Tit for Tat: How Members and Companies Benefit From Loyalty Programs

Airlines are far from the only companies to use loyalty programs -- the average American has 13 different memberships, half of which are actually in use.

In this episode of Industry Focus: Consumer Goods, Vincent Shen and senior Fool.com contributor Asit Sharma shed some light on the rapid rise of this marketing strategy across various industries.

The cast takes recent case studies from Chipotle Mexican Grill (CMG -1.34%) and Dunkin' Brands (DNKN) to highlight what a successful affinity program bring to to a company.

A full transcript follows the video.

This podcast was recorded on Nov. 1, 2016.

Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market each day. It is Tuesday, Nov. 1, and I'm your host, Vincent Shen. With me is Asit Sharma, who is joining us via Skype. How are you, sir?

Asit Sharma: I'm doing well, Vince! Thank you very much for asking.

Shen: Did you dress up for Halloween?

Sharma: I have to mention really quick for our listeners, Halloween was just OK. I dressed up as a werewolf, but a retired werewolf. I had to give the kids in the neighborhood some life advice, but they didn't respond that well. They were like, "Just give me the candy."

Shen: How about your two boys, did they dress up?

Sharma: Three boys! This was the first year -- they're 17, 15 and 13. This was the first year they didn't really dress up, but they orchestrated hiding in the bushes and scaring some other teens that came by, and handing out candy to the smaller kids. That was good to see.

Shen: OK, so they're at that age, and I'm sure the youngest is influenced by his older brothers, where it's not cool to get dressed up anymore.

Sharma: Yeah. He's on the fence, maybe next year. How about you? Did you have a good Halloween?

Shen: Yeah, pretty uneventful, quiet. At least the day of. Then, over the weekend, I was just home with family, which was nice. So, not as much dressing up for me, either, actually. 

So, Asit, you brought up to me some of the supertrends that we talked about in previous episodes. There was customization, then there was, on the flip side of that, simplification, SKU rationalization, last time I had you on the show. For our third supertrend, you had identified, in the consumer retail world, loyalty programs and their very rapid proliferation in the past 20 or 30 years. Think credit cards, supermarkets, airlines, restaurants, online retailers. Everyone has jumped on this bandwagon. But I was actually very surprised to learn that these programs have been around for way longer than most people realize, I think. And they did not start, definitely, with airlines and credit cards.

Sharma: I was surprised, too, doing a little bit of research. Loyalty programs date back, apparently, to the Revolutionary War period in the United States. Both before and after the war, coins often came into acute shortages, so folks produced these copper tokens, and you would use the tokens to buy merchandise, the goods that you needed to get through the week. After the coins would resume in circulation, some savvy merchants started handing out tokens with purchases. After you had amassed a certain amount of tokens, you could trade those in for goods. Does that sound familiar?

Shen: That sounds pretty familiar to me. The coins that you mention, I couldn't believe it dates all the way back to the Revolutionary War period, but eventually the coins gave way to other forms of tokens, like stamps, box tops, which were still around when I was a kid, paper coupons and more. I think, the more modern age of the loyalty program movement definitely was ushered in with the airline industry. American Airlines introduced its frequent flyer program in 1981. United Airlines very quickly followed suit. When we look at these loyalty programs, the core idea behind such an offering is that they get customers to come back over and over again typically with the allure of some type of award or benefit. 

On the flip side, I think it's really important as investors to look at what these companies get out of offering such programs. Airline industries are a really good example of that, especially in early years. They had an issue, especially if you think back to flying 30 to 40 years ago, where travel agents dominated the industry. They were the ones that you contacted as a traveler, as a consumer, if you needed a flight for a vacation or a business trip. The airlines felt very far removed from their own customers, and the loyalty programs, the frequent flyer programs that they created in the early eighties were a way of re-establishing that connection. And, to get a much better view of travel patterns, price points, things along those lines. I think that expansion, that data element of it and the insights that it offers into customer behavior is super important, and is the main driver behind why loyalty programs in general have become this huge trend across consumer retail and other industries. What do you think?

