ITEM 1. BUSINESS
Pacific Sunwear of California, Inc. (together with its wholly owned subsidiaries, the “Company,” “Registrant,” “we,” “us,” or “our”) is a leading specialty retailer of everyday casual apparel, accessories and footwear designed to meet the needs of active teens and young adults.
We operate three nationwide, primarily mall-based chains of retail stores under the names “Pacific Sunwear” (also “PacSun”), “Pacific Sunwear Outlet” (also “PacSun Outlet”), and “demo.” PacSun and PacSun Outlet stores specialize in board-sport inspired casual apparel, footwear and related accessories catering to teenagers and young adults. demo specializes in fashion-focused streetwear, including casual apparel, footwear and related accessories catering to teenagers and young adults. In addition, we sell PacSun and demo merchandise online. We also began testing a new mall-based specialty retail footwear concept under the name “One Thousand Steps” in April 2006.
The Company, a California corporation, was incorporated in August 1982. As of the dates presented, we leased and operated the following number of stores among all 50 states and Puerto Rico:
On February 2, 2007, the Board of Directors of the Company approved management’s recommendation to close 74 underperforming demo stores. We are in the process of closing these 74 stores and expect the closures to occur predominantly late in our first fiscal quarter or early in the second quarter.
For details concerning the operating performance of the Company’s reportable segments, please see Note 12 to the Consolidated Financial Statements, which note is incorporated herein by reference.
Our executive offices are located at 3450 East Miraloma Avenue, Anaheim, California, 92806; the telephone
number is (714) 414-4000; and our internet addresses are www.pacsun.com, www.demostores.com and
www.onethousandsteps.com. Through our PacSun website at www.pacsun.com, we make available free of charge, as soon as reasonably practicable after such information has been filed or furnished to the Securities and Exchange Commission (the “Commission”), our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”).
The Company’s fiscal year is the 52- or 53-week period ending on the Saturday closest to January 31. Fiscal year-end dates for all periods presented or discussed herein are as follows:
2 Pacific Sunwear of California, Inc. Annual Report 2006
Our Mission and Strategies
Our mission is to be the leading lifestyle retailer of casual fashion apparel, footwear and accessories for teens and young adults. Our target customers are young men and women between the ages of 12 and 24. We believe our customers want to stay current with, or ahead of, fashion trends and continually seek newness in their everyday wear. We offer a complete selection of apparel, accessories and footwear representing fashion trends considered timely by our target customers. We believe the following items are the key strategic elements necessary to achieve our mission:
Offer Popular Name Brands Supplemented by Proprietary Brands. In each of our store formats, we offer a carefully developed selection of popular name brands supplemented by our own proprietary brands, with the goal of being seen by our teenage and young adult customers as the source for apparel, accessories and footwear choices appropriate to their lifestyle. We believe that our merchandising strategy differentiates our stores from competitors who may offer 100% proprietary brands or seek to serve a wider customer base and age range. See “Merchandising.”
Promote the Brand Images of Our Store Concepts. We promote the brand image of each of our store concepts through in-store marketing designed to enhance our customers’ shopping experience, in-store promotional events in cooperation with our primary vendors, and national print advertising in major magazines that target teens and young adults.
Actively Manage Merchandise Trends. We do not attempt to dictate fashion, but instead devote considerable effort to identifying emerging fashion trends and brand names. We use focus groups, listen to our customers and store employees, monitor sell-through trends, test small quantities of new merchandise in a limited number of stores, and maintain close domestic and international sourcing relationships. We believe that these practices enhance our ability to identify and respond to emerging fashion trends and brand names as well as develop new proprietary brand styles in order to capitalize on existing fashion trends.
Maintain Strong Vendor Relationships. We view our vendor relationships as important to our success and we promote frequent personal interaction with our vendors. We believe many of our vendors view PacSun, PacSun Outlet and demo stores as important distribution channels due to our nationwide presence and ability to introduce products to a broad audience. We tend to be one of the largest, if not the largest, customers for many of our vendors and we work closely with them to respond to emerging fashion trends and to obtain PacSun and demo “exclusives,” which are products that cannot be found at any other retailer.
Provide Attentive Customer Service. We are committed to offering courteous, professional and non-intrusive customer service. We strive to give our young customers the same level of respect that is generally given to adult customers at other retail stores, and to provide friendly and informed customer service for parents. Responding to the expressed preferences of our customers, we train our employees to greet each customer, to give prompt and courteous assistance when asked, and to thank customers after purchases are made, but to refrain from giving extensive unsolicited advice. PacSun and PacSun Outlet stores display large assortments of name brands and proprietary brands, merchandised by category. demo merchandise is displayed by brand accompanied by vendor logo signage. Additionally, the stores provide a friendly and social atmosphere for teens with appropriate background music, while also providing a comfortable environment for parents and other adults. We believe the combination of our attentive customer service and unique store environments is key to our success.
Continually Assess Existing Store Performance while Seeking Strategic Real Estate Opportunities to Improve Overall Operational Performance. In each of the last three fiscal years in the period ended February 3, 2007, we opened 94, 115, and 113 net new stores, respectively. While we intend to continue to seek strategic growth opportunities for each of our store concepts, we plan to prioritize our efforts at reassessing our existing store performance and reinvesting in our most productive locations in the near future. We believe that we can more profitably operate our existing retail concepts through strategic reinvestment in our existing store fleet as opposed to continuing to open new stores in tertiary markets or lower-grade malls. On February 2, 2007, we announced our decision to close 74 underperforming demo stores. We also plan to continue carefully evaluating existing stores and recent store openings and will close underperforming stores as we determine appropriate. This shift in strategy will result in fewer total new store openings per year than has been typical in
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the recent past. See “Store Expansion” and “Store Closures” within the “Stores” section of this document for further details regarding plans for fiscal 2007.
Offer Merchandise for Sale Online. We sell merchandise online at www.pacsun.com and www.demostores.com. The websites offer a selection of the same merchandise carried in our stores. We maintain a substantial database of e-mail addresses that we use for marketing purposes. We also advertise our websites as shopping destinations on certain internet portals and search engines and market our websites in our stores using in-store signage, merchandise bags and receipts. Our internet strategy benefits from the nationwide retail presence of our stores, the strong brand recognition of PacSun and demo, a loyal and internet-savvy customer base, the participation of our key brands and the ability to return merchandise to our stores.
