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

YEAR IN REVIEW

For the 46th consecutive year, the Company was profitable, recording GAAP and non-GAAP results for 2018 and 2017 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.

The fiscal years ended December 31, 2017 and 2016 reflect recast financial information related to the Company's January 1, 2018, adoption of the New Revenue Standard, the New Retirement Standard, and the New Hedging Standard, as detailed in Note 2 to the Consolidated Financial Statements.

		Year ended
		December 31,
(in millions, except per share amounts)		2018				2017				Percent Change
GAAP						As Recast
Operating income		$	3,206			$	3,407			(5.9)
Net income		$	2,465			$	3,357			(26.6)
Net income per share, diluted		$	4.29			$	5.57			(23.0)
Non-GAAP
Operating income		$	3,167			$	3,347			(5.4)
Net income		$	2,435			$	2,116			15.1
Net income per share, diluted		$	4.24			$	3.51			20.8

Net income for the year ended December 31, 2018, was $2.47 billion, a 26.6 percent decrease year-over-year, as compared to the 2017 record Net income of $3.36 billion. Diluted earnings per share for 2018 was $4.29, as compared to the 2017 record diluted earnings per share of $5.57. Non-GAAP Net income was a record of $2.44 billion, a 15.1 percent increase year-over-year. Non-GAAP diluted earnings per share for 2018 was a record of $4.24. The decrease in GAAP Net income was primarily driven by a prior year $1.3 billion adjustment to reduce the Company's Provision for income taxes related to the Tax Cuts and Jobs Act legislation enacted in December 2017 ("Tax Reform"), 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, 2018, was $3.2 billion, a decrease of 5.9 percent year-over-year, and non-GAAP Operating income was also $3.2 billion. The decrease in Operating income was primarily driven by higher market jet fuel prices. These factors were partially offset by a 3.5 percent increase in Passenger revenues driven by a 3.9 percent increase in capacity, as strong demand enabled the Company to fill the majority of the additional seats offered.

For the twelve months ended December 31, 2018, the Company's earnings performance, combined with its actions to manage invested capital, produced a 23.6 percent pre-tax non-GAAP return on invested capital ("ROIC"), or 18.4 percent on an after-tax basis, compared with the Company's pre-tax ROIC of 27.6 percent, or 17.6 percent on an after-tax basis, for the twelve months ended December 31, 2017. The cause of the year-over-year decline in pre-tax ROIC was the decrease in Operating income for the twelve months ended December 31, 2018, compared with the twelve months ended December 31, 2017, as well as the increase in Equity, driven by the impacts of Tax Reform. The increase in after-tax ROIC was primarily due to the reduction in the federal corporate tax rate in 2018. 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 2018, the Company continued to return value to its Shareholders. The Company returned $2.3 billion to Shareholders through $332 million in dividend payments and $2.0 billion through four separate accelerated share repurchase programs. During October 2018, the Company launched the Fourth Quarter 2018 ASR Program by advancing $500 million to a financial institution in a privately negotiated transaction. The Company received 9.8

million shares in total under the Fourth Quarter 2018 ASR Program, which was completed in December 2018. The purchase was recorded as a treasury share purchase for purposes of calculating earnings per share.

On January 28, 2019, the Company launched a new accelerated share repurchase program by advancing $500 million to a financial institution in a privately negotiated transaction ("First Quarter 2019 ASR Program"). The specific number of shares that the Company ultimately will repurchase under the First Quarter 2019 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 April 2019. 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 2019 ASR Program, the Company has $850 million remaining under its May 2018 $2.0 billion share repurchase authorization. See Part II, Item 5 for further information on the Company's share repurchase authorizations.

Company Overview

The Company now serves 99 destinations across 40 states and ten near-international countries, and operates over 4,000 departures a day. Additionally, the Company has announced plans to begin service to Hawaii, subject to requisite governmental approvals, including approval from the Federal Aviation Administration (the "FAA") for Extended Operations ("ETOPS"), a regulatory requirement to operate between the U.S. mainland and the Hawaiian Islands. The Company has also announced its intent to begin service to four Hawaiian airports: Honolulu International Airport, Lihue Airport, Kona International Airport at Keahole, and Kahului Airport, from four initial gateway airports in California: Oakland Metropolitan Airport, San Diego International Airport, Mineta San Jose International Airport, and Sacramento International Airport. The Company has further announced its decision to cease service at Benito Juárez Mexico City International Airport, with the last day of service scheduled on March 30, 2019.

During 2018, the Company took delivery of 26 new 737-800 aircraft and 18 new 737 MAX 8 aircraft from Boeing, as well as 1 pre-owned Boeing 737-700 aircraft from a third party. 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. As of December 31, 2018, the Company had firm orders in place with Boeing for 219 737 MAX 8 aircraft and 30 737 MAX 7 aircraft. For 2019, the Company's current firm aircraft commitments and forecasted Boeing 737-700 retirements would result in approximately 775 aircraft by year-end 2019. 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 2019 available seat miles no more than five percent, year-over-year, with first quarter 2019 year-over-year growth in the 3.5 to 4 percent range. The Company continues to expect the retirement of its Boeing 737-300 ("Classic") aircraft, the last of which took place at the end of third quarter 2017, 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. As expected, the new reservation system produced incremental benefits in pretax results of approximately $200 million in 2018 through the deployment of certain revenue management tools and techniques.

