10-K 1 luv-12312017x10k.htm FORM 10-K Document


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

(Mark One)
þ
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the fiscal year ended December 31, 2017
 
or
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from ________ to ________
Commission File No. 1-7259
 southwestfinal.jpg
Southwest Airlines Co.
(Exact name of registrant as specified in its charter)
TEXAS
74-1563240
(State or other jurisdiction of
(IRS Employer
incorporation or organization)
Identification No.)
P.O. Box 36611
 
Dallas, Texas
75235-1611
(Address of principal executive offices)
(Zip Code)
Registrant's telephone number, including area code:  (214) 792-4000
 
 
Securities registered pursuant to Section 12(b) of the Act:
Title of Each Class
 
Name of Each Exchange on Which Registered
Common Stock ($1.00 par value)
 
New York Stock Exchange
Securities registered pursuant to Section 12(g) of the Act:
None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  þ    No  ¨
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes ¨   No  þ
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  þ    No  ¨




Indicate by checkmark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  þ    No  ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.    ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of "large accelerated filer," "accelerated filer," "smaller reporting company," and "emerging growth company" in Rule 12b-2 of the Exchange Act.
Large accelerated filer þ
 
Accelerated filer ¨
Non-accelerated filer ¨
 
Smaller reporting company ¨
 
 
Emerging growth company ¨
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).    Yes  ¨    No  þ
The aggregate market value of the common stock held by non-affiliates of the registrant was approximately $37,211,057,645 computed by reference to the closing sale price of the common stock on the New York Stock Exchange on June 30, 2017, the last trading day of the registrant’s most recently completed second fiscal quarter.
Number of shares of common stock outstanding as of the close of business on February 5, 2018: 587,950,973 shares
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Definitive Proxy Statement for the Company’s Annual Meeting of Shareholders to be held May 16, 2018, are incorporated into Part III of this Annual Report on Form 10-K.
 





TABLE OF CONTENTS

 
 
 
 
PART I
 
Item 1.
Item 1A.
Item 1B.
Item 2.
Item 3.
Item 4.
 
 
 
 
PART II
 
Item 5.
Item 6.
Item 7.
 
 
 
Item 7A.
Item 8.
 
 
 
 
 
 
Item 9.
Item 9A.
Item 9B.
 
 
 
 
PART III
 
Item 10.
Item 11.
Item 12.
Item 13.
Item 14.
 
 
 
 
PART IV
 
Item 15.
Item 16.



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PART I 
Item 1.
Business
Company Overview
Southwest Airlines Co. (the "Company" or "Southwest") operates Southwest Airlines, a major passenger airline that provides scheduled air transportation in the United States and near-international markets. For the 45th consecutive year, the Company was profitable, earning $3.5 billion in net income.
Southwest commenced service on June 18, 1971, with three Boeing 737 aircraft serving three Texas cities: Dallas, Houston, and San Antonio. At December 31, 2017, Southwest operated a total of 706 Boeing 737 aircraft and served 100 destinations in 40 states, the District of Columbia, the Commonwealth of Puerto Rico, and ten near-international countries: Mexico, Jamaica, The Bahamas, Aruba, Dominican Republic, Costa Rica, Belize, Cuba, the Cayman Islands, and Turks and Caicos.
The Company expanded its international footprint during 2017, with the commencement of service to Owen Roberts International Airport in Grand Cayman and Providenciales International Airport in Turks and Caicos, both from Fort Lauderdale-Hollywood International Airport. The Company also commenced service to Cincinnati/Northern Kentucky International Airport in 2017, giving the Company’s Customers access to a full complement of the top 50 markets across the 48 contiguous United States.
During 2017, the Company announced plans to begin selling tickets in 2018 for service to Hawaii, subject to requisite governmental approvals, including approval from the Federal Aviation Administration ("FAA") for Extended Operations ("ETOPS"), a regulatory requirement to operate between the U.S. mainland and the Hawaiian Islands. The Company further announced its decision to cease service at Bishop International Airport in Flint, Michigan, with the last day of service on June 6, 2018. In January 2018, the Company announced its intent to begin service at a new commercial aircraft facility at Paine Field in Everett, Washington, scheduled to be completed in 2018.
In 2017, the Company completed its deployment of a new single reservation system, the largest technology project in the Company's history. The new reservation system was designed to improve flight scheduling and inventory management, enable revenue enhancements, support additional international growth, and enable other foundational and operational capabilities.
Further, in 2017, the Company became the first airline in North America to offer scheduled service utilizing Boeing's new, more fuel efficient, 737 MAX 8 aircraft. The Company also retired its remaining Boeing 737-300 aircraft.
Based on the most recent data available from the U.S. Department of Transportation (the "DOT"), as of September 30, 2017, Southwest was the largest domestic air carrier in the United States, as measured by the number of domestic originating passengers boarded.
Industry
The airline industry has historically been an extremely volatile industry subject to numerous challenges. Among other things, it has been cyclical, energy intensive, labor intensive, capital intensive, technology intensive, highly regulated, heavily taxed, and extremely competitive. The airline industry has also been particularly susceptible to detrimental events such as acts of terrorism, poor weather, and natural disasters.
The U.S. airline industry benefited from modest economic growth during 2017 and was further aided by a relatively stable fuel environment. In recent years, the U.S. airline industry, including Southwest, has increased available seat miles (also referred to as "capacity," an available seat mile is one seat, empty or full, flown one mile and is a measure of space available to carry passengers in a given period), and has increased the number of seats per trip (or "gauge") through slimline seat retrofits and the use of larger aircraft. Strategic capacity increases are expected to continue in 2018.
In 2017, the airline industry continued to be impacted by the significant growth of "Ultra-Low Cost Carriers" ("ULCCs"). ULCCs offer "unbundled" service offerings, which enable them to appeal to price-sensitive travelers through promotion to consumers of an extremely low relative base fare for a seat, while separately charging for related services and products. In response, certain major U.S. airlines (sometimes referred to as "legacy" or "network" carriers) have introduced new fare products, such as a "Basic Economy" product. The Basic Economy product provides for a lower

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base fare to compete with a ULCC base fare, but includes significant additional restrictions on amenities such as seat assignments (including restrictions on group and family seating), order of boarding, checked baggage and use of overhead bin space, flight changes and refunds, and eligibility for upgrades. Also in response to ULCC pricing, some legacy carriers have removed their fare floors for certain routes, leading to lower fares across the industry. Conversely, some legacy carriers offer a "Premium Economy" fare that targets consumers willing to pay extra for additional amenities such as more favorable seating options in segmented aircraft.
Company Operations
Route Structure
Southwest principally provides point-to-point service, rather than the "hub-and-spoke" service provided by most major U.S. airlines. The hub-and-spoke system concentrates most of an airline's operations at a limited number of central hub cities and serves most other destinations in the system by providing one-stop or connecting service through a hub. By not concentrating operations through one or more central transfer points, Southwest's point-to-point route structure has allowed for more direct nonstop routing than hub-and-spoke service. Approximately 76 percent of the Company's Customers flew nonstop during 2017, and, as of December 31, 2017, Southwest served 675 nonstop city pairs.
Southwest’s point-to-point service has also enabled it to provide its markets with frequent, conveniently timed flights and low fares. For example, Southwest currently offers 19 weekday roundtrips between Dallas Love Field and Houston Hobby, 12 weekday roundtrips between Burbank and Oakland, 12 weekday roundtrips between San Diego and San Jose, eight weekday roundtrips between Denver and Chicago Midway, and 10 weekday roundtrips between Los Angeles International and Las Vegas.
Southwest complements its high-frequency short-haul routes with long-haul nonstop service between markets such as Los Angeles and Nashville, Las Vegas and Orlando, San Diego and Baltimore, Houston and New York LaGuardia, and Oakland and Baltimore. During 2017, the Company introduced the Boeing 737 Max 8 to its fleet and continued to incorporate the Boeing 737-800 aircraft into its fleet, both of which offer significantly more Customer seating capacity than the Company’s other aircraft. This has enabled the Company to more economically serve long-haul routes, as well as high-demand, slot-controlled, and gate-restricted airports, by adding seats for such routes without increasing the number of flights (a "slot" is the right of an air carrier, pursuant to regulations of the FAA, to operate a takeoff or landing at a specific time at certain airports). For 2017, the Company’s average aircraft trip stage length was 754 miles, with an average duration of approximately 2.0 hours, as compared with an average aircraft trip stage length of 760 miles and an average duration of approximately 2.0 hours in 2016.
The Company continued its focus on California in 2017, and continues to invest significant resources to solidify its leadership position in California, including the planned addition of new domestic and international destination options and flights for California Customers, as well as additional marketing programs, loyalty incentives, and local outreach efforts designed to retain, engage, and acquire Customers. Based on the most recent data available from the DOT, for the year ending October 31, 2017, Southwest carried more domestic Revenue Passengers to, from, and within California than any other airline.
The Company ended 2017 with international service to 14 destinations through 16 international gateway cities within the 48 contiguous United States. During 2017, the Company commenced international service out of Oakland, San Diego, Nashville, and St. Louis. In addition, the Company announced commencement in 2018 of international service out of Indianapolis, San Jose, Sacramento, Columbus, New Orleans, Pittsburgh, and Raleigh-Durham. The Company has also concentrated its service to Cuba in Havana and ceased operations during 2017 to Varadero and Santa Clara, Cuba.
In 2017, to further support its near-international operations, the Company opened a new five-gate international concourse at Fort Lauderdale-Hollywood International Airport (FLL). The Company expanded its international flight schedule for South Florida to a total of nine international nonstop destinations including Montego Bay, Jamaica; Belize City, Belize; Cancun, Mexico; Grand Cayman; Havana, Cuba; Nassau, The Bahamas; San Jose, Costa Rica; Punta Cana, Dominican Republic; and Turks and Caicos. Additional information regarding the Company’s involvement with construction of the new concourse at FLL is provided below under "Management’s Discussion and Analysis of Financial Condition and Results of Operations" and in Note 4 to the Consolidated Financial Statements.

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Approximately $595 million, approximately $383 million, and approximately $287 million of the Company's operating revenues in 2017, 2016, and 2015, respectively, were attributable to foreign operations. The remainder of the Company's operating revenues, approximately $20.6 billion, approximately $20.0 billion, and approximately $19.5 billion in 2017, 2016, and 2015, respectively, were attributable to domestic operations. The Company's assets are not allocated to a geographic area because the Company's tangible assets primarily consist of flight equipment, the majority of which are interchangeable and are deployed systemwide, with no individual aircraft dedicated to any specific route or region.
Cost Structure
A key component of the Company's business strategy is its focus on cost discipline and profitably charging competitively low fares. Adjusted for stage length, the Company has lower unit costs, on average, than the majority of major domestic carriers. The Company's strategy includes the use of a single aircraft type, the Boeing 737, the Company's operationally efficient point-to-point route structure, and its highly productive Employees. Southwest's use of a single aircraft type allows for simplified scheduling, maintenance, flight operations, and training activities. Southwest's point-to-point route structure includes service to and from many secondary or downtown airports such as Dallas Love Field, Houston Hobby, Chicago Midway, Baltimore-Washington International, Burbank, Manchester, Oakland, San Jose, Providence, and Ft. Lauderdale-Hollywood. These conveniently located airports are typically less congested than other airlines' hub airports, which has contributed to Southwest's ability to achieve high asset utilization because aircraft can be scheduled to minimize the amount of time they are on the ground. This, in turn, has reduced the number of aircraft and gate facilities that would otherwise be required and allows for high Employee productivity (lower headcount per aircraft).
The Company's focus on controlling costs also includes a continued commitment to pursuing, implementing, and enhancing initiatives to reduce fuel consumption and improve fuel efficiency. Fuel and oil expense remained the Company's second largest operating cost in 2017. Although 2017 fuel prices were moderately higher than 2016 fuel prices, as evidenced by the table below, energy prices can fluctuate significantly in a relatively short amount of time. The table below shows the Company's average cost of jet fuel for each year beginning in 2003 and during each quarter of 2017.
Year
 
Cost
(Millions)
 
Average
Cost Per
Gallon
 
Percentage of    
Operating
Expenses
2003
 
$
920

 
$
0.80

 
16.5
%
2004
 
$
1,106

 
$
0.92

 
18.1
%
2005
 
$
1,470

 
$
1.13

 
21.4
%
2006
 
$
2,284

 
$
1.64

 
28.0
%
2007
 
$
2,690

 
$
1.80

 
29.7
%
2008
 
$
3,713

 
$
2.44

 
35.1
%
2009
 
$
3,044

 
$
2.12

 
30.2
%
2010
 
$
3,620

 
$
2.51

 
32.6
%
2011
 
$
5,644

 
$
3.19

 
37.7
%
2012
 
$
6,120

 
$
3.30

 
37.2
%
2013
 
$
5,763

 
$
3.16

 
35.1
%
2014
 
$
5,293

 
$
2.93

 
32.3
%
2015
 
$
3,616

 
$
1.90

 
23.0
%
2016
 
$
3,647

 
$
1.82

 
21.9
%
2017
 
$
3,940

 
$
1.92

 
22.3
%
First Quarter 2017
 
$
922

 
$
1.89

 
21.8
%
Second Quarter 2017
 
$
990

 
$
1.84

 
22.0
%
Third Quarter 2017
 
$
1,003

 
$
1.92

 
22.6
%
Fourth Quarter 2017
 
$
1,025

 
$
2.04

 
22.8
%
The Company focuses on reducing fuel consumption and improving fuel efficiency through fleet modernization and other fuel initiatives. For example, during 2017, the Company continued to replace its older aircraft with newer aircraft that are less maintenance intensive and more fuel efficient. The Company retired all remaining Boeing 737-300 aircraft

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from its fleet in September 2017 and began scheduled service with its first Boeing 737 MAX 8 aircraft in October 2017. The Boeing 737 MAX 8 is expected to significantly reduce fuel use and CO2 emissions, as compared with the Company's other aircraft. The Company ended 2017 with 13 Boeing 737 MAX 8 aircraft in its fleet. The Company's fleet composition and delivery schedules are discussed in more detail below under "Properties - Aircraft." The Company has also undertaken a number of other fuel conservation initiatives which are discussed in detail under "Regulation - Environmental Regulation."
To illustrate the results of the Company's efforts to reduce fuel consumption and improve fuel efficiency, the table below sets forth the Company's available seat miles produced per fuel gallon consumed over the last five years:
  
 
Year ended December 31,
 
 
2017
 
2016
 
2015
 
2014
 
2013
Available seat miles per fuel gallon consumed
 
75.2
 
74.4
 
73.9
 
72.8
 
71.7
The Company also enters into fuel derivative contracts to manage its risk associated with significant increases in fuel prices. The Company's fuel hedging activities, as well as the risks associated with high and/or volatile fuel prices, are discussed in more detail below under "Risk Factors," "Management’s Discussion and Analysis of Financial Condition and Results of Operations," and Note 10 to the Consolidated Financial Statements.
Salaries, wages, and benefits expense constituted approximately 41 percent of the Company's operating expenses during 2017 and was the Company's largest operating cost. The Company's ability to control labor costs is limited by the terms of its collective-bargaining agreements, and increased labor costs have negatively impacted the Company's low-cost competitive position. The Company's labor costs, and risks associated therewith, are discussed in more detail below under "Risk Factors" and "Management’s Discussion and Analysis of Financial Condition and Results of Operations."
Fare Structure
General
Southwest offers a relatively simple fare structure that features competitive fares and product benefits, including unrestricted fares as well as lower fares available on a restricted basis. Southwest fare products include three major categories: "Wanna Get Away®," "Anytime," and "Business Select®," with the goal of making it easier for Customers to choose the fare they prefer. All fare products include the privilege of two free checked bags (weight and size limits apply), complimentary soft drinks and snacks, as well as free live and on-demand television where available. In addition, regardless of the fare product, Southwest does not charge fees for changes to flight reservations although fare differences may apply.
"Wanna Get Away" fares are generally the lowest fares and are typically subject to advance purchase requirements. They are nonrefundable, but, subject to Southwest's No Show Policy, funds may be applied to future travel on Southwest.
"Anytime" fares are, subject to Southwest's No Show Policy, refundable if canceled, or funds may be applied towards future travel on Southwest. A change or modification to a flight reservation will result in the fare becoming nonrefundable. In addition, if this fare is purchased with nonrefundable funds, then the flight would be nonrefundable if canceled. Anytime fares also include a higher frequent flyer point multiplier under Southwest's Rapid Rewards® frequent flyer program compared with "Wanna Get Away" fares. The Company's frequent flyer program is discussed below under "Rapid Rewards Frequent Flyer Program."
"Business Select" fares are, subject to Southwest's No Show Policy, refundable if canceled, or funds may be applied towards future travel on Southwest. A change or modification to a flight reservation will result in the fare becoming nonrefundable. In addition, if this fare is purchased with nonrefundable funds, then the flight would be nonrefundable if canceled. Upgrading to "Business Select" from another fare type will result in the fare becoming nonrefundable. Business Select fares also include additional perks such as priority boarding with a boarding position in the first 15 boarding positions within boarding group "A," the highest frequent flyer point multiplier of all Southwest fare products, "Fly By®" priority security and/or ticket counter access in participating airports, and one complimentary adult beverage coupon for the day of travel (for Customers of legal drinking age).

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Southwest's No Show Policy applies if a Customer does not change or cancel a flight segment at least ten minutes prior to scheduled departure and the Customer does not travel on the scheduled flight. In such event, subject to certain exceptions, all segments associated with the reservation will be canceled, and (i) with respect to a "Wanna Get Away" fare, unused funds will be forfeited; and (ii) with respect to an "Anytime" or "Business Select" fare, unused funds will be held as travel credit for future travel by the Customer on Southwest.
Ancillary Services
The Company offers ancillary services such as Southwest's EarlyBird Check-In® and transportation of pets and unaccompanied minors, in accordance with Southwest's respective policies. EarlyBird Check-In provides Customers with automatic check-in and an assigned boarding position before general boarding positions become available, thereby improving Customers' seat selection options (priority boarding privileges are already a benefit of being an "A-List" tier member under the Company's Rapid Rewards Frequent Flyer Program). Southwest’s Pet Policy provides Customers an opportunity to bring a small cat or dog into the aircraft cabin. Southwest also has an unaccompanied minor travel policy to address the administrative costs and the extra care necessary to safely transport these Customers.
When available, Southwest also sells Upgraded Boarding at the airport. These are open priority boarding positions in the first 15 positions in its "A" boarding group.
Southwest has inflight satellite-based WiFi equipped on all of its aircraft. During 2017, Southwest upgraded its WiFi product to increase onboard bandwidth and refreshed its inflight entertainment portal and television options. Southwest's onboard entertainment options on WiFi-enabled aircraft for viewing on Customers' personal wireless devices include free access to Southwest's live and on-demand television product (although free live TV may not be available onboard international flights due to licensing restrictions). The refreshed television product currently consists of nearly 20 live channels and up to 75 on-demand recorded episodes from popular television series. Southwest also provides movies-on-demand and offers a Messaging-only option, including all WiFi-enabled stops and connections. The Messaging service allows access to iMessage and pre-downloaded apps for Viber and WhatsApp. Customers do not have to purchase WiFi to access television offerings, movies-on-demand, or the Messaging-only service.
Rapid Rewards Frequent Flyer Program
Southwest's Rapid Rewards frequent flyer program enables program members ("Members") to earn points for every dollar spent on Southwest fares. The amount of points earned under the program is based on the fare and fare class purchased, with higher fare products (e.g., Business Select) earning more points than lower fare products (e.g., Wanna Get Away). Each fare class is associated with a points earning multiplier, and points for flights are calculated by multiplying the fare for the flight by the fare class multiplier. Likewise, the amount of points required to be redeemed for a flight is based on the fare and fare class purchased. Under the program (i) Members are able to redeem their points for every available seat, every day, on every flight, with no blackout dates; and (ii) points do not expire so long as the Member has points-earning activity during the most recent 24 months.
Under the program, Members continue to accumulate points until the time they decide to redeem them. As a result, the program provides Members significant flexibility and options for earning and redeeming rewards. For example, Members can earn more points (and/or achieve tiered status such as A-List and Companion Pass faster) by purchasing higher fare tickets. Members also have significant flexibility in redeeming points, such as the opportunity to book in advance to take advantage of a lower fare (including many fare sales) ticket by redeeming fewer points or by being able to redeem more points and book at the last minute if seats are still available for sale. Members can also earn points through qualifying purchases with Rapid Rewards Partners (which include, for example, car rental agencies, hotels, restaurants, and retailers), as well as by using Southwest's co-branded Chase® Visa credit card. In addition, holders of Southwest's co-branded Chase Visa credit card are able to redeem their points for items other than travel on Southwest, such as international flights on other airlines, cruises, hotel stays, rental cars, gift cards, event tickets, and more. In addition to earning points for revenue flights and qualifying purchases with Rapid Rewards Partners, Members also have the ability to purchase, gift, and transfer points, as well as the ability to donate points to selected charities.
Southwest's Rapid Rewards frequent flyer program features tier and Companion Pass programs for the most active Members, including "A-List" and "A-List Preferred" status. Both A-List and A-List Preferred Members enjoy benefits such as "Fly By®" priority check-in and security lane access, where available, as well as dedicated phone lines, standby priority, and an earnings bonus on eligible revenue flights (25 percent for A-List and 100 percent for A-List Preferred).

