Lehman Brothers Tuesday downgraded Delta Air Lines ( DAL) to equal-weight from overweight, saying that while the stock is its first choice in the space, the price has gotten ahead of fundamentals. Analyst Gary Chase recommended investors take a look at Northwest Airlines ( NWAC) or AirTran ( AAI) instead, upgrading both to overweight from equal-weight.

"These ratings changes are valuation-based, and do not reflect a significant shift in our fundamental views on any of the affected companies," said Chase. "Delta has nearly achieved our previous $16 target, and, even on our new numbers, we see less near-term equity upside in Delta than in AirTran and Northwest."

Northwest shares jumped on the note, gaining 49 cents, or 4.5%, to $11.36, joined by AirTran, up 42 cents, or 4.9%, to $9.02. Delta was off 16 cents, or 1%, to $15.34.

Despite concerns over valuation, the Lehman note was optimistic about industry fundamentals, narrowing loss estimates for fiscal 2003 and establishing new forecasts for fiscal 2005 and 2006. By 2005, Chase said, all of the major airlines he covers will be profitable, and while Chase said the 2006 earnings forecasts were for "illustrative purposes only," he added that it could represent peak earnings potential for the sector.

Based on his new estimates, by 2006, the share prices of Delta, Continental Airlines ( CAL), Alaska Airlines ( ALK) and America West ( AWA) could be double current levels, with Northwest potentially tripling, Chase said.

Because the airline industry is cyclical in nature, airlines have used this downturn in business to make deep cuts to fixed costs like wages, aircraft leases and pension plans, giving them leverage when business picks up. And because there's a lag between a potential increase in demand and the amount of time it takes to deliver deferred airplanes, Chase said, airlines could be on track for an powerful snapback from depressed levels.

"The severity of the current down cycle and the draconian nature of the adjustment process ... should drive a powerful earnings cycle perhaps better than any the industry has seen to date," Chase said.

But while the long-term picture seems bright, Chase added that airlines face turbulence in the next few months. For one, airlines have been unable to raise prices and travelers have been trained to buy tickets when they're on sale. As a result, most of the recent improvements have been due to cutting prices and increasing load factors, or the number of people in planes.

Also, with the summer naturally causing an increase in travel demand, Chase argues that airlines will look far less attractive this fall, when leisure travel dries up. And with fuel prices remaining high and the government's six-month reprieve from charging security fees set to expire in November, airlines will need some uptick in business travel to help with the revenue picture.

Chase warned investors against "reckless buying" in the sector and cautioned that the long-term recovery was nascent and subject to many risks, especially when it comes to staggering debt loads.

"We firmly believe that with a debt load as heavy as that facing the network airlines, equity valuation metrics can be misleading," he said. "Clearly, if investors seek to earn adequate returns on their investments, the industry will have to perform materially better than our current estimates suggest."

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