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PacSun’s Annual Report: Missions, Strategies, Prospects

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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.               

 

 

PacSun’s October 30 Quarter; Big Changes Take Time

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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.           

 

 

I Wonder if PacSun Might Carry Hard Goods; And What Would Zumiez Think?

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Just for a moment, hypothetically, let’s think about PacSun’s turnaround strategy, whether it might make sense for them to start carrying hard goods, and how other companies might react.

PacSun’s Strategy

That PacSun is in the middle of a turnaround is hardly disputable, if only because their management has characterized it that way. And in my judgment, they are pretty much doing the right things. First and foremost, they acknowledged that their stores had stopped being a destination for their target customers, and they are working to fix that. They want to “Reestablish PacSun as a destination for great brands.” What does that mean exactly?
 
First, it means completely revamping their management team- to the point where at their last conference call they said they had cut back their juniors inventory because they did not have the right leadership or strategy in place. The management changes are well under way and, when we listen to their next conference call (okay, when I listen to it), probably within a couple of weeks, we may find it’s complete.
 
That impresses me. While there’s absolutely nothing as disruptive to a company as a total makeover of top management, there’s also no way for a company to succeed if the team isn’t aligned and in agreement as to the company’s strategy. Those of you who were at the Group Y Action Sports Conference a couple of weeks ago heard exactly the same thing from Van’s Vice President of Marketing Doug Palladini as he explained Van’s success.
 
Second, they’ve recognized they can’t have the same merchandise selection in all stores, regardless of location, and are working to localize their inventory. Third they are starting, like a lot of other brands, to emphasize speed and freshness in product. “The days of shopping in Europe for trends and then delivering a whole new collection are pretty much behind us,” was how they put it. We may all bemoan fast fashion, but there’s no choice but to react to it if it’s what the customer wants.
 
Fourth, they are going to be more cautious with private label and have eliminated private label board shorts. Fifth, they’ve rolled out a new advertising and promotion campaign that has a more appropriate focus. Last, they’ve recognized that more stores isn’t the answer and are focusing on making the ones they have better places to shop.
 
The Hard Goods Issue
All good stuff. If I were a hard goods brand and PacSun asked me to sell them some hard goods I’d get excited by the fact that Pac Sun could buy a whole lot of product from me (though I doubt any hard goods brand can expect to be in all their stores). On the other hand, I’d need to feel good about their chances for making their stores an attractive destination for my customers again. If they were lame, I wouldn’t want to be there because the lameness might rub off on my brand.   I would, in other words, need to feel good about PacSun’s ability to implement the strategy I’ve described above.
 
I’d get to feel good by spending some time with the people in charge of implementing the hard goods strategy for PacSun.    Assuming there was such a strategy, that is.
 
I’d want to roll out the product in, say, 10 or 20 stores initially. And I’d want those to be stores that already reflected PacSun’s revised strategy- ones that were remodeled to reflect the new focus, had a reduced reliance on house brand product, and had inventory specifically selected for the location. I’d want to have some involvement in how my product was merchandised and I’d like to know where PacSun was going to get sales people who could represent and sell hard goods. And while all these discussions were going on, I’d be chatting with my friendly competitors who also make hard goods to try and find out if they were selling to PacSun.
 
Some level of hard goods can make sense for PacSun as part of a strategy of regaining credibility with their target customer.   It’s certainly part of what has differentiated Zumiez among mall stores and made them successful, and that brings us to an interesting part of the discussion.
 
Though both are mall based chains with an overlapping focus, Zumiez is not PacSun and PacSun is not Zumiez. They have different ambiances, and different, though obviously overlapping, target customers. Zumiez has always carried hard goods and has prided itself on having employees at all levels that are in touch with the action sports culture. Though PacSun may have originally been closer to the “core” than it is now, it was never as close as Zumiez and it drifted even further away with growth and some of the decisions it made.   Zumiez has always been closer.   That has been important in how it has kept its credibility with customers even as it has grown.
 
PacSun wants some of that credibility back. I have to assume Zumiez would rather not share that market space with a nine hundred store gorilla. Even though Zumiez is only more or less one third the size of PacSun by number of stores and their geography doesn’t completely overlap( PacSun is in all 50 states, Zumiez in 35) I have to believe that PacSun’s problems made life easier for Zumiez in some ways and in some locations.
 
