PacSun’s Strategic Positioning and Results for the Year

There are two things I really like about PacSun’s 10K annual report (read it here) which was filed last Friday. The first is that they are more or less through closing stores. From a peak of 950 stores in 2008, they ended their February 3rd fiscal year with 644 stores. They closed 38 stores in fiscal 2008, 40 in 2009, 44 in fiscal 2010, 119 in 2011 and 92 in 2012. This fiscal year, they expect to close 20 to 30 due to lease expirations or kick-out rights (where they have a lease they can get out from under if, for example, certain sales levels aren’t reached). 

There’s the positive impact on financial results where they aren’t operating poorly performing stores, taking asset impairment charges, incurring cash costs for closings, and lower inventory margins and possible write downs as they close stores. There’s also the fact that they can stop focusing management time, attention and resources on this fundamentally “not fun” even if necessary task. 
With that out of the way, what they can do now is focus all their energy on their strategy. As you know, before CEO Gary Schoenfeld took over, PacSun had lost its way. For a variety of reasons, its targeted customers no longer had a reason to visit their stores. PacSun wasn’t cool. 
This is an issue that has been recognized since Gary’s tenure started. But they were busy turning over the whole senior management team, closing stores, and dealing with financial issues. With the introduction of their Golden State of Mind brand positioning in 2012, they are primarily focused on implementing the strategy that is to address this. 
PacSun characterizes itself as “…a leading specialty retailer rooted in the action sports, fashion and music influences of the California lifestyle.” 
They go on to say, “Our mission is to provide our customers with a compelling product assortment and great shopping experience that together highlight a great mix of both branded and proprietary merchandise that speak to the action sports, fashion and music influences of the California lifestyle. PacSun’s foundation has traditionally been built upon a great collection of aspirational brands, including Billabong, Crooks and Castles, DC Shoes, Diamond Supply Co., Fox Racing, Hurley, Neff, Nike, O’Neill, Roxy, RVCA, Vans, Volcom, and Young and Reckless, among others. We also continue to invest in and grow our proprietary brands, which include Bullhead , Kirra , LA Hearts , On the Byas , Black Poppy and Nollie…Taken together, we believe that this mix of brands gives us the capability to offer our customers an unmatched selection of fashionable and authentic products synonymous with the creativity, optimism and diversity that is uniquely California.” 
Equally interesting is a presentation Gary made this January at an investors’ conference where he showed how the men’s brand mix had changed from 2009 to 2013. The two empty boxes are for new brands being introduced in 2013. One of them is Neff.
Talking about the men’s business in the conference call, CEO Schoenfeld said, “Strong growth continued within our emerging brands and in our footwear business, which was driven by the strong performance by both Nike and Vans but was offset by continued declines in some of our heritage brands and the decline in some of proprietary business as the make up of our brand mix continues a pretty significant shift and in a direction that we are excited about.” 
You can decide for yourselves what it means. The point is that they are looking at their brand strategy carefully in terms of the competitive positioning they have chosen and making changes they consider appropriate. In the conference call, CEO Schoenfeld said, “We continued to partner with highly covetable emerging brands that are beginning to make PacSun, once again, the brand destination in the mall.” 
Their three main strategic focuses haven’t changed. They are, according to Schoenfeld, “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.”   Their targeted customers are the “…17 to 24-year-old guys and girls who value great brands and have a confident sense of their own style.” 
Okay, that’s enough. This is starting to sound like a PacSun commercial, but you get the picture. 
Their proprietary brands were 48% of net sales in the year ended February 2nd, 2013. There was a time I would have thought that way too high. But in the era of brands becoming retailers and retailers becoming brands, I don’t necessarily believe that. What PacSun is doing feels a lot like what Buckles does, with the private brands completely integrated into the retailer’s overall strategy, and not just an opportunity for a little more margin. I still wonder when we’re going to see some retailer take one of its successful private brands and sell it to other retailers. Or maybe it’s happened and I’ve missed it? Obviously, brands that have become retailers are doing it. Let me know if you’re aware of an example. 
As with all serious retailers, PacSun has a focus on the quality of its information systems and supply chain management. Getting the right product to the right store at the right time is worth a lot in terms of customer satisfaction, not to mention the financial benefits of better inventory and cost management. Typically, each PacSun store received new merchandise twice a week.
The Numbers 
Most of the numbers in the 10K are for the year, but I’ll give you what we’ve got for the quarter before moving on. Revenue of $228 million was up 4.3% from $209 million in the same quarter last year. However, the year ended February 2, 2013 included an extra week compared to the prior year that generated an incremental $8 million in sales. The gross profit margin was 21.1%, up from 19.3% in last year’s quarter. The loss from continuing operations fell from $26.7 million to $22.5 million. The bottom line improved from a net loss of $38.1 million to a net loss of $19.1 million however discontinued operations (stores being closed) showed income of $2.6 million in this year’s quarter compared to a loss of $11.4 million in the prior year’s quarter. 
The balance sheet isn’t as strong as it was a year ago, with the current ratio falling from 1.58 to 1.37. Total liabilities to equity rose from 2.14 to 3.88 which is quite an increase. The liabilities didn’t change much, but equity fell $113 million to $64 million.
Inventory rose a bit from $88.7 to $90.7 million. Might have expected some decline with the store closings.  But as I recall, a lot of those closures happened in the first part of 2013, so perhaps we will see it early this year. In the conference call they tell us the inventory was up “…due primarily to timing of a 1 week later end to the fiscal year…leading to increased in-transit inventory. Store inventory per square foot at fiscal year-end was down 11%.” 
Net sales for the year rose from $777 to $803 million, or by 3.3%. Comparable store sales grew by 2% during the year. That accounted for most of the revenue growth. Men’s apparel represented 48% of revenue, down from 49% the prior year. Women’s apparel stayed the same at 37%. Footwear and accessories rose from 14% to 15%. Denim overall was 17% of sales, down from 19% in the prior year. Internet sales were 7% of the total, up 1% from the prior year. 
The gross margin grew a bunch from 21.9% to 25%. Most of that came from the merchandise gross margin increasing from 46.9% to 49.1%. Selling, general and administrative expenses fell from $242 to $239 million. That includes advertising costs of $15 and $14 million respectively for the two years. There was a $5 million decline in depreciation expense. 
Noncash impairment charges for stores fell from $14.8 million last year to $5.3 million this year.  Obviously, those decline as store closures fall, but I would note that most of the charges in the year just ended ($5.2 million of the total) were “Impairment charges from continuing operations.” 
The operating loss was $38 million, down from $78 million the prior year. Interest expense rose from $4.4 to $13.3 million so the loss from continuing operations after tax was $52.2 million, down from $82.1 million. The net loss was $52 million compared to $106 million last year. In the year ended January 28, 2012 there was a loss of $24 million from discontinued operations. That loss was $144,000 in the year ended February 2, 2013. 
Finally, I’d note that net cash provided by operating activities was $6.4 million, compared to a negative $47.4 million the prior year, and a negative $40.9 million the year before that. That’s good to see. 

So what have we got here? Well, we’ve got a focused strategy that seems to make sense. Whether it’s the right one will become known in the fullness of time. We’ve got financial results that are improving but still poor. Losing $52 million, even though it’s less than last year just isn’t success quite yet.   And we’ve got a weakening balance sheet. The questions seems to be, as it’s been for PacSun before, can the strategy be successful enough quickly enough before the balance sheet deteriorates further. If not, what other sources of capital will be available to them?