Southwest Airlines Could Order Hundreds More Boeing 737s

After facing a sales slowdown last year, Boeing (NYSE: BA) has benefited from a rebound in order activity in 2017. As usual, the popular 737 family of narrowbody jets has led the way.

Last week, Boeing lost out on a big potential order for the next-generation 737 MAX, as Delta Air Lines opted to buy 100 Airbus A321neos instead. Some pundits saw this as a major blow to Boeing. However, Boeing could be in line for hundreds of additional 737 MAX orders within the next couple of years from one of its best customers: Southwest Airlines (NYSE: LUV).

Southwest Airlines has lots of growth potential

Today, Southwest Airlines is the fourth largest airline in the U.S., with annual revenue of more than $21 billion. Nevertheless, the company has enormous growth potential.

Within the U.S., Southwest Airlines has had to rein in capacity growth this year due to a temporary shortage of aircraft. However, it routinely has one of the highest profit margins in the airline industry, highlighting the strong demand for its services. Thus, Southwest has meaningful opportunities to grow and regain its "natural share" of the domestic market.

Meanwhile, the carrier has been expanding gradually to more international destinations. It is just scratching the surface in places like Mexico, Central America, and the Caribbean. Most recently, Southwest Airlines announced that it will start selling tickets for Hawaii flights during 2018, confirming long-running rumors. (The first flights may not occur until 2019.)

Through the end of November, Southwest Airlines had increased its capacity by 3.7% in 2017, following a 5.7% increase in 2016 and a 7.2% increase in 2015. Based on its numerous expansion opportunities, Southwest could probably sustain a 4% to 5% annual capacity growth rate for the foreseeable future.

More planes needed

There are lots of places where Southwest could grow profitably, but right now, its fleet plan is extremely conservative. Next year, the carrier is scheduled to add 39 new Boeing 737s to its fleet, along with four used 737s. This will make up for a decline in Southwest's fleet count this year, enabling capacity growth of about 5% in 2018.

On the other hand, Southwest Airlines is currently scheduled to take delivery of just 58 planes between 2019 and 2022. That's only enough to support a 2% to 3% growth rate. Southwest then has 115 firm orders for delivery between 2023 and 2025: just slightly more than the number needed to replace planes that will reach the end of their 25-year useful lives during that period.

If Southwest were to aim for a 5% annual capacity growth rate, while retiring older aircraft at the 25-year mark, it would need to increase its firm order book for the 2019-2025 period by about 150 aircraft. Meanwhile, it doesn't have any firm orders beyond 2025 yet. Even if Southwest's growth rate slows, it would need to buy at least 50 planes annually after 2025 due to the massive number of aircraft that will be reaching retirement age each year.

Tax reform makes aircraft orders even more appealing

Thus, Southwest Airlines will need to order lots of Boeing 737s just to meet its normal growth and replacement needs. The tax reform bill that is currently making its way through Congress would give it an incentive to buy even more aircraft in the next few years.

First, the tax bill will lower the statutory corporate tax rate from 35% to 21%. This will boost Southwest's after-tax profit by more than 20%, encouraging faster growth. Second, companies will be able to fully deduct the cost of capital expenditures for the next five years, rather than depreciating them over a longer period of time. (This "full expensing" provision will sunset over the following five-year period.)

The result is that airlines have a big incentive to ramp up capital spending in the short run. CEO Gary Kelly has stated that Southwest will consider both faster fleet growth and accelerating the retirement of older planes.

Southwest could plausibly put an additional 200-250 planes to work in its fleet between 2019 and 2025. If it speeds up the retirement of its Boeing 737-700s, that would create a need for an additional 150-200 orders. Right now, Southwest Airlines has fewer than 200 firm orders for the 2019-2025 period.

As a result, Southwest may want to order another 200-250 Boeing 737 MAX planes for delivery by 2025, plus hundreds more for the rest of the 2020s. In this context, losing the Delta order to Airbus is no big deal for Boeing.

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Adam Levine-Weinberg owns shares of Delta Air Lines. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.