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Strength and Vulnerability

California's economy is healthy, but the housing slowdown and higher energy costs might represent perils for apparel retailing and manufacturing.

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With more than 36.5 million residents and an economy larger than Canada’s, what happens in California never stays in California.

The rest of the nation looks to the Golden State as a financial, political and cultural harbinger. Although economists maintain that California is generally in good financial health, citing low unemployment and strong business development, they also acknowledge there are problems. The housing market has cooled, energy prices are volatile and building-material costs are rising. These are weaknesses that may hurt many sectors, including apparel retailing and manufacturing.

In fact, some retail executives already see evidence of this happening. Mark Werts, owner and founder of the four-unit contemporary specialty store American Rag Cie, said his business has felt fallout from declines in residential real estate.

“Things have been more challenging since the correction in the housing market,” said the Los Angeles-based retailer. “When the housing market was booming along in 2005 and [early] 2006 and everyone’s house was increasing $200,000 a year, people felt rich. They went out to dinner more, they vacationed more….To say we’re not impacted by the housing market would be like going out on a cloudy day and saying it’s sunny. People are more careful with their [spending]…and take longer to make decisions on the sales floor.”

Still, California should have moderate economic gains and inflation this year, said Elizabeth G. Hill, chief fiscal analyst for the state legislature.

Unemployment last year was at its lowest this decade, 4.2 percent, compared with 5.4 percent in 2005 and 6.2 percent in 2004.

“Personal income and jobs statewide are a little stronger than the nation as a whole,” Hill said. “We have a very diversified economy. When some sectors are doing well, that can offset some of the softness in other areas — particularly in housing.

“We see risks to the economy,” she said. “Most worrisome are housing and energy. We’ve seen a slowdown in the residential housing market that’s affected employment…and oil prices per barrel have been quite volatile.”

In addition, state government continues to have budgetary woes. In a report released in November by the Legislative Analyst’s Office, Hill noted that California would face an operating shortfall of $4.5 billion to $5 billion by the end of this year. For 2007-2008, expenditures were forecast to exceed revenues by more than $5.5 billion. The gap largely was attributed to “the state’s real estate downturn.”

This story first appeared in the March 21, 2007 issue of WWD.  Subscribe Today.

Despite the economy’s relative strength, “new building will be down this year in most areas,” said Jack Kyser, senior vice president and chief economist for the Los Angeles County Economic Development Corp. “But if there’s any silver lining, people are going to find that home prices have leveled and are declining, with foreclosures expected to increase. This should help with affordability.”

California’s housing boom, which ramped up in 2002, began winding down in late 2005. The slowdown follows a period in which the rapid increase in prices simply made houses unaffordable for many would-be buyers.

The California Association of Realtors said in a February report that in mid-2006 monthly sales fell to fewer than 500,000 homes for the first time in more than three years, representing a 23 percent slide from the same period in the previous year. The percentage of first-time buyers in the third quarter of 2006 shrank to 24 percent from 28 percent. The situation has resulted in an inventory build-up. Homes were on the market for an average of 6.4 weeks last year, compared with 2.1 weeks in 2005.

Although median home prices in major markets, including metropolitan Los Angeles, San Francisco and San Diego, continued to make single-digit gains last year, prices in parts of the Central Valley, the state’s rural breadbasket, declined by 5 to 10 percent.

Hill predicted that housing sales would continue to slow for the first half of this year before stabilizing. “They will start to move back up in the latter part of 2007, early 2008,” she added.

The slump is the most obvious blemish on California’s economic landscape, but opinions vary about whether the deceleration is damaging bottom lines. That’s because the ripple effects of what many consider to be a price correction in an over-valued housing market are still tough to consistently track statewide.

Economists and analysts did agree that retailers with a direct connection to home sales, including furniture outlets and housewares stores such as Pottery Barn and Williams-Sonoma, take hits when would-be homeowners postpone buying. However, Dale Achabal, director of the Retail Management Institute at Santa Clara University, said the connection between apparel revenue and “for sale” signs was tenuous.

“There doesn’t appear to be a high correlation between what happens in the housing market and what happens in most sectors of retail, certainly not on the apparel side,” Achabal said. “If you are a specialty apparel retailer, there are probably other factors that are more important in driving your business.” He listed personal income as one of those factors.