Merchandising
Merchandise. PacSun, PacSun Outlet and demo stores offer a broad selection of casual apparel, related accessories and footwear for young men (“guys”) and young women (“girls”), with the goal of being viewed by our customers as the dominant retailer for their lifestyle. One Thousand Steps stores specialize in fashion-forward footwear and accessories catering to young adults. The following tables set forth our merchandise assortment as a percentage of net sales for the most recent three fiscal years:
We offer many name brands best known by our target customers. PacSun offers a wide selection of well-known board-sport inspired name brands, such as Billabong/Element, Quiksilver/Roxy/DC Shoes, Volcom, Hurley and O’Neill. demo offers well-known name brands sought by its target customers, such as Ecko, Rocawear, Phat Farm/Baby Phat, Enyce, Akademiks, Apple Bottoms and Sean John. In addition, we continuously add and support up-and-coming new brands in both PacSun and demo. During fiscal 2006, Billabong (which includes both Billabong and Element brands) and Quiksilver (which includes the Quiksilver, Roxy, and DC Shoes brands) each accounted for 11% of total net sales. No other individual branded vendor accounted for more than 7% of total net sales during fiscal 2006.
We supplement our name brand offerings with our own proprietary brands. Proprietary brands provide us with an opportunity to broaden our customer base by providing merchandise of comparable quality to brand name merchandise,
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to capitalize on emerging fashion trends when branded merchandise is not available in sufficient quantities, and to exercise a greater degree of control over the flow of our merchandise. Our own product design group, in collaboration with our buying staff, designs our proprietary brand merchandise. We have a sourcing group that oversees the manufacture and delivery of our proprietary brand merchandise, with manufacturing sourced both domestically and internationally. Proprietary brand merchandise sales accounted for approximately 28%, 31%, and 30% of total net sales in each of fiscal 2006, 2005, and 2004, respectively. For fiscal 2006, proprietary brand merchandise sales accounted for 30% of total PacSun/Outlet net sales, 16% of total demo net sales and 3% of total One Thousand Steps net sales.
Vendor and Contract Manufacturer Relationships. We maintain strong and interactive relationships with our vendors, many of whose philosophies of controlled distribution and merchandise development are consistent with our own strategy. We generally purchase merchandise from vendors who prefer distributing through specialty retailers, small boutiques and, in some cases, better department stores, rather than distributing their merchandise through mass-market channels.
To encourage the design and development of new merchandise, we frequently share ideas regarding fashion trends and merchandise sell-through information with our vendors. We also suggest merchandise design and fabrication to certain vendors. We encourage the development of new vendor relationships by attending trade shows and inviting potential new vendors to make presentations of their merchandise to our buying staff.
We have cultivated our proprietary brand sources with a view toward high-quality merchandise, production reliability and consistency of fit. We source our proprietary brand merchandise both domestically and internationally in order to benefit from the lower costs associated with foreign manufacturing and the shorter lead times associated with domestic manufacturing.
Purchasing, Allocation and Distribution. Our merchandising department oversees the purchasing and allocation of our merchandise. Our buyers are responsible for reviewing branded merchandise lines from new and existing vendors, identifying emerging fashion trends, and selecting branded and proprietary brand merchandise styles in quantities, colors and sizes to meet inventory levels established by Company management. Our planning and allocation department is responsible for management of inventory levels by store and by class, allocation of merchandise to stores and inventory replenishment based upon information generated by our merchandise management information systems. These systems provide the planning department with current inventory levels at each store and for the Company as a whole, as well as current selling history within each store by merchandise classification and by style. See “Information Systems.”
All merchandise is delivered to our distribution facility in Anaheim, California, where it is inspected, received, allocated to stores, ticketed when necessary, and boxed for distribution to our stores or packaged for delivery to our internet customers. Each store is typically shipped merchandise three to five times a week, providing it with a steady flow of new merchandise. We use a national and a regional small package carrier to ship merchandise to our stores and internet customers. We may occasionally use air freight to ship merchandise to stores when necessary. In the first half of fiscal 2007, we will begin operating a second distribution center in Olathe, Kansas.
Stores
Locations. We operate stores in each of the 50 states and Puerto Rico. For a geographical breakdown of stores by state for each of our store concepts, see Item 2, “Properties.”
Store Expansion. During fiscal 2006, we opened 94 net new stores, which included 38 PacSun stores, 20 PacSun Outlet stores, 27 demo stores and 9 One Thousand Steps stores, and also expanded or relocated an additional 38 existing stores. During fiscal 2007, we plan to open approximately 20 new stores, consisting of a mixture of PacSun, PacSun Outlet and demo locations. We also plan to expand or relocate approximately 20-25 of our most productive stores to larger locations during fiscal 2007. In addition, we plan to remodel approximately 50 of our existing PacSun stores and approximately 15 of our existing demo stores to an updated store design package that we have been testing during fiscal 2006. We believe we can more effectively enhance Company profitability by reinvesting in our existing store fleet rather
Pacific Sunwear of California, Inc. Annual Report 2006 5
than continuing to open new stores in tertiary markets or lower-grade malls. As of the date of this filing, approximately 36% of the leases related to fiscal 2007 store plans have been executed.
Our store site selection strategy is to locate our stores primarily in high-traffic, regional malls serving markets that meet our demographic criteria, including average household income and population density. We also consider mall sales per square foot, the performance of other retail tenants serving teens and young adult customers, anchor tenants and occupancy costs. We currently seek PacSun and PacSun Outlet store locations of approximately 4,000 square feet and demo store locations of approximately 3,000 square feet. One Thousand Steps stores currently average approximately 2,600 square feet. For details concerning average costs to build and stock new and relocated stores in fiscal 2006, see Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, “Liquidity and Capital Resources.”
Our continued growth depends upon our ability to open, expand and remodel stores on a profitable basis. Our ability to grow profitably will be dependent upon a number of factors, including sufficient demand for our merchandise in existing and new markets, our ability to locate and obtain favorable store sites, negotiate acceptable lease terms, obtain adequate merchandise supply, and hire and train qualified management and other employees.
Store Closures. In a report on Form 8-K dated February 2, 2007, we have previously announced our plan to close 74 underperforming demo stores during fiscal 2007. In addition to those closures, we plan to continue to evaluate existing stores and recent store openings in each of our store concepts and will close additional underperforming stores during fiscal 2007 as we determine appropriate. We will, in many instances, achieve these closures through the exercise of available kick-out clauses in our store leases where we believe taking such action will enhance the overall performance of our real estate portfolio. Kick-out clauses relieve us of any future obligation under a lease if specified sales levels for our stores or mall occupancy targets are not achieved by a specified date. The actual number of store closures will be subject to our ongoing business performance review of our stores and will likely be higher than that of recent years.