Sharma: Man, you brought up so many great points there, where do I start? Let me start with the main takeaway from what you just said. There's another term that we use, which is more in vogue with the industry, rather than loyalty programs we call these affinity programs. If you were to look these two words up in the dictionary, loyalty means standing by somebody, being there for them. Affinity is a little bit more subtle of a concept. It means that you have a sympathetic view of something, or you have something that you like, you share with somebody. What you're talking about is reciprocity between brands and consumers that happens when you have something the consumer can get out of the equation, and on the flip side, something that the manufacturer/retailer can get out of it. That's what we saw out of the airlines. They increased frequency flights, made more money, and consumers, with those miles, were able to travel to see things they hadn't seen before. That's a really powerful reason to show up with an affinity program for your customers.

Diving into your second point, we like to look at why things are super trends. Loyalty has come up very strongly in the last couple years due to the availability of big data to retailers. Retailers now can create customized dashboards. These dashboards don't just give aggregate statistics. They can drill down to the personal level. So, they can look at Asit Sharma, and have a profile of his sex, his age, their best guesses at his income, and on that same dashboard, combine that with statistics of how much he purchases every week or every month. Most of the companies that are out there offering affinity programs don't do this themselves, they hire third-party software companies which specialize in CRM -- customer relationship management -- software to do this. This is why the trend has exploded and become a supertrend, because you can really operate on a much more precise level as a retailer, and you can then drive the behaviors you want using the data you collect.

Shen: Yeah, I think the benefits of that big data and the insight that the companies get on the customers and how to basically push them to come back, and when they're there, to buy more, or to make that purchase in the first place, is very powerful. Just to give listeners some context into how much this super trend has grown, at this point, there are over 3 billion loyalty memberships in the United States. The average American is a member of 13 of these different programs, and is usually active on about half of those. If you just look at your keys or in your wallet, I'm sure you can see, between your supermarket, your credit cards, and maybe some other membership cards you have hanging from your keys, there are a lot of these programs, all across every facet of your life.

The two companies that we wanted to focus on today, and what they're doing in terms of -- in one case, catching up with the competition; in the second case, using the data and this loyalty program to recover their business. The first is Dunkin' Donuts. I think when it comes to a quick breakfast, coffee, their bigger competitor being Starbucks has really set a very, very high bar for what a loyalty program can look like, and also how incredibly successful it can be. So, what has Dunkin' Donuts been doing in its approach to this supertrend?

Sharma: Dunkin' Donuts is probably, for a long time, going to be the red-headed stepchild compared to Starbucks. Starbucks has over 12 million customers in its own rewards program. But Dunkin' Brands has over 5 million, and that's actually pretty robust when you look at its smaller footprint globally compared to Starbucks. The program itself is pretty simple. It's called DD Perks. It combines physical cards with a mobile app, which also has an order ahead feature. You get 5 points for every dollar you spend. Once you accumulate 200 points, you get a free beverage. We want to break down today with that type of mathematical interchange of reciprocity that I talked about on both sides. This is a great example. If it takes you about $40 to get that first reward, and you choose a reward of a medium latte, that's going to run you $3 to $4 based on the options. So, about 10% of the purchase that you made leading up to that reward can be seen as a discount. So, Dunkin Donuts is offering about a 10% discount on its products by having you come back. But, what they've gotten out of you, the customer is nine repeat visits after that first one.

Vince, this goes back to a larger stat that I also found doing research. On average, retailers, if they have a loyalty program, will get, over the lifetime of a customer, about 10 times the initial purchase. So, some customers aren't going to use their loyalty cards. As you pointed out, they just stay in the wallet and are never used. But some of us are really loyal to the brands we love. So, the economics work out on both sides of that equation.

