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

By Markets Fool.com

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.

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In this episode ofIndustry 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(NYSE: CMG) and Dunkin' Brands(NASDAQ: DNKN) to highlight what a successful affinity program bring to to a company.

A full transcript follows the video.

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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 isjoining us viaSkype. How are you, sir?

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

Shen: Did youdress up for Halloween?

Sharma: I have to mention really quick for our listeners, Halloween was just OK. I dressed upas awerewolf, but a retired werewolf. I had to give the kids in the neighborhoodsome life advice, but they didn't respondthat well. They were like, "Justgive me the candy."

Shen: Howabout 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 theydidn't really dress up,but they orchestrated hiding in the bushesand scaring some other teens that came by, and handing out candy to the smaller kids. That was good to see.

Shen: OK, sothey'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 onthe fence, maybe next year. How about you? Did youhave 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 thesupertrends that we talked about in previous episodes. There wascustomization,then there was,on the flip side of that, simplification, SKUrationalization, last time I had you on the show. For our third supertrend, you hadidentified, in the consumer retail world, loyalty programs and theirvery rapid proliferation in the past20 or 30 years. Think credit cards, supermarkets, airlines,restaurants, online retailers. Everyone has jumped on this bandwagon. ButI was actually very surprised to learn that these programs have beenaround 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 periodin the United States. Both before and after the war, coins often came into acute shortages, so folksproduced these copper tokens,and you would use the tokens to buymerchandise, the goods thatyou needed to get through the week. Afterthe coins would resume in circulation, some savvy merchants startedhanding out tokens with purchases. After you had amassed a certain amount oftokens, you could trade those in for goods. Does that sound familiar?

Shen: Thatsounds pretty familiar to me. The coins that you mention,I couldn't believe it dates all the way back to the Revolutionary War period, buteventually the coins gave way to other forms of tokens, like stamps, box tops, which were stillaround when I was a kid, paper coupons and more. I think, the more modern age of theloyalty program movementdefinitely was ushered in with the airline industry.American Airlinesintroduced itsfrequent flyer program in 1981.United Airlinesvery quickly followed suit. Whenwe look at these loyalty programs, the core idea behind such an offering is that they getcustomers to come back over and overagaintypically with the allure ofsome type of award or benefit.

On the flip side, I think it's really important as investors to look at what thesecompanies get out of offering such programs. Airline industries are a really goodexample of that, especially in early years. They had an issue,especially if you think back to flying 30 to 40 years ago, wheretravel 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 feltvery far removed from their own customers,and the loyalty programs, the frequent flyer programs that theycreated in the early eighties were a way ofre-establishing that connection. And, to get a much better view oftravel patterns, price points, things along those lines. I think that expansion, that data element of itand the insights that it offers intocustomer behavior is super important, and is the main driver behind whyloyalty 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'sanother term that we use, which is more in vogue with the industry,rather than loyalty programs we call theseaffinity programs. If you were to look these two wordsup in the dictionary,loyalty meansstanding by somebody, being there for them. Affinityis a little bit more subtle of a concept. It means that you have a sympathetic view of something, or you havesomething that you like, you share with somebody. Whatyou're talking about isreciprocity betweenbrands and consumersthat happens when you havesomething the consumer can get out of the equation, and on the flip side,something that the manufacturer/retailer can get out of it. That'swhat we saw out of the airlines. They increased frequency flights, made more money, and consumers,with those miles, were able to travelto 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 hascome up very strongly in the last couple years due to the availability of big data to retailers. Retailers nowcan create customized dashboards. These dashboards don'tjust 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, andon that same dashboard, combine that with statistics of how much he purchasesevery week or every month. Most of the companies that areout there offering affinity programsdon't do this themselves, they hirethird-party software companies which specialize in CRM -- customer relationship management -- software to do this. This is why the trend hasexploded and become a supertrend, because you can really operate on a much more precise levelas a retailer,and you can then drive thebehaviors you wantusing the data you collect.

Shen: Yeah,I think the benefits of that big dataand the insight thatthe companies get on the customers andhow 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 theUnited States. The average Americanis a member of 13 of these different programs, and isusually 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 twocompanies that we wanted to focus ontoday, 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 isDunkin' Donuts. I think when it comes to aquick breakfast, coffee, theirbigger competitor beingStarbucks has really set a very, very high bar forwhat a loyalty program can look like, and also howincredibly successful it can be. So, what has Dunkin' Donuts beendoing in its approach to this supertrend?