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In addition, A-List Preferred Members enjoy free inflight WiFi on equipped flights. Members who attain A-List or A-List Preferred status receive priority boarding privileges for an entire year. When these Customers purchase travel at least 36 hours prior to flight time, they receive the best boarding pass number available (generally, an "A" boarding pass). During the day of travel, if an A-List or A-List Preferred Member's plans change, they have free same-day standby privileges, which allow them to fly on earlier flights between the same city pairs if space is available. Members who fly 100 qualifying one-way flights or earn 110,000 qualifying points in a calendar year automatically receive a Companion Pass, which provides for unlimited travel free of airline charges (does not include taxes and fees from $5.60 one-way). The Companion Pass is valid for the remainder of the calendar year in which status was earned and for the following full calendar year to any destination available on Southwest for a designated companion of the qualifying Member. The Member and designated companion must travel together on the same flight.
Southwest's Rapid Rewards frequent flyer program has been designed to drive more revenue by (i) bringing in new Customers, including new Members, as well as new holders of Southwest's co-branded Chase Visa credit card; (ii) increasing business from existing Customers; and (iii) strengthening the Company's Rapid Rewards hotel, rental car, credit card, and retail partnerships.
For the Company's 2017 consolidated results, Customers of Southwest redeemed approximately 9.6 million flight awards, accounting for approximately 13.8 percent of revenue passenger miles flown. For the Company's 2016 consolidated results, Customers of Southwest redeemed approximately 8.3 million flight awards, accounting for approximately 12.7 percent of revenue passenger miles flown. For the Company's 2015 consolidated results, Customers of Southwest redeemed approximately 7.3 million flight awards, accounting for approximately 12.0 percent of revenue passenger miles flown. The Company's accounting policies with respect to its frequent flyer programs are discussed in more detail in Note 1 to the Consolidated Financial Statements.
Digital Customer Platforms including Southwest.com
The Company offers a suite of digital platforms to support Customers' needs across the travel journey including Southwest.com®, mobile.southwest.com, an iOS app, an Android app, an email subscription service, and push notifications. The Company also offers Swabiz.com, a website tailored for business Customers that offers businesses shared stored company credit cards, company activity reporting, and centralized traveler management. These digital tools are designed to help make the Customer's experience personal and intuitive with features such as recognizing the Customer's location to provide relevant deals, remembering recent searches to make it easy to get to trips of interest, offering a calendar view to find the best date to travel for the lowest fare, and providing a "My Account" section to provide a detailed view into a Customer's travel and loyalty activity.
The Company's digital assets are also used to highlight points of differentiation between Southwest and other air carriers, as well as provide information on the Company's fare and ancillary products. In addition, Southwest.com and Swabiz.com are available in a translated Spanish version, which provides Customers who prefer to transact in Spanish the same level of Customer Service provided by the English versions of the websites. Both sites meet Web Content Accessibility Guidelines (2.0, Level AA) in order to provide an optimal experience for Customers with accessibility needs.
The Company continues to invest to broaden and improve these digital assets. In 2017, the Company launched enhanced Customer experiences on the desktop application for Car Bookings, Viewing Flight Reservations, and Flight Checkin, which were all launched on a new modern architecture that is expected to be used for additional enhancements in the future. The Company continues to invest in growing mobile applications, such as adding the ability to buy EarlyBird within the booking path, offering buttons to view Inflight Drinks and Entertainment options while flying, building mobile friendly versions of Special Offers, simplifying the checkout process, redesigning the apps' homepages, and adding targeting capabilities to better match Customers with relevant information.
For the year ended December 31, 2017, approximately 80 percent of the Company’s Passenger revenues originated from its websites (including revenues from Swabiz.com).
Marketing
During 2017, the Company continued to aggressively market and benefit from Southwest's points of differentiation from its competitors. For example, the Company's TransfarencySM campaign emphasizes Southwest's approach to

9



treating Customers fairly, honestly, and respectfully, with its low fares and no unexpected bag fees, change fees, or hidden fees.
Southwest continues to be the only major U.S. airline that offers to all ticketed Customers up to two checked bags that fly free (weight and size limits apply). Through both its national and local marketing campaigns, Southwest has continued to aggressively promote this point of differentiation from its competitors with its "Bags Fly Free®" message. The Company believes its decision not to charge for first and second checked bags, as reinforced by the Company's related marketing, has driven an increase in the Company's market share and a resulting net increase in revenues.
Southwest is also the only major U.S. airline that does not charge a fee on any of its fares for a Customer change in flight reservations. The Company has continued to incorporate this key point of differentiation in its marketing campaigns. The campaigns highlight the importance to Southwest of Customer Service by showing that Southwest understands plans can change and therefore does not charge a change fee. While a Customer may pay a difference in airfare, the Customer will not be charged a change fee on top of any difference in airfare.
Also unlike many of its competitors, Southwest does not impose additional fees for items such as seat selection, snacks, curb-side check-in, and telephone reservations. In addition, Southwest allows each ticketed Customer to check one stroller and one car seat free of charge, in addition to the two free checked bags.
The Company also continues to promote all of the many other reasons to fly Southwest such as its low fares, network size, Customer Service, free live television offerings, and its Rapid Rewards frequent flyer program.
The Company's visual expression of its brand - Heart - is a part of the Company's aircraft livery, airport experience, and logo, and symbolizes the Company's care, trust, and belief in providing exceptional Hospitality, and its Employees' dedication to connecting Customers with what is important in their lives. The Company's 737-800 and 737 MAX 8 aircraft include a Heart cabin interior, which gives Southwest Customers a look and feel of the future, with bold blue seats and additional seat width and legroom, an adjustable headrest, enhanced back comfort, and extra room for personal belongings. In addition, in 2017, the Company launched the final major element of its Heart brand refresh when front-line Employees began wearing Employee-designed uniforms that highlight the Company's red and blue Heart brand.

Technology Initiatives
The Company has committed significant resources to technology improvements in support of its ongoing operations and initiatives. In 2017, the Company completed a multi-year initiative to completely transition its reservation system to the Amadeus Altéa Passenger Service System. The new reservation system, which represented the single largest technology project in the Company's history, was designed to improve flight scheduling and inventory management, enable operational enhancements to manage flight disruptions, such as those caused by extreme weather conditions, enable revenue enhancements, further schedule optimization, support additional international growth, and enable other foundational and operational capabilities.
The Company continues to invest significantly in technology resources including, among others, the Company's systems related to (i) aircraft maintenance record keeping, (ii) flight planning and scheduling, (iii) crew scheduling, and (iv) technical operations.

Regulation
The airline industry is heavily regulated, especially by the federal government, and there are a significant number of governmental agencies and legislative bodies that have the ability to directly or indirectly affect the Company and/or the airline industry financially and/or operationally. Examples of regulations affecting the Company and/or the airline industry, imposed by several of these governmental agencies and legislative bodies, are discussed below.


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Economic and Operational Regulation

Consumer Protection Regulation by the U.S. Department of Transportation
The DOT regulates economic operating authority for air carriers and consumer protection for airline passengers. The FAA, a sub-agency of the DOT, regulates aviation safety. The DOT may impose civil penalties on air carriers for violating its regulations.
To provide passenger transportation in the United States, a domestic airline is required to hold both a Certificate of Public Convenience & Necessity from the DOT and an Air Carrier Operating Certificate from the FAA. A Certificate of Public Convenience & Necessity is unlimited in duration, and the Company’s certificate generally permits it to operate among any points within the United States and its territories and possessions. Additional DOT authority, in the form of a certificate or exemption from certificate requirements, is required for a U.S. airline to serve foreign destinations either with its own aircraft or via code-sharing with another airline. Exemptions granted by the DOT to serve international markets are generally limited in duration and are subject to periodic renewal requirements. The DOT also has jurisdiction over international tariffs and pricing in certain markets. The DOT may revoke a certificate or exemption, in whole or in part, for intentional failure to comply with federal aviation statutes, regulations, orders, or the terms of the certificate itself.
The DOT's consumer protection and enforcement activities relate to areas such as unfair and deceptive practices and unfair competition by air carriers, deceptive airline advertising (concerning, e.g., fares, ontime performance, schedules, and code-sharing), and violations of rules concerning denied boarding compensation, ticket refunds, and baggage liability requirements. The DOT is also charged with prohibiting discrimination by airlines against consumers on the basis of race, religion, national origin, sex, or ancestry.
Under the above-described authority, the DOT has adopted so-called "Passenger Protection Rules," which address a wide variety of matters, including flight delays on the tarmac, chronically delayed flights, denied boarding compensation, and advertising of airfares, among others. Under the Passenger Protection Rules, U.S. passenger airlines are required to adopt contingency plans that include the following: (i) assurances that no domestic flight will remain on the airport tarmac for more than three hours before beginning to return to the gate and that no international flight will remain on the tarmac at a U.S. airport for more than four hours before beginning to return to the gate, unless the pilot-in-command determines there is a safety-related or security-related impediment to deplaning passengers, or air traffic control advises the pilot-in-command that returning to the gate or permitting passengers to disembark elsewhere would significantly disrupt airport operations; (ii) an assurance that air carriers will provide adequate food and potable drinking water no later than two hours after the aircraft leaves the gate (in the case of departure) or touches down (in the case of arrival) if the aircraft remains on the tarmac, unless the pilot-in-command determines that safety or security considerations preclude such service; and (iii) an assurance of operable lavatories, as well as adequate medical attention, if needed. Air carriers are required to publish their contingency plans on their websites.
The Passenger Protection Rules also subject airlines to potential DOT enforcement action for unfair and deceptive practices in the event of chronically delayed domestic flights (i.e., domestic flights that operate at least ten times a month and arrive more than 30 minutes late more than 50 percent of the time during that month). In addition, airlines are required to (i) display ontime performance on their websites; (ii) adopt customer service plans, publish those plans on their website, and audit their own compliance with their plans; (iii) designate an employee to monitor the performance of their flights; (iv) provide information to passengers on how to file complaints; and (v) respond in a timely and substantive fashion to consumer complaints.
The Passenger Protection Rules also require airlines to (i) pay up to $1,350 in compensation to each passenger denied boarding involuntarily from an oversold flight; (ii) refund any checked bag fee for permanently lost luggage; (iii) prominently disclose all potential fees for optional ancillary services on their websites; and (iv) refund passenger fees paid for ancillary services if a flight cancels or oversells and a passenger is unable to take advantage of such services.
The Passenger Protection Rules also require that (i) advertised airfares include all government-mandated taxes and fees; (ii) passengers be allowed to either hold a reservation for up to 24 hours without making a payment or cancel a paid reservation without penalty for 24 hours after the reservation is made, as long as the reservation is made at least seven days in advance of travel; (iii) fares may not increase after purchase; (iv) baggage fees must be disclosed to the

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passenger at the time of booking; (v) the same baggage allowances and fees must apply throughout a passenger’s trip; (vi) baggage fees must be disclosed on e-ticket confirmations; and (vii) passengers must be promptly notified in the event of delays of more than 30 minutes or if there is a cancellation or diversion of their flight.
In November 2016, the DOT finalized an additional "Passenger Protection Rule." The new rule is intended to enhance the performance quality information collected by the DOT and made available to the public. The DOT removed the assumption that every passenger checks a bag, and now calculates mishandled bags per overall checked bags, rather than per enplaned passengers. The new rule also expands the pool of air carriers that must report performance data to the DOT's Bureau of Transportation Statistics by requiring reporting air carriers to include data for their domestic scheduled flights operated by their code-share partners.
The DOT has expressed its intent to aggressively investigate alleged violations of its consumer protection rules. Airlines that violate any DOT regulation are subject to potential fines of up to $32,140 per occurrence.
The Company is also monitoring other potential rulemakings that could impact its business. The DOT is preparing a proposed rule for the purpose of improving accessibility of lavatories on single-aisle aircraft and of in-flight entertainment. The proposed rule may require both short-term and long-term measures be taken to fully address the challenges persons with mobility impairments face when traveling on single-aisle aircraft, including the eventual requirement that accessible lavatories be available for individuals who use wheelchairs. The future proposed rule is also expected to address the improvement of accessibility of in-flight entertainment by requiring certain movies and shows displayed on such aircraft to be captioned to provide access to deaf and hard of hearing passengers. In addition, audio described entertainment would be available to enable people who are blind to listen to the visual narration of movies and shows.
The DOT is also preparing a proposed rule to consider, among other things, (i) whether carriers should be required to supply in-flight medical oxygen for a fee to passengers who require it to access air transportation; and (ii) whether to broaden the scope of passengers with disabilities who must be afforded seats with extra leg room, and whether carriers should be required to provide seating accommodations with extra leg room in all classes of service. Additionally, the DOT is preparing a proposed rule that would address the definition of a service animal to reduce the likelihood of passengers falsely claiming that their pets are service animals.
Aviation Taxes and Fees
The statutory authority for the federal government to collect most types of aviation taxes, which are used, in part, to finance programs administered by the FAA, must be periodically reauthorized by the U.S. Congress. In 2012, Congress adopted the FAA Modernization and Reform Act of 2012, which extended most commercial aviation taxes through September 30, 2015. In September 2015, in July 2016, and again in September 2017, Congress extended the expiration date, which is currently March 31, 2018. Congress is expected to try to enact a new FAA reauthorization bill in 2018, which may make substantive changes with respect to aviation taxes (including, possibly, an increase in airport-assessed Passenger Facility Charges ("PFCs")) and/or FAA offices and programs that are financed through aviation tax revenue. Congress must either adopt a new FAA reauthorization bill or pass a "status quo" extension by March 31, 2018; otherwise, a lapse in the statutory authority could affect the airlines' and passengers' respective tax burdens, as well as impact the FAA's ability to fund airport grants and regulate the airline industry.
In addition to FAA-related taxes, there are additional federal taxes related to the U.S. Department of Homeland Security. These taxes do not need to be reauthorized periodically. Congress has set the Transportation Security Fee paid by passengers at $5.60 per one-way passenger trip. In addition, inbound international passengers are subject to immigration and customs fees that are indexed to inflation. These fees are used to support the operations of U.S. Customs and Border Protection ("CBP"). Finally, the U.S. Department of Agriculture's Animal and Plant Health Inspection Service imposes a per-passenger agriculture inspection fee of $5.00 and a per-commercial aircraft fee of $225.00.
In 2018, the Company expects to benefit from the comprehensive U.S. tax reform legislation enacted by Congress in late 2017, which includes, among other items, a reduced federal corporate tax rate. At the same time, the legislation eliminates certain tax deductions and preferences. These changes not only impact the Company directly, but could impact the U.S. economy as a whole, including consumer demand.
Finally, the annual congressional budget process is another legislative vehicle in which new aviation taxes or regulations may be imposed. Congress is expected to approve an "omnibus" or comprehensive appropriations package for federal

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fiscal year 2018 in early 2018. This legislation will fund the federal government - including the DOT, the FAA, the Transportation Security Administration (the "TSA"), and CBP - through October 1, 2018. Passage of this legislation could result in an increase in the maximum PFC and/or new mandates on the DOT to begin or complete rulemakings related to airline consumer protection. By the summer of 2018, the House and Senate Appropriations Committees will start to work on the federal fiscal year 2019 appropriations bills, which could address many of the same issues and may be completed by the end of calendar year 2018.
Operational, Safety, and Health Regulation
The FAA has the authority to regulate safety aspects of civil aviation operations. Specifically, the Company and its third-party service providers are subject to the jurisdiction of the FAA with respect to aircraft maintenance and operations, including equipment, ground facilities, dispatch, communications, flight training personnel, and other matters affecting air safety. The FAA, acting through its own powers or through the appropriate U.S. Attorney, has the power to bring proceedings for the imposition and collection of fines for violation of the FAA regulations.
The FAA requires airlines to obtain and maintain an Air Carrier Operating Certificate, as well as other certificates, approvals, and authorities. These certificates, approvals, and authorities are subject to suspension or revocation for cause.
The FAA has rules in effect with respect to flight, duty, and rest regulations. Among other things, the rules require a ten hour minimum rest period prior to a pilot’s flight duty period; mandate that a pilot must have an opportunity for eight hours of uninterrupted sleep within the rest period; and impose pilot "flight time" and "duty time" limitations based upon report times, the number of scheduled flight segments, and other operational factors. The rules affect the Company’s staffing flexibility, which could impact the Company’s operational performance, costs, and Customer Experience.
In addition to its role as safety regulator, the FAA also operates the nation’s air traffic control system and has continued its lengthy and ongoing effort to implement a multi-faceted, air traffic control modernization program called "NextGen." The Air Traffic Organization ("ATO") is the operational arm of the FAA. The ATO is responsible for providing safe and efficient air navigation services to all of the United States and large portions of the Atlantic and Pacific Oceans and the Gulf of Mexico. The Company is subject to any operational changes imposed by the FAA/ATO as they relate to the "NextGen" program, as well as the day-to-day management of the air traffic control system.
The FAA reauthorization bill and annual appropriations legislation discussed above under "Aviation Taxes and Fees" could include provisions impacting future FAA safety-related activities and ATO operations in 2018 and beyond. For instance, a key issue for congressional consideration in the FAA reauthorization process is whether to create a private, not-for-profit corporation to replace the ATO in its day-to-day management of the air traffic control system and its implementation of the NextGen modernization program. Under the legislation, the FAA would retain its authority to regulate aviation safety. Regardless of the outcome of this legislative effort, it is not expected to impact air traffic control operations or the NextGen program in 2018 as any reform measure is expected to take several years to implement.
During 2017, the Company announced plans to begin selling tickets in 2018 for service to Hawaii, subject to requisite governmental approvals, including authorization from the FAA for ETOPS, a regulatory requirement to operate between the U.S. mainland and the Hawaiian Islands. In January 2018, the Company submitted a formal request, along with supporting application materials, to the FAA for authorization to conduct ETOPS using Boeing 737-800 aircraft.
The Company is subject to various other federal, state, and local laws and regulations relating to occupational safety and health, including Occupational Safety and Health Administration and Food and Drug Administration regulations.
Security Regulation
Pursuant to the Aviation and Transportation Security Act ("ATSA"), the Transportation Security Administration, a division of the U.S. Department of Homeland Security, is responsible for certain civil aviation security matters. ATSA and subsequent TSA regulations and procedures implementing ATSA address, among other things, (i) flight deck security; (ii) the use of federal air marshals onboard flights; (iii) airport perimeter access security; (iv) airline crew security training; (v) security screening of passengers, baggage, cargo, mail, employees, and vendors; (vi) training and qualifications of security screening personnel; (vii) provision of passenger data to CBP; and (viii) background checks.

