Questions Linger on Air Industry Demand

NEW YORK_Investors have been hammering airline stocks, anxious about possible weakness in domestic travel.

But analysts disagree on how much a cooling U.S. market would hurt the industry. Some say it could imperil expected 2008 earnings; others say carriers could overcome it due to continued strength in overseas travel. One analyst thinks the premise itself may be faulty, and the domestic market seems to be holding up okay.

The result of the debate was a 3.6 percent slump in just two days last week for the Amex Airline Index, which tracks 11 network, low-cost and regional carriers. Among the hardest hit were Continental Airlines Inc. and American Airlines' parent, AMR Corp. Both companies last week reported their first first-quarter profits in years.

The deluge began after Southwest reported a first-quarter profit that met Wall Street's expectations but also added a warning that growth in domestic air travel may be cooling. Looking ahead, the company said it may become "less reliant on fare increases."

As an industry pacesetter for pricing, that sent shivers through the market, analysts said.

Airlines have only recently recovered from years of layoffs, billions of dollars in losses and bankruptcy reorganizations. Through restructuring, several carriers cut back on the capacity of available seats in the air, allowing airlines recently to boost fares and bolster their bottom lines.

When Continental announced its earnings last week, President Jeff Smisek also said domestic fares were under pressure, but the international system "is performing superbly."

To J.P. Morgan analyst Jamie Baker, the numbers and comments show a clear worry.

"Let's not kid ourselves," he wrote in a recent research report. "There is a growing body of evidence that domestic demand is deteriorating. Granted, international trends remain robust, but the international is unlikely to carry airlines to the finish line currently implied by consensus."

But Cathay Financial analyst Susan Donofrio was more optimistic. She cut her 2007 earnings expectations for Continental but set her 2008 projection above Wall Street's consensus estimate.

In a research report, she wrote that Continental's international offerings - which made up about 47 percent of its 2006 capacity - should help mitigate the slowing domestic market.

Monthly traffic reports put out by airlines show a chasm in growth between domestic and overseas travel. Among the top eight U.S. airlines, domestic traffic grew less than 1 percent during the first quarter. International traffic, meanwhile, jumped more than 6 percent over the same period.

"We wonder if things are that bleak," Bear Stearns' Frank Boroch wrote in a recent research report. Even with an expected 2 percent decline in domestic unit revenue - a key financial gauge that measures revenue per passenger flown one mile - he said strong international unit-revenue growth should produce overall gains of about 2 percent.

While that's a steep drop from the halcyon days of 10 percent growth in 2006, Boroch wrote, "we'll take 2-3 percent (unit revenue) growth and oil under $62."

Prudential analyst Bob McAdoo, though, thinks the reports about the demise of domestic demand may be premature.

Domestic unit revenue grew 2.3 percent across legacy network carriers in March, and the problem may be limited to Southwest, McAdoo wrote in a recent research report.

Southwest has been more aggressive recently in charging higher prices for last-minute walkup fares, and that may have driven some customers away and created the weakness, he wrote.

"We believe some of Southwest's problems are driven by these prices," he wrote. "They are working hard to drive revenues up to offset higher fuel. Perhaps they have gone too far in this regard."