Store Operations. Our stores are open for business during mall shopping hours. Each store has a manager, one or more co-managers or assistant managers, and approximately six to twelve part-time sales associates. District managers supervise approximately seven to twelve stores and approximately six to ten district managers report to a regional director. District and store managers as well as store co-managers participate in a bonus program based on achieving predetermined metrics, including sales and inventory shrinkage targets. We have well-established store operating policies and procedures and an extensive in-store training program for new store managers and co-managers. We place great emphasis on loss prevention programs in order to control inventory shrinkage. These programs include the installation of electronic article surveillance systems in all stores, education of store personnel on loss prevention, and monitoring of returns, voids and employee sales. As a result of these programs, our historical inventory shrinkage rates have been below 1.7% of net sales at retail (0.6% at cost).
Information Systems
Our merchandise, financial and store computer systems are fully integrated and operate using primarily IBM equipment. Our software is regularly upgraded or modified as needs arise or change. Our information systems provide Company management, buyers and planners with comprehensive data that helps them identify emerging trends and manage inventories. The systems include purchase order management, electronic data interchange, open order reporting, open-to-buy, receiving, distribution, merchandise allocation, basic stock replenishment, inter-store transfers, inventory and price management. Company management uses weekly best/worst item sales reports to enhance the timeliness and effectiveness of purchasing and markdown decisions. Merchandise purchases are based on planned sales and inventory levels and are frequently revised to reflect changes in demand for a particular item or classification.
All of our stores have a point-of-sale system operating on IBM in-store computer hardware. The system features bar-coded ticket scanning, automatic price look-up, electronic check and credit/debit authorization, and automatic nightly transmittal of data between the store and our corporate offices. Each of the regional directors and district managers uses a laptop computer and can instantly access appropriate or relevant Company-wide information, including actual and
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budgeted sales by store, district and region, transaction information and payroll data. We believe our management information systems are adequate to support our planned expansion at least through fiscal 2007.
Competition
The retail apparel, footwear and accessory business is highly competitive. PacSun stores, PacSun Outlets and demo stores compete on a national level with certain leading department stores and national chains that offer the same or similar brands and styles of merchandise. Our PacSun stores compete nationally with Abercrombie and Fitch, Hollister, American Eagle Outfitters, The Gap, Aeropostale, Hot Topic, Zumiez and others as well as a wide variety of regional and local specialty stores. Our demo stores compete with leading department stores and a wide variety of regional and local specialty stores. Many of our competitors are larger and have significantly greater resources than we do. We believe the principal competitive factors in our industry are fashion, merchandise assortment, quality, price, store location, environment and customer service.
Trademarks and Service Marks
We are the owner in the United States of the marks “Pacific Sunwear of California,” “PacSun,” “Pacific Sunwear,” “demo,” and “One Thousand Steps.” We also use and have registered, or have a pending registration on, a number of other marks, including those attributable to our proprietary brands. We have also registered many of our marks outside of the United States. We believe our rights in our marks are important to our business and intend to maintain our marks and the related registrations.
Seasonality
For details concerning the seasonality of our business, see Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, “Seasonality and Quarterly Results.”
Working Capital Concentration
A significant portion of our working capital is related to merchandise inventories available for sale to customers as well as in our distribution center. For details concerning working capital and the merchandising risk associated with our inventories, see “Risk Factors” in Item 1A
ITEM 1A. RISK FACTORS
Cautionary Note Regarding Forward-Looking Statements
This report on Form 10-K contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Exchange Act, and we intend that such forward-looking statements be subject to the safe harbors created thereby. We are hereby providing cautionary statements identifying important factors that could cause our actual results to differ materially from those projected in forward-looking statements of the Company herein. Any statements that express, or involve discussions as to, expectations, beliefs, plans, objectives, assumptions, future events or performance (often, but not always identifiable by the use of words or phrases such as “will result,” “expects to,” “will continue,” “anticipates,” “plans,” “intends,” “estimated,” “projects” and “outlook”) are not historical facts and may be forward-looking and, accordingly, such statements involve estimates, assumptions and uncertainties which could cause actual results to differ materially from those expressed in the forward-looking statements. All forward-looking statements included in this report, including forecasts of fiscal 2007 planned new store openings, store closures, and future capital expenditures, and the statement of our belief that we can enhance profitability by reinvesting in our existing store fleet, are based on information available to us as of the date hereof, and we assume no obligation to update or revise any such forward-looking statements to reflect events or circumstances that occur after such statements are made.
Our comparable store net sales results will fluctuate significantly, which can cause volatility in our operating performance and stock price. Our comparable store net sales results have fluctuated significantly on a monthly, quarterly, and annual basis, and are expected to continue to fluctuate in the future. For example, over the past five years, monthly comparable store net sales results have varied from a low of minus 11% to a high of plus 20%. A variety of factors
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affect our comparable store net sales results, including changes in fashion trends and customer preferences, changes in our merchandise mix, calendar shifts of holiday periods, actions by competitors, weather conditions and general economic conditions. Our comparable store net sales results for any particular fiscal month, quarter or year may decrease. As a result of these or other factors, our comparable store net sales results, both past and future, are likely to have a significant effect on our operating performance and the market price of our common stock.
Our failure to identify and respond appropriately to changing consumer preferences and fashion trends in a timely manner could have a material adverse impact on our profitability. Our success is largely dependent upon our ability to gauge the fashion tastes of our customers and to provide merchandise at competitive prices and in adequate quantities that satisfies customer demand in a timely manner. Our failure to anticipate, identify or react appropriately in a timely manner to changes in fashion trends could have a material adverse effect on our same store sales results, gross margins, operating margins, financial condition and results of operations. Misjudgments or unanticipated fashion changes could also have a material adverse effect on our image with our customers. Some of our vendors have limited resources, production capacities and operating histories and some have intentionally limited the distribution of their merchandise. The inability or unwillingness on the part of key vendors to expand their operations to keep pace with the anticipated growth of our store concepts, or the loss of one or more key vendors or proprietary brand sources for any reason, could have a material adverse effect on our business.
