Can the Golden State of Mind Take Hold? PacSun’s First Quarter

Though PacSun still reported a loss in the quarter ended May 3, the income statement improved compared to the same quarter last year. Sales were up 2.9% from $166.4 to $171.1 million. The increase was the result of comparable store sales being up 3% compared to last year’s quarter. The average sales transaction was up 6%, though the number of transactions was down 3%. Ecommerce sales during the quarter grew 6% compared to last year’s quarter and represented 7% of total sales.

The store count was down to 618 from 638 a year ago. They expect to open four stores during the remainder of the year and close another 10 to 20.

 The gross profit margin rose from 25.1% to 26.1%. The merchandise margin rose 1.4% but increases in other costs left Pacsun with a net gain of 1%.
Selling, general and administrative expenses fell slightly from $52.8 to $52 million. As a percentage of sales they were down from 31.7% to 30.4%.
Higher sales and gross margin combined with unchanged SG&A expense meant that the operating loss fell 33% from $11 to $7.4 million. The net loss was $10.4 million, down from $24.2 million in last year’s quarter.
In between operating income and net income is the dreaded “(Gain) loss on derivative liability” which is related to the 1,000 shares of convertible series B preferred stock issued to Golden Gate Capital as part of a $60 million term loan they got a couple of years ago. In last year’s quarter, it was reported as a loss of $9.3 million. This year’s quarter showed a gain of $1.2 million. That’s a cumulative difference of $10.5 million before the impact on income taxes.
I imagine most of you will be both thrilled and relieved to learn that I am not going to spend time discussing how those numbers are calculated. Feel free to review footnote 10 of the 10Q here if you just can’t stand not to know.

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PacSun’s Annual Report and Quarter: Improvement, But More Needed

PacSun’s 2013 fiscal year ended February 1, 2014, and that’s the year we’re discussing here. You can review the 10K yourself here. I’d like to start with CEO Gary Schoenfeld’s mention in the conference call of the “…four key pillars of our overall strategy.” They are, he says: 

“…our commitment to showcasing distinct brand identities derived from the best of brands that are inspired by the streets, the beaches, the skate parks, music, art, and culture that lives across the state of California. Second is to be a leader in anticipating and recognizing the fashion trends that emerges from our backyard and translate them to the marketplace with the expediency that today’s digital world now requires.”
“Third is to bring the creativity, diversity and optimism that is quintessentially California to every consumer touch point through our Golden State of Mind platform. Fourth is to continue to build the top talent organization across the country that similarly thrives on creativity, fashion, and a relentless desire to be the best.”
I’m in favor of all of those but especially like number three- the Golden State of Mind- because it’s the only one of the four that might offer a point of differentiation from other retailers. The other three are what all retailers in this space are trying to achieve. Maybe PacSun will do them better than their competitors.
PacSun ended its fiscal year with 618 stores. It increased its sales for the year from $785 to $798 million. That’s up from $759 million and $756 million in the two years before that. The fact that there was one less week in fiscal 2013 compared to fiscal 2012 meant that they had $8 million less in revenue than they would otherwise have had.
Remember that over recent years their sales results were achieved while closing nearly three hundred stores. They closed 30 during the just completed fiscal year. At the end of the 2009 fiscal year they had 894 stores. They think they will close another 10-20 during this fiscal year. 
Comparable store sales were up 2% as they were the prior year and accounted for almost all of the sales increase. That number includes PacSun’s internet sales, which were 7% of total sales during each of the last two years. Men’s apparel fell from 48% to 46% of revenues. Women’s rose from 37% to 39% and footwear and accessories remained at 15%. As for most retailers, the denim category is tough. It fell from 17% to 13% of revenues during the year.
Nike, including Hurley, represented 10% of revenues during the year. More interesting to me was that their proprietary brands represented 49% of total net sales, up from 47% the previous year. There was a time some years ago when I would have said (did say) that was too big a percentage to get from their own brands. But times change, and some brands don’t have the pull they used to have with PacSun’s target customers. In addition, as PacSun notes, proprietary brands allow them to offer better value to the customers who are looking for that (there’s a lot of that going around), manage their inventory better and respond to fashion trends more promptly. And hopefully PacSun makes a few more points of margin.
The gross profit margin at 25% was the same as the prior year. SG&A expense as a percentage of sales fell from 29.9% to 27.7%. In dollars it fell from $235 to $221 million. Most of the decrease in SG&A was the result of lower depreciation and a decline in payroll and payroll related expenses.
The operating loss improved from $38.4 to $21.4 million. The net loss was $48.7 million compared to $52.1 million last year. I should point out that they booked a loss on their derivative liability of $10.6 million compared to almost nothing last year.
Sales for the fourth quarter were $218.6 million with a net loss of $22.5 million. In last year’s fourth quarter, sales were $222.9 million and the loss was $19.9 million. Remember that fourth quarter ended February 1.
The balance sheet continues to deteriorate, which is what can happen when you lose money. Total equity fell from $64.4 to $18.1 million. As a result, total liabilities to equity increased dramatically from 1.88 to 14 times. The current ratio declined from 1.37 to 1.14. Cash at year end fell from $48.7 to $27.8 million and we see on the cash flow that operations used $7.7 million in cash compared to generating $6.4 million the prior year.
I’m not prepared to blame all of PacSun’s problems on the economy but, like many retailers, their numbers have yet to recover from the economy cratering in 2007-8. Economic conditions still aren’t favorable, especially for the target customers of PacSun and similar retailers.
CEO Schoenfeld, responding to an analyst question talked about “…the reality of PacSun being I think pretty unique from just about any other retailer in the mall today.” I hope it’s true, because that kind of distinctiveness is what they need. Unfortunately, the analyst didn’t follow up and ask him to clarify that comment.
As I’ve said before, the balance sheet places some urgency under PacSun’s need to at least cut their losses significantly and pretty quickly. I agree with most of what they are doing but what they really need is for the youth employment situation to improve. I would not be surprised to see some kind of new financing arrangement in the fairly near future unless PacSun’s results improve dramatically.  



