PacSun’s October 30 Quarter; Big Changes Take Time

PacSun released their earnings and had a conference call on November 22nd. So why am I just getting around to writing about it? It’s because they didn’t file their 10Q until December 9th. I’m funny like that- I like to have the most complete information I can before doing much analysis.

What I was hoping for, but not expecting, was some detailed discussion of the company’s strategy. I didn’t really get it. The quarterly numbers are important, and I’m interested in hearing about cost pressures, and how various segments are doing. But what I really want to know is how Pacific Sunwear is going to make itself relevant to its target market again. We have the broad outlines of that strategy, but it’s too soon to know how it’s going to work out. Let’s take a short detour into the company’s recent history to understand what ‘s going on.

Recent History
 
Gary Schoenfeld took over as PacSun’s President and CEO on June 29, 2009, replacing Sally Frames Kasaks. Ms. Kasaks had a stellar background in retail, but it was never clear she quite “got it” in the action sports/youth culture space. Mr. Schoenfeld (former President and CEO of Vans) clearly does “get it” and is taking a different approach.
 
She had taken PacSun out of shoes, and he reversed that decision. Her merchandising strategy had the same assortment at all the stores. He’s moving to make it specific to location. He mentions in the conference call that he’s been cautious about rolling the localization strategy out and that the “…actual execution didn’t begin to materialize until towards back to school.” This is a critical strategy that should impact margins and sales. To some extent, the strategy had been delayed because they didn’t have somebody who could lead the execution, a problem now resolved. I talk below about their management transition and its impact.
 
Gary Schoenfeld talked about the need to reconnect with the customer and the culture in a way Sally Kasaks never did and he has rolled out some marketing initiatives to do that. As he put it in the conference call, “I talked [when he first took the job] about the importance of reestablishing our relationships with brands, improving our merchandising and selling culture within our stores, connecting with our customers, and reigniting a culture of passion and creativity within Pac Sun.” Zumiez could have written that.
 
He’s cut the number of stores from over 900 when he started to 877 at the end of October and expects to be at about 850 by the end of January 2011. Depending on how accommodating landlords are, we may see a further cut of over 100 stores in the next couple of years.
 
To me, the most telling thing he’s done is to hire eight new vice presidents and promote a ninth in the last 11 month. The most recent hires were in September and October. There were, obviously, some vice presidents who left the company as well. They’ve also changed their whole regional director team in the last 12 months.
 
The list of management on their web site only has 12 people, including Mr. Schoenfeld. So these changes represent a nearly complete turnover. My experience is it takes a minimum of at least a couple of months for a new senior manager to become fully effective.
So we’ve got a big management transition going on along with an attempt to change and reinvigorate the culture. That ought to keep them off the streets. And, like every other company, they are doing it in a difficult economy. Like other companies, they are concerned about sourcing and product costs hurting their margins. Also like other companies, they don’t expect to be able to pass these costs along to consumers. CEO Schoenfeld notes they “…are committed to working aggressively to try to maintain our gross margins next year through better product assortments, localization initiatives, detailed review of product specs, and refined pricing strategies.” I expect there will be some price increases as well.  
 
I have neither a crystal ball nor a level of arrogance that allows me to think I can predict whether they will succeed or not. With the level of change they’ve undertaken, it’s just too soon to tell. But I do know this; if PacSun had continued along the same path it was on, it would be in a world of hurt. Like I keep saying, the biggest risk is to take no risk at all.
 
And Now, the Numbers
 
I’ve got the balance sheet from a year ago to compare the October 30, 2010 one to. I feel more like I’m comparing apples to apples that way.
 
Current assets have actually grown a bit, but that’s mostly because they’ve got some more cash and that’s almost never a bad thing. In August, PacSun borrowed $28 million in term money secured by some of their facilities.
 
I was a bit surprised to see that their inventory was down only $2 million to $166 million. With lower sales, fewer stores, and the kind of tight inventory management we’re seeing from other companies, I expected more of a decline. CEO Schoenfeld said they “…were down modestly, and consistent with our expectations in terms of how were planning the quarter.” They don’t say this, but I wonder if it might have something to do with their decision to localize assortments. Maybe until they get that dialed in, it requires a little extra product.
 
Net property and equipment is down about $60 million.
 
Accounts payable rose from $63 million to $77 million. Long term liabilities were up due to the mortgage debt they took on in August. The current ratio is essentially the same, riding from 1.93 to 2.02 over the year. Total liabilities to equity is up from 0.57 to 0.89. This is mostly explained by the loss the company has incurred. At the end of the quarter, they had no direct borrowings under their line of credit and $95 million in availability.
 
Sales for the quarter fell 3.9% to $257.9 million. Comparable store sales were down 3%. That’s the smallest quarterly drop this fiscal year.  Gross profit fell from $73.4 million to $64.4 million. Gross profit margin was down from 27.4% to 25%. Most of that decline was due to a “Decrease in merchandise margin as a percentage of sales primarily due to a decrease in initial markups and increase in markdowns, particularly within denim and wovens.”
 
They cut their selling, general and administrative expenses by 20.5% to $71.1 million. As a percentage of sales, that’s down from 33.4% to 27.6%. 1.6% came from a decline in payroll expense. 2.8% was because their $2 million noncash charge in this category for underperforming stores was so much lower than the $9 million charge in the same quarter last year.
 
The reduction in expenses was what allowed them to cut their operating loss from $15.9 million in the third quarter last year to $7.1 million this year. Their net loss was about $7 million for the quarter compared to a loss of $10.9 million in the same quarter last year. Their income tax provision this quarter was only $173,000 compared to $5.04 million in the same quarter last year, so maybe we’re better off looking the pretax loss, which fell from $15.9 million to $7.1 million.
 
For nine months, the pretax loss was $53.2.0 million last year and rose to $61.1 million for the nine months ended October 30, 2010.
 
We need to give Pacific Sunwear some more time. The extent of the change they are undertaking requires it. I wish they didn’t have to climb the mountain of a lousy economy while they did it.