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

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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,
GAAP20172016Percent Change
Operating income$3,515$3,760(6.5)
Net income$3,488$2,24455.4
Net income per share, diluted$5.79$3.5563.1
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.

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.

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:

Year ended December 31,Per ASMPercent
(in cents, except for percentages)20172016changechange
Salaries, wages, and benefits4.76¢4.57¢0.19¢4.2%
Fuel and oil2.562.460.104.1
Maintenance materials and repairs0.650.70(0.05)(7.1)
Aircraft rentals0.130.15(0.02)(13.3)
Landing fees and other rentals0.840.820.022.4
Depreciation and amortization0.790.82(0.03)(3.7)
Other operating expenses1.751.700.052.9
Total11.48¢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 GroupApproximate Number of EmployeesRepresentativesAmendable Date
Southwest Material Specialists (formerly known as Stock Clerks)300International Brotherhood of Teamsters, Local 19 ("IBT 19")August 2013
Southwest Mechanics2,400Aircraft Mechanics Fraternal Association ("AMFA")August 2012

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 increased 2.5 percent, compared with 2016, while year-over-year capacity increased 3.6 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:

PeriodMaximum 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)
201878%
201963%
202031%
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):

YearFair value of fuel derivative contracts at December 31, 2017Amount of gains (losses) deferred in AOCI at December 31, 2017 (net of tax)
2018$112$(9)
2019758
2020423
Beyond 202019—
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 barrel1Q 2018Full 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 costsApproximately $34 millionApproximately $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

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

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)20172016
Mark-to-market impact from fuel contracts settling in future periods$69$9
Ineffectiveness from fuel hedges settling in future periods31(11)
Realized ineffectiveness and mark-to-market (gains) or losses65
Premium cost of fuel contracts135153
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

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 ASMPercent change
(in cents, except for percentages)20162015change
Salaries, wages, and benefits4.57¢4.54¢0.03¢0.7%
Fuel and oil2.462.58(0.12)(4.7)
Maintenance materials and repairs0.700.72(0.02)(2.8)
Aircraft rentals0.150.17(0.02)(11.8)
Landing fees and other rentals0.820.83(0.01)(1.2)
Depreciation and amortization0.820.720.10—
Acquisition and integration—0.03(0.03)(100.0)
Other operating expenses1.701.590.116.9
Total11.22¢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.

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.

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)20162015
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 losses572
Premium cost of fuel contracts153124
Other6(4)
$162$556

Income Taxes

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

Reconciliation of Reported Amounts to Non-GAAP Financial Measures (unaudited) (in millions, except per share and per ASM amounts)

Year ended December 31,Percent
20172016Change
Fuel and oil expense, unhedged$3,524$2,827
Add: Fuel hedge (gains) losses included in Fuel and oil expense, net416820
Fuel and oil expense, as reported$3,940$3,647
Add: Net impact from fuel contracts156202
Fuel and oil expense, excluding special items (economic)$4,096$3,8496.4%
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 contracts65
Add: Contracts settling in the current period, but for which gains and/or (losses) have been recognized in a prior period (a)150197
Deduct: Asset impairment—(21)
Deduct: Lease termination expense(33)(22)
Deduct: Aircraft grounding charge(63)—
Total operating expenses, excluding special items$17,716$16,4687.6%
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 expense3322
Add: Aircraft grounding charge63—
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)1774
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 periods699
Add (Deduct): Ineffectiveness from fuel hedges settling in future periods31(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 expense3322
Add: Aircraft grounding charge63—
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)%
Year ended December 31,Percent
20172016Change
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 items0.160.63
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.

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

Year EndedYear EndedYear Ended
December 31, 2017December 31, 2016December 31, 2015
Operating income, as reported$3,515$3,760$4,116
Special revenue adjustment (a)——(172)
Contract ratification bonuses—356334
Net impact from fuel contracts(156)(202)(323)
Acquisition and integration costs——39
Litigation settlement——(37)
Asset impairment—21—
Lease termination expense3322—
Aircraft grounding charge63——
Operating income, non-GAAP3,4553,9573,957
Net adjustment for aircraft leases (b)109111114
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)8,8817,8337,032
Net present value of aircraft operating leases (d)7851,0151,223
Average invested capital$12,925$12,152$11,037
Equity adjustment for hedge accounting (c)2968861,027
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.

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;
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 requirements, as they are subject to negotiation with third party lessors; and
8.An adjustment to 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 adjustment is a non-cash item and is being treated as a special item.

Because management believes each of these items can distort the trends associated with the Company’s ongoing performance as an airline, the Company believes that evaluation of its financial performance can be enhanced by a supplemental presentation of results that exclude the impact of these items in order to enhance consistency and comparativeness with results in prior periods that do not include such items and as a basis for evaluating operating results in future periods. The following measures are often provided, excluding special items, and utilized by the Company’s management, analysts, and investors to enhance comparability of year-over-year results, as well as to industry trends: Total operating expenses, non-GAAP; Operating income, non-GAAP; Provision for income taxes, non-GAAP; Net income, non-GAAP; Net income per share, diluted, non-GAAP; and Operating expenses per ASM, non-GAAP, excluding Fuel and oil and special items.

The Company has also provided its calculation of return on invested capital, which is a measure of financial performance used by management to evaluate its investment returns on capital. Return on invested capital is not a substitute for financial results as reported in accordance with GAAP, and should not be utilized in place of such GAAP results. Although return on invested capital is not a measure defined by GAAP, it is calculated by the Company, in part, using non-GAAP financial measures. Those non-GAAP financial measures are utilized for the same reasons as those noted above for Net income, non-GAAP and Operating income, non-GAAP - the comparable GAAP measures include charges or benefits that are deemed "special items" that the Company believes make its results difficult to compare to prior periods, anticipated future periods, or industry trends, and the Company’s profitability targets and estimates, both internally and externally, are based on non-GAAP results since in the vast majority of cases the "special items" cannot be reliably predicted or estimated. The Company believes non-GAAP return on invested capital is a meaningful measure because it quantifies the Company's effectiveness in generating returns relative to the capital it has invested in its business. Although return on invested capital is commonly used as a measure of capital efficiency, definitions of return on invested capital differ; therefore, the Company is providing an explanation of its calculation for non-GAAP return on invested capital in the accompanying reconciliation, in order to allow investors to compare and contrast its calculation to those provided by other companies.