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Under ATSA, substantially all security officers at airports are federal employees, and significant other elements of airline and airport security are overseen and performed by federal employees, including federal security managers, federal law enforcement officers, and federal air marshals. TSA personnel and TSA-mandated security procedures can affect the Company's operations, costs, and Customer experience. For example, as part of its security measures, the TSA regulates the types of liquid items that can be carried onboard aircraft. In addition, as part of its Secure Flight program, the TSA requires airlines to collect a passenger's full name (as it appears on a government-issued ID), date of birth, gender, and Redress Number (if applicable). Airlines must transmit this information to Secure Flight, which uses the information to perform matching against terrorist watch lists. After matching passenger information against the watch lists, Secure Flight transmits the matching results back to airlines. This serves to identify individuals for enhanced security screening and to prevent individuals on watch lists from boarding an aircraft. It also helps prevent the misidentification of passengers who have names similar to individuals on watch lists. The TSA has also implemented enhanced security procedures as part of its enhanced, multi-layer approach to airport security, including physical pat down procedures, at security checkpoints. Such enhanced security procedures have raised privacy concerns by some air travelers, and have caused delays at screening checkpoints.
The Company, in conjunction with the TSA, participates in TSA PreCheck™, a pre-screening initiative that allows a select group of low risk passengers to move through security checkpoints with greater efficiency and ease when traveling. Eligible passengers may use dedicated screening lanes at certain airports the Company serves for screening benefits, which include leaving on shoes, light outerwear, and belts, as well as leaving laptops and permitted liquids in carryon bags. A similar CBP-administered program, Global Entry®, allows expedited clearance for pre-approved, low-risk international travelers upon arrival in the United States.
The Company also participates in the TSA Known Crewmember® program, which is a risk-based screening system that enables TSA security officers to positively verify the identity and employment status of flight-crew members. The program expedites flight crew member access to sterile areas of airports.
The Company works collaboratively with foreign national governments and airports to provide risk-based security measures at international departure locations.
In 2017, the Department of Homeland Security granted the Company designation coverage under the Support Anti-Terrorism by Fostering Effective Technologies Act of 2002 (the "SAFETY Act") for a five year term. The designation is based on certain safety and security procedures put in place by the Company to date related to the protection of its Employees, Customers, and assets from terrorists and other criminal activities. The designation coverage affords the Company certain limitations of liability for claims arising out of an "act of terrorism," as defined under the SAFETY Act.
The Company has also made significant investments to address the effect of security regulations, including investments in facilities, equipment, and technology to process Customers, checked baggage, and cargo efficiently; however, the Company is not able to predict the impact, if any, that various security measures or the lack of TSA resources at certain airports will have on Passenger revenues and the Company’s costs, either in the short-term or the long-term.
Environmental Regulation
The Company is subject to various federal laws and regulations relating to the protection of the environment, including the Clean Air Act, the Resource Conservation and Recovery Act, the Clean Water Act, the Safe Drinking Water Act, and the Comprehensive Environmental Response, Compensation and Liability Act, as well as state and local laws and regulations. These laws and regulations govern aircraft drinking water, emissions, storm water discharges from operations, and the disposal of materials such as jet fuel, chemicals, hazardous waste, and aircraft deicing fluid.
Additionally, in conjunction with airport authorities, other airlines, and state and local environmental regulatory agencies, the Company, as a normal course of business, undertakes voluntary investigation or remediation of soil or groundwater contamination at various airport sites. The Company does not believe that any environmental liability associated with these airport sites will have a material adverse effect on the Company's operations, costs, or profitability, nor has it experienced any such liability in the past that has had a material adverse effect on its operations, costs, or profitability.
Further regulatory developments pertaining to the control of engine exhaust emissions from ground support equipment could increase operating costs in the airline industry. The Company does not believe, however, that pending

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environmental regulatory developments in this area will have a material effect on the Company's capital expenditures or otherwise materially adversely affect its operations, operating costs, or competitive position.
The federal government, as well as several state and local governments, the governments of other countries, and the United Nations’ International Civil Aviation Organization ("ICAO") are considering legislative and regulatory proposals and voluntary measures to address climate change by reducing green-house gas emissions. At the federal level, in July 2016, the Environmental Protection Agency (the "EPA") issued a final endangerment finding for greenhouse gas emissions from certain types of aircraft engines, which the agency determined contribute to the pollution that causes climate change and endangers public health and the environment. Following this endangerment finding, per the federal Clean Air Act, the EPA is required to promulgate new regulations for controlling greenhouse gas emissions from aircraft, including potential new carbon-efficiency standards on aircraft and engine manufacturers.
The EPA's endangerment finding preceded adoption by the ICAO Assembly of a new "global market-based measure" framework in an effort to control carbon dioxide emissions from international aviation. The focal point of this framework is a future carbon offsetting system on aircraft operators designed to cap the growth of emissions related to international aviation emissions. Details of this system are expected to be further developed in 2018 and, assuming the U.S. Government remains committed to the ICAO framework agreement and adopts terms for implementing it into U.S. law, this system is scheduled to be phased-in beginning in 2021. Regardless of the method of regulation, policy changes with regard to climate change are possible, which could significantly increase operating costs in the airline industry and, as a result, adversely affect operations.
In addition to climate change, aircraft noise continues to be an environmental focus, especially as the FAA implements new flight procedures as part of its NextGen airspace modernization program discussed above. The Airport Noise and Capacity Act of 1990 gives airport operators the right, under certain circumstances, to implement local noise abatement programs, provided they do not unreasonably interfere with interstate or foreign commerce or the national air transportation system. Some airports have established airport restrictions to limit noise, including restrictions on aircraft types to be used and limits on the number of hourly or daily operations or the time of operations. These types of restrictions can cause curtailments in service or increases in operating costs and can limit the ability of air carriers to expand operations at the affected airports.
At the federal level, the FAA is considering changes to enhance community engagement when developing new flight procedures, and there is a possibility that Congress may enact legislation in 2018 to address local noise concerns at one or more commercial airports in the United States, via either the FAA reauthorization or annual appropriations process. In 2017, the FAA published a final rule adopting the ICAO noise standard for future new type design aircraft submitted for certification after December 31, 2017, for large aircraft. This standard does not affect the Company's in-service fleet, nor does it require that manufacturers who produce existing types, such as the Boeing 737, meet the standard as they continue to produce those types in the future.
The Company remains steadfast in its desire to pursue, implement, and enhance initiatives that will reduce fuel consumption and improve fuel efficiency. During 2017, the Company benefited from the introduction of the Boeing 737 MAX 8 aircraft to the Company's fleet and the retirement of the Company's Classic aircraft. In addition, over the years, the Company has undertaken a number of other fuel conservation and carbon emission reduction initiatives such as the following:
installation of blended winglets, which reduce drag and increase fuel efficiency, on all aircraft in the Company's fleet;
upgrading of the Company's 737-800 fleet with newly designed, split scimitar winglets;
periodic engine washes;
use of electric ground power for aircraft air and power at the gate and for ground support equipment at select locations;
deployment of auto-throttle and vertical navigation to maintain optimum cruising speeds;
implementation of engine start procedures to support the Company's single engine taxi procedures;

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adjustment of the timing of auxiliary power unit starts on originating flights to reduce auxiliary power unit usage;
implementation of fuel planning initiatives to safely reduce loading of excess fuel;
aircraft cabin interior retrofitting to reduce weight;
reduction of aircraft engine idle speed while on the ground, which also increases engine life;
galley refreshes with dry goods weight reduction;
Company optimized routes (flying the best wind routes to take advantage of tailwinds or to minimize headwinds);
improvements in flight planning algorithms to better match the Company's aircraft flight management system (and thereby enabling the Company to fly at the most efficient altitudes);
substitution of Pilot and Flight Attendant flight bags with lighter Electronic Flight Bag tablets; and
implementation of Real Time Descent Winds (automatic uplinking of up-to-date wind data to the aircraft allowing crews to time the descent to minimize thrust inputs).
The Company has also participated in Required Navigation Performance ("RNP") operations as part of the FAA's Performance Based Navigation program, which is intended to modernize the U.S. air traffic control system by addressing limitations on air transportation capacity and making more safe and efficient use of airspace. RNP combines the capabilities of advanced aircraft avionics, Global Positioning System ("GPS") satellite navigation (instead of less precise ground-based navigation), and new flight procedures to (i) enable aircraft to carry navigation capabilities rather than relying on airports; (ii) improve operational capabilities by opening up many new and more direct airport approach paths to produce safer and more efficient flight patterns; and (iii) conserve fuel and reduce carbon emissions. Since its first use of RNP in 2011, Southwest has conducted approximately 58,000 RNP approaches, including over 19,000 in 2017. Southwest must rely on RNP approaches published by the FAA, and the rate of introduction and utilization of RNP approaches continues to be slower than expected, with fuel efficient RNP approaches currently available at only 50 of Southwest's airports. In addition, even at airports with approved RNP approaches, the clearance required from air traffic controllers to perform RNP approaches is sometimes not granted. Southwest continues to work with the FAA to develop and seek more use of RNP approaches and to evolve air traffic control rules to support greater utilization of RNP.
As part of its commitment to corporate sustainability, the Company has published the Southwest One ReportTM describing the Company's sustainability strategies, which include the foregoing and other efforts to reduce greenhouse gas emissions and address other environmental matters such as energy and water conservation, waste minimization, and recycling. Information contained in the Southwest One Report is not incorporated by reference into, and does not constitute a part of, this Form 10-K.
International Regulation
All international air service is subject to certain U.S. federal requirements and approvals, as well as the regulatory requirements of the appropriate authorities of the foreign countries involved. The Company has obtained the necessary economic authority from the DOT, as well as approvals required by the FAA and applicable foreign government entities, to conduct operations, under certain circumstances, to points outside of the continental United States currently served by the Company. Certain international authorities and approvals held by the Company are subject to periodic renewal requirements. The Company requests extensions of such authorities and approvals when and as appropriate. To the extent the Company seeks to serve additional foreign destinations in the future, or to renew its authority to serve certain routes, it may be required to obtain necessary authority from the DOT and/or approvals from the FAA, as well as any applicable foreign government entity.
Certain international route authorities are governed by bilateral air transportation agreements between the United States and foreign countries. Changes in U.S. or foreign government aviation policies could result in the alteration or termination of such agreements, diminish the value of the Company's existing international authorities, present barriers to renewing existing or securing new authorities, or otherwise affect the Company's international operations. In particular, there is still a degree of uncertainty about the future of scheduled commercial flight operations between the

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United States and Cuba as a result of changes in diplomatic relations between the two governments, as well as travel and trade restrictions implemented by the U.S. government in 2017. There are also capacity limitations at certain airports in Mexico and the Caribbean, which could impact future service levels. In general, bilateral agreements between the United States and foreign countries the Company currently serves, or may serve in the future, may be subject to renegotiation or reinterpretation from time to time. While the U.S. government has negotiated "open skies" agreements with many countries, which allow for unrestricted access between the United States and respective foreign destinations, agreements with other countries may restrict the Company's entry and/or growth opportunities.
The CBP is the federal agency of the U.S. Department of Homeland Security charged with facilitating international trade, collecting import duties, and enforcing U.S. regulations with respect to trade, customs, and immigration. As the Company expands its international flight offerings, CBP and its requirements and resources will also become increasingly important considerations to the Company. For instance, with the exception of flights from a small number of foreign "preclearance" locations, arriving international flights may only land at CBP-designated airports, and CBP officers must be present and in sufficient quantities at those airports to effectively process and inspect arriving international passengers and cargo. Thus, CBP personnel and CBP-mandated procedures can affect the Company's operations, costs, and Customer experience. The Company has made and expects to continue to make significant investments in facilities, equipment, and technologies at certain airports in order to improve the Customer experience and to assist CBP with its inspection and processing duties; however, the Company is not able to predict the impact, if any, that various CBP measures or the lack of CBP resources will have on Company revenues and costs, either in the short-term or the long-term.
Insurance
The Company carries insurance of types customary in the airline industry and in amounts the Company deems adequate to protect the Company and its property and to comply both with federal regulations and certain of the Company's credit and lease agreements. The policies principally provide coverage for public and passenger liability, property damage, cargo and baggage liability, loss or damage to aircraft, engines, and spare parts, and workers’ compensation. In addition, the Company carries a cyber-security insurance policy with regards to data protection and business interruption associated with both security breaches from malicious parties and from certain system failures.
Although the Company has been able to purchase aviation, property, liability, and professional insurance via the commercial insurance marketplace, available commercial insurance could be more expensive in the future and/or have material differences in coverage than insurance that has historically been provided and may not be adequate to protect the Company's risk of loss from future events, including acts of terrorism. Further, available cyber-security insurance with regards to data protection and business interruption could be more expensive in the future and/or have material differences in coverage than insurance that has historically been provided and may not be adequate to protect the Company's risk of loss.
Competition
Competition within the airline industry is intense and highly unpredictable, and Southwest currently competes with other airlines on virtually all of its scheduled routes. As a result of moderately improved economic conditions and an increased focus by airlines on costs, the airline industry has become increasingly competitive in recent years with a healthier financial condition and improved profitability.
Key competitive factors within the airline industry include (i) pricing and cost structure; (ii) routes, frequent flyer programs, and schedules; and (iii) customer service, operational reliability, and amenities. Southwest also competes for customers with other forms of transportation, as well as alternatives to travel. In recent years, the majority of domestic airline service has been provided by Southwest and the other largest major U.S. airlines, including American Airlines, Delta Air Lines, and United Airlines. The DOT defines major U.S. airlines as those airlines with annual revenues of at least $1 billion; there are currently 14 passenger airlines offering scheduled service, including Southwest, that meet this standard.
Pricing and Cost Structure
Pricing is a significant competitive factor in the airline industry, and the availability of fare information on the Internet allows travelers to easily compare fares and identify competitor promotions and discounts. During 2017, the Company experienced additional competitive challenges associated with industry changes from both a fare level and product

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offering perspective. As discussed above under "Business - Industry," legacy carrier offerings ranged from a "Basic Economy" fare product, designed to compete with ULCC fares, to a "Premium Economy" product, targeted to appeal to customers willing to pay a premium for additional amenities. Also in response to ULCC pricing, some legacy carriers have removed their fare floors for certain routes, leading to lower fares across the industry. These changes have put increased pressure on the industry's fare environment and have created a challenging revenue environment.
Pricing can be driven by a variety of factors. For example, airlines often discount fares to drive traffic in new markets or to stimulate traffic when necessary to improve load factors and/or cash flow. In addition, multiple airlines have been able to reduce fares because they have been able to lower their operating costs as a result of reorganization within and outside of bankruptcy. Further, some of the Company's competitors have continued to grow and modernize their fleets and expand their networks, potentially enabling them to better control costs per available seat mile (the average cost to fly an aircraft seat (empty or full) one mile), which in turn may enable them to lower their fares.
The Company believes its low-cost operating structure continues to provide it with an advantage over many of its airline competitors by enabling it to continue to charge low fares. However, ULCCs, which have increased capacity in the Company's markets, have surpassed the Company's cost advantage with larger gauge aircraft, increased seat density, and lower wages. The Company believes it continues to have a competitive advantage through its differentiation of Southwest from many of its competitors by not charging additional fees for items such as first and second checked bags for each ticketed Customer, flight changes, seat selection, snacks, curb-side check-in, and telephone reservations; nevertheless it has become increasingly difficult for the Company to improve upon its industry cost position.
Routes, Frequent Flyer Programs, and Schedules
The Company also competes with other airlines based on markets served, frequent flyer opportunities, and flight schedules. Some major airlines have more extensive route structures than Southwest, including more extensive international networks. In addition, many competitors have entered into significant commercial relationships with other airlines, such as global alliances, code-sharing, and capacity purchase agreements, which increase the airlines' opportunities to expand their route offerings. An alliance or code-sharing agreement enables an airline to offer flights that are operated by another airline and also allows the airline’s customers to book travel that includes segments on different airlines through a single reservation or ticket. As a result, depending on the nature of the specific alliance or code-sharing arrangement, a participating airline may be able to, among other things, (i) offer its customers access to more destinations than it would be able to serve on its own, (ii) gain exposure in markets it does not otherwise serve, and (iii) increase the perceived frequency of its flights on certain routes. Alliance and code-sharing arrangements not only provide additional route flexibility for participating airlines, they can also allow these airlines to offer their customers more opportunities to earn and redeem frequent flyer miles or points. A capacity purchase agreement enables an airline to expand its route structure by paying another airline (e.g., a regional airline with smaller aircraft) to operate flights on its behalf in markets that it does not, or cannot, serve itself. The Company continues to evaluate and implement initiatives to better enable itself to offer additional itineraries.
Customer Service, Operational Reliability, and Amenities
Southwest also competes with other airlines with respect to customer service, operational reliability (such as ontime performance), and passenger amenities. According to statistics published by the DOT, Southwest consistently ranks at or near the top among domestic carriers in Customer Satisfaction for having the lowest Customer complaint ratio. However, carriers are increasingly focusing on operational reliability as an opportunity to win and retain Customers. In addition, some airlines have more seating options and associated passenger amenities than does Southwest, including first-class, business class, and other premium seating and related amenities. New and different types of aircraft flown by competitors could have operational attributes and passenger amenities that could be considered more favorable than those associated with the Company's existing fleet.
Other Forms of Competition
The airline industry is subject to varying degrees of competition from surface transportation by automobiles, buses, and trains. Inconveniences and delays associated with air travel security measures can increase surface competition. In addition, surface competition can be significant during economic downturns when consumers cut back on discretionary spending and fewer choose to fly, or when gasoline prices are lower, making surface transportation a less expensive option. Because of the relatively high percentage of short-haul travel provided by Southwest, it is particularly

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exposed to competition from surface transportation in these instances. The airline industry is also subject to competition from alternatives to travel such as videoconferencing and the Internet, which can increase in the event of travel inconveniences and economic downturns. The Company is subject to the risk that air travel inconveniences and economic downturns may, in some cases, result in permanent changes to consumer behavior in favor of surface transportation and electronic communications.
Seasonality
The Company's business is seasonal. Generally, in most markets the Company serves, demand for air travel is greater during the summer months, and therefore, revenues in the airline industry tend to be stronger in the second (April 1 - June 30) and third (July 1 - September 30) quarters of the year than in the first (January 1 - March 31) and fourth (October 1 - December 31) quarters of the year. As a result, in many cases, the Company's results of operations reflect this seasonality. Factors that could alter this seasonality include, among others, the price of fuel, general economic conditions, extreme or severe weather and natural disasters, fears of terrorism or war, or changes in the competitive environment. Therefore, the Company's quarterly operating results are not necessarily indicative of operating results for the entire year, and historical operating results in a quarterly or annual period are not necessarily indicative of future operating results.
Employees
At December 31, 2017, the Company had approximately 56,100 active fulltime equivalent Employees, consisting of approximately 23,600 flight, 3,000 maintenance, 20,000 ground, Customer, and fleet service, and 9,500 management, technology, finance, marketing, and clerical personnel (associated with non-operational departments). Approximately 83 percent of these Employees were represented by labor unions. The Railway Labor Act establishes the right of airline employees to organize and bargain collectively. Under the Railway Labor Act, collective-bargaining agreements between an airline and a labor union generally do not expire, but instead become amendable as of an agreed date. By the amendable date, if either party wishes to modify the terms of the agreement, it must notify the other party in the manner required by the Railway Labor Act and/or described in the agreement. After receipt of the notice, the parties must meet for direct negotiations. If no agreement is reached, either party may request the National Mediation Board to appoint a federal mediator. If no agreement is reached in mediation, the National Mediation Board may determine an impasse exists and offer binding arbitration to the parties. If either party rejects binding arbitration, a 30-day "cooling off" period begins. At the end of this 30-day period, the parties may engage in "self-help," unless a Presidential Emergency Board is established to investigate and report on the dispute. The appointment of a Presidential Emergency Board maintains the "status quo" for an additional period of time. If the parties do not reach agreement during this period, the parties may then engage in "self-help." "Self-help" includes, among other things, a strike by the union or the airline’s imposition of any or all of its proposed amendments and the hiring of new employees to replace any striking workers. The following table sets forth the Company's Employee groups subject to collective bargaining and the status of their respective collective-bargaining agreements as of December 31, 2017:



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Employee Group
Approximate Number of Employees
Representatives
Status of Agreement
Southwest Pilots
8,600
Southwest Airlines Pilots' Association ("SWAPA")
Amendable September 2020
Southwest Flight Attendants
14,500
Transportation Workers of America, AFL-CIO, Local 556 ("TWU 556")
Amendable November 2018
Southwest Ramp, Operations, Provisioning, Freight Agents
12,800
Transportation Workers of America, AFL-CIO, Local 555 ("TWU 555")
Amendable February 2021
Southwest Customer Service Agents, Customer Representatives, and Source of Support Representatives
7,400
International Association of Machinists and Aerospace Workers, AFL-CIO ("IAM 142")
Amendable December 2018
Southwest Material Specialists (formerly known as Stock Clerks)
300
International Brotherhood of Teamsters, Local 19 ("IBT 19")
In negotiations
Southwest Mechanics
2,400
Aircraft Mechanics Fraternal Association ("AMFA")
In negotiations
Southwest Aircraft Appearance Technicians
200
AMFA
Amendable November 2020
Southwest Facilities Maintenance Technicians
40
AMFA
Amendable November 2022
Southwest Dispatchers
350
Transportation Workers of America, AFL-CIO, Local 550 ("TWU 550")
Amendable June 2019
Southwest Flight Simulator Technicians
50
International Brotherhood of Teamsters ("IBT")
Amendable May 2019
Southwest Flight Crew Training Instructors
120
Transportation Workers of America, AFL-CIO, Local 557 ("TWU 557")
Amendable January 2020
Southwest Meteorologists
10
TWU 550
Amendable June 2019
Additional Information About the Company
The Company was incorporated in Texas in 1967. The following documents are available free of charge through the Company's website, www.southwest.com: the Company’s annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports that are filed with or furnished to the Securities and Exchange Commission ("SEC") pursuant to Sections 13(a) or 15(d) of the Securities Exchange Act of 1934. These materials are made available through the Company's website as soon as reasonably practicable after they are electronically filed with, or furnished to, the SEC. In addition to its reports filed or furnished with the SEC, the Company publicly discloses material information from time to time in its press releases, at annual meetings of Shareholders, in publicly accessible conferences and Investor presentations, and through its website (principally in its Press Room and Investor Relations pages). References to the Company's website in this Form 10-K are provided as a convenience and do not constitute, and should not be deemed, an incorporation by reference of the information contained on, or available through, the website, and such information should not be considered part of this Form 10-K.



