SOUTHWEST AIRLINES CO. 2017 ANNUAL REPORT TO …

SOUTHWEST AIRLINES CO. 2017 ANNUAL REPORT TO SHAREHOLDERS

To our Shareholders:

I am very pleased to report another strong year of earnings in 2017. It marked our 45th consecutive year of profitability, unmatched by any competitor in the U.S. airline industry. Despite an unprecedented string of hurricanes, earthquakes, and wildfires, our 2017 results compared admirably to 2016's record results. Our stock price (LUV) ended the year 2017 at $65.45, an approximate 30 percent increase from the prior year and an approximate 540 percent increase over the last five years. Both periods led the industry and, in fact, placed us first against all industrials in the S&P 500 Index and ninth in the overall S&P 500 for the five years ended 2017.

Our 2017 net income was a record $3.5 billion, or $5.79 per diluted share. These results include a $1.4 billion reduction in our deferred income tax expense resulting from the Tax Cuts and Jobs Act. Excluding this and other special items1, our 2017 net income was $2.1 billion, or $3.50 per diluted share, compared with $2.4 billion, or $3.75 per diluted share in 2016.

Total operating revenues were a record $21.2 billion, up 3.7 percent versus a year ago. Available seat mile (ASM) capacity increased 3.6 percent, resulting in a slight increase in revenue per ASM (RASM), year-over-year. This reflects a more stable revenue yield environment than what we experienced the previous 24 months; however, the fare environment remains vigorous.

It was another successful year for our Commercial group, and they made significant progress in strengthening Southwest's revenue-generating capabilities and reach. First, we successfully deployed our new reservation system in May 2017. Beginning in 2018, we estimate the new system will drive incremental improvements in pre-tax results of $200 million, escalating to $500 million by 2020; however, we experienced a reduction in revenues of approximately $80 million in 2017 in connection with the transition from the old to the new system.

Second, we launched service to several new destinations including Cincinnati, Ohio; Grand Cayman; and Turks & Caicos. And, we announced our commitment to begin selling Southwest flights to Hawaii in 2018.

Finally, after three years of construction, we opened a brand new international concourse at Ft. Lauderdale-Hollywood International Airport and launched international service to Belize; Cancun, Mexico; Grand Cayman; Montego Bay, Jamaica; and San Jose, Costa Rica.

1 See Note Regarding Use of Non-GAAP Financial Measures and related reconciliations included in the accompanying Form 10-K for the fiscal year ended December 31, 2017, for additional information on special items.

Operating expenses increased 5.9 percent to $17.7 billion, or 2.3 percent per available seat mile, year-over-year. Jet fuel costs (economic) were up 4.2 percent to $2.00 per gallon from a year ago2, while fuel efficiency3 improved a welcome 1.1 percent.

We also had several notable achievements in the Operations group in 2017. We began flying Boeing's new 737 MAX 8 aircraft on October 1 of last year, which we believe is the best narrow-body airplane of comparable size in the world. We are pleased with the initial performance and are realizing over 13 percent less fuel consumed per mile along with a 40 percent reduction in noise, as compared with the prior generation 737-800. We ended 2017 with 13 of the new MAX 8 aircraft. Coincident with that historic milestone, we simplified our fleet for operational and financial purposes by completing the early retirement of our remaining 62 Boeing 737-300 (Classic) aircraft in September 2017. The effect of that was a $96 million charge in 2017, but we expect to receive economic benefits through year 2020 of an estimated $200 million stemming from lower fuel, maintenance, repairs, and out-of-service costs.

Our ontime performance was 78.7 percent for the year, a satisfactory performance given the challenging weather environment but still below our goal of over 80 percent. Our baggage handling continued to be superb (and improved). Most importantly, and for the 23rd time in the last 27 years, we were first in the U.S. Department of Transportation's category of fewest Customer complaints4. All in all, a very satisfactory performance from our Operations groups' perspective.

