For the past several weeks, Southwest Airlines (NYSE:LUV) CEO Gary Kelly has been hinting that the recently passed tax reform bill would cause Southwest to order more aircraft. After all, the tax bill permanently lowered the statutory corporate tax rate from 35% to 21%, while providing additional incentives for companies to increase capital spending in the next few years.
Sure enough, Southwest Airlines announced an increase to its Boeing (NYSE:BA) order book on Tuesday. The low-cost airline giant exercised 40 options for Boeing 737 MAX 8 airplanes, with deliveries scheduled in 2019 and 2020.
Not much growth in the old fleet plan
As of late October, Southwest Airlines was scheduled to add 43 aircraft to its fleet in 2018, bringing its fleet count to 750 by year-end. This will offset a decline in the fleet count during 2017 -- driven by the retirement of Southwest's aging fleet of Boeing 737 Classics -- and provide for moderate growth.
By contrast, until placing its recent order, Southwest Airlines was scheduled to receive just 14-15 airplanes a year between 2019 and 2022. This would imply annual fleet growth of about 2%. Even including the impact of having more seats on each plane and operating longer flights, this would have limited Southwest's annual capacity growth to 3% or so after 2018.
Based on its strong profitability -- Southwest Airlines' pre-tax margin has routinely been in the 15%-20% range in recent years -- the carrier clearly can afford to grow faster. Indeed, management sees ample room to expand in the continental U.S., add more international routes, and begin flying to Hawaii within the next few years. To capitalize on these opportunities, Southwest will need to expand its fleet at a faster rate.
Retooling the order book
Southwest's recent order for 40 737 MAX 8s will enable faster growth for the next few years. The first 15 aircraft from this order will arrive in 2019, with the remaining 25 coming in 2020.
Meanwhile, Southwest Airlines will defer 23 of its 30 orders for the 737 MAX 7 from the 2019-2021 period to 2023 and 2024. This will partially offset the impact of the new order on its near-term growth. However, Boeing probably couldn't have supplied more 737 MAX aircraft during this time frame, given that it had nearly 4,500 unfilled orders for the 737 family as of the end of November and is currently building just 47 per month.
Based on its restructured order book, Southwest Airlines is now set to add 47 aircraft to its fleet in 2019 and 2020 combined. This will boost its average annual fleet growth for that period to a little more than 3%.
Switching most of the orders to the 737 MAX 8 will also contribute to faster growth, as the MAX 8 has 175 seats in Southwest's configuration, compared to 150 seats for the 737 MAX 7. In total, Southwest Airlines is now positioned to increase its capacity at an average annual rate of roughly 5% for the next three years.
Starting small -- but there's more to come
Last month, I wrote that the tax reform bill could potentially spur Southwest Airlines to order hundreds more Boeing 737s. The recent order for another 40 737 MAX 8s represents a much more modest commitment on Southwest's part.
That said, while Southwest Airlines needed to move quickly to secure additional delivery slots in 2019 and 2020, it already has 20 737 MAX 8 options for 2021 and 21 737 MAX 8 options for 2022. This gives it the flexibility to wait a year or two before ordering more airplanes. By then, Southwest will know more about the impact of rising oil prices on its profitability and it will be able to confirm that its growth markets are living up to expectations.
Barring an unlikely collapse in its profitability, Southwest Airlines will probably exercise most or all of its Boeing 737 options for the early 2020s in order to maintain a mid-single-digit growth rate. Furthermore, if oil prices continue to trend higher, it may opt to accelerate the retirement of its oldest 737-700s in favor of the vastly more fuel-efficient 737 MAX 8. This could lead Southwest to order lots of additional Boeing 737s in the next few years.