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DISCLOSURE REGARDING FORWARD-LOOKING INFORMATION
This Form 10-K contains "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements are based on, and include statements about, the Company’s estimates, expectations, beliefs, intentions, and strategies for the future, and the assumptions underlying these forward-looking statements. Specific forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts and include, without limitation, words such as "anticipates," "believes," "estimates," "expects," "intends," "may," "will," "would," "could," "should," "projects," "plans," "goal," and similar expressions. Although management believes these forward-looking statements are reasonable as and when made, forward-looking statements are not guarantees of future performance and involve risks and uncertainties that are difficult to predict. Therefore, actual results may differ materially from what is expressed in or indicated by the Company's forward-looking statements or from historical experience or the Company's present expectations. Known material risk factors that could cause these differences are set forth below under "Risk Factors." Additional risks or uncertainties (i) that are not currently known to the Company, (ii) that the Company currently deems to be immaterial, or (iii) that could apply to any company, could also materially adversely affect the Company's business, financial condition, or future results.
Caution should be taken not to place undue reliance on the Company's forward-looking statements, which represent the Company's views only as of the date this Form 10-K is filed. The Company undertakes no obligation to update publicly or revise any forward-looking statement, whether as a result of new information, future events, or otherwise.
Item 1A.    Risk Factors
The airline industry is particularly sensitive to changes in economic conditions; in the event of unfavorable economic conditions or economic uncertainty, the Company's results of operations could be negatively affected, which could require the Company to adjust its business strategies.
The airline industry, which is subject to relatively high fixed costs and highly variable and unpredictable demand, is particularly sensitive to changes in economic conditions. Historically, unfavorable U.S. economic conditions have driven changes in travel patterns and have resulted in reduced spending for both leisure and business travel. For some consumers, leisure travel is a discretionary expense, and short-haul travelers, in particular, have the option to replace air travel with surface travel. Businesses are able to forego air travel by using communication alternatives such as videoconferencing and the Internet or may be more likely to purchase less expensive tickets to reduce costs, which can result in a decrease in average revenue per seat. Unfavorable economic conditions, when low fares are often used to stimulate traffic, have also historically hampered the ability of airlines to raise fares to counteract any increases in fuel, labor, and other costs. Although the U.S. economy has experienced modest economic growth over the course of the past several years, any continuing or future U.S. or global economic uncertainty could negatively affect the Company's results of operations and could cause the Company to adjust its business strategies.
The Company's business can be significantly impacted by high and/or volatile fuel prices, and the Company's operations are subject to disruption in the event of any delayed supply of fuel; therefore, the Company's strategic plans and future profitability are likely to be impacted by the Company's ability to effectively address fuel price increases and fuel price volatility and availability.
Airlines are inherently dependent upon energy to operate, and jet fuel and oil represented approximately 22 percent of the Company's operating expenses for 2017. Although 2017 fuel prices were moderately higher than 2016 fuel prices, as discussed above under "Business - Cost Structure," the cost of fuel can be extremely volatile and unpredictable, and even a small change in market fuel prices can significantly affect profitability. Furthermore, volatility in fuel prices can be due to many external factors that are beyond the Company's control. For example, fuel prices can be impacted by political and economic factors, such as (i) dependency on foreign imports of crude oil and the potential for hostilities or other conflicts in oil producing areas; (ii) limited domestic refining or pipeline capacity due to weather, natural disasters, or other factors; (iii) worldwide demand for fuel, particularly in developing countries, which can result in inflated energy prices; (iv) changes in U.S. governmental policies on fuel production, transportation, taxes, and marketing; and (v) changes in currency exchange rates.
The Company's ability to effectively address fuel price increases could be limited by factors such as its historical low-fare reputation, the portion of its Customer base that purchases travel for leisure purposes, the competitive nature of

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the airline industry generally, and the risk that higher fares will drive a decrease in demand. The Company attempts to manage its risk associated with volatile jet fuel prices by utilizing over-the-counter fuel derivative instruments to hedge a portion of its future jet fuel purchases. However, energy prices can fluctuate significantly in a relatively short amount of time. Because the Company uses a variety of different derivative instruments at different price points, the Company is subject to the risk that the fuel derivatives it uses will not provide adequate protection against significant increases in fuel prices and could in fact result in hedging losses, and the Company effectively paying higher than market prices for fuel, thus creating additional volatility in the Company's earnings. The Company is also subject to the risk that cash collateral may be required to be posted to fuel hedge counterparties, which could have a significant impact on the Company's financial position and liquidity.
In addition, the Company is subject to the risk that its fuel derivatives will not be effective or that they will no longer qualify for hedge accounting under applicable accounting standards, which can create additional earnings volatility. Adjustments in the Company's overall fuel hedging strategy, as well as the ability of the commodities used in fuel hedging to qualify for special hedge accounting, are likely to continue to affect the Company's results of operations. In addition, there can be no assurance that the Company will be able to cost-effectively hedge against increases in fuel prices. Also, see Note 2 to the Consolidated Financial Statements for information on future changes in applicable standards for hedge accounting.
The Company's fuel hedging arrangements and the various potential impacts of hedge accounting on the Company's financial position, cash flows, and results of operations are discussed in more detail under "Management’s Discussion and Analysis of Financial Condition and Results of Operations," "Quantitative and Qualitative Disclosures About Market Risk," and in Note 1 and Note 10 to the Consolidated Financial Statements.
The Company is also reliant upon the readily available supply and timely delivery of jet fuel to the airports that it serves. A disruption in that supply could present significant challenges to the Company's operations and could ultimately cause the cancellation of flights and/or the inability of the Company to provide service to a particular airport.
The Company's low-cost structure has historically been one of its primary competitive advantages, and many factors have affected and could continue to affect the Company's ability to control its costs.
The Company's low-cost structure has historically been one of its primary competitive advantages, as it has enabled it to offer low fares, drive traffic volume, grow market share, and protect profits. The Company's low-cost position has become even more significant with the increased presence of ULCCs and changes to the legacy fare offerings discussed above; however, it has become increasingly difficult for the Company to improve upon its industry cost position. For example, labor and fuel costs, as well as other costs such as regulatory compliance costs, can negatively affect the Company's ability to control its costs. Furthermore, the Company has limited control over many of these costs.
Jet fuel and oil constituted approximately 22 percent of the Company's operating expenses during 2017, and the Company's ability to control the cost of fuel is subject to the external factors discussed in the second Risk Factor above.
Salaries, wages, and benefits constituted approximately 41 percent of the Company's operating expenses during 2017. The Company's ability to control labor costs is limited by the terms of its collective-bargaining agreements, and increased labor costs have negatively impacted the Company's low-cost competitive position. As discussed further under "Management’s Discussion and Analysis of Financial Condition and Results of Operations," the Company's unionized workforce, which makes up approximately 83 percent of its Employees, has had pay scale increases as a result of contractual rate increases. Additionally, the majority of Southwest's unionized Employees, including its Pilots; Flight Attendants; Ramp, Operations, Provisioning, and Freight Agents; Aircraft Appearance Technicians; and Flight Crew Training Instructors, ratified new collective-bargaining agreements during 2016, which have put pressure on the Company's low-cost structure. Furthermore, as indicated above under "Business - Employees," other Southwest unionized Employees, including its Mechanics and Material Specialists, are in unions currently in negotiations for labor agreements, which could result in additional pressure on the Company's low-cost structure.
As discussed above under "Business - Regulation," the airline industry is heavily regulated, and the Company's regulatory compliance costs are subject to potentially significant increases from time to time based on actions by regulatory agencies that are out of the Company's control. Additionally, the Company cannot control decisions by other airlines to reduce their capacity. When this occurs, airport costs are allocated among a fewer number of total flights,

22



which can result in increased landing fees and other costs for the Company. The Company is also reliant upon third party vendors and service providers, in particular with respect to its fleet and technology initiatives and performance, and the Company's low-cost advantage is also dependent in part on its ability to obtain and maintain commercially reasonable terms with those parties.
As discussed above under "Business - Insurance," the Company carries insurance of types customary in the airline industry. Although the Company has been able to purchase aviation, property, liability, and professional insurance via the commercial insurance marketplace, available commercial insurance could be more expensive in the future and/or have material differences in coverage than insurance that has historically been provided and may not be adequate to protect against the Company's risk of loss from future events, including acts of terrorism. Further, available cyber-security insurance with regards to data protection and business interruption could be more expensive in the future and/or have material differences in coverage than insurance that has historically been provided and may not be adequate to protect the Company's risk of loss. In addition, an accident or other incident involving Southwest aircraft could result in costs in excess of its related insurance coverage, which costs could be substantial. Any aircraft accident or other incident, even if fully insured, could also have a material adverse effect on the public's perception of the Company.
The Company cannot guarantee it will be able to maintain or improve upon its current level of low-cost advantage over many of its airline competitors. ULCCs, which have increased capacity in the Company's markets, have surpassed the Company's cost advantage. When competitors grow their fleets and expand their networks, they are potentially able to better control costs per available seat mile. In addition, like Southwest, some competitors have added a significant number of new and different aircraft to their fleets, which could potentially decrease their operating costs through better fuel efficiencies and lower maintenance costs.
The Company is increasingly dependent on technology to operate its business and continues to implement substantial changes to its information systems; any failure, disruption, breach, or delay in implementation of the Company's information systems could materially adversely affect its operations.
The Company is increasingly dependent on the use of complex technology and systems to run its ongoing operations and support its strategic objectives.
Implementation and integration of complex systems and technology presents significant challenges in terms of costs, human resources, and development of effective internal controls. Implementation and integration require a balancing between the introduction of new capabilities and the managing of existing systems, and present the risk of operational or security inadequacy or interruption, which could materially affect the Company's ability to effectively operate its business and/or could negatively impact the Company's results of operations. The Company is also reliant upon the performance of its third party vendors for timely and effective completion of many of its technology initiatives and for maintaining adequate information security measures.
In the ordinary course of business, the Company's systems will continue to require modification and refinements to address growth and changing business requirements, including requirements related to international operations. In addition, the Company's systems may require modification to enable the Company to comply with changing regulatory requirements. Modifications and refinements to the Company's systems have been and are expected to continue to be expensive to implement and can divert management’s attention from other matters. In addition, the Company's operations could be adversely affected, or it could face imposition of regulatory penalties, if it were unable to timely or effectively modify its systems as necessary or appropriately balance the introduction of new capabilities with the management of existing systems.
The Company has experienced system interruptions and delays that make its websites and services unavailable or slow to respond, which can prevent the Company from efficiently processing Customer transactions or providing services, and these could continue to occur in the future. These system interruptions and delays can reduce the Company's operating revenues and the attractiveness of its services, as well as increase the Company's costs. The Company's computer and communications systems and operations could be damaged or interrupted by catastrophic events such as fires, floods, earthquakes, tornadoes and hurricanes, power loss, computer and telecommunications failures, acts of war or terrorism, computer viruses, security breaches, and similar events or disruptions. Any of these events could cause system interruptions, delays, and loss of critical data, and could prevent the Company from processing Customer transactions or providing services, which could make the Company's business and services less attractive and subject the Company to liability. Any of these events could damage the Company's reputation and be expensive to remedy.

23




The Company's business is labor intensive; therefore, the Company would be adversely affected if it were unable to maintain satisfactory relations with its Employees or its Employees' Representatives.

The airline business is labor intensive. Salaries, wages, and benefits represented approximately 41 percent of the Company's operating expenses for the year ended December 31, 2017. In addition, as of December 31, 2017, approximately 83 percent of the Company's Employees were represented for collective bargaining purposes by labor unions, making the Company particularly exposed in the event of labor-related job actions. Employment-related issues that have, and continue to, impact the Company's results of operations, some of which are negotiated items, include hiring/retention rates, pay rates, outsourcing costs, work rules, health care costs, and retirement benefits.

The Company is currently dependent on single aircraft and engine suppliers, as well as single suppliers of certain other parts; therefore, the Company would be materially adversely affected if it were unable to obtain additional equipment or support from any of these suppliers, in the event of a mechanical or regulatory issue associated with their equipment, or in the event the pricing and operational attributes of the Company's equipment become less competitive.

The Company is dependent on Boeing as its sole supplier for aircraft and many of its aircraft parts and is dependent on other suppliers for certain other aircraft parts. Although the Company is able to purchase some aircraft from parties other than Boeing, most of its purchases are directly from Boeing. Therefore, if the Company was unable to acquire additional aircraft from Boeing, or if Boeing was unable or unwilling to make timely deliveries of aircraft or to provide adequate support for its products, the Company's operations would be materially adversely affected. In addition, the Company would be materially adversely affected in the event of a mechanical or regulatory issue associated with the Boeing 737 aircraft type, whether as a result of downtime for part or all of the Company's fleet, increased maintenance costs, or because of a negative perception by the flying public. The Company believes, however, that its years of experience with the Boeing 737 aircraft type, as well as the efficiencies Southwest has historically achieved by operating with a single aircraft type, continue to outweigh the risks associated with its single aircraft supplier strategy. The Company is also dependent on sole suppliers for aircraft engines and certain other aircraft parts and would therefore also be materially adversely affected in the event of the unavailability of, or a mechanical or regulatory issue associated with, engines and other parts. The Company could also be materially adversely affected if the pricing or operational attributes of its equipment were to become less competitive.

Any failure of the Company to maintain the security of certain Customer-related information could result in damage to the Company's reputation and could be costly to remediate.

The Company must receive information related to its Customers in order to run its business, and the Company's operations depend upon secure retention and the secure transmission of information over public networks, including information permitting cashless payments. This information is subject to the risk of intrusion, tampering, and theft. Although the Company maintains systems to defend against this from occurring, these systems require ongoing monitoring and updating as technologies change, and security could be compromised, confidential information could be misappropriated, or system disruptions could occur. In the ordinary course of its business, the Company also provides certain confidential, proprietary, and personal information to third parties. While the Company seeks to obtain assurances that these third parties will protect this information, there is a risk the security of data held by third parties could be breached. A compromise of the Company's security systems could adversely affect the Company's reputation and disrupt its operations and could also result in litigation against the Company or the imposition of penalties. In addition, it could be costly to remediate. Although the Company has not experienced cyber incidents that are individually, or in the aggregate, material, the Company has experienced cyber-attacks in the past, which have thus far been mitigated by preventative, detective, and responsive measures put in place by the Company.

The Company's results of operations could be adversely impacted if it is unable to grow or to effectively execute its strategic plans.

Southwest has historically been regarded as a growth airline. However, organic growth remains challenging because (i) the opportunities for domestic expansion are limited; (ii) the Company's international network is relatively small

24



and international expansion presents unique challenges; and (iii) the Company has faced an increased presence of other low-cost, low-fare carriers. As a result, the Company is reliant on the success of its revenue strategies to help offset certain increasing costs. The timely and effective execution of the Company's strategic plans could be negatively affected by (i) the Company's ability to timely and effectively implement, transition, and maintain related information technology systems and infrastructure; (ii) the Company's ability to effectively balance its investment of incremental operating expenses and capital expenditures related to its strategies against the need to effectively control costs; and (iii) the Company's dependence on third parties with respect to its strategic plans.

The airline industry has faced on-going security concerns and related cost burdens; further threatened or actual terrorist attacks, or other hostilities, could significantly harm the airline industry and the Company's operations.

Terrorist attacks or other crimes and hostilities, actual and threatened, have from time to time materially adversely affected the demand for air travel and also have resulted in increased safety and security costs for the Company and the airline industry generally. Safety measures create delays and inconveniences and can, in particular, reduce the Company's competitiveness against surface transportation for short-haul routes. Additional terrorist attacks or other hostilities, even if not made directly on the airline industry, or the fear of such attacks or other hostilities (including elevated national threat warnings or selective cancellation or redirection of flights due to terror threats) would likely have a further significant negative impact on the Company and the airline industry.

Airport capacity constraints and air traffic control inefficiencies have limited and could continue to limit the Company's growth; changes in or additional governmental regulation could increase the Company's operating costs or otherwise limit the Company's ability to conduct business.

Almost all commercial service airports are owned and/or operated by units of local or state governments. Airlines are largely dependent on these governmental entities to provide adequate airport facilities and capacity at an affordable cost. Similarly, the federal government singularly controls all U.S. airspace, and airlines are completely dependent on the FAA operating that airspace in a safe and efficient manner. The current air traffic control system is mainly radar-based and supported in large part by antiquated equipment and technologies. The FAA's protracted transition to a satellite-based air traffic control system, as well as the implementation of policies and standards that account for the precision of global positioning system-supported aircraft technologies, could continue to adversely impact airspace capacity and the overall efficiency of the system, resulting in limited opportunities for the Company to grow, longer scheduled flight times, increased delays and cancellations, and increased fuel consumption and aircraft emissions. As discussed above under "Business - Regulation," airlines are also subject to other extensive regulatory requirements. These requirements often impose substantial costs on airlines. The Company's strategic plans and results of operations could be negatively affected by changes in law and future actions taken by domestic and foreign governmental agencies having jurisdiction over its operations, including, but not limited to:

increases in airport rates and charges;
limitations on airport gate capacity or use of other airport facilities such as the 2016 and 2017 reallocation of slots at John Wayne Airport in Orange County, California, which caused the Company to reduce service at that airport;
limitations on route authorities;
actions and decisions that create difficulties in obtaining access at slot-controlled airports;
actions and decisions that create difficulties in obtaining operating permits and approvals;
changes to environmental regulations;
new or increased taxes or fees;
changes to laws that affect the services that can be offered by airlines in particular markets and at particular airports;
restrictions on competitive practices;
changes in laws that increase costs for safety, security, compliance, or other Customer Service standards;
changes in laws that may limit the Company's ability to enter into fuel derivative contracts to hedge against increases in fuel prices;
changes in laws that may limit or regulate the Company's ability to promote the Company’s business or fares; and

25



the adoption of more restrictive locally-imposed noise regulations.

Because expenses of a flight do not vary significantly with the number of passengers carried, a relatively small change in the number of passengers can have a disproportionate effect on an airline’s operating and financial results. Therefore, any general reduction in airline passenger traffic as a result of any of the factors listed above could adversely affect the Company's results of operations. In addition, in instances where the airline industry shrinks, many airport operating costs are essentially unchanged and must be shared by the remaining operating carriers, which can therefore increase the Company's costs.

The airline industry is affected by many conditions that are beyond its control, which can impact the Company's business strategies and results of operations.

In addition to the unpredictable economic conditions and fuel costs discussed above, the Company, like the airline industry in general, is affected by conditions that are largely unforeseeable and outside of its control, including, among others:

adverse weather and natural disasters such as the hurricanes and earthquakes in third quarter 2017, which resulted in approximately $100 million in reduced revenues for the Company as a result of approximately 5,000 canceled flights;
changes in consumer preferences, perceptions, spending patterns, or demographic trends (including, without limitation, changes in government travel patterns due to government shutdowns or sequestration);
actual or potential disruptions in the air traffic control system (including, without limitation, as a result of potential FAA budget cuts due to government shutdowns or sequestration);
changes in the competitive environment due to industry consolidation, industry bankruptcies, and other factors;
air traffic congestion and other air traffic control issues;
outbreaks of disease; and
actual or threatened war, terrorist attacks, and political instability.
The airline industry is intensely competitive.
As discussed in more detail above under "Business - Competition," the airline industry is intensely competitive. The Company's primary competitors include other major domestic airlines, as well as regional and new entrant airlines, surface transportation, and alternatives to transportation such as videoconferencing and the Internet. The Company's revenues are sensitive to the actions of other carriers with respect to pricing, routes, frequent flyer programs, scheduling, capacity, customer service, operational reliability, comfort and amenities, cost structure, aircraft fleet, and code-sharing and similar activities.
The Company's future results will suffer if it does not effectively manage its expanded international operations and/or Extended Operations ("ETOPS").
With the expansion of the Company's international flight offerings, the U.S. Customs and Border Protection ("CBP") has become an increasingly important federal agency. CBP personnel and CBP-mandated procedures can affect the Company's operations, costs, and Customer experience. The Company has made, and is continuing to make, significant investments in facilities, equipment, and technologies at certain airports in order to improve the Customer experience and to assist CBP with its inspection and processing duties; however, the Company is not able to predict the impact, if any, that various CBP measures or the lack of CBP resources will have on Company revenues and costs, either in the short-term or the long-term.
International flying requires the Company to modify certain processes, as the airport environment is dramatically different in certain international locations with respect to, among other things, common-use ticket counters and gate areas, local operating requirements, and cultural preferences. In addition, international flying exposes the Company to certain foreign currency risks to the extent the Company chooses to, or is required to, transact in currencies other than the U.S. dollar. To the extent the Company seeks to serve additional foreign destinations in the future, or to renew its authority to serve certain routes, it may be required to obtain necessary authority from the DOT and/or approvals from the FAA, as well as any applicable foreign government entity.

