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California's woes may hurt companies

Analysts say California’s economic woes could spell trouble for Wall Street too if firms that do a large amount of business in the state are hurt by measures to fix the world’s fifth-largest economy.
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With a multibillion-dollar budget deficit to contend with, California’s economy is stuck in one of its worst financial fixes ever. But analysts say the Golden State’s economic woes could spell trouble for Wall Street too if firms that do a large amount of business in the state are hurt by measures to fix the world’s fifth-largest economy.

A drive to unseat California Gov. Gray Davis, precipitated by the state’s budget disarray, has brought California’s economic problems to the fore.

The largest state in terms of population, California’s jobless rate is the country’s seventh highest at 6.7 percent and above the national level of 6.2 percent. The high-tech industry has suffered greatly from the national economic slump. And the cost of doing business in the state, from energy costs to workers’ compensation insurance, is up sharply.

Although it’s too soon to say how the state will deal with its budget problems and the impact on companies, the state’s decisions should be monitored closely, some analysts counsel. Stocks with high exposure to the California region could be impacted.

And given the severity of the budget shortfall, the outlook for the state and companies that operate in it don’t look positive, observers say. California’s budget problems could make businesses targets of higher taxes and costs to bridge the gap.

Consumers could be tax targets too and that in turn would hurt businesses according to A.C. Moore, investment strategist at Dunvegan Associates, a money management firm in Santa Barbara, Calif.

“Californians don’t feel as wealthy as they used to, but they are going to have to pay more to support the budget deficit,” Moore said. “Perhaps we’ll see a moderation in consumer demand,” something that could weigh on company profits, he added.

A stopgap solution
A temporary solution the state’s budget mess was recently approved by the California state assembly. The measure closes the budget gap for this year, while the state faces an $8 billion gap for the next fiscal year.

Analysts say the stopgap measure, which led to downgrades of the state’s debt ratings by Standard & Poor’s and Lehman Brothers, simply defers difficult decisions on how to deal with the state’s $38 billion budget deficit.

“I don’t think the budget that just passed will do anything except push our problems off until next year,” said Chip Hanlon, chief domestic strategist at Euro Pacific Capital, a money management firm in Newport Beach, Calif. “Next year we’ll have to deal with all the structural problems, and it’s very likely that whoever gets in will have to raise taxes.”

Hanlon sees problems in the housing sector compounding the budget issue.

“The Californian economy is very tied to the real estate business, so if you get to a position where interest rates are not going to go back down again then the real estate business will see less refinancing and so less money,” said Hanlon. “Retailers and banks could feel it too.”

California suffered through similar troubles in the early 1990s when the demise of the defense industry led to a recession and growing unemployment. But Bob Pariseau, portfolio manager of the $720 million USAA California Bond Fund, thinks the state’s current troubles pale in comparison to those it faces just over a decade ago.

“Unless the legislature imposes draconian new taxes that scare away business from California the current crisis is fundamentally a state fiscal predicament, not a California economic problem,” Pariseau said.

“I see good coming out of the [gubernatorial] election,” Pariseau added. “If the state can find a solution for its problems in three to five years from now all this will be a bad memory.”

Companies may be hurt
Given the size of California’s economy, the way the state deals with the budget deficit after the gubernatorial recall election, scheduled for Oct. 7, will have a significant impact on companies that do business in California according to Henry Dixon, chief investment strategist at Lehman Brothers.

In a research report, Dixon notes that if taxes and fees are raised to plug the deficit it will be problematic for companies. Dickson also argues that, longer term, California’s policy steps will influence its competitive position to attract businesses and form new jobs.

“If the fiscal condition of California deteriorates, we believe the principal initial risk would be headline risk, as investors would apply a lower valuation to companies with high California exposure,” Dixon wrote.

Longer term, Dixon worries about the potentially lower margins that would result from the even higher cost of doing business in the state, and the resulting slower growth rate.

Sectors likely to be impacted include banks and thrifts, managed care companies, retailers and restaurants. Companies that fall into these categories, the report shows, include names like Washington Mutual, Long’s Drug Stores and Essex Property Trust. Dixon also shows that a basket of California-related stocks has underperformed the benchmark Standard & Poor’s 500-stock index by an average of about 5 percent over the last year.

The issue for these companies is “how their potential growth rate is altered if the California economy weakens because of the deficit, and, second, one of margin compression to maintain market share and targeted growth rates,” Dixon wrote.

Friendlier to business
Over time, high labor, rent, tax, and utility costs can impair job growth, Dixon noted, as opportunity flows to states or countries that create fewer headwinds for business. Certainly, over-regulation of business, most notably the soaring costs of the state’s workers’ compensation insurance, has driven a number of companies from the state.

In a survey conducted in April by the California Business Roundtable and California Chamber of Commerce, one out of five California business leaders said they plan to expand or move their companies outside California because of high business costs and excessive regulation, including a rise in worker’s compensation benefits. Tax breaks and other financial incentives are luring these firms to nearby states like Texas and Nevada.

“If you ask these companies where they’d rather be, the answer will begin with a ‘C,’” said Bob Pariseau. “The challenge for California is will it lose the technology innovators, the makers of wealth that are so vital to an economy.”

Dixon counsels the adoption of a more business-friendly approach to the state’s budgetary problem. “There is a multiplier effect when new jobs are created because every new job has a positive impact on the state economy,” noted Dixon. With this in mind, legislators should do all they can not to hinder industries where the multiplier effect is greatest, he added. Those industries include insurance, lodging and recreation services.