After finalizing terms for $5.8 billion of CARES Act payroll support grants two months ago, American Airlines (NASDAQ:AAL) turned its attention to lining up a secured loan under the same program. The $4.75 billion loan it is potentially eligible for represents the crux of the airline's plan to boost liquidity to more than $11 billion by the end of June.

Last Friday, American Airlines told investors that it plans to pledge the AAdvantage loyalty program as collateral for the loan. The company said that third-party appraisals have pegged the program's value at anywhere between $19.5 billion and an eye-popping $31.5 billion.

Considering that American Airlines' market cap is less than $10 billion, these estimates might seem to suggest that investors are undervaluing the company as a whole. However, it's more likely that the appraisals are wildly overvaluing the AAdvantage program.

Running short on collateral

While the loan portion of airlines' payroll support funds is unsecured, the CARES Act calls for any additional loans to be secured, in order to protect taxpayers from potential losses.

During American Airlines' first-quarter earnings call, management indicated that between aircraft and spare parts; international slots, gates, and routes; corporate real estate; and other assets, the carrier had at least $10 billion of unencumbered assets. Given that the collateral must be worth significantly more than the loan value to provide adequate protection, American might have needed to pledge nearly all of these assets to get the full $4.75 billion loan it wants.

An American Airlines plane parked on the tarmac

Image source: American Airlines.

However, American Airlines will almost certainly need to raise additional debt this year. If United Airlines' recent forecast is a guide, American is likely to continue burning tens of millions of dollars a day in the second half of 2020, potentially consuming $4 billion or more of cash. Without collateral to enable additional secured financings, the company could fall below its desired minimum cash position of $7 billion by year-end.

Pledging the AAdvantage program as collateral for the government loan will fix that problem. Once it locks down the CARES Act loan, American Airlines will have the flexibility to use its more traditional collateral to raise additional debt.

The problem with valuing loyalty programs

The AAdvantage loyalty program is certainly worth a meaningful amount. American's lucrative co-branded credit cards generate substantial cash flow. Furthermore, due to the lack of price competition, profit margins are much higher for the sale/issuance and redemption of miles compared to regular cash ticket purchases.

That said, the AAdvantage program is an integral part of American Airlines' business. As a theoretical stand-alone entity, the only asset belonging exclusively to AAdvantage is data: a list of customers' names, contact information, flight history, and perhaps also purchase histories for credit card holders. That's certainly worth something, but nowhere near $19.5 billion, let alone $31.5 billion.

Most of AAdvantage's value derives from its relationships and contracts with the airline, its credit card partners, and customers. Yet if American Airlines were to go out of business or stop using AAdvantage miles as a currency, the AAdvantage program would be far less valuable to customers and key partners like the credit card companies.

This is not just a theoretical concern. Air Canada was the first airline to spin off its loyalty program, a process it completed just before the Great Recession. The resulting company, Aimia, produced strong margins and was initially a popular investment. However, the spinoff meant that Air Canada lost control of its relationships with its best customers. Air Canada's contract with the loyalty program ran through 2020, and three years ago, it said that it would launch a new in-house loyalty program upon expiration of its contract with Aimia. You can see for yourself the results for Aimia stock.

AIM Chart

Aimia Stock Performance by YCharts.

Ultimately, Air Canada agreed in 2018 to buy the program back from Aimia for just 450 million Canadian dollars ($345 million). In short, the loyalty program was worth far less than investors had believed, as its value mostly derived from its contract with Air Canada. Once that contract expired, the true value (or lack thereof) of the loyalty program as distinct from the airline business became evident.

Whatever AAdvantage is worth, it's not $31.5 billion

The lesson from the Air Canada-Aimia debacle is that the relationship between an airline and its loyalty program is at best a zero-sum game. A longer contract and more favorable terms increase the value of the loyalty program, but if the terms are too onerous, the airline could be forced into bankruptcy. In that case, the contract could be worthless, severely reducing the value of the loyalty program.

American Airlines' adjusted net income totaled between $2.1 billion and $2.2 billion in 2018 and 2019. Operating cash flow before pension contributions was about $5 billion last year and $4 billion a year earlier, while management has estimated steady-state annual capital expenditures at $3 billion a year. Minimum pension funding averages about $500 million annually over the next five years.

In short, American Airlines is not producing enough cash under steady-state conditions for the entire business to be worth anywhere near $31.5 billion. Moreover, it could be several years before profitability returns to pre-pandemic levels. As a result, the loyalty program cannot be worth $31.5 billion.

Indeed, if we were to assume annual free cash flow of $1.5 billion for the AAdvantage program -- which might be consistent with a $31.5 billion valuation -- separating that cash flow from the airline would leave the rest of American Airlines as a heavily indebted company that could barely break even during the best of times. It would be ripe for bankruptcy, which would in turn destroy the loyalty program's value. The loyalty program may be able to serve as collateral for American Airlines' CARES Act loan, but investors shouldn't count on the company tapping any further value from it.