My Farewell to PacSun as a Public Company

It was a couple of weeks ago that PacSun finally released its year end financials for January 30, 2016.  Arguably, nobody cares given the time that’s passed, the bankruptcy filing and the fact that they’ve now emerged from bankruptcy.

But a brief review of the numbers tells us something about how the company deteriorated to the point where a bankruptcy filing was the only real choice.  It’s also good information to have as we take a look at how they came out of bankruptcy.

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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.

Where do They Go from Here? PacSun’s Quarter

It’s my belief that PacSun CEO Gary Schoenfeld has mostly done the right things since he joined the company. But so far PacSun hasn’t been able to reclaim the competitive position in the market it used to have.   Maybe, if this wasn’t a brutally competitive, over supplied, retail environment, things would be different. But they aren’t and now I see PacSun’s finding its ability to compete constrained by a weakening balance sheet and cash flow issues.

Here’s how CEO Schoenfeld describes the competitive environment helping me, I think, make my points:

“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.”

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PacSun’s August 1 Quarter; Expense Cuts and Debt Restructuring Doesn’t Create Customers

For the quarter ended August 1, PacSun’s revenues fell 7.6% to $195.6 million from $211.7 million in the same quarter last year. Comparable store sales, including ecommerce, were down 6%. The gross margin fell from 29.1% to 25.8%.

1.1% of the gross margin decline was due to a decrease in their merchandise margin. 2.1% was the result of spreading occupancy costs over a lower sales base.

“Selling, general and administrative (“SG&A”) expenses were $53.9 million for the second quarter of fiscal 2015 compared to $60.6 million for the second quarter of fiscal 2014. As a percentage of net sales, these expenses decreased to 27.5% in the second quarter of fiscal 2015 from 28.6% in the second quarter of fiscal 2014.”

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PacSun’s Quarterly Results: More of the Same

There wasn’t that much to say in either the 10-Q for May 2nd or the conference call. Bottom line is we’re all kind of hanging out waiting to see if PacSun can get further traction with its strategy before the continuing losses take too big a toll on the balance sheet and some more dramatic action is required.

Sales fell 2.7% from $171million in last year’s quarter to $167 million in this year’s. The west coast port slowdown had some impact there.

“For the first quarter of fiscal 2015, comparable store net sales decreased 2%, average sales transactions increased 13% and total transactions decreased 13%, as compared to the same period a year ago. E-commerce net sales decreased 3% for the first quarter of fiscal 2015 compared to fiscal 2014. Excluding the impact of e-commerce net sales, comparable retail store net sales for the first quarter of fiscal 2015 decreased 2% compared to fiscal 2014.”

The gross margin improved slightly from 26.1% to 26.8%. The merchandise margin rose form 54.3% to 55.6%. SG&A expenses were pretty much unchanged at $52.1 million, though as a percentage of sales they rose from 30.4% to 31.3%.

The operating loss, at $7.5 million was just slightly higher than the $7.4 million of the previous year. The net loss declined from $10 million to $2.6 million, but that’s due to the noncash gain on their derivative liability rising from $1.2 million $9.1 million. That moves around ever quarter.

PacSun ended the quarter with 605 stores, down from 618 a year ago. They expect to open 10 new ones during the balance of the year and close between 10 and 20. In discussing stores, CEO Gary Schoenfeld noted in the conference call that opening those 10 new stores is, “…the first for us in many years. I would add to that last week’s meeting with key landlords at ICSC [ph] in Las Vegas. The renewed enthusiasm for PacSun was quite different from years past and much of this year’s new store openings will be funded with TI dollars from landlords.”

I wonder how much of that enthusiasm is based on there being a lot of retail space available.

On the balance sheet, shareholders’ equity was a negative $12.7 million compared to $8.1 million a year ago. Cash fell by $4.7 million to $15.2 million and inventory was pretty much stable at $95.4 million. Current liabilities fell by about $5 million to $121.5 million. Long term liabilities rose around $8 million to $147.7 million in spite of the derivative liability falling by $10 million.

