Qantas finds value in frequent flyer loyalty

Financial Journalist
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Qantas Airways’ $2.8 billion statutory loss, one of the biggest in aviation history, made front-page news. But beneath the massive loss for 2013-14 was some excellent news: the full retention of the Qantas Loyalty frequent flyer points business.

Speculation was rife that Qantas would sell 30-40% of its loyalty business to free up cash and pay down debt. Analysts estimate the business is worth $2.5-$3 billion, based on multiples for sales of similar loyalty programs here and overseas.

More airlines are unlocking the value of their frequent flyer programs. Virgin Australia Holdings in August announced it was selling 35% of Velocity Frequent Flyer to the private equity fund, Affinity Equity Partners, valuing the loyalty program at $960 million.

Several overseas airlines have also sold, or partially sold, their loyalty programs to free up cash. As the global airline industry faces unrelenting pressure, selling keenly sought assets such as points programs has become a quick fix for embattled CEOs.

The value

These programs have huge strategic value. Virgin’s Velocity Frequent Flyer program has doubled its membership to 4.5 million in four years. Qantas Loyalty has doubled membership to 10.1 million since 2008, with its points program the envy of the global aviation industry.

Think about that for a moment. Qantas Loyalty gives the airline a touch point with almost one in two Australians. The program sells points to Qantas, a host of retailers, including Woolworths, and is used extensively in data mining and through Qantas consulting services.

Some frequent business travellers I know view Qantas points as Australia’s de-facto currency and a critical tool to buy their next overseas air trip, accommodation or other goods and services.

It is no surprise that the market applauded Qantas’ decision to keep the program. In an August 28 research note, Macquarie Equities Research described Qantas Loyalty as a star performer in the airline’s recent full-year profit result. It has a $1.84 share price target over 12 months for Qantas, and an outperform recommendation.

Bank of America Merrill Lynch said of the decision to retain Qantas Loyalty: “We regard it as a significant positive that even a minority stake of Qantas Frequent Flyers will not be sold. The division remains a strong cash generator, with FY14 earnings before interest and tax (EBIT) up 10%. Qantas has said there is no justification for a sale; long-term investors agree.” Bank of America has a hold recommendation on Qantas.

Analysts mostly believed any decision to sell the frequent flyer program would be a “short-term fix” at the expense of the asset’s long-term potential. The market agreed, driving Qantas from a $1.30 in late August to $1.56, and signalling that the worst is behind the airline.

The decision

Did Qantas make the right decision? If the Qantas Frequent Flyer program is worth more than $2.5 billion, a reasonable valuation given the much smaller Velocity Frequent Flyer program was valued at $960 million, what is the rest of Qantas worth? The airline is capitalised at about $3.2 billion.

Qantas has a lousy annualised shareholder return (capital growth and dividends) of minus 12% over five years, and minus 5% over 10 years. Long-suffering shareholders might have seen the divestment of Qantas Loyalty as unlocking considerable latent value in the Qantas Airways valuation, and giving the program even more momentum as a stand-alone entity. It’s always a problem when great businesses are dragged down by other underperforming divisions.

I like the decision to retain Qantas Loyalty for two reasons. The first is short term. The business is performing strongly: its underlying earnings rose 10% to a record $286 million in the latest Qantas result, underpinned by 8% growth in customer numbers and billings. Selling all or part of Qantas Loyalty would have stripped a significant growth engine out of the airline.

It could have led to significant disruption in other parts of the business. Concerns about the points program might have encouraged more travellers to cash in their points, switch programs, or even use other airlines. There were also questions about how Qantas would have used the points program to fill unused seats on its planes, had it divested the asset.

The points program will become even more popular in the next few years as consumers, who are struggling with the worst wages growth in 17 years, pay more attention to the value in their points program, and use the points to pay for travel and other treats.

Longer term, Qantas Loyalty is the airline’s best asset and arguably the main reason to buy the stock. I always avoid airline stocks: their earnings have low visibility, they have huge upfront and ongoing capital expenditure, and are subject to myriad risks such as weather, security, oil prices, currency, and safety. Airlines have few hallmarks of exceptional companies.

Big data, big opportunities

But the rapidly expanding points program gives Qantas a shot at something different and much bigger: the potential to leverage the brand and customer relationships, and find uncontested market spaces, or so-called “radical adjacencies”, as Qantas moves well beyond transport into new industries.

Growth in data mining, where companies process huge amounts of real-time customer information, is a big tailwind for Qantas Loyalty.

In fact, the most valuable hub for Qantas will have nothing to do with airlines in coming years. The big upside is becoming the hub in a giant network of retailers, using points and customer information through data mining to help other retailers grow their business.

Unlike the cost-intensive airlines, this is a virtual, technology-based business with recurring income and high barriers to entry. It is also a business where Qantas has a genuine, sustainable competitive advantage through its size, scale and brand. With that comes higher switching costs for customers who leave the program, and latent pricing power for Qantas Loyalty.

But it is still not enough to buy Qantas at the current price. Upside from Qantas Loyalty is dampened by the poor economics of aviation and lingering uncertainty in the global airline industry. On a risk-adjusted basis, there are better stocks to own in the long run.

  • Tony Featherstone is a former managing editor of BRW and Shares magazines. All prices and analysis at 3 September 2014.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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