Last week, Congress passed a business-friendly tax reform bill that will reduce the statutory corporate tax rate from 35% to 21%. Furthermore, businesses will be allowed to "expense" their capital expenditures for the next five years, further reducing the cash tax liabilities of companies in capital-intensive industries.
Airlines are set to be some of the biggest winners from tax reform. Most airlines pay the full statutory tax rate today and have very high capex requirements.
However, tax reform may not be good news for struggling legacy carriers American Airlines (NASDAQ:AAL) and United Continental (NYSE:UAL). Neither carrier will see any cash savings in the next few years. Meanwhile, tax reform could encourage smaller, more profitable airlines like Southwest Airlines (NYSE:LUV) to grow faster, putting pressure on unit revenue and profit margins throughout the industry.
Profit has been sinking at American and United
A few years ago, American Airlines and United Continental were flying high as a decline in oil prices added billions of dollars to their bottom lines. Unfortunately, 2017 has been a rough year for both carriers. Fuel costs have started to rebound, while labor costs are moving higher. Additionally, United Airlines has posted mediocre unit revenue results recently.
As a result, in the first nine months of 2017, American Airlines' adjusted pre-tax margin fell to 9.8% from 14.1% a year earlier, while United's adjusted pre-tax margin fell to 9% from 13.1% a year earlier. Both carriers are on track for further margin erosion in the fourth quarter.
In the meantime, oil prices have continued to rise this year. Even with slower non-fuel unit cost inflation in 2018, American and United will probably need unit revenue growth of 3%-4% just to keep pre-tax profit steady.
In this context, the passage of the tax reform bill might seem like great news. Like most other U.S. airlines, both carriers report effective tax rates of 35% or more. The move to a 21% federal corporate tax rate will create an EPS tailwind of at least 20%.
What tax savings?
Thus, on paper, tax reform looks good for American Airlines and United Continental. However, both companies accumulated huge losses during the 2000s. The resulting net operating loss (NOL) credits have allowed them to avoid paying any cash taxes up to this point.
As of the end of 2016, American Airlines still had $10.5 billion of NOL carryforwards on its balance sheet. United Continental had $4.4 billion of NOL carryforwards.
Even under existing tax law, United probably wouldn't have become a cash taxpayer until at least 2019 or 2020. American Airlines would have been able to avoid cash taxes for an even longer period of time. In other words, in the near term, neither carrier will see any cash savings relative to what they would have owed otherwise. And in the long run, their cash tax burdens can only go up, given that they aren't paying anything right now.
Smaller airlines could accelerate their growth
The calculus is much different for highly profitable airlines like Southwest. In recent years, Southwest Airlines' pre-tax margin has been around 19%. The company's profitability should rise further in 2018, as it will no longer be incurring fuel hedging losses. Southwest's stellar profitability indicates that it probably has a lot of attractive growth opportunities.
Furthermore, Southwest has been incurring a significant cash tax burden in recent years. It paid $1.4 billion in taxes during 2015, $902 million in 2016 and $611 million in the first nine months of 2017.
The "full expensing" of capital expenditures for the next five years represents a big incentive for airlines to buy more planes in order to reduce their near-term tax payments. Indeed, Southwest Airlines is interested in accelerating its growth, according to CEO Gary Kelly. This could drive down airfares, due to the carrier's massive reach and low cost structure.
Bad news for American Airlines and United Continental
Looking at Southwest Airlines' largest markets, it's clear that American and United have the most to lose if the low-fare leader increases its growth rate to reduce its tax burden. Southwest has major operations in Chicago, Dallas, Denver, Houston, Los Angeles, and Phoenix -- all of which are hub cities for American Airlines, United Airlines, or both. It could look to expand in many of these markets.
Many smaller low-fare carriers will face the same incentives favoring faster growth. Higher capacity almost inevitably leads to lower fares, which could push industry pre-tax margins lower.
For most airlines, tax savings and faster growth rates would more than make up for the negative impact of lower pre-tax profit margins. By contrast, American and United won't see any cash tax savings, and based on their low profitability, they have no reason to grow faster. Tax reform will certainly drive a short-term jump in EPS for both companies. But in the long run, it will probably lead to more competition -- and lower profit margins.