Shen: Yeah. I think that the 10% you mentioned is probably something that a lot of people are used to. I think back to a lot of the bodegas, when I was living in New York, a lot of these sandwich shops, you go there, you go for lunch, you spend a certain amount, call it $10, and they stamp a very simple card for you that I kept in my wallet. After 10 of those, I would get a free $10 meal. It comes out to around 10% off. I know that Starbucks recently, for example, changed the way that their program works. You built up and accumulated rewards. And there were some complaints from that, but overall, basing it in terms of dollars spent instead of visits is something that allows the company to control that a little bit more carefully.

Sharma: Right. There's a step beyond the basic economics. Once you get your program rolling and have an appreciable membership, which is, how does it relate to the overall strategy for your company? Dunkin' Brands has been excellent in the way they have implemented their DD Perks program. They now see it as part of their overall strategy. In fact, I think it's one of the four pillars, digital strategy. I want to quote from CEO Nigel Travis from earlier this year, he said, "Our goal is to provide our guests with targeted offers through our perks loyalty program that are relevant to them to drive visits and tickets." This is step No. 2: Once you incentivize the visits, then you want to drive the traffic further, and you want to target the customer. I talked earlier about the customer relationship management dashboard that a company like Dunkin' Brands can use. They want to extend this concept a little further. They have a concept they call one-to-one marketing, which you'll come across if you're into the retail business. This means they want to have that personal relationship with you, and be able to activate you when sales, let's say in the morning rush hour, are lagging during the quarter. They want to activate an army of loyal customers to bring those numbers up. So, you can imagine, thousands of points of one-to-one marketing is how they achieve this.

Now, some of our listeners, readers of Wired and other information magazines, remember that a couple years ago, it was in vogue to say that email was going away. But anyone who participates in a loyalty program knows that email is going to be here for a long time, because you get a ton of emails from these companies. It's a very effective way for them to, through text messaging, through emails, to activate you toward a certain behavior. So, strategically, again, get the program rolling, and then see how you can architect mass behavior almost at will. That's the end goal for DD Perks, and that's why I think Dunkin' Donuts has one of the best programs out there in the marketplace, because they really think of it, they have this overarching view of mass customer behavior, and how that can affect their revenue and profits.

Shen: OK. I want to take our conversation now to our second company. Whereas Dunkin' Brands has, I think, instituted a very competitive program even against a very well-established incumbent with its own very competitive and successful offering, we have Chipotle. Chipotle obviously has experienced a ton of challenges, we've talked about them on the show previously together, in the past year, with food safety scandals. Over the summer, July, August, and September, they had their temporary Chiptopia program. During those three months, essentially, based on the frequency with which you visited their locations, you could reach one of three tiers: mild, medium, or hot. Each one came with its own benefits. Going four times in a month, you would reach mild status. Another four times on top of that, medium. Another four times on top of that, you'd reach hot. 

The big carrot that they offered to members of Chiptopia were the catered meal for 20. Basically, if you can reach hot status with 12 visits each month for each month of the program, at the end of the program, they will give you a catered meal for 20, which is about a $240 value. I think this was obviously reserved for the real die-hard fans. With this show, today, I was with my brother over the weekend, he mentioned that he had just recently eaten his last free meal that he got from Chiptopia. I think he was a regular medium level member over the three months. But, 75,000 people actually managed to reach that hot status, and to get that catered meal for 20. 75,000 people, a $240 value. I think the company said that over the next six months, they're going to have to give out about $18 million in free food, on top of the approximately $2 million in free burritos those customers were already getting, assuming you're paying about $9 per meal.

The program overall attracted about 6 million people, with 2.5 million actually earning rewards through the program. What were your thoughts on Chiptopia? The company recently released earnings -- the stock took quite a hit, I think they're down about 11% since they release earnings last week. What do you think about the program? And do you think this will be a preview of something they establish on a more permanent basis in terms of a loyalty program?

