With demand growing and capacity shrinking, the airline industry appears to finally be recovering after sustaining losses of $35 billion during the past five years.

Now, for a change, airlines have become upside leaders on earnings. UAL ( UAUA) became the latest example Monday, saying per-share profits will be more than twice analysts' estimates. The parent of United Airlines expects to make 93 cents a diluted share on revenue of $5.1 billion for the second quarter, compared with the Thomson Financial analyst consensus estimate of 46 cents.

Last week, three carriers reported exceptionally strong results. Southwest ( LUV) reported its most profitable quarter ever, American Airlines parent AMR ( AMR) posted its best second quarter in eight years and Continental Airlines ( CAL) reported its best quarter in five years.

As a whole, the airline industry showed record revenue improvement in June, according to the Air Transport Association. The outlook seems generally bright for the eight U.S. airlines that report this week, and for the third quarter as well, although record-high fuel prices continue to pose a threat.

"If you look at the ATA data that came out on revenue, you will see better year-over-year data at the majority of carriers," Continental CEO Larry Kellner said Thursday during a conference call. Kellner acknowledged that American, Continental and Southwest "may be a little stronger than the others," but he added that "in general, you will see strength across the industry."

Keeping Order

In June, industry revenue per available seat mile, or RASM, a closely watched industry indicator, rose 12.5%, the ATA said. The figure marks "the strongest revenue improvement ever measured" and provides evidence that "surging RASM isn't solely a function of capacity, but underlying demand recovery as well," JPMorgan analyst Jamie Baker wrote in a recent research report.

Surprisingly, the strong second-quarter results were achieved despite already-high fuel prices. Reduced capacity -- due to downsizing by bankrupt carriers and the shutdown of Independence Air -- coupled with impressive demand has enabled carriers to raise prices as fuel prices increase. This year, fares have risen 11.3%, although they remain 11.8% below their 2000 level, according to ATA figures.

"The improving revenue picture has helped all airlines," said Standard & Poor's airline analyst Philip Baggaley. "However, each airline has varying participation in various markets, so the degree of benefit varies."

Baggaley said the recent upturn has been strongest in the domestic market, which has been most helpful to carriers with a smaller percentage of international flying, including American, Delta Air Lines ( DALRQ) and the low-cost carriers.

By contrast, he said, the level of international flying is higher at Continental, Northwest Airlines ( NWACQ) and UAL ( UAUA) unit United Airlines.

Going forward, Baggaley said, there is a risk that further increases in oil prices could squeeze profits, because airlines would face higher costs but have less ability to raise fares in a slowing U.S. economy.

Carriers differ on whether the ability to continue raising fares has diminished.

Southwest CEO Gary Kelly said during a conference call last Wednesday that fare increases are causing booking slowdowns in select markets, which he declined to specify. "There have been a lot of fare increases over the last two years," he said. "It's not surprising that customers will balk at a certain point."

However, both Kellner and American CEO Gerard Arpey said they have seen no resistance to higher fares. As recently as last week, "bookings have been very strong," Kellner said, and the outlook is for continued improvement in passenger-load factors, which are already at record levels.

The gap in the airlines' experiences is "potentially a function of discounter bias toward price-sensitive leisure passengers, whereas legacies are largely corporate appendages," analyst Baker wrote.

Upbeat on Another Year

At discounter AirTran Airways ( AAI), passengers aren't balking at fare increase, but the possibility "is something we're always conscious of," Kevin Healy, vice president of planning, said in an interview Thursday.

"It's a real strong demand environment, and the main thing for us is being vigilant and sensitive to any changes, particularly since we're growing," Healy said. "We continue to have sales."

In fact, AirTran launched a sale Thursday, affecting all of its destinations and offering fares as low as $39 each way for travel though Nov. 16. The lowest fares are for travel on Tuesday and Wednesday, the best times to find smaller crowds during a summer of heavy travel.

Meanwhile, low-cost carrier Frontier Airlines ( FRNT) reported the strongest passenger loads in its history in June, despite increasing capacity. "We haven't seen any material damper on demand moving forward," says spokesman Joe Hodas.

Merrill Lynch analyst Mike Linenberg wrote recently that "notwithstanding record high fuel prices, industry fundamentals have not been this good in years. As a result, we think the current up-cycle could be extended at least another year as long as the industry continues to demonstrate restraint when it comes to adding capacity, particularly in domestic markets."

Nevertheless, Linenberg recently downgraded American, Continental and US Airways ( LCC) from buy to neutral because of their rapid run-up during the past nine months, saying he prefers underperformers including AirTran, Alaska Airlines ( ALK) and United.

Merrill has had various compensatory business relationships with all six of the companies during the past 12 months, some of which continue, including acting as a market maker for all six.