How Our Market is Changing: PacSun’s August 3 Quarter

We will, of course, get to the numbers. Among other things, we’ll talk about the impact of an extra week and their derivative liability.   But let’s start by jumping right to the conference call and noting some things CEO Gary Schoenfeld says.

He defines their core customer as “…the more fashion-savvy, older teen and early 20 consumer…” He does that in the context of discussing some of their new brands, “…which includes Kendall & Kylie and Brandy Melville.” Like me, you may not have wanted to know that Kendall and Kylie are the two youngest Kardashian sisters.  I’ve provided links to these two brands (Kendall & Kylie appears to be exclusive to PacSun) so you can get a look at the product if you aren’t already familiar with it. 
 
I note that one of the four key drivers of PacSun’s business is, “is to be a leader in anticipating and recognizing the fashion trends that emerge from our backyard and translate these to the marketplace with the expediency that today’s digital world now require…” I wonder the extent which that means “fast fashion.” The price points on the Kendall & Kylie product and the fact that a bunch is sold out suggests there’s an element of that. Go look at it yourself.    
 
Moving on to their men’s business, Gary notes “…emerging brands, footwear and accessories continued to perform well, yet this has been offset by softness in summer seasonal categories such as shorts and board shorts, resulting in a minus 2% comp for the second quarter.” He also notes that “Lack of newness in basic denim is similarly stifling the Men’s business as we transition to fall…” 
 
I’ve been increasingly thinking of denim as moving towards a commodity, and I haven’t seen anything recently to make myself change my mind. Gary says “…basic denim in both Men’s and Women’s has become somewhat of a commoditized category across the mall…” But he notes that their chino business is expanding.
 
I sit here considering the possibility that the highlighted trends in denim, shorts and board shorts are a longer term trend and wonder how t-shirts are selling. What business does that leave core action sports brands in? I’ll get back to you on that, but here’s what Gary thinks: 
 
“So the Men’s business is transitioning. The old PacSun was a short, board short, basic denim and T-shirt business, and I think we’re going through what I believe will ultimately be a healthy transition to a new group of brands, to further growth in footwear and accessories but also further recognition for us as a leader in style and again, taking our inspiration from what we see coming from our backyard here in California.” 
 
To be clear, I am not critical of what PacSun is doing. I may not be thrilled with Kendall & Kylie and Brandy Melville replacing some traditional action sports brands, but I think PacSun’s focus on new brands and fashion is appropriate and necessary. The “inspiration” they are taking from what they see in California has a lot less to do with action sports than it used to have. 
 
Zumiez must be viewing this with interest. On the one hand, they seem to own the core action sports space in the mall. On the other hand, what exactly is that space and what kind of comparable store growth can they expect from it? Their 10Q just come out this morning, and Quik is next. Also, I’m theoretically on vacation this week, so give me a break. 
 
Income Statement
 
We’ve made it to the numbers. Below is the summary income statement from the 10Q.
 
 
 
There’s a $17.9 million sales increase. However, there was a one week calendar shift in the quarter compared to last year. That means this year’s quarter included a peak back to school week instead of a not quite so good week in May. The 10Q says, “This resulted in an approximately $9 million increase in net sales, a 1.2% improvement in gross margin, and a $0.06 per share improvement to our loss from continuing operations per share for the second quarter of fiscal 2013, compared to the second quarter of fiscal 2012…” 
 
They also note that “…comparable store net sales increased 3%, average sales transactions increased 2% and total transactions increased 1%, as compared to the same period a year ago,” but of course that’s impacted by the extra $9 million in sales as well. Women’s were up 11% on a comparable basis, while men’s declined by 2%. 
 
The gross margin rose from 27.4% to 29.6% but, as already noted, a chunk of that was the result of the extra week. 
 
Selling, general and administrative expenses were down in total dollars and also fell as a percent of revenue from 30.5% to 27.1%. 1.7% of that decrease was the result lower payroll and related expenses. Probably from closing stores. 1.4% was the result of less depreciation mostly from store closures and 0.7% was from non-cash impairment charges declining from $2 million to $1 million. Other SG&A expenses increased by 0.4%. 
 