Our continued growth depends on our ability to develop new store concepts and to open, expand and remodel stores in our existing concepts on a profitable basis. Any failure to do so may negatively impact our stock price and operational performance. Our continued growth depends to a significant degree on the success of our existing retail stores, our ability to open, expand and remodel stores on a profitable basis, and to manage our planned expansion. Our store concepts are located principally in enclosed regional shopping malls. Our PacSun concept is a relatively mature concept with limited domestic opportunities to open new stores in such malls. The performance of our demo concept has been inconsistent and the size of the market for this concept is uncertain. Our newest concept, One Thousand Steps, is at a very early stage (nine stores) and is not yet proven. Given the current trend of our business, we have slowed the pace of planned store openings and increased our planned store closings for fiscal 2007. There can be no assurance that we will achieve our planned expansion, that such expansion will be profitable, or that we will be able to manage our growth effectively. In addition, our ability to sustain future long-term growth is dependent, in part, on our ability to successfully develop, implement and evolve new retail concepts, including demo and One Thousand Steps. Our planned expansion is dependent upon a number of factors, including the performance of our existing stores, our ability to locate and obtain favorable store sites, negotiate acceptable lease terms, obtain adequate supplies of merchandise and hire and train additional qualified management level and other employees with the skills required to create or acquire new, unrelated retail concepts. Factors beyond our control may also affect our ability to expand, including general economic and business conditions affecting consumer spending. Any failure to manage growth or develop profitable new retail concepts could have a material adverse effect on our business, stock price, financial condition and results of operations.
We launched operations of a new retail concept, One Thousand Steps, in fiscal 2006, which could divert attention from existing operations. We have launched operations for One Thousand Steps in fiscal 2006 through the opening of the first nine test stores. This new concept is at a very early stage and is not yet proven. Our ability to make this new retail concept successful is subject to numerous risks, including, but not limited to, (i) lower productivity (in terms of sales per square foot) than anticipated or required to make the concept profitable and expandable, (ii) higher than anticipated construction costs, (iii) unanticipated operating problems, (iv) lack of customer acceptance, (v) new vendor relationships, (vi) competition from existing and new retailers, and (vii) lack of sufficient product differentiation. There can be no assurance that this new retail concept will achieve sales and profitability levels that justify the Company’s investment in it. Additionally, the expansion of this new retail concept involves other risks that could have a material adverse effect on the Company, including, but not limited to, (i) diversion of management’s attention from the Company’s core businesses, (ii) inability to attract, train and retain qualified personnel, including management and product designers, and (iii) difficulty in locating and obtaining favorable store sites and negotiating acceptable lease terms. Any inability to
Pacific Sunwear of California, Inc. Annual Report 2006 9
succeed in developing this new retail concept could have a material adverse effect on our continued growth and results of operations.
We face significant competition from both vertically-integrated and brand-based competitors that are growing rapidly, which could have a material adverse effect on our business. The retail apparel, footwear and accessory business is highly competitive. All of our store concepts compete on a national level with a diverse group of retailers, including vertically-integrated and brand-based national, regional and local specialty retail stores and certain leading department stores that offer the same or similar brands and styles of merchandise as we do. Many of our competitors are larger and have significantly greater resources than we do. We believe the principal competitive factors in our industry are fashion, merchandise assortment, quality, price, store location, environment and customer service.
Our customers may not prefer our proprietary brand merchandise, which may negatively impact our profitability. Sales from proprietary brand merchandise accounted for approximately 28%, 31%, and 30% of net sales in fiscal 2006, 2005, and 2004, respectively. There can be no assurance that we will be able to achieve increases in proprietary brand merchandise sales as a percentage of net sales. Because our proprietary brand merchandise generally carries higher merchandise margins than our other merchandise, our failure to anticipate, identify and react in a timely manner to fashion trends with our proprietary brand merchandise, particularly if the percentage of net sales derived from proprietary brand merchandise changes significantly (up or down), may have a material adverse effect on our same store sales results, operating margins, financial condition and results of operations.
Our current or prospective vendors may be unable or unwilling to supply us with adequate quantities of their merchandise in a timely manner or at acceptable prices, which could have a material adverse impact on our business. The success of our business is dependant upon developing and maintaining good relationships with our vendors. We work very closely with our vendors to develop and acquire appropriate merchandise at acceptable prices for our stores. However, we do not have any contractual relationships with our vendors. In addition, some of our vendors are relatively unsophisticated or underdeveloped and may have difficulty in providing adequate quantities or quality of merchandise to us in a timely manner. Also, certain of our vendors sell their merchandise directly to retail customers in direct competition with us. Our vendors could discontinue their relationship with us or raise prices on their merchandise at any time. There can be no assurance that we will be able to acquire sufficient quantities of quality merchandise at acceptable prices in a timely manner in the future. Any inability to do so, or the loss of one or more of our key vendors, could have a material adverse impact on our business, results of operations and financial condition.
Our foreign sources of production may not always be reliable, which may result in a disruption in the flow of new merchandise to our stores. We purchase merchandise directly in foreign markets for our proprietary brands. In addition, we purchase merchandise from domestic vendors, some of which is manufactured overseas. We do not have any long-term merchandise supply contracts and our imports are subject to existing or potential duties, tariffs and quotas. We face competition from other companies for production facilities and import quota capacity. We also face a variety of other risks generally associated with doing business in foreign markets and importing merchandise from abroad, such as: (i) political instability; (ii) enhanced security measures at United States ports, which could delay delivery of imports; (iii) imposition of new legislation relating to import quotas that may limit the quantity of goods which may be imported into the United States from countries in a region within which we do business; (iv) imposition of duties, taxes, and other charges on imports; (v) delayed receipt or non-delivery of goods due to the failure of foreign-source suppliers to comply with applicable import regulations; (vi) delayed receipt or non-delivery of goods due to organized labor strikes or unexpected or significant port congestion at United States ports; and (vii) local business practice and political issues, including issues relating to compliance with domestic or international labor standards which may result in adverse publicity. New initiatives may be proposed that may have an impact on the trading status of certain countries and may include retaliatory duties or other trade sanctions that, if enacted, would increase the cost of products purchased from suppliers in countries that we do business with. Any inability on our part to rely on our foreign sources of production due to any of the factors listed above could have a material adverse effect on our business, financial condition and results of operations.
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We are currently evaluating store design alternatives for all of our retail concepts, which may not result in improved operational performance. We believe that store design is an important element in the customer shopping experience. Many of our stores have been in operation for many years and have not been updated or renovated since opening. Some of our competitors are in the process of updating, or have updated, their store designs, which may make our stores appear less attractive visually. We have been testing or plan to test new store design alternatives for all of our retail concepts in an attempt to update the look of our stores and improve their productivity. This process carries additional risks such as higher than anticipated construction costs, lack of customer acceptance, and lower store productivity than planned or anticipated, among others. There can be no assurance that this process will prove successful in improving operational results or that we can achieve meaningful results in an adequate timeframe. Any inability on our part to successfully implement new store designs in a timely manner could have a material adverse effect on our business, financial condition and results of operations.