PacSun’s Quarter: The Transition Continues

I have been writing for a while now, without having a really good answer, about just what market we are in as action sports doesn’t, for most of our companies, adequately describe the customer base or competitive environment. Outdoor, youth culture, fashion are all words bandied about to describe it. It’s probably some of all of those. 

Pacific Sunwear has figured this out. It’s recognized that action sports isn’t a big enough market to support its plans. As a public company it has to seek some growth and it needs the broader market to find that. It’s choice of brands and positioning as a southern California lifestyle company is indicative of this. I think they’ve made the right choice (in fact the only choice they could make) even though it puts them in a position to have to compete against other fashion focused retailers like Forever 21 that Zumiez, for example, with its action sports positioning and focus doesn’t compete against quite so directly.
Reported sales for the quarter ended November 2nd fell 4% from $215.5 million to $206.6 million. However, due to the retail calendar shift, fiscal 2012 had an extra week in it. 
“Due to the inclusion of a 53rd week in fiscal 2012, there is a one-week calendar shift in the comparison of the third quarter of fiscal 2013 ended November 2, 2013, to the third quarter of fiscal 2012 ended October 27, 2012. The third quarter of fiscal 2012 included a higher volume back-to-school week as a result of the 53rd week retail calendar shift compared to the third quarter of fiscal 2013. This resulted in a decrease in net sales of approximately $11 million, a 1.9% decrease in gross margin…”
So there would have been higher margins and sales if not for the shift in the calendar. Gross margin fell from 28.1% during the quarter to 25% in the same quarter last year. It was basically all due to the calendar shift. 1.9% of the decline was due to lower merchandise margins. The rest of the gross margin decline was also due to the calendar shift because it caused an “Increase in occupancy, distribution costs and all other non-merchandise margin costs…”
In the conference call they tell us, “The decline in gross margin in the third quarter was the result of a challenging and competitive back-to-school landscape, leading to a higher promotional activity.” I wish somebody had asked them to compare what the 10Q says about gross margin with that statement from the conference call.
Selling, general and administrative expenses as a percentage of sales fell from 27.5% to 26.1%. Half the decline was due to a reduction in depreciation that resulted from store closings. The rest was from lower expenses. PacSun reported an operating loss of $2.24 million compared to an operating profit of $1.15 million in last year’s quarter. For the nine months ended November 2nd, the operating loss fell to $8.1 million compared to $22.8 million in the comparable nine months the previous year.
 Net income for the quarter rose from $948,000 to $17.2 million. Obviously, when you have an operating loss but a positive net income, there has to be something interesting going on between the middle of the income statement and the bottom- and there is.
There’s a gain on derivative liability of $23.4 million. In last year’s quarter the gain was $5.6 million. That is a non cash item associated with some of their financing activities that I’ve described before. You may read the footnotes in the 10Q if you have a compelling urge to know the details.
If we remove that non cash item from both quarters, we find that the loss in last year’s quarter before taxes and discontinued operations would have been $2.01 million. In this year’s quarter, it would have been $5.8 million.
In the cash flow, we see PacSun continues to use, rather than generate cash in operations. They used a bit over $21 million in both this fiscal year’s 9 months and last year’s. On the balance sheet, the current ratio has fallen from 1.38 to 1.21 and total liabilities to equity rose from 3.18 to 6.99 times compared to a year ago. Current liabilities in this quarter include a separate line item for derivative liability of $27.1 million. It was not broken out in last year’s quarter. I assume it was included in other current liabilities.
Merchandise inventories were almost constant at $137 million. They ended the quarter with 635 stores compared to 722 stores a year ago. They are, by the way, going to close another 15 to 20 stores during this quarter.
I might have expected a 12% decline in store count to result in some inventory reduction. They note in the conference call that “Adjusting for the timing of the 53rd week calendar shift, total inventory was down approximately 3% on a comparable store basis,” but I don’t think that takes closed stores into effect.
If I were running PacSun I think I’d have done basically what they’ve done. Because I don’t see a second viable choice. The balance sheet is still weakening. What PacSun (not to mention a host of other retailers) needs is some improvement in consumer spending.