Our cash flow from operations was $3.9 billion, and our free cash flow5 was $1.8 billion. Our strengthened financial position earned us an upgrade in our investmentgrade credit rating to A3 with Moody's Investors Service and BBB+ with Standard & Poor's. We continue to target debt-to-total-capital (including off-balance sheet aircraft leases) in the low to mid-30 percent range. Our liquidity remained strong with $3.3 billion in year-end cash and short-term investments, plus our fully-available $1.0 billion bank line of credit. We returned $1.9 billion to Shareholders in 2017, through $274 million in dividends and $1.6 billion in share repurchases. In May 2017, in recognition of our exceptionally strong results, our Board of Directors authorized a $2.0 billion share repurchase program and increased the quarterly dividend by 25 percent to $.125 per share.

Once again, we are off to a solid start to the year. With corporate income tax reform passed through Congress and signed by the President late last year, we expect our effective income tax rate to drop to between 23 and 23.5 percent. That is expected to result in a significant boost to earnings and cash flow, compared with 2017, all else being equal. It is a welcome change 1) for our country, as it makes us more competitive around the world; 2) for our transportation sector, as it levels the federal income tax "playing field" among industries; and 3) for Southwest Airlines as the largest cash taxpayer in the

2 See Note Regarding Use of Non-GAAP Financial Measures and related reconciliations included in the accompanying Form 10-K for the fiscal year ended December 31, 2017, for additional information on economic fuel costs. 3 Calculated as available seat miles produced per fuel gallon consumed. 4 Source: Air Travel Consumer Reports. Rankings based on complaints filed with the U.S. Department of Transportation per 100,000 passengers enplaned. 5 Free cash flow is calculated as operating cash flows of $3.9 billion less capital expenditures of $2.1 billion less assets constructed for others of $126 million plus reimbursements for assets constructed for others of $126 million.

U.S. airline industry. Beyond income tax reform, we continue to hope for regulatory reform and air traffic control modernization. We were disappointed with Congress's recent decision to table air traffic control reform as this was the only viable path forward to modernization; however, we will continue our efforts to work with the Federal Aviation Administration and Members of Congress to achieve the air traffic control efficiencies we so desperately need.

U.S. domestic economic growth seems stable, and the 2017 tax reform should provide a further boost. Energy prices are stable at moderate prices, and travel demand remains strong in a competitive environment. We currently plan to grow our 2018 ASM capacity in the low five percent range, year-over-year. We ended the year 2017 with 706 aircraft in our all-Boeing 737 fleet. We are focused on restoring our fleet to its previous size prior to retiring the 737 Classic fleet, and then growing to approximately 750 aircraft at year-end 2018. Expansion to Hawaii from California is our near-term priority, along with consolidating our Central Michigan operations in Detroit by closing our Flint operation.

The year 2017 brought to a close a significant transformation of Southwest's Customer Experience, beginning with a new boarding process in 2007, to an all-new Rapid Rewards program in 2011, to an all-new reservation system in 2017, to name just a few. This year, 2018, is the first in a decade where we do not have planned a major deployment. So, in addition to readying ourselves for Hawaii service, we are focused on the basics: 1) the Reliability of our Operation; 2) the Hospitality of our Customer Service; and 3) the perpetuation of low operating costs. That is not to say we are done with innovation and change. New technologies will continue to be deployed, and improvements will continue to be enthusiastically pursued. More than anything, 2018 is a time for us to perfect the changes that have been implemented over the last decade and harvest the benefits from these significant investments.

Southwest is stronger than ever, and we are positioned better than ever, to compete in a very competitive airline environment. I am extremely grateful to all of our superb Employees, without whom, there would be no Southwest. They have built a great Company, and for the 24th consecutive year, landed us in the Top 10 of FORTUNE's list of World's Most Admired Companies: #8.

Please join me in thanking all 56,110 Employees for their hard work, Hospitality, can-do spirits, and exceptional results!

Sincerely,

Gary C. Kelly Chairman and Chief Executive Officer March 23, 2018

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark One)

?

