The PacSun Bankruptcy

Nobody who’s followed PacSun or my analysis of it was very surprised by yesterday morning’s filing of a Chapter 11 bankruptcy.  We’ve had a number of retail bankruptcies and I expect more.

Somebody suggested to me that the filing might occur around this time because their 10-K with audited financials would be due to be published, and their auditor would have to give them a “qualified” opinion as part of the audit.  That is, they’d say they had concerns about PacSun’s ability to continue as a “going concern.”   That tends to make lenders and suppliers uneasy.

Looks like the person who suggested that was right on.

If you’ve read the press release from PacSun, you know that the filing is being done as part of a plan negotiated with their debt holder, Golden Gate Capital and Wells Fargo who has a line of credit to PacSun.  This is optional, but here’s a link to the article I wrote on PacSun back on December 20 after their published their last 10-Q.  I said in that article:

“As I’ve reminded you before, they also have a $75.6 million payment to make for a term loan and some “payment in kind” interest due December 7th 2016. The line of credit from Wells Fargo matures the same day.  It’s pretty clear they won’t be able to make that payment from their own cash flow. They are talking with the lender (Golden Gate) about how that might be managed.”

The writing was on the wall at least back then.  I’d say sooner, but obviously it’s nice to get through the holiday season before you take this kind of step.

Let’s take a look at the proposed plan as described in the press release and then move on to the numbers for the last quarter and the fiscal year.

What’s the Plan?

Golden State Capital is going to end up owning PacSun as a private company.  Shades of how the Quiksilver bankruptcy ended up.  Regular readers already know, and are probably tired of my saying it ad nauseum, that there’s a conflict between being a successful brand and a public company in our current and projected economic environment.  That’s especially true in our industry.

“Golden State Capital will be converting more than 65% of its term loan debt into the equity of the reorganized company and providing a minimum of $20 million in additional capital to the reorganized Company upon its emergence from Chapter 11 to support its long-term growth objectives.”

Literally as I write this, PacSun has just filed the 8K describing the bankruptcy filing in more detail.  Golden State will end up owning 100% of PacSun’s equity.  So if you are a common stockholder from before the filing, sorry, because “…on the effective date of the Plan, all previously outstanding equity securities of the Company shall be cancelled and discharged.”

The term loan is about $77 million.  65% of that is $50 million.  At the end of the fiscal year, on January 30, the line of credit outstanding was $18 million.  Wells Fargo was providing the line of credit.  As part of the bankruptcy filing and restructuring plan, Wells Fargo will provide a $100 million debtor in possession (DIP) line of credit.  “Wells Fargo has also committed to provide a five-year $100 million revolving line of credit effective upon the Company’s emergence from Chapter 11 and subject to certain conditions.”   DIP financing has a priority over certain debt of the company prior to the bankruptcy filing, so it’s more secure than you might expect lending to a company in bankruptcy to be.

I still think PacSun President and CEO Gary Schoenfeld has pretty much done all the right things since he took over some years ago.  He inherited a chain that had lost relevance to its target market.  Reclaiming that was a hard, long term project under any circumstances.  Here’s how he described it in his last conference call.

“Without a doubt, the bar keeps getting raised in terms of what it takes to be successful, given overall headwinds in retail and apparel and the battles for consumer discretionary spending. Clear merchandising strategies, consistent in-store execution across our entire chain and further penetration into the digital world of our customers, are all essential.”

He goes on to say, ““Our liquidity has been adversely impacted by our negative operating results and we cannot assure you that we will have sufficient liquidity going forward if certain negative trends continue, or if we are not able to refinance the Term Loan in light of the upcoming maturity of the Wells Credit Facility and the Term Loan.”

PacSun ran out of cash and, as a result, time.  CEO Schoenfeld explains in the press release that the bankruptcy is meant to solve two “…structural issues that operationally we could not fix on our own.  First is a very high occupancy cost of approximately $140 million per year, and second is nearly $90 million of long-term debt coming due later this year.”

The debt issue and associated interest expense is resolved by conversion of 65% of the Golden Gate debt to equity.  The occupancy cost (store lease) issue will be managed “…either through landlord negotiations or lease rejections…” as part of the bankruptcy process.”   I expect to see some further store closings and I consider those necessary and appropriate.