The loss of key personnel could have a material adverse effect on our business at any time. Our continued success is dependent to a significant degree upon the services of our key personnel, particularly our executive officers. The loss of the services of any member of our senior management team could have a material adverse effect on our business, financial condition and results of operations. Our success in the future will also be dependent upon our ability to attract and retain qualified personnel. Our inability to attract and retain qualified personnel in the future could have a material adverse effect on our business, financial condition and results of operations.
Ms. Kasaks currently serves as our Interim Chief Executive Officer. We have been and are continuing a search for a permanent Chief Executive Officer. Delays in identifying and engaging a new Chief Executive Officer could adversely affect our business, and once engaged, we cannot be certain how much time will be required for the new Chief Executive Officer to become fully familiar with our business.
Our information systems may not be adequate to support future growth, which could disrupt business operations. We have experienced periods of rapid growth in the past. While we regularly evaluate our information systems capabilities and requirements, there can be no assurance that our existing information systems will be adequate to support future growth or will remain adequate to support the existing needs of our business. In order to support future growth, we may have to undertake significant information system implementations, modifications and/or upgrades in the future at significant cost to us. Such projects involve inherent risks associated with replacing and/or changing existing systems, such as system disruptions and the failure to accurately capture data, among others. Information system disruptions, if not anticipated and appropriately mitigated, could have a material adverse effect on our business, results of operations and financial condition.
Adverse outcomes of litigation matters could significantly affect our operational results. We are involved from time to time in litigation incidental to our business. We believe that the outcome of current litigation will not have a material adverse effect upon our results of operations or financial condition. However, our assessment of current litigation could change in light of the discovery of facts with respect to legal actions pending against us not presently known to us or determinations by judges, juries or other finders of fact which do not accord with our evaluation of the possible liability or outcome of such litigation.
Our dependence on a single distribution facility exposes us to significant business disruption risks. All of our current distribution functions continue to reside within a single facility in Anaheim, California. The Company plans to begin operating a second distribution center in Olathe, Kansas in the first half of fiscal 2007. Any significant interruption in the operation of the existing distribution facility or delay of the opening of our second distribution center due to natural disasters, accidents, system failures or other unforeseen causes would have a material adverse effect on our business, financial condition and results of operations. There can be no assurance that our current distribution center will be adequate to support our future growth.
Our stock price can fluctuate significantly due to a variety of factors, which can negatively impact our total market value. The market price of our common stock has fluctuated substantially and there can be no assurance that the
Pacific Sunwear of California, Inc. Annual Report 2006 11
market price of the common stock will not continue to fluctuate significantly. Future announcements or management discussions concerning the Company or its competitors, net sales and profitability results, quarterly variations in operating results or comparable store net sales, changes in earnings estimates made by management or analysts, or changes in accounting policies, among other factors, could cause the market price of the common stock to fluctuate substantially. In addition, stock markets have experienced extreme price and volume volatility in the past. This volatility has had a substantial effect on the market prices of securities of many public companies for reasons frequently unrelated to the operating performance of the specific companies.
Selling merchandise over the internet carries particular risks that can have a negative impact on our business. Our internet operations are subject to numerous risks that could have a material adverse effect on our operational results, including unanticipated operating problems, reliance on third party computer hardware and software providers, system failures and the need to invest in additional computer systems. Specific risks include: (i) diversion of sales from our stores; (ii) rapid technological change; (iii) liability for online content; and (iv) risks related to the failure of the computer systems that operate the website and its related support systems, including computer viruses, telecommunication failures and electronic break-ins and similar disruptions. In addition, internet operations involve risks which are beyond our control that could have a material adverse effect on our operational results, including: (i) price competition involving the items we intend to sell; (ii) the entry of our vendors into the internet business, in direct competition with us; (iii) the level of merchandise returns experienced by us; (iv) governmental regulation; (v) online security breaches involving unauthorized access to Company and/or customer information; (vi) credit card fraud; and (vii) competition and general economic conditions specific to the internet, online commerce and the apparel industry.
Any failure by us to maintain credit facility financial covenants could have a material adverse impact on our business. A significant decrease in our operating results could adversely affect our ability to maintain required financial ratios under our credit facility. Required financial ratios include a rolling four-quarter minimum fixed charge coverage ratio as well as a maximum leverage ratio. If these financial ratios are not maintained, the lenders will have the option to terminate the facility and require immediate repayment of all amounts outstanding under the credit facility, if any. The alternatives available to the Company if in default of its covenants would include renegotiating certain terms of the credit agreement, obtaining waivers from the lenders, or obtaining a new credit agreement with another bank or group of lenders, which may contain different terms. If we were unable to obtain waivers or renegotiate acceptable lending terms, there can be no guarantee that we would be able to obtain a new credit agreement with another bank or group of lenders on similar terms or at all.
The effects of terrorism or war could significantly impact consumer spending and our operational performance. The majority of our stores are located in regional shopping malls. Any threat or actual act of terrorism, particularly in public areas, could lead to lower customer traffic in regional shopping malls. In addition, local authorities or mall management could close regional shopping malls in response to any immediate security concern. Mall closures, as well as lower customer traffic due to security concerns, could result in decreased sales. Additionally, war or the threat of war could significantly diminish consumer spending, resulting in decreased sales for the Company. Decreased sales would have a material adverse effect on our business, financial condition and results of operations.
*************
We caution that the risk factors described above could cause actual results or outcomes to differ materially from those expressed in any forward-looking statements made by us or on behalf of the Company. Further, we cannot assess the impact of each such factor on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements.
ITEM 1B.
ITEM 1B.
UNRESOLVED STAFF COMMENTS
None.
12 Pacific Sunwear of California, Inc. Annual Report 2006
ITEM 2.
ITEM 2.
PROPERTIES
We operate retail apparel stores in all 50 states and Puerto Rico. At the end of fiscal 2006, the geographic distribution of our stores by concept was as follows:
We lease our retail stores under operating lease agreements with initial terms ranging from approximately eight to ten years that expire at various dates through January 2019 (see Note 8 to the consolidated financial statements).
Our corporate office and distribution center are located in Anaheim, California and encompass a total of approximately 550,000 square feet. We will begin operating a second distribution center in Olathe, Kansas in the first half of fiscal 2007. We believe these facilities are capable of servicing our operational needs through fiscal 2007. We also purchased additional land in Anaheim in 2006 for the construction of a new, additional corporate office.
ITEM 3.
ITEM 3.