2018 Compared with 2017

Operating Revenues

Passenger revenues for 2018 increased by $692 million, or 3.5 percent, compared with 2017. The increase was largely due to a 3.9 percent increase in capacity, as strong demand enabled the Company to fill the majority of the additional seats offered. Passenger revenues for 2018 included an estimated $130 million negative impact to revenue due to temporarily lower passenger yields from an aggressive May 2018 fare sale for June through October 2018 travel, which was offered in conjunction with the Company’s broad marketing efforts following the Flight 1380 accident. On April 17, 2018, Southwest Airlines Flight 1380 from New York-LaGuardia to Dallas Love Field suffered an uncontained failure of its port CFM56-7B engine, resulting in a Customer fatality. On a unit basis, Passenger revenues decreased 0.4 percent, year-over-year, driven by a slight decrease in Load factor to 83.4 percent, partially offset by a 0.1 percent increase in Passenger revenue yield. The increase in yield was largely due to the successful deployment of several revenue management enhancements enabled by the Company's new reservation system, an improved fare environment in second half 2018, and strong passenger demand for low fares.

Freight revenues for 2018 increased by $2 million, or 1.2 percent, compared with 2017, primarily due to increased capacity. Based on current trends, the Company currently expects Freight revenues in first quarter 2019 to increase, compared with first quarter 2018.

Other revenues for 2018 increased by $125 million, or 10.3 percent, compared with 2017, primarily due to an increase in revenues associated with cardholder spend on the Company's co-branded Chase® Visa credit card. The Company currently expects Other revenues in first quarter 2019 to increase, compared with first quarter 2018.

Operating unit revenues for 2018 were flat compared with 2017. Based on revenue and booking trends thus far in first quarter 2019, and assuming no further significant impact on bookings from the recent government shutdown, the Company currently estimates first quarter 2019 operating unit revenues to increase in the four to five percent range, compared with first quarter 2018.

Operating Expenses

Operating expenses for 2018 increased by $1.0 billion, or 5.8 percent, compared with 2017, while capacity increased 3.9 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 2018 and 2017, followed by explanations of these changes on a per ASM basis and dollar basis:

	Year ended December 31,
	2018				2017				Per ASM				Percent
(in cents, except for percentages)					As Recast				change				change
Salaries, wages, and benefits		4.79	¢			4.74	¢			0.05	¢		1.1	%
Fuel and oil	2.89				2.65				0.24				9.1
Maintenance materials and repairs	0.69				0.65				0.04				6.2
Landing fees and airport rentals	0.83				0.84				(0.01		)		(1.2	)
Depreciation and amortization	0.75				0.79				(0.04		)		(5.1	)
Other operating expenses	1.79				1.86				(0.07		)		(3.8	)
Total		11.74	¢			11.53	¢			0.21	¢		1.8	%

Operating expenses per ASM for 2018 increased by 1.8 percent, compared with 2017, primarily due to increases in market jet fuel prices. Operating expenses per ASM for 2018, excluding Fuel and oil expense and special items (a non-GAAP financial measure), increased 0.6 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 and profitsharing expense, the Company expects its first quarter 2019 unit costs to increase approximately six percent, compared with first quarter 2018's unit costs of 8.65, which excluded Fuel and oil expense, profitsharing expense, and special items.

Salaries, wages, and benefits expense for 2018 increased by $344 million, or 4.7 percent, compared with 2017. Salaries, wages, and benefits expense per ASM for 2018 increased 1.1 percent, compared with 2017. On both a dollar and per ASM basis, the majority of the increases were the result of higher salaries expense, primarily driven by contractual wage rate increases. These increases more than offset the impact in 2017 of the $1,000 per Employee bonus awarded as a result of Tax Reform, which totaled $70 million in the 2017 results. Based on current cost trends and anticipated capacity, the Company expects first quarter 2019 Salaries, wages, and benefits expense per ASM, excluding profitsharing expense, to increase, compared with first quarter 2018.

During 2018, the Company conducted negotiations with various unionized Employee groups. The following table sets

forth the Company’s unionized Employee groups that are currently in negotiations on collective-bargaining agreements:

Employee Group	Approximate Number of Employees	Representatives	Amendable Date
Southwest Flight Attendants	15,200	Transportation Workers of America, AFL-CIO, Local 556 ("TWU 556")	November 2018
Southwest Customer Service Agents, Customer Representatives, and Source of Support Representatives	7,400	International Association of Machinists and Aerospace Workers, AFL-CIO ("IAM 142")	December 2018
Southwest Material Specialists (formerly known as Stock Clerks)	300	International Brotherhood of Teamsters, Local 19 ("IBT 19")	August 2013. The Company reached a tentative agreement with IBT 19 in January 2019. If ratified by the Company's Material Specialists, the contract will become amendable in 2024.
Southwest Mechanics	2,400	Aircraft Mechanics Fraternal Association ("AMFA")	August 2012
Southwest Flight Simulator Technicians	50	International Brotherhood of Teamsters ("IBT")	May 2019. The Company reached a tentative agreement with IBT in February 2019. If ratified by the Company's Flight Simulator Technicians, the contract will become amendable in 2024.