How might things go if PacSun starts carrying hard goods? A couple of years ago, I might have said that if they represent the brands well it would be good for everybody. But economic times are different and I think that’s less likely. It will also depend on what hard goods, exactly, they carry. I don’t imagine it will be snowboards (though of course I don’t know that). I can certainly imagine skate and while surf fits PacSun (and not really Zumiez) it’s generally difficult to imagine selling surf boards in mall stores.
 
I’m sure Pac Sun expects to make money on any hard goods it sells, but that wouldn’t be the primary motivation. They want to rebuilt credibility with their target market and get that customer back in the store. It’s a component of their overall strategy.   Superficially at least, a PacSun with hard goods will have moved a bit towards Zumiez’s in its positioning. Will the customers see that? Will Zumiez’s customers be more likely to shop at PacSun? Or will customers who chose PacSun over Zumiez be disappointed? Depends on just how much actual customer overlap there is I guess. But unless they subscribe to the “a rising tide raises all boats” theory, I can’t see Zumiez as thrilled.
 
Other brands, not hard goods, are currently sold at both Zumiez and PacSun. Wonder how they would see this if it happened. Would PacSun pick up some apparel or other products from the hard goods brands they decided to carry? 
 
 A PacSun who carries hard goods and uses that to revive their credibility with the action sport oriented consumer is a stronger competitor to Zumiez.   A PacSun who carries hard goods and does it badly damages the idea of such stores in malls, and that could reflect on Zumiez. It’s not that PacSun will be the same as Zumiez, or even that they will necessarily target exactly the same customer group. But some of those customers may only see the superficial similarities. Think how consumer looked at Hollister.
 
As Zumiez, PacSun, and any hard goods brands that might consider selling to PacSun know, having hard goods doesn’t instantly give you credibility and attract customers. You have to do it just right and the devil is in the details.

 

 

PacSun Oct. 31 Quarter Results: New Strategic Focus From New CEO

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Okay, so I finally hold in my hand both the transcript of the conference call and the actual quarterly report filed with the Securities and Exchange Commission. I’ve read them and cogitated on their meaning and finally have a couple of things to say that maybe somebody besides me will find interesting.

The most interesting stuff is strategic in nature. A couple of years ago I wrote that PacSun’s biggest problem was their market positioning. Nobody knew what they stood for. I’m still not sure I know, but at least new CEO Gary Schoenfeld knows that’s a problem. Former CEO Sally Frame Kasak had her hands full just stabilizing the situation and cleaning up the mess, and perhaps that’s why she didn’t address it. Perhaps it’s also part of the reason she’s no longer CEO.