Some executives on the front lines of retailing differ with Achabal’s conclusions.

Rick Leto, president of Hayward, Calif.-based moderate department store chain Mervyns, said the company has soft sales in regions that developed rapidly between 2005 and 2006, but have now slowed — including the Inland Empire area in Southern California and the Central Valley.

“Being positioned at the lower end of the midtier category, we feel it when the housing market starts to slump,” Leto said. “We started to feel it at the end of last year. Our customers are the people building the houses, not buying the houses. They’re the people in the service industry, those who support the building industry.”

Leto also cited rising gasoline prices and an increase in the amounts that employees must contribute to health care plans as factors affecting sales. “All of this impacts disposable income,” he said. “It leaves less and less money available to make clothing purchases. But I will say that the month of March has started off very strongly.”

Analyst Hill also cited the pattern of steep ups and downs in oil pricing. “In the summer, they were $73 a barrel, then dropped to $52 a barrel. Now we’re around $60 a barrel,” she said. “We’ve had to make assumptions [on energy prices] in order to advise the legislature about the economy. It affects consumers and business.”

Dov Charney, founder and president of Los Angeles-based American Apparel, said his sportswear company has been less affected because of some key factors, including a young target consumer.

“Our sales are really driven by people in cities,” he said. “That’s where most of our stores are….Adults who own homes and live in Orange County are maybe feeling the pinch. But I’m dealing with younger people that are emerging into their careers. I don’t know how tied they are to the cycle of mortgages. If the real estate market goes down, it could provide cheaper housing for younger people and that could actually work out [well] for [sales].”

Ron Roaks, broker for Prudential Commercial Real Estate in Modesto, Calif., maintained that “retail follows population, not the housing market. Right now in central California, we see a decline in residential prices, but not…in population. And the cost of housing doesn’t translate into a decline in population. Retail has been doing quite well here. We’re seeing that office demand is not as strong as it was. The industrial [market is] kind of flat.”

The volume of inquiries regarding commercial spaces from national companies has not slackened since 2004, he said.

Still, increased home mortgage payments — should interest rates rise — could alter consumption patterns. Mary Gilly, a professor in the Paul Merage School of Business at the University of California, Irvine, said homeowners ultimately would “need to cut back…and retail is one area where that is easy to do — just don’t buy new clothes, or shop at TJ Maxx rather than Nordstrom.”

Shopping center developers said their primary economic concern is the rising cost of building materials.

Steve Geil, president and chief executive of the Fresno County Economic Development Corp., said relief is not at hand.

“The cost of materials is continuing to escalate at a rapid pace,” he said. “With all the building activity globally, we no longer compete state by state, we compete with China, which is going through the roof. Concrete and wood products are…being affected by the demand. [Demand] always brings more competitive pricing.”

Randy Brant, senior vice president of development and leasing for Santa Monica, Calif.-based

developer Macerich, which owns and operates 22 malls in California, said the higher costs coincide with an advantageous period for reinvestment in existing properties. “At the forefront is the cost of construction. It’s something that is a challenge for us in light of the fact that it’s hitting at the time that we have the most opportunity to improve and change our centers. With the recent consolidation of department stores, it’s offered us a great opportunity to

reposition our centers.”

Brant added that a slumping housing market might actually lower building costs because of lower demand for materials.

“I don’t think we’ve seen or felt the affects of the housing market yet,” he said. “But common sense tells me that our next proposed development may not occur as soon as we thought it would.”

The company doesn’t have plans to build new centers in the state because “there just aren’t that many opportunities,” Brant said.

Materials prices are always an issue, said Rick Caruso, founder and president of Caruso Affiliated, a Los Angeles-based shopping center development and management company.

“We have over $1 billion of [property] under construction,” Caruso said. “When pricing moves, it affects us….Our rental rates are moving up, so we’re being able to absorb it. Labor cost has not moved significantly…consumer spending has stayed strong. [Rising] unemployment would hurt us, but that’s not happening. It’s almost a little bit scary because it’s too good.”