Fuel and oil expense for 2018 increased by $540 million, or 13.2 percent, compared with 2017. On a per ASM basis, Fuel and oil expense for 2018 increased 9.1 percent, compared with 2017. On both a dollar and per ASM basis, the increases were attributable to higher market jet fuel prices, partially offset by the recognition of $168 million in net hedging gains in 2018 versus the recognition of $416 million in net hedging losses in 2017. 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. These totals include cash settlements realized from the settlement of fuel derivative contracts associated with the Company's economic fuel hedge totaling $154 million received from counterparties in 2018, compared with $572 million paid to counterparties in 2017. However, these cash settlement totals exclude the impact from derivatives that did not qualify for hedge accounting for both periods, and gains and/or losses recognized from hedge ineffectiveness in 2017. Those items are recorded as a component of Other (gains) losses, net. See Note 10 to the Consolidated Financial Statements. The Company's average economic jet fuel cost per gallon, which includes hedge settlements in both years, increased 6.8 percent, year-over-year, to $2.20 during 2018 from $2.06 during 2017. These figures include premium expense associated with the Company's fuel hedges, which on a per gallon basis equated to approximately $0.06 and $0.07 for 2018 and 2017, respectively. The Company also slightly improved its fuel efficiency during 2018, compared with 2017, when measured on the basis of ASMs generated per gallon of fuel, driven primarily by the retirement of the Classic aircraft and the addition of the more fuel-

efficient 737-800 and 737 MAX 8 aircraft. Fuel gallons consumed increased 2.4 percent, compared with 2017, while year-over-year capacity increased 3.9 percent.

As of January 18, 2019, on an economic basis, the Company had derivative contracts in place related to expected future fuel consumption as follows:

Period	Maximum percent of estimated fuel consumption covered by fuel derivative contracts at varying West Texas Intermediate/Brent Crude Oil, Heating Oil, and Gulf Coast Jet Fuel-equivalent price levels (a)
2019	70%
2020	53%
2021	25%
Beyond 2021	less than 5%

(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. See Note 10 to the Consolidated Financial Statements for further information.

As a result of applying hedge accounting in prior periods, the Company has amounts in Accumulated other comprehensive income (loss) ("AOCI") that 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, 2018, and the expected future periods in which these items are expected to settle and/or be recognized in earnings (in millions):

Year		Fair value of fuel derivative contracts at December 31, 2018				Amount of losses deferred in AOCI at December 31, 2018 (net of tax)
2019		$	43			$	(36	)
2020		65				(6		)
2021		26				(1		)
2022		4				—
Total		$	138			$	(43	)

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 considering only the expected net cash receipts related to hedges that will settle, the Company is providing the below sensitivity table for first quarter 2019 and full year 2019 jet fuel prices at different crude oil assumptions as of January 18, 2019, and for expected premium costs associated with settling contracts each period, respectively.

	Estimated economic fuel price per gallon, including taxes and fuel hedging premiums (e)
Average Brent Crude Oil price per barrel	First Quarter 2019 (c)		Full Year 2019 (d)
$50	$1.75 - $1.80		$1.65 - $1.75
$55	$1.85 - $1.90		$1.80 - $1.90
Current Market (a)	$2.00 - $2.05		$2.00 - $2.10
$70	$2.15 - $2.20		$2.20 - $2.30
$80	$2.25 - $2.30		$2.35 - $2.45
$90	$2.30 - $2.35		$2.50 - $2.60
Estimated fuel hedging premium expense per gallon (b)	$0.06		$0.04

(a) Brent crude oil average market prices as of January 18, 2019, were approximately $62.01 and $62.40 per barrel for first quarter 2019 and full year 2019, respectively.

(b) Fuel hedging premium expense per gallon is included in the Company's estimated economic fuel price per gallon estimates above.

(c) Based on the Company's existing fuel derivative contracts and market prices as of January 18, 2019, first quarter 2019 GAAP and economic fuel costs are estimated to be in the $2.00 to $2.05 per gallon range, including fuel hedging premium expense of approximately $28 million, or $.06 per gallon, and an estimated $.02 per gallon in favorable cash settlements from fuel derivative contracts. See Note Regarding Use of Non-GAAP Financial Measures.

(d) Based on the Company's existing fuel derivative contracts and market prices as of January 18, 2019, annual 2019 GAAP and economic fuel costs are estimated to be in the $2.00 to $2.10 per gallon range, including fuel hedging premium expense of approximately $95 million, or $.04 per gallon, and an estimated $.01 per gallon in favorable cash settlements from fuel derivative contracts. See Note Regarding Use of Non-GAAP Financial Measures.

(e) The Company's current hedge positions contain a combination of instruments based in West Texas Intermediate and Brent crude oil; however, 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 18, 2019.

Maintenance materials and repairs expense for 2018 increased by $106 million, or 10.6 percent, compared with 2017. On a per ASM basis, Maintenance materials and repairs expense for 2018 increased 6.2 percent, compared with 2017. On both a dollar and per ASM basis, the majority of the increases were due to the timing of regular airframe maintenance checks. The remainder of the increases were due to engine maintenance and repairs. The Company currently expects Maintenance materials and repairs expense per ASM for first quarter 2019 to increase, compared with first quarter 2018.

Landing fees and airport rentals expense for 2018 increased by $42 million, or 3.3 percent, compared with 2017. On a per ASM basis, Landing fees and airport rentals expense for 2018 decreased 1.2 percent, compared with 2017, as the dollar increases were more than offset by the 3.9 percent increase in capacity. On a dollar basis, the majority of the increase was due to an increase in rental rates at various stations throughout the network. The Company currently expects Landing fees and airport rentals expense per ASM for first quarter 2019 to increase, compared with first quarter 2018.

Depreciation and amortization expense for 2018 decreased by $17 million, or 1.4 percent, compared with 2017. On a per ASM basis, Depreciation and amortization expense decreased 5.1 percent, compared with 2017. On both a dollar and per ASM basis, the majority of the decreases were associated with the reduction in depreciation expense associated with the accelerated retirement of the Company's Classic fleet in third quarter 2017, as this exceeded the additional depreciation associated with purchases of new owned aircraft and pre-owned aircraft on capital leases. The Company currently expects Depreciation and amortization expense per ASM for first quarter 2019 to increase, compared with first quarter 2018.