How Our Market is Changing: PacSun’s August 3 Quarter

We will, of course, get to the numbers. Among other things, we’ll talk about the impact of an extra week and their derivative liability.   But let’s start by jumping right to the conference call and noting some things CEO Gary Schoenfeld says.

He defines their core customer as “…the more fashion-savvy, older teen and early 20 consumer…” He does that in the context of discussing some of their new brands, “…which includes Kendall & Kylie and Brandy Melville.” Like me, you may not have wanted to know that Kendall and Kylie are the two youngest Kardashian sisters.  I’ve provided links to these two brands (Kendall & Kylie appears to be exclusive to PacSun) so you can get a look at the product if you aren’t already familiar with it. 
I note that one of the four key drivers of PacSun’s business is, “is to be a leader in anticipating and recognizing the fashion trends that emerge from our backyard and translate these to the marketplace with the expediency that today’s digital world now require…” I wonder the extent which that means “fast fashion.” The price points on the Kendall & Kylie product and the fact that a bunch is sold out suggests there’s an element of that. Go look at it yourself.    
Moving on to their men’s business, Gary notes “…emerging brands, footwear and accessories continued to perform well, yet this has been offset by softness in summer seasonal categories such as shorts and board shorts, resulting in a minus 2% comp for the second quarter.” He also notes that “Lack of newness in basic denim is similarly stifling the Men’s business as we transition to fall…” 
I’ve been increasingly thinking of denim as moving towards a commodity, and I haven’t seen anything recently to make myself change my mind. Gary says “…basic denim in both Men’s and Women’s has become somewhat of a commoditized category across the mall…” But he notes that their chino business is expanding.
I sit here considering the possibility that the highlighted trends in denim, shorts and board shorts are a longer term trend and wonder how t-shirts are selling. What business does that leave core action sports brands in? I’ll get back to you on that, but here’s what Gary thinks: 
“So the Men’s business is transitioning. The old PacSun was a short, board short, basic denim and T-shirt business, and I think we’re going through what I believe will ultimately be a healthy transition to a new group of brands, to further growth in footwear and accessories but also further recognition for us as a leader in style and again, taking our inspiration from what we see coming from our backyard here in California.” 
To be clear, I am not critical of what PacSun is doing. I may not be thrilled with Kendall & Kylie and Brandy Melville replacing some traditional action sports brands, but I think PacSun’s focus on new brands and fashion is appropriate and necessary. The “inspiration” they are taking from what they see in California has a lot less to do with action sports than it used to have. 
Zumiez must be viewing this with interest. On the one hand, they seem to own the core action sports space in the mall. On the other hand, what exactly is that space and what kind of comparable store growth can they expect from it? Their 10Q just come out this morning, and Quik is next. Also, I’m theoretically on vacation this week, so give me a break. 
Income Statement
We’ve made it to the numbers. Below is the summary income statement from the 10Q.
There’s a $17.9 million sales increase. However, there was a one week calendar shift in the quarter compared to last year. That means this year’s quarter included a peak back to school week instead of a not quite so good week in May. The 10Q says, “This resulted in an approximately $9 million increase in net sales, a 1.2% improvement in gross margin, and a $0.06 per share improvement to our loss from continuing operations per share for the second quarter of fiscal 2013, compared to the second quarter of fiscal 2012…” 