Sharma: First, on a personal level, I reached medium status in our household. My youngest is a Chipotle freak. We didn't obtain the highest reward simply because I had to say no after a while. But this, I think if you extrapolate this, I think it's very indicative of Chipotle's approach and how it's very different from Dunkin's. Chipotle started with the premise that we do have this core of really loyal customers. So, they weren't trying to build loyalty. They hit a rough patch with their norovirus and E. coli scare, and they're still modeling in the revenue trough, honestly. So their proposition was, why don't we -- I'm going to use this key word today -- activate some of these loyal customers. If you are a casual eater of Chipotle and happened to look at the rewards chart that Vince was talking about, it really rewarded very frequent visits. It wasn't really just a dollar spend. You had to show up at Chipotle. What they were trying to do was rekindle the fire and enthusiasm of their peak visitors. This is one of the reasons, in the first place, to institute a loyalty program. It's much cheaper to get a current customer to spend again than it is to go out and acquire a new customer. So, for Chipotle, this made all the more sense. And I think this was a tremendous cost they undertook. I, too, was really surprised by those statistics, hearing them on the conference call. Yet, it's exactly what Chipotle needed to do, which was to solidify -- if I can use this phrase in the political season -- they needed to solidify their base. This cost they're incurring now is really an investment in stabilizing of revenue. As they add items to their menu, they'll be able to have newer customers come on.

But, my personal take is, it was a very appropriate action for Chipotle. I'm going to make a prediction that we'll see a revival of Chiptopia. It may not be called that. But you'll see a program leaning toward rewarding frequency. Chipotle wants you back in the stores. It's a little less concerned in the near-term with how much you spend. They want you to have that experience so that you begin to build a deeper innate trust in their product once again, just like they enjoyed before all this food scare came and walloped the company.

Shen: Yeah. There's some good points there that I want to touch on, especially with the idea of solidifying their base. I really like that because, in the end, a behavior they saw in some of their customer base was, they had some really die-hard fans. As a result of the food safety scares, some of those die-hard fans stopped coming. The idea was, "Let's offer this very attractive program in Chiptopia, and bring these people back, hopefully reestablishing what was a habit for some of our biggest and most loyal customers." I have a quote here from chief marketing and development officer Mark Crumpacker. In terms of the loyalty benefit that Chiptopia offered, he said, "Throughout the course of the promotion, we saw increased transaction and frequency levels. But most important, we've newly returned to pre-crisis levels among our most loyal customers. After the completion of the program, we anticipated traffic to fall slightly, but we've instead seen our improved sales levels generally continue to hold, which is very encouraging."

On that loyalty side, obviously, these affinity programs or loyalty programs keep the customers coming back. In this case, with the rewards of free food. But on the flip side of that, too, Mark Crumpacker goes on to speak to the data benefit as well for how the company is leveraging some of the transactional data that it was able to accumulate. He said, "By combining transactional information with other customer data, we are now able to identify more than half of our customers and reach them with specific offers and tailored messages. This important breakthrough not only allows us to target messages and offers to current and lapsed customers, but it also allows us to accurately measure the effectiveness of those efforts by tracking return visits." So, just like you had mentioned with Dunkin' Brands, here's a case where that one-to-one marketing, being able to cater your marketing, your promotions, to each customer, you're much better able to do that the more you know about them, the more you know about their buying behavior at your business.

