The economics of IAG’s loyalty programme

IAG highlights record profits from its loyalty division

IAG runs its loyalty operations and manages its reward currency Avios through a separate subsidiary, Avios Group Limited (AGL), trading as IAG Loyalty.

For the first time, IAG disclosed the results of its loyalty arm as a separate segment in its 2022 full year results. In previous years they have been bundled in with “other group companies”. The results have been available for a while through the published accounts of AGL. However those figures are released with quite some delay, typically taking until September or October of the following year to be available from Companies House.

Since we have up to date figures available for the first time, I thought it would be interested to look at what they show.

By way of full disclosure, I was the Chairman of AGL up until the time I left IAG in mid 2019. I obviously won’t be sharing any confidential information, but the new disclosures give us plenty of publicly available information to work with.

Five year profitability history

When IAG published the 2022 figures, they also gave us the 2021 comparative figures. That allows us to check them against the published accounts of AGL, to ensure that they are on the same basis. I’ve done that, and within the limits of approximation required when comparing IAG figures reported in euros to AGL figures reported in pounds, all the figures look like they line up. That means we can combine the recently published figures from IAG with older accounts for AGL to give us a five year history of revenue and profits for the company.

Source: Company reports, GridPoint analysis and estimates

You can see that revenues fell considerably during the pandemic, but have now recovered. In 2022 revenue was actually 5% above the 2019 level. Profits also fell, but by less than revenue, with margins improving. That meant that 2022 profits were 55% above 2019 levels. Before I explain how that was achieved, let us take a quick look at the volume metrics.

Volume metrics

AGL provides some volume metrics in their published accounts (see chart below). You can see the collapse in activity levels during the pandemic, although even with airline activity largely shut down, people continued to earn and use their Avios points with non-air partners, which cushioned the blow. 2022 was clearly a recovery year, although IAG only gave us an updated figure for redemption volumes (points used). Those recovered to 88% of 2019 levels.

IAG didn’t provide a 2022 figure for accrual volumes (points issued), but I’ve had a go at estimating it using the financial value of points issued, a figure which you can find in the group accounts. I’ve assumed that the value per point remained the same it was in 2021. If my estimate is correct, points issued in 2022 were around 73% of 2019 levels, undoubtedly continuing to suffer from a sluggish recovery in business travel, which is the biggest driver of points issuance.

We also didn’t get an updated figure for the number of active members, which IAG measures as the number of customers who have earned or redeemed points in the last 12 months. I would guess that it must have gone up compared to 2021 as both accrual and redemption volumes recovered, but I would think it remains some way below pre-pandemic levels. IAG instead chose to focus on the fact that 25% more members enrolled into an IAG loyalty programme than in 2019.

Source: Company accounts, GridPoint estimates and analysis

So what explains the recovery in revenue and profits?

As we’ve just seen, all the volume metrics remained below 2019 levels during 2022. So how did this turn into a record year for revenue and profits?

When a point is sold by AGL, either to one of the IAG airlines or to other partners, that revenue gets deferred until the point is redeemed. So it is redemption volumes that are the biggest driver of revenue, and as we’ve seen those have recovered faster than issuance.

The value of every point being released at redemption has also gone up. I’ve calculated how much revenue was being deferred by AGL for every point issued over time, which I’ve put on the next chart. The points deferred in 2021 were valued at a 15% higher level than those that were deferred in 2018. Those figures are ultimately pegged to the discounted commercial fares on sale by IAG airlines, which have increased considerably since 2019. This means that a point being redeemed in 2022 will have driven more revenue than one redeemed in 2019.

Source: Company reports, GridPoint analysis

The final thing driving revenue and profits faster than you’d think from the volume metrics is the increased mix of sales to third parties. When AGL sells points to IAG airlines, the price of that point is mainly driven by the expected cost of providing redemption capacity, most of which is purchased from the same airlines. The way the transfer pricing is set up, this is not a high margin activity for AGL. From the perspective of the airlines, AGL is mainly administering the management of points. But the price for points sold to other partners is set by the market and access to IAG customers and the broader group of Avios collectors commands a premium price. Whilst issuance of points for flights on IAG airlines has remained depressed, sales to third parties have continued to grow. IAG said that “revenue from external partners [in 2022] was 25 per cent higher than in 2019 and now accounts for 80 per cent of all billed revenue”.

Leveraging loyalty for liquidity

The US airlines used their loyalty arms as a source of collateral to raise huge amounts of cash during the pandemic. For example, United Airlines pledged its loyalty programme as security for a $5 billion loan. IAG did something similar, albeit on a more modest scale.

In the third quarter of 2020, IAG concluded a deal with its main credit card partner, American Express. Amex provided a £750 cash injection, which mainly consisted of an advance purchase of points, presumably at a discounted price. This was the main reason behind AGL’s cash balance jumping by £862m during 2020, to a total of £1,125m at the year end. That cash balance has since fallen back to about £870m, as the Amex credit is consumed in what was described as an eight year deal. But it is still over £600m higher than it was back in 2019.

The accounts also reveal that £185m of AGL cash was loaned up to IAG during 2019. Initially that loan was supposed to be repaid by June 2021, but the December 2021 accounts for AGL still show it in place. It was listed under “Debtors: amounts falling due after more than one year”. So the terms have clearly been extended by at least 18 months.

I’ve shown a summary chart of the company’s balance sheet below. You can see the jump in cash (in green) during 2020 and the associated increase in deferred revenue (in red). The category I’ve labelled as “Deferred revenue and other creditors” is virtually all deferred revenue and represents a provision for the cost of redeeming all the Avios points issued. On the asset side of the balance sheet, this is matched by cash, the loan to IAG and a flight prepayment asset. Rather than sit on IAG airlines’ cash whilst AGL waits for the points to be redeemed, the company pre-purchases redemption capacity. So the equivalent of making a booking and paying for the redemption seat at the time that the points are issued. They clearly didn’t do that for Amex’s advance purchase of points, so the cash has remained in AGL.

Source: Company accounts, GridPoint analysis

Will IAG sell off its loyalty division?

All airlines with large and profitable loyalty programmes are constantly asked by bankers whether they are going to sell them off. The bankers of course are heavily interested in all the fees that would be generated by such a transaction, but the argument goes that earnings from loyalty programmes are more highly valued by the market than airline earnings. So selling off part or all of their programmes would boost shareholder value.

If you are a believer in valuing companies on fundamentals, this argument is decidedly suspect. Yes, loyalty cashflows are more stable than airline cashflows and should therefore attract a higher multiple. However, selling them off will make the airline cashflows that are left even less stable, driving down the airline multiple to even lower levels.

The counterargument is that airline multiples are already at rock bottom and can’t go any lower. So it is mainly the debt holders that would suffer from the increased risk if an airline sells off its loyalty division and distributes the proceeds to shareholders. If the proceeds are instead used to pay down debt, then the debt holders should worry less.

Whatever you think about the financial engineering logic, the bigger questions are really operational and strategic ones. Rewarding loyalty for its most valuable customers is a pretty strategic issue for most airlines. Diluting control through selling off all or part of its loyalty division has considerable risks. Most of the airlines that listened to the bankers and sold off their loyalty schemes have ended up buying them back later. Using the scheme as collateral to secure cheap finance instead has now become the “go to” option for airlines who need to generate liquidity.

Based on how the company has answered analyst questions about its intentions, it is clear that IAG is well aware of the risks of selling off equity in its loyalty division. Personally, I think it would be a mistake, unless the company really needs the money for something even more strategic and can get it no other way.

But I’m sure the fee-hungry bankers will keep asking the question anyway.