An analyst asked the following question:   “Looking at the strategies that have played out over the last two years, is it your position and the board’s position that you have sort of aggravated the effect of an already bad environment? I mean, you are reversing many of the things that were done under previous management, so can we take it that what has happened to your business is not just the environment but things that, strategies that you have pursued, that the company has pursued that have just been flawed?”
Gary Schoenfeld’s answer: “I’m not sure that I want to say it quite as blunt as you just did but your conclusions — you know, I can’t say are way off the mark…”
Which strategies are they talking about? CEO Schoenfeld says they have “four essential priorities.”
First is “people and culture.” They’ve got five senior positions they are looking to fill, and they want to affect “…a transformation in leadership, accountability, teamwork, and an absolute commitment to wow our customers every day…” I won’t be surprised if they take a page or two out of Zumiez’s handbook for this. I expect it to reach down to the sales associates on the floor. Good.
Second is product. They are bringing back footwear, though in a more limited way then before. They are going to shift to some lower price points. “…retailers like Target have become a leader amongst girls in this category and we are actively having conversations with our key heritage brands to recognize that there probably are some changes that need to further be made for all of us to regain this critical segment. “ They also need to be more fashion focused, he indicated. They expect to narrow some assortments and “…do a better job of bringing newness to a market where wear now has clearly become the mantra for teen shoppers.”
The third strategy is the customer connection, which is related to the people and culture issue. “…it is more important than ever that our store associates are able to communicate effectively about the brands and fashion that we carry and able to clearly articulate the latest promotions to customers looking for value. We believe that through improved education and training, and frankly more selective hiring and promotion, our store teams will become much more effective engaging with customers and the critical role that they play in driving sales.” Yup, a page out of Zumiez’s playbook for sure.
Fourth, they will “…move towards a much more thoughtful localized store assortment and allocation process in order to make this happen. We simply cannot be successful without a much deeper understanding of our different customers and how their style and brand preferences vary across 900 stores in 50 states. Simply put, we are missing sales, hurting our margins, and damaging the customer experience by having had too much of a one-size-fits-all approach to merchandising.”
I agree that one size fits all is a mistake. But when they talk about a “localized assortment strategy,” what exactly does that mean? Do you differentiate by store, by city, by region? Who does the buying? Would buying and merchandising for different categories or different brands be done differently by geography? Do the responsibilities of store or district managers change? Gary Schoenfeld says he expect to do it “without any major investment in systems.” I wonder. This is one of those issues where the devil’s in the details and the details can be as complex as you want to make them..
What’s the goal if they successfully implement those four strategies? CEO Schoenfeld puts it this way. “…at the moment, PacSun doesn’t offer a clear point of difference and that is what we need to go about addressing and when I talk about becoming their [teens] favorite place to shop, I choose those words particularly because I think that’s what we need to do. We need to be a place where they are excited to go, they love the brands that we carry, the marketing that the brands do and the excitement that creates in our stores complemented by things that we can design and develop ourselves that gives us the flexibility to move quicker and to hit key price points that may be dictated by our competitors.”
The last thing I found interesting was the following statement by Gary: “I don’t know that the world ever needed 900 domestic PacSun stores and if you had a perfect sheet of paper, that number might be closer to 600, 700 stores. I think we will end this year under 900 and as we look at 30 to 40 leases coming up over each of the next three years, it probably puts us to where we are — in three years time we are probably somewhere in 750 to 800, and that probably puts us in a pretty good position.”
I think he’s right, and that a smaller number of stores is consistent with the strategy he’s outlined. I wonder, though, if you’re an analyst interested in the price of the stock what you thought of that. With fewer stores, lower inventory per square foot, and reduced consumer spending, where does the growth come from? Right now, that’s not where the focus is, and nobody asked that question. Let’s hope things improve enough so that they are focused on growth.
On to the numbers starting with the balance sheet. Total assets are down from a year ago 25% from $713 to $537 million. $111 of this drop was in property, plant and equipment. Current assets fell 36% or $112 million to $200 million. Cash rose by $10 million, while inventories were way down (which you would expect). Other current assets, which includes stuff like prepaid expenses, income taxes receivable, and non-trade accounts receivable, declined from $74 to $16 million.
Current liabilities are down by almost half from $204 to $103 million. That includes paying off $43 million of their line of credit, which is now at zero.    Long term liabilities, which include things like deferred lease incentives and deferred rents and the mysterious “other” long term liabilities fell a bit from $111 to $92 million.
Total equity is down from $398 to $341 million. The current ratio improved from 1.53 to 1.93, and total equity improved from 0.79 to .059. So the balance sheet is smaller, as expected, but stronger by both measures. Remember all these balance sheet numbers compare the October 31, 2009 balance sheet with the one at November 1, 2008- a year ago.
Sales for the quarter were down 17% to $268 million compared to the same quarter the prior year. This was mostly due to an 18% decline in comparable store net sales. For nine months, sales fell from $903 to $734 million, or 19%.  Gross margin percentage for the quarter fell from 28.7% to 27.4% and for nine months, from 29.2% to 26.2%. The merchandise margin for the quarter actually improved by 1.7%, but the need to spread occupancy costs over a smaller sales base cost them 3%. 
Selling, general and administrative expenses were down 6.2% for the quarter to $89.4 million, but as a percentage of net sales, they rose from 29.5% to 33.4%. For nine months they fell 12.8% to $245 million, but rose as a percentage of sales from 31.1% to 33.4%. The loss for the quarter grew from $2.5 to $10.9 million. For nine months, it fell from $36.8 to $33.8 million. Total stores were 904 compared to 940 at the end of the quarter last year.
The four strategies seem right to me but the issue of what PacSun stands for in the market and why it should be a destination for teens isn’t clear right now. Maybe with the implementation of these strategies, it will become clear. 

