Retail Positioning and PacSun’s Quarter

For the quarter ended November 2^nd, PacSun reported its 11^th 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.