Tax Reform May Trim Spending on New Jetliners
Like shoppers rushing to beat a Christmas deadline, the nation’s airlines have been buying nearly every airplane in sight for the last few years. Since 1979, the industry has bought more than $25 billion worth of new aircraft, and another $35 billion worth is on order or option.
But now, for a variety of reasons, the shopping spree is about to end. Most importantly, it will soon cost more to buy airplanes.
Under the tax reform law that takes effect Jan. 1, the carriers are losing their 10% investment tax credit, a major incentive that has saved them millions of dollars when they have bought new airliners. The credits are deducted directly from the companies’ tax bills.
Also, the new tax code lengthens--to seven from five years--the period over which the value of equipment such as airplanes can be written off, or depreciated, against revenue. The more depreciation a company can claim in any year, the less tax it pays and the greater the amount of money available to buy new airplanes.
The new tax law “may have a tidal wave effect” that will hurt airlines’ earnings and consequently roll back their expenditures on new planes, warned George W. James, president of Airline Economics Inc., a Washington consulting firm.
For profitable airlines, the new tax law, which also reduces corporate income taxes, is expected to be ultimately beneficial, though perhaps not immediately. For money-losing carriers, it does not matter how low the corporate tax rate becomes because they generally pay no income taxes anyway. Also, the investment tax credit cannot be deducted from zero taxes.
“We’ll be slightly hurt for a couple of years,” said John L. Cowan, vice chairman and chief financial officer of UAL Inc., parent company of United Airlines. “Then we will be helped by the (tax reform) bill’s reduced statutory corporate income tax rates,” which will drop to 34%.
The investment tax credit, though most airline officials deny that it was the determining factor in investment decisions, is widely believed to have encouraged airlines to add one or two extra planes to their orders.
And that meant major additional investments because jet airliners cost anywhere from $25 million to more than $100 million.
William Hawkins, vice president for finance and taxation of the Air Transport Assn., the industry trade group, said: “An airline might buy 10 of those planes, but the (investment tax credit) would give it the incentive and ability to step from the 10th to the 11th and 12th plane, which it otherwise might not buy.”
The tax changes are not the only reasons that most observers predict a decrease in the number of airliners purchased in the next few years.
Lower wages and fuel prices also are having an effect, meaning that older planes, which burn more fuel and require a three-member crew in the cockpit, are being kept around longer.
The sharp dive in the price of fuel in the past year has made it much less necessary to replace old planes with new, fuel-efficient aircraft. Fuel makes up about 20% of the cost of operating an airline.
Lower Pay Scales
And the lower pay scales that flight crews are being forced to accept at many airlines are also cutting the cost of flying older jets, even though planes with two pilots in the cockpit are much cheaper to operate than are those that need three.
For example, the industry average crew cost for a Lockheed L-1011 wide-body jet with three in the cockpit is $634.92 per hour; for a Boeing 767 with a two-member cockpit crew, the cost is $508.57 an hour.
Experts say it would take fuel costs of $1.50 per gallon to make the Boeing 727-200 uneconomical for airlines to operate.
And a gallon of domestic jet fuel now costs only about 45 cents, compared to the 85 cents that it cost in May, 1984, suggesting that the workhorse 727-200 and other planes with three engines and three crew members in the cockpit will be flying for years to come.
Competition among airlines has been so intense in recent years that they are having difficulty filling their planes with passengers, and profits have dropped.
As a result, some carriers are getting to the point that they simply cannot afford new equipment. Further, mergers in the industry have resulted in a consolidation that has reduced demand for airliners even by those who can afford them.
“It becomes a very tough economic decision,” said Thomas Plaskett, president of Continental Airlines, “given the present price of fuel, the cost of capital . . . to justify airplanes on a replacement-cost basis--to take an airplane in my fleet and buy a new one.”
Michael Derchin, airline analyst with First Boston Corp., a New York-based brokerage house, said: “Managements are very hesitant to bet the store on new multibillion-dollar aircraft orders.”
Expects Fewer Orders
This year, Boeing generated $19 billion in orders for new planes, up from about $15 billion a year earlier.
“The orders are certainly going to be reduced (in 1987),” a spokesman said. “After you have a year like this, you never come in with a second heavy year.”
Using Delta Air Lines as an example, it quickly becomes evident how the pending elimination of the investment tax credit (ITC) will cost the airlines dearly. The effects of the removal of the ITC will begin slowly and gradually pick up steam.
Equipment ordered before last April 1 and delivered before the end of 1989 will come under transition rules that retain some of the tax credits.
Delta has 50 planes on order, each costing about $30 million, for a total of $1.5 billion.
Had the investment tax credit stayed at the current 10%, Delta would have saved $150 million of that. But in 1987, all companies making capital investments will lose 35% of the ITC unless they pay for them by July 1.
As a result, Delta will be able to benefit only from a 6.5% ITC, according to Robert Oppenlander, the airline’s vice chairman and chief financial officer. “We will have lost $50 million of it,” he lamented.
The net effect of the ITC repeal and the changes in depreciation schedules could increase the after-tax cost of aircraft ownership by 30%, calculates Maeda Klein, an aerospace analyst with the New York brokerage house of L. F. Rothschild, Unterberg, Towbin.
The loss of the tax subsidy will cost airlines about $5 billion during the rest of the decade, Airline Economics’ James estimated. “That is approximately $1 billion annually, an amount which exceeds the industry’s average annual net profit of $850 million over the last two years,” he says.