PacSun Quarter and 9 Months Ended 10/28/06- Good Tactics. What’s the Strategy?

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         Pacific Sunwear’s (NASDAQ: PSUN) official SEC filing isn’t out yet (I’m writing this November 26 because I love working Sundays), but I’ve read the press release, reviewed the associated financial statements for the quarter and nine months ended October 28, and listened to the conference call. Let’s look at the numbers first, and then talk about the conference call.

 The Numbers
        The quarter showed a slight decline in sales from $377 to $375 million. But gross margin fell from $144 to $106 million—or from 38.2% to 28.3%. Selling and General and Administrative expenses rose from $81 to $93 million. Net income fell from $40.5 to $9 million or from $0.54 to $0.13 per share on a fully diluted basis.

         On the balance sheet, the current asset fell from 3.45 a year ago to a still strong 2.34 at the end of this October. The only other thing I’d note from the balance sheet is that, even after a write down, inventory—at $253 million—was still nearly $10 million higher than a year ago.

         In the mix was a same-store sales decrease of 6.7% and the ten cents a share inventory write down—primarily for footwear and accessory categories. The CEO resigned and was replaced by Company Lead Director Sally Frame Kasaks as interim chief executive officer. At different times in her career, Ms. Kasaks was Chairman and CEO of Ann Taylor Stores, President and CEO of Abercrombie & Fitch, and Chairman and CEO of Talbot’s, Inc. I think we can conclude she knows a bit about specialty retailing.

         With financial results like that, the stock must have cratered, right? Nope. The press release was dated November 9. The stock closed that day at $17.27. The next day it rose to $18.56—a 7.47% gain on volume that was 3.76 times the average volume. The company’s most recent closing price as I write this was $19.48. The conference call was held on the November 10 at 5:30 in the morning Pacific Time. No, I did not listen to it live.

       Clearly some people were pleased with what they heard on that call, and maybe had been expecting quarterly numbers that were worse than they were. But what made them so happy?
 
The Conference Call
        I wish they made transcripts of conference calls available or—if they do—I wish I knew where I could get them. Trying to write down all the good things Ms. Kasaks said they were doing as quickly as she was talking was a real pain in the butt. I kept trying to stop and restart the replay, but Media Player isn’t built for rewinding fifteen seconds. And another thing, left-handed people with lousy writing should not be allowed to own fountain pens—much less try and take fast notes with them. Uh, I seem to have gotten off track.

         Anyway, Ms. Kasaks highlighted three key big ideas for Pac Sun to focus on. They were:
      1. A commitment to build the juniors business to increase sales and store productivity.
      2. A focus on improving the in-store presentation of merchandise.
      3. A strategic assessment to understand how they can reconnect with their customers.
 
These three big ideas followed a list of initiatives Pac Sun was undertaking. I want to quote one of those initiatives: “Put more focus on transitional merchandise with the implementation of our spring floor set at the end of January. This will insure that our spring product is presented earlier than last year while being merchandised with more wear now product than in the past.”

         I thought this initiative required a little explanation and discussion.
 