The 10Q disclosed that in the second quarter (the quarter we’re in now) PacSun “…borrowed $15 million on the Wells Credit Facility primarily for the purposes of financing inventory purchases in advance of the peak back-to-school selling season. The Company expects to repay such borrowings during the third quarter of fiscal 2015.” That borrowing does not show up on the most recent balance sheet.

PacSun also has a term loan with the principal plus accrued interest due on December 7, 2016. The principal balance due on that date is $75.6 million. I have a hard time imaging circumstances under which PacSun can make that payment and expect the debt to be restructured or refinanced.

CEO Schoenfeld tell us in the conference call that the goal is to establish “…PacSun as the number one specialty retailer on the most relevant Men’s and Women’s brands for 17 to 24 year old guys and girls.”

Among the strategies are “…not to let us [PacSun] fall back into that private label abyss that the company entered into many years ago.”

It was noted above that total transactions fell 13%, but the size of the average transaction was up 13%. Now, keep in mind that those don’t necessarily balance each other out, but in response to a question about it, Gary said, “…I think the bigger thing is more coveted products and brands that are going out with higher AURs [average unit retail]…”

You know I’m a big fan of retailers carrying “coveted” brands and products.

I think, and have said before, that the PacSun team has done most things right since Gary Schoenfeld became CEO. However, the positioning goal is a tough one given PacSun’s roots as a surf retailer, the economy, and generally difficult retail conditions.   They are taking PacSun into a difficult competitive space and, though I think it’s probably where they had to go, they don’t have endless time to translate it into profitability.

PacSun’s Results for the Year; The Good and the Bad

It’s always the same conversation around PacSun. They are doing a lot of things right, and you see progress in the income statement (though there’s still a net loss). But you worry about the turnaround advancing far enough and fast enough before liquidity becomes an issue.

As usual, we’ll dive into the financials, but I also wanted to point out a couple of interesting things they say that seem to me to be indicative of where the whole retail environment is going.

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Retail Positioning and PacSun’s Quarter

For the quarter ended November 2nd, PacSun reported its 11th straight quarter of positive comparative store sales growth. They grew sales 4.7% to $212.4 million compared to $202.8 million in the same quarter last year. $7.1 million came from the increase in comparable store sales.

The gross profit margin rose from 25.2% to 26.7%. 1.1% of the 1.5% increase came from higher merchandise margins. CEO Gary Schoenfeld notes that they will have improved their gross margin by about 4% in the last three years if they make their fourth quarter guidance.

The operating loss improved from a loss of $1.795 million to one of $1.337 million.

Ecommerce represented 7% of total sales during the quarter, up 1% from last year’s quarter. Gary noted very specifically that they aren’t happy with PacSun’s ecommerce performance and had some catching up to do. He noted that during the turnaround they have been (reasonably I’d say) focused on the 600 stores that generate 93% of their revenue. Kind of a blinding glimpse of the obvious but worth saying.

Net income declined from a profit of $17.2 million to a loss of $469,000. BUT I have to remind you, as I do every quarter, that they have to report a noncash gain or loss on the derivative liability that results from the convertible preferred stock they issued to Golden Gate Capital as part of a $60 million term loan.

In last year’s quarter, PacSun reported a gain of $23.4 million on the derivative liability. This year, the reported gain was $4.9 million. That’s an $18 million difference. Except for that gain on the derivative, the numbers below operating income didn’t cumulatively change very much. As a result, the best place to see how they are doing is that operating line where they lost a little less money than they did in last year’s quarter even with the improvement in revenue and gross margin.

For the first nine months of the current fiscal year, they reported an operating loss of $7.7 million compared to $6.9 million in the previous nine month period.

On the balance sheet, total shareholders’ equity has fallen from $40.3 to $16.2 million, boosting total liabilities to equity from 7 times to 17.4 times. During the nine months of the year, cash used in operations was $4.28 million, an improvement from the $21.1 million during last year’s nine months.

I’ll briefly repeat what I’ve said before. Operationally and strategically, PacSun has done a lot of things right since Gary Schoenfeld took over as CEO. But for whatever reason, when he took over PacSun was no longer a place its target customers (now the 17 to 24 years olds, Gary reminds us in the conference call) wanted to shop.