LEGAL PROCEEDINGS
We are involved from time to time in litigation incidental to our business. In connection with our undertakings to close 74 demo stores, landlords have, in some instances, threatened or initiated actions alleging breach of the underlying store leases and seek to recover remaining lease payments for the duration of the underlying leases. We are undertaking to reach agreements with landlords of the stores being closed to address our underlying lease obligations. As previously
Pacific Sunwear of California, Inc. Annual Report 2006 13
announced, we estimate that we will incur lease termination charges of approximately $8-12 million associated with the lease termination negotiations associated with these demo closures. Actual lease termination charges could be significantly higher than our estimates. We believe that the outcome of current and threatened litigation, including litigation relating to the demo store closures, will not likely have a material adverse effect on our results of operations or financial condition.
ITEM 4.
ITEM 4.
SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of the Company’s shareholders during the fourth quarter of the fiscal year covered by this report.
PART II
ITEM 5.
ITEM 5.
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Our common stock trades on the NASDAQ Global Select Market under the symbol “PSUN”. The following table sets forth for the quarterly periods indicated the high and low sale prices per share of the common stock as reported by NASDAQ:
As of March 28, 2007, the number of holders of record of common stock of the Company was approximately 500, and the number of beneficial holders of the common stock was approximately 17,600.
We have never declared or paid any dividends on our common stock.
14 Pacific Sunwear of California, Inc. Annual Report 2006
THE FOLLOWING PERFORMANCE GRAPH SHALL NOT BE DEEMED TO BE SOLICITING MATERIAL OR TO BE FILED WITH THE SECURITIES AND EXCHANGE COMMISSION UNDER THE SECURITIES ACT OF 1933 OR THE SECURITIES EXCHANGE ACT OF 1934 OR INCORPORATED BY REFERENCE IN ANY DOCUMENT SO FILED.
PERFORMANCE GRAPH
Set forth below is a line graph comparing the percentage change in the cumulative total return on the Company’s common stock with the cumulative total return of the CRSP Total Return Index for the NASDAQ Stock Market (U.S. Companies) (“NASDAQ U.S. Market”) and the CRSP Total Return Industry Index for the NASDAQ Retail Trade Stocks (“NASDAQ Retail Index”) for the period commencing on February 2, 2002 and ending on February 3, 2007.
Comparison of Cumulative Total Return from February 2, 2002 through February 3, 2007(1)
(1) Returns are calculated based on the premise that $100 is invested in each of PacSun stock, the NASDAQ U.S. market and the NASDAQ Retail Index on February 2, 2002. Over a five year period, and based on the actual price movement of these investments, the original $100 would have turned into the amounts shown as of the end of each PacSun fiscal year. Shareholder returns over the indicated period should not be considered indicative of future shareholder returns.
Common Stock Repurchase and Retirement - Information regarding our common stock repurchase activity for fiscal 2006 is contained in Note 9 to the consolidated financial statements, which note is incorporated herein by this reference.
In its discretion, our Board of Directors authorized the stock repurchase plan as a means to reduce our overall number of shares outstanding, thereby providing greater value to our shareholders through increased earnings per share. We do not expect the impact of the stock repurchases we have made to be significant to our overall liquidity needs as we expect sufficient cash flows from operations in the future to finance our operations. We believe this was a prudent use of a portion of the cash and short-term investments available to us in order to enhance shareholder value.
ITEM 6.
ITEM 6.
SELECTED FINANCIAL DATA
The selected consolidated income statement data for each of fiscal 2006, 2005 and 2004 and consolidated balance sheet data as of the end of fiscal 2006 and 2005, are derived from audited consolidated financial statements of the Company included herein and should be read in conjunction with such financial statements. Such data and the selected consolidated operating data below should also be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in this report. The consolidated income statement data for fiscal 2003 and
Pacific Sunwear of California, Inc. Annual Report 2006 15
2002, as well as the consolidated balance sheet data as of the end of fiscal 2004, 2003 and 2002, are derived from audited consolidated financial statements of the Company, which are not included herein. All amounts presented below are in millions, except per share and selected consolidated operating data.
(1) Gross margin (after buying, distribution and occupancy costs) decreased in fiscal 2006 primarily due to higher markdown activity associated with negative same store sales. Operating income and net income declined during fiscal 2006 primarily due (1) to the higher markdown activity noted above and (2) the inventory and asset impairment charges taken in association with the planned closure of 74 demo stores. See Note 2 to the consolidated financial statements.
(2) Stores are deemed comparable stores on the first day of the first month following the one-year anniversary of their opening, relocation, expansion or conversion.
(3) For purposes of calculating these amounts, the number of stores and the amount of square footage reflect the number of months during the period that new stores and closed stores were open.
(4) The Company repurchased and retired common stock of $99 million, $66 million, and $110 million during fiscal 2006, 2005, and 2004, respectively.
ITEM 7.
ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Consolidated Financial Statements and Notes thereto of the Company included elsewhere in this Form 10-K. The discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including those set forth under “Risk Factors” within Item 1A.
Executive Overview
We consider the following items to be key performance indicators in evaluating Company performance:
Comparable (or “same store”) sales - Stores are deemed comparable stores on the first day of the month following the one-year anniversary of their opening or expansion/relocation. We consider same store sales to be an important indicator of current Company performance. Same store sales results are important in achieving operating leverage of certain expenses such as store payroll, store occupancy, depreciation, general and administrative expenses, and other costs that are somewhat fixed. Positive same store sales results generate greater operating leverage of expenses while negative same store sales results negatively impact operating leverage. Same store sales results also have a direct impact on our total net sales, cash, and working capital.
16 Pacific Sunwear of California, Inc. Annual Report 2006
Net merchandise margins - We analyze the components of net merchandise margins, specifically initial markup and markdowns as a percentage of net sales. Any inability to obtain acceptable levels of initial markups or any significant increase in our use of markdowns could have an adverse impact on our gross margin results and results of operations. Due to the negative same store sales results during fiscal 2006, our markdowns at cost were $60 million higher in fiscal 2006 than in fiscal 2005. As a percentage of net sales, markdowns at cost were 14.0% for fiscal 2006 versus 10.2% for fiscal 2005 and 10.4% for fiscal 2004.
Operating margin - We view operating margin as a key indicator of our success. The key drivers of operating margins are comparable store net sales, net merchandise margins, and our ability to control operating expenses. Operating margin as a percentage of net sales for fiscal 2006, 2005, and 2004 was 4.1%, 14.2% and 13.8%, respectively. The 4.1% operating margin result for fiscal 2006 was reflected in negative same store sales results, higher markdowns as a result of the negative same store sales, and the inventory and asset impairments associated with the planned closure of 74 demo stores. During fiscal 2007, we expect to incur total estimated lease termination, severance and related charges of approximately $10-15 million associated with the 74 demo store closures. These charges will be recognized and paid as each lease termination is negotiated. We are not able to determine the actual amount and specific timing of these lease termination charges at this time. As a result, actual lease termination charges could differ materially from our estimates and could adversely affect results of operations for any or all fiscal quarters during fiscal 2007. For a discussion of the changes in the components comprising operating margins during fiscal 2006, 2005 and 2004, see “Results of Operations” in this section.
