SOUTHWEST AIRLINES CO (LUV) FY 2023 MD&A

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

YEAR IN REVIEW

The Company had record full year 2023 revenue performance, producing operating revenues of $26.1 billion, due to healthy leisure demand and continued yield strength combined with record ancillary revenue, loyalty program revenue, and passengers carried. The Company’s 2022 results were somewhat impacted by the COVID-19 pandemic, as the Omicron variant of COVID-19 both impacted travel demand and created staffing challenges for the Company, particularly during January and February 2022. However, strong travel demand, especially associated with leisure travel, accelerated during March 2022 and continued through 2023. In 2023, the Company was able to focus on completing a comprehensive winter action plan, restoring its network and operational stability, reaching full utilization of its fleet, and delivering on significant new capabilities for its Customers.

In late December 2022, the Company experienced a wide-scale operational disruption as extreme winter weather across a significant portion of the United States impacted its operational plan and flight schedules. Subsequent to Winter Storm Elliott, the Company was challenged to realign flight crews, flight schedules, and aircraft for a period of several days during this peak demand travel period. This disruption and subsequent recovery efforts resulted in the cancellation of more than 16,700 flights during the period from December 21 through December 31, 2022. For fourth quarter 2022, the Company estimated the financial impact of this disruption was approximately $800 million on a pre-tax basis. A significant portion of this impact in fourth quarter 2022 was due to the loss of Operating revenue associated with the flight cancellations that was estimated to be approximately $410 million, and the remaining impact primarily related to a net increase of approximately $390 million in operating expenses, primarily due to travel expense reimbursements to Customers, the estimated value of Rapid Rewards points offered as a gesture of goodwill to Customers that were expected to be redeemed, and premium pay and additional compensation for Employees, which were partially offset by lower fuel and oil and profitsharing expenses. For first quarter 2023, these events also created a deceleration in bookings, largely isolated to January and February 2023, as well as additional expenses primarily in the form of reimbursing Customers for costs incurred as a result of the flight cancellations. The financial impact of this disruption on first quarter 2023 results was approximately $380 million on a pre-tax basis. On October 27, 2023, the Department of Transportation ("DOT") notified the Company that it determined the Company had failed to provide adequate customer service assistance, prompt flight status notifications, and proper and prompt refunds and that the assessment of a civil penalty was warranted. During fourth quarter 2023, the Company accrued an expense of $107 million associated with a settlement reached with the DOT in December 2023 based on their investigation into the disruption, which includes a cash penalty and incorporates a future commitment for Southwest Customer care with a new Customer compensation policy. An additional $33 million penalty was also assessed by the DOT, but was able to be credited against the substantial value the Company had already provided to its Customers impacted by the disruption, and therefore did not result in further impact to the Company's financial results for 2023. Other than the fourth quarter 2023 charge associated with the DOT settlement, there were no material impacts to operating revenues or expenses as a result of this disruption beyond first quarter 2023.

To boost operational resiliency in key areas across the Company and to mitigate the risk of a recurrence, the Company developed a three-part tactical action plan focused on improving winter operations, accelerating

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operational-related investments, and enhancing cross-team collaboration. The Company's action plan was released in March 2023 and key winter operations steps were completed as of October 2023, as planned.

The Company recorded results for 2023 and 2022, on an accounting principles generally accepted in the United States ("GAAP") and non-GAAP basis, 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 Company's financial results, as shown above on a GAAP and non-GAAP basis for the year ended December 31, 2023 versus the year ended December 31, 2022, were affected by higher salaries, wages, and benefits expense and maintenance materials and repairs expense. On a GAAP basis, the Company's results for the year ended December 31, 2023 included incremental expense of $180 million for changes in estimate related to the contract ratification bonus for the Company's Flight Attendants as part of a tentative agreement reached in October 2023 and an incremental expense of $354 million for changes in estimate related to the contract ratification bonus for the Company's Pilots as part of a tentative agreement reached in December 2023, both of which were treated as special items and excluded from the Company's presentation of non-GAAP results. Additionally, due to the December 2022 operational disruption, as described above, the financial results on a GAAP and non-GAAP basis for the year ended December 31, 2023 included a negative financial impact of approximately $380 million on a pre-tax basis in first quarter 2023 and, on a GAAP basis, a $107 million charge on a pre-tax basis for the DOT settlement in fourth quarter 2023. The expense related to the tentative agreement with Pilots combined with the charge related to the settlement with the DOT resulted in the Company reporting a net loss of $252 million on a GAAP basis for fourth quarter 2023. Furthermore, on a GAAP and non-GAAP basis, the financial results for the year ended December 31, 2022 included a negative financial impact of approximately $800 million on a pre-tax basis in fourth quarter 2022 related to the December 2022 operational disruption and, on a GAAP basis, the financial results for the year ended December 31, 2022 included a $193 million pre-tax loss on extinguishment of debt primarily due to the repurchase of a portion of the Company's May 1, 2020 public offering of $2.3 billion aggregate principal amount of Convertible Senior notes (the "Convertible Notes"). 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.

Operating Statistics

The Company provides the operating data below for the years ended December 31, 2023 and 2022 because these statistics are commonly used in the airline industry and, therefore, allow readers to compare the Company’s performance against its results for the prior year period, as well as against the performance of the Company’s peers.

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(a)A revenue passenger mile is one paying passenger flown one mile. Also referred to as "traffic," which is a measure of demand for a given period.

(b)An available seat mile is one seat (empty or full) flown one mile. Also referred to as "capacity," which is a measure of the space available to carry passengers in a given period.

(c)Revenue passenger miles divided by available seat miles.

(d)Seats flown is calculated using total number of seats available by aircraft type multiplied by the total trips flown by the same aircraft type during a particular period.

(e)Seats per trip is calculated by dividing seats flown by trips flown.

(f)Calculated as passenger revenue divided by revenue passenger miles. Also referred to as "yield," this is the average cost paid by a paying passenger to fly one mile, which is a measure of revenue production and fares.