They also note that “…comparable store net sales increased 3%, average sales transactions increased 2% and total transactions increased 1%, as compared to the same period a year ago,” but of course that’s impacted by the extra $9 million in sales as well. Women’s were up 11% on a comparable basis, while men’s declined by 2%. 
The gross margin rose from 27.4% to 29.6% but, as already noted, a chunk of that was the result of the extra week. 
Selling, general and administrative expenses were down in total dollars and also fell as a percent of revenue from 30.5% to 27.1%. 1.7% of that decrease was the result lower payroll and related expenses. Probably from closing stores. 1.4% was the result of less depreciation mostly from store closures and 0.7% was from non-cash impairment charges declining from $2 million to $1 million. Other SG&A expenses increased by 0.4%. 
It looks to me like if we take into account the extra $9 million in sales and the impact of store closing, it’s hard to tell if these expenses increased or decreased as a percentage of sales. 
Anyway, that leaves us with an operating result which improved from a loss of $6.1 million to a profit of $5.3 million. I don’t know what it would have been without the $9 million of extra revenue. 
Now, I’m afraid, it’s time for fun with the derivative liabilities, which you can see as a separate line item in the statement above. I’ll keep this short. This is a noncash item, as they love to tell us. The convertible preferred stock issued to Golden Gate Capital has to be valued every year. The higher the stock price, the more it’s worth because the conversion price doesn’t change. While it’s not cash, it does represent a claim on income that will not be available to other shareholders, so it needs to be included as an expense. Okay, that’s it. 
We have, then, a loss that’s increased some. The comparison from last year’s quarter is negatively impacted by the increased derivative liability but positively impacted by the extra $9 million in sales. In the conference call, we learn that if we ignore the derivative liability, exclude the store closing charges and use an income tax rate of 37%, PacSun had income from continuing operations of about $1 million compared to a loss of $6 million. 
The company ended the quarter with 637 stores compared to 727 year ago. They plan to close 20 to 30 stores during fiscal 2013 as previously reported. 
Balance Sheet and Cash Flow 
The cash flow shows that operations used $17.1 million in cash during the first six months of the year compared to $13.5 million in last year’s six months. Someday, that needs to turn positive. The thing that catches my eye on the balance sheet is that shareholders’ equity is down to $22.5 million from $81.2 million a year ago. Total liabilities to equity have increased form 3.64 times a year ago to 13.9 times now. Cash is down from $34.8 to $26.9 million. 
Inventory has fallen only slightly from $144.8 to $140.3 million. Given that they have 90 less stores, I might have expected more of a decline. Perhaps this has to do with the transition of brands that’s going on. The current ratio has fallen from 1.27 to 1.05. That’s potentially kind of tight, though remember it’s just the number at one specific day. 
When PacSun mortgaged its real estate and made the deal with Golden Gate Capital, I said they’d bought themselves some time to implement their strategy. Even with the extra week thing, they’ve increased sales compared to last year’s quarter with 90 less stores. And I think their strategy and brand turnover is realistic and appropriate. 
Their balance sheet has my attention now. They haven’t drawn their line of credit and don’t think they will need to over the next 12 months if their forecasts are reasonable. But if their losses continue and they keep using (rather than generating) cash in operations, they may have to start.