Liquidity and Capital Resources

Net cash provided by operating activities for 2017, 2016, and 2015 was $3.9 billion, $4.3 billion, and $3.2 billion, respectively. Operating cash inflows are primarily derived from providing air transportation to Customers. The vast majority of tickets are purchased prior to the day on which travel is provided and, in some cases, several months before the anticipated travel date. Operating cash outflows are related to the recurring expenses of airline operations. The operating cash flows for 2017, 2016, and 2015 were impacted primarily by the Company's results of operations, as adjusted for non-cash items as well as changes in the Air traffic liability and Accrued liabilities balances. Operating cash flows also can be significantly impacted by the Company’s fuel and interest rate hedge positions and the corresponding cash collateral requirements associated with those positions. The Company has the ability to post aircraft in lieu of cash collateral in certain situations. See Note 10 to the Consolidated Financial Statements for further information. During 2017 and 2016, the Company had net cash inflows of $316 million and $535 million, respectively, in cash collateral from derivative counterparties. During 2015, the Company provided $570 million in cash collateral to derivative counterparties. Cash flows related to the purchase of derivatives utilized to offset a portion of the Company's future fuel hedge positions prior to their settlement, as well as new fuel derivatives, which are also classified as Other, net, operating cash flows, were net outflows of $142 million in 2017, $165 million in 2016, and $556 million in 2015. Net cash provided by operating activities is primarily used to finance capital expenditures, repay debt, fund stock repurchases, pay dividends, and provide working capital.

Net cash used in investing activities for 2017, 2016, and 2015 was $2.4 billion, $2.3 billion, and $1.9 billion, respectively. Investing activities in 2017, 2016, and 2015 included Capital expenditures, primarily related to aircraft and other equipment, and payments associated with airport construction projects, denoted as Assets constructed for others, and also included purchases and sales of short-term and noncurrent investments. See Note 4 to the Consolidated Financial Statements for further information. During 2017, Capital expenditures were $2.1 billion, the majority of which were payments for new aircraft delivered to the Company, but also included payments associated with airport and other facility construction projects and technology projects. This compared with $2.0 billion in Capital expenditures during both 2016 and 2015. During 2017 and 2016, the Company's purchases and sales of short-term and noncurrent investments resulted in net cash outflows of $159 million and $125 million, respectively, and a net cash inflow of $237 million in 2015. The Company currently estimates its 2018 capital expenditures will be approximately $1.9 billion.

Net cash used in financing activities for 2017, 2016, and 2015 was $1.7 billion, $1.9 billion, and $1.0 billion, respectively. During 2017, the Company repaid $592 million in debt and capital lease obligations, compared with $591 million (including convertible notes) and $213 million during 2016 and 2015, respectively. During 2017, the Company issued, under its shelf registration statement, $300 million 2.75% senior unsecured notes due 2022 and $300 million 3.45% senior unsecured notes due 2027, compared with the 2016 borrowing of $215 million under a secured term loan agreement and issuance of $300 million 3.00% senior unsecured notes due 2026 under its shelf registration statement, and the 2015 issuance of $500 million 2.65% senior unsecured notes due 2020 under its shelf registration statement. See Note 6 to the Consolidated Financial Statements for further information. The Company repurchased $1.6 billion of its outstanding common stock through authorized share repurchases during 2017, compared with repurchases of $1.8 billion and $1.2 billion during 2016 and 2015, respectively. The Company also paid $274 million in dividends to Shareholders during 2017, compared with $222 million in 2016 and $180 million in 2015. Although the Company currently intends to continue paying dividends on a quarterly basis for the foreseeable future, the Company's Board of Directors may change the timing, amount, and payment of dividends on the basis of results of operations, financial condition, cash requirements, future prospects, and other factors deemed relevant by the Board of Directors.

The Company is a "well-known seasoned issuer" and currently has an effective shelf registration statement registering an indeterminate amount of debt and equity securities for future sales. The Company currently intends to use the proceeds from any future securities sales off this shelf registration statement for general corporate purposes.

The Company has access to a $1 billion unsecured revolving credit facility expiring in August 2022. The revolving credit agreement has an accordion feature that would allow the Company, subject to, among other things, the procurement of incremental commitments, to increase the size of the facility to $1.5 billion. Interest on the facility is based on the Company's credit ratings at the time of borrowing. At the Company's current ratings, the interest cost

would be LIBOR plus a spread of 100.0 basis points. The facility contains a financial covenant requiring a minimum coverage ratio of adjusted pre-tax income to fixed obligations, as defined. As of December 31, 2017, the Company was in compliance with this covenant and there were no amounts outstanding under the revolving credit facility.

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. Following the launch of the Fourth Quarter 2017 ASR Program, during the period from November 29, 2017 to December 15, 2017, the Company repurchased 1.6 million shares of its common stock on the open market. See Part II, Item 5 for further information on the Company's share repurchase authorizations.

During second quarter 2017, the Company completed its previously authorized $2.0 billion share repurchase program, bringing in a total of 41.3 million shares over the course of the program. On May 17, 2017, the Company's Board of Directors approved a new $2.0 billion share repurchase program. Following the Board of Directors' authorization of the Company's new $2.0 billion share repurchase program, the Company entered into the following share repurchases:

Share repurchases (in millions)Shares receivedCash paid
Third Quarter 2017 Accelerated Share Repurchase Program5.3$300
Fourth Quarter 2017 Accelerated Share Repurchase Program4.1250
Open Market Share Repurchases1.6100
Total11.0$650

On June 1, 2017, Moody's upgraded the Company's secured equipment trust certificates and its senior unsecured debt rating to "A3" from "Baa1." The upgrade of the Company's senior unsecured debt rating was based on the Company's strong liquidity, manageable funded debt, competitive fares, and expanding network. Also on August 14, 2017, Standard & Poor's upgraded the Company's investment grade credit ratings to "BBB+" from "BBB." The upgrade of the Company's investment grade rating was based on the Company's consistent profitability and cost advantage, exceptional liquidity, and manageable funded debt. The Company maintained its investment grade credit ratings of "BBB+" with Fitch.