(g)Calculated as operating revenues divided by available seat miles. Also referred to as "operating unit revenues" or "RASM," this is a measure of operating revenue production based on the total available seat miles flown during a particular period.

(h)Calculated as passenger revenue divided by available seat miles. Also referred to as "passenger unit revenues," this is a measure of passenger revenue production based on the total available seat miles flown during a particular period.

(i)Calculated as operating expenses divided by available seat miles. Also referred to as "unit costs" or "cost per available seat mile," this is the average cost to fly an aircraft seat (empty or full) one mile, which is a measure of cost efficiencies.

(j)Included four Boeing 737-700 ("700") Next Generation aircraft in temporary storage as of December 31, 2022.

2024 Outlook

The following tables present selected financial guidance for first quarter and full year 2024:

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(a) Operating revenue per available seat mile ("RASM" or "unit revenues").

(b) Available seat miles ("ASMs" or "capacity"). The Company's flight schedule is currently published for sale through October 2, 2024. The Company currently expects second quarter 2024 capacity to increase in the range of 8 percent to 10 percent, year-over-year, and third quarter 2024 capacity to increase in the range of 3 percent to 5 percent, year-over-year.

(c) See Note Regarding Use of Non-GAAP Financial Measures for additional information on special items. In addition, information regarding special items and economic results is included in the accompanying table Reconciliation of Reported Amounts to Non-GAAP Items (also referred to as "excluding special items").

(d) Based on the Company's existing fuel derivative contracts and market prices as of January 17, 2024, first quarter and full year 2024 economic fuel costs per gallon are estimated to be in the range of $2.70 to $2.80 and $2.55 to $2.65, respectively. Economic fuel cost projections do not reflect the potential impact of special items because the Company cannot reliably predict or estimate the hedge accounting impact associated with the volatility of the energy markets, or the impact to its financial statements in future periods. Accordingly, the Company believes a reconciliation of non-GAAP financial measures to the equivalent GAAP financial measures for projected results is not meaningful or available without unreasonable effort. See Note Regarding Use of Non-GAAP Financial Measures.

(e) Operating expenses per available seat mile, excluding fuel and oil expense, special items, and profitsharing ("CASM-X").

(f) Projections do not reflect the potential impact of fuel and oil expense, special items, and profitsharing because the Company cannot reliably predict or estimate those items or expenses or their impact to its financial statements in future periods, especially considering the significant volatility of the fuel and oil expense line item. Accordingly, the Company believes a reconciliation of non-GAAP financial measures to the equivalent GAAP financial measures for these projected results is not meaningful or available without unreasonable effort.

(g) Aircraft on property, end of period. The Company currently plans for approximately 79 Boeing 737 MAX ("MAX") aircraft deliveries and 49 aircraft retirements in 2024, including 45 Boeing 737-700s ("-700") and four Boeing 737-800s ("-800"). The delivery schedule for the 737-7 ("-7") is dependent on the Federal Aviation Administration ("FAA") issuing required certifications and approvals to The Boeing Company ("Boeing") and the Company. The FAA will ultimately determine the timing of the -7 certification and entry into service, and Boeing may continue to experience supply chain challenges, so the Company offers no assurances that current estimations and timelines will be met.

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The Company expects first quarter 2024 RASM to increase in the range of 2.5 percent to 4.5 percent, year-over-year. This increase includes an approximate five point tailwind due to the negative revenue impact incurred in first quarter 2023 associated with the December 2022 operational disruption. Sequentially, the performance represents a healthy improvement driven primarily by network optimization, market share contributions from the Company's Global Distribution System initiative, growth in the Rapid Rewards loyalty program, and continued strength in overall demand. The network optimization is materially complete with the March 2024 schedule, at which point the Company expects a return to profitability.

The Company currently expects its first quarter 2024 CASM-X to increase in the range of 5 percent to 6 percent, year-over-year. Approximately two to three points of the increase are driven by higher 2024 market wage rate accruals for Employee workgroups with open agreements and for overall 2024 labor cost increases, including the wage rate increases and agreed-upon work rule changes associated with the recently ratified Pilot contract. The majority of the remaining increase is driven by year-over-year pressure from maintenance expenses.

Furthermore, the Company currently expects similar cost pressures throughout the year, driving 2024 CASM-X to increase approximately 5.5 percent to 7 percent, year-over-year. Specifically, the Company expects approximately four to five points of the increase to be driven by higher year-over-year labor costs, and the balance of the increase is driven primarily by higher year-over-year maintenance expenses. Progressing through the year, the Company's focus will be on regaining efficiencies to counter inflationary cost pressures. To this end, the Company plans to end the year with headcount in the range of flat to down on a year-over-year basis.

The Company's 2024 plan leverages a set of initiatives, which most importantly, includes better aligning the route network to new demand patterns. The Company expects these initiatives to contribute roughly $1.5 billion in incremental year-over-year pre-tax profits. As a result, the Company expects double-digit year-over-year operating revenue growth and year-over-year operating margin expansion. The Company believes its 2024 plan provides a line of sight to improve profitability year-over-year, earn its cost of capital this year, and provide significant progress toward its long-term goal to exceed its cost of capital.

Company Overview

The Company ended 2023 with 817 Boeing 737 aircraft, including 223 Boeing 737-8 ("-8") aircraft. During 2023, the Company retired 39 -700 aircraft and took delivery of 86 -8 aircraft. On October 25, 2023, the Company secured an order book with Boeing that is expected to help modernize the Company's fleet with less carbon-intensive aircraft and enable the Company's long-term plan for orderly and measured growth. The Company's order book with Boeing as of January 25, 2024, consists of a total of 495 MAX firm orders (307 -7 aircraft and 188 -8 aircraft) for the years 2024 through 2031 and 199 MAX options (-7s or -8s) for the years 2025 through 2031. The Company is currently planning for approximately 79 MAX aircraft deliveries in 2024, which differs from its contractual order book due to Boeing's continued supply chain challenges and the current status of the -7 certification. The Company plans to retire approximately 49 aircraft, including 45 -700s and four -800s, ending 2024 with roughly 847 aircraft in its fleet. The timing of future deliveries could be affected by any potential or prolonged delays in the manufacturing process or with the -7 certification. The Company retains significant flexibility to manage its fleet size, including opportunities to accelerate fleet modernization efforts if growth opportunities do not materialize.

