Gift : something you always wanted but never wanted to feel the pain of paying for
    • these products have a knack of carrying higher profit margins
    • the loyalty company will use its purchasing power pool to negotiate hefty discounts from retail cost on these high-margin products
      • Result n2.: sales mix is typically profitable for redemption partners (perfume, seat or hotel upgrades) and loyalty partner will take a nice piece of those economics

Case study from the past: Buffett & Munger’s investment in Blue Chip Stamps

I now want to present a very interesting case study from the past, Buffett and Munger’s purchase of loyalty program Blue Chip Stamps (’70s business).

 

The main takeaway is that Blue Chip Stamps’ revenue (~’gross billings’) declined heftily in 10 years, while the float more or less kept up. Why?

  • part of the declining revenue cumulatively adds to the float, while
  • the redemption frequency drops as the program loses mindshare and people forget/delay spending points

bluechip

In other words, permanently declining loyalty programs can still be valuable vehicles to compound investments in, using other people’s money.

Case study today: Aimia

Today, Aimia is trading at ~1.5 x current cash flow, with gross assets (excl. loyalty card liabilities) worth about 2x current share price because of the uncertainty surrounding the major partner Air Canada “AC” that is leaving in 2020 (10% of accumulation but 50% of redemption).

Aimia’s loyalty card “Aeroplan” is one of the biggest in Canada.

Network effects of being big

There is many-sided network effects involved.

What makes the program valuable?

  • # of Accumulation Partners (partners that pay upfront cash “billings” to Aimia for offering clients miles)
  • # of Redemption Partners (partners that allow to redeem miles with products, getting paid by Aimia)
  • # of Clients

Each category interacts, e.g. more redemption and accumulation partners makes the program more valuable for clients, more redemption partners and clients makes the program more valuable for accumulation partners, etc.

Lastly, it’s all about “the big data” nowadays. More # of each category makes Aeroplan’s data analytics more valuable because the number of interactions (data) increases faster than the individual amounts.

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Case study investment case

IF

  • Aeroplan’s cash flow remains stable until 2020 and
  • post-2020 cash flows minus its real liabilities are worth at least 0, this is an attractive investment (worth ~10$ per share).

It seems unlikely that management would not be able to manage its way through a “run on the bank” redemption before the 2020 expiry of AC by delaying customer redemptions through two control mechanisms that induce clients to delay and forget:

  1. “gating” (offering limited redemption options ‘temporarily’, e.g. only flights on wednesday and sunday)
  2. devaluing points faster: this has the effect that more people will have insufficient miles to redeem products they deem valuable, hence delay and forget

Given the network effects and switching hassle for customers, I do not believe Aeroplan is going away abruptly as the market seems to think (maybe slowly, but then again Blue Chip Stamps is an interesting case).

Disclaimer: no position*

*Not yet comfortable in the industry.

Comments are welcome.

MC & TC