The PacSun team is making the business run more efficiently; not easy, but you know how to go about it. But they also have to make that target customer want to shop at PacSun. It’s never easy to “know” how to do that, but when the economy is not as strong as it once was, the country’s over retailed, ecommerce is making so many things into commodities, and your target customer has trouble getting a job- especially one that pays well- it’s even tougher.

Those are issues all retailers in our space have in common. While PacSun is improving, I’d guess that those issues are slowing the rate of improvement. Meanwhile the balance sheet continues to deteriorate. I’m all for making an accounting profit, but what I’m really looking to see, as I do in any turnaround, is positive cash generation from operations.

They don’t have all the time in the world to do that. Partly, I assume, because they know that, on July 1 they extended the $29.8 million mortgage loan they received in August of 2010. It had been on a 25 year amortization schedule with the balance due September 1, 2017.

The new loan is for $28.2 million (note that’s more than the original loan) and is due July 1, 2021. The lender lent them half a million dollars “…to fund the payment of fees, commissions and expenses incurred by the Company…” to get the new loan done.

Then there’s the term loan from Golden Gate Capital. It has a bullet payment of $70.9 million due December 7, 2016. I would so not have chosen Pearl Harbor day. Anyway, cash on PacSun’s balance sheet at November 1, 2014 totaled $12.3 million. Let’s hope their strategy catches fire and they generate enough cash to make that payment. But I wouldn’t be surprised to see that loan restructured as well.

Finally, I’d note that there was some discussion about Brandy Melville, Kendall & Kylie, and the new Reed Space concept coming to some PacSun stores. When I first heard about the Kendall & Kylie partnership, I wrote that I wondered if this didn’t indicate a certain level of struggling by PacSun to figure out just what its niche was. I even thought it might be indicative of the beginning of the end for PacSun, as I was unsure they could compete is that fashion space.

I’ve decided I was too critical. What choice did they have after all? They weren’t going to be an action sports retailer. That market was no longer as distinctive as it once was and as the market has evolved it wasn’t a large enough niche for PacSun. Anyway, Zumiez kind of owned it in the mall.

They had to find a space in the fashion world with maybe an echo of action sports, a sprinkle of street wear, and perhaps a hint of outdoor and urban. But mostly, they had to listen to their customers tell them what brands to carry. That’s what most retailers do these days, I hope.

It’s not so much that I was wrong in the concern I expressed as I didn’t recognize PacSun’s limited options.

It’s not enough in this market, however, to just say “We’re a teen/young adult retailer.” That makes you the same as too many other retailers. PacSun tried to differentiate itself by emphasizing their California roots and sensibilities through their Golden State of Mind campaign. What that’s supposed to do is create an umbrella under which your customers can conceptualize what PacSun means to them. Feels like I haven’t seen it as much as when they announced it, but then I’m not part 0f the target market and, anyway, I don’t get out much.

Doing a lot of things right isn’t yet enough for PacSun’s turnaround. It feels like PacSun is still working to create a market position where it can defend and differentiate itself. It has to do this in an improving but still not strong economy that has been especially tough on its target customers. And its deteriorating balance sheet imposes certain constraints not just on what it can do but when it has to do it by.

All I want for Christmas is a positive operating cash flow from PacSun. I expect management would like to find that under the tree too.

The Issue Continues to be Competitive Positioning: PacSun’s Quarter

Back in its glory days, PacSun was a destination for its young customers and expanded to around 900 stores. It lost its way for reasons that included too much growth and overexposure, unattractive stores, problems getting the right product to the right stores at the right time, thoughtful, better positioned competitors, and a weak economy.

I remember Gary Schoenfeld, in his first earnings conference call as CEO, saying something like, “Nobody needs 900 PacSun stores.” By the end of this year’s August 3rd quarter, the company was down to 618 stores. During his tenure, Gary has improved the executive team and in process turned it almost completely over, worked to better merchandise the stores, and invested in systems to get the right product to the right stores at the right time. Well, the list is longer than that, but basically Gary and his team are doing the things a CEO of a large retail chain should be doing.