The Company has published its flight schedule through October 2, 2024. The Company continues to focus on operational excellence and reliability, regaining efficiencies, increasing productivity, and returning margins back to historical levels.

For the year ended December 31, 2023, the Company added approximately 8,100 Employees, net of attrition. The Company's number of active full-time equivalent Employees increased by 12.2 percent from December 31, 2022 to December 31, 2023, primarily to support the Company's restoration of its flight schedule after emerging from the pandemic, as well as the year-over-year growth in its fleet. The Company has made additional investments to attract

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and retain talent, including raising the Company's starting hourly pay rates for certain of its workgroups, subject, in each case, to acceptance of such change by the applicable union.

During third quarter 2023, the Company announced two new benefits as part of an ongoing commitment to provide Customers with more choices, more flexibility, and more value when they fly Southwest. Customers traveling on Wanna Get Away fares now are able to make same-day standby changes and add standby listings online or on the Southwest app. Previously, only Rapid Rewards Tier Members and Customers traveling on Business Select, Anytime, and Wanna Get Away Plus fares had flexibility to list on a different flight free of charge on their day of scheduled travel. This new offering expands the same-day standby benefit to all Southwest Customers. The Company also began offering free Inflight Internet for Customers who purchase a Business Select fare.

During October 2023, the Company announced enhancements to its Rapid Rewards loyalty program to reward loyal Members by making it easier for Customers to earn tier status, awarding A-List Preferred Members with up to two complimentary premium drinks, and, starting in spring of 2024, allowing Customers to pay for flights by using a combination of cash and Rapid Rewards points, starting with as few as 1,000 points.

The Company's Board of Directors (the "Board") reinstated and declared a quarterly cash dividend of $0.18 per share on December 6, 2022, which was paid in first quarter 2023, and has continued to pay quarterly dividends through 2023. The Company previously suspended the payment of dividends in second quarter 2020 through September 30, 2022, pursuant to payroll funding support agreements with the U.S. Department of the Treasury ("Treasury"). The Company's current quarterly dividend of $0.18 per share, or $0.72 per share annualized, is equivalent to its quarterly dividend prior to the pandemic. During 2023, the Company returned $429 million to Shareholders in dividend payments.

On November 2, 2023, the Company announced an offtake agreement with USA BioEnergy, LLC, for up to 680 million gallons of neat sustainable aviation fuel ("SAF"). The Company plans to begin purchasing SAF from USA BioEnergy's facility near Bon Wier, Texas, as early as 2028. Additionally, as part of the offtake agreement, the Company and USA BioEnergy have established a long-term strategic relationship offering the Company the opportunity to purchase up to another projected 180 million gallons of SAF per year from future planned production facilities.

As part of its commitment to corporate sustainability, the Company published its 2022 One Report describing the Company's sustainability strategies on May 3, 2023, which include the Company’s fuel conservation and emissions mitigation initiatives and other efforts to minimize greenhouse gas emissions and address other environmental matters such as energy and water conservation, waste minimization, and recycling. The Company also published its Diversity, Equity, and Inclusion ("DEI") Report on May 3, 2023. A companion piece to the One Report, the DEI Report takes a deeper dive into the Company's DEI goals and initiatives and highlights the Company's DEI plans for the future. Information contained in the Southwest One Report and/or the DEI Report is not incorporated by reference into, and does not constitute a part of, this Form 10-K. While the Company believes that the disclosures contained in the Southwest One Report, the DEI Report, and other voluntary disclosures regarding environmental, social, and governance (“ESG”) matters are responsive to various areas of investor interest, the Company believes that certain of these disclosures do not currently address matters that are material in the near term to the Company’s operations, strategy, financial condition, or financial results, although this view may change in the future based on new information that could materially alter the estimates, assumptions, or timelines used to create these disclosures. Given the estimates, assumptions, and timelines used to create the Southwest One Report, the DEI Report, and other voluntary disclosures, the materiality of these disclosures is inherently difficult to assess.

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2023 Compared with 2022

Operating Revenues

Passenger revenues for 2023 increased by $2.2 billion, or 10.4 percent, compared with 2022. On a unit basis, Passenger revenues decreased 3.7 percent, year-over-year. The dollar increase was primarily due to a 14.7 percent increase in capacity, combined with healthy leisure demand and continued yield strength for 2023 versus 2022. For 2023, the year-over-year Passenger revenue yield per ASM decrease was primarily driven by a 3.4 point decrease in Load factor as the capacity growth of 14.7 percent outpaced the growth in Revenue passenger miles of 10.0 percent.

Other revenues for 2023 increased by $50 million, or 2.2 percent, compared with 2022. On a dollar basis, the increase was primarily due to additional marketing revenue from Chase Bank USA, N.A., driven by improved retail spend on the Company's co-brand credit cards.

Operating Expenses

Operating expenses for 2023 increased by $3.1 billion, or 13.5 percent, compared with 2022, and capacity increased 14.7 percent over the same prior year period. Approximately 60 percent of the operating expenses increase was due to higher Salaries, wages, and benefits expense (inclusive of accruals related to anticipated pay raises associated with open collective bargaining agreements) and approximately 10 percent was due to higher Maintenance, materials, and repairs expense. 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 2023 and 2022, followed by explanations of these changes on a dollar basis. Unless otherwise specified, changes on a per ASM basis were driven by changes in capacity, which increased with the improvement in travel demand and the Company's focus on restoring its network, causing the Company's fixed costs to be spread over significantly more ASMs.