Sharma: I totally agree, Vince. I want to add to that that the food scare took away one of Chipotle's greatest weapons. It enjoyed extremely elastic pricing before all this happened. Customers loved the product so much, they could consistently raise, in small increments, prices, let's say the beef burrito, et cetera. That has really been impacted by a decrease in trust and a real reservation of customers to come back. So, fighting in the trenches with their most loyal customers, is a way, if you look at a P&L [profit and loss] statement, it's one way to compensate for margins that might be a little squeezed. Especially, we know Chipotle has a higher labor costs, a higher food waste component now, as it's trying to ensure that they are a place that you can return to with a 100% degree of confidence. They have to find another way to be able to nudge margin up. This is the beginning of a long process which will enable them to get there, this data mining. It really, in the future, becomes about volume and margin. At the point where they can combine both of those, in other words, let's say they have some new menu introductions which, there's an uptake of their most loyal customers. Maybe the chorizo continues to become a popular burrito filling, or they introduced yet another filling. That's going to be for them the same degree of margin leverage that they had when it was easy for them to raise prices. So, I think there's a lot going on in what you just mentioned and the quote you gave to us. Long-term holders of Chipotle should watch for this, watch these frequency numbers. I think they'll be talking about them on conference calls for many quarters to come.

Shen: Yes. Final takeaways before we wrap up here. In terms of the most recent earnings that came out last week, with the stock trading down double-digits since then, some of you were probably very disappointed in the continued double-digit declines for overall revenue, comparable sales, foot traffic, operating margins are at half the prior-year levels. Asit, you had touched on those. I think, the 95% decline in income was probably particularly painful for a lot of shareholders. But, there's a lot of potential here as well in what Chipotle is adopting, what they're pursuing. You mentioned some of the rising costs with labor, food, food disposal and waste. But I think they announced about $100 million in cost-cutting measures. Also, something else that had investors concerned was, they're ending their ShopHouse Kitchen concept. I think there's 15 locations in three markets. They failed to gain traction. A big proponent of growth that investors believed Chipotle offered was the fact that they could take the success of the flagship chain and apply it to new concepts. Still, the company still has their pizza and their new burger concepts to pursue. I think, for 2017 in general, the company has a much more positive outlook in terms of comparable sales, the restaurant-level operating margins should recover quite well, and they'll just have better comparisons overall as the company laps some of its lows from early 2016.

One more thing touching on the data -- one more quote from Mr. Crumpacker. He said, "For example, using the data, we now know that during the last six months, we saw nearly 30 million new customers at Chipotle. These new customers are customers we have not seen since the food safety events of last year. In fact, transactions from these customers account for nearly half of all transactions over the last six months. Additionally, we know how many of these customers returned to Chipotle for additional visits, and how many of them became regular customers." I think that kind of information -- and, that 30 million number is very encouraging. Overall, despite some of the negative reception from the earnings, Chipotle is in an improving position, absolutely, following their troubles in this year.

Sharma: Yeah, I am of the same mind. Really briefly, you know how you look at a stock chart that's spread out five years, and you kick yourself for selling a stock when it was down, or maybe you bought it when it was low priced and now it has gone up a lot and you've sold it, the same phenomenon is occurring here with Chipotle. It's very hard to see, with the trees right in front of us, how many good things are going on in terms of better operations, in terms of the data that we've been talking about in this episode that they are definitely mining, the new customers. But all these factors will combine over the longer term, and they will come out of this with stronger revenue. And I believe that margins will recover. 

I want to make one last point, too, about the ShopHouse concept. I was sort of disappointed, too. But look at it from management's perspective. I remember management said, a couple years ago in a conference call, that for them, when a field manager walks into a ShopHouse kitchen, he or she does not see the ShopHouse. He or she sees a Chipotle. So, it's a matter of finding the right concept, and then expanding that one. Investors don't want Chipotle to throw good money after bad. If they find a concept isn't getting traction, as you said, shelve it. There are a number of other concepts in the fast-casual space that they can put their operational model to. And I believe they're going to do that. I'm not really that fazed about it long term. I did like the ShopHouse concept, and I enjoyed eating there. So, again, on a personal level, that was sort of bad.

Shen: That's all the time we have for today. Thank you, Asit, for joining me! Any listeners who want to continue the conversation with us and the rest of the Industry Focus crew, you can hit us up on Twitter @MFIndustryFocus, or you can send us any questions or comments via email to [email protected]. People on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Thank you for listening and Fool on!