Ken Wong, president of U.S. sales for shopping center development company the Westfield Group, which operates 24 centers in California, said construction costs have been increasing for as long as five years, “but we’re seeing a slight slowdown in the rate of increase lately.”

Like Macerich, Westfield has focused on reinvesting rather than ground-up construction.

“In California, we’ve really emphasized reinvestment of existing centers,” Wong said. “The pricing of assets still favors redevelopment of existing holdings versus acquisition. If interest rates go to a nice percent instead of a prevailing 6 percent — which they are now — asset pricing will shift accordingly. The emphasis of how we’re investing capital would change.”

The outlook for apparel manufacturers likely will be influenced by the higher minimum wage. The state increased the rate by 75 cents to $7.50 on Jan. 1 and plans to boost it another 50 cents to $8 in 2008. As a result, manufacturers are struggling with how to maintain production in California and keep costs down.

“That’s going to be difficult for us,” said Sharon Lebon, president and chief executive officer of Three Dots LLC, a contemporary knitwear company that employs about 200 people in its headquarters and factory in Garden Grove, Calif. “Our dye houses will raise the prices. We buy a lot of our fabrics in California. Minimum wage is going to go up again. It’s going to have an impact on our prices.”

To offset higher costs and maintain profit margins, Lebon said Three Dots might raise prices on basic items, such as tops made of 1×1 ringspun combed cotton, by the end of the year. It also might consider manufacturing some items overseas. Still, Lebon said keeping production in California is advantageous because it allows the company to closely monitor quality and continue to ship new products to stores each month. Lebon said she expects sales to grow 25 to 30 percent to between $80 million and $100 million at retail this year from 2006.

Jerry Leigh Inc., a Van Nuys, Calif.-based company that makes clothes under license for Harajuku Lovers, Walt Disney, Levi’s Red Tab and other labels, said although its costs are running a little higher because of the minimum wage increase, it is researching technology that would help automate warehouse operations.

“We’re investing heavily in upgrading our computer pick-and-pack warehouse operations systems,” said Jeff Silver, chief operating officer at Jerry Leigh, which employs about half of its 600 workers in Van Nuys and the rest in Central America and New York. “We’re trying to look at every aspect of the supply chain and find where there might be efficiencies to counteract the increased labor costs we have.”

Companies looking to expand their manufacturing and corporate base this year likely will see few vacancies in established industrial cities such as Vernon and Riverside, said Ilse Metchek, executive director of the California Fashion Association in Los Angeles. “There’s a 1.5 percent industrial vacancy rate in the Los Angeles region,” she said. “If you are a high-margin company, you cannot find the room for the factories. Technology firms and everyone else are vying for the same spaces.”

Office and industrial developments have moved inland from Los Angeles in recent years, resulting in an increase in vehicular traffic in suburban areas, said Metchek, who added: “In those areas, you also don’t have proximity to the cities or the Alameda Corridor [trucking route].”

The economy isn’t the only factor affecting the apparel business in California. Retailers said less predictable influences, including weather patterns and celebrity-driven trends, exert considerable sway over consumer spending habits.

Manuela Frignani-Perkins, owner of designer specialty store Angelica Haley in Fresno, said the unseasonably warm winter season has left her with a surplus of unsold inventory.

“The weather had a heavy impact on fur,” she said. “People bypassed all of those heavy purchases. In years past, that type of garment was really successful for us.”

This month, Huntington Beach, Calif.-based Quiksilver blamed disappointing fourth-quarter results on the lack of snow in the U.S. and Europe, which resulted in poor sales of ski equipment and other hard goods.

Fraser Ross, owner of the Kitson-branded stores in Los Angeles, said fickle weather patterns influence sales more than any outlying economic factor, adding: “We’re already selling summer goods as opposed to spring goods [because] of how warm it is.”

Merchants said keeping up with celebrity-driven trends, which are dictated by a cadre of stylists, fashion editors and costumers, is becoming ever more important.

Ron Herman, owner of the influential Ron Herman boutiques in the Los Angeles area, considers his company to be less about retail and more about entertainment. “That’s really our industry,” he said. “Television, fashion, clubs, movies and music….Those things are what affect my business. That’s the economics of Southern California.”

— With contributions from Khanh T.L. Tran

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