The Company routinely carries a working capital deficit, in which its current liabilities exceed its current assets. This is common within the airline industry and is primarily due to the nature of the Air traffic liability account, which is related to advance ticket sales and frequent flyer deferred revenue, which are performance obligations for future customer flights, do not require future settlement in cash, and are mostly nonrefundable. The Company believes that its current liquidity position, including unrestricted cash and short-term investments of $3.3 billion as of December 31, 2017, anticipated future internally generated funds from operations, and its fully available, unsecured revolving credit facility of $1.0 billion that expires in August 2022, will enable it to meet its future known obligations in the ordinary course of business. However, if a liquidity need were to arise, the Company believes it has access to financing arrangements because of its investment grade credit ratings, large value of unencumbered assets, and modest leverage, which should enable it to meet its ongoing capital, operating, and other liquidity requirements. The Company will continue to consider various borrowing or leasing options to maximize liquidity and supplement cash requirements, as necessary.

The Company has a large net deferred tax liability on its Consolidated Balance Sheet. The deferral of income taxes has resulted in a significant benefit to the Company and its liquidity position. Since the Company purchases the majority of the aircraft it acquires, it has been able to utilize accelerated depreciation methods (including bonus depreciation) available under the Internal Revenue Code of 1986, as amended, in 2017 and in previous years, which has enabled the Company to defer the cash tax payments associated with these depreciable assets to future years. Based on the Company’s scheduled future aircraft deliveries from Boeing and existing tax laws in effect, the Company will continue to defer a portion of cash income taxes to future years. The Company has paid in the past, and will continue to pay in the future, significant cash taxes to the various taxing jurisdictions where it operates. The Company expects to be able

to continue to meet such obligations utilizing cash and investments on hand, as well as cash generated from its ongoing operations.

Off-Balance Sheet Arrangements, Contractual Obligations, and Contingent Liabilities and Commitments

The Company has contractual obligations and commitments primarily with regard to future purchases of aircraft, payment of debt, and lease arrangements. The Company revised its future firm order delivery schedule with Boeing

during fourth quarter 2017, to support future growth opportunities and fleet modernization. During fourth quarter 2017, the Company exercised 40 737 MAX 8 options for 15 firm orders in 2019 and 25 firm orders in 2020. The Company also deferred 23 737 MAX 7 firm orders from 2019 through 2021 to 12 firm orders in 2023 and 11 firm orders in 2024. The Company also accelerated 23 737 MAX 8 firm orders from 2023 through 2024 to an additional 21 firm orders in 2021 and 2 firm orders in 2022. Earlier in 2017, the Company also exercised five 737-800 options for 2018, and substituted four 737-800 options for two 737 MAX 8 options for both 2021 and 2022. For aircraft commitments with Boeing, the Company is required to make cash deposits toward the purchase of aircraft in advance. These deposits are classified as Deposits on flight equipment purchase contracts in the Consolidated Balance Sheet until the aircraft is delivered, at which time deposits previously made are deducted from the final purchase price of the aircraft and are reclassified as Flight equipment. See Part 1, Item 2 for a complete table of the Company’s firm deliveries and options for Boeing 737-700, 737-800, 737 MAX 7, and 737 MAX 8 aircraft, and Note 4 to the Consolidated Financial Statements for the financial commitments related to these firm deliveries.

The leasing of aircraft (including the sale and leaseback of aircraft) provides flexibility to the Company as a source of financing. Although the Company is responsible for all maintenance, insurance, and expense associated with operating leased aircraft, and retains the risk of loss for these aircraft, it has not made guarantees to the lessors regarding the residual value (or market value) of the aircraft at the end of the lease terms. As of December 31, 2017, the Company had 215 leased aircraft, including 78 B717s subleased to Delta and 15 Classic aircraft grounded in September 2017. Of these leased aircraft, 144 are under operating leases, including 76 B717s subleased to Delta and 15 Classic aircraft. See Note 7 to the Consolidated Financial Statements for further information on this transaction. Assets and obligations under operating leases are not included in the Company’s Consolidated Balance Sheet. Disclosure of the contractual obligations associated with the Company’s leased aircraft is included below.

The Company is required to provide standby letters of credit to support certain obligations that arise in the ordinary course of business and may choose to provide letters of credit in place of posting cash collateral related to its fuel hedging positions. Although the letters of credit are off-balance sheet, the majority of the obligations to which they relate are reflected as liabilities in the Consolidated Balance Sheet. Outstanding letters of credit totaled $167 million at December 31, 2017.

The following table aggregates the Company’s material expected contractual obligations and commitments as of December 31, 2017:

Obligations by period (in millions)
Contractual obligations20182019 - 20202021 - 2022ThereafterTotal
Long-term debt (a)$256$1,239$481$818$2,794
Interest commitments - fixed (b)7711683121397
Interest commitments - floating (c)31561012109
Facility construction commitments (d)65130130232557
Facility operating lease commitments34644589232
Aircraft operating lease commitments (e)22335513780795
Aircraft capital lease commitments (f)107211196416930
Aircraft purchase commitments (g)8741,7172,1745,1919,956
Other commitments17122984322806
Total contractual obligations$1,838$4,117$3,340$7,281$16,576
(a)Includes principal only. See Note 6 to the Consolidated Financial Statements.
(b)Related to fixed-rate debt (either at issuance or through swaps) only.
(c)Interest obligations associated with floating-rate debt (either at issuance or through swaps) is estimated utilizing forward interest rate curves as of December 31, 2017, and can be subject to significant fluctuation.
(d)Includes some lease payments that are considered variable which have a related construction obligation. See Note 4 to the Consolidated Financial Statements.
(e)Includes the impact of the B717 lease/sublease transaction entered into in 2012. Also includes 15 remaining Classic aircraft on operating leases, which net remaining lease payments were included in the $63 million grounding charge recorded during 2017. See Note 7 to the Consolidated Financial Statements.
(f)Includes principal and interest on capital leases.
(g)Firm orders from Boeing.