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?


Pacific Sunwear’s Quarter; Look! It’s a Profit!

PacSun earned $948,000 in the quarter ended October 27 compared to a loss of $17.6 million in the same quarter last year. Their comparable store sales rose 1%. It’s the first time that’s happened since the third quarter of 2007. Their loss for nine months is $32.2 million compared to a loss of $68.3 million in nine months in the previous year. 

Okay, progress though not the end of the turnaround road. They did it by increasing their gross margin from 24.4% in last year’s quarter to 26.6% this year and by cutting selling, general and administrative expenses (SG& A) from 30.2% of sales to 27.2% of sales. Sales increased only slightly from $226.8 million to $228.4 million.
Remember, this is a company that’s still closing stores. They closed a net of five during the quarter and ended it with 722 stores compared to 820 a year ago. They expect to have closed an additional 75 stores by the end of the fourth quarter in January. I would guess that those closings will largely happen after the holiday shopping season.
Most of the gross margin increase came from the improvement in the merchandise margin from 47.2% to 49%. Of the 3% decline in SG& A, 1.80% came from a decline in non-cash impairment charges for long lived assets. These assets are mostly furniture, fixtures, equipment and leasehold improvements for stores being closed. In last year’s quarter, the charge was a bit over $7 million. This year, it was only $533,000.
They’ve now written those assets down to $6 million and, as of the end of the quarter, think they can recover it all. Is so, we shouldn’t see any future write downs for store closings.
There was also a 0.8% decrease in depreciation (which you’d expect as stores get closed and there are fewer assets to depreciate). There was also a 1.1% decrease in other SG& A expenses “…primarily due to the timing of advertising expenses and a decrease in consulting fees.” To the extent the decline was due to timing, I assume it just moved to the next quarter. Finally, there was an offsetting 0.7% increase in compensation due to an increase in employee benefits.
I also want to point out that net income includes a $5.6 million “Gain on derivative liability.” This has to do with their estimate of the fair value of the Series B Preferred shares using “highly subjective” inputs. Now I’m guessing that nobody really wants to get into those details, but should I be wrong, you can check out footnote nine in their 10Q. My holiday gift to you.
Over on the balance sheet, we see that cash has risen from $8.3 million a year ago to $23.9 million. Cash is good. Inventories are down from $152 million to $137 million as you’d expect with stores being closed. The inventory decline on a comparable store basis was about 4%. Current assets at $182 million are down just $3 million with cash basically replacing inventory on the balance sheet.
Net property and equipment has declined from $158 million to $131 million with the store closures and asset write offs we’ve discussed. Total assets are down $28 million to $348 million.
Current liabilities are up slightly from $129 million to $132 million, which is a bit of a surprise. Accounts payable are down $22 million which again makes sense with stores closing, but other current liabilities have jumped from $39 million to $65 million over a year. Oh- that’s mostly the derivative liability thing and a $6 million increase in accrued compensation and benefits.
Long term liabilities have risen 37% from $96.4 million to $132.2 million. Deferred lease incentives and rent are down (again, it’s the store closings). But other long term debt and liabilities have risen in a year from $55.2 million to $100.5 million. Shareholder equity is down 45% from $150.4 million to $83.3 million.
Okay, well those balance sheet numbers make me scurry to the cash flow for nine months. I see that net cash used in operating activities has fallen from $45 million to $22 million. And cash used in investing activities has fallen from $9.8 million to $3.1 million. That’s an improvement, but we’re still a long way from a positive operating cash flow.
CEO Gary Schoenfeld told the analysts that PacSun continues 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.”
He left it to poor Mike Kaplan, the CFO, to provide the guidance for the fourth quarter. Excluding the stores to be close by the end of the quarter, they expect comparable store sales to be down 1% to 3%. They project a “…non-GAAP net loss per share from continuing operations of $0.09 to $0.17 for the quarter…” I imagine that will translate into a loss at the net income line.
They reasonably pointed out that this year’s fourth quarter includes an extra week, which incurs expenses at the usual rate, but has weak revenue because of the time of the year.
I was all excited when I saw the profit and positive comp for the quarter, but less excited after I’d been through the numbers. There’s no doubt there’s been a tremendous amount of progress. Lots of battles won, but the war goes on. The company is still cash negative, and to some extent the positive comp (and it was only 1%) is the inevitable result of closing enough stores that aren’t performing. But when you get down to your good stores, you need to be doing better than 1%.
It’s not easy for me to evaluate PacSun while they are still closing bunches of stores. Apparently, that will mostly be over at the end of January. It’s interesting that yesterday I was reading and writing about Zumiez, and wrote that they had a solid market niche that they had to continually validate but also break out of as the action sports lifestyle market changed. That’s both their challenge and their opportunity.
PacSun’s challenge, on the other hand, is to figure out and establish to the satisfaction of their customers what their market niche is. They lost their “distinctive customer connection” and are working to get it back. But that means they aren’t gated, at least compared to Zumiez, by their historical market positioning. And that might be a good situation to be in right now.



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.



PacSun’s Quarterly Results: The Financial Statements Show Progress

The strategic issue hasn’t changed. As CEO Gary Schoenfeld put it in the conference call, “Regrettably, over the past several years, PacSun lost some of its identity as a brand and its relevance among target consumers…” If they can fix that, they can succeed. Gary Schoenfeld took the job because he thinks they can. 