Other operating expenses for 2018 increased by $5 million, or 0.2 percent, compared with 2017. On a per ASM basis, Other operating expenses for 2018 decreased 3.8 percent, compared with 2017, as the dollar increases were more than offset by the 3.9 percent increase in capacity. Other operating expenses in 2017 included charges totaling $96 million,

associated with the grounding 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 and $33 million of lease termination expenses associated with eight Classic aircraft that were acquired during 2017 prior to their grounding. During first quarter 2018, the Company also recognized $25 million of gains from the sale of 39 owned Classic aircraft and a number of spare engines to a third party which reduced Other operating expenses. The charges related to the grounding of the Classic fleet, as well as the gain on sale of grounded aircraft, 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. Excluding these items, approximately 50 percent of the year-over-year dollar increase was due to technology-related expenses associated with various projects, 30 percent due to revenue related costs as a result of the 3.6 percent increase in Revenue Passengers carried, and the remainder was due to higher property taxes assessed in 2018. The Company currently expects Other operating expenses per ASM for first quarter 2019 to increase, compared with first quarter 2018.

Other

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

Interest expense for 2018 increased by $17 million, or 14.9 percent, compared with 2017, primarily due to the issuance of two debt facilities in November 2017, including $300 million of 2.75% senior unsecured notes and $300 million of 3.45% senior unsecured notes.

Capitalized interest for 2018 decreased by $11 million, or 22.4 percent, compared with 2017, primarily due to timing of aircraft deliveries and progress payments associated with future orders.

Interest income for 2018 increased by $34 million, or 97.1 percent, compared with 2017, primarily due to higher interest rates.

Other (gains) losses, net, primarily includes amounts recorded as a result of the Company's hedging activities. With the adoption of the New Hedging Standard, the elimination of the requirement to separately measure and record ineffectiveness for all future cash flow hedges in a hedging relationship, as well as a change in classification of premium expense associated with option contracts from Other (gains) losses, net, in the Consolidated Statement of Income, to Fuel and oil expense, has significantly reduced amounts reflected for hedging activities in Other (gains) losses, net. With the adoption of the New Retirement Standard, the Company is required to include all components of its net periodic benefit cost (income), with the exception of service cost, in Other (gains) losses, net, versus previously having been classified and reported as operating expenses in Salaries, wages, and benefits. For 2018, this periodic benefit cost was $12 million. See Note 2 to the Consolidated Financial Statements for further information on both new standards. Also, 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, 2018, and 2017:

	Year ended December 31,
(in millions)	2018				2017
					As Recast
Mark-to-market impact from fuel contracts settling in future periods	$	—			$	69
Ineffectiveness from fuel hedges settling in future periods (a)	—				31
Realized ineffectiveness and mark-to-market (gains) or losses (a)	—				6
Other	18				6			(b)
	$	18			$	112

(a) With the adoption of the New Hedging Standard, the separate measurement and recording of ineffectiveness has been eliminated for all cash flow hedges in a hedging relationship effective January 1, 2018. See Note 2 to the Consolidated Financial Statements for further information.

(b) Includes $14 million reclassified from Salaries, wages, and benefits to Other (gains) losses, net, as a result of the New Retirement Standard. See Note 2 to the Consolidated Financial Statements for further information.

Income Taxes

The Company's effective tax rate was 22.1 percent for 2018, compared with a 2.8 percent benefit for 2017. The increase in rate was driven by a prior year $1.3 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's 2018 effective tax rate of 22.1 percent was lower than its previously forecasted rate of approximately 23 percent, primarily due to additional tax credits realized during fourth quarter 2018. The Company currently projects a full year 2019 effective tax rate to be approximately 23.5 percent based on currently forecasted financial results.

2017 Compared with 2016

Operating Revenues

Passenger revenues for 2017 increased by $695 million, or 3.6 percent, compared with 2016. The increase was primarily attributable to a 3.6 percent increase in capacity, as strong demand enabled the Company to fill the majority of the additional seats offered. This increase was 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 was relatively flat. 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.

Other revenues for 2017 increased by $160 million, or 15.2 percent, compared with 2016, primarily due to an increase in revenues associated with cardholder spend on the Company's co-branded Chase® Visa credit card.

Operating Expenses

Operating expenses for 2017 increased by $972 million, or 5.8 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,
	2017				2016				Per ASM				Percent
(in cents, except for percentages)	As Recast				As Recast				change				change
Salaries, wages, and benefits		4.74	¢			4.57	¢			0.17	¢		3.7	%
Fuel and oil	2.65				2.56				0.09				3.5
Maintenance materials and repairs	0.65				0.70				(0.05		)		(7.1	)
Landing fees and airport rentals	0.84				0.82				0.02				2.4
Depreciation and amortization	0.79				0.82				(0.03		)		(3.7	)
Other operating expenses	1.86				1.82				0.04				2.2
Total		11.53	¢			11.29	¢			0.24	¢		2.1	%

Operating expenses per ASM for 2017 increased 2.1 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. Operating expenses in 2016 included $356 million of accrued ratification bonuses, 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 4.3 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.

Salaries, wages, and benefits expense for 2017 increased by $519 million, or 7.6 percent, compared with 2016. Salaries, wages, and benefits expense per ASM for 2017 increased 3.7 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. Salaries, wages, and benefits expense in 2016 included $356 million of accrued ratification bonuses, associated with collective-bargaining agreements reached with multiple unionized workgroups.

Fuel and oil expense for 2017 increased by $275 million, or 7.2 percent, compared with 2016. On a per ASM basis, Fuel and oil expense for 2017 increased 3.5 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 3.0 percent, year-over-year, to $2.06 during 2017 from $2.00 during 2016. These figures include premium expense associated with the Company's fuel hedges, which on a per gallon basis equated to approximately $0.07 and $0.08 for 2017 and 2016, 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. These cash settlement totals exclude gains and/or losses recognized from hedge ineffectiveness for both years and from derivatives that did not qualify for hedge accounting for both periods. Those items are recorded as a component of Other (gains) losses, net.