Airport Projects

The Company has commitments associated with various airport improvement projects that will impact its future liquidity needs in differing ways. These projects include the construction of new facilities and the rebuilding or modernization of existing facilities and are discussed in more detail in Note 4 to the Consolidated Financial Statements.

Dallas Love Field

For the rebuilding of the facilities at Dallas Love Field, the Company guaranteed principal, premium, and interest on $456 million in bonds issued by the Love Field Airport Modernization Corporation ("LFAMC") that were utilized to fund the majority of the project. The amount of bonds outstanding as of December 31, 2017, was $424 million. Repayment of the bonds is through the "Facilities Payments" described below. Reimbursement of the Company for its payment of Facilities Payments is made through recurring ground rents, fees, and other revenues collected at the airport.

Prior to the issuance of the bonds by the LFAMC, the Company entered into two separate funding agreements: (i) a "Facilities Agreement" pursuant to which the Company is obligated to make debt service payments on the principal and interest amounts associated with the bonds ("Facilities Payments"), less other sources of funds the City of Dallas may apply to the repayment of the bonds (including but not limited to passenger facility charges collected from passengers originating from the airport); and (ii) a "Revenue Credit Agreement" pursuant to which the City of Dallas reimburses the Company for the Facilities Payments made by the Company.

A majority of the monies transferred from the City of Dallas to the Company under the Revenue Credit Agreement originate from a reimbursement account created in the "Use and Lease Agreement" between the City of Dallas and the Company. The Use and Lease Agreement is a 20-year agreement providing for, among other things, the Company’s lease of space at the Airport from the City of Dallas. The remainder of such monies transferred from the City of Dallas

to the Company under the Revenue Credit Agreement originates from (i) use and lease agreements with other airlines, (ii) various concession agreements, and (iii) other airport miscellaneous revenues.

The Company’s liquidity could be impacted by this project to the extent there are timing differences between the Company’s payment of the Facilities Payments pursuant to the Facilities Agreement and the transfer of monies back to the Company pursuant to the Revenue Credit Agreement; however, the Company does not currently expect that to occur. The project has not had a significant impact on the Company’s capital resources or financial position.

Fort Lauderdale-Hollywood International Airport

The Company has committed to oversee and manage the design and construction of Fort Lauderdale-Hollywood International Airport's Terminal 1 Modernization Project, including the design and construction of a new five-gate Concourse A with an international processing facility, at a cost not to exceed $333 million. Funding for the project has come directly from Broward County aviation sources, but flows through the Company in its capacity as manager of the project. Construction of Concourse A was completed during second quarter 2017, and construction on Terminal 1 is estimated to be completed by mid-2018. In general, as work is being completed on the project by various contractors, invoices are submitted to Broward County for initial payment to the Company, which then makes such payments to the contractors performing the work.

The Company’s liquidity could be impacted by this project to the extent there are instances in which the Company chooses to make payments to contractors prior to receiving initial payment from Broward County, although the Company currently does not expect this to occur often based on its past experience with smaller projects conducted at the airport. The project is not expected to have a significant impact on the Company’s capital resources or financial position.

Los Angeles International Airport

In March 2013, the Company executed a lease agreement (the "T1 Lease") with Los Angeles World Airports ("LAWA"), which owns and operates Los Angeles International Airport ("LAX"). Under the T1 Lease, which was amended in June 2014 and September 2017, the Company is overseeing and managing the design, development, financing, construction, and commissioning of the airport's Terminal 1 Modernization Project at a cost not to exceed $526 million (including proprietary renovations, or $510 million excluding proprietary renovations). In October 2017, the Company executed a separate lease agreement with LAWA (the "T1.5 Lease"). The Company intends to oversee and manage the design, development, financing, construction, and commissioning of a passenger processing facility between Terminal 1 and 2 (the "Terminal 1.5 Project"). The Terminal 1.5 Project is expected to include ticketing, baggage claim, passenger screening, and a bus gate at a cost not to exceed $479 million for site improvements and non-proprietary improvements.

These projects are being funded primarily using the Regional Airports Improvement Corporation ("RAIC"), which is a quasi-governmental special purpose entity that acts as a conduit borrower under syndicated credit facilities provided by groups of lenders. Loans made under the separate credit facilities for the Terminal 1 Modernization Project and the Terminal 1.5 Project are being used to fund the development of each of these projects, and the outstanding loans will be repaid with the proceeds of LAWA’s payments to purchase completed construction phases. The Company has guaranteed the obligations of the RAIC under each of the credit facilities of the respective lease agreements.

The Company’s liquidity could be impacted by these projects under certain circumstances; however, the Company does not expect this to occur based on its past experience with other projects. These projects are not expected to have a significant impact on the Company’s capital resources or financial position. Construction on the Terminal 1 Modernization Project began during 2014 and is estimated to be completed during 2018. Construction on the Terminal 1.5 Project began during third quarter 2017 and is estimated to be completed during 2020.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The Company’s Consolidated Financial Statements have been prepared in accordance with GAAP. The Company’s significant accounting policies are described in Note 1 to the Consolidated Financial Statements. The preparation of

financial statements in accordance with GAAP requires the Company’s management to make estimates and assumptions that affect the amounts reported in the Consolidated Financial Statements and accompanying footnotes. The Company’s estimates and assumptions are based on historical experience and changes in the business environment. However, actual results may differ from estimates under different conditions, sometimes materially. Critical accounting policies and estimates are defined as those that both (i) are most important to the portrayal of the Company’s financial condition and results and (ii) require management’s most subjective judgments. The Company’s most critical accounting policies and estimates are described below.

