Why would the following arrangement cause SkyWest's market valuation to increase?
SkyWest, a regional airline, negotiated a financial arrangement with Delta and United Airlines to provide regional jet service. SkyWest agreed to paint its jets the colors of Delta Connection and United Express and to fly routes specified by the two airlines. In return, Delta and United agreed to pay SkyWest a predetermined profit margin and to cover most of the regional airline’s costs. While the deal limited the amount of profit SkyWest could earn, it also insulated the smaller airline from volatility in earnings since the major airlines covered SkyWest’s fuel costs, increased its percentage of seats occupied and managed its ticket prices.
Wall Street responded by increasing SkyWest’s market valuation from $143 million to $1.1 billion after the arrangement was made. Explain, in economic terms, how this arrangement with Delta and United could have caused the value of SkyWest to increase so dramatically even though it limited the amount of profit the company could earn.
Most of the answer to this is contained in the explanation you have provided. This arrangement has caused SkyWest to have a guaranteed profit margin with guaranteed costs. This means that there is very little risk involved in investing in this airline.
With this arrangement, investors get certainty. They know what profit margin SkyWest will make for the lifetime of the deal. They know that they do not have to worry about the airline being hit by rising costs. They also know that the airline is likely to gain passengers because of its connection to the larger airlines.
For these reasons, SkyWest becomes a much more attractive investment. It may not have a huge potential for gain because of the limits imposed on it, but it also does not have much potential for loss. This makes it a safe investment and allows its value to increase.