PacSun’s Quarter: Still Losing Money, But Elements of the Strategy Becoming Clearer

Strategies don’t bear fruit in a quarter, or even in a year. There’s still a lot of work to be done before we can say that PacSun’s strategy has been successful if only because the company is still losing money. The goal has been the same for a couple of years now; to make PacSun relevant to its target customers again. Let’s see how they’re doing.

First the bad news. As reported, PacSun had a net loss of $17.5 million in the quarter ended July 28th compared to a loss of $19.3 million in the pcp (prior calendar period- the same quarter the previous year). Here’s where you can see the 10Q yourself.

Sales, however, rose 4.7% from $200.9 million to $210.3 million. Gross margin rose from 23.6% to 27.5%. They credit 2.6% of the gross margin increase to the merchandise margin going from 48.8% to 51.4% “…due to an increase in initial markups and a decrease in promotions.” 1.1% of the gross margin was due to same store sales rising by 5% and some “…reduction in rent expense related to negotiations with our landlords.” Comparative store sales were up 7% in men’s and 2% in women’s. On line sales rose 15%. They mention in the conference call that they are seeing a higher average unit retail “…offsetting a modest decline in traffic.” They expect that to continue in their third quarter.
PacSun had 727 stores open at the end of the quarter compared to 821 in the pcp. They expect to end the year with 625 stores.
For any new readers, I’ll remind you that a brand’s gross margin is mostly its merchandise cost while a retailer’s gross margin adds other expenses to cost. In PacSun’s case this includes buying, distribution and occupancy expenses.
Selling, general and administrative expenses were essentially stable at $64 million. As a percentage of sales they fell from 31.8% to 30.2%. The loss from discontinued operations was zero compared to $1.8 million in the pcp.
That results in a loss from continuing operations after taxes of about $17.5 million for both periods. However, this year’s quarter includes an $8.2 million loss on a derivative liability that’s related to the 1,000 preferred shares of stock issued to Golden Gate Capital as part of the $60 million term loan PacSun received from it. The change in value has to be reported at fair value every quarter. If you look at their operating loss before that and taxes it fell from $16.5 million to $5.7 million.
The balance sheet shows a current ratio that fell slightly from 1.44 to 1.27 over the year. Total liabilities to equity improved from 1.43 times to 0.78 times. Cash on hand rose from $13 million to $34 million. Inventory declined 11.4% to $145 million, consistent with the closing of stores. More importantly, on a comparable store basis, it was down 6%. Shareholders’ equity fell by half, from $166 million to $82 million.
They reported $18 million in positive cash flow. Net cash used in operating activities declined from $43.7 million to $13.5 million.
I’m sure you’re all tired of boring numbers by now, so let’s get on to the fun, uplifting strategic stuff.
In his opening comments on the conference call, CEO Gary Schoenfeld described their strategy this way:
“…we continue to be focused on 3 main tenets of our strategy: authentic brands, trend-right merchandising and reestablishing a distinctive customer connection that once again makes PacSun synonymous with the creativity, optimism and diversity that is uniquely California.”
They talk about the important role of new brands. CEO Schoenfeld mentions how they are finding them at trade shows he’s just come back from.
It’s interesting to watch the relationship between brands and retailers evolve. Years ago, I cautioned new brands about getting too involved with big retailers too quickly. I wouldn’t give that advice anymore. There used to be a certain negative stigma to a brand jumping out of the core specialty channel too quickly. As the customer base has broadened, the number of core specialty retailers declined, and the sensitivity of large retailers to brand management improved, a strong relationship with a major retailer can jump start a small brand.
We all know retailers are building their own brands, and some brands have made exclusive arrangements with big retailers. I wonder if we won’t see large retailers trying to buy brands as they become important to that retailer.
New brands fit into PacSun’s positioning as a California lifestyle brand. Take a look at their Golden State of Mind web site. The web site “…allows the user to experience all things California in 6 key categories, including fashion, music, art, entertainment, action sports, and of course, with our brands.” For PacSun (and for most others I’d say) it’s not just about action sports anymore. Hasn’t been for a while.
Schoenfeld goes on to say, “Customers are experiencing our brand and our unique filter of California lifestyle through multiple touch points in our stores and online, and we believe this will continue to be a critical differentiator for PacSun as we reestablish and emotional connection with customers across the entire United States.” True, but of course they aren’t the only one trying to do it.
Now the next piece of the mix. Remember that before Gary Schoenfeld became CEO, PacSun was placing the same assortment in all its stores? He started the process of changing that. This involves improved or new systems with timely information about what’s selling where. But it also requires discussions with the brands you buy and the manufacturers of your owned brands and some changes in logistics and inventory management. It’s operations, but it’s also marketing. You can’t separate the two in the existing competitive environment.
One more quote from Gary Schoenfeld: 
“I think we have gotten better at how we segment between store groups. But all of that, I think we can continue to improve upon as we go forward. And then probably the fourth element that’s common to both genders has been just an overall effort towards reducing SKU count, and therefore, making the stores easier to shop and easier to showcase key brands on the Men’s side and key fashion ideas, as well as critical essentials business on the Women’s side.”
Regular readers will know I’ve been writing for years about how operating well is a requirement just to get the chance to compete- not a competitive advantage. And even more recently I’ve described how a number of industry companies are bringing together online and brick and mortar, controlling all their consumer touch points, and working to provide the unique experience the consumers is demanding.
As they describe it, that’s what PacSun is trying to do. I don’t have any doubt that it’s the right approach. The market is demanding it. Though there are savings from operating well, I see the strategy as costing some money to implement.
PacSun got the $60 million term loan from Golden Gate Capital to have the resources and buy some time to implement its strategy. Some of the quarter’s financial metrics are encouraging and, as I said, I think it’s the right strategy.  But others are taking the same approach and have more financial resources.
I’ll end where I started. Strategies don’t bear fruit in a quarter, or even a year. This is a work in progress.