Loyalty Program

A Loyalty Program is a marketing strategy designed by a company to encourage customers to continue shopping at or using the services of the business associated with the program. Think of airline miles, hotel points, or your favorite coffee shop's “buy ten, get one free” punch card. These programs reward and incentivize repeat business by offering points, discounts, or special perks. From a business perspective, the goals are simple: retain existing customers (which is far cheaper than acquiring new ones), increase the frequency and value of their purchases, and gather valuable data on consumer behavior. For the customer, it's a way to get more value from their spending. For the savvy investor, however, a loyalty program is much more than a marketing gimmick; it can be a powerful indicator of a company's competitive strength or a hidden financial risk.

As an investor, you shouldn't be dazzled by the freebies. Instead, you need to analyze a loyalty program with a critical eye, asking one key question: Does this program build a durable competitive advantage for the business? A well-designed program can be a fortress, while a poorly designed one is just a money pit.

The best loyalty programs create a powerful economic moat for a company, specifically in the form of high switching cost. When a customer has accumulated significant points, status, or benefits with one company, the perceived cost and hassle of starting from scratch with a competitor become very high. Imagine a business traveler who has top-tier “Diamond” status and a million miles with a specific airline. Are they likely to fly with a rival to save $50 on a ticket? Unlikely. They would lose perks like lounge access, free upgrades, and priority boarding. This loyalty gives the airline pricing power, allowing it to charge slightly more than its competitors without losing its most valuable customers. Great examples of loyalty programs building moats include:

• Airlines and Hotels: Programs like American Airlines AAdvantage or Marriott Bonvoy create a sticky ecosystem for frequent travelers.
• Retail: Amazon Prime is a masterclass in loyalty. The annual fee locks customers in with “free” shipping and a suite of other services, making it their default online store.
• Coffee Shops: The Starbucks Rewards program uses gamification and personalization to drive repeat visits and higher spending per customer.

While a strong loyalty program can be a huge asset, it can also hide significant risks.

• A Growing Liability: Those unredeemed points aren't just imaginary numbers; they represent a promise of future goods or services that the company owes its customers. This obligation is recorded as a liability on the company's balance sheet. An investor must check the size of this liability and see if it's growing at a manageable rate. A ballooning liability could signal future trouble for the company's profitability.
• Devaluation Risk: Companies hold the power to change the rules. They can increase the number of points needed for a reward at any time, effectively devaluing the points you've earned. While this can cut costs for the company in the short term, it can also infuriate loyal customers, damage the brand's goodwill, and erode the very moat the program was meant to build.
• A Drain on Profits: A loyalty program is ultimately a marketing expense. If it doesn't generate enough incremental business to cover its costs, it's simply destroying value. A program that just offers discounts competitors can easily match is not a moat; it's a race to the bottom that erodes profit margins for the entire industry.

When you're analyzing a company that leans heavily on its loyalty program, ask yourself these questions:

• Is it a Moat or a Millstone? Does the program create genuine, high switching costs, or is it just a glorified discount scheme that competitors can easily copy? Look for exclusive perks and status tiers that can't be replicated.
• How Engaged are the Members? Dig through the company's annual reports for metrics like the number of active members, redemption rates, and sales generated from program members. High engagement is a sign of a healthy program.
• What's the Liability Situation? Check the balance sheet. Is the loyalty liability a small, manageable figure, or is it a looming mountain of debt?
• What's the Track Record? Has the company devalued its points in the past? If so, how did customers and the stock price react? Frequent devaluations are a red flag.
• Is it Profitable? Does management talk about the program's return on investment? A great loyalty program should be a profit center, not just a cost center.