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF

1934

For the fiscal year ended December 31, 2017

or

`

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF

1934

For the transition period from

to

Commission File No. 1-7259

Southwest Airlines Co.

(Exact name of registrant as specified in its charter)

TEXAS (State or other jurisdiction of incorporation or organization)

P.O. Box 36611 Dallas, Texas (Address of principal executive offices)

74-1563240 (IRS Employer Identification No.)

75235-1611 (Zip Code)

Registrant's telephone number, including area code: (214) 792-4000

Securities registered pursuant to Section 12(b) of the Act:

Title of Each Class

Name of Each Exchange on Which Registered

Common Stock ($1.00 par value)

New York Stock Exchange

Securities registered pursuant to Section 12(g) of the Act:

None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ? No `

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ` No ?

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ? No `

Indicate by checkmark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ? No `

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. `

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of "large accelerated filer," "accelerated filer," "smaller reporting company," and "emerging growth company" in Rule 12b-2 of the Exchange Act.

Large accelerated filer ? Accelerated filer ` Non-accelerated filer ` Smaller reporting company ` Emerging growth company `

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. `

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ` No ?

The aggregate market value of the common stock held by non-affiliates of the registrant was approximately $37,211,057,645 computed by reference to the closing sale price of the common stock on the New York Stock Exchange on June 30, 2017, the last trading day of the registrant's most recently completed second fiscal quarter.

Number of shares of common stock outstanding as of the close of business on February 5, 2018: 587,950,973 shares

DOCUMENTS INCORPORATED BY REFERENCE Portions of the Definitive Proxy Statement for the Company's Annual Meeting of Shareholders to be held May 16, 2018, are incorporated into Part III of this Annual Report on Form 10-K.

TABLE OF CONTENTS

PART I

Item 1. Business

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Item 1A. Risk Factors

23

Item 1B. Unresolved Staff Comments

32

Item 2. Properties

32

Item 3. Legal Proceedings

33

Item 4. Mine Safety Disclosures

35

PART II

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

Equity Securities

38

Item 6. Selected Financial Data

41

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

43

Liquidity and Capital Resources

61

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

Commitments

64

Critical Accounting Policies and Estimates

67

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

75

Item 8. Financial Statements and Supplementary Data

81

Southwest Airlines Co. Consolidated Balance Sheet

81

Southwest Airlines Co. Consolidated Statement of Income

82

Southwest Airlines Co. Consolidated Statement of Comprehensive Income

83

Southwest Airlines Co. Consolidated Statement of Stockholders' Equity

84

Southwest Airlines Co. Consolidated Statement of Cash Flows

85

Notes to Consolidated Financial Statements

86

Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure

130

Item 9A. Controls and Procedures

130

Item 9B. Other Information

131

PART III

Item 10. Directors, Executive Officers, and Corporate Governance

132

Item 11. Executive Compensation

132

Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder

Matters

132

Item 13. Certain Relationships and Related Transactions, and Director Independence

133

Item 14. Principal Accounting Fees and Services

133

PART IV

Item 15. Exhibits and Financial Statement Schedules

134

Item 16. Form 10-K Summary

141

Signatures

142

Item 1. Business

PART I

Company Overview

Southwest Airlines Co. (the "Company" or "Southwest") operates Southwest Airlines, a major passenger airline that provides scheduled air transportation in the United States and near-international markets. For the 45th consecutive year, the Company was profitable, earning $3.5 billion in net income.

Southwest commenced service on June 18, 1971, with three Boeing 737 aircraft serving three Texas cities: Dallas, Houston, and San Antonio. At December 31, 2017, Southwest operated a total of 706 Boeing 737 aircraft and served 100 destinations in 40 states, the District of Columbia, the Commonwealth of Puerto Rico, and ten near-international countries: Mexico, Jamaica, The Bahamas, Aruba, Dominican Republic, Costa Rica, Belize, Cuba, the Cayman Islands, and Turks and Caicos.

