PacSun Quarter and 9 Months Ended 10/28/06- Good Tactics. What’s the Strategy?

         Pacific Sunwear’s (NASDAQ: PSUN) official SEC filing isn’t out yet (I’m writing this November 26 because I love working Sundays), but I’ve read the press release, reviewed the associated financial statements for the quarter and nine months ended October 28, and listened to the conference call. Let’s look at the numbers first, and then talk about the conference call.

 The Numbers
        The quarter showed a slight decline in sales from $377 to $375 million. But gross margin fell from $144 to $106 million—or from 38.2% to 28.3%. Selling and General and Administrative expenses rose from $81 to $93 million. Net income fell from $40.5 to $9 million or from $0.54 to $0.13 per share on a fully diluted basis.

         On the balance sheet, the current asset fell from 3.45 a year ago to a still strong 2.34 at the end of this October. The only other thing I’d note from the balance sheet is that, even after a write down, inventory—at $253 million—was still nearly $10 million higher than a year ago.

         In the mix was a same-store sales decrease of 6.7% and the ten cents a share inventory write down—primarily for footwear and accessory categories. The CEO resigned and was replaced by Company Lead Director Sally Frame Kasaks as interim chief executive officer. At different times in her career, Ms. Kasaks was Chairman and CEO of Ann Taylor Stores, President and CEO of Abercrombie & Fitch, and Chairman and CEO of Talbot’s, Inc. I think we can conclude she knows a bit about specialty retailing.

         With financial results like that, the stock must have cratered, right? Nope. The press release was dated November 9. The stock closed that day at $17.27. The next day it rose to $18.56—a 7.47% gain on volume that was 3.76 times the average volume. The company’s most recent closing price as I write this was $19.48. The conference call was held on the November 10 at 5:30 in the morning Pacific Time. No, I did not listen to it live.

       Clearly some people were pleased with what they heard on that call, and maybe had been expecting quarterly numbers that were worse than they were. But what made them so happy?
The Conference Call
        I wish they made transcripts of conference calls available or—if they do—I wish I knew where I could get them. Trying to write down all the good things Ms. Kasaks said they were doing as quickly as she was talking was a real pain in the butt. I kept trying to stop and restart the replay, but Media Player isn’t built for rewinding fifteen seconds. And another thing, left-handed people with lousy writing should not be allowed to own fountain pens—much less try and take fast notes with them. Uh, I seem to have gotten off track.

         Anyway, Ms. Kasaks highlighted three key big ideas for Pac Sun to focus on. They were:
      1. A commitment to build the juniors business to increase sales and store productivity.
      2. A focus on improving the in-store presentation of merchandise.
      3. A strategic assessment to understand how they can reconnect with their customers.
These three big ideas followed a list of initiatives Pac Sun was undertaking. I want to quote one of those initiatives: “Put more focus on transitional merchandise with the implementation of our spring floor set at the end of January. This will insure that our spring product is presented earlier than last year while being merchandised with more wear now product than in the past.”

         I thought this initiative required a little explanation and discussion.
Transitional merchandise is product that’s brought in during one season (winter in this case) and can be worn in that season, but can also be worn during the upcoming season (spring). Sweaters in spring colors might be an example. You sell it now and wear it now—but they carry over into the next season.
         The reason you do this is that it has the potential to improve your sales in the existing quarter. The danger is that if you don’t do a really good job in selecting merchandise, picking the right quantities, and merchandising it well, you may get to the next quarter with assortments that are old.
         In other words, at the extreme, you could theoretically end up just transferring sales from one quarter to an earlier one. PacSun spent some time on its conference call discussing some issues in just these areas, so it will be interesting to watch them implement this initiative.
         I think there were seven initiatives in total, including the one I quoted above. Somehow, I’ve managed to write down nine. I was either listening too slowly or writing too quickly. They included a review of the company’s customer communications program and in-depth customer research. Other initiatives will focus on inventory and in-store presentation. They want to reduce inventory density in their stores “to provide assortment clarity and in store presentation.” They noted a decline in their sneaker business and have plans to improve their assortment.  They will review it “to be in line with customer preferences.”
         They have plans to improve their merchandise presentation “without undertaking a major investment in time and capital.” They are utilizing something they called a “refresh” format that involves certain new design and layout elements. And they’re trying to improve the process by which they update their monthly floor sets.
         Due to time and cost constraints, you can’t wave a magic wand and have all 1,169 stores (835 are PacSun) updated. They are working to figure out what seems most likely to work and to implement the changes as time and capital permit. They are developing a new logo and new layout that provides what they characterized as a much more sophisticated look, and expect to do 30 to 40 remodels utilizing this concept next year. Sounds like the right direction and right process to me.
         That they are doing this isn’t a surprise to anybody who has been in a PacSun, Zumiez, and Hollister store lately. In Hollister, there’s a certain calmness that makes you feel like you’re on the beach. Their attempt to connect to the surf market—and they seem to do it pretty well—is clear. Zumiez carries hard goods. That has given them credibility in the market even as their store numbers expand. PacSun has the right brands and competitive prices but needs, in the words from the conference call, “To understand how they can reconnect with their customers.”
         During the conference call, Ms. Kasaks acknowledged that she doesn’t think PacSun can be authentic at their size. While that may cause a gasp of dismay and prognostications of their demise in some action-sports circles, I found it refreshing. It’s inevitably true for a company with this many stores. So you recognize it, work on evolving your inventory and your look, and undertake a strategic reassessment.
         So what’s the strategy? That’s what PacSun management is figuring out. They’ve done an awful lot in three months. They’ve been open about their issues and have moved to implement tactics that address them. I can’t wait to walk into one of their remodeled stores and see where the strategic reassessment came out. In the meantime, we’ll all keep watching PacSun as a barometer of what’s happening in the broader lifestyle market and worry about how their initiatives impact orders and sales of our brands.