Most airline officials deny that they decided to order planes this year just because of the impending tax bill. But there are some who concede that they advanced their orders a bit.
Expedited Process
Phoenix-based America West Airlines has 15 Boeing 737-300s on order for delivery by the end of 1988. “We would have made the decision to order anyway,” company Chairman Edward Beauvais said, “but we expedited the decision-making process” to take advantage of the tax law’s transition period.
Jack C. Pope, senior vice president for finance of American Airlines, said: “We placed orders sooner than we otherwise would have.” American, one of the nation’s most profitable carriers, will take delivery of about $1 billion worth of new planes in each of the next two years.
Western Airlines, which has just become a subsidiary of Delta, had ordered a dozen aircraft worth $400 million before the merger.
“When we were taking a hard look at whether to buy the new aircraft,” said Thomas J. Roeck, senior vice president and chief financial officer, “we had a real incentive to order sooner rather than later.”
However, not everybody agrees that any reduction in orders for new airplanes will be the result of the elimination of the investment tax credit.
“I don’t think that capital investment in the airline industry has been driven by tax considerations,” said Richard F. Walsh, director of the Transportation Department’s Office of Economics.
“There is a high correlation between profits and buying,” he added. “When they (the airlines) have hard times, they don’t buy much equipment. The amount of new equipment will depend upon the profitability of the industry as a whole rather than on the tax laws.”
Many Lease Planes
Actually, however, many airlines have not bought their planes, increasingly preferring to lease them. Leasing was especially attractive for money-losing airlines.
With no profits, they were unable to use their investment tax credits anyway. The leasing company, because it did have profits, could take advantage of the tax shelter. And it could bank on the residual price of the plane at the end of the lease. In return, the airline could get a good lease price.
But, with the elimination of the tax credit, leasing costs are expected to rise by as much as 15%, according to Warren & Selbert, a Santa Barbara lease-consulting firm.
Despite the anticipated increase in leasing costs, leasing airplanes is expected to become increasingly popular in the airline industry, and leasing companies are steadily increasing the number of planes they own--and are buying them earlier.
In the past, even airlines that planned ultimately to lease their planes usually placed the initial orders with the manufacturer. Then, at delivery time, a leasing company took them over.
Now, in an unusual deal, Mitsui of Japan has ordered five McDonnell Douglas MD-11 advanced technology trijets.
The order by Mitsui, which leases planes to carriers, came before McDonnell Douglas had even formally decided to put the plane into production. According to the aircraft company, Mitsui got its order in early so it could get early delivery of the plane.
“This is the first time I know that a leasing company has taken a launch position,” Don Hanson, a spokesman for McDonnell Douglas, said. “Such increased interest and activity by leasing company is a reflection of the demise of the ITC.”
Because of the general expectation that airplane orders will drop in the near future, the manufacturers are scrambling for business. And the recent mergers in the airline industry have resulted in fewer but larger customers--each having more clout.
A Buyer’s Market
“Clearly, it’s a buyer’s market,” said First Boston’s Derchin. “For the first time since deregulation, the . . . aircraft manufacturers will be dealing with a small handful of powerful U.S. carriers for a large percentage of their potential sales.”
As a result there are some bargains around.
According to Paul Turk, research director of Avmark, an aviation marketing and management service in Arlington, Va., “slow sellers like the 757 and the 767 are being discounted up to 20%, and even hot sellers like the 737 and the MD-80 are being marked down at least 15% as Boeing, McDonnell Douglas and Airbus fight for market position.”
Texas Air, which owns Continental Airlines, New York Air and Eastern Airlines and is in the process of acquiring People Express, is an example of a combination with considerable influence over aircraft manufacturers because of its size.
“You’ve got to be in a position to buy big numbers,” Phil Bakes, Eastern Airlines’ president and chief executive, said.
Before it merged with Texas Air, he continued, “Eastern was sitting by itself. . . . Now we’re large enough to determine timing on delivery, airplane specifications and we can get a better price.”
The recent order that Northwest Airlines placed with Airbus Industrie (a consortium of companies in Britain, France, West Germany and Spain) is an example of how much influence airlines can have over the airplane makers.
In an unprecedented agreement, Northwest signed with Airbus for the purchase of up to 100 Airbus A320-200 aircraft. What is significant about the $3.2-billion deal is its flexibility. Northwest will be able to replace the older aircraft in its fleet in accord with market needs, economic conditions and its financing capability.
Waived Penalty Fee
Under terms of the highly unusual transaction, Northwest could take delivery of only the first 10 planes in the order and cancel the balance, without penalty, if conditions warrant.
Normally, when an airline drops an option for a plane, it must pay a penalty fee. This is one of the few times that a manufacturer has agreed to share the risk of developing a fleet with a major airline.
“This suggests that a new trend toward greater flexibility on the part of the manufacturers in dealings with the airlines will be a feature of the consolidation phase of deregulation,” Derchin said.
Such creative arrangements, combined with other factors, ensure that airliner sales will not remain depressed forever.
Oil producers are already trying to force oil prices back up, regenerating interest in fuel-conserving planes.
“The first time you see the price of fuel starting to shoot up again,” said Louis Marckesano, airline analyst with Janney Montgomery Scott, a Philadelphia broker, “you’ll see a wave of voluntary (airplane) retirements.”
Furthermore, the basic competitiveness of the airline industry will continue to require airlines to upgrade their fleets--whatever the changes in the tax laws.
