A few weeks ago, I named Alaska Air (NYSE:ALK), Hawaiian Holdings (NASDAQ:HA), JetBlue Airways (NASDAQ:JBLU), and Spirit Airlines (NYSE:SAVE) as the best airline stocks for investors to buy right now. All four stocks trade at very reasonable valuations and have far greater growth prospects than their larger rivals.
In my earlier analysis, I didn't mention anything about the potential for tax reform. However, if congressional Republicans manage to pass a tax reform bill in the coming weeks, it would provide a big profit boost for Alaska, Hawaiian, JetBlue, and Spirit.
Tax reform inches closer -- but there are no guarantees
Earlier this month, the House of Representatives passed a highly anticipated tax reform bill. The bulk of the proposed tax cuts would go to corporations, thanks to three key provisions. First, the bill permanently lowers the statutory corporate tax rate from 35% to 20%. Second, businesses will be allowed to deduct capital expenditures from their taxable income immediately, rather than depreciating those investments over a longer period. Third, companies will no longer have to pay taxes on income earned outside the U.S.
Senate Republicans plan to bring their own version of the tax reform bill to the floor this week. The Senate tax reform bill is similar to the House bill for corporate taxes. The one big difference is that to save money, the Senate version doesn't cut the corporate tax rate to 20% until 2019.
Still, while Republicans are close to achieving their goal of corporate tax cuts, their plans could stall out in the Senate. At least six Republican senators have major concerns about the current proposal, and the leadership can only afford to lose two votes, given that no Democrats will sign on. Finding an acceptable compromise will be tricky.
Airlines will be big winners
Many pundits have noted that cutting the corporate tax rate from 35% to 20% isn't as significant as it might seem, because most companies don't pay the full statutory tax rate. Companies that spend heavily on research and development or earn lots of money from overseas subsidiaries tend to have the lowest effective tax rates today.
By contrast, most airlines accrue income tax at the full statutory rate -- or something very close to it. They benefit from few, if any, of the tax breaks that other corporations use.
Furthermore, the airline industry is a capital-intensive business. While airlines have been able to utilize bonus depreciation allowances to defer some taxes based on their capital expenditures, a move to full deductibility of capital spending would lead to even greater savings.
Small, growing airlines will be the biggest winners
All profitable U.S. airlines would benefit from tax reform. However, the three legacy carriers won't see any tangible benefits for a while, because they're still using prior losses to offset their current income. As a result, they may not owe cash taxes to the federal government for years. Meanwhile, Southwest Airlines plans to reduce its aircraft capex for the next few years, so it won't benefit from the new rules on expensing capital spending for a while.
On the other hand, Alaska Air, Hawaiian Holdings, JetBlue Airways, and Spirit Airlines are all cash taxpayers today. Thus, they would get an immediate benefit from a lower statutory corporate tax rate.
All four companies are also set to spend a lot of money on new aircraft in the next few years, relative to the depreciation and amortization (D&A) expense they are currently reporting, mainly because of their significant growth plans. That means they could further reduce their effective tax rates by expensing their capital investments.
Alaska Air's scheduled capex averages more than $700 million over the next three years, nearly double its current annual D&A. JetBlue plans to spend an average of $1.1 billion annually on aircraft over that period, compared with annual D&A of less than $500 million. Hawaiian's annual committed aircraft capex for the next three years averages $399 million, more than three times its annual D&A. Finally, Spirit plans to spend an average of more than $700 million annually on new aircraft for the next few years, which is almost five times its D&A expense.
As a result, the current tax reform proposals would probably eliminate Spirit Airlines' cash tax bill for at least the next few years. Hawaiian Holdings, JetBlue Airways, and Alaska Air would all owe very little in cash taxes as well.
Thus, beyond the EPS boost from a lower statutory tax rate, the windfall from expensing capital investments would allow all four carriers to return a lot more cash to shareholders. That could give these stocks a big boost in 2018 if tax reform passes.