PacSun’s Annual Report: Missions, Strategies, Prospects

PacSun rode the economic expansion to 950 plus mostly mall based stores (they were down to 852 at the end of the year). They got over extended, had systems that didn’t give them the ability to merchandise as they needed to, didn’t keep their stores updated, became too dependent on their own brands, and basically lost the cool factor that made their target customers come to their stores. Then came the recession and cratering of the juniors market (38% of their revenues in 2010).

Since becoming CEO, Gary Schoenfeld has started to make the changes required to address these issues. But as I said when I wrote about them last December, change takes time. And money. In a word, what PacSun has to do is make itself relevant again to the “teens and young adults” it’s focused on. While they’ve got the time and money to do it.

Before the analysis, here’s the link to their 10K if you want to see it.

Missions and Strategies
 
PacSun’s objective “…is to provide our customers with a compelling merchandise assortment and great shopping experience that together highlight a great mix of heritage brands, proprietary brands and emerging brands that speak to the action sports, fashion and music influences of the California lifestyle.”
 
Their first strategy is to have a strong emphasis on brands. They divide those brands into three components; the industry brands they’ve worked with for a long time (heritage brands they call them), their proprietary brands, and new, emerging brands. But their proprietary brands were 46% of revenue in 2010. That’s down from 48% the prior year, but way up from 38% the year before that.
 
Retailers should have their own brands. But at some level of revenue, those brands are no longer complimentary, but competitive with the industry brands the retailer carries. At 46%, PacSun is focused on the performance of their own brands. Yet those owned brands obviously can’t compete with Quiksilver or Volcom from a market position point of view, so it becomes at least partly a price game. And at 46% of revenue, well, what kind of store are you? Are you a store where customers come to get good deals on less well known brands? PacSun warns in its risk factors that “Our customers may not prefer our proprietary brand merchandise which may negatively impact our profitability.” Probably wouldn’t need that risk factor if their brands were 15% of revenue instead of 46%.
 
I recognize that PacSun can’t change this dependency quickly if only because of cash flow implications, but I hope they work to reduce it. I think it might be difficult for them to become important again to their target consumers if they don’t unless they have a whole lot of money to spend on promoting their own brands. Then, of course, they would become direct competitors with their heritage brands.
 
Their next strategy is to undertake “New Strategic Marketing Initiatives.” We’ve seen some positive activities from them in this area. They also note that they are working with key heritage brands to “…create new programs and approaches to generate excitement around PacSun and the California lifestyle we embody…” But they plan to do it “without meaningfully increasing our total marketing expenses.” Advertising expense was $17 million in 2010, $14 million in 2009, and $16 million in 2008.
 
Related to marketing, they have a risk factor that focuses on the danger of not reinvesting in existing stores. They say, in part, “We believe that store design is an important element in the customer shopping experience. Many of our stores have been in operation for many years and have not been updated or renovated since opening. Some of our competitors are in the process of updating, or have updated, their store designs, which may make our stores appear less attractive in comparison. Due to the current economic environment and store performance, we have significantly scaled back our store refresh program.”
 
What I’m hearing is that they know what they need to do, but have some constraints in terms of what they can afford. More on that when we get into the financials.
 
Their third strategy is localized assortment planning. They are moving away from the “one size fits all” method of allocating inventory and starting to do it according to what sells best where. Good idea. I’m not sure it rises to the level of a strategy, however. It’s just something retailers have to do to be competitive. Let’s call it an operating imperative.
 
While they don’t call it a strategy, they’ve closed 44, 40 and 38 stores respectively in each of the last three years. They expect to close 30 to 50 during 2011. They have close to 400 leases that end or can be modified through 2013, so I expect we’ll continue to see either store closing or better results from stores where negotiations with landlords are successful. They note that they will be closing more stores than they open.
 
The Financials
 
In the fourth quarter, PacSun lost $35.2 million on sales of $263 million. For the year ended January 29, 2011, sales fell 9.5% from $1.027 billion to $930 million. The loss increased from $70.3 million to $96.6 million.
 
Sales per square foot for the year fell from $275 to $258. In 2007, it was $350. Well, we’ve all taken some hits since 2007. Internet sales represented 5% of sales in both 2010 and 2009. That mean internet sales fell for PacSun. Average dollar sales per store were $1 million, down from $1.1 million the previous year and $1.3 million the year before that. Comparable store sales fell 8%. Men’s increased 2% but women’s was down 19%.
   
Management says that a big factor in the sales per square foot decline was the performance of denim. It was 22% of revenues in 2009 “…driven by our proprietary Bullhead denim and our foundational ‘skinny’ fit.” In 2010, PacSun’s denim sales fell by 20% because “….denim became a very price-competitive business with very little newness or uniqueness in the marketplace in terms of fit or trend.”
Everybody had a hard time with denim in 2010. But what I think I’m hearing is that their Bullhead proprietary brand didn’t have the brand positioning it needed to withstand the difficult competitive conditions. Uh, you might go back up and read what I wrote about proprietary brands above. Maybe I’m onto something?
 
The other factor in the sales per square foot decline PacSun mentions is accessories and footwear. It represented 30% of sales in 2007, but only 12% in 2009. Remember they got out of the shoe business? They have reentered it and now have shoes in 450 stores.
Gross margin fell from 25.2% to 22.1%. Please note that gross margin as PacSun defines it is after buying, distribution and occupancy cost. They indicate that 1.6% of that decline came from having to spread costs over a smaller sales base. 1.4% came from the merchandise margins (what many of you think of as gross margin) falling from 48.1% to 46.7% “…due to a decrease in initial markups and an increase in markdowns…”
 
Selling, general and administrative expenses were down $40 million to $301 million. They also fell as a percentage of sales.
Okay, now let’s take a look at the balance sheet and its change over the year. The current ratio fell from 2.42 to 2.11. Cash declined from $93 million to $64 million. Interestingly, inventory rose from $89.7 million to $95.7 million at a time when sales are down and stores are being closed. I would not have expected to see that. Total debt to equity rose from 0.56 to 0.87. Equity is down by about one-third from $307 million to $214 million.
 
In August, PacSun did a couple of mortgage transactions, borrowing a total of $29.8 million. They note in the Management Discussion (as well as in the risk factors), “If we were to experience a same-store sales decline similar to what occurred in fiscal 2010, combined with further gross margin erosion, we may have to access most, if not all, of our credit facility and potentially require other sources of financing to fund our operations, which might not be available.”
 
Since Gary Schoenfeld became CEO, PacSun has done most things right. In my mind, there are two major issues. First is whether the financial constraints they appear to be operating under will allow them to finish the turnaround without additional capital. Second, and actually more important, is whether they can get the customer they want back. The company’s decline and then some time spent treading water has given PacSun’s target customers an awfully long time and good reasons to shop elsewhere. It might take as long to get them to come back.