PacSun Makes Progress; Third Quarter Results, Store Closings, and Financing
When I looked at PacSun’s previous quarter I wrote, “The question in my mind, which hasn’t changed much since the last time I took a look at PacSun, is whether there’s enough uniqueness so they can afford to implement it [their strategy] given the economy and the company’s financial circumstances.”
Whether or not their strategy is a good one, they were becoming too cash constrained to implement it. If you were paying attention to this post at Boardistan in late November and the associated New York Post article, you knew something was going to happen.
Now it’s happened. As part of their conference call yesterday and release of their 10Q for the quarter ended October 29th, PacSun announced a $100 million line of credit from Wells Fargo that basically replaces their old line, a five year term loan of $60 million from private equity firm Golden Gate Capital (GGC), and plans to close 190 stores by the end of January 2013. Most of the closings will come near the end of the fiscal years. That makes sense as you’d like the holiday season to help you move inventory.
At the end of this quarter, PacSun had 820 stores and inventory of $152 million (at cost). 190 stores are 23% of their total stores. Assuming inventory is equally distributed among all the stores, they would have to reduce their inventory by 23% or $35 million. If you’re a brand that sells to PacSun, how do you think about that? Will PacSun move it to other stores? Will they close it out? Will they try and get you to take it back? Will they sell it somewhere you’d really rather it wasn’t sold? What’s the impact on your brand going to be when a chunk of your sales to PacSun just disappear?
One of the analysts kind of asked about this in the conference call saying, “Could you talk about conversations you’re having at the same level with the brands and your suppliers to make sure that you’re still in the best products and getting goods timely at the best prices and getting the best products from the key vendors?”
CEO Schoenfeld answered, “Yes, I really feel good about relationships, both with our key brand partners and our suppliers on our proprietary products. And they’ve been critical to the progress we’ve made and recognize that we still got work to do to get ourselves back to profitability, and they continue to be very supportive of our efforts.”
It’s the expected conference call kind of answer, and as always the devil will be in the details of the relationship with each brand.
I’ll bet lots of brands are thinking about this issue. Makes those who tried to reduce their dependence on PacSun over the last year or two look pretty clever.
Tactics
You know what it takes to close stores and revamp the ones you’ve got left (about 620 by the end of January 2013)? It takes money, and PacSun didn’t have enough. After the deal with GGC, they say they do. As CEO Gary Schoenfeld put it, “Securing this additional capital will enable us to fund the lease terminations previously mentioned, make selective store refresh and technology investments and supplement any further near-term operational cash flow needs.”
The deal gave GGC two seats on PacSun’s Board of Directors. The interest rate is 13%. 5.5% has to be paid in cash quarterly. The other 7.5% is accrues annually in arrears. That is, they increase the amount they owe and pay interest on that increase as well. PacSun also issued to GGC convertible preferred stock that can be converted into about 20% of the company’s stock at $1.75 a share. Expensive money, but they needed to do it.
Note that the date at which the deals with Wells Fargo and with GGC were signed was December 7th– the same date as the conference call and release of quarterly results. What clever person said, “The task expands to fill the time available?”
We also find out that before the quarter ended Pacsun was madly negotiating with its landlords and had negotiated buyouts of 75 leases at a cost of $13 million, short term lease extensions for 50 stores, and termination on lease expiration for 115 stores. They think they will close 80 stores during the rest of this fiscal year and 110 in the next one. They expect savings in the year that starts February 1, 2012 of $9 million before the buyout payments. Those annual savings should rise as more stores are closed and, of course, those savings are annual while the buyout payments are one time. So the return on invested capital looks pretty good.
The stores they are closing had average sales of $600,000 over the last 12 months and their sales were down 9% compared to the previous year. The 600 stores they expect to have left when the closing process is completed average $1.1 million in revenue and their comparative store sales were only down 1%.
The store closures are expected to reduce revenue by $100 million to $125 million, but improve EBITDA by $10 million to $15 million. The reduction in inventory should offer a similar improvement to the balance sheet.
I assume that the landlord negotiations, GGC loan, and Wells Fargo credit negotiation didn’t each take place in a vacuum. Much like when Quiksilver got the Rhone investment, I’m guessing there were multiple party dependencies that had to come together. Must have been interesting, though that might not be the word you’d use if you were in the middle of it.
The Numbers
Over the year that ended October 29, 2011, PacSun’s balance sheet weakened some due to the ongoing losses. Over the year, the current ratio fell from 2.02 to 1.44. And total liabilities to equity rose from 0.89 to 1.5. Inventory fell 8%.
Even with sales down 6.2% this quarter compared to the same quarter last year, current liabilities rose 15% from $112 million to $129 million. It’s possible that’s nothing more than timing differences, but I think we can say that PacSun needed to find some additional resources so they could pursue their strategy faster. The GGC term loan won’t improve the balance sheet since it’s debt, but it will give PacSun the cash it needs to move forward. In a turnaround, cash flow is way, way more important than your balance sheet I can tell you from experience.
$13 million of the sales decline resulted from store closures. Another $7 million was from a 3% decrease in comparable store sales. They gained $4 million from stores not yet included in the comparable store calculation and from a 12% increase in ecommerce sales. Men’s sales were flat and women’s down about 5%.
The gross profit margin fell slightly from 25.0% to 24.2%. You would think there’d be a big opportunity to improve that if PacSun could get its coolness back. Selling, general and administrative expenses actually rose 6% from $71.1 million to $75.4 million. As a percentage of sales that’s up from 27.6% to 31.1%. This included $6.2 million in charges related to closing stores ($4.4 million of which was noncash).
The net loss rose 153% to $17.6 million from $7 million in the same quarter last year.
Strategy
I characterize the store closings, new line of credit, and term loan as tactics that allow PacSun to pursue its strategy. I don’t think that strategy has really changed since Gary Schoenfeld became CEO two years ago. As he puts it, “We still have more to do to reestablish our brand identity and emotional connection with our customers, but I believe we are on the right path to make this happen.” He continues in another part of the conference call, “So we do continue to recognize that part of our turnaround is getting people excited again about PacSun and what our brand means and strengthening that emotional connection."
I agree with that. I’ll bet everybody in the industry agree with it because that’s what we all try to do with our brands. We don’t have, and I wouldn’t expect, details on exactly how they are going about that. To some extent, as I’ve written, they’ve been ham strung by a lack of financial resources. Now that’s resolved, and I guess we’ll get to see if PacSun can become cool again. Remember, even the stores they are keeping have 1% negative comps and the economy is still tough and the competitive environment highly promotional, so this isn’t a slam dunk even with some cash in the bank.
I was wondering how diluted common stockholders will get once GCC converts their preferred shares. Also, the portion of the 10-Q that explains the “Shareholder Protection Rights Plan” confuses me. Was this included to protect shareholders that owned a large portion of shares prior to the GCC 20% ownership?
Hi Justin,
Sorry for the delay. I’ve been on a golf trip with friends. Well, GGC can convert their shares to 19.9% of the company’s stock, so that looks like a 20% dilution to me. The one paragraph description of the shareholder protection rights plan confused me too. It sounds like the rights are worthless when issued. And the board of directors has an option (but they don’t have to do it) to exchange a share for each right if somebody acquires between 15% and 50% of the company. I honestly don’t quite know if this is protection for GGC or protection for the company. You’ve now got me curious enough that I may call the company.
Sorry I don’t have better information.
Thanks for the comment,
J.