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The Company's expansion of its operations into non-U.S. jurisdictions also expands the scope of the laws to which the Company is subject, both domestically and internationally. In addition, operations in non-U.S. jurisdictions are in many cases subject to the laws of those jurisdictions rather than U.S. laws. Laws in some jurisdictions differ in significant respects from those in the United States, and these differences can affect the Company's ability to react to changes in its business, and its rights or ability to enforce rights may be different than would be expected under U.S. laws. Furthermore, enforcement of laws in some jurisdictions can be inconsistent and unpredictable, which can affect both the Company's ability to enforce its rights and to undertake activities that it believes are beneficial to its business. As a result, the Company's ability to generate revenue and its expenses in non-U.S. jurisdictions may differ from what would be expected if U.S. laws governed these operations. Although the Company has policies and procedures in place that are designed to promote compliance with the laws of the jurisdictions in which it operates, a violation by the Company's Employees, contractors, or agents or other intermediaries, could nonetheless occur. Any violation (or alleged or perceived violation), even if prohibited by the Company's policies, could have an adverse effect on the Company's reputation and/or its results of operations.
As discussed above under “Regulation – Operational, Safety, and Health Regulation,” in January 2018, the Company submitted a formal application to the FAA for authorization to conduct ETOPS using Boeing 737-800 aircraft, in connection with the Company’s plans to begin service to Hawaii. If the Company receives FAA authorization and commences ETOPS, the Company will be subject to additional, ongoing, ETOPS-specific regulatory and procedural requirements, which could add operational and compliance risks to the Company’s business, including costs associated therewith.
The Company is currently subject to pending litigation, and if judgment were to be rendered against the Company in the litigation, such judgment could adversely affect the Company's operating results.
As discussed below under "Legal Proceedings," the Company and its AirTran subsidiary are subject to pending litigation.
Regardless of merit, these litigation matters and any potential future claims against the Company or AirTran may be both time consuming and disruptive to the Company's operations and cause significant expense and diversion of management attention. Should the Company or AirTran fail to prevail in these or other matters, the Company may be faced with significant monetary damages or injunctive relief that could materially adversely affect its business and might materially affect its financial condition and operating results.

Item 1B.    Unresolved Staff Comments
None.


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Item 2.        Properties
Aircraft
Southwest operated a total of 706 Boeing 737 aircraft as of December 31, 2017, of which 53 and 69 were under operating and capital leases, respectively. The following table details information on the 706 aircraft as of December 31, 2017:
Type
 
Seats
 
Average
Age
(Yrs)
 
Number of
Aircraft
 
Number
Owned (a)
 
Number
Leased
737-700
 
143
 
14

 
512

 
397

 
115

737-800
 
175
 
3

 
181

 
174

 
7

737 MAX 8
 
175
 

 
13

 
13

 

Totals
 
 
 
11

 
706

 
584

 
122

 
(a)
As discussed further in Note 6 to the Consolidated Financial Statements, 203 of the Company's aircraft were pledged as collateral as of December 31, 2017, for secured borrowings and/or in the case that the Company has obligations related to its fuel derivative instruments with counterparties that exceed certain thresholds.

As of December 31, 2017, the Company had firm deliveries and options for Boeing 737-700, 737-800, 737 MAX 7, and 737 MAX 8 aircraft as follows:
 
The Boeing Company
 
 
 
 
-800 Firm Orders
MAX 7 Firm Orders
MAX 8 Firm Orders
 
MAX 8 Options
 
Additional -700s
 
Total
2018
26


14

 

 
4

 
44

2019

7

15

 

 

 
22

2020


25

 

 

 
25

2021


34

 

 

 
34

2022


17

 
14

 

 
31

2023

12

22

 
23

 

 
57

2024

11

30

 
23

 

 
64

2025


40

 
36

 

 
76

2026



 
36

 

 
36

2027



 
23

 

 
23

 
26

30

197

(a)
155

 
4

(b)
412

(a) The Company has flexibility to substitute 737 MAX 7 in lieu of 737 MAX 8 firm orders beginning in 2019.
(b) To be acquired in leases from various third parties.
Ground Facilities and Services
Southwest either leases or pays a usage fee for terminal passenger service facilities at each of the airports it serves, to which various leasehold improvements have been made. The Company leases the land and/or structures on a long-term basis for its aircraft maintenance centers (located at Dallas Love Field, Houston Hobby, Phoenix Sky Harbor, Chicago Midway, Hartsfield-Jackson Atlanta International Airport, and Orlando International Airport) and its main corporate headquarters building, also located near Dallas Love Field. The Company also leases a warehouse and engine repair facility in Atlanta.
The Company has commitments associated with various airport improvement projects, including ongoing construction at Los Angeles International Airport. These projects include the construction of new facilities and the rebuilding or modernization of existing facilities. Additional information regarding these projects is provided below under "Management’s Discussion and Analysis of Financial Condition and Results of Operations" and in Note 4 to the Consolidated Financial Statements.

28



The Company owns an additional headquarters building, located across the street from the Company's main headquarters building, on land owned by the Company. This energy-efficient, modern building, called TOPS, houses certain operational and training functions, including its 24-hour operations. In 2016, the Company broke ground on an additional headquarters complex, called the Wings Complex, consisting of a Leadership Education and Aircrew Development (LEAD) Center (designed to house flight simulators and classroom space for Pilot training), an additional office building, and a parking garage. The Wings Complex is scheduled to be completed in 2018 and is also located across the street from the Company's main headquarters building on land owned by the Company. The Company began moving its Boeing 737 flight simulators to the LEAD Center during 2017 and expects to have 15 Boeing 737 flight simulators in the LEAD Center by mid-2018. As of December 31, 2017, the Company operated seven Customer Support and Services call centers. The centers located in Atlanta, San Antonio, Chicago, Albuquerque, and Oklahoma City occupy leased space. The Company owns its Houston and Phoenix centers.
The Company performs substantially all line maintenance on its aircraft and provides ground support services at most of the airports it serves. However, the Company has arrangements with certain aircraft maintenance firms for major component inspections and repairs for its airframes and engines, which comprise the majority of the Company's annual aircraft maintenance costs.

29



Item 3.        Legal Proceedings
A complaint alleging violations of federal antitrust laws and seeking certification as a class action was filed against Delta Air Lines, Inc. and AirTran Holdings, Inc. and its subsidiary AirTran Airways, Inc. (collectively with AirTran Holdings, Inc., "AirTran") in the United States District Court for the Northern District of Georgia in Atlanta on May 22, 2009. The complaint alleged, among other things, that AirTran attempted to monopolize air travel in violation of Section 2 of the Sherman Act, and conspired with Delta in imposing $15-per-bag fees for the first item of checked luggage in violation of Section 1 of the Sherman Act. The initial complaint sought treble damages on behalf of a putative class of persons or entities in the United States who directly paid Delta and/or AirTran such fees on domestic flights beginning December 5, 2008. After the filing of the May 2009 complaint, various other nearly identical complaints also seeking certification as class actions were filed in federal district courts in Atlanta, Georgia; Orlando, Florida; and Las Vegas, Nevada. All of the cases were consolidated before a single federal district court judge in Atlanta. A Consolidated Amended Complaint was filed in the consolidated action on February 1, 2010, which broadened the allegations to add claims that Delta and AirTran conspired to reduce capacity on competitive routes and to raise prices in violation of Section 1 of the Sherman Act. In addition to treble damages for the amount of first baggage fees paid to AirTran and to Delta, the Consolidated Amended Complaint sought injunctive relief against a broad range of alleged anticompetitive activities, as well as attorneys' fees. On August 2, 2010, the Court dismissed plaintiffs' claims that AirTran and Delta had violated Section 2 of the Sherman Act; the Court let stand the claims of a conspiracy with respect to the imposition of a first bag fee and the airlines' capacity and pricing decisions. On June 30, 2010, the plaintiffs filed a motion to certify a class, which AirTran and Delta opposed. On June 18, 2012, the parties filed a Stipulation and Order that plaintiffs abandoned their claim that AirTran and Delta conspired to reduce capacity. On August 31, 2012, AirTran and Delta moved for summary judgment on all of plaintiffs' remaining claims. On July 12, 2016, the Court granted plaintiffs' motion to certify a class of all persons who paid first bag fees to AirTran or Delta from December 8, 2008 to November 1, 2014 (the date on which AirTran stopped charging first bag fees). Defendants have appealed that decision. On March 29, 2017, the Court granted defendants’ motion for summary judgment and dismissed all claims against AirTran. On April 13, 2017, the plaintiffs filed a notice of appeal from the district court's judgment, and on April 24, 2017, AirTran filed a conditional notice of cross-appeal to appeal the Court's order certifying a class. The appeals of the class certification and summary judgment orders have been consolidated. The Court has scheduled oral argument for the appeals on March 7, 2018. AirTran denies all allegations of wrongdoing, including those in the Consolidated Amended Complaint, and intends to defend vigorously any and all such allegations.
Also, on June 30, 2015, the U.S. Department of Justice ("DOJ") issued a Civil Investigative Demand ("CID") to the Company. The CID seeks information and documents about the Company’s capacity from January 2010 to the date of the CID including public statements and communications with third parties about capacity. In June 2015, the Company also received a letter from the Connecticut Attorney General requesting information about capacity; and on August 21, 2015, the Attorney General of the State of Ohio issued an investigative demand seeking information and documents about the Company’s capacity from December 2013 to the date of the CID. The Company is cooperating fully with the DOJ CID and these two state inquiries.
Further, on July 1, 2015, a complaint was filed in the United States District Court for the Southern District of New York on behalf of putative classes of consumers alleging collusion among the Company, American Airlines, Delta Air Lines, and United Airlines to limit capacity and maintain higher fares in violation of Section 1 of the Sherman Act. Since then, a number of similar class action complaints were filed in the United States District Courts for the Central District of California, the Northern District of California, the District of Columbia, the Middle District of Florida, the Southern District of Florida, the Northern District of Georgia, the Northern District of Illinois, the Southern District of Indiana, the Eastern District of Louisiana, the District of Minnesota, the District of New Jersey, the Eastern District of New York, the Southern District of New York, the Middle District of North Carolina, the District of Oklahoma, the Eastern District of Pennsylvania, the Northern District of Texas, the District of Vermont, and the Eastern District of Wisconsin. On October 13, 2015, the Judicial Panel on Multi-District Litigation centralized the cases to the United States District Court in the District of Columbia. On March 25, 2016, the plaintiffs filed a Consolidated Amended Complaint in the consolidated cases alleging that the defendants conspired to restrict capacity from 2009 to present. The plaintiffs seek to bring their claims on behalf of a class of persons who purchased tickets for domestic airline travel on the defendants' airlines from July 1, 2011 to present. They seek treble damages, injunctive relief, and attorneys' fees and expenses. On May 11, 2016, the defendants moved to dismiss the Consolidated Amended Complaint, and on October 28, 2016, the Court denied this motion. On December 20, 2017, the Company reached an agreement to settle

30



these cases with a proposed class of all persons who purchased domestic airline transportation services from July 1, 2011, to the date of the settlement. The Company agreed to pay $15 million and to provide certain cooperation with the plaintiffs as set forth in the settlement agreement. The Court granted preliminary approval of the settlement on January 3, 2018, and it is anticipated that the Court will establish a schedule for providing notice to the class, for class members to object or opt out, and for a final fairness hearing. The Company denies all allegations of wrongdoing.
In addition, on July 8, 2015, the Company was named as a defendant in a putative class action filed in the Federal Court in Canada alleging that the Company, Air Canada, American Airlines, Delta Air Lines, and United Airlines colluded to restrict capacity and maintain higher fares for Canadian residents traveling in the United States and for travel between the United States and Canada. Similar lawsuits were filed in the Supreme Court of British Columbia on July 15, 2015, Court of Queen's Bench for Saskatchewan on August 4, 2015, Superior Court of the Province of Quebec on September 21, 2015, and Ontario Superior Court of Justice on October 6, 2015. In December 2015, the Company entered into Tolling and Discontinuance agreements with putative class counsel in the Federal Court, British Columbia, and Ontario proceedings and a discontinuance agreement with putative class counsel in the Quebec proceeding. The other defendants entered into an agreement with the same putative class counsel to stay the Federal Court, British Columbia, and Quebec proceedings and to proceed in Ontario. On June 10, 2016, the Federal Court granted plaintiffs' motion to discontinue that action against the Company without prejudice and stayed the action against the other defendants. On July 13, 2016, the plaintiff unilaterally discontinued the action against the Company in British Columbia. On February 14, 2017, the Quebec Court granted the plaintiff’s motion to discontinue the Quebec proceeding against the Company and to stay that proceeding against the other defendants. On March 10, 2017, the Ontario Court granted the plaintiff’s motion to discontinue that proceeding as to the Company. On September 29, 2017, the Company and the other defendants entered into a tolling agreement suspending any limitations periods that may apply to possible claims among them for contribution and indemnity arising from the Canadian litigation. The Saskatchewan claim has not been served on the Company, and the time for the Company to respond to that complaint has not yet begun to run. The plaintiff in that case generally seeks damages (including punitive damages in certain cases), prejudgment interest, disgorgement of any benefits accrued by the defendants as a result of the allegations, injunctive relief, and attorneys' fees and other costs. The Company denies all allegations of wrongdoing and intends to vigorously defend this civil case in Canada. The Company does not currently serve Canada.
The Company is from time to time subject to various legal proceedings and claims arising in the ordinary course of business, including, but not limited to, examinations by the Internal Revenue Service.
The Company’s management does not expect that the outcome in any of its currently ongoing legal proceedings or the outcome of any proposed adjustments presented to date by the Internal Revenue Service, individually or collectively, will have a material adverse effect on the Company’s financial condition, results of operations, or cash flow.
Item 4.
Mine Safety Disclosures
  
Not applicable.


31



EXECUTIVE OFFICERS OF THE REGISTRANT
The following information regarding the Company’s executive officers is as of February 1, 2018.
 
Name
Position
Age
Gary C. Kelly
Chairman of the Board & Chief Executive Officer
62
Thomas M. Nealon
President
56
Michael G. Van de Ven
Chief Operating Officer
56
Robert E. Jordan
Executive Vice President Corporate Services
57
Tammy Romo
Executive Vice President & Chief Financial Officer
55
Andrew M. Watterson
Executive Vice President & Chief Revenue Officer
51
Gregory D. Wells
Executive Vice President Daily Operations
59
Mark R. Shaw
Senior Vice President, General Counsel, & Corporate Secretary
55
Set forth below is a description of the background of each of the Company’s executive officers.
Gary C. Kelly has served as the Company's Chairman of the Board since May 2008 and as its Chief Executive Officer since July 2004. Mr. Kelly also served as President from July 2008 to January 2017, Executive Vice President & Chief Financial Officer from June 2001 to July 2004, and Vice President Finance & Chief Financial Officer from 1989 to 2001. Mr. Kelly joined the Company in 1986 as its Controller.
Thomas M. Nealon has served as the Company's President since January 2017. Mr. Nealon also served as Executive Vice President Strategy & Innovation from January 2016 to January 2017. Prior to becoming an executive officer of the Company, Mr. Nealon served on the Company’s Board of Directors from December 2010 until November 2015. Mr. Nealon has also served as Group Executive Vice President of J.C. Penney Company, Inc., a retail company, from August 2010 until December 2011. In this role Mr. Nealon was responsible for Strategy, jcp.com, Information Technology, Customer Insights, and Digital Ventures. Mr. Nealon also served as J.C. Penney’s Executive Vice President & Chief Information Officer from September 2006 until August 2010. Prior to joining J.C. Penney, Mr. Nealon was a partner with The Feld Group, a provider of information technology consulting services, where he served in a consultant capacity as Senior Vice President & Chief Information Officer for the Company from 2002 to 2006. Mr. Nealon also served as Chief Information Officer for Frito-Lay, a division of PepsiCo, Inc., from 1996 to 2000, and in various software engineering, systems engineering, and management positions for Frito-Lay from 1983 to 1996.
Michael G. Van de Ven has served as the Company's Chief Operating Officer since May 2008. Mr. Van de Ven also served as Executive Vice President & Chief Operating Officer from May 2008 to January 2017, Chief of Operations from September 2006 to May 2008, Executive Vice President Aircraft Operations from November 2005 through August 2006, Senior Vice President Planning from August 2004 to November 2005, Vice President Financial Planning & Analysis from 2001 to 2004, Senior Director Financial Planning & Analysis from 2000 to 2001, and Director Financial Planning & Analysis from 1997 to 2000. Mr. Van de Ven joined the Company in 1993 as its Director Internal Audit.
Robert E. Jordan has served as the Company's Executive Vice President Corporate Services since July 2017 and as President of AirTran Airways, Inc. since May 2011. Mr. Jordan also served as Executive Vice President & Chief Commercial Officer from September 2011 to July 2017, Executive Vice President Strategy & Planning from May 2008 to September 2011, Executive Vice President Strategy & Technology from September 2006 to May 2008, Senior Vice President Enterprise Spend Management from August 2004 to September 2006, Vice President Technology from 2002 to 2004, Vice President Purchasing from 2001 to 2002, Controller from 1997 to 2001, Director Revenue Accounting from 1994 to 1997, and Manager Sales Accounting from 1990 to 1994. Mr. Jordan joined the Company in 1988 as a programmer.
Tammy Romo has served as the Company's Executive Vice President & Chief Financial Officer since July 2015. Ms. Romo also served as Senior Vice President Finance & Chief Financial Officer from September 2012 to July 2015, Senior Vice President of Planning from February 2010 to September 2012, Vice President of Financial Planning from September 2008 to February 2010, Vice President Controller from February 2006 to August 2008, Vice President Treasurer from September 2004 to February 2006, Senior Director of Investor Relations from March 2002 to September

32



2004, Director of Investor Relations from December 1994 to March 2002, Manager of Investor Relations from September 1994 to December 1994, and Manager of Financial Reporting from September 1991 to September 1994.
Andrew M. Watterson has served as the Company's Executive Vice President & Chief Revenue Officer since July 2017. Mr. Watterson also served as Senior Vice President & Chief Revenue Officer from January 2017 to July 2017, Senior Vice President of Network & Revenue from January 2016 to January 2017, and as Vice President of Network Planning & Performance from October 2013 to January 2016. Prior to becoming an officer of the Company, Mr. Watterson served as Vice President of Planning and Revenue Management at Hawaiian Airlines from May 2011 to October 2013.
Gregory D. Wells has served as the Company's Executive Vice President Daily Operations since January 2017. Mr. Wells also served as Senior Vice President Operational Performance from October 2013 to January 2017, Senior Vice President Operations from September 2006 to October 2013, Senior Vice President Ground Operations from November 2005 to September 2006, Vice President Ground Operations from September 2004 to November 2005, Vice President Safety, Security, and Flight Dispatch from October 2001 to September 2004, Director Flight Dispatch from February 1999 to October 2001, Senior Director Ground Operations from August 1998 to February 1999, and Director Ground Operations from August 1996 to August 1998. Prior to August 1996, Mr. Wells had various other operational experience with the Company including as Station Manager in both San Jose and Phoenix. Mr. Wells has over 35 years of experience with the Company.
Mark R. Shaw has served as the Company's Senior Vice President, General Counsel, & Corporate Secretary since July 2015. Mr. Shaw also served as Vice President, General Counsel, & Corporate Secretary from February 2013 to July 2015 and as Associate General Counsel - Corporate & Transactions from February 2008 to February 2013. Mr. Shaw joined the Company in 2000 as an Attorney in the General Counsel Department.


33



PART II

Item 5.        Market for Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities

The Company’s common stock is listed on the New York Stock Exchange ("NYSE") and is traded under the symbol "LUV." The following table shows the high and low prices per share of the Company’s common stock, as reported on the NYSE Composite Tape, and the cash dividends per share declared on the Company’s common stock.
 
Period
 
Dividend  
 
High  
 
Low    
2017
 
 
 
 
 
 
1st Quarter
 
$
0.10000

 
$
59.68

 
$
48.75

2nd Quarter
 
0.12500

 
62.74

 
52.89

3rd Quarter
 
0.12500

 
64.39

 
49.76

4th Quarter
 
0.12500

 
66.99

 
52.78

2016
 
 
 
 
 
 
1st Quarter
 
$
0.07500

 
$
45.39

 
$
33.96

2nd Quarter
 
0.10000

 
48.00

 
36.48

3rd Quarter
 
0.10000

 
45.00

 
35.42

4th Quarter
 
0.10000

 
51.31

 
36.91


The Company currently intends to continue declaring dividends on a quarterly basis for the foreseeable future; however, the Company’s Board of Directors may elect to alter the timing, amount, and payment of dividends on the basis of operational results, financial condition, cash requirements, future prospects, and other factors deemed relevant by the Board. As of February 5, 2018, there were approximately 12,531 holders of record of the Company’s common stock.