It looks to me like if we take into account the extra $9 million in sales and the impact of store closing, it’s hard to tell if these expenses increased or decreased as a percentage of sales. 
 
Anyway, that leaves us with an operating result which improved from a loss of $6.1 million to a profit of $5.3 million. I don’t know what it would have been without the $9 million of extra revenue. 
 
Now, I’m afraid, it’s time for fun with the derivative liabilities, which you can see as a separate line item in the statement above. I’ll keep this short. This is a noncash item, as they love to tell us. The convertible preferred stock issued to Golden Gate Capital has to be valued every year. The higher the stock price, the more it’s worth because the conversion price doesn’t change. While it’s not cash, it does represent a claim on income that will not be available to other shareholders, so it needs to be included as an expense. Okay, that’s it. 
 
We have, then, a loss that’s increased some. The comparison from last year’s quarter is negatively impacted by the increased derivative liability but positively impacted by the extra $9 million in sales. In the conference call, we learn that if we ignore the derivative liability, exclude the store closing charges and use an income tax rate of 37%, PacSun had income from continuing operations of about $1 million compared to a loss of $6 million. 
 
The company ended the quarter with 637 stores compared to 727 year ago. They plan to close 20 to 30 stores during fiscal 2013 as previously reported. 
 
Balance Sheet and Cash Flow 
 
The cash flow shows that operations used $17.1 million in cash during the first six months of the year compared to $13.5 million in last year’s six months. Someday, that needs to turn positive. The thing that catches my eye on the balance sheet is that shareholders’ equity is down to $22.5 million from $81.2 million a year ago. Total liabilities to equity have increased form 3.64 times a year ago to 13.9 times now. Cash is down from $34.8 to $26.9 million. 
 
Inventory has fallen only slightly from $144.8 to $140.3 million. Given that they have 90 less stores, I might have expected more of a decline. Perhaps this has to do with the transition of brands that’s going on. The current ratio has fallen from 1.27 to 1.05. That’s potentially kind of tight, though remember it’s just the number at one specific day. 
 
When PacSun mortgaged its real estate and made the deal with Golden Gate Capital, I said they’d bought themselves some time to implement their strategy. Even with the extra week thing, they’ve increased sales compared to last year’s quarter with 90 less stores. And I think their strategy and brand turnover is realistic and appropriate. 
 
Their balance sheet has my attention now. They haven’t drawn their line of credit and don’t think they will need to over the next 12 months if their forecasts are reasonable. But if their losses continue and they keep using (rather than generating) cash in operations, they may have to start.

   

4 replies
  1. fran richards
    fran richards says:

    It’s great to see Gary Schoenfeld and his public company team looking at a big picture and reacting to the broader product and fashion issues of “sameness of product” that many our entrenched and insular suppliers ( most notably the surf and skate centric brands) have hoped that no one would notice.

    I’m impressed. Keep changing and make sure to take some risk on the merchandising and brand fronts. Bravo.

    • jeff
      jeff says:

      Hi Fran,

      I agree (which you already know because that’s what I wrote). My concern is now how much time they need to make some money and have a positive cash flow, because their balance sheet is starting to weaken again. I suspect the extent of the required change is way more than Gary thought when he took the job- if only because the whole market has continued to change so quickly.

      J.

  2. Abercromb Ian Fitch
    Abercromb Ian Fitch says:

    To me, what’s interesting is their election to buck the trend of moving back to the core audience in times of lean, and trying to “rebrand” as a fashion retailer with less emphasis on action sports. I thought the “Golden State of Mind” campaign was smart, in trying to capture their marketing demographic in a unified way, but I am a little confused as to their goals here, which seem too broadly dispersed, and without the needed emphasis on beach culture that got them their initial successes. Just my 2 cents.

    • jeff
      jeff says:

      Good morning Mr. Fitch,

      The real core market just isn’t big enough to support them as a 600 store retailer in the mall all over the country. They really have no choice. Their concept of what’s California based is interesting, and goes way beyond how you and I have traditionally thought of that. Too broad? Maybe. We’ll see. It needs to work quickly.

      Thanks for the comment.

      J.

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