Revenue Recognition

Tickets sold for Passenger air travel are initially deferred as Air traffic liability. Passenger revenue is recognized and Air traffic liability is reduced when the service is provided (i.e., when the flight takes place). Air traffic liability primarily represents tickets sold for future travel dates and funds that are past flight date and remain unused, as well as a portion of the Company’s liability associated with its frequent flyer program. Air traffic liability fluctuates throughout the year based on seasonal travel patterns, fare sale activity, and activity associated with the Company’s frequent flyer program. See Note 2 to the Consolidated Financial Statements for information about changes to Accounting Standards Update ("ASU") No. 2014-09 for revenue recognition that are effective for 2018.

For air travel on Southwest, the amount of tickets that will expire unused are estimated and recognized in Passenger revenue once the scheduled flight date has passed. Estimating the amount of tickets that will expire unused involves some level of subjectivity and judgment. The majority of Southwest’s tickets sold are nonrefundable, which is the primary source of unused tickets. Southwest has a No Show policy that applies to fares that are not canceled or changed by a Customer at least ten minutes prior to a flight's scheduled departure. See Note 1 to the Consolidated Financial Statements for further information. According to Southwest’s current "Contract of Carriage," all refundable tickets that are sold but not flown on the travel date can be reused for another flight up to a year from the date of sale, or some tickets can be refunded. This policy also applies to unused Customer funds that may be the result of an exchange downgrade, in which a Customer exchanges their ticket from a previously purchased flight for a lower priced ticket, with the price difference being available for use by the Customer towards travel up to twelve months from the date of original purchase. Fully refundable tickets rarely expire unused. Estimates of tickets that will expire unused are based on historical experience over many years. Southwest has consistently applied this accounting method to estimate revenue from unused tickets at the date of scheduled travel.

Events and circumstances outside of historical fare sale activity or historical Customer travel patterns can result in actual spoiled tickets differing significantly from estimates. The Company evaluates its estimates within a narrow range of acceptable amounts. If actual spoilage results in an amount outside of this range, estimates and assumptions are reviewed and adjustments to Air traffic liability and to Passenger revenue are recorded, as necessary. Additional factors that may affect estimated spoiled tickets include, but may not be limited to, changes to the Company’s ticketing policies, the Company’s refund, exchange, and unused funds policies, the mix of refundable and nonrefundable fares, promotional fare activity, events leading to significant flight cancellations, and the impact of the economic environment on Customer behavior. The Company’s estimation techniques have been consistently applied from year to year; however, as with any estimates, actual spoiled tickets may vary from estimated amounts.

The Company believes it is unlikely that materially different estimates for future spoiled tickets would be reported based on other reasonable assumptions or conditions suggested by actual historical experience and other data available at the time estimates were made.

Accounting for Long-Lived Assets

Flight equipment and related assets make up the majority of the Company’s long-lived assets. Flight equipment primarily relates to the 653 Boeing 737 aircraft in the Company’s fleet at December 31, 2017, which are either owned or on capital lease. The remaining 53 Boeing 737 aircraft in the Company’s fleet at December 31, 2017, are operated under operating leases. The Company also has 88 B717 aircraft, which are part of the lease/sublease with Delta. As these aircraft are not in service for the Company, they are not included in the fleet count as of December 31, 2017 or 2016.

In addition, the Company retired its remaining Classic aircraft during the year as part of an accelerated retirement schedule, including 54 of which are still owned or on operating lease. As these aircraft are not in service for the Company, they are not included in the fleet count as of December 31, 2017. See Note 7 to the Consolidated Financial Statements for further information. In accounting for long-lived assets, the Company must make estimates about the expected useful lives of the assets, the expected residual values of the assets, and the potential for impairment based on the fair value of the assets and their future expected cash flows.

The following table shows a breakdown of the Company’s long-lived asset groups along with information about estimated useful lives and residual values for new assets generally purchased from the manufacturer and assets constructed for others:

Estimated useful lifeEstimated residual value
Airframes and engines25 years15 percent
Aircraft partsFleet life4 percent
Assets constructed for others10 to 30 years17 to 75 percent
Ground property and equipment5 to 30 years0 to 10 percent

In estimating the lives and expected residual values of its aircraft, the Company primarily has relied upon actual experience with the same or similar aircraft types, current and projected future market information, and recommendations from Boeing. Aircraft estimated useful lives are based on the number of "cycles" flown (one take-off and landing) as well as the aircraft age. The Company has made a conversion of cycles into years based on both historical and anticipated future utilization of the aircraft. Subsequent revisions to these estimates, which can be significant, could be caused by changes to aircraft maintenance programs, changes in utilization of the aircraft (actual cycles during a given period of time), governmental regulations on aging aircraft, and changing market prices of new and used aircraft of the same or similar types. The Company evaluates its estimates and assumptions each reporting period and, when warranted, adjusts these estimates and assumptions. Generally, these adjustments are accounted for on a prospective basis through depreciation and amortization expense. See Note 1 to the Consolidated Financial Statements for further information.

The Company believes it is unlikely that materially different estimates for expected lives, expected residual values, and impairment evaluations would be made or reported based on other reasonable assumptions or conditions suggested by actual historical experience and other data available at the time estimates were made.

Financial Derivative Instruments

The Company utilizes financial derivative instruments primarily to manage its risk associated with changing jet fuel prices. See "Quantitative and Qualitative Disclosures about Market Risk" for more information on these risk management activities, and see Note 10 to the Consolidated Financial Statements for more information on the Company’s fuel hedging program and financial derivative instruments. Also, see Note 2 to the Consolidated Financial Statements for information about future required changes to hedge accounting per ASU No. 2017-12.

