Industry's Plentiful Seats Nettle Continental

Updated from 10:06 a.m. EDT

Airline stocks slid Monday as oil prices rose and

Continental Airlines

(CAL) - Get Report

warned that the bloated state of the industry continues to hold down revenue.

Continental reported first-quarter results Monday morning that beat lowered analyst estimates. But even as it booked its first profitable month since Sept. 11, the company stressed that overcapacity is penalizing profits. Meanwhile, continuing unrest in the Middle East and Venezuela lifted oil prices, pressuring the stocks of the big U.S. carriers as they prepare to report first-quarter earnings this week.

Continental, the fifth-largest U.S. airline, posted a first-quarter loss of $114 million, or $1.79 a share, excluding a charge for permanently retiring some DC-10s. This easily topped lowered analyst estimates that called for a loss of $1.97 a share, according the Thomson Financial/First Call. Including charges, Continental lost $166 million, or $2.61 a share, reversing the year-ago profit of 16 cents a share.

"Industry capacity excesses overshadow our successes in operational performance, revenue generation and cost management," said CEO Gordon Bethune in a press release. The major carriers slipped 3%-4% in midday trading Monday, with Continental leading the way down, off $1.30 at $28.71.

Old Hat

Capacity worries are hardly new.

Two weeks ago, Continental warned that first-quarter losses would be "significant." The company said at the time that rising fuel prices and overcapacity could hurt the company's chances of reaching profitability in the second quarter.

The hit can be seen most clearly on the revenue side, where discounted ticket prices have eroded revenue even as Continental manages to fill its planes. Indeed, Continental's load factor, the percentage of seats filled in its airplanes, hit a record 74% in the first quarter -- but that's a far cry from the 80.8% the company would need to be profitable. While loads were high, first-quarter revenue fell 19% from a year ago to $1.9 billion.

In a conference call Monday, Continental execs said they had been expecting second-quarter industrywide domestic capacity to fall 15%, which would help airlines by reducing the number of available seats, forcing travelers to bid ticket prices higher. But now they expect it to fall by just 8%, which is likely to mean that profits everywhere will remain weak no matter how eager Americans are to travel.

With

Delta

(DAL) - Get Report

set to release earnings tomorrow and other airlines soon to follow suit, observers say investors must close attention to capacity. If levels stay too high, analysts say, profits will stay weak, hamstringing Continental and others as they seek to return to the black after months of 9/11-deepened red ink. In that regard, Continental's conservative remarks in recent weeks could foreshadow continued tough times for the industry, which many investors think must consolidate before any of the big carriers can return to health.

Spare the Rod...

"What the industry needs to turn profitable is continued capacity discipline," says Gary Chase, airline analyst for Lehman Brothers. But signs of that have been fleeting: While Continental,

AMR

(AMR)

and Delta all boosted leisure prices on Friday, the fare rise failed to stick when

Northwest Airlines

failed to go along. "If demand recovers, the reduced capacity creates pricing power," Chases says.

On the bright side, Continental finished the quarter with $1.2 billion in cash and short-term investments and recorded positive pretax income of $25 million during March, its first profitable month since Sept. 11. The company didn't comment on second-quarter financial expectations, but said it planned to go ahead with its planned initial public offering of ExpressJet Holdings, its regional jet unit. The move could prove lucrative, since

JetBlue

(JBLU) - Get Report

soared 67% in its first day of trading

last week.

But with profitable business travelers still shying away from airports and recent events in Venezuela and the Middle East threatening oil supplies, Continental and the rest of the airline industry have much to grapple with before profits return.

"The pricing recovery is likely to take a few quarters," Chase says. "We don't anticipate seeing a healthy pricing environment until the second half."