What this doesn’t address, obviously, is the strategic issue of PacSun’s market position and its relevancy to its target customers.  Have they made progress?  I think so.  Are they there yet?  Apparently Golden State thinks they are or can be with a lower cost financial structure that allows them to pursue their strategy.  We’ll see.

Financial Results

The quarter and year ended January 31, 2016.  Know that I’m doing this based on the financials in the press release, rather than the 10-K which isn’t out yet.

For the quarter, net sales were more or less constant at $232 million.  The gross margin fell from 26.1% to 24.3%.  The operating loss declined from $7.42 to $5.49 million, largely due to expenses that fell from $67.8 to $62.1 million.  The net loss declined from $26.0 to $10.0 million, but the decline is almost entirely the result of having a loss of $14.3 million loss on the derivative liability in last year’s quarter compared to a gain of $192,000 in this year’s quarter.

For the year, sales were down 3.13% from $826.8 to $800.9 million.  The gross profit margin fell from 27% to 25.4%.  They reduced expenses from $238.4 to $221.6 million, but the operating loss rose from $15.1 to $18.0 million.  Interest expense, by the way, was $17.3 million, and much of that cost goes away in the conversion of debt to equity.  The reported gain on that derivative liability was $2.3 million last year and $27.7 million this year.  Take that into account as I tell you the net loss improved from $29.4 to $8.5 million.

The expenses include the $140 million in occupancy costs Gary Schoenfeld refers to in the press release, and that will be reduced as PacSun works its way through bankruptcy, but we don’t know by how much.  You can see that between some reduction there and the decline in interest expense, all other things being equal, the year just ended probably would have been profitable.

PacSun ended the year with 601 stores compared to 605 at the end of last year.  126 were outlet stores, up from 120.

The balance sheet is, well, kind of irrelevant since it’s about to change dramatically.  However there are a few telltale signs worth highlighting.  First, cash and cash equivalents fell from $22.6 to $6.2 million.  I’d note that net cash provided by operations went from a positive $10.7 million last year to a negative $15.1 million in the year just ended.

Inventory, interestingly, rose 18.2% from $81.7 to $96.5 million.  Wouldn’t necessarily expect that with cash constraints and constant sales.  Hard to imagine them buying in anticipation of a bankruptcy in this industry where what’s selling changes so quickly.  Hard to imagine brands not being cautious in selling to them as I’m hardly the only one who saw this coming.

Speaking of inventory, I guess I should remind anybody who has product at PacSun on consignment and thinks that they either can get paid or get their inventory back what happened with the Sports Authority bankruptcy.  Here’s the link to the article I wrote about the litigation over this issue on my site.  Don’t know if this will be an issue with PacSun or not.

One of the headlines in the press release says, “ALL KEY SUPPLIERS TO BE PAID.”  I have a couple of comments.  First, I wonder what “key” means.  Second, I wonder when.  Under the bankruptcy law, no old debt can be paid except as part of the plan when the company comes out of bankruptcy.  However, bankruptcy judges have wide discretion and you probably remember Quiksilver getting the court’s permission to pay some important suppliers.  Wonder if they called them “key?”

Third, I wonder if paid mean paid in full and, if so, why they didn’t say that.  Fourth and finally, I wonder how much, if anything, suppliers who aren’t “key” will get paid.

On the liability side of the balance sheet, accounts payable rose 17.8% from $36.8 to $43.3 million.  The line of credit was $0 last year and $18 million at this year’s end.  PacSun had told us they expected to borrow up to $35 million for inventory and to pay “most” of the advance back by year end.

Current portion of long term debt went from $541,000 to $77.4 million at January 31 as the note to Golden Gate came to within a year of being due.  Long term saw a similar drop, from $94.4 to $26.8 million.  PacSun also has long term debt for a mortgage on a facility they own.

Equity is a negative $15.5 million compared to negative $9.4 million at the end of last year.

Though I can’t quantify them, I see the significant financial benefits that will accrue to PacSun under the proposed plan.  But retail conditions remain somewhere between difficult and brutal and I’m still waiting to be completely convinced that PacSun can again become a destination store for its target customers.