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 of that fleet to replace a portion of the retired Classic aircraft.

Landing fees and airport rentals expense for 2017 increased by $81 million, or 6.7 percent, compared with 2016. On a per ASM basis, Landing fees and airport 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.

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.

Other operating expenses for 2017 increased by $144 million, or 5.3 percent, compared with 2016. On a per ASM basis, Other operating expenses for 2017 increased 2.2 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.

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. With the adoption of the New Hedging Standard, the elimination of the requirement to separately measure and record ineffectiveness for all future cash flow hedges in a hedging relationship, as well as a change in classification of premium expense associated with option contracts from Other (gains) losses, net, in the Consolidated Statement of Income, to Fuel and oil expense, has significantly reduced amounts reflected for hedging activities in Other (gains) losses, net. With the adoption of the New Retirement Standard, the Company is required to include all components of its net periodic benefit cost (income), with the exception of service cost, in Other (gains) losses, net, versus previously having classified and reported such items as operating expenses in Salaries, wages, and benefits. See Note 2 to the Consolidated Financial Statements for further information on both new standards. See Note 10 to the Consolidated Financial Statements for further information on the Company's hedging activities. The following table displays the components of Other (gains) losses, net, for the years ended December 31, 2017, and 2016:

	Year ended December 31,
(in millions)	2017				2016
	As Recast				As Recast
Mark-to-market impact from fuel contracts settling in future periods	$	69			$	9
Ineffectiveness from fuel hedges settling in future periods (a)	31				(11		)
Realized ineffectiveness and mark-to-market (gains) or losses (a)	6				5
Other (b)	6				18
	$	112			$	21

(a) With the adoption of the New Hedging Standard, the separate measurement and recording of ineffectiveness has been eliminated for all cash flow hedges in a hedging relationship effective January 1, 2018. See Note 2 to the Consolidated Financial Statements for further information.

(b) Includes $14 million for 2017 and $12 million for 2016 reclassified from Salaries, wages, and benefits to Other (gains) losses, net, as a result of the New Retirement Standard. See Note 2 to the Consolidated Financial Statements for further information.

Income Taxes

The Company's effective tax rate was a 2.8 percent benefit for 2017, compared with 36.7 percent for 2016. The decrease in rate was driven by a $1.3 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.

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

	Year ended December 31,
	2018				2017				Percent
					As Recast				Change
Fuel and oil expense, unhedged	$	4,649			$	3,524
Premium cost of fuel contracts	135				136
Add (Deduct): Fuel hedge (gains) losses included in Fuel and oil expense, net	(168		)		416
Fuel and oil expense, as reported	$	4,616			$	4,076
Add: Net impact from fuel contracts	14				156
Fuel and oil expense, excluding special items (economic)	$	4,630			$	4,232			9.4	%
Total operating expenses, as reported	$	18,759			$	17,739
Add: Reclassification between Fuel and oil and Other (gains) losses, net, associated with current period settled contracts	—				6
Add: Contracts settling in the current period, but for which gains and/or (losses) have been recognized in a prior period (a)	14				150
Deduct: Lease termination expense	—				(33		)
Deduct: Aircraft grounding charge	—				(63		)
Add: Gain on sale of grounded aircraft	25				—
Total operating expenses, excluding special items	$	18,798			$	17,799			5.6	%
Operating income, as reported	$	3,206			$	3,407
Deduct: Reclassification between Fuel and oil and Other (gains) losses, net, associated with current period settled contracts	—				(6		)
Deduct: Contracts settling in the current period, but for which gains and/or (losses) have been recognized in a prior period (a)	(14		)		(150		)
Add: Lease termination expense	—				33
Add: Aircraft grounding charge	—				63
Deduct: Gain on sale of grounded aircraft	(25		)		—
Operating income, excluding special items	$	3,167			$	3,347			(5.4	)%
Provision (benefit) for income taxes, as reported	$	699			$	(92	)
Add (Deduct): Net income tax impact of special items, excluding Tax reform impact (b)	(9		)		17
Add: Tax reform impact (c)	—				1,270
Provision for income taxes, excluding special items	$	690			$	1,195			(42.3	)%
Net income, as reported	$	2,465			$	3,357
Add: Mark-to-market impact from fuel contracts settling in future periods	—				69
Add: Ineffectiveness from fuel hedges settling in future periods	—				31
Deduct: Other net impact of fuel contracts settling in the current or a prior period (excluding reclassifications)	(14		)		(150		)
Add: Lease termination expense	—				33
Add: Aircraft grounding charge	—				63
Deduct: Gain on sale of grounded aircraft	(25		)		—
Add (Deduct): Net income tax impact of special items, excluding Tax reform impact (b)	9				(17		)
Deduct: Tax reform impact (c)	—				(1,270		)
Net income, excluding special items	$	2,435			$	2,116			15.1	%