Transitional merchandise is product that’s brought in during one season (winter in this case) and can be worn in that season, but can also be worn during the upcoming season (spring). Sweaters in spring colors might be an example. You sell it now and wear it now—but they carry over into the next season.
         The reason you do this is that it has the potential to improve your sales in the existing quarter. The danger is that if you don’t do a really good job in selecting merchandise, picking the right quantities, and merchandising it well, you may get to the next quarter with assortments that are old.
         In other words, at the extreme, you could theoretically end up just transferring sales from one quarter to an earlier one. PacSun spent some time on its conference call discussing some issues in just these areas, so it will be interesting to watch them implement this initiative.
         I think there were seven initiatives in total, including the one I quoted above. Somehow, I’ve managed to write down nine. I was either listening too slowly or writing too quickly. They included a review of the company’s customer communications program and in-depth customer research. Other initiatives will focus on inventory and in-store presentation. They want to reduce inventory density in their stores “to provide assortment clarity and in store presentation.” They noted a decline in their sneaker business and have plans to improve their assortment.  They will review it “to be in line with customer preferences.”
         They have plans to improve their merchandise presentation “without undertaking a major investment in time and capital.” They are utilizing something they called a “refresh” format that involves certain new design and layout elements. And they’re trying to improve the process by which they update their monthly floor sets.
         Due to time and cost constraints, you can’t wave a magic wand and have all 1,169 stores (835 are PacSun) updated. They are working to figure out what seems most likely to work and to implement the changes as time and capital permit. They are developing a new logo and new layout that provides what they characterized as a much more sophisticated look, and expect to do 30 to 40 remodels utilizing this concept next year. Sounds like the right direction and right process to me.
         That they are doing this isn’t a surprise to anybody who has been in a PacSun, Zumiez, and Hollister store lately. In Hollister, there’s a certain calmness that makes you feel like you’re on the beach. Their attempt to connect to the surf market—and they seem to do it pretty well—is clear. Zumiez carries hard goods. That has given them credibility in the market even as their store numbers expand. PacSun has the right brands and competitive prices but needs, in the words from the conference call, “To understand how they can reconnect with their customers.”
         During the conference call, Ms. Kasaks acknowledged that she doesn’t think PacSun can be authentic at their size. While that may cause a gasp of dismay and prognostications of their demise in some action-sports circles, I found it refreshing. It’s inevitably true for a company with this many stores. So you recognize it, work on evolving your inventory and your look, and undertake a strategic reassessment.
         So what’s the strategy? That’s what PacSun management is figuring out. They’ve done an awful lot in three months. They’ve been open about their issues and have moved to implement tactics that address them. I can’t wait to walk into one of their remodeled stores and see where the strategic reassessment came out. In the meantime, we’ll all keep watching PacSun as a barometer of what’s happening in the broader lifestyle market and worry about how their initiatives impact orders and sales of our brands.

 

PacSun’s Quarter Ended 7/29/06; Numbers and Industry Implications

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I guess if you’re going to talk about a quarterly earnings release, you have to mention the numbers. Okay, fine. PacSun’s net income for the quarter ended July 29, 2006 was $0.14 a share compared to $0.28 a share for the same quarter the previous year. For the six months ended the same date, it was $0.30 a share compared to $0.51 for the same period the previous year. Those are drops of 50% and 41% respectively. Sales for the quarter grew only 1.3% from $309 million in the same quarter the previous year. Sales for the six month ended July 29, 2006 were up only 4.2% to $614 million.

 
What happened? Gross margin fell and expenses rose while sales were flat. That will put the kibosh on the old bottom line every time. On August 31st, PacSun announced that August sales were down 4.0% from August of last year and that same store sales for the period were down 9.4%.
 
If you’ve ever looked at PacSun’s stock chart, you maybe weren’t all that surprised by this. The stock fell about 10% the day after the announcement of the quarterly results, but the trend had been down for a while. The stock peaked at $29.05 way back on March 7, 2005. It fell as low as $20.33 on May 12, 2005, rallied back to almost $28 in November and has been mostly falling since. People who study this stuff tell me that a stock’s chart often shows weakness before the company’s fundamentals turn over. Speaking more generally, the stock market often leads the economy.
 
I hasten to add that PacSun’s chart doesn’t look much different from some other industry public companies, which is maybe a good way to move on to implications for our industry.
 
In its conference call on the quarterly results, PacSun acknowledged that business was tough, and that they were taking the usual and appropriate measures to respond. These included watching costs closely, controlling/reducing inventory and being cautious about their orders. Well, what would you expect them to do? They sounded like a competent management team in touch with reality. I imagine that’s because they are.
 
They also talked about meeting with the leading brands more often and earlier because of the challenging environment. They said they were trying to be “more responsive to their [the brand’s] insights around product.”
 
They talked about weakness in branded fashion denim sales, with the exception being Levis. They indicated they had added a specially designed selection of Levis for back to school in 200 stores and that the results had been “very positive.” They also talked in general about adding new brands for back to school.
 
