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.