But the really hard thing here is the competitive positioning issue. When you’ve lost your target customers’ attention- their commitment to come to your store or buy from you on line- how do you get it back in a weak economy that’s over retailed and offers the customer endless alternatives?

Part of PacSun’s answer to trying to reengage its “teen and young adult” target customers is its Golden State of Mind campaign, which I like a lot. My liking it, of course, is irrelevant. I’m a few decades removed from being the target customer, and get strange looks when I walk in a PacSun store. But they’ve put a stake in the ground. They’ve identified what they think is a point of differentiation and are trying to make it work. Good. Here’s how CEO Schoenfeld put it in the conference call.

“We remain keenly focused on differentiating and elevating PacSun through the best branded assortment and specialty retail, continuously elevating our merchandising mix to appeal to our trend and style savvy 17 to 24 year old guys and girls and connecting our customers to the creativity, diversity and as I like to say, the optimism that is so uniquely California lifestyle and synonymous with PacSun.”

As we review PacSun’s numbers, and their discussion of those results, don’t get distracted from the issue of competitive positioning. They can do everything else right but if ultimately they can’t distinguish themselves from their many competitors in a way that makes their target customers want to buy from them, it won’t matter. Just like for every business.

Revenue rose slightly from the same quarter last year from $210 to $211 million. Comparable store sales were up 0.3%. The average sales transaction was up 7%, but the total number of transactions fell by 6%;

The gross margin fell from 29.8% to 29.1%. Remember the gross margin is after buying, distribution and occupancy costs. The merchandise margin fell from 53% to 52.3%

Selling, general and administrative expenses rose from $56.7 to $60.6 million. As a percentage of sales, they increased from 27.0% to 28.6%. 0.8% of that increase is the result of marketing costs that happened earlier than expected. The other 0.8% results from “…consulting costs supporting long-term strategies and store impairment charges, partially offset by a decrease in store payroll and payroll-related expenses.”

This left PacSun with an operating income that fell from $5.9 million to $1 million.

The next item on the income statement is the “(Gain) loss on derivative liability” we get to discuss every quarter. This relates to 1,000 shares of convertible preferred stock PacSun issued to Golden Gate Capital as part of getting a $60 million term loan. The value moves around a lot every quarter and impacts the income statement. In last year’s quarter, it was a loss of $21.2 million. For this year’s quarter, it’s a gain of $10.4 million. That’s a $31.6 million difference from last year to this year.

The bottom line impact is that PacSun showed a $19.2 million loss in last year’s quarter and a profit of $7.5 million in this year’s. Obviously, the big change in the value of the derivative liability distorts that, and will in future quarters. I recommend you look at the change in operating income when you consider how PacSun is doing.

On the balance sheet, the current ratio improved slightly from 1.05 to 1.12. Total liabilities to equity deteriorated from 13.89 to 18.29 times. However, once again we’ve got to point out that derivative liability which is carried as a current liability. It was $50.5 million at the end of last year’s quarter and is down to $19.1 million at August 2nd this year. If that didn’t exist, the current ratio would have declined from 1.47 to 1.28. We learn in the conference call that inventory on a comparable store basis was down 5%.

I want to highlight something they say about operating cash flows. “Net cash provided by operating activities in the first half of fiscal 2014 was $1.1 million, compared to $17.1 million of cash used for the first half of fiscal 2013. This increase of $18.2 million was due primarily to increases in accounts payable and other current liabilities.” One interpretation would be that they are paying their bills a little more slowly. That’s not necessarily a bad thing, as we former cash managers can tell you.

CEO Schoenfeld also notes in the conference call that the overall market is very competitive and specifically points to denim as “…not a very fun business to be in right now.” I think we all know that.

He also makes an interesting comment about how PacSun had, in the last couple of years, moved its non-apparel women’s business “…to a more private label and trying to compete on price with some of the more aggressive fast fashion retailers.” He makes it clear that didn’t work, and they are once again focused on who PacSun is and what it stands for.

That’s where they have to be focused. As I indicated, I like the Golden State of Mind positioning concept, but as they’ve moved into the different competitive environment of the broader fashion business I am waiting to see how that resonates.

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.