You can see their 10Q here. The headline is that they cut their operating loss by 34%, from $27.8 million in the quarter ended April 28th to $18.3 million in the same quarter last year.
Their net loss fell by even more, from $31.5 million to $15.6 million. But last year in the quarter there was a $2.8 million loss on discontinued operations (none this year- see below). And this year they had a $6.3 million gain on derivative liability associated with the Golden Gate Capital loan and $3.3 million in other expenses below the operating line that didn’t show up in the quarter last year. That’s why I started with the operating numbers.   
Sales grew only slightly from $171.9 million to $173.8 million. Remember they are working with 729 stores at the end of the quarter compared to 827 a year ago.
They had a 1% increase in comparable store sales in both men’s and women’s. It’s the first time they’ve done that in a quarter since fiscal 2005, they reported.
Mostly, they improved their results by increasing their gross margin from 19.3% to 23.6%. 1.6% of the increase was from higher initial markups and a decrease in promotions. 2.2% was from leveraging occupancy costs over higher comparable store sales.
When you close 98 stores, you get rid of a lot of costs. But of course you also lose the sales associated with those stores. CEO Schoenfeld talked a bit about these stores during PacSun’s presentation at the Piper Jaffray Consumer Conference on June 6. He noted that many of these closed stores were low volume stores and that there was simply no way to fix them. You can click through from PacSun’s web site to listen to that presentation.
You can see the impact of these stores from a 10Q footnote on discontinued operations (number 12 if anybody cares). As defined, they didn’t have discontinued operations for the quarter ended this April (they only closed 5 stores and the cash flow implications weren’t “significant”).
But in the quarter ended April 30, 2011 they closed 25 stores. Those stores had revenue of $13.9 million and generated a net loss of $2.8 million on a gross profit margin of only 16.6%. Boy, you can really hear those dogs barking. PacSun will close another 100 stores this year- mostly after the holiday season, which makes sense, and you can imagine the positive impact that will have if their numbers are similar.
PacSun reduced its selling, general and administrative expenses from $61 million to $59.3 million. As a percent of sales it fell from 35.5% to 34.1%.
The balance sheet weakened, as you would expect with continuing losses and the loan from Golden Gate. But inventories were down a bit over 10%, which you’d expect with the store closings. They pointed out in the conference call that inventories fell 3% on a comparable store basis.
Implicit in some of the discussion in the conference call and the presentation was the way PacSun was thinking about brands and its mix of purchased and proprietary brands. What I heard was that they were being a little more thoughtful- maybe more purposeful is a good way to put it- about how the two work with each other. Proprietary brands are no longer just what you use to make some extra gross margin to the extent your store merchandising can stand it. They are being used in coordination with purchased brands to offer customers the best assortment of pricing, design, features, and merchandising they can. PacSun isn’t the only retailer thinking that way of course, but it’s an important change nevertheless.
Sitting in my ivory tower, I can make various pronouncements that PacSun needs to make its stores “cool” and a destination again. At the Piper Jaffray conference, Gary Schoenfeld reminded the audience (and me) that accomplishing that involves “…doing lots of blocking and tackling…” every day. “Cool” is the results is thousands of individual actions over an extended period of time. It’s a lot of work and takes a solid management team. In the case of PacSun, the management team underwent an almost complete change after Schoenfeld came in.
Making that change and then getting new ideas, processes, and attitudes to filter down to the rest of the organization takes a while. You can hear it’s getting some traction now.
It will also be interesting to see how PacSun performs a year or so from now when those last 100 stores are closed. You don’t celebrate having to do that, but the cost, management focus, perception of the company, and just having that hanging over you isn’t good. No positive energy there.
Hopefully, getting that done along with the impact of the new management team will do a lot for PacSun’s performance.      



PacSun Makes Progress; Third Quarter Results, Store Closings, and Financing

When I looked at PacSun’s previous quarter I wrote, “The question in my mind, which hasn’t changed much since the last time I took a look at PacSun, is whether there’s enough uniqueness so they can afford to implement it [their strategy] given the economy and the company’s financial circumstances.”

Whether or not their strategy is a good one, they were becoming too cash constrained to implement it. If you were paying attention to this post at Boardistan in late November and the associated New York Post article, you knew something was going to happen.