Store sales trends - We evaluate store sales trends in assessing the operational performance of our store expansion strategies. Important store sales trends include average net sales per store and average net sales per square foot. Average net sales per store (in millions) for fiscal 2006, 2005 and 2004 were $1.24, $1.31 and $1.29, respectively. Average net sales per square foot were $346, $371 and $374, respectively.
Cash flow and liquidity (working capital) - We evaluate cash flow from operations, liquidity and working capital to determine our short-term operational financing needs. Cash flows from operations for fiscal 2006, 2005 and 2004 (in millions) were $162, $184 and $143, respectively. We expect cash flows from operations will be sufficient to finance operations without borrowing under our credit facility during fiscal 2007.
Critical Accounting Policies
The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America necessarily requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements as well as the reported revenues and expenses during the reported period. Actual results could differ from these estimates. The accounting policies that we believe are the most critical to aid in fully understanding and evaluating reported financial results include the following:
Recognition of Revenue - Sales are recognized upon purchase by customers at our retail store locations or upon delivery to and acceptance by the customer for orders placed through our website. We accrue for estimated sales returns by customers based on historical sales return results. Actual return rates have historically been within our expectations and the reserves established. However, in the event that the actual rate of sales returns by customers increased significantly, our operational results could be adversely affected. We record the sale of gift cards as a current liability and recognize a sale when a customer redeems a gift card. The amount of the gift card liability is determined taking into account our estimate of the portion of gift cards that will not be redeemed or recovered (“gift card breakage”). Gift card breakage is recognized as revenue after 24 months, at which time the likelihood of redemption is considered remote based on our historical redemption data.
Valuation of Inventories - Merchandise inventories are stated at the lower of average cost or market utilizing the retail method. At any given time, inventories include items that have been marked down to management’s best estimate of their fair market value. We base the decision to mark down merchandise primarily upon its current rate of sale and the age of the item, among other factors. To the extent that our estimates differ from actual results, additional markdowns may have to be recorded, which could reduce our gross margins and operating results.
Pacific Sunwear of California, Inc. Annual Report 2006 17
Determination of Stock-Based Compensation Expense - Effective January 29, 2006, we adopted the fair value recognition provisions of SFAS 123(R) using the modified prospective transition method. Under this method we recognize compensation expense for all stock-based compensation awards granted after January 28, 2006 and prior to but not yet vested as of, January 28, 2006, in accordance with SFAS 123(R). Under the fair value recognition provisions of SFAS 123(R), we recognize stock-based compensation net of an estimated forfeiture rate and only recognize compensation cost for those shares expected to vest using the graded vesting method over the requisite service period of the award. Prior to SFAS 123(R) adoption, we accounted for stock-based payments under APB 25, “Accounting for Stock Issued to Employees,” and accordingly, we were not required to recognize compensation expense for options granted to employees that had an exercise price equal to the market value of the underlying common stock on the date of grant. Prior periods have not been restated.
Determining the appropriate fair value model and calculating the fair value of stock-based compensation awards require the input of highly subjective assumptions, including the expected life of the stock-based compensation awards and stock price volatility. We use the Black-Scholes option-pricing model to determine compensation expense. The assumptions used in calculating the fair value of stock-based compensation awards represent management’s best estimates, but the estimates involve inherent uncertainties and the application of management judgment. As a result, if factors change and we use different assumptions, our stock-based compensation expense could be materially different in the future. See “Stock-Based Compensation” within Note 1 to the condensed consolidated financial statements for a further discussion on stock-based compensation.
Store Operating Lease Accounting - Rent expense from store operating leases represents one of the largest expenses incurred in operating our stores. We account for store rent expense in accordance with SFAS 13, “Accounting for Leases,” and FASB Technical Bulletin 85-3, “Accounting for Operating Leases with Scheduled Rent Increases.” Accordingly, rent expense under our store operating leases is recognized on a straight-line basis over the original term of each store’s lease, inclusive of rent holiday periods during store construction and excluding any lease renewal options. Beginning in fiscal 2006, we began expensing pre-opening rent in accordance with FASB Staff Position 13-1, “Accounting for Rental Costs Incurred during a Construction Period.” In prior years, we capitalized rent expense incurred during the build-out period of our stores as a component cost of construction and amortized this amount over the life of the related store’s lease term once construction had completed, generally upon the commencement of store operations. The Company accounts for landlord allowances received in connection with store operating leases in accordance with SFAS 13, “Accounting for Leases,” and FASB Technical Bulletin 88-1, “Issues Relating to Accounting for Leases.” Accordingly, all amounts received from landlords to fund tenant improvements are recorded as a deferred lease incentive liability, which is then amortized as a credit to rent expense over the related store’s lease term.
Evaluation of Long-Lived Assets - In the normal course of business, we acquire tangible and intangible assets. We periodically evaluate the recoverability of the carrying amount of our long-lived assets (including property, plant and equipment, and other intangible assets) whenever events or changes in circumstances indicate that the carrying amount of an asset may not be fully recoverable. Impairment is assessed when the undiscounted expected future cash flows derived from an asset or asset group are less than its carrying amount. The amount of impairment loss recognized is equal to the difference between the carrying value and the estimated fair value of the asset, with such estimated fair values determined using the best information available, generally the discounted future cash flows of the assets using a rate that approximates the Company’s weighted average cost of capital. Impairments are recognized in operating earnings. We use our best judgment based on the most current facts and circumstances surrounding our business when applying these impairment rules to determine the timing of the impairment test, the undiscounted cash flows used to assess impairments, and the fair value of a potentially impaired asset. Changes in assumptions used could have a significant impact on our assessment of recoverability. Numerous factors, including changes in our business, industry segment, and the global economy, could significantly impact our decision to retain, dispose of, or idle certain of our long-lived assets.
18 Pacific Sunwear of California, Inc. Annual Report 2006
The estimation of future cash flows from operating activities requires significant estimates of factors that include future sales growth and gross margin performance. If our sales growth, gross margin performance or other estimated operating results are not achieved at or above our forecasted level, the carrying value of certain of our retail stores may prove unrecoverable and we may incur additional impairment charges in the future.