Operating expenses per ASM for 2023 decreased by 1.1 percent, compared with 2022. The majority of the year-over-year unit cost decrease was driven by a decrease in the Company's fuel cost per gallon, partially offset by higher salaries, wages, and benefits expense. Operating expenses per ASM for 2023, excluding Fuel and oil expense, profitsharing, and special items (a non-GAAP financial measure), decreased 1.2 percent, year-over-year. 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 2023 increased by $1.8 billion, or 18.9 percent, compared with 2022. On a per ASM basis, Salaries, wages, and benefits expense for 2023 increased 3.8 percent, compared with 2022. On a dollar basis, approximately 45 percent of the increase was due to step/pay rate increases for certain workgroups, including market wage rate accruals for open collective bargaining agreements (inclusive of $180 million and $354 million on a GAAP basis in additional compensation related to past services negotiated as part of the tentative agreements reached with the Transport Workers Union 556 ("TWU 556") and SWAPA, respectively) and approximately 20 percent of the increase was driven by an increase in capacity and trips flown. 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 measures.

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The following table sets forth the Company’s unionized Employee groups with contracts that are currently in negotiations on collective-bargaining agreements:

On January 31, 2023, the Company's 50 Facilities Maintenance Technicians, represented by the Aircraft Mechanics Fraternal Association ("AMFA"), ratified a new four-year collective bargaining agreement with the Company. The newly ratified agreement becomes amendable in November 2027.

On February 4, 2023, the Company's more than 470 Dispatchers, represented by the Transportation Workers of America, AFL-CIO, Local 550 ("TWU 550"), ratified a new four-year collective bargaining agreement with the Company. The newly ratified agreement becomes amendable in June 2027.

On April 30, 2023, the Company's 12 Meteorologists, represented by TWU 550, ratified a new five-year collective bargaining agreement with the Company. The newly ratified agreement becomes amendable in May 2028.

On July 27, 2023, the Company's 2,865 Mechanics & Related Employees, represented by AMFA, voted to ratify a four-year contract extension with the Company. The newly ratified agreement becomes amendable in August 2027.

On August 15, 2023, the Company reached a tentative collective-bargaining agreement with TWU 555, which represents the Company's nearly 18,000 Ramp, Operations, Provisioning, and Freight Agents. However, during September 2023, TWU 555 membership voted not to ratify the agreement. The Company will continue to engage in discussions on a new agreement with TWU 555.

On October 6, 2023, the Company's more than 480 Material Specialists, represented by IBT, voted to ratify a three-year contract extension with the Company. The newly ratified agreement becomes amendable in October 2026.

On October 25, 2023, the Company reached a tentative collective-bargaining agreement with TWU 556, which represents the Company's nearly 20,000 Flight Attendants. However, during December 2023, TWU 556 membership voted not to ratify the agreement. The Company will continue to engage in discussions on a new agreement with TWU 556.

On January 22, 2024, the Company's nearly 11,000 Pilots, represented by SWAPA, voted to ratify a five-year contract extension with the Company. The newly ratified agreement becomes amendable in January 2029.

Fuel and oil expense for 2023 increased by $242 million, or 4.1 percent, compared with 2022. On a per ASM basis, Fuel and oil expense for 2023 decreased 9.4 percent. On a dollar basis, the increase was primarily attributable to an increase in fuel gallons consumed, partially offset by a decrease in jet fuel prices per gallon. On a per ASM basis, the decrease was primarily due to lower jet fuel prices. The following table provides more information on the Company's economic fuel cost per gallon, including the impact of fuel hedging premium expense and fuel derivative contracts:

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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 2023 available seat miles per gallon ("fuel efficiency") improved 2.8 percent, year-over-year, due to lower load factors and more -8 aircraft, the Company's most fuel-efficient aircraft, as a percentage of its fleet. The continued deliveries of MAX aircraft are expected to remain critical to the Company's efforts to modernize its fleet, reduce carbon emissions intensity, and achieve its near-term environmental sustainability goals.

In addition, the Company is providing its maximum percentage of estimated fuel consumption covered by fuel derivative contracts in the following table:

(a) Based on the Company's current available seat mile plans. The Company is currently 60 percent hedged in first quarter 2024, 55 percent hedged in second quarter 2024, and 56 percent hedged in second half 2024.

(b) The Company's maximum fuel hedged percentage is calculated using the maximum number of gallons that are covered by derivative contracts divided by the Company's estimate of total fuel gallons to be consumed for each respective period. The Company's maximum number of gallons that are covered by derivative contracts may be at different strike prices and at strike prices materially higher than the current market prices. The volume of gallons covered by derivative contracts that ultimately get exercised in any given period may vary significantly from the volumes used to calculate the Company's maximum fuel hedged percentages, as market prices and the Company's fuel consumption fluctuate.

As a result of applying hedge accounting in prior periods, the Company has amounts in Accumulated other comprehensive income ("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 11 to the Consolidated Financial Statements for further information), as well as the deferred amounts in AOCI as of December 31, 2023, and the expected future periods in which these items are expected to settle and/or be recognized in earnings (in millions):

The Company's multi-year fuel hedging program continues to provide protection against spikes in energy prices. The Company's current fuel derivative contracts contain a combination of instruments based in West Texas Intermediate and Brent crude oil. The economic fuel price per gallon sensitivities provided in the table below assume the relationship between Brent crude oil and refined products based on market prices as of January 17, 2024.

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(a) Brent crude oil average market prices as of January 17, 2024, were approximately $77 and $76 per barrel for first quarter 2024 and full year 2024, respectively.

(b) Based on the Company's existing fuel derivative contracts and market prices as of January 17, 2024, first quarter and full year 2024 economic fuel costs per gallon are estimated to be in the range of $2.70 to $2.80 and $2.55 to $2.65, respectively. Economic fuel cost projections do not reflect the potential impact of special items because the Company cannot reliably predict or estimate the hedge accounting impact associated with the volatility of the energy markets, or the impact to its financial statements in future periods. Accordingly, the Company believes a reconciliation of non-GAAP financial measures to the equivalent GAAP financial measures for projected results is not meaningful or available without unreasonable effort. See Note Regarding Use of Non-GAAP Financial Measures.