The Company expanded its international footprint during 2017, with the commencement of service to Owen Roberts International Airport in Grand Cayman and Providenciales International Airport in Turks and Caicos, both from Fort Lauderdale-Hollywood International Airport. The Company also commenced service to Cincinnati/Northern Kentucky International Airport in 2017, giving the Company's Customers access to a full complement of the top 50 markets across the 48 contiguous United States.

During 2017, the Company announced plans to begin selling tickets in 2018 for service to Hawaii, subject to requisite governmental approvals, including approval from the Federal Aviation Administration ("FAA") for Extended Operations ("ETOPS"), a regulatory requirement to operate between the U.S. mainland and the Hawaiian Islands. The Company further announced its decision to cease service at Bishop International Airport in Flint, Michigan, with the last day of service on June 6, 2018. In January 2018, the Company announced its intent to begin service at a new commercial aircraft facility at Paine Field in Everett, Washington, scheduled to be completed in 2018.

In 2017, the Company completed its deployment of a new single reservation system, the largest technology project in the Company's history. The new reservation system was designed to improve flight scheduling and inventory management, enable revenue enhancements, support additional international growth, and enable other foundational and operational capabilities.

Further, in 2017, the Company became the first airline in North America to offer scheduled service utilizing Boeing's new, more fuel efficient, 737 MAX 8 aircraft. The Company also retired its remaining Boeing 737-300 aircraft.

Based on the most recent data available from the U.S. Department of Transportation (the "DOT"), as of September 30, 2017, Southwest was the largest domestic air carrier in the United States, as measured by the number of domestic originating passengers boarded.

Industry

The airline industry has historically been an extremely volatile industry subject to numerous challenges. Among other things, it has been cyclical, energy intensive, labor intensive, capital

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intensive, technology intensive, highly regulated, heavily taxed, and extremely competitive. The airline industry has also been particularly susceptible to detrimental events such as acts of terrorism, poor weather, and natural disasters.

The U.S. airline industry benefited from modest economic growth during 2017 and was further aided by a relatively stable fuel environment. In recent years, the U.S. airline industry, including Southwest, has increased available seat miles (also referred to as "capacity," an available seat mile is one seat, empty or full, flown one mile and is a measure of space available to carry passengers in a given period), and has increased the number of seats per trip (or "gauge") through slimline seat retrofits and the use of larger aircraft. Strategic capacity increases are expected to continue in 2018.

In 2017, the airline industry continued to be impacted by the significant growth of "Ultra-Low Cost Carriers" ("ULCCs"). ULCCs offer "unbundled" service offerings, which enable them to appeal to price-sensitive travelers through promotion to consumers of an extremely low relative base fare for a seat, while separately charging for related services and products. In response, certain major U.S. airlines (sometimes referred to as "legacy" or "network" carriers) have introduced new fare products, such as a "Basic Economy" product. The Basic Economy product provides for a lower base fare to compete with a ULCC base fare, but includes significant additional restrictions on amenities such as seat assignments (including restrictions on group and family seating), order of boarding, checked baggage and use of overhead bin space, flight changes and refunds, and eligibility for upgrades. Also in response to ULCC pricing, some legacy carriers have removed their fare floors for certain routes, leading to lower fares across the industry. Conversely, some legacy carriers offer a "Premium Economy" fare that targets consumers willing to pay extra for additional amenities such as more favorable seating options in segmented aircraft.

Company Operations

Route Structure

Southwest principally provides point-to-point service, rather than the "hub-and-spoke" service provided by most major U.S. airlines. The hub-and-spoke system concentrates most of an airline's operations at a limited number of central hub cities and serves most other destinations in the system by providing one-stop or connecting service through a hub. By not concentrating operations through one or more central transfer points, Southwest's point-to-point route structure has allowed for more direct nonstop routing than hub-and-spoke service. Approximately 76 percent of the Company's Customers flew nonstop during 2017, and, as of December 31, 2017, Southwest served 675 nonstop city pairs.