Sharma: Dunkin' Donuts is probably,for a long time, going to be the red-headed stepchild compared toStarbucks. Starbucks hasover 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 itssmaller footprint globallycompared to Starbucks. The program itselfis pretty simple. It's called DD Perks. It combinesphysical cards with a mobile app,which also has an order aheadfeature. You get 5 pointsfor every dollar you spend. Once you accumulate 200 points,you get a free beverage. We want to break down todaywith that type of mathematical interchangeof reciprocitythat 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 areward of a medium latte, that's going to run you $3 to $4based 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 itsproducts by having you come back. But,what they've gotten out of you, the customer is ninerepeat visits after that first one.

Vince,this goes back to a larger stat thatI also found doing research. On average, retailers,if they have a loyalty program, will get,over the lifetime of a customer, about 10 times theinitial 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 arereally loyal to the brands we love. So, theeconomics work out on both sides of that equation.

Shen: Yeah. I think that the 10% youmentioned 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 spenda certain amount, call it $10, and theystamp 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 andaccumulated rewards. And there were some complaints from that, but overall, basing itin terms of dollars spent instead of visits issomething that allows the company tocontrol that a little bit more carefully.

Sharma: Right. There's a stepbeyond the basic economics. Once you get your program rolling and have anappreciable membership, which is, how does it relate to the overall strategy for your company? Dunkin' Brands has beenexcellent in the way they have implemented their DD Perks program. They now see it aspart of their overall strategy. In fact, I think it's one of the four pillars,digital strategy. I want to quotefrom CEO Nigel Travis from earlier this year, he said, "Our goal is toprovide our guestswith targeted offers through our perksloyalty program that arerelevant to them to drive visits and tickets." This is step No. 2: Once youincentivize the visits, then you want to drive the trafficfurther, 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 thatemail was going away. But anyone who participates in a loyaltyprogram knows that email is going to be here for a long time,because you get a ton of emailsfrom 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 architectmass behavioralmost at will. That's the end goal for DD Perks, and that's whyI 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 programeven against a very well-establishedincumbent with its ownvery competitive and successfuloffering, we haveChipotle. Chipotle obviously hasexperienced 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 temporaryChiptopia program. During those three months,essentially, based on the frequency with which you visited their locations, you could reachone 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 acatered meal for 20,which is about a $240 value. I think this was obviously reservedfor the real die-hard fans. With this show, today, I was with my brother over the weekend,he mentioned that he had just recently eatenhis last free mealthat he got from Chiptopia. I thinkhe was a regular medium level member over the three months. But, 75,000people 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'regoing to have to give out about $18 million in free food,on top of the approximately $2 million infree burritos those customers were already getting,assuming you're paying about $9 per meal.

Theprogram overall attracted about 6 million people, with2.5 million actually earningrewards 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 theyrelease earnings last week. What do youthink about the program? Anddo you think this will be a preview of somethingthey establishon a more permanent basis in terms of a loyalty program?

Sharma: First, on a personal level, I reached medium status in our household. Myyoungest is a Chipotle freak. We didn't obtain the highestreward 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 thatwe do have this core of really loyal customers. So,they weren't trying to build loyalty. They hit a rough patchwith theirnorovirus and E. coli scare, and they're stillmodeling in the revenue trough,honestly. So their proposition was, why don't we --I'm going to use this key word today -- activatesome of these loyal customers. If you are a casual eater of Chipotleand happened to look at the rewards chart that Vince was talking about, it reallyrewarded very frequent visits. It wasn't really just a dollar spend. You had to show up at Chipotle. What they were trying to do wasrekindle 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 acurrent customer to spend again than it is togo out and acquire a new customer. So,for Chipotle, this made all the more sense. AndI 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 instabilizing of revenue. As they additems 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 towardrewarding 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 thatexperience 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 ofsolidifying their base. I really likethat because, in the end, abehavior 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 veryattractive program in Chiptopia, and bring these people back,hopefully reestablishing what was a habit for some of ourbiggest 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'venewly returned to pre-crisis levelsamong our most loyalcustomers. After the completion of the program, we anticipated traffic to fall slightly, but we've instead seen ourimproved sales levelsgenerally continue to hold, which is very encouraging."