Maintenance materials and repairs expense for 2023 increased by $336 million, or 39.4 percent, compared with 2022. On a per ASM basis, Maintenance materials and repairs expense increased 20.7 percent, compared with 2022. On a dollar and per ASM basis, approximately 70 percent of the increase was due to an increase in engine shop visits and the remainder of the increase was due to various other engine repairs. The number of engines inducted for planned performance restoration shop visits for the Company’s -700 fleet increased as a result of utilization. Planned shop visits for the -800 fleet increased as the -800 aircraft emerged from their maintenance “honeymoon” period during which the engines have required significantly lower levels of maintenance while in the early phases of their useful lives.

Landing fees and airport rentals expense for 2023 increased by $281 million, or 18.6 percent, compared with 2022. On a per ASM basis, Landing fees and airport rentals expense increased 2.9 percent, compared with 2022. On a dollar basis, approximately 45 percent of the increase was largely due to higher airport rental expense throughout the network, associated with both higher rates and additional space leased at airports, and approximately 40 percent of the increase was attributable to higher landing fees, primarily driven both by the increase in trips flown and higher rates charged by airports.

Depreciation and amortization expense for 2023 increased by $171 million, or 12.7 percent, compared with 2022. On a per ASM basis, Depreciation and amortization expense decreased by 2.2 percent, compared with 2022. On a dollar basis, approximately 65 percent of the increase was primarily due to the acquisition of 86 -8 aircraft since 2022. The majority of the remainder was due to accelerating the depreciation for certain -700 aircraft planned for early retirement in 2023 and 2024.

Other operating expenses for 2023 increased by $264 million, or 7.1 percent, compared with 2022. Included within this line item was aircraft rentals expenses in the amount of $198 million and $195 million for 2023 and 2022, respectively. On a per ASM basis, Other operating expenses decreased 6.4 percent, compared with 2022. On a dollar basis, the increase was due to (i) higher professional fees, driven by an increase in technology projects, (ii) higher personnel expenses, driven by an increase in Crew lodging expenses associated with the increase in capacity and inflationary pressure, and (iii) an increase driven by recording the $107 million DOT settlement in December

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2023. The majority of the remaining increase was due to various flight-driven expenses. These increases were partially offset by a decrease in costs associated with the Company's December 2022 Operational Disruption, the majority of which were accrued in 2022.

Other expenses (income)

Interest expense for 2023 decreased by $81 million, or 23.8 percent, compared with 2022, primarily due to various debt repurchases in 2022.

Capitalized interest for 2023 decreased by $16 million, or 41.0 percent, compared with 2022, primarily due to a significant amount of assets being placed into service, most notably 86 -8 aircraft being delivered since 2022.

Interest income for 2023 increased by $366 million, compared with 2022, primarily due to higher interest rates earned on the Company's cash and short-term investments.

Loss on extinguishment of debt for 2023 decreased by $193 million, compared with 2022, primarily due to the partial extinguishment of the Company's Convertible Notes in 2022, compared with none in 2023.

Other (gains) losses, net, primarily includes amounts recorded as a result of the Company's deferred compensation and hedging activities. See Note 11 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 2023 and 2022:

Income Taxes

The Company's annual 2023 effective tax rate was 26.5 percent, compared with 25.9 percent in 2022. The year-over-year increase in the tax rate is primarily due to the DOT settlement, which is treated as a disallowed tax deduction in 2023, and higher state taxes. The rate increases were partially offset by the absence of repurchases of the Convertible Notes which resulted in disallowed tax deductions and a higher tax rate in 2022.

2022 Compared with 2021

The Company's comparison of 2022 results to 2021 results is included in the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2022, under Part II Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations.

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

(a) Represents changes in estimate related to the contract ratification bonus for the Company’s Flight Attendants as part of the tentative agreement reached in October 2023 with TWU 556. The Company began accruing for all of its open labor contracts on April 1, 2022, and this incremental $180 million expense extends the timeframe covered by the ratification bonus to the date the Flight Attendant contract became amendable on November 1, 2018, to compensate for missed wage increases over that time period. The Company’s consolidated financial statements for the year ended December 31, 2023 include market rate wage accrual for all workgroups with open collective bargaining agreements. See the Note Regarding Use of Non-GAAP Financial Measures for further information.

(b) Represents changes in estimate related to the contract ratification bonus for the Company’s Pilots as part of the tentative agreement reached in December 2023 with SWAPA. The Company began accruing for all of its open labor contracts on April 1, 2022, and this incremental $354 million expense represents an increase in retroactive pay associated with wage rates for purposes of calculating the ratification bonus agreed to for Pilots for periods prior to 2023. See the Note Regarding Use of Non-GAAP Financial Measures for further information.

(c) See Note 11 to Consolidated Financial Statements for further information.

(d) 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.

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

(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 in the denominator adjusts for the cumulative impacts, in Accumulated other comprehensive income and Retained earnings, of gains and/or losses that will settle in future periods, including those associated with the Company's fuel hedges. 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 full year tax rate as of December 31, 2023, was 26.5 percent, and the full year Non-GAAP tax rate was 23.5 percent. See Note Regarding Use of Non-GAAP Financial Measures for additional information.

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Note Regarding Use of Non-GAAP Financial Measures

The Company's Consolidated Financial Statements are prepared in accordance with GAAP. These GAAP financial statements may 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 expenses, non-GAAP excluding Fuel and oil expense; Operating expenses, non-GAAP excluding Fuel and oil expense and profitsharing; Operating income, non-GAAP; Other (gains) losses, net, non-GAAP; Income before income taxes, non-GAAP; Provision for income taxes, net, non-GAAP; Net income, non-GAAP; Net income per share, diluted, non-GAAP; and Operating expenses per ASM, non-GAAP, excluding Fuel and oil expense and profitsharing (cents). 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 into 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 11 to the Consolidated Financial Statements.