	Year ended December 31,
	2018				2017				Percent
					As Recast				Change
Net income per share, diluted, as reported	$	4.29			$	5.57
Deduct: Net impact to net income above from fuel contracts divided by dilutive shares	(0.02		)		(0.08		)
Add (Deduct): Impact of special items	(0.04		)		0.16
Add (Deduct): Net income tax impact of special items, excluding Tax reform impact (b)	0.01				(0.03		)
Deduct: Tax reform impact (c)	—				(2.11		)
Net income per share, diluted, excluding special items	$	4.24			$	3.51			20.8	%
Operating expenses per ASM (cents)		11.74	¢			11.53	¢
Deduct: Fuel and oil expense divided by ASMs	(2.89		)		(2.65		)
Deduct: Profitsharing expense divided by ASMs	(0.34		)		(0.35		)
Add (Deduct): Impact of special items	0.02				(0.06		)
Operating expenses per ASM, excluding profitsharing, Fuel and oil expense, and special items (cents)		8.53	¢			8.47	¢		0.7	%

(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 Ended				Year Ended				Year Ended
	December 31, 2018				December 31, 2017				December 31, 2016
Operating income, as reported	$	3,206			$	3,407			$	3,522
Contract ratification bonuses	—				—				356
Net impact from fuel contracts	(14		)		(156		)		(201		)
Asset impairment	—				—				21
Lease termination expense	—				33				22
Aircraft grounding charge	—				63				—
Gain on sale of grounded aircraft	(25		)		—				—
Operating income, non-GAAP	3,167				3,347				3,720
Net adjustment for aircraft leases (a)	99				110				110
Adjusted operating income, non-GAAP (A)	$	3,266			$	3,457			$	3,830
Non-GAAP tax rate (B)	22.1		%	(d)	36.1		%	(e)	36.7		%	(f)
Net operating profit after-tax, NOPAT (A* (1-B) = C)	$	2,545			$	2,210			$	2,424
Debt, including capital leases (b)	$	3,521			$	3,259			$	3,304
Equity (b)	9,853				8,194				7,195
Net present value of aircraft operating leases (b)	584				785				1,015
Average invested capital	$	13,958			$	12,238			$	11,514
Equity adjustment for hedge accounting (c)	(144		)		296				886
Adjusted average invested capital (D)	$	13,814			$	12,534			$	12,400
Non-GAAP ROIC, pre-tax (A/D)	23.6		%		27.6		%		30.9		%
Non-GAAP ROIC, after tax (C/D)	18.4		%		17.6		%		19.5		%

As of January 1, 2018, the Company adopted ASU 2014-09: Revenue from Contracts with Customers, ASU 2017-07: Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost, and ASU 2017-12: Targeted Improvements to Accounting for Hedging Activities. As a result, certain prior period results have been recast due to the transition methods applied. See Note 2 to the Consolidated Financial Statements for further information.

(a) 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.

(b) 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.

(c) The Equity adjustment for hedge accounting in the denominator adjusts for the cumulative impacts, in AOCI 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 is reflected in the Net impact from fuel contracts in the numerator.

(d) The GAAP annual tax rate as of December 31, 2018, was 22.1 percent, and the annual Non-GAAP tax rate was also 22.1 percent. See Note Regarding Use of Non-GAAP Financial Measures for additional information

(e) The GAAP annual tax rate as of December 31, 2017, was a 2.8 percent tax benefit due to the significant impact the Tax Cuts and Jobs Act legislation enacted in December 2017 had on corporate tax rates, and the annual Non-GAAP tax rate was 36.1 percent. See Note Regarding Use of Non-GAAP Financial Measures for additional information.

(f) The GAAP annual tax rate as of December 31, 2016, was 36.7 percent, and the annual Non-GAAP tax rate was also 36.7 percent. See Note Regarding Use of Non-GAAP Financial Measures for additional information.

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; Adjusted operating income, non-GAAP; Income tax rate, 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 profitsharing and Fuel and oil expense. 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 that are designated as hedges are reflected as a component of Fuel and oil expense, 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 2 and Note 10 to the Consolidated Financial Statements, which also discusses the Company's January 1, 2018 adoption of the New Hedging Standard.

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.

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;

2.	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;

3.

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;

4.

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 were subject to negotiation with third party lessors;

5.	A gain recognized in first quarter 2018, associated with the sale of 39 owned Boeing 737-300 aircraft and a number of spare engines to a third party. These aircraft were previously retired as part of the Company's exit of its Classic fleet. The gain was not anticipated, and the Company associates it with the grounding charge recorded in third quarter 2017; and

6.	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 was a non-cash item and was 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; Adjusted operating income, non-GAAP; Income tax rate, 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 profitsharing and Fuel and oil expense.

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 the calculations provided by other companies.

Liquidity and Capital Resources

Net cash provided by operating activities for 2018, 2017, and 2016 was $4.9 billion, $3.9 billion, and $4.3 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 2018, 2017, and 2016 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. During 2018, the Company's operating cash flows were positively impacted by the reduction in the federal corporate tax rate to 21 percent, from the previous rate of 35 percent. 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 2018, the Company had net cash outflows of $15 million in cash collateral to derivative counterparties. During 2017 and 2016, the Company had net cash inflows of $316 million and $535 million, respectively, in cash collateral from derivative counterparties. Cash flows associated with entering into new fuel derivatives, which are also classified as Other, net, operating cash flows, were net outflows of $63 million in 2018, $142 million in 2017, and $165 million in 2016. 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 2018, 2017, and 2016 was $2.0 billion, $2.4 billion, and $2.3 billion, respectively. Investing activities in 2018, 2017, and 2016 included Capital expenditures, primarily related to aircraft and other equipment, technology projects, payments associated with airport construction projects, denoted as Assets constructed for others, and changes in the balance of the Company's short-term and noncurrent investments. See Note 4 to the Consolidated Financial Statements for further information. During 2018, Capital expenditures were $1.9 billion, the majority of which were payments for new aircraft delivered to the Company. During 2017 and 2016, Capital expenditures were $2.1 billion and $2.0 billion, respectively. During 2018, 2017, and 2016, the Company's purchases and sales of short-term and noncurrent investments resulted in net cash outflows of $67 million, $159 million, and $125 million, respectively. The Company currently estimates its 2019 capital expenditures will be approximately $1.9 billion.