All derivatives are required to be reflected at fair value and recorded on the Consolidated Balance Sheet. At December 31, 2017, the Company was a party to over 400 separate financial derivative instruments related to its fuel hedging program for future periods. Changes in the fair values of these instruments can vary dramatically based on changes in the underlying commodity prices. For example, during 2017, market "spot" prices for Brent crude oil peaked at a high of approximately $67 per barrel and hit a low price of approximately $45 per barrel. During 2016, market spot prices ranged from a high of approximately $57 per barrel to a low of approximately $28 per barrel. Market price changes can be driven by factors such as supply and demand, inventory levels, weather events, refinery capacity, political agendas, the value of the U.S. dollar, geopolitical events, and general economic conditions, among other items. The financial derivative instruments utilized by the Company primarily are a combination of collars, purchased call options, call spreads, put spreads, and fixed price swap agreements.

The Company enters into financial derivative instruments with third party institutions in "over-the-counter" markets. Since the majority of the Company’s financial derivative instruments are not traded on a market exchange, the Company estimates their fair values. Depending on the type of instrument, the values are determined by the use of present value methods or standard option value models with assumptions about commodity prices based on those observed in underlying markets. Also, since there is not a reliable forward market for jet fuel beyond approximately 24 months, the Company must estimate the future prices of jet fuel in order to measure the effectiveness of the hedging instruments in offsetting changes to those prices. Forward jet fuel prices are estimated through the observation of similar commodity futures prices (such as crude oil, heating oil, and unleaded gasoline) and adjusted based on variations of those like commodities to the Company’s ultimate expected price to be paid for jet fuel at the specific locations in which the Company hedges.

Fair values for financial derivative instruments and forward jet fuel prices are estimated prior to the time that the financial derivative instruments settle and the time that jet fuel is purchased and consumed, respectively. However, once settlement of the financial derivative instruments occurs and the hedged jet fuel is purchased and consumed, all values and prices are known and are recognized in the financial statements. Although the Company continues to use a prospective assessment to determine that commodities continue to qualify for hedge accounting in specific locations where the Company hedges, there are no assurances that these commodities will continue to qualify in the future. This is due to the fact that future price changes in these refined products may not be consistent with historical price changes. Increased volatility in these commodity markets for an extended period of time, especially if such volatility were to worsen, could cause the Company to lose hedge accounting altogether for the commodities used in its fuel hedging program, which would create further volatility in the Company’s GAAP financial results.

Estimating the fair value of these fuel derivative instruments and forward prices for jet fuel will also result in changes in their fair values from period to period and thus determine their accounting treatment. To the extent that the change in the estimated fair value of a fuel derivative instrument differs from the change in the estimated price of the associated jet fuel to be purchased, both on a cumulative and a period-to-period basis, ineffectiveness of the fuel hedge can result. This could result in the immediate recording of non-cash charges or income, representing the change in the fair value of the derivative, even though the derivative instrument may not expire/settle until a future period. Likewise, if a derivative contract ceases to qualify for hedge accounting, the change in the fair value of the derivative instrument is recorded every period to Other (gains) and losses, net in the Consolidated Statement of Income in the period of the change.

Under current hedge accounting guidance, ineffectiveness is inherent in hedging jet fuel with derivative positions based in other crude oil related commodities, especially given the past volatility in the prices of refined products. Due to the volatility in markets for crude oil and related products, the Company is unable to predict the amount of ineffectiveness each period, including the loss of hedge accounting, which could be determined on a derivative by derivative basis or in the aggregate for a specific commodity. This may result, and has historically resulted, in increased volatility in the Company’s financial statements. The amount of hedge ineffectiveness and unrealized gains and losses due to the change in fair value of derivative contracts settling in future periods, recorded during historical periods, has been due to a number of factors. These factors include: the significant fluctuation in energy prices, the number of derivative positions the Company holds, significant weather events that have affected refinery capacity and the production of refined products, and the volatility of the different types of products the Company uses for mitigation of fuel price volatility. The discontinuation of hedge accounting for specific hedges and for specific refined products, such as unleaded gasoline, can also be a result of these factors. Depending on the level at which the Company is hedged at any point in time, as the fair value of the Company’s hedge positions fluctuate in amount from period to period, there could be continued variability recorded in the Consolidated Statement of Income, and furthermore, the amount of hedge ineffectiveness and unrealized gains or losses recorded in earnings may be material. This is primarily because small differences in the correlation of crude oil related products could be leveraged over large volumes.

The Company continually looks for better and more accurate methodologies in forecasting expected future cash flows relating to its jet fuel hedging program. These estimates are an important component used in the measurement of effectiveness for the Company’s fuel hedges. The current methodology used by the Company in forecasting forward jet fuel prices is primarily based on the idea that different types of commodities are statistically better predictors of

forward jet fuel prices, depending on specific geographic locations in which the Company hedges. The Company then adjusts for certain items, such as transportation costs, that are stated in fuel purchasing contracts with its vendors, in order to estimate the actual price paid for jet fuel associated with each hedge. This methodology for estimating expected future cash flows (i.e., jet fuel prices) has been consistently applied during 2017, 2016, and 2015, and has not changed for either assessing or measuring hedge ineffectiveness during these periods.

The Company believes it is unlikely that materially different estimates for the fair value of financial derivative instruments and forward jet fuel prices would be made or reported based on other reasonable assumptions or conditions suggested by actual historical experience and other data available at the time estimates were made.

Fair Value Measurements

The Company utilizes unobservable (Level 3) inputs in determining the fair value of certain assets and liabilities. At December 31, 2017, these consisted of a portion of its fuel derivative option contracts, which were a net asset of $248 million.