The Company’s GAAP results in the applicable periods may 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. For the periods presented, in addition to the items discussed above, special items include:

1.Incremental expense associated with the recently ratified Pilot contract and ongoing labor contract negotiations with TWU 556 which represents the Company's Flight Attendants. The change in estimate recognized in 2023 relates to additional compensation for services performed by Employees outside of the applicable fiscal period;

2.Noncash impairment charges, primarily associated with adjustments to the salvage values for previously retired airframes;

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3.A charge associated with a settlement reached with the DOT as a result of the Company's December 2022 operational disruption;

4.A charge associated with a tentative litigation settlement regarding certain California state meal-and-rest-break regulations for flight attendants;

5.Unrealized mark-to-market adjustment associated with certain available for sale securities; and

6.Losses associated with the partial extinguishment of the Company's Convertible Notes and early prepayment of debt. Such losses are incurred as a result of opportunistic decisions made by the Company to prepay portions of its debt, most of which was incurred during the pandemic in order to provide liquidity during the prolonged downturn in air travel.

Because management believes special 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 special 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: Fuel and oil expense, non-GAAP; Total operating expenses, non-GAAP; Operating expenses, non-GAAP excluding Fuel and oil expense; Operating expenses, non-GAAP excluding Fuel and oil expense and profitsharing; Operating income, non-GAAP; Other (gains) losses, net, non-GAAP; Income before income taxes, non-GAAP; Provision for income taxes, net, non-GAAP; Net income, non-GAAP; Net income per share, diluted, non-GAAP; and Operating expenses per ASM, non-GAAP, excluding Fuel and oil expense and profitsharing (cents).

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 "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.

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Liquidity and Capital Resources

The enormous impact of the COVID-19 pandemic on the U.S. travel industry created an urgent liquidity crisis for the entire airline industry, including the Company. However, due to the Company's pre-pandemic low balance sheet leverage, large base of unencumbered assets, and investment-grade credit ratings, the Company was able to quickly access additional liquidity during 2020, as Customer cancellations and ticket refunds spiked and sales and revenues dropped while the Company continued to experience significant fixed operating expenses. See Note 2 and Note 7 to the Consolidated Financial Statements for further information regarding the impact of the COVID-19 pandemic, as well as the transactions completed and financial assistance obtained from Treasury under payroll support programs.

Net cash provided by operating activities for 2023 was $3.2 billion, and net cash provided by operating activities for 2022 was $3.8 billion. Operating cash inflows are historically 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 2023 were largely impacted by the Company's net income (as adjusted for noncash items), a $29 million increase in Air traffic liability driven by higher ticket sales related to an increase in travel demand, partially offset by a $273 million decrease related to the purchase of fuel derivative instruments, which is included within Other, net operating cash flows in the accompanying Consolidated Statement of Cash Flows (see Note 11 to the Consolidated Financial Statements for further information), and a $215 million decrease due to the payment of Customer reimbursement expenses in first quarter 2023 related to the December 2022 operational disruption. Operating cash flows for 2022 included a $525 million increase in Air traffic liability driven by increased ticket sales related to an increase in leisure travel demand, a $472 million cash tax refund associated with the 2020 tax year, and a $139 million cash excise tax refund, partially offset by an $81 million decrease related to the purchase of fuel derivative instruments. Net cash provided by operating activities is primarily used to finance capital expenditures, repay debt, and provide working capital. Historically, the Company has also used Net cash provided by operating activities to fund stock repurchases and pay dividends. The Board reinstated and declared a quarterly cash dividend of $0.18 per share on December 6, 2022, and has continued to pay quarterly dividends through 2023. The Company has suspended share repurchase activity until further notice.

Net cash used in investing activities for 2023 was $2.9 billion, and net cash used in investing activities for 2022 was $3.7 billion. Investing activities in both years included Capital expenditures and changes in the balance of the Company's short-term and noncurrent investments. Capital expenditures were $3.5 billion for 2023, compared with $3.9 billion in the same prior year period, and decreased largely due to a decrease in progress and delivery payments made for current period and future aircraft deliveries during 2023. Capital expenditures during 2023 also included approximately $79 million associated with the Company's purchase of finance leased aircraft, compared to approximately $174 million associated with finance leased aircraft purchased during 2022. See Note 8 to the Consolidated Financial Statements for further information.

The Company estimates its 2024 capital spending to be in the range of $3.5 billion to $4.0 billion, which includes approximately $2.2 billion in aircraft capital spending, assuming approximately 79 MAX aircraft deliveries in 2024, and $1.6 billion in non-aircraft capital spending. Including both capital spending and operating expense budgets, the Company currently expects to spend approximately $1.7 billion in 2024 on technology investments, upgrades, and system maintenance. The Company currently estimates its average annual capital spending to be approximately $4 billion through 2027 and will continue to evaluate this level of capital spending based on the Company's performance compared with its long-term financial goals.

Net cash used in financing activities for 2023 was $436 million, and net cash used in financing activities for 2022 was $3.0 billion. The Company paid $428 million in cash dividends to Shareholders and repaid $85 million in finance lease obligations during the year ended December 31, 2023. The Company may engage in early debt repurchases from time to time at its discretion; however, any early future repurchases are not included in the Company's current maturities of long-term debt. During 2022, the Company's financing activities included repaying $3.1 billion in debt and finance lease obligations, including the prepayment of $1.3 billion for all of its outstanding 4.75% Notes due 2023, and the extinguishment of $486 million in principal of its Convertible Notes for cash

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payments totaling $648 million. See Note 8 to the Consolidated Financial Statements for further information on the Company's purchase of finance leased aircraft, which resulted in the elimination of the Company’s remaining financial lease obligations for these aircraft of $191 million and $53 million in 2022 and 2023, respectively.

A discussion of the Company's most significant drivers impacting cash flow for 2021 are included in the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2022, under Part II Item 7, Liquidity and Capital Resources.