This caused one analyst to ask whether PacSun was expecting to transition its business away from the core skate/surf brands. I seem to recall a reference to Volcom in the question.
 
PacSun’s answer was that the addition of new brands was a normal, ongoing, practice, that orders had been reduced consistent with the decline in business, and that they had no intention of transitioning the business away from the core brands.
 
But I think the analyst’s question went, or should have gone, deeper than that. What they were really asking was, “PacSun, what are you? Are you a skate/surf/lifestyle brand committed to the same market you’ve always focused on, or will a slowdown in that market’s growth and a saturation of its selling opportunities require that you expand your appeal? If so, how do you do that without losing your original, and very successful, franchise?
 
I think it was four years ago at the Surf Industry Conference where Bob McKnight warned us that the uptrend wouldn’t last forever. If the trend has stopped upping, is it a hiccup, or the beginning or a new kind of market? I don’t know. PacSun, and hopefully lots of other companies, are taking the appropriate tactical steps to manage it in the short term. But the longer term question is the one the analyst may have meant to ask but didn’t quite- What are you?

 

 

Chasing the Demographics; Pacific Sunware Focuses on Youth

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There’s got a way to make this story exciting. Oh the injustice of making me write about a company with a strong balance sheet, growing revenue and earnings, no meaningful litigation, and an experienced management team with a clear strategic focus. I’ve got to stir up some drama somewhere if there’s to be any hope that people will make it all the way to the end of the article.

The drama is in the execution of the strategy. Pacific Sunware started out as the store where young, white males could get the trendy, casual brands they wanted. Now, twenty two percent of their sales are to females. The new d.e.m.o. stores are focusing on cross cultural trends. Pacific Sunware sells snowboard clothing. They are selling their own private label brands.
 
Can they expand their target market, but keep their focus and their niche? Can they keep the loyalty of a notoriously finicky customer group? Inquiring minds want to know. But first, the boring stuff.
 
SIDEBAR
 
Pacific Sunware: A Snapshot
 
As of the fiscal year ended January 31, 1999, Pacific Sunware (PacSun, as they seem to want to be known) had 342 stores in 42 states. Their customers are young men, and increasingly women, between the ages of 12 to 22 who prefer a casual look. Revenues have grown from $85 million in 1994 to $321 million for the year ended January 31, 1999. Net income has climbed from $3.9 to $23.5 million during the same period. They had 4,058 employees of whom 3,822 were store employees. Of the store employees 2,700 were part time. Management is mostly in their 40s. Most of the team has been with the company since 1994 or before.
 
END OF SIDEBAR
 
 
PacSun by the Numbers
 
At May 2, 1999, the balance sheet was, well, boring. There’s eleven million dollars of cash and a current ratio of 3.16. There’s basically no long-term debt, and the total debt to equity ratio is 0.25. The piece of information I would like but don’t have is a way to judge the quality of the forty six million dollars of inventory. Obviously, when you’re selling trendy goods to young people, you’d better be right on your inventory selection. On the other hand, even if a chunk of that inventory were obsolete, this balance sheet would still be strong.
 
One caveat on evaluating the balance sheet of any fast growing retail business- comparisons from one balance sheet date to the next are difficult due to both growth and seasonality. Ratios will tell you the strength of the balance sheet, but getting a handle on operational efficiencies using the balance sheet is tough when, for example, inventory goes up a bunch, but so did the number of stores.
 
For the thirteen weeks ending May 2, 1999 sales were $81.4 million, up 33 percent from the same period the previous year. Income grew forty percent to $4.04 million. Gross profit margins were essentially constant in these two periods at 32.1%.
 
Similar trends can be seen in comparing the two years ending January 31, 1999 and February 1, 1998. Sales grew 41.4% to $321 million. Net income was up 43.7% to $23.5 million. Gross margin fell two tenths of a percent to 33.7. Operating expenses as a percentage of sales fell from 22.5 to 21.9 percent, largely as a result of the rapid growth in sales.
 
Also important to note is that the average inventory between these two dates was $37.3 million. They did $321 million in sales. So they turned their inventory 8.6 times, and that is a great place to move into how the PacSun’s market strategy and how it dovetails with their financial and operational strategies.
 