The Company determines the fair value of fuel derivative option contracts utilizing an option pricing model based on inputs that are either readily available in public markets, can be derived from information available in publicly quoted markets, or are quoted by its counterparties. In situations where the Company obtains inputs via quotes from its counterparties, it verifies the reasonableness of these quotes via similar quotes from another counterparty as of each date for which financial statements are prepared. The Company has consistently applied these valuation techniques in all periods presented and believes it has obtained the most accurate information available for the types of derivative contracts it holds. Due to the fact that certain inputs used in determining estimated fair value of its option contracts are considered unobservable (primarily implied volatility), the Company has categorized these option contracts as Level 3. Although implied volatility is not directly observable, it is derived primarily from changes in market prices, which are observable. Based on the Company’s portfolio of option contracts as of December 31, 2017, a 10 percent change in implied volatility, holding all other factors constant, would have resulted in a change in the fair value of this portfolio of less than $35 million.

As discussed in Note 10 to the Consolidated Financial Statements, any changes in fair value of cash flow hedges that are considered to be effective, as defined, are offset within AOCI until the period in which the expected future cash flow impacts earnings. Any changes in the fair value of fuel derivatives that are ineffective, as defined, or that do not qualify for hedge accounting, are reflected in earnings within Other (gains) losses, net, in the period of the change. Because the Company has extensive historical experience in valuing the derivative instruments it holds, and such experience is continually evaluated against its counterparties each period when such instruments expire and are settled for cash, the Company believes it is unlikely that an independent third party would value the Company’s derivative contracts at a significantly different amount than what is reflected in the Company’s financial statements. In addition, the Company also has bilateral credit provisions in some of its counterparty agreements, which provide for parties (or the Company) to provide cash collateral when the fair value of fuel derivatives with a single party exceeds certain threshold levels. Since this cash collateral is based on the estimated fair value of the Company’s outstanding fuel derivative contracts, this provides further validation to the Company’s estimate of fair values.

Frequent Flyer Accounting

The Company utilizes estimates in the recognition of liabilities associated with its frequent flyer program. These estimates primarily include the liability associated with Rapid Rewards frequent flyer member ("Member") account balances that are expected to be redeemed for travel or other products at a future date. Frequent flyer account balances include points earned through flights taken, points sold to Customers, or points earned through business partners participating in the frequent flyer program.

Under the Southwest Rapid Rewards frequent flyer program, Members earn points for every dollar spent. 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 Rapid Rewards Member has points-earning activity during a 24-month time period. In addition, Southwest co-branded Chase Visa credit card holders are able to redeem their points for items other than travel on Southwest Airlines, 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, Rapid Rewards Members also have the ability to purchase, gift, and transfer points, as well as the ability to donate points to selected charities.

The Company utilizes the incremental cost method of accounting for points earned through flights taken in its frequent flyer program. Liabilities are recorded for the estimated incremental cost of providing free travel as points are being earned and companion passes earned. The liabilities recorded represent the total number of points expected to be redeemed by Members, regardless of whether the Members may have enough to qualify for a full travel award. The incremental cost liabilities are primarily composed of direct Passenger costs such as fuel, food, and other operational costs, but do not include any contribution to fixed overhead costs or profit. At December 31, 2017, the incremental cost liabilities were approximately $76 million. As previously discussed, the Company will adopt ASU No. 2014-09, Revenue from Contracts with Customers, as of January 1, 2018. See Note 2 to the Consolidated Financial Statements for further information.

The Company also sells frequent flyer points and related services to business partners participating in the frequent flyer program. The majority of the points sold to business partners are through the Southwest co-branded Chase Visa credit card. Prior to third quarter 2015, funds received from the sale of points associated with these agreements were accounted for under the residual method. Under the residual method, the Company estimated the percent of the amount received from frequent flyer points sold associated with Southwest’s co-branded Chase Visa credit card that related to free travel. The estimated amounts associated with free travel were deferred and recognized as Passenger revenue when the ultimate free travel awards were flown. During third quarter 2015, the Company executed an amended co-branded credit card agreement ("Agreement") with Chase Bank USA, N.A. ("Chase"), which materially modified the previously existing agreement between Chase and the Company. Consideration received as part of this Agreement is subject to ASU No. 2009-13, Multiple-Deliverable Revenue Arrangements - a consensus of the FASB Emerging Issues Task Force. The modified Agreement has the following multiple elements: travel points to be awarded; use of the Southwest Airlines’ brand and access to Rapid Reward Member lists; advertising elements; and the Company’s resource team. Under ASU No. 2009-13, these deliverables are accounted for separately and allocation of consideration from the Agreement is determined based on the relative selling price of each deliverable. The application of ASU No. 2009-13 to the Agreement decreases the relative value of the air transportation deliverables that the Company records as deferred revenue (and ultimately Passenger revenues when redeemed awards are flown) and increases the relative value of the marketing-related deliverables recorded in Other revenues at the time these marketing-related deliverables are provided. This is principally due to the previous application of the residual method, which effectively applied the entire discount associated with the agreement to the marketing deliverables.

Significant management judgment was used to estimate the selling price of each of the deliverables. The objective was to determine the price at which the Company would transact a sale if the product or service was sold on a stand-alone basis. The Company determined the best estimate of selling price by considering multiple inputs and methods including, but not limited to, the estimated selling price of comparable travel, discounted cash flows, brand value, published selling prices, number of points awarded, and the number of points redeemed. The Company estimated the selling prices and volumes over the term of the Agreement in order to determine the allocation of proceeds to each of the multiple deliverables. The Company records passenger revenue related to air transportation and certificates for discounted companion travel when the transportation is delivered. A one percent increase or decrease in the Company's estimate of the standalone selling prices, implemented as of January 1, 2017, resulting in an allocation of proceeds to air transportation would have changed the Company's Operating revenues by less than $17 million for 2017.

