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By even the most optimistic predictions, the airline industry won't return to profitability for a year and a half, so when

Continental Airlines

(CAL) - Get Report

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kicks off the airlines earnings season, expect to see massive losses and marginal improvement.

What you most likely won't see, however, are significant signs of recovery.

In the second quarter, Continental is expected to lose 83 cents a share while the airline industry is expected to lose between $1.4 billion and $1.7 billion, depending on which analyst you ask. And while the cost-cutting efforts of

US Air

,

UAL

-unit United Airlines and

AMR

(AMR)

-unit American Airlines have done much to help other carriers cut costs, the bottom line is that the top line isn't improving.

"We're hopeful for a profit in 2005 and maybe have pockets of profitability in 2004, but the industry cannot continue to borrow to fund its losses," said Helane Becker, airline analyst at The Benchmark Company. "If another one or two companies go bankrupt, and there may well be, then things will change."

But airline stocks, as tracked by the Amex Airline Index, are up 105% since March 11, four times as high as the

S&P 500

. Investor expectations are high that the industry is really recovering and not simply shrugging off its postwar, post-SARS, post-Sept. 11 malaise. With management sure to hype any uptick in business metrics, it's all too easy to think a minor improvement is a major deal, while overlooking places where airlines are falling short.

Here's how to see if the recovery is for real.

Look for RASM Recovery

No matter how much the industry can cut costs by closing operations and laying off employees, in order to return to profitability, airlines are going to have to see a pickup in demand. And because costs are largely fixed in the industry, any revenue improvement will fall straight to the bottom line as a profit.

"Stock market exuberance notwithstanding, it's hard to be excited about

current

airline industry fundamentals," said Sam Buttrick, analyst at UBS Warburg, in a recent report. "Sure, the industry is 'recovering' -- but that's a relative concept, isn't it? Indeed, every dollar of observed revenue recovery relates solely to recovering revenue lost during the Iraq war -- as opposed to a sustainable macroeconomic recovery."

Buttrick's research drives this point home. By his estimates, the industry was on track to rack up nearly $5 billion in revenue during April, but actual revenue came in about $500 million under his estimates, due to the war. Buttrick said the industry won't be back on track until August, which means second-quarter improvements in revenue per available seat mile, or RASM, are more about a postwar recovery than an economic recovery.

"I would keep a close eye on yields or RASM," said Jim Corridore, equity analyst at Standard & Poor's. "And I would put more credence on what I see in the future instead of the second quarter. It's all about the second half and 2004."

And in the second quarter, while UBS Warburg expects

Delta

(DAL) - Get Report

and

America West

(AWA)

to show sizable RASM gains, the industry's RASM is expected to drop 0.3% from last year's levels. But because cost per available seat mile, or CASM, will be down 1.2% year over year (and down 3%, excluding fuel), the industry will look like it's recovering.

Downplay Load-Factor Improvements

In addition to cutting costs, the airlines also have cut capacity to meet the reduced demand, parking hundreds of planes in the Arizona desert. The end result of this action is that airlines are filling a larger percentage of seats, a metric known as load factor.

But in order to fill those planes, airlines have sharply reduced the price of tickets, which means they've cut into their own margins and need to fill even more seats to turn a profit. According to the Air Transport Association, airline ticket prices, excluding taxes, hit $117.83 on average in May, off 4.3% from last year and the same price you could get in the 1980s. Planes are as full as they were three years ago, when the industry had a profit, but losses remain incredibly steep.

"High load factors are all well and good. They're within a couple ticks of the highest level we've ever seen, but look at the losses we're sustaining, when you fly a plane with fares that are below break-even," points out Corridore. "You need a good load factor with reasonable price points."

Over the last two months, airlines have seen definite improvement in load factor, with the top six network carriers reporting a two percentage-point boost to load factors over last year. But without a similar uptick in ticket prices, returning a profit will be extremely difficult. In the end, the hype around load factors tells only half the story.

The Capacity Conundrum

The last area to keep a close eye on is capacity -- or traffic -- which fell 3.2% at the top six network carriers in the first six months of 2003, but grew 17% over the same span at the top six low-cost airlines.

Indeed, while Continental and others defer delivery of planes and park them in the Arizona desert, low-cost carriers have launched ambitious plans to expand both fleets and service.

JetBlue

(JBLU) - Get Report

recently announced the purchase of 100 Embraer 190 jets,

AirTran

(AAI)

bought an identical number of Boeing 737s, and

Southwest

(LUV) - Get Report

is expanding its transcontinental service.

"Capacity discipline by the majors has been significant in historical context, but the rapid growth of low-fare carriers is muting some of the benefits of those capacity reductions," said Gary Chase, airline analyst at Lehman Brothers, in a note last week, who concluded, "Reductions have not been and will not be extensive enough to allow profitability in the current demand environment."

The end result is that even if network carriers resist the urge to add back traffic and keep capacity low, the low-cost carriers can exacerbate the overcapacity problem and continue expanding with cheap, profitable flights their hub-and-spoke competitors cannot match. And this is precisely what is happening now, with JetBlue increasing its national market share to 2.3% from 1.3% in the last six months.

Through the first six months of 2003, low-cost carriers accounted for 26% of the national market share, up three percentage points over last year. Now American Airlines faces low-cost competition on more than 80% of its routes, up from 50% a year ago. And while the big network names struggled to control costs and boost performance in the second quarter, these low-cost names will continue to post profits and expand.

Without a solid plan in place to combat these carriers -- like Delta's low-cost Song unit -- it will be extremely hard for airlines to compete unless lucrative business travel can make a sizable recovery, which is uncertain. Cost cuts and load-factor increases won't be enough to save the industry -- only demand can bring about the meaningful recovery many hope is at hand.

"The second quarter should unfortunately mark another abysmal performance for the industry in what has historically been the industry's strongest quarter," said Chase. "While beating reduced estimates is great, the hub-and-spoke airlines will have to prove they can beat the abysmal performance levels they were achieving prior to the war."