Fortune magazine reported that SkyWest, an independent regional airline, negotiated a financial arrangement with Delta and United to provide regional jet service for the two major airlines. For its part of the deal, 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. Fortune explained that while the deal limited volatility in earnings since Delta and United covered SkyWest's fuel costs, increased its load factor (the percentage of seats occupied), and managed its ticket prices.
Fortune suggested that Wall Street liked the deal because SkyWest's market valuation instead from $143 million to $1.1 billion after it began its service with the two major airlines. Explain carefully how this arrangement with Delta and United could have caused the value of SkyWest to increase dramatically even though it limited the amount of profit SkyWest could earn.
The arrangement with Delta and United caused the value of SkyWest to increase dramatically because it provided the company with several key benefits:
1. Revenue Stability: By entering into agreements with Delta and United, SkyWest secured a stable stream of revenue. The major airlines agreed to pay SkyWest a predetermined profit margin, ensuring that SkyWest would have a consistent source of income. This stability in revenue reduces the volatility in earnings and provides a sense of financial security, which is attractive to investors.
2. Cost Coverage: Another advantage of the arrangement was that Delta and United agreed to cover most of SkyWest's costs, including fuel expenses. Fuel costs can be a significant burden for airlines, so the fact that Delta and United took on this responsibility relieved SkyWest of a major financial burden. This cost coverage further contributes to the stability of SkyWest's earnings and reduces the risk associated with fluctuating fuel prices.
3. Increased Load Factor: The load factor refers to the percentage of seats occupied on an aircraft. By flying routes specified by Delta and United, SkyWest was able to increase its load factor. This means that more seats were being filled on their planes, resulting in better capacity utilization and overall improved efficiency. Higher load factors translate into increased revenue per flight, which positively impacts the financial performance of the airline.
4. Managed Ticket Prices: The agreement also allowed Delta and United to manage SkyWest's ticket prices. This means that the major airlines could control the pricing strategy for SkyWest's flights, ensuring that ticket prices remained competitive and attractive to customers. By effectively managing ticket prices, Delta and United aimed to maximize passenger bookings and increase the profitability of SkyWest's operations.
Overall, this arrangement with Delta and United provided stability, cost coverage, increased load factors, and effective pricing management for SkyWest. These factors collectively boosted investor confidence and interest, leading to a significant increase in the market valuation of the company. Despite the limitations on the profit SkyWest could earn, the benefits offered by this arrangement outweighed the potential loss in profit, making it an attractive proposition for investors and ultimately increasing the value of the company.