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 $1.0 billion under its amended and restated revolving credit facility (the "Amended Credit Agreement"). In August 2023, this facility was amended to, among other things, (i) extend the expiration date to August 2028, (ii) release all aircraft and other assets constituting collateral securing loans under the facility, (iii) eliminate the minimum liquidity covenant, (iv) add a Coverage Ratio financial covenant, and (v) amend the covenant requiring that a pool of lien-free specified aircraft and related assets have a minimum aggregate appraised value. There were no amounts outstanding under the Amended Credit Agreement as of December 31, 2023. See Note 7 to the Consolidated Financial Statements for further information.

Although not the case at December 31, 2023 due to the Company's significant financing activities throughout the early stages of the pandemic, the Company has historically carried 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 flight credits 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 6 to the Consolidated Financial Statements for further information.

The Company believes it has various options available to meet its capital and operating commitments, including unrestricted cash and short-term investments of $11.5 billion as of December 31, 2023, and anticipated future internally generated funds from operations. The Company continues to have a large base of unencumbered assets with a net book value of approximately $17.3 billion, including $14.5 billion in aircraft value and $2.8 billion in non-aircraft assets such as spare engines, ground equipment, and real estate. In addition, the Company continues to maintain investment-grade credit ratings by all three major credit agencies (Moody's, S&P Global, and Fitch).

The following discussion includes various short-term and long-term material cash requirements from known contractual and other obligations, but does not include amounts that are contingent on events or other factors that are uncertain or unknown at this time. Given the Company's current liquidity position, available resources, and prevailing outlook, it expects to be able to fulfill both its short-term and long-term material cash requirements. The amounts disclosed are based on various estimates, including estimates regarding the timing of payments, prevailing interest rates, volumes purchased, the occurrence of certain events and other factors. Accordingly, the actual results may vary materially from the amounts discussed herein.

Debt

As detailed in Notes 2 and 7 to the Consolidated Financial Statements, in connection with the major negative impact of COVID-19 on air carriers, the Company received significant financial assistance from Treasury in the form of payroll support, and this assistance had a significant impact on the Company's reported GAAP financial results in 2021. Such impact ended in third quarter 2021, and the Company's 2022 and 2023 results do not reflect the benefit of this payroll support, and its future periods are not expected to benefit from such payroll support. However, future cash flows will be impacted through the portion of payroll support that was in the form of loans that remain outstanding and will have to be repaid to Treasury.

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See Note 7 to the Consolidated Financial Statements for further detail on the Company's debt and the timing of expected and future principal payments. The Company also has significant future obligations associated with fixed interest payments associated with its debt. As of December 31, 2023, future interest payments associated with its fixed rate debt (excluding interest associated with finance leases) were $239 million in 2024, $198 million in 2025, $166 million in 2026, $114 million in 2027, $56 million in 2028, and $105 million thereafter.

The Company's Convertible Notes did not meet the criteria to be converted by holders as of the date of the financial statements, and thus are classified as Long-term debt in the accompanying Consolidated Balance Sheet as of December 31, 2023. If the provisions were met to allow holders to exercise their conversion option on these instruments, all of the remaining Convertible Notes would be reclassified as a current obligation. Also, the Company has engaged in transactions with certain convertible debt holders to purchase their instruments in private transactions from time to time in cash, and may continue to do so in future periods. The Company considers its prevailing stock price, the trading price of its convertible debt instruments, and its available liquidity in determining how much of these instruments it may attempt to repurchase in such transactions.

Leases

The Company enters into leases for aircraft, airports and other real property, and other types of equipment in the normal course of business. See Note 8 to the Consolidated Financial Statements for further detail.

Aircraft purchase commitments

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 aircraft and are reclassified as Flight equipment. See Part I, Item 2 for a complete table of the Company's contractual firm deliveries and options for -7 and -8 aircraft, and Note 5 to the Consolidated Financial Statements for the financial commitments related to these firm deliveries.

Other

The Company's other material cash requirements primarily consist of outlays associated with normal operating expenses of the airline, including payroll, fuel, airport costs, etc. While many of these expenses are variable in nature, some of the expenditures can be somewhat fixed in the short-term due to the lead-time involved in publishing the Company's flight schedule in advance and providing for resources to be available to operate those schedules.

As a result of the Company's Pilots ratifying a new labor contract in January 2024, the Company is scheduled to pay out contract ratification bonuses to its Pilots in first quarter 2024 totaling approximately $1.35 billion, which includes a contractual $1.28 billion in wages and Non-elective retirement contributions, plus the applicable payroll taxes on such amounts.

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 2023 and in previous years, which has enabled the Company to accelerate cash tax benefits of depreciation. Based on the Company’s scheduled future aircraft deliveries from Boeing and existing tax laws in effect, the Company will continue to accelerate the cash income tax benefits related to aircraft purchases. Due to the Company's net taxable loss incurred in 2020, and a provision within the CARES Act that allowed entities to carry back such 2020 losses to prior periods of up to five years, and claim refunds of federal taxes paid, the Company received a significant cash tax refund of $472 million associated with this taxable loss from the Internal Revenue Service during second quarter 2022. The Company has federal and state operating loss carryforwards, $268 million and $36 million (tax-effected), respectively, to reduce

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taxable income in future periods. See Note 15 to the Consolidated Financial Statements for further information. The Company has paid in the past, and will continue to pay in the future, 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.

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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.

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, flight credits that are expected to be used in the future, and loyalty benefits that are expected to be redeemed in the future. Air traffic liability typically fluctuates throughout the year based on seasonal travel patterns, fare sale activity, and activity associated with the Company’s loyalty program. See Note 1 to the Consolidated Financial Statements for information about the Company's revenue recognition policies.

For air travel on Southwest, the amount of tickets (which includes flight credits—also referred to as partial tickets) that will go unused, referred to as breakage, is estimated and recognized in Passenger revenue once the scheduled flight date has passed, in proportion to the pattern of rights exercised by the Customer, in accordance with Accounting Standards Codification 606, Revenue From Contracts With Customers ("ASC 606"). Estimating the amount of tickets that will ultimately go unused involves some level of subjectivity and judgment. The majority of the Company's tickets sold are nonrefundable, although flight credits created when a Customer cancels or modifies an existing flight itinerary can be applied towards the purchase of future travel. Unused flight credits are the primary source of breakage. Breakage estimates are based on historical experience over many years. Fully refundable tickets rarely go unused.