Evaluation of Insurance Reserves - We are responsible for workers’ compensation and medical insurance claims up to a specified aggregate stop loss amount. We maintain reserves for estimated claims, both reported and incurred but not reported, based on historical claims experience and other estimated assumptions. Actual claims activity has historically been within our expectations and the reserves established. To the extent claims experience or our estimates change, additional charges may be recorded in the future up to the aggregate stop loss amount for each policy year.
Evaluation of Income Taxes - Current income tax expense is the amount of income taxes expected to be payable for the current reporting period. The combined federal and state income tax expense was calculated using estimated effective annual tax rates. A deferred income tax asset or liability is established for the expected future consequences of temporary differences in the financial reporting and tax bases of assets and liabilities. We consider future taxable income and ongoing prudent and feasible tax planning in assessing the value of our deferred tax assets. Evaluating the value of these assets is necessarily based on our judgment. If we determined that it was more likely than not that the carrying value of these assets would not be realized, we would reduce the value of these assets to their expected realizable value through a valuation allowance, thereby decreasing net income. If we subsequently determined that the carrying value of these assets, which had been written down, would be realized in the future, the value of the deferred tax assets would be increased, thereby increasing net income in the period when that determination was made.
Evaluation of Litigation Matters - We are involved from time to time in litigation incidental to our business. We believe that the outcome of current litigation will not likely have a material adverse effect on our results of operations or financial condition and, from time to time, may make provisions for probable litigation losses. Depending on the actual outcome of pending litigation, charges in excess of any provisions could be recorded in the future, which may have an adverse effect on our operating results.
Results of Operations
The following table sets forth selected income statement data of the Company expressed as a percentage of net sales for the fiscal years indicated. The discussion that follows should be read in conjunction with the following table:
Pacific Sunwear of California, Inc. Annual Report 2006 19
The following table sets forth the Company’s number of stores and total square footage as of the dates indicated:
Fiscal 2006 Compared to Fiscal 2005
Net Sales
Net sales increased to $1.45 billion in fiscal 2006 from $1.39 billion in fiscal 2005, an increase of $56 million, or 4.0%. The components of this $56 million increase in net sales are as follows:
Of the (4.7)% decrease in comparable store net sales in fiscal 2006, PacSun and PacSun Outlet comparable store net sales decreased a combined (4.2)% and demo comparable store net sales decreased (7.9)%. The average sale in a comparable store was down low single digits, primarily driven by a low single digit decrease in average retail prices per unit and a low single digit decrease in total transactions per comparable store.
Within PacSun and PacSun Outlet, comparable store net sales of guys’ and girls’ merchandise decreased (1.9)% and (7.3)%, respectively. Guys’ comparable store net sales results were characterized by weakness in sneakers and accessories, partially offset by strength in long-sleeve knits, shorts, and basic denim. Girls’ comparable store net sales results were characterized by weakness in sneakers, short-sleeve tees, pants, knits and wovens, partially offset by strength in shorts, swimwear and long-sleeve tees.
Within demo, comparable store net sales of guys’ and girls’ merchandise decreased (9.6)% and (6.2)%, respectively. Guys’ comparable store net sales results were characterized by weakness in denim, wovens and tees, partially offset by strength in fleece, polos, and accessories. Girls’ comparable store net sales results were characterized by weakness in tops and denim, partially offset by strength in non-denim pants and footwear.
Gross Margin
Gross margin, after buying, distribution and occupancy costs, decreased to $445 million in fiscal 2006 from $506 million in fiscal 2005, a decrease of $61 million, or 12.1%. As a percentage of net sales, gross margin was 30.8% and 36.4% for fiscal 2006 and 2005, respectively. The 5.6% decrease in gross margin as a percentage of net sales was largely attributable to higher markdowns as a result of negative same store sales results in fiscal 2006 ($203 million at cost) compared to fiscal 2005 ($142 million at cost), resulting in a 3.8% decrease in gross margin as a percentage of net sales. Included in the higher markdown rate was an inventory write-down charge of approximately $11 million at cost during the
20 Pacific Sunwear of California, Inc. Annual Report 2006
third quarter of fiscal 2006, targeted primarily at our poorly performing sneaker and accessories businesses in PacSun. We have changed our inventory strategy to operate our stores with a lower overall inventory density, which we believe will allow us to improve the presentation and clarity of our merchandising assortments going forward. In addition, as a result of the planned closures of 74 demo stores and the anticipated inventory liquidation sales, we recorded a $2.1 million charge to cost of sales to write-down the inventory to its estimated net realizable value. Other significant factors contributing to the gross margin decline were a deleveraging of occupancy, distribution and buying costs (a decline of 1.8% in gross margin as a percentage of net sales) due to the negative same-store sales results in fiscal 2006 as compared to fiscal 2005.
Selling, General and Administrative Expenses
Selling, general and administrative expenses increased to $386 million in fiscal 2006 from $309 million in fiscal 2005, an increase of $77 million, or 24.9%. As a percentage of net sales, these expenses increased to 26.7% from 22.2%. The components of this 4.5% net increase in selling, general and administrative expenses as a percentage of net sales were as follows:
Asset Impairment
As previously announced in a report on Form 8-K, on February 2, 2007, the Board of Directors of the Company approved management’s recommendation to close 74 demo stores. The determination to take this action resulted from a comprehensive review and evaluation of the real estate portfolio and profit performance of the Company’s demo stores. The stores to be closed, which in total generated a pre-tax operating loss of approximately $9 million in fiscal 2006, are expected to close during the first half of fiscal 2007. Accordingly, we conducted an impairment evaluation of these stores as of February 3, 2007. Based on the results of these analyses, we wrote down the carrying value of the long-lived assets associated with these stores during fiscal 2006 by $22 million.
In addition, based on our quarterly assessments of the carrying value of long-lived assets conducted in accordance with SFAS No. 144, in fiscal 2006, we identified 11 stores with asset carrying values in excess of such stores’ respective forecasted undiscounted cash flows. Accordingly, we incurred non-cash charges of $2 million to write down these stores to their respective fair values.
Net Interest Income
Net interest income was $5 million in fiscal 2006 compared to $6 million in fiscal 2005. Interest income generated by higher interest rates was offset by the Company having lower average cash and short-term investment balances during
Pacific Sunwear of California, Inc. Annual Report 2006 21
fiscal 2006 versus 2005. The lower cash and investment balances were the result of stock repurchase activity earlier in the year (see Note 9 to the condensed consolidated financial statements) and negative same-store sales results.
Income Tax Expense
Income tax expense was $25 million in fiscal 