34



Stock Performance Graph

The following Performance Graph and related information shall not be deemed "soliciting material" or "filed" with the Securities and Exchange Commission, nor shall such information be incorporated by reference into any future filing under the Securities Act of 1933 or Securities Exchange Act of 1934.

The following graph compares the cumulative total shareholder return on the Company’s common stock over the five-year period ended December 31, 2017, with the cumulative total return during such period of the Standard and Poor’s 500 Stock Index and the NYSE ARCA Airline Index. The comparison assumes $100 was invested on December 31, 2012, in the Company’s common stock and in each of the foregoing indices and assumes reinvestment of dividends. The stock performance shown on the graph below represents historical stock performance and is not necessarily indicative of future stock price performance.

COMPARISON OF FIVE YEAR CUMULATIVE TOTAL RETURN AMONG SOUTHWEST AIRLINES CO., S&P 500 INDEX, AND NYSE ARCA AIRLINE INDEX
chart.jpg
 
 
12/31/2012
 
12/31/2013
 
12/31/2014
 
12/31/2015
 
12/31/2016
 
12/31/2017
Southwest Airlines Co.
 
$
100

 
$
185

 
$
418

 
$
428

 
$
500

 
$
661

S&P 500
 
$
100

 
$
132

 
$
150

 
$
152

 
$
170

 
$
206

NYSE ARCA Airline
 
$
100

 
$
158

 
$
237

 
$
201

 
$
258

 
$
274




35



Issuer Repurchases
 
Issuer Purchases of Equity Securities (1)
 
 
 
(a)
 
(b)
 
(c)
 
(d)
 
 
 
 
 
 
 
Total number of
 
Maximum dollar
 
 
 
 
 
 
 
shares purchased
 
value of shares that
 
 
 
Total number
 
Average
 
as part of publicly
 
may yet be purchased
 
 
 
of shares
 
price paid
 
announced plans
 
under the plans
 
Period
 
purchased
 
per share
 
or programs
 
or programs
 
October 1, 2017 through
  October 31, 2017
 
1,206,365

 
$

(2)
1,206,365

 
$
1,700,000,000

 
November 1, 2017 through
  November 30, 2017
 
670,000

 
$

(3)(4)
670,000

 
$
1,410,017,716

 
December 1, 2017 through
  December 31, 2017
 
4,280,204

 
$

(3)(5)
4,280,204

 
$
1,350,032,588

 
Total
 
6,156,569

 
 
 
6,156,569

 
 
 

(1)
On May 17, 2017, the Company’s Board of Directors authorized the repurchase of up to $2.0 billion of the Company’s common stock. Repurchases are made in accordance with applicable securities laws in open market, private, or accelerated repurchase transactions from time to time, depending on market conditions, and may be discontinued at any time.
(2)
Under an accelerated share repurchase program entered into by the Company with a third party financial institution in third quarter 2017 (the "Third Quarter 2017 ASR Program"), the Company paid $300 million and received an initial delivery of 4,130,592 shares during August 2017, representing an estimated 75 percent of the shares to be purchased by the Company under the Third Quarter 2017 ASR Program based on a volume-weighted average price of $54.4716 per share, which was the closing price of the Company’s common stock on the New York Stock Exchange during a calculation period between August 1, 2017 and August 24, 2017. Final settlement of the Third Quarter 2017 ASR Program occurred in October 2017 and was determined based generally on a discount to the volume-weighted average price per share of the Company's common stock during a calculation period completed in October 2017. Upon settlement, the third party financial institution delivered 1,206,365 additional shares of the Company’s common stock to the Company. In total, the average purchase price per share for the 5,336,957 shares repurchased under the Third Quarter 2017 ASR Program, upon completion of the Third Quarter 2017 ASR Program in October 2017, was $56.2118.
(3)
Under an accelerated share repurchase program entered into by the Company with a third party financial institution in fourth quarter 2017 (the "Fourth Quarter 2017 ASR Program"), the Company paid $250 million in November 2017 and received an initial delivery of 3,323,537 shares during December 2017, representing an estimated 75 percent of the shares to be purchased by the Company under the Fourth Quarter 2017 ASR Program based on a volume-weighted average price of $56.4158 per share of the Company’s common stock on the New York Stock Exchange during a calculation period between November 8, 2017 and December 6, 2017. Final settlement of the Fourth Quarter 2017 ASR Program occurred in January 2018 and was determined based generally on a discount to the volume-weighted average price per share of the Company's common stock during a calculation period completed in January 2018. Upon settlement, the third party financial institution delivered 736,838 additional shares of the Company’s common stock to the Company. In total, the average purchase price per share for the 4,060,375 shares repurchased under the Fourth Quarter 2017 ASR Program, upon completion of the Fourth Quarter 2017 ASR Program in January 2018, was $61.5707.
(4)
During the period from November 29, 2017 through November 30, 2017, the Company repurchased 670,000 shares of its common stock on the open market at an average price of $59.6751 per share.
(5)
During the period from December 1, 2017 through December 15, 2017, the Company repurchased 956,667 shares of its common stock on the open market at an average price of $62.7022 per share.


36



Item 6.         Selected Financial Data

The following financial information, for the five years ended December 31, 2017, has been derived from the Company’s Consolidated Financial Statements. This information should be viewed in conjunction with the Consolidated Financial Statements and related notes thereto included elsewhere herein. The Company provides the operating data below because these statistics are commonly used in the airline industry and, therefore, allow readers to compare the Company’s performance against its results for prior periods, as well as against the performance of the Company’s peers.
 
  
 
Year ended December 31,
 
 
2017
 
2016
 
2015
 
2014
 
2013
Financial Data (in millions, except per share amounts):
 
 
 
 
 
 
 
 
 
 
Operating revenues
 
$
21,171

 
$
20,425

 
$
19,820

 
$
18,605

 
$
17,699

Operating expenses
 
17,656

 
16,665

 
15,704

 
16,380

 
16,421

Operating income
 
3,515

 
3,760

 
4,116

 
2,225

 
1,278

Other expenses (income) net
 
264

 
213

 
637

 
409

 
69

Income before taxes
 
3,251

 
3,547

 
3,479

 
1,816

 
1,209

Provision for income taxes
 
(237
)
 
1,303

 
1,298

 
680

 
455

Net income
 
$
3,488

 
$
2,244

 
$
2,181

 
$
1,136

 
$
754

Net income per share, basic
 
$
5.80

 
$
3.58

 
$
3.30

 
$
1.65

 
$
1.06

Net income per share, diluted
 
$
5.79

 
$
3.55

 
$
3.27

 
$
1.64

 
$
1.05

Cash dividends per common share
 
$
0.4750

 
$
0.3750

 
$
0.2850

 
$
0.2200

 
$
0.1300

Total assets at period-end
 
$
25,110

 
$
23,286

 
$
21,312

 
$
19,723

 
$
19,177

Long-term obligations at period-end
 
$
3,320

 
$
2,821

 
$
2,541

 
$
2,434

 
$
2,191

Stockholders’ equity at period-end
 
$
10,430

 
$
8,441

 
$
7,358

 
$
6,775

 
$
7,336

Operating Data:
 
 
 
 
 
 
 
 
 
 
Revenue passengers carried
 
130,256,190

 
124,719,765

 
118,171,211

 
110,496,912

 
108,075,976

Enplaned passengers
 
157,677,218

 
151,740,357

 
144,574,882

 
135,767,188

 
133,155,030

Revenue passenger miles (RPMs) (000s) (a)
 
129,041,420

 
124,797,986

 
117,499,879

 
108,035,133

 
104,348,216

Available seat miles (ASMs) (000s) (b)
 
153,811,072

 
148,522,051

 
140,501,409

 
131,003,957

 
130,344,072

Load factor (c)
 
83.9
%
 
84.0
%
 
83.6
%
 
82.5
%
 
80.1
%
Average length of passenger haul (miles)
 
991

 
1,001

 
994

 
978

 
966

Average aircraft stage length (miles)
 
754

 
760

 
750

 
721

 
703

Trips flown
 
1,347,893

 
1,311,149

 
1,267,358

 
1,255,502

 
1,312,785

Seats flown (d)
 
200,878,967

 
193,167,695

 
184,955,094

 
179,733,055

 
183,563,527

Seats per trip (e)
 
149.03

 
147.33

 
145.94

 
143.16

 
139.83

Average passenger fare (j)
 
$
146.95

 
$
149.09

 
$
154.85

 
$
159.80

 
$
154.72

Passenger revenue yield per RPM (cents) (f)(j)
 
14.83

 
14.90

 
15.57

 
16.34

 
16.02

Operating revenue per ASM (cents) (g)
 
13.76

 
13.75

 
13.98

 
14.20

 
13.58

Passenger revenue per ASM (cents) (h)(j)
 
12.44

 
12.52

 
13.02

 
13.48

 
12.83

Operating expenses per ASM (cents) (i)
 
11.48

 
11.22

 
11.18

 
12.50

 
12.60

Operating expenses per ASM, excluding fuel (cents)
 
8.92

 
8.76

 
8.60

 
8.46

 
8.18

Operating expenses per ASM, excluding fuel and profitsharing (cents)
 
8.56

 
8.37

 
8.16

 
8.19

 
8.01

Fuel costs per gallon, including fuel tax
 
$
1.92

 
$
1.82

 
$
1.90

 
$
2.93

 
$
3.16

Fuel costs per gallon, including fuel tax, economic
 
$
2.00

 
$
1.92

 
$
2.07

 
$
2.92

 
$
3.12

Fuel consumed, in gallons (millions)
 
2,045

 
1,996

 
1,901

 
1,801

 
1,818

Active fulltime equivalent Employees
 
56,110

 
53,536

 
49,583

 
46,278

 
44,381

Aircraft at end of period
 
706

 
723

 
704

 
665

 
681

(a)
A revenue passenger mile is one paying passenger flown one mile. Also referred to as "traffic," which is a measure of demand for a given period.
(b)
An available seat mile is one seat (empty or full) flown one mile. Also referred to as "capacity," which is a measure of the space available to carry passengers in a given period.
(c)
Revenue passenger miles divided by available seat miles.
(d)
Seats flown is calculated using total number of seats available by aircraft type multiplied by the total trips flown by the same aircraft type during a particular period.
(e)
Seats per trip is calculated using seats flown divided by trips flown. Also referred to as "gauge."
(f)
Calculated as passenger revenue divided by revenue passenger miles. Also referred to as "yield," this is the average cost paid by a paying passenger to fly one mile, which is a measure of revenue production and fares.

37



(g)
Calculated as operating revenues divided by available seat miles. Also referred to as "operating unit revenues" or "RASM," this is a measure of operating revenue production based on the total available seat miles flown during a particular period. Year ended 2015 RASM excludes a $172 million one-time special revenue adjustment. Including the special revenue adjustment, RASM would have been 14.11 cents for the year ended 2015. Additional information regarding this special item is provided in the Note Regarding Use of Non-GAAP Financial Measures.
(h)
Calculated as passenger revenue divided by available seat miles. Also referred to as "passenger unit revenues," this is a measure of passenger revenue production based on the total available seat miles flown during a particular period.
(i)
Calculated as operating expenses divided by available seat miles. Also referred to as "unit costs" or "cost per available seat mile," this is the average cost to fly an aircraft seat (empty or full) one mile, which is a measure of cost efficiencies.
(j)
Refer to Note 1 to the Consolidated Financial Statements for additional information regarding the impact from the Company's July 2015 amended co-branded credit card agreement with Chase Bank USA, N.A.

38



Item 7.        Management's Discussion and Analysis of Financial Condition and Results of Operations

YEAR IN REVIEW

For the 45th consecutive year, the Company was profitable, recording GAAP and non-GAAP results for 2017 and 2016 as noted in the following tables. See Note Regarding Use of Non-GAAP Financial Measures and the Reconciliation of Reported Amounts to Non-GAAP Financial Measures for additional detail regarding non-GAAP financial measures.
 
 
Year ended
 
 
(in millions, except per share amounts)
 
December 31,
 
 
GAAP
 
2017
 
2016
 
Percent Change
Operating income
 
$
3,515

 
$
3,760

 
(6.5)
Net income
 
$
3,488

 
$
2,244

 
55.4
Net income per share, diluted
 
$
5.79

 
$
3.55

 
63.1
 
 
 

 
 

 
 
Non-GAAP
 
 
 
 
 
 
Operating income
 
$
3,455

 
$
3,957

 
(12.7)
Net income
 
$
2,107

 
$
2,370

 
(11.1)
Net income per share, diluted
 
$
3.50

 
$
3.75

 
(6.7)

Net income for the year ended December 31, 2017, was $3.5 billion, a 55.4 percent increase year-over-year, or $5.79 per diluted share, and non-GAAP Net income was $2.1 billion, an 11.1 percent decrease year-over-year, or $3.50 per diluted share. The increase in GAAP Net income was primarily driven by a $1.4 billion reduction in Provision for income taxes related to the Tax Cuts and Jobs Act legislation enacted in December 2017, which resulted in a re-measurement of the Company's deferred tax assets and liabilities at the new federal corporate tax rate of 21 percent. This non-cash item is excluded from the Company's non-GAAP results. Operating income for the year ended December 31, 2017 was $3.52 billion, a decrease of 6.5 percent year-over-year, and non-GAAP Operating income was $3.46 billion. The decrease in Operating Income was driven by a 7.7 percent increase in Salaries, wages, and benefits expense, primarily due to wage rate increases resulting from amended collective-bargaining agreements reached with multiple unionized workgroups, coupled with an 8.0 percent increase in Fuel and oil expense, primarily due to increases in market prices. These factors were partially offset by a 2.9 percent increase in Passenger revenues driven by strong demand for low-fare air travel and a 3.6 percent year-over-year capacity growth, holding Load factor and Passenger yield constant. Prior year results included $356 million of contract ratification bonuses accrued in Salaries, wages, and benefits expense associated with tentative collective-bargaining agreements reached with multiple unionized workgroups.

For the twelve months ended December 31, 2017, the Company's earnings performance, combined with its actions to manage invested capital, produced a 25.9 percent pre-tax non-GAAP return on invested capital ("ROIC"), compared with the Company's ROIC of 30.0 percent for the twelve months ended December 31, 2016. The primary cause of the year-over-year decline in ROIC was the decrease in Operating income for the twelve months ended December 31, 2017, compared with the twelve months ended December 31, 2016. See the Company's calculation of ROIC in the accompanying reconciliation tables as well as the Note Regarding Use of Non-GAAP Financial Measures.

During 2017, the Company continued to return value to its Shareholders. The Company returned $1.9 billion to Shareholders through $274 million in dividend payments and $1.6 billion through four separate accelerated share repurchase programs and other open market repurchases. During November 2017, the Company launched the Fourth Quarter 2017 ASR Program by advancing $250 million to a financial institution in a privately negotiated transaction. The Company received 4.1 million shares in total under the Fourth Quarter 2017 ASR Program, which was completed in January 2018. The purchase was recorded as a treasury share purchase for purposes of calculating earnings per share.


39



On January 31, 2018, the Company launched a new accelerated share repurchase program by advancing $500 million to a financial institution in a privately negotiated transaction ("First Quarter 2018 ASR Program"). The specific number of shares that the Company ultimately will repurchase under the First Quarter 2018 ASR Program will be determined based generally on a discount to the volume-weighted average price per share of the Company's common stock during a calculation period to be completed no later than May 2018. The purchase will be recorded as a treasury share purchase for purposes of calculating earnings per share. Subsequent to the launch of the First Quarter 2018 ASR Program, the Company has $850 million remaining under its May 2017 $2.0 billion share repurchase authorization. See Part II, Item 5 for further information on the Company's share repurchase authorizations.

Company Overview

During 2017, the Company began scheduled service to new international destinations of Grand Cayman Island and Providenciales, Turks & Caicos, as well as new domestic service to Cincinnati/Northern Kentucky International airport. With the addition of these new markets, the Company now serves 100 destinations across 40 states and ten near-international countries, and operates over 4,000 departures a day. Additionally, the Company announced plans to begin selling tickets in 2018 for service to Hawaii, subject to requisite governmental approvals, including approval from the FAA for Extended Operations ("ETOPS"), a regulatory requirement to operate between the U.S. mainland and the Hawaiian Islands.

During 2017, the Company took delivery of 39 new 737-800 aircraft from Boeing, 13 new 737 MAX 8 aircraft from Boeing, and 18 pre-owned Boeing 737-700 aircraft from third parties. The Company also retired its remaining 87 Boeing 737-300 ("Classic") aircraft, which included 61 Classic aircraft grounded in September 2017 as part of an accelerated retirement schedule. The Company recorded a charge of $63 million related to the leased portion of the Classic fleet, representing the remaining net lease payments due and certain lease return requirements that could have to be performed on these leased aircraft prior to their return to the lessors, as of the cease-use date. For 2018, the Company's current firm aircraft commitments would result in 750 aircraft by year-end 2018. See Part I, Item 2 for further information.

The Company became the first airline in North America to offer scheduled service utilizing Boeing’s new, more fuel-efficient, 737 MAX 8 aircraft, which entered service in fourth quarter 2017. The Company is scheduled to be the launch customer for the Boeing 737 MAX 7 series aircraft, with deliveries expected to begin in 2019. Currently, the Company has firm orders in place for 197 737 MAX 8 aircraft and 30 737 MAX 7 aircraft. See Part I, Item 2 for further information.

The Company plans to continue its route network and schedule optimization efforts through the addition of new markets and itineraries, while also pruning less profitable flights from its schedule. The Company currently plans to grow its 2018 available seat miles in the low five percent range, year-over-year, with first half 2018 year-over-year growth in the low three percent range and second half 2018 year-over-year growth in the low seven percent range. The Company continues to expect the retirement of its Classic aircraft to produce significant incremental cost savings and improvements in pre-tax results of at least $200 million, cumulatively, by the end of 2020.

On May 9, 2017, the Company completed a multi-year initiative to completely transition its reservation system to the Amadeus Altéa Passenger Service System. The new reservation system, which represented the largest technology project in the Company's history, was designed to improve flight scheduling and inventory management, enable operational enhancements to manage flight disruptions, such as those caused by extreme weather conditions, enable revenue enhancements, further schedule optimization, support additional international growth, and enable other foundational and operational capabilities. The Company continues to expect the new reservation system to produce incremental benefits in pretax results of approximately $200 million in 2018.

During November 2017, the Company's Facilities Maintenance Technicians, represented by Aircraft Mechanics Fraternal Association ("AMFA"), ratified a tentative collective-bargaining agreement with the Company. The newly ratified contract becomes amendable in November 2022.


40



2017 Compared with 2016

Operating Revenues

Passenger revenues for 2017 increased by $547 million, or 2.9 percent, compared with 2016. Holding Load factor and Passenger yield constant, the increase was primarily attributable to a 3.6 percent increase in capacity, partially offset by approximately $100 million in reduced revenues as a result of the hurricanes and earthquakes during third quarter 2017. On a unit basis, Passenger revenues decreased 0.6 percent, year-over-year, largely driven by a 0.5 percent decrease in Passenger revenue yield due to the industry's competitive domestic fare environment. Load factor remained solid at 83.9 percent.

Freight revenues for 2017 increased by $2 million, or 1.2 percent, compared with 2016, primarily due to increased demand. Based on current trends, the Company currently expects Freight revenues in first quarter 2018 to increase, compared with first quarter 2017.

Other revenues for 2017 increased by $197 million, or 11.9 percent, compared with 2016. Approximately 70 percent of the increase was due to an increase in revenue associated with cardholder spend on the Company's co-branded Chase® Visa credit card, and the remainder of the increase was due to higher ancillary revenues primarily as a result of EarlyBird Check-In revenues of $358 million in 2017, an increase of $29 million, or 8.7 percent, compared with 2016. The Company currently expects Other revenues in first quarter 2018 to increase, compared with first quarter 2017. The Company currently expects EarlyBird Check-in revenues to have a similar year-over-year growth rate in 2018, as compared with 2017.

Based on revenue and booking trends thus far in first quarter 2018, the Company is currently expecting first quarter 2018 operating unit revenues to increase in the one to two percent range, compared with first quarter 2017.