Now it’s happened. As part of their conference call yesterday and release of their 10Q for the quarter ended October 29th, PacSun announced a $100 million line of credit from Wells Fargo that basically replaces their old line, a five year term loan of $60 million from private equity firm Golden Gate Capital (GGC), and plans to close 190 stores by the end of January 2013. Most of the closings will come near the end of the fiscal years. That makes sense as you’d like the holiday season to help you move inventory.
At the end of this quarter, PacSun had 820 stores and inventory of $152 million (at cost). 190 stores are 23% of their total stores. Assuming inventory is equally distributed among all the stores, they would have to reduce their inventory by 23% or $35 million. If you’re a brand that sells to PacSun, how do you think about that? Will PacSun move it to other stores? Will they close it out? Will they try and get you to take it back? Will they sell it somewhere you’d really rather it wasn’t sold? What’s the impact on your brand going to be when a chunk of your sales to PacSun just disappear?
One of the analysts kind of asked about this in the conference call saying, “Could you talk about conversations you’re having at the same level with the brands and your suppliers to make sure that you’re still in the best products and getting goods timely at the best prices and getting the best products from the key vendors?”
CEO Schoenfeld answered, “Yes, I really feel good about relationships, both with our key brand partners and our suppliers on our proprietary products. And they’ve been critical to the progress we’ve made and recognize that we still got work to do to get ourselves back to profitability, and they continue to be very supportive of our efforts.”
It’s the expected conference call kind of answer, and as always the devil will be in the details of the relationship with each brand.   
I’ll bet lots of brands are thinking about this issue. Makes those who tried to reduce their dependence on PacSun over the last year or two look pretty clever.
You know what it takes to close stores and revamp the ones you’ve got left (about 620 by the end of January 2013)? It takes money, and PacSun didn’t have enough. After the deal with GGC, they say they do. As CEO Gary Schoenfeld put it, “Securing this additional capital will enable us to fund the lease terminations previously mentioned, make selective store refresh and technology investments and supplement any further near-term operational cash flow needs.”
The deal gave GGC two seats on PacSun’s Board of Directors. The interest rate is 13%. 5.5% has to be paid in cash quarterly. The other 7.5% is accrues annually in arrears. That is, they increase the amount they owe and pay interest on that increase as well. PacSun also issued to GGC convertible preferred stock that can be converted into about 20% of the company’s stock at $1.75 a share. Expensive money, but they needed to do it.
Note that the date at which the deals with Wells Fargo and with GGC were signed was December 7th– the same date as the conference call and release of quarterly results. What clever person said, “The task expands to fill the time available?”
We also find out that before the quarter ended Pacsun was madly negotiating with its landlords and had negotiated buyouts of 75 leases at a cost of $13 million, short term lease extensions for 50 stores, and termination on lease expiration for 115 stores. They think they will close 80 stores during the rest of this fiscal year and 110 in the next one. They expect savings in the year that starts February 1, 2012 of $9 million before the buyout payments. Those annual savings should rise as more stores are closed and, of course, those savings are annual while the buyout payments are one time. So the return on invested capital looks pretty good.
The stores they are closing had average sales of $600,000 over the last 12 months and their sales were down 9% compared to the previous year. The 600 stores they expect to have left when the closing process is completed average $1.1 million in revenue and their comparative store sales were only down 1%.
The store closures are expected to reduce revenue by $100 million to $125 million, but improve EBITDA by $10 million to $15 million. The reduction in inventory should offer a similar improvement to the balance sheet. 
I assume that the landlord negotiations, GGC loan, and Wells Fargo credit negotiation didn’t each take place in a vacuum. Much like when Quiksilver got the Rhone investment, I’m guessing there were multiple party dependencies that had to come together. Must have been interesting, though that might not be the word you’d use if you were in the middle of it.
The Numbers
Over the year that ended October 29, 2011, PacSun’s balance sheet weakened some due to the ongoing losses. Over the year, the current ratio fell from 2.02 to 1.44. And total liabilities to equity rose from 0.89 to 1.5. Inventory fell 8%.
Even with sales down 6.2% this quarter compared to the same quarter last year, current liabilities rose 15% from $112 million to $129 million. It’s possible that’s nothing more than timing differences, but I think we can say that PacSun needed to find some additional resources so they could pursue their strategy faster. The GGC term loan won’t improve the balance sheet since it’s debt, but it will give PacSun the cash it needs to move forward. In a turnaround, cash flow is way, way more important than your balance sheet I can tell you from experience.
$13 million of the sales decline resulted from store closures. Another $7 million was from a 3% decrease in comparable store sales. They gained $4 million from stores not yet included in the comparable store calculation and from a 12% increase in ecommerce sales. Men’s sales were flat and women’s down about 5%.
The gross profit margin fell slightly from 25.0% to 24.2%. You would think there’d be a big opportunity to improve that if PacSun could get its coolness back. Selling, general and administrative expenses actually rose 6% from $71.1 million to $75.4 million. As a percentage of sales that’s up from 27.6% to 31.1%. This included $6.2 million in charges related to closing stores ($4.4 million of which was noncash).
The net loss rose 153% to $17.6 million from $7 million in the same quarter last year.
I characterize the store closings, new line of credit, and term loan as tactics that allow PacSun to pursue its strategy. I don’t think that strategy has really changed since Gary Schoenfeld became CEO two years ago. As he puts it, “We still have more to do to reestablish our brand identity and emotional connection with our customers, but I believe we are on the right path to make this happen.” He continues in another part of the conference call, “So we do continue to recognize that part of our turnaround is getting people excited again about PacSun and what our brand means and strengthening that emotional connection."
I agree with that. I’ll bet everybody in the industry agree with it because that’s what we all try to do with our brands. We don’t have, and I wouldn’t expect, details on exactly how they are going about that. To some extent, as I’ve written, they’ve been ham strung by a lack of financial resources. Now that’s resolved, and I guess we’ll get to see if PacSun can become cool again. Remember, even the stores they are keeping have 1% negative comps and the economy is still tough and the competitive environment highly promotional, so this isn’t a slam dunk even with some cash in the bank.



