Morgan Stanley downgraded its rating on the airlines sector to In-Line from Attractive, citing the combination of increased capacity and "uninspiring" free cash flow and margins.

RISING SUPPLY, MARGINS WEAKENING: Airlines' capacity in the U.S. will grow 4%-5% in 2017 and 2018, but prices will "stagnate" and margins will "deteriorate," warned Morgan Stanley analyst Rajeev Lalwani. Supply growth may even exceed 4%-5% "over time," spurred partly by lower fuel prices and weaker competition, he warned. Given the increase in supply, prices will probably not rise meaningfully for a significant amount of time, Lalwani believes. Consequently, the airlines' passenger revenue per available seat mile will be "flat to down," he predicted.

PREFERRED NAMES: Given the industry outlook, investors should favor airlines "with stronger margins, healthier balance sheets, and idiosyncratic revenue potential," the analyst stated. Fitting that description are Alaska Air (ALK), Delta Air Lines (DAL), and Southwest (LUV), wrote Lalwani, who kept Overweight ratings on all of those stocks.

DOWNGRADE: Conversely, Lalwani downgraded American Airlines (AAL) to Equal Weight from Overweight, saying that the company has "below-average margins, lackluster cash flows," and the highest debt levels in the sector.

SHORT-TERM VERSUS MEDIUM TERM: Spurred by second quarter revenue guidance and "maturing initiatives," airlines stocks may rise over the short-term, according to Lalwani. However, over the longer term, an In-Line view of the sector is appropriate, he added.

TARGETS: Lalwani cut his price target on Alaska Air to $105 from $109, on Delta to $54 from $60, on Southwest to $60 from $61, and on American to $44 from $52.

WHAT'S NOTABLE: China Southern Airlines (ZNH), whose stock is halted in New York pending news, is in talks to sell a stake to American, according to Bloomberg, citing people familiar with the matter. The U.S.-based carrier is in advanced negotiations to make an investment of about $200M in China Southern's Hong Kong-listed shares, the report said.

PRICE ACTION: In morning trading, Alaska Air fell 0.5%, Delta lost 1.2%, Southwest added 0.1% and American declined 2.5% to $39.40 per share. Other publicly traded companies in the space include JetBlue (JBLU) and United Continental (UAL).