Southwest's point-to-point service has also enabled it to provide its markets with frequent, conveniently timed flights and low fares. For example, Southwest currently offers 19 weekday roundtrips between Dallas Love Field and Houston Hobby, 12 weekday roundtrips between Burbank and Oakland, 12 weekday roundtrips between San Diego and San Jose, eight weekday roundtrips between Denver and Chicago Midway, and 10 weekday roundtrips between Los Angeles International and Las Vegas.

Southwest complements its high-frequency short-haul routes with long-haul nonstop service between markets such as Los Angeles and Nashville, Las Vegas and Orlando, San Diego and Baltimore, Houston and New York LaGuardia, and Oakland and Baltimore. During 2017, the Company introduced the Boeing 737 Max 8 to its fleet and continued to incorporate the Boeing 737-800 aircraft into its fleet, both of which offer significantly more Customer seating capacity than the Company's

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other aircraft. This has enabled the Company to more economically serve long-haul routes, as well as high-demand, slot-controlled, and gate-restricted airports, by adding seats for such routes without increasing the number of flights (a "slot" is the right of an air carrier, pursuant to regulations of the FAA, to operate a takeoff or landing at a specific time at certain airports). For 2017, the Company's average aircraft trip stage length was 754 miles, with an average duration of approximately 2.0 hours, as compared with an average aircraft trip stage length of 760 miles and an average duration of approximately 2.0 hours in 2016.

The Company continued its focus on California in 2017, and continues to invest significant resources to solidify its leadership position in California, including the planned addition of new domestic and international destination options and flights for California Customers, as well as additional marketing programs, loyalty incentives, and local outreach efforts designed to retain, engage, and acquire Customers. Based on the most recent data available from the DOT, for the year ending October 31, 2017, Southwest carried more domestic Revenue Passengers to, from, and within California than any other airline.

The Company ended 2017 with international service to 14 destinations through 16 international gateway cities within the 48 contiguous United States. During 2017, the Company commenced international service out of Oakland, San Diego, Nashville, and St. Louis. In addition, the Company announced commencement in 2018 of international service out of Indianapolis, San Jose, Sacramento, Columbus, New Orleans, Pittsburgh, and Raleigh-Durham. The Company has also concentrated its service to Cuba in Havana and ceased operations during 2017 to Varadero and Santa Clara, Cuba.

In 2017, to further support its near-international operations, the Company opened a new five-gate international concourse at Fort Lauderdale-Hollywood International Airport (FLL). The Company expanded its international flight schedule for South Florida to a total of nine international nonstop destinations including Montego Bay, Jamaica; Belize City, Belize; Cancun, Mexico; Grand Cayman; Havana, Cuba; Nassau, The Bahamas; San Jose, Costa Rica; Punta Cana, Dominican Republic; and Turks and Caicos. Additional information regarding the Company's involvement with construction of the new concourse at FLL is provided below under "Management's Discussion and Analysis of Financial Condition and Results of Operations" and in Note 4 to the Consolidated Financial Statements.

Approximately $595 million, approximately $383 million, and approximately $287 million of the Company's operating revenues in 2017, 2016, and 2015, respectively, were attributable to foreign operations. The remainder of the Company's operating revenues, approximately $20.6 billion, approximately $20.0 billion, and approximately $19.5 billion in 2017, 2016, and 2015, respectively, were attributable to domestic operations. The Company's assets are not allocated to a geographic area because the Company's tangible assets primarily consist of flight equipment, the majority of which are interchangeable and are deployed systemwide, with no individual aircraft dedicated to any specific route or region.

Cost Structure

A key component of the Company's business strategy is its focus on cost discipline and profitably charging competitively low fares. Adjusted for stage length, the Company has lower unit costs, on average, than the majority of major domestic carriers. The Company's strategy includes the use of a single aircraft type, the Boeing 737, the Company's operationally efficient point-to-point route structure, and its highly productive Employees. Southwest's use of a single aircraft type allows for

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