Net cash used in financing activities for 2018, 2017, and 2016 was $2.5 billion, $1.7 billion, and $1.9 billion, respectively. During 2018, the Company repaid $342 million in debt and capital lease obligations, compared with $592 million and $591 million (including convertible notes) during 2017 and 2016, 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. See Note 6 to the Consolidated Financial Statements for further information. During 2018, the Company received a reimbursement from the City of Houston for $116 million for the investment and updates made at Houston William P. Hobby Airport. See Note 4 to the Consolidated Financial Statements for further information regarding the reimbursement. The Company repurchased $2.0 billion of its outstanding common stock through authorized share repurchases during 2018, compared with repurchases of $1.6 billion and $1.8 billion during 2017 and 2016, respectively. The Company also paid $332 million in dividends to Shareholders during 2018, compared with $274 million in 2017 and $222 million in 2016. 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, 2018, the Company was in compliance with this covenant and there were no amounts outstanding under the revolving credit facility.

The Company entered into the following accelerated share repurchases during 2018, which were each recorded as a treasury share purchase for purposes of calculating earnings per share. See Part II, Item 5 for further information on the Company's share repurchase authorizations.

Share repurchases (in millions)		Shares received		Cash paid
First Quarter 2018 Accelerated Share Repurchase Program		8.73		$	500
Second Quarter 2018 Accelerated Share Repurchase Program		9.69		500
Third Quarter 2018 Accelerated Share Repurchase Program		8.20		500
Fourth Quarter 2018 Accelerated Share Repurchase Program		9.84		500
Total		36.46		$	2,000

The Company maintained its investment grade credit ratings of "A3" with Moody's, "BBB+" with Standard & Poor's, and "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, unused funds available to Customers, and loyalty deferred revenue, which are performance obligations for future Customer flights, do not require future settlement in cash, and are mostly nonrefundable. See Note 5 to the Consolidated Financial Statements for further information. The Company believes that its current liquidity position, including unrestricted cash and short-term investments of $3.7 billion as of December 31, 2018, 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 2018 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. In 2018, the Company exercised 40 737 MAX 8 options, which added 10 additional firm orders in each year 2019 through 2022. Additionally, four 737 MAX 8 firm orders were shifted from 2019 into fourth quarter 2018, and commitments for three pre-owned 737-700 aircraft previously scheduled for delivery in 2018 were replaced with commitments for three 737 MAX 8 aircraft to be delivered in 2019. 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 I, Item 2 for a complete table of the Company’s firm deliveries and options for Boeing 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 generally 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, 2018, the Company had 198 leased aircraft, including 75 B717s subleased to Delta. Of these leased aircraft, 124 are under operating leases, including 73 B717s subleased to Delta. 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 $170 million at December 31, 2018.

The following table aggregates the Company’s material expected contractual obligations and commitments as of December 31, 2018:

		Obligations by period (in millions)
Contractual obligations		2019				2020 - 2021				2022 - 2023				Thereafter				Total
Long-term debt (a)		$	506			$	821			$	414			$	797			$	2,538
Interest commitments - fixed (b)		64				95				66				94				319
Interest commitments - floating (c)		37				30				9				8				84
Facility construction commitments (d)		70				141				135				168				514
Facility operating lease commitments		36				65				31				42				174
Aircraft operating lease commitments (e)		220				417				263				431				1,331
Aircraft capital lease commitments (f)		111				214				197				335				857
Aircraft purchase commitments (g)		924				3,042				2,798				3,444				10,208
Other commitments		144				188				115				325				772
Total contractual obligations		$	2,112			$	5,013			$	4,028			$	5,644			$	16,797

(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, 2018, 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. 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, 2018, was $416 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 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 was substantially complete and operational as of the end of third quarter 2018. In general, as work was being completed on the project by various contractors, invoices were submitted to Broward County for initial payment to the Company, which then made such payments to the contractors performing the work. The project did not 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 oversaw and managed 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"). Under the T1.5 Lease, the Company is overseeing and managing 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 (the "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 associated with 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 was substantially complete and operational during fourth quarter 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 critical accounting policies and estimates are described below. As a result of the Company's January 1, 2018 adoption of the New Revenue Standard and the New Hedging Standard, it has updated its discussions of critical accounting policies related to Revenue Recognition, Financial Derivative Instruments, Fair Value Measurements, and Loyalty Accounting. Also, see Note 2 to the Consolidated Financial Statements for further information about the accounting implications of these ASUs.

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 the Company’s liability associated with its loyalty program. Air traffic liability fluctuates throughout the year based on seasonal travel patterns, fare sale activity, and activity associated with the Company’s loyalty program. See Note 2 to the Consolidated Financial Statements for information about the New Revenue Standard and the Company's revenue recognition policies.

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 5 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 effectively refunded through it being made 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. Holding other factors constant, a 10 percent change in the Company’s estimate of the amount of tickets that will expire unused would

have resulted in a $63 million, or less than one percent, change in Passenger revenues recognized for the year ended December 31, 2018.

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 699 Boeing 737 aircraft in the Company’s fleet at December 31, 2018, which are either owned or on capital lease. The remaining 51 Boeing 737 aircraft in the Company’s fleet at December 31, 2018, are operated under operating leases. The Company also has 85 B717 aircraft, which are part of the lease/sublease with Delta. As these aircraft were not in service for the Company, they were not included in the fleet count as of December 31, 2018 or 2017. 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 life		Estimated residual value
Airframes and engines		25 years		15 percent
Spare aircraft engines		25 years		20 percent
Aircraft parts		Fleet life		4 percent
Assets constructed for others (a)		5 to 30 years		17 to 75 percent
Ground property and equipment		5 to 30 years		0 to 10 percent

(a) Within the given range, LFMP and HOU assets are at the high end of the range, while the FLL and LAX assets are at the low end of the range. See Note 4 for further information on the Company's Assets constructed for others.