Setting the Stage
 
PacSun either figured out or fell into the fact that it’s not just surfers that buy surf wear, snowboarders that buy snowboard clothing and skateboarders that buy skate clothing anymore. The specialty markets are crossing over each other. Fashion and lifestyle are as important as participation in the sport that originally spawned the apparel. If it were just surfers who wore surf apparel, the company wouldn’t be planning to increase its square footage by forty two percent this fiscal year.
 
So Pacific Sunwear has positioned itself, it hopes, at the cross roads where everybody passes through but nobody is confused or put off by seeing surf/skate/snow in one place. The theory is that you aren’t selling out anymore as long as you’ve got the cool stuff to sell.
 
Trouble is that somebody keeps changing the road signs at the crossroad. Fashions come and go as fast as commemorative postage stamps. Faster, probably. How does Pacific Sunwear hope to keep its road map accurate?
 
Real Marketing!
 
It’s my personal observation that most action sports companies think advertising and promotional tactics are marketing. Pacific Sunwear doesn’t seem to suffer from that delusion. Chief Financial Officer Carl Womack described the two-hour focus groups they do each year in half a dozen cities and have been doing for seven or eight years. He explained that their on-line inventory reporting allowed them to see what was selling and what wasn’t on a daily basis.
 
“Not only does this allow us to manage our inventory on a day to day basis, but it helps us anticipate trends so we can respond on a timely basis.”
 
He emphasized the close relationships they had with suppliers as a critical source of market trend data. They share ideas regarding fashion trends and merchandise self through with their vendors. “We always pay our suppliers on time- sometimes even early if they need it,” he indicated. That ought to go a long way towards creating good working relationships.
 
They experiment with new colors, styles and items by ordering small number (maybe twelve dozen) and seeing how they sell.
 
To sum it all up, it seems that marketing (that is, figuring out what the customer wants) is institutionalized at Pacific Sunware. Everybody thinks about it all the time and is required, as described below, to react to what they learn.
 
Running the Business
 
So PacSun’s success depends on their ability to respond to the dynamic fashion whims of young people aged twelve to twenty-two. How do they run their business to accomplish that?
 
All the stores of a given class are the same in terms of size, fixtures and inventory. Nobody has to do a study to figure out how build out and stock a new store. It’s a good thing, since they plan to open 108 new stores in fiscal 1999. Sixty-seven are planned to be Pacific Sunwear stores, sixteen Outlet stores, and twenty-five d.e.m.o. stores.
 
Though stores have the same inventory selection, the timing of inventory receipt will vary according to store locations. It gets colder some places earlier in the year than in others.
 
The company manages inventory through what CFO Womack called “permanent markdowns.” Every two weeks, based on the daily sales data, the store managers get to work to find the markdowns already downloaded into their store registers. All they have to do is put up the “On Sale!” signs. No slow moving inventory is allowed to linger in the hope that it will suddenly become hot. The inventory turns quickly, and the customer doesn’t wait for big sales promotion before coming into the store.
 
Stores have daily, weekly and monthly sales goals against which performance is measured. Feedback is immediate, as are bonuses for meeting monthly goals. Yet the store managers have no involvement in the actual selection of merchandise, though of course their input and ideas are solicited.
 
So what’s going on here? Pacific Sunwear’s systems and operating procedures dovetail nicely with their marketing imperatives. Need to have the right inventory? Better have the systems to know what selling so you can move what’s not. Want to grow quickly? The stores better be more or less the same. Want to be on top of trends? Better get along with your suppliers. The financial results are good expense control, minimizing writedowns and inventory levels, and high margins.  And a strong bottom-line.
 
Notice how all the pieces work together. There seems to be a company wide strategic focus that makes it immediately clear to management when something is “right” and when it is “wrong.” I’m usually not this gah-gah over a company. What could go wrong?
 
I’d focus on three things. First, management could lose touch with trends. Age does that no matter how good your systems and marketing are. Second, defections from a management team that has been together this long could be a problem. I hope the golden handcuffs are reinforced with titanium, and I hope the district and regional managers have a lot of input. Finally, fast growth can cause problems all by itself, but that’s a risk it looks like we’ve going to have to live with.