As a result of the COVID-19 pandemic, for all Customer flight credits created or scheduled to expire between March 1 and September 7, 2020 associated with flight cancellations, the Company initially extended the expiration date to September 7, 2022. See Note 6 to the Consolidated Financial Statements for further information regarding these extended flight credits. Since the Company did not have historical data to enable it to accurately estimate the pattern of usage of these extended credits, these credits have been classified as a current liability throughout their history. Subsequently, on July 28, 2022, the Company modified its policy and announced that all unexpired flight credits as of that date, including these extended flight credits, will no longer have an expiration date and thus will be able to be redeemed by Customers indefinitely. This change in policy was considered a contract modification under ASC 606 and the Company accounted for such change prospectively in third quarter 2022. The Company’s balance of existing Customer flight credits as of the modification date was approximately $1.9 billion, including the extended flight credits that had been set to expire on September 7, 2022.

As a result of changes in observed Customer travel habits and behaviors during 2021 and 2022, the Company increased its estimates of “normal” Customer flight credits that are expected to go unused, as Customer redemptions of these "normal" credits had been at a slower rate than the Company’s historical data for similar credits in periods prior to the COVID-19 pandemic. Although the Company continues to believe a portion of Customer flight credits will go unused following the Company's change in policy, including a portion of flight credits issued after July 28, 2022, the Company expects its prospective breakage rate associated with such flight credits to be at or slightly lower than historical pre-pandemic levels due to the fact that such flight credits no longer have an expiration date. Although the Company's estimated breakage rate was consistent throughout 2023, a one percentage point change in the amount of breakage, as a factor of total flight credits issued, would have resulted in a change of Passenger

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revenues of approximately $26 million. The Company also does not currently anticipate any changes to its estimated breakage rate for 2024.

Observed Customer behavior that differs from historical experience can cause actual ticket breakage to differ significantly from estimates. Assumptions about Customer behavior are reviewed frequently and corresponding adjustments are made to breakage estimates, as needed, when observed behaviors differ from historical experience. Assumptions about Customer behavior can be impacted by several factors including, but not limited to: fare increases, fare sales, changes to the Company's ticketing policies, changes to the Company’s refund, exchange and unused flight credit policies, seat availability, and economic factors. The Company’s estimation techniques have been consistently applied from year to year; however, as with any estimates, actual ticket breakage may vary from estimated amounts.

Fair Value Measurements and Financial Derivative Instruments

The Company utilizes unobservable (Level 3) inputs in determining the fair value of certain assets and liabilities. As of December 31, 2023, these consisted of its fuel derivative option contracts, which were an asset of $223 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 11 to the Consolidated Financial Statements for more information on the Company’s fuel hedging program and financial derivative instruments, and Note 12 to the Consolidated Financial Statements for more information about fair value measurements.

All derivatives are required to be reflected at fair value and recorded on the Consolidated Balance Sheet. As of December 31, 2023, 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 2023, market "spot" prices for Brent crude oil peaked at a high average daily price of approximately $97 per barrel and hit a low average daily price of approximately $72 per barrel. During 2022, market spot prices ranged from a high average daily price of approximately $128 per barrel to a low average daily price of approximately $76 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, the extent of the COVID-19 pandemic, and general economic conditions, among other items. Historically, 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, 2023, 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 $34 million.

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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. Further, should the anticipated fuel purchases covered by the Company's fuel hedges no longer be probable of occurring, the Company would discontinue hedge accounting. The loss of hedge accounting would create further volatility in the Company’s GAAP financial results.

As discussed in Note 11 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 on Southwest base fares. The amount of points earned under the program is based on the fare amount and fare type, with higher fare types (e.g., Business Select) earning more points than lower fare types (e.g., Wanna Get Away). Each fare type is associated with a points earning multiplier, and points for flights are calculated by multiplying the fare amount for the flight by the fare type multiplier. Likewise, the amount of points required to be redeemed for a flight can differ based on the fare type 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. 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. As of December 31, 2023, the loyalty liabilities were approximately $4.9 billion, including $3.2 billion classified within Air traffic liability and $1.7 billion classified as Air traffic liability – noncurrent.

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In order to determine the value of each loyalty point, certain assumptions must be made at the time of measurement, which include an allocation of passenger revenue between the flight and loyalty points earned by passengers, and the fair value of Rapid Rewards points, which are generally based on their redemption value to the Customer. See Note 6 to the Consolidated Financial Statements for further information on determining the estimated fair value of each loyalty point.

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 ASC 606. The most recent instance in which the Agreement was amended was in fourth quarter 2021. 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, including each time in which the Agreement has been materially amended. 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, 2023, causing a change to the allocation of proceeds to air transportation would not have had a material impact on the Company's Operating revenues for the year ended December 31, 2023.

Under its current program, Southwest estimates the portion of loyalty points that will not be redeemed. In estimating the breakage, 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 are typically representative of a Member’s level of engagement in the loyalty program. They include, but are not limited to, tenure with the program, points accrued in the program, and points redeemed in the program. The Company believes it has obtained sufficient historical behavioral data to develop a predictive statistical model to analyze the amount of breakage expected for all loyalty points. The Company updates this model at least annually, and applies the new breakage rates effective October 1st each year, or more frequently if required by changes in the business. Changes in the breakage rates applied annually in recent years have not had a material impact on Passenger revenues. For the year ended December 31, 2023, based on actual redemptions of points sold to business partners and earned through flights, a hypothetical one percentage point change in the estimated breakage rate would have resulted in a change to Passenger revenue of approximately $235 million (an increase in breakage would have resulted in an increase in revenue and a decrease in breakage would have resulted in a decrease in revenue). Given that Member behavior may fluctuate over time, 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.

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