Accounting Standards Update ("ASU") No. 2014-09, Revenue from Contracts with Customers, is effective for fiscal years, and interim periods within those years, beginning after December 15, 2017. Therefore, the Company will adopt the standard as of January 1, 2018, utilizing the full retrospective method of adoption allowed by the standard, in order to provide for comparative results in all periods presented. As such, in the Company's first quarter 2018 Form 10–Q, both first quarter 2018 results and first quarter 2017 results will be presented under the new standard. On the Consolidated Statement of Income, the estimated impact of this ASU for full year 2017 and 2016 will be a decrease to Operating revenues of approximately $25 million and $135 million, respectively, and a decrease to Operating expenses of approximately $40 million in each year. The ASU will also result in the reclassification of certain ancillary revenues from Other revenues to Passenger revenues for each period. See Note 2 to the Consolidated Financial Statements for further information.

Operating Expenses

Operating expenses for 2017 increased by $991 million, or 5.9 percent, compared with 2016, while capacity increased 3.6 percent over the same period. Historically, except for changes in the price of fuel, changes in Operating expenses for airlines have been largely driven by changes in capacity, or ASMs. The following table presents the Company's Operating expenses per ASM for 2017 and 2016, followed by explanations of these changes on a per ASM basis and dollar basis:


41



 
Year ended December 31,
 
Per ASM
 
Percent
(in cents, except for percentages)
2017
 
2016
 
change
 
change
Salaries, wages, and benefits

4.76
¢
 

4.57
¢
 

0.19
¢
 
4.2
 %
Fuel and oil
2.56

 
2.46

 
0.10

 
4.1

Maintenance materials and repairs
0.65

 
0.70

 
(0.05
)
 
(7.1
)
Aircraft rentals
0.13

 
0.15

 
(0.02
)
 
(13.3
)
Landing fees and other rentals
0.84

 
0.82

 
0.02

 
2.4

Depreciation and amortization
0.79

 
0.82

 
(0.03
)
 
(3.7
)
Other operating expenses
1.75

 
1.70

 
0.05

 
2.9

Total

11.48
¢
 

11.22
¢
 

0.26
¢
 
2.3
 %

Operating expenses per ASM for 2017 increased 2.3 percent, compared with 2016, primarily due to wage rate increases, increases in market jet fuel prices, and charges associated with the grounding of the Company's remaining Classic aircraft. Prior year results included $356 million of ratification bonuses accrued during 2016, associated with collective-bargaining agreements reached with multiple unionized workgroups. Operating expenses per ASM for 2017, excluding Fuel and oil expense and special items (a non-GAAP financial measure), increased 4.2 percent year-over-year, primarily due to wage rate increases. See Note Regarding Use of Non-GAAP Financial Measures and the Reconciliation of Reported Amounts to Non-GAAP Financial Measures for additional detail regarding non-GAAP financial measures. Based on current trends and excluding Fuel and oil expense, special items, and profitsharing expense, the Company expects its first quarter 2018 unit costs to increase in the range of 0.5 to 1.5 percent, compared with first quarter 2017. The year-over-year projections do not reflect the potential impact of Fuel and oil expense, special items, and profitsharing expense in both years because the Company cannot reliably predict or estimate those items or expenses or their impact to its financial statements in future periods, especially considering the significant volatility of the Fuel and oil expense line item. Accordingly, the Company believes a reconciliation of non-GAAP financial measures to the equivalent GAAP financial measures for projected results is not meaningful or available without unreasonable effort.

Salaries, wages, and benefits expense for 2017 increased by $521 million, or 7.7 percent, compared with 2016. Salaries, wages, and benefits expense per ASM for 2017 increased 4.2 percent, compared with 2016. On both a dollar and per ASM basis, the majority of the increases were the result of higher salaries and resulting Company contributions to the Company sponsored 401(k) plans, primarily driven by wage rate increases. In addition, the Company announced a $1,000 per Employee bonus as a result of the 2017 tax reform, which comprised approximately $70 million of the increase in Salaries, wages, and benefits expense. Prior year results included $356 million of ratification bonuses accrued during 2016, associated with collective-bargaining agreements reached with multiple unionized workgroups. Based on current cost trends and anticipated capacity, the Company expects first quarter 2018 Salaries, wages, and benefits expense per ASM, excluding profitsharing expense, to increase, compared with first quarter 2017. The year-over-year projection does not reflect the potential impact of profitsharing expense in both years because the Company cannot reliably predict or estimate that expense or its impact to the Company's financial statements in future periods. Accordingly, the Company believes a reconciliation of non-GAAP financial measures to the equivalent GAAP financial measures for projected results is not meaningful or available without unreasonable effort.

During 2017, the Company conducted negotiations with various unionized Employee groups. See the above discussion in Company Overview regarding an agreement reached during the year. The following table sets forth the Company’s unionized Employee groups that are currently in negotiations on collective-bargaining agreements:
 
Employee Group
Approximate Number of Employees
Representatives
Amendable Date
Southwest Material Specialists (formerly known as Stock Clerks)
300
International Brotherhood of Teamsters, Local 19 ("IBT 19")
August 2013
Southwest Mechanics
2,400
Aircraft Mechanics Fraternal Association ("AMFA")
August 2012


42




Fuel and oil expense for 2017 increased by $293 million, or 8.0 percent, compared with 2016. On a per ASM basis, Fuel and oil expense for 2017 increased 4.1 percent, compared with 2016. On both a dollar and per ASM basis, the increases were attributable to higher market jet fuel prices, partially offset by a decrease in net hedging losses recognized compared to 2016. See Note Regarding Use of Non-GAAP Financial Measures and the Reconciliation of Reported Amounts to Non-GAAP Financial Measures for additional detail regarding non-GAAP financial measures. The Company's average economic jet fuel price per gallon increased 4.2 percent, year-over-year, from $1.92 for 2016 to $2.00 for 2017. These figures do not include premium expense associated with the Company's fuel hedges, which on a per gallon basis equated to approximately $0.08 and $0.06 for 2016 and 2017, respectively. The Company also improved its fuel efficiency during 2017, compared with 2016, when measured on the basis of ASMs generated per gallon of fuel. Fuel gallons consumed increase2.5 percent, compared with 2016, while year-over-year capacity increase3.6 percent. As a result of the Company's fuel hedging program, the Company recognized net losses totaling $416 million in Fuel and oil expense for 2017, compared with net losses totaling $820 million for 2016. These totals include cash settlements realized from the settlement of fuel derivative contracts associated with the Company's economic fuel hedge totaling $572 million paid to counterparties for 2017, compared with $1.0 billion paid to counterparties for 2016. Additionally, these totals exclude gains and/or losses recognized from hedge ineffectiveness and from derivatives that did not qualify for hedge accounting. These items are recorded as a component of Other (gains) losses, net. See Note 10 to the Consolidated Financial Statements.

As of January 19, 2018, on an economic basis, the Company had derivative contracts in place related to expected future fuel consumption as follows:

Period
Maximum percent of estimated fuel consumption covered by fuel derivative contracts at varying West Texas Intermediate/Brent Crude Oil, Heating Oil, and Gulf Coast Jet Fuel-equivalent price levels (a)
2018
78%
2019
63%
2020
31%
Beyond 2020 (b)
11%

(a) The Company's hedge position can vary significantly at different price levels, including prices at which the Company considers "catastrophic" coverage. The percentages provided are not indicative of the Company's hedge coverage at every price, but represent the highest level of coverage at a single price. The Company believes its coverage related to first quarter 2018 is best reflected within the jet fuel forecast price sensitivity table provided below. See Note 10 to the Consolidated Financial Statements for further information.
(b) The Company's coverage for 2021 was approximately 11 percent of estimated fuel consumption. The coverage beyond 2021 was not significant.

As a result of applying hedge accounting in prior periods, including related to hedge positions that have either been offset or settled early on a cash basis, the Company has amounts "frozen" in Accumulated other comprehensive income (loss) ("AOCI"), and these amounts will be recognized in earnings in future periods when the underlying fuel derivative contracts settle. The following table displays the Company's estimated fair value of remaining fuel derivative contracts (not considering the impact of the cash collateral provided to or received from counterparties - see Note 10 to the Consolidated Financial Statements for further information), as well as the amount of deferred gains/losses in AOCI at December 31, 2017, and the expected future periods in which these items are expected to settle and/or be recognized in earnings (in millions):


43



Year
 
Fair value of fuel
derivative contracts
at December 31, 2017
 
Amount of gains (losses) deferred
in AOCI at December 31,
2017 (net of tax)
2018
 
$
112

 
$
(9
)
2019
 
75

 
8

2020
 
42

 
3

Beyond 2020
 
19

 

Total
 
$
248

 
$
2


Based on forward market prices and the amounts in the above table (and excluding any other subsequent changes to the fuel hedge portfolio), the Company's jet fuel costs per gallon could exceed market (i.e., unhedged) prices during some of these future periods. This is based primarily on expected future cash settlements associated with fuel derivatives, but excludes any impact associated with the ineffectiveness of fuel hedges or fuel derivatives that are marked to market because they do not qualify for hedge accounting. See Note 10 to the Consolidated Financial Statements for further information. Assuming no changes to the Company's current fuel derivative portfolio, but including all previous hedge activity for fuel derivatives that have not yet settled and expected fuel hedge premium costs associated with settling contracts each period, and considering only the expected net cash payments and/or receipts related to hedges that will settle, the Company is providing the below sensitivity table for first quarter 2018 and full year 2018 jet fuel prices at different crude oil assumptions as of January 19, 2018, and for expected premium costs associated with settling contracts each period, respectively.

 
Fuel hedging premium expense per gallon (b)
Estimated economic fuel price per gallon, including taxes and premiums (c)(e)
Fuel hedging premium expense per gallon (b)
Estimated economic fuel price per gallon, including taxes and premiums (d)(e)
Average Brent Crude Oil
price per barrel
1Q 2018
Full Year 2018
$55
$0.07
$1.85 - $1.90
$0.06
$1.75 - $1.80
$65
$0.07
$2.05 - $2.10
$0.06
$2.00 - $2.05
Current Market (a)
$0.07
$2.10 - $2.15
$0.06
$2.10 - $2.15
$75
$0.07
$2.25 - $2.30
$0.06
$2.30 - $2.35
$80
$0.07
$2.30 - $2.35
$0.06
$2.35 - $2.40
$85
$0.07
$2.35 - $2.40
$0.06
$2.45 - $2.50
Estimated premium costs
Approximately $34 million
Approximately $135 million

(a) Brent crude oil average market prices as of January 19, 2018, were approximately $68 and $67 per barrel for first quarter 2018 and full year 2018, respectively.
(b) In accordance with the Company's planned early adoption of Accounting Standards Update No. 2017-12, Targeting Improvements to Accounting for Hedging Activities, the Company will begin reporting premium expense within Fuel and oil expense as of January 1, 2018.
(c) Based on the Company's existing fuel derivative contracts and market prices as of January 19, 2018, first quarter 2018 economic fuel costs are estimated to be in the $2.10 to $2.15 per gallon range, including fuel hedging premium expense of approximately $34 million, or $0.07 per gallon. First quarter 2018's expected economic fuel cost range of $2.10 to $2.15 per gallon compares with first quarter 2017's economic fuel cost of $1.96 per gallon, as reported, but including fuel hedging premium expense of $34 million, or $.07 per gallon, will be recast as $2.03 per gallon.
(d) Based on the Company's existing fuel derivative contracts and market prices as of January 19, 2018, annual 2018 economic fuel costs are estimated to be in the $2.10 to $2.15 per gallon range, including fuel hedging premium expense of approximately $135 million, or $.06 per gallon. 2018's annual expected economic fuel cost range of $2.10 to $2.15 per gallon compares with 2017's annual economic fuel costs of $2.00 per gallon, as reported herein, but including fuel hedging premium expense of $135 million, or $.06 per gallon, will be recast as $2.06 per gallon.
(e) The economic fuel price per gallon sensitivities provided assume the relationship between Brent crude oil and refined products based on market prices as of January 19, 2018. Economic fuel cost projections do not reflect the potential impact of special items because the Company cannot reliably predict or estimate the hedge accounting impact associated with the volatility of the energy

44



markets or the impact to its financial statements in future periods. Accordingly, the Company believes a reconciliation of non-GAAP financial measures to the equivalent GAAP financial measures for projected results is not meaningful or available without unreasonable effort.

ASU No. 2017-12, Targeted Improvements to Accounting for Hedging Activities, is effective for fiscal years, and interim periods within those years, beginning after December 15, 2018, with early adoption permitted in any interim or annual period. The Company plans to adopt the standard as of January 1, 2018. See Note 2 to the Consolidated Financial Statements for further information.

Maintenance materials and repairs expense for 2017 decreased by $44 million, or 4.2 percent, compared with 2016. On a per ASM basis, Maintenance materials and repairs expense for 2017 decreased 7.1 percent, compared with 2016. On both a dollar and per ASM basis, the majority of the decreases were attributable to a decrease in airframe maintenance expenses primarily as a result of the retirement of the Company's Classic fleet, partially offset by increases in Boeing 737-700 engine maintenance due to increased utilization. The Company currently expects Maintenance materials and repairs expense per ASM for first quarter 2018 to increase, compared with first quarter 2017.

Aircraft rentals expense for 2017 decreased by $31 million, or 13.5 percent, compared with 2016. On a per ASM basis, Aircraft rentals expense decreased 13.3 percent, compared with 2016. On both a dollar and per ASM basis, the majority of the decreases were due to 737-300 lease returns and the purchase of ten 737-300 aircraft, that were previously on operating leases, since 2016. See the accompanying Note Regarding Use of Non-GAAP Financial Measures for further information. The Company currently expects Aircraft rentals expense per ASM for first quarter 2018 to decrease, compared with first quarter 2017.

Landing fees and other rentals expense for 2017 increased by $81 million, or 6.7 percent, compared with 2016. On a per ASM basis, Landing fees and other rentals expense for 2017 increased 2.4 percent, compared with 2016. On a dollar basis, approximately 50 percent of the increase was due to an increase in Landing fees as a result of the 2.8 percent increase in Trips flown and a change in fleet mix to larger capacity aircraft. Approximately 25 percent of the increase on a dollar basis was an increase in space rentals related to rate escalations and capital projects at many airports across the Company's network. The remaining increase was due to growth in international markets which gives rise to additional fees. The increase per ASM was primarily due to rate escalations at many airports across the Company's network. The Company currently expects Landing fees and other rentals expense per ASM for first quarter 2018 to increase, compared with first quarter 2017.

Depreciation and amortization expense for 2017 decreased by $3 million, or 0.2 percent, compared with 2016. On a per ASM basis, Depreciation and amortization expense decreased 3.7 percent, compared with 2016. On both a dollar and per ASM basis, the majority of the decreases were associated with a net decrease in depreciation expense related to the Company's flight equipment, as the decrease from the retirement of the Company's Classic fleet exceeded the additional depreciation from the addition of new 737 MAX 8 aircraft, new 737-800 aircraft, and pre-owned 737-700 aircraft on capital leases. These decreases were partially offset by the deployment of new technology assets. The Company currently expects Depreciation and amortization expense per ASM for first quarter 2018 to decrease, compared with first quarter 2017.

Other operating expenses for 2017 increased by $174 million, or 6.9 percent, compared with 2016. On a per ASM basis, Other operating expenses for 2017 increased 2.9 percent, compared with 2016. These increases were both impacted by charges associated with the retirement of the Company's remaining Classic aircraft. These charges included a $63 million aircraft grounding charge related to the leased portion of the Classic fleet, representing the remaining net lease payments due and certain lease return requirements that could have to be performed on these leased aircraft prior to their return to the lessors, as of the cease-use date. The Classic fleet charges in 2017 also included $33 million in lease termination expenses associated with Classic aircraft being acquired off their operating leases, compared with $22 million related to the acquisition of aircraft coming off operating leases in 2016. These charges related to the grounding or cease-use of the Classic fleet were considered special items and thus excluded from the Company's non-GAAP results. See Note Regarding Use of Non-GAAP Financial Measures and the Reconciliation of Reported Amounts to Non-GAAP Financial Measures for additional detail regarding non-GAAP financial measures. The remainder of

45



the increase on a dollar basis was primarily due to increased personnel expenses due to higher travel expenses for Flight Crews and higher hotel rates, as well as new Heart-themed uniforms for the Company's operations personnel. The Company currently expects Other operating expenses per ASM for first quarter 2018 to increase slightly, compared with first quarter 2017.

Other

Other expenses (income) include interest expense, capitalized interest, interest income, and other gains and losses.

Interest expense for 2017 decreased by $8 million, or 6.6 percent, compared with 2016, primarily due to the timing of debt activity. The Company had three debt facilities mature during or since 2016 with higher interest expense than the four debt facilities issued during or since 2016. The three debt facilities that matured during or since 2016 included the Company's remaining 5.25% convertible senior notes in October 2016, $300 million of 5.75% senior unsecured notes in December 2016, and $300 million of 5.125% senior unsecured notes in March 2017. The four debt facilities issued during or since 2016 included a $215 million floating rate term loan in October 2016, $300 million of 3.00% senior unsecured notes in November 2016, $300 million of 2.75% senior unsecured notes in November 2017, and $300 million of 3.45% senior unsecured notes in November 2017.

Capitalized interest for 2017 increased by $2 million, or 4.3 percent, compared with 2016, primarily due to interest on facility construction projects.

Interest income for 2017 increased by $11 million, or 45.8 percent, compared with 2016, primarily due to higher interest rates.

Other (gains) losses, net, primarily includes amounts recorded as a result of the Company's hedging activities. See Note 10 to the Consolidated Financial Statements for further information on the Company's hedging activities. The following table displays the components of Other (gains) losses, net, for the years ended December 31, 2017, and 2016:
 
Year ended December 31,
(in millions)
2017
 
2016
Mark-to-market impact from fuel contracts settling in future periods
$
69

 
$
9

Ineffectiveness from fuel hedges settling in future periods
31

 
(11
)
Realized ineffectiveness and mark-to-market (gains) or losses
6

 
5

Premium cost of fuel contracts
135

 
153

Other
(7
)
 
6

 
$
234

 
$
162


Income Taxes

The Company's effective tax rate was (7.3) percent for 2017, compared with 36.8 percent for 2016. The decrease in rate was driven by a $1.4 billion reduction in Provision for income taxes related to the Tax Cuts and Jobs Act legislation enacted in December 2017, which resulted in a re-measurement of the Company's deferred tax assets and liabilities at the new federal corporate tax rate of 21 percent. The Company currently projects a full year 2018 effective tax rate to be in the 23 to 23.5 percent range, as a result of a lower federal corporate tax rate, and including the estimated impact of state taxes.

2016 Compared with 2015

Operating Revenues

Passenger revenues for 2016 increased by $295 million, or 1.6 percent, compared with 2015. Holding Load factor and Passenger yield constant, the increase was primarily attributable to a 5.7 percent increase in capacity as strong

46



Customer demand for low-fare air travel enabled the Company to fill the additional seats, as evidenced by a Company record annual load factor of 84.0 percent. On a unit basis, Passenger revenues decreased 3.8 percent, year-over-year, largely driven by a 4.3 percent decrease in passenger revenue yield, year-over-year, which included a reduction to 2016 Passenger revenues associated with the Company's July 2015 amended co-branded credit card agreement ("Agreement") with Chase Bank USA, N.A. ("Chase") and a resulting required change in accounting methodology. See Note 1 to the Consolidated Financial Statements for further information. The Agreement resulted in an acceleration of the timing of revenue recognition on a prospective basis beginning July 1, 2015, as well as a change in classification.

Freight revenues for 2016 decreased by $8 million, or 4.5 percent, compared with 2015, primarily due to sluggish demand.

The Company recorded a Special revenue adjustment during 2015 of $172 million. This adjustment represented a one-time non-cash reduction to deferred revenue liability as a result of the Agreement with Chase and the resulting required change in accounting methodology, and is classified as a special item and thus excluded from the Company's 2015 non-GAAP financial results. See Note 1 to the Consolidated Financial Statements and the Note Regarding Use of Non-GAAP Financial Measures for further information.

Other revenues for 2016 increased by $490 million, or 41.9 percent, compared with 2015, primarily as a result of the Agreement with Chase and the resulting required change in accounting methodology. This change resulted in approximately 90 percent of the increase to Other revenue year-over-year. Excluding this impact of the Agreement with Chase, Other revenues increased primarily due to higher ancillary revenues associated with EarlyBird Check-in® and A1-15 select open priority boarding positions sold at the airport.