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 provided by independent third parties, and recommendations from Boeing. Flight equipment 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.

Fair Value Measurements and Financial Derivative Instruments

The Company utilizes unobservable (Level 3) inputs in determining the fair value of certain assets and liabilities. At December 31, 2018, these consisted of its fuel derivative option contracts, which were an asset of $138 million. 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, Note 10 to the Consolidated Financial Statements for more information on the Company’s fuel hedging program and financial derivative instruments, and Note 11 for more information about fair value measurements. Also, see Note 2 to the Consolidated Financial Statements for information about required changes to hedge accounting per the New Hedging Standard.

All derivatives are required to be reflected at fair value and recorded on the Consolidated Balance Sheet. At December 31, 2018, the Company was a party to over 200 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 2018, market "spot" prices for Brent crude oil peaked at a high of approximately $86 per barrel and hit a low price of approximately $50 per barrel. During 2017, market spot prices ranged from a high of approximately $67 per barrel to a low of approximately $45 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.

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 the 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, 2018, 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 $12 million.

Fair values for financial derivative instruments are estimated prior to the time that the financial derivative instruments settle. 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.

As discussed in Note 10 to the Consolidated Financial Statements, any changes in fair value of cash flow derivatives designated as hedges 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 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.

Loyalty Accounting

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

Under the Southwest Rapid Rewards loyalty 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 can differ based on the fare purchased. Under the program, (i) Members are able to redeem their points for every available seat, every day, on every flight, with no blackout dates; and (ii) points do not expire so long as the Member has points-earning activity during a 24-month time period. In addition, Members 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, 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 deferred revenue method of accounting for points earned through flights taken in its loyalty program. The Company also sells points and related services to business partners participating in the loyalty program. Liabilities are recorded for the relative standalone selling price of the Rapid Rewards points which are awarded each period. 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. At December 31, 2018, the loyalty liabilities were approximately $3.0 billion, including $2.1 billion classified within Air traffic liability and $936 million classified as Air traffic liability – noncurrent.

In order to determine the value of each loyalty point, certain assumptions must be made at the time of measurement, which include the following:

•

Allocation of Passenger Revenue - Revenues from Passengers, related to travel, who also earn Rapid Rewards Points have been allocated between flight (recognized as revenue when transportation is provided) and Rapid Rewards Points (deferred until points are redeemed or spoil) based on each obligation’s relative standalone selling price. The Company utilizes historical earning patterns to assist in this allocation.

•

Fair Value of Rapid Rewards Points - Determined from the base fare value of tickets which were purchased using prior point redemptions for travel and other products and services, which the Company believes to be indicative of the fair value of points as perceived by Customers and representative of the value of each point at the time of redemption. The Company’s booking site allows a Customer to toggle between fares utilizing either cash or point redemptions, which provides the Customer with an approximation of the equivalent value of their points. The value can differ, however, based on demand, the amount of time prior to the flight, and other factors. The fare mix during the period measured represents a constraint, which could result in the assumptions above changing at the measurement date, as fare classes can have different coefficients used to determine the total loyalty points needed to purchase an award ticket. The mixture of these fare classes could cause the fair value per point to increase or decrease.

The majority of the points sold to business partners are through the Southwest co-branded credit card agreement ("Agreement") with Chase Bank USA, N.A. Consideration received as part of this Agreement is subject to Accounting Standards Codification 606, Revenue From Contracts With Customers ("ASC 606"). The Agreement has the following multiple elements: travel points to be awarded, use of the Southwest Airlines’ brand and access to Rapid Rewards Member lists, advertising elements, and the Company’s resource team. These elements are combined into two performance obligations, transportation and marketing, and consideration from the Agreement is allocated based on the relative selling price of each performance obligation.

Significant management judgment was used to estimate the selling price of each of the performance obligations in the Agreement at inception. The objective is 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 determines 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 estimates the selling prices and volumes over the term of the Agreement in order to determine the allocation of proceeds to each of the multiple performance obligations. The Company records revenue related to air transportation when the transportation is delivered and revenue related to marketing elements when the performance obligation is satisfied. A one percent increase or decrease in the Company's estimate of the standalone selling prices, implemented as of January 1, 2018, resulting in an allocation of proceeds to air transportation would have changed the Company's Operating revenues by approximately $6 million for the year ended December 31, 2018.

Under its current program, Southwest estimates the portion of loyalty points that will not be redeemed. In estimating the 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 the program, points accrued in the program, and whether or not the Member has a co-branded credit card. The Company believes it has obtained sufficient historical behavioral data to develop a predictive statistical model to analyze the amount of spoilage expected for all loyalty points. 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. Changes in the spoilage rates applied annually in recent years have not had a material impact on Passenger revenues. However, given the Company's January 1, 2018 adoption of the New Revenue Standard and elimination of the incremental cost method of accounting for flight points, the value of the loyalty liabilities subject to changes in the spoilage rates has significantly increased. Therefore, future spoilage rate changes are much more likely to cause volatility in Passenger revenues. For the year ended December 31, 2018, based on actual redemptions of points sold to business partners and earned through flights, a hypothetical one percentage point change in the estimated spoilage rate would have resulted in a change to Passenger revenue of approximately $107 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.