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.”

Operating income declined from a profit of $976,000 to a loss of $3.37 million. Net income actually rose from $7.5 to $8.3 million, but that’s only because of the $15.7 million gain on their derivative liability. In last year’s quarter, that gain was $10.4 million.

Chris Tedford, VP and interim CFO, tell us in the conference call that, “On a non-GAAP basis excluding the financial impact of our derivative liability and assuming an income tax benefit of approximately $3.3 million our net loss was approximately $4.4 million… in Q2 of 2015 compared to a net loss of $1.8 million…in Q2 of 2014.”

I’m not getting warm fuzzy feelings here. I continue to believe CEO Gary Schoenfeld and his team have done most things right, but it doesn’t seem to be getting traction as fast as they need. Let me quote Gary about what he sees as the cause of the results.

“…first our declines in key seasonal categories including shorts, tanks, swim and sandals in both genders. Those merchandizing shortfalls are really the biggest cause of our declines. Second, our significant disparities between top-tier stores and lower-tier stores. Our highest volume tier-1 stores continue to achieve positive comps, while traffic declines continue to adversely affect lowest one third of our stores in particular.”

With regards to the declines in some categories, Gary doesn’t sound that much different from other retail CEOs. But when he highlights issues in the lowest one third of their stores (they had 608 stores at the end of the quarter, so we’re talking about 200 stores), that gets my attention. In response to an analyst’s question about whether “…there is an opportunity to maybe rationalize some of the lower tier stores or do you think that’s something that’s fixable?” Gary had the following response.

“So I would say for probably the lower third of our stores, so out of the 600 there is probably 400 stores that really are the drivers of the business and those remaining stores are probably some of the ones that are the most challenged in terms of traffic and I think is somewhat going to be a function of how landlords choose to approach those stores, what we’ve seen… is landlords continuing to kind of make adjustments on short-term rental deals that they see the brand mix and merchandising mix we have and the customer we bring in as additive to those malls. So if that continues and we can run those stores profitably even at perhaps lower sales level then we’ll continue to keep those stores open, but at the same time being very realistic about what the trends are in these malls. And at some point it’s very possible that we start making some different decisions about closing those stores.”
“So long way of saying probably if you look down the road, we’re probably closer to 500 stores than we are 600 stores, but there isn’t any action plan right now”

My translation of that rather long quote: Somewhere between 100 and 200 stores have to change, either by closing or making a better deal with landlords. And this is a fairly short term issue, because PacSun can’t continue to support negative cash flow stores. But their expectation is still to close 15 to 20 stores at the end of the year. We’ll see.

CEO Schoenfeld goes on to talk about other reasons for the poor results, “Third are probably some self-inflicted wounds as we tried to further optimize inventory turnover and merchandise margins, which has resulted in some cases of shallow revised and a somewhat over assorted SKU counts. And then fourth, our decline in non-apparel that we experienced in both women’s as well as men’s.”

I imagine that most retailers are suffering some “self-inflicted wounds” in this area. The trouble is that doing this well- getting the right product to the right place at the right time- is now a condition of having a chance to compete rather than a “nice to be able to do.” It’s expensive, difficult, and there a steep learning curve.

I’m thinking it was two years ago when PacSun rolled out its Golden State of Mind positioning campaign. That repositioning makes the learning curve even steeper. Responding to an analyst’s question, Gary says, “We have stores north of $3 million to stores well under $1 million and figuring out the right merchandizing mix between those is something that I think is required more diligent effort,” so it sounds like he’s with me on that one.

PacSun is taking a couple of actions in response to the condition it’s in. First, they are cutting an additional $15 million in expenses. They expect to have that done by the end of 2016. Second, they have “…begun to explore the potential of a long-term leads back for our two company-owned properties here in Anaheim and our distribution center in Kansas…”

They’ve got $88 million in long term debt due in December, 2016. They expect that the sale-leaseback, if successful, would generate “…substantial eight figure net proceeds.”

Neither cutting expenses, closing stores, nor refinancing debt solves the issue of getting more customers to buy more stuff in PacSun stores. We didn’t get much discussion of that and I will watch to see if PacSun doesn’t take some more aggressive action.