Operating Expenses

Operating expenses for 2016 increased by $961 million, or 6.1 percent, compared with 2015, while capacity increased 5.7 percent over the same period. Historically, except for changes in the price of fuel, changes in Operating expenses for airlines have been largely driven by changes in capacity, or ASMs. The following table presents the Company's Operating expenses per ASM for 2016 and 2015, followed by explanations of these changes on a per ASM basis and/or on a dollar basis:
 
 
Year ended December 31,
 
Per ASM
 
Percent
change        
(in cents, except for percentages)
2016
 
2015
 
change
Salaries, wages, and benefits

4.57
¢
 

4.54
¢
 

0.03
¢
 
0.7
 %
Fuel and oil
2.46

 
2.58

 
(0.12
)
 
(4.7
)
Maintenance materials and repairs
0.70

 
0.72

 
(0.02
)
 
(2.8
)
Aircraft rentals
0.15

 
0.17

 
(0.02
)
 
(11.8
)
Landing fees and other rentals
0.82

 
0.83

 
(0.01
)
 
(1.2
)
Depreciation and amortization
0.82

 
0.72

 
0.10

 

Acquisition and integration

 
0.03

 
(0.03
)
 
(100.0
)
Other operating expenses
1.70

 
1.59

 
0.11

 
6.9

Total

11.22
¢
 

11.18
¢
 

0.04
¢
 
0.4
 %

Operating expenses per ASM for 2016 increased 0.4 percent, compared with 2015, primarily due to the accelerated depreciation expense associated with the planned early retirement of the Classic fleet, higher contract programming and consulting expenses associated with large technology projects, and higher wage rates due to new labor agreements. These increases were partially offset by lower jet fuel prices and lower profitsharing expense. See Note 1 to the Consolidated Financial Statements for further information on the early retirement of the Classic fleet. Operating expenses per ASM for 2016, excluding Fuel and oil expense and special items (a non-GAAP financial measure), increased 1.6 percent year-over-year. See Note Regarding Use of Non-GAAP Financial Measures for additional detail regarding non-GAAP financial measures.

47




Salaries, wages, and benefits expense for 2016 increased by $415 million, or 6.5 percent, compared with 2015. Salaries, wages, and benefits expense per ASM for 2016 increased 0.7 percent, compared with 2015. On both a dollar and per ASM basis, the increases were primarily due to wage rate increases as a result of agreements reached with multiple workgroups, increased training, additional headcount, and contractual increases.

Fuel and oil expense for 2016 increased by $31 million, or 0.9 percent, compared with 2015. On a per ASM basis, Fuel and oil expense for 2016 decreased 4.7 percent, compared with 2015, as the dollar increases were more than offset by the 5.7 percent increase in capacity. On a dollar basis, the increase was attributable to the $566 million increase in net losses resulting from the Company's fuel hedging program. Excluding the impact of hedging, Fuel and oil expense would have decreased by $535 million, or 15.9 percent, compared with 2015, due to lower market jet fuel prices. The Company's average economic jet fuel price per gallon decreased 7.2 percent year-over-year, from $2.07 for 2015 to $1.92 for 2016, not including premium expense of $0.06 and $0.08 per gallon, respectively. Fuel gallons consumed increased 5.0 percent, compared with 2015, while year-over-year capacity increased 5.7 percent. As a result of the Company's fuel hedging program, the Company recognized net losses totaling $820 million in Fuel and oil expense for 2016, compared with net losses totaling $254 million for 2015. These totals include cash settlements realized from the settlement of fuel derivative contracts associated with the Company's economic fuel hedge totaling $1.0 billion paid to counterparties for 2016, compared with $577 million paid to counterparties for 2015. Additionally, these totals exclude gains and/or losses recognized from hedge ineffectiveness and from derivatives that did not qualify for hedge accounting. These items are recorded as a component of Other (gains) losses, net.

Maintenance materials and repairs expense for 2016 increased by $40 million, or 4.0 percent, compared with 2015. On a per ASM basis, Maintenance materials and repairs expense for 2016 decreased 2.8 percent, compared with 2015, as the dollar increases were more than offset by the 5.7 percent increase in capacity. On a dollar basis, the majority of the increase was attributable to the timing of regular maintenance checks and ongoing cabin refresh projects including updates for the Company's new Heart cabin interior. These increases were partially offset by lower engine expense as a result of the early retirement of the Classic fleet, as this decrease in engine repairs was only partially offset by higher 737-700 engine expense due to increased flight hours.

Aircraft rentals expense for 2016 decreased by $9 million, or 3.8 percent, compared with 2015. On a per ASM basis, Aircraft rentals expense decreased 11.8 percent, compared with 2015. On both a dollar and per ASM basis, the decreases were primarily due to the retirement of five 737-300 leased aircraft and two 737-500 leased aircraft since 2015, as well as the purchase of five leased 737-300s that were previously on operating lease during 2016. See Note Regarding Use of Non-GAAP Financial Measures for further information.

Landing fees and other rentals expense for 2016 increased by $45 million, or 3.9 percent, compared with 2015. On a per ASM basis, Landing fees and other rentals expense for 2016 decreased 1.2 percent, compared with 2015, as the dollar increases were more than offset by the 5.7 percent increase in capacity. On a dollar basis, approximately 70 percent of the increase was due to higher space rental rates and usage at various airports. The remainder was due to a 3.5 percent increase in Trips flown coupled with heavier landing weights for the Company's higher capacity 737-800 aircraft, which in 2016 made up a larger portion of the Company's fleet than in 2015.

Depreciation and amortization expense for 2016 increased by $206 million, or 20.3 percent, compared with 2015. On a per ASM basis, Depreciation and amortization expense increased 13.9 percent, compared with 2015. On both a dollar and per ASM basis, approximately 60 percent of the increases were due to the accelerated depreciation expense resulting from a change in the estimated retirement dates of many of the Company's owned Classic fleet from mid-2021 to third quarter 2017. The remainder of the increases were due to the purchase and capital lease of new and used aircraft since 2015.

The Company incurred no Acquisition and integration costs in 2016, compared with $39 million in 2015. The 2015 costs primarily consisted of Employee training and certain expenses associated with the grounding and conversion costs resulting from the transition of the Company's Boeing 717-200 fleet ("B717s") to Delta Air Lines ("Delta"). See Note 7 to the Consolidated Financial Statements for further information.

48




Other operating expenses for 2016 increased by $272 million, or 12.1 percent, compared with 2015. On a per ASM basis, Other operating expenses for 2016 increased 6.9 percent, compared with 2015. On both a dollar and per ASM basis, approximately 30 percent of the increases were due to higher contract programming and consulting expenses associated with large technology projects and approximately 15 percent of the increases were due to increased personnel expenses. Other operating expenses for 2016 also increased as the result of a $37 million litigation settlement received during 2015 which reduced 2015 Other operating expenses, a $22 million lease termination expense as a result of the Company acquiring five of its Boeing 737-300 aircraft off operating leases, and a $21 million increase due to an impairment charge related to leased slots at Newark Liberty International Airport. The remainder of the increases were due to revenue related costs driven by the 5.5 percent increase in Revenue Passengers Carried.

Other

Other expenses (income) include interest expense, capitalized interest, interest income, and other gains and losses.

Interest expense for 2016 increased by $1 million, or 0.8 percent, compared with 2015, primarily due to the timing of debt issuances and payoffs in 2015 and 2016.

Capitalized interest for 2016 increased by $16 million, or 51.6 percent, compared with 2015, primarily due to an increase in average progress payment balances for scheduled future aircraft deliveries.

Interest income for 2016 increased by $15 million, or 166.7 percent, compared with 2015, primarily due to higher interest rates coupled with a greater amount of interest earned on cash collateral held by counterparties. See Note 10 to the Consolidated Financial Statements for further information on the Company's derivatives.

Other (gains) losses, net, primarily includes amounts recorded as a result of the Company's hedging activities. See Note 10 to the Consolidated Financial Statements for further information on the Company's hedging activities. The following table displays the components of Other (gains) losses, net, for the years ended December 31, 2016, and 2015:

 
Year ended December 31,
(in millions)
2016
 
2015
Mark-to-market impact from fuel contracts settling in future periods
$
9

 
$
373

Ineffectiveness from fuel hedges settling in future periods
(11
)
 
(9
)
Realized ineffectiveness and mark-to-market (gains) or losses
5

 
72

Premium cost of fuel contracts
153

 
124

Other
6

 
(4
)
 
$
162

 
$
556


Income Taxes

The Company's effective tax rate was 36.8 percent for 2016, compared with 37.3 percent for 2015.


49



Reconciliation of Reported Amounts to Non-GAAP Financial Measures (unaudited) (in millions, except per share and per ASM amounts)
 
Year ended December 31,
 
Percent
 
2017
 
2016
 
Change
Fuel and oil expense, unhedged
$
3,524

 
$
2,827

 
 
Add: Fuel hedge (gains) losses included in Fuel and oil expense, net
416

 
820

 
 
Fuel and oil expense, as reported
$
3,940

 
$
3,647

 
 
Add: Net impact from fuel contracts
156

 
202

 
 
Fuel and oil expense, excluding special items (economic)
$
4,096

 
$
3,849

 
6.4
 %
 
 
 
 
 
 
Total operating expenses, as reported
$
17,656

 
$
16,665

 
 
Deduct: Contract ratification bonuses

 
(356
)
 
 
Add: Reclassification between Fuel and oil and Other (gains) losses, net,
  associated with current period settled contracts
6

 
5

 
 
Add: Contracts settling in the current period, but for which gains and/or (losses)
  have been recognized in a prior period (a)
150

 
197

 
 
Deduct: Asset impairment

 
(21
)
 
 
Deduct: Lease termination expense
(33
)
 
(22
)
 
 
Deduct: Aircraft grounding charge
(63
)
 

 
 
Total operating expenses, excluding special items
$
17,716

 
$
16,468

 
7.6
 %
 
 
 
 
 
 
Operating income, as reported
$
3,515

 
$
3,760

 
 
Add: Contract ratification bonuses

 
356

 
 
Deduct: Reclassification between Fuel and oil and Other (gains) losses, net,
  associated with current period settled contracts
(6
)
 
(5
)
 
 
Deduct: Contracts settling in the current period, but for which gains and/or (losses)
  have been recognized in a prior period (a)
(150
)
 
(197
)
 
 
Add: Asset impairment

 
21

 
 
Add: Lease termination expense
33

 
22

 
 
Add: Aircraft grounding charge
63

 

 
 
Operating income, excluding special items
$
3,455

 
$
3,957

 
(12.7
)%
 
 
 
 
 
 
Provision for income taxes, as reported
$
(237
)
 
$
1,303

 
 
Add: Income tax impact of fuel and special items, excluding Tax reform
   impact (b)
17

 
74

 
 
Add: Tax reform impact (c)
1,410

 

 
 
Provision for income taxes, excluding special items
$
1,190

 
$
1,377

 
(13.6
)%
 
 
 
 
 
 
Net income, as reported
$
3,488

 
$
2,244

 
 
Add: Contract ratification bonuses

 
356

 
 
Add: Mark-to-market impact from fuel contracts settling in future periods
69

 
9

 
 
Add (Deduct): Ineffectiveness from fuel hedges settling in future periods
31

 
(11
)
 
 
Deduct: Other net impact of fuel contracts settling in the current or a prior period
  (excluding reclassifications)
(150
)
 
(197
)
 
 
Add: Asset impairment

 
21

 
 
Add: Lease termination expense
33

 
22

 
 
Add: Aircraft grounding charge
63

 

 
 
Deduct: Net income tax impact from fuel and special items (b)
(17
)
 
(74
)
 
 
Deduct: Tax reform impact (c)
(1,410
)
 

 
 
Net income, excluding special items
$
2,107

 
$
2,370

 
(11.1
)%


50



 
Year ended December 31,
 
Percent
 
2017
 
2016
 
Change
Net income per share, diluted, as reported
$
5.79

 
$
3.55

 
 
Deduct: Net impact to net income above from fuel contracts divided by
  dilutive shares
(0.08
)
 
(0.31
)
 
 
Add: Impact of special items
0.16

 
0.63

 
 
Deduct: Net income tax impact of fuel and special items, excluding Tax reform
  impact (b)
(0.03
)
 
(0.12
)
 
 
Deduct: Tax reform impact (c)
(2.34
)
 

 
 
Net income per share, diluted, excluding special items
$
3.50

 
$
3.75

 
(6.7
)%
 
 
 
 
 
 
Operating expenses per ASM (cents)

11.48
¢
 

11.22
¢
 
 
Deduct: Fuel expense divided by ASMs
(2.56
)
 
(2.46
)
 
 
Deduct: Impact of special items
(0.07
)
 
(0.27
)
 
 
Operating expenses per ASM, excluding Fuel and oil and special items (cents)

8.85
¢
 

8.49
¢
 
4.2
 %
(a) As a result of prior hedge ineffectiveness and/or contracts marked to market through earnings.
(b) Tax amounts for each individual special item are calculated at the Company's effective rate for the applicable period and totaled in this line item.
(c) Adjustment related to the Tax Cuts and Jobs Act legislation enacted in December 2017, which resulted in a re-measurement of the Company's deferred tax assets and liabilities at the new federal corporate tax rate of 21 percent.


51



Non-GAAP Return on Invested Capital (ROIC) (in millions) (unaudited)

 
Year Ended
 
Year Ended
 
Year Ended
 
December 31, 2017
 
December 31, 2016
 
December 31, 2015
Operating income, as reported
$
3,515

 
$
3,760

 
$
4,116

Special revenue adjustment (a)

 

 
(172
)
Contract ratification bonuses

 
356

 
334

Net impact from fuel contracts
(156
)
 
(202
)
 
(323
)
Acquisition and integration costs

 

 
39

Litigation settlement

 

 
(37
)
Asset impairment

 
21

 

Lease termination expense
33

 
22

 

Aircraft grounding charge
63

 

 

Operating income, non-GAAP
3,455

 
3,957

 
3,957

Net adjustment for aircraft leases (b)
109

 
111

 
114

Adjustment for fuel hedge accounting (c)
(135
)
 
(152
)
 
(124
)
Adjusted Operating income, non-GAAP (A)
$
3,429

 
$
3,916

 
$
3,947

 
 
 
 
 
 
Debt, including capital leases (d)
$
3,259

 
$
3,304

 
$
2,782

Equity (d)
8,881

 
7,833

 
7,032

Net present value of aircraft operating leases (d)
785

 
1,015

 
1,223

Average invested capital
$
12,925

 
$
12,152

 
$
11,037

Equity adjustment for hedge accounting (c)
296

 
886

 
1,027

Adjusted average invested capital (B)
$
13,221

 
$
13,038

 
$
12,064

 
 
 
 
 
 
Non-GAAP ROIC, pre-tax (A/B)
25.9
%
 
30.0
%
 
32.7
%

(a) The adjustment related to the execution of the Agreement with Chase and the resulting required change in accounting methodology. See Note 1 to the Consolidated Financial Statements for further information.
(b) Net adjustment related to presumption that all aircraft in fleet are owned (i.e., the impact of eliminating aircraft rent expense and replacing with estimated depreciation expense for those same aircraft). The Company makes this adjustment to enhance comparability to other entities that have different capital structures by utilizing alternative financing decisions.
(c) The Adjustment for fuel hedge accounting in the numerator is due to the Company’s accounting policy decision to classify fuel hedge accounting premiums below the Operating income line, and thus is adjusting Operating income to reflect such policy decision. The Equity adjustment for hedge accounting in the denominator adjusts for the cumulative impacts, in Accumulated other comprehensive income and Retained earnings, of gains and/or losses associated with hedge accounting related to fuel hedge derivatives that will settle in future periods. The current period impact of these gains and/or losses are reflected in the Net impact from fuel contracts in the numerator.
(d) Calculated as an average of the five most recent quarter end balances or remaining obligations. The Net present value of aircraft operating leases represents the assumption that all aircraft in the Company’s fleet are owned, as it reflects the remaining contractual commitments discounted at the Company's estimated incremental borrowing rate as of the time each individual lease was signed.


52



Note Regarding Use of Non-GAAP Financial Measures

The Company's Consolidated Financial Statements are prepared in accordance with accounting principles generally accepted in the United States ("GAAP"). These GAAP financial statements include (i) unrealized noncash adjustments and reclassifications, which can be significant, as a result of accounting requirements and elections made under accounting pronouncements relating to derivative instruments and hedging and (ii) other charges and benefits the Company believes are unusual and/or infrequent in nature and thus may make comparisons to its prior or future performance difficult.

As a result, the Company also provides financial information in this filing that was not prepared in accordance with GAAP and should not be considered as an alternative to the information prepared in accordance with GAAP. The Company provides supplemental non-GAAP financial information (also referred to as "excluding special items"), including results that it refers to as "economic," which the Company's management utilizes to evaluate its ongoing financial performance and the Company believes provides additional insight to investors as supplemental information to its GAAP results. The non-GAAP measures provided that relate to the Company’s performance on an economic fuel cost basis include Fuel and oil expense, non-GAAP; Total operating expenses, non-GAAP; Operating income, non-GAAP; Net income, non-GAAP; and Net income per share, diluted, non-GAAP. The Company's economic Fuel and oil expense results differ from GAAP results in that they only include the actual cash settlements from fuel hedge contracts - all reflected within Fuel and oil expense in the period of settlement. Thus, Fuel and oil expense on an economic basis has historically been utilized by the Company, as well as some of the other airlines that utilize fuel hedging, as it reflects the Company’s actual net cash outlays for fuel during the applicable period, inclusive of settled fuel derivative contracts. Any net premium costs paid related to option contracts are reflected as a component of Other (gains) losses, net, for both GAAP and non-GAAP (including economic) purposes in the period of contract settlement. The Company believes these economic results provide further insight on the impact of the Company's fuel hedges on its operating performance and liquidity since they exclude the unrealized, noncash adjustments and reclassifications that are recorded in GAAP results in accordance with accounting guidance relating to derivative instruments, and they reflect all cash settlements related to fuel derivative contracts within Fuel and oil expense. This enables the Company's management, as well as investors and analysts, to consistently assess the Company's operating performance on a year-over-year or quarter-over-quarter basis after considering all efforts in place to manage fuel expense. However, because these measures are not determined in accordance with GAAP, such measures are susceptible to varying calculations, and not all companies calculate the measures in the same manner. As a result, the aforementioned measures, as presented, may not be directly comparable to similarly titled measures presented by other companies.

Further information on (i) the Company's fuel hedging program, (ii) the requirements of accounting for derivative instruments, and (iii) the causes of hedge ineffectiveness and/or mark-to-market gains or losses from derivative instruments is included in Note 10 to the Consolidated Financial Statements.

The Company’s GAAP results in the applicable periods include other charges or benefits that are also deemed "special items" that the Company believes make its results difficult to compare to prior periods, anticipated future periods, or industry trends. Financial measures identified as non-GAAP (or as excluding special items) have been adjusted to exclude special items. Special items include:

1.
A one-time $172 million Special revenue adjustment in July 2015 as a result of the Agreement with Chase and the resulting required change in accounting methodology. This increase to revenue represented a nonrecurring required acceleration of revenues associated with the adoption of Accounting Standards Update 2009-13;
2.
Contract ratification bonuses recorded for certain workgroups. As the bonuses would only be paid at ratification of the associated tentative agreement and would not represent an ongoing expense to the Company, management believes its results for the associated periods are more usefully compared if the impacts of ratification bonus amounts are excluded from results. Generally, union contract agreements cover a specified three- to five- year period, although such contracts officially never expire, and the agreed upon terms remain in place until a revised agreement is reached, which can be several years following the amendable date;

53



3.
Expenses associated with the Company’s acquisition and integration of AirTran. Such expenses were primarily incurred during the acquisition and integration period of the two companies from 2011 through 2015 as a result of the Company’s acquisition of AirTran, which closed on May 2, 2011. The exclusion of these expenses provides investors with a more applicable basis with which to compare results in future periods now that the integration process has been completed;
4.
A gain resulting from a litigation settlement received in January 2015. This cash settlement meaningfully lowered Other operating expenses during the applicable period and the Company does not expect a similar impact on its cost structure in the future;
5.
A noncash impairment charge related to leased slots at Newark Liberty International Airport as a result of the FAA announcement in April 2016 that this airport was being changed to a Level 2 schedule-facilitated airport from its previous designation as Level 3;
6.
Lease termination costs recorded as a result of the Company acquiring 13 of its Boeing 737-300 aircraft off operating leases as part of the Company’s strategic effort to remove its Classic aircraft from operations on or before September 29, 2017, in the most economically advantageous manner possible. The Company had not budgeted for these early lease termination costs, as they were subject to negotiations being concluded with the third party lessors. The Company recorded the fair value of the aircraft acquired off operating leases, as well as any associated remaining obligations to the balance sheet as debt;
7.
An Aircraft grounding charge recorded in third quarter 2017, as a result of the Company grounding its remaining Boeing 737-300 aircraft on September 29, 2017. The loss was a result of the remaining net lease payments due and certain lease return requirements that could have to be performed on these leased aircraft prior to their return to the lessors as of the cease-use date. The Company had not budgeted for the lease return requireme