The Company followed the transition approach of ASU No. 2009-13, which required that the Company's existing deferred revenue balance, classified within Air traffic liability, be adjusted to reflect the value, on a relative selling

price basis, of any undelivered element remaining at the date of contract modification. The relative selling price of the undelivered element (air transportation) was lower than the rate at which it had been deferred under the previous contract and the Company recorded a one-time, non-cash adjustment to decrease frequent flyer deferred revenue and increase revenue through the recording of a Special revenue adjustment of $172 million during 2015. In addition, 2015, 2016, and 2017 Operating revenues increased year-over-year by an estimated net $255 million, $544 million, and $544 million respectively, as a result of the amended Agreement with Chase and the resulting July 1, 2015, required change in accounting methodology. See Note 1 to the Consolidated Financial Statements for further information.

Under its current program, Southwest estimates the portion of frequent flyer points that will not be redeemed. In estimating spoilage, the Company takes into account the Member’s past behavior, as well as several factors related to the Member’s account that are expected to be indicative of the likelihood of future point redemption. These factors include, but are not limited to, tenure with program, points accrued in the program, and whether or not the customer has a co-branded credit card. During fourth quarter 2014, the Company obtained sufficient historical behavioral data to develop a predictive statistical model to analyze the amount of spoilage expected for points sold to business partners. The Company updates this model at least annually, and applies the new spoilage rates effective October 1st each year, or more frequently if required by changes in the business. The new spoilage rates applied in 2015, 2016, and 2017 did not have a material impact to Passenger revenues during 2015, 2016, or 2017. For the year ended December 31, 2017, based on actual redemptions of points sold to business partners, a hypothetical one percentage point change in the estimated spoilage rate would have resulted in a change to Passenger revenue of approximately $48 million (an increase in spoilage would have resulted in an increase in revenue and a decrease in spoilage would have resulted in a decrease in revenue). Given that Member behavior will continue to develop as the program matures, the Company expects the current estimates may change in future periods. However, the Company believes its current estimates are reasonable given current facts and circumstances.

Goodwill and Other Intangible Assets

As a result of the Company’s acquisition of AirTran on May 2, 2011, the Company has reflected Goodwill on its Consolidated Balance Sheet in the amount of $970 million at December 31, 2017, the excess of the consideration transferred over the fair value of AirTran’s assets and liabilities on the acquisition date. In addition, the Company's other intangible assets have a net carrying amount of approximately $413 million at December 31, 2017, of which $295 million related to indefinite-lived intangible assets. Indefinite-lived assets are not amortized and primarily consist of take-off and landing slots at certain domestic slot-controlled airports. Goodwill and indefinite-lived intangible assets are not amortized, but tested for impairment annually, as of October 1st, or more frequently if events or circumstances indicate that impairment may exist.

The Company applies a fair value based impairment test to the carrying value of goodwill and indefinite-lived intangible assets annually on October 1st, or more frequently if certain events or circumstances indicate that an impairment loss may have been incurred. The Company assesses the value of goodwill and indefinite-lived assets under either a qualitative or quantitative approach. Under a qualitative approach, the Company considers various market factors, including applicable key assumptions listed below. These factors are analyzed to determine if events and circumstances have affected the fair value of goodwill and indefinite-lived intangible assets. If the Company determines that it is more likely than not that an indefinite-lived intangible asset is impaired, the quantitative approach is used to assess the asset’s fair value and the amount of the impairment. Under a quantitative approach, the fair value is calculated based on key assumptions listed below. If the asset’s carrying value exceeds its fair value calculated using the quantitative approach, an impairment charge is recorded for the difference in fair value and carrying value.

When performing a quantitative impairment assessment of goodwill and indefinite-lived intangible assets, fair value is estimated based on (i) recent market transactions, where available; (ii) projected discounted cash flows (an income approach); or (iii) a combination of limited market transactions and the lease savings method (which reflects potential annual after-tax lease savings arising from owning the slots rather than leasing them from another airline at market rates).

Key assumptions and/or estimates made in the Company’s impairment tests include: (i) a projection of revenues, expenses, and cash flows; (ii) terminal period revenue growth and cash flows; (iii) an estimated weighted average cost

of capital; (iv) an assumed discount rate depending on the asset; (v) a tax rate; and (vi) market prices for comparable assets. The Company believes these assumptions are consistent with those a hypothetical market participant would use given circumstances that were present at the time the estimates were made. However, actual results and amounts may be significantly different from the Company’s estimates.

As part of this evaluation, the Company assesses whether changes in (i) macroeconomic conditions; (ii) industry and market conditions; (iii) cost factors; (iv) overall financial performance; and (v) Company-specific events, have occurred which would impact the use and/or fair value of these assets since the Company's quantitative analysis in 2013. In 2017 and 2016, the Company performed a qualitative assessment of goodwill and determined that there was no indication that goodwill was impaired. The qualitative assessments included analyses and weighting of all relevant factors noted above. The Company performed a quantitative assessment of all indefinite-lived intangible assets in 2015 and a qualitative assessment in 2016 and 2017 and determined that there was no impairment in any of these years as a result of the assessments. The Company did record a $21 million noncash impairment charge related to leased slots at Newark Liberty International Airport (not indefinite-lived assets) 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. Southwest does not believe this FAA decision is indicative of a similar decision being made at its other slot-controlled airports.

Future impairment of Goodwill and indefinite-lived intangible assets may result from changes in assumptions, estimates, or circumstances, some of which are beyond the Company’s control. Factors which could result in an impairment of Goodwill, holding other assumptions constant, could include, but are not limited to: (i) a significant reduction in passenger demand as a result of domestic or global economic conditions; (ii) significantly higher prices for jet fuel; (iii) lower fares or passenger yields as a result of increased competition or lower demand; (iv) a significant increase in future capital expenditure commitments; and (v) significant disruptions to the Company’s operations as a result of both internal and external events such as terrorist activities, actual or threatened war, labor actions by Employees, or further industry regulation. Factors which could result in an impairment of owned domestic slots, holding other assumptions constant, could include, but are not limited to: (i) a change in competition in the slotted airport; (ii) a change in governmental regulations in the slotted airport; (iii) significantly higher prices for jet fuel; and (iv) increased competition at a nearby airport.

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