Too much manufacturing capacity coupled with too little demand for electronic goods is hurting margins and earnings for contract manufacturers, according to a report by Deutsche Bank Securities, which on Monday downgraded all six companies in the sector.

Dropped to sell from hold by analyst Chris Whitmore were: Jabil ( JBL - Get Report), Solectron Plexus ( PLXS - Get Report) and Sanmina-SCI ( SANM - Get Report).

Downgraded to hold from buy were Flextronics ( FLEX - Get Report) and Celestica ( CLS). The news pushed shares of those companies down 2% to 5%, with the exception of Solectron which was unchanged.

"We believe the group could experience a major correction over the next three to six months as a result of downward EPS revisions and multiple contraction," Whitmore wrote in a note to clients.

Although contract manufacturers (also known as electronic manufacturing services, or EMS) are sometimes seen as a proxy for the health of the entire electronics industry, including computer sales, Whitmore warned against extrapolating too broadly from his report, since some of the problems for EMS companies are sector-specific.

Nonetheless, the report isn't a happy read for anyone betting on a recovery for computer makers or consumer electronics, and it contains estimates on earnings and revenues for the coming year that are significantly lower than the Wall Street consensus.

The overarching problem for the EMS group is a glut of capacity. Plant utilization is now at a historic low, dropping from 75% in 2000 to as low as 44% in 2002. Meanwhile, plant utilization across the entire electronics industry will decline from 68% or 69% in 2002 to 64% or 65% in 2003, he estimates.

"We expect this imbalance and additional low-cost capacity coming online in China to translate into pricing pressure across the electronics industry," Whitmore said. Ongoing restructuring and consolidation in the EMS sector could push up utilization rates slightly in the coming year, but Deutsche Bank has not made a specific forecast.

Companies are moving quickly to build plants in China, which, in the long run, will position them for lower-cost manufacturing. But until older capacity goes off line, there is more consolidation in the sector or demands picks up, there will be too much capacity, Whitmore said. "We're bearish on recovery in IT hardware spending. It's going to be another difficult year for PCs, servers, storage and networking hardware," he said.

Whitmore, who is generally seen as fairly bearish, said he expects a 7% drop in capital spending for communications infrastructure, and added that he expects consumer spending on electronic goods to remain weak in 2003.

DB's estimates for calendar 2003 earnings per share in the sector are roughly 20% lower than consensus, while Whitmore's revenue projections are about 3% lower than consensus.

Much more positive about the EMS group is Alexander Blanton, of Ingalls & Snyder. Although he acknowledges that IT spending remains weak, he points to increases in outsourcing of consumer, automotive and medical electronics and believes the EMS companies will continue to win business in those areas.

Solectron, for example, recorded $95 million in revenue derived from automotive electronics in the November quarter, double the previous quarter, while Jabil reported that contracts to build similar products rose to $104 million in the last quarter, compared with $68 million the previous year. And that, says Blanton, is just the beginning. The cost of goods sold in automotive electronics is about $50 billion, Blanton says, but only about $1 billion a year is outsourced.

He expects capacity utilization to improve this year as restructuring takes hold.

Shares in Celestica lost 30 cents, or 1.73%, to $17; Flextronics dropped 4 cents, or 0.43%, to $9.34; Jabil Circuit lost $1.04, or 5.2%, to $18.88; Plexus lost 64 cents, or 6.4%, to $9.35; Sanmina-SCI shed 38 cents, or 7.2%, to $4.90; and Solectron was unchanged at $4.26.