On that loyalty side, obviously,these affinity programs or loyalty programskeep 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 forhow the company is leveragingsome of the transactional data that it was able to accumulate. He said, "Bycombining transactional information with other customer data,we are now able to identifymore than half of our customers and reach them withspecific offers and tailored messages. This important breakthrough not only allows us to target messages andoffers 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 thatthe more you know about them, the more you knowabout their buying behavior at your business.

Sharma: I totally agree, Vince. I want to add to that that the food scare took away one ofChipotle's greatest weapons. It enjoyedextremely elastic pricingbefore all this happened. Customers loved the productso much, they could consistently raise, in smallincrements, prices,let's say the beef burrito, et cetera. That has really been impactedby a decrease in trust and a real reservation of customers to come back. So, fighting in the trenches with their mostloyal customers, is a way,if you look at a P&L [profit and loss] statement, it's one way tocompensate for margins that might be a little squeezed. Especially, we know Chipotlehas a higher labor costs, a higher food wastecomponent now,as it's trying to ensure that they are a place that you canreturn to with a 100% degree of confidence. Theyhave 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 volumeand margin. At the point where they can combineboth of those,in other words, let's say they have some new menu introductions which, there's an uptakeof their most loyal customers. Maybe the chorizo continues to become a popular burrito filling,or they introduced yet anotherfilling. That'sgoing to be for them the samedegree of margin leveragethat they had when it was easy for themto raise prices. So, I think there's a lot going onin what you just mentionedand the quote you gave to us. Long-term holders of Chipotleshould watch for this,watch these frequency numbers. I think they'll be talking aboutthem on conference callsfor many quarters to come.

Shen: Yes. Finaltakeaways before we wrap uphere. In terms of the most recentearnings that came out last week,with the stock trading downdouble-digits since then,some of you were probably very disappointed in thecontinued double-digit declines foroverall revenue, comparable sales, foottraffic, operating margins are at half the prior-year levels. Asit, you had touched on those. I think, the95% decline in incomewas probably particularly painful fora lot of shareholders. But, there's a lot of potential here as well in what Chipotle is adopting, what they'repursuing. You mentionedsome of the rising costs with labor, food,food disposal and waste. But I think they announced about $100million in cost-cutting measures. Also, something else that had investors concerned was, they'reending their ShopHouse Kitchen concept.I think there's 15 locations in three markets. Theyfailed to gain traction. A bigproponent of growththat investors believed Chipotle offered was the fact that they could take thesuccess of the flagship chain and apply it tonew concepts. Still, the company still has their pizza and their new burger concepts to pursue. I think, for 2017in general, the company has a much morepositive outlook in terms of comparable sales, the restaurant-level operating marginsshould recover quite well,and they'll just have better comparisons overallas 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, "Forexample, using the data, we now know thatduring the last six months, we saw nearly 30 millionnew customers at Chipotle. These new customers arecustomers we have not seen since the food safety events of last year. In fact, transactionsfrom these customers account for nearly halfof all transactions over the last six months. Additionally,we know how many of these customers returned to Chipotle foradditional visits, and how many of them became regular customers."I think that kind of information -- and, that 30 millionnumber is very encouraging. Overall, despite some of the negativereception 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 nowit 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 ofbetter operations, in terms of the datathat we've been talking about in this episode that they are definitely mining, the new customers. Butall these factorswill combine over the longer term, and they will come out of this withstronger revenue. And I believe that margins will recover.

I want to make one lastpoint, too, about the ShopHouse concept. I was sort of disappointed, too. Butlook at it from management's perspective. I remember management said, a couple years ago in a conference call, that for them, when a fieldmanager 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 wantChipotle to throwgood 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 thatthey can put their operational model to. AndI 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! Anylisteners who want to continue the conversation with usand the rest of the Industry Focus crew,you can hit us up onTwitter@MFIndustryFocus,or you can send us any questions or comments via email to industryfocus@fool.com.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!

Asit Sharma has no position in any stocks mentioned. Vincent Shen has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Chipotle Mexican Grill and Starbucks. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.