PacSun’s Quarter. Can the Strategy Work in this Economy?

PacSun’s 10Q was filed two days ago. I’ve been through it and it offers a few tidbits of interesting information. But mostly, PacSun CEO Gary Schoenfeld said a lot of what needs to be said, at least strategically, in the conference call. Here are his most relevant comments:

“The economy is not getting better and competition remains fierce for a limited amount of discretionary spending. As a team, we remain committed to our turnaround strategy that includes a long-term focus on delivering trend-right products and creating a distinctive PacSun brand identity and experience tied to our unique California heritage.”

“But we also know our store gets shopped, but we’ve got to move up higher. There’s 8, 10, 12 good choices for her in the mall. And where you sit in that pecking order is pretty important.”
It’s hard to argue with the strategy, though it isn’t very distinctive and has elements of what most brands want to do. If a strategy lacks uniqueness, it can be expensive to implement. The question in my mind, which hasn’t changed much since the last time I took a look at PacSun, is whether there’s enough uniqueness so they can afford to implement it given the economy and the company’s financial circumstances.
Oh damn, I seem to have written the conclusion first. I guess I’ll just ignore that and move on to the numbers.
Sales for the quarter ended July 30 fell 1.6% to $214.9 million compared to the same quarter last year. I should point out they closed 31 stores during the first six months and expect to close 50 to 60 for the whole fiscal year.  Closing stores reduced sales by $8 million in the quarter. But stores not yet included in the comparable store calculation and a slight increase in comparable store sales increased sales $5 million, resulting in the net decline of $3 million. Women’s comparable store sales rose by 1%. Men’s were flat.
The gross margin fell from 23.2% to 23.0%. Merchandise margins fell by 1.3% but occupancy and buying and distribution costs fell so the decline in the gross margin was minimal.
Sales, general and administrative expenses fell 8% from $74 million to $68 million. As a percentage of sales it was down fro0m 33.9% to 31.6%. Most of the decline was payroll expense ($5 million) and depreciation ($4 million). You kind of wonder if their strategy doesn’t call for increasing certain of these expenses, but there’s that conflict between financial capability and the requirements of the strategy.
Inventory on the balance sheet fell from $174.8 million a year ago to $163.3 million at July 30, 2011. They have 59 less stores than they had a year ago. Total store count is now 821, down 59 from a year ago. Reported inventory is down 7%, but management indicated it would have been down 10% if they hadn’t taken some back to school deliveries early. There’s no discussion of the impact of any higher costs on inventory levels.
Cash was down from $25 million to $13.3 million. The current ratio fell from 1.61 to 1.44 over the year. Total debt to equity rose from 0.85 to 1.43. At least according to this cursory evaluation, the balance sheet has weakened a bit. They have nothing drawn on their line of credit, but indicate they might have to use it if current trends continue.
After the quarter ended, PacSun completed negotiations with some landlords. They are making payments of $1.3 million to buy out the leases on five stores which will be closed by the end of the year. They also made deals with 95 stores to reduce rents and extend leases at more favorable terms. They indicate this will save them $9.5 million over the lives of these leases (through most of fiscal 2012). They also issued 900,000 shares of stock (to the landlords I assume) as partial compensation for these lease changes.
One cool thing they did was to roll out Apple iPads in 300 stores. I’ve had the experience of shopping where clerks are equipped with them, and I like it a lot.
Along with other companies, PacSun has found the start of back to school difficult. As they describe it, “…the primary drivers included declining consumer confidence and a higher competitive promotional environment.” As a result, they are anticipating that same store sales “…will be in the mid to high negative single digits for the third quarter…”
I really miss the good, old fashioned reliable kind of recession where supply gets ahead of demand, companies pull back, we have a recession, then move forward as demand catches up. These debt excessive leverage recessions (of which this is my first one) are hard and very, very long because people paying down debt don’t buy stuff. It sucks to be a company- any company- trying to sell product to consumers that they can easily put off buying.
Okay, I’m done.  Like I said, I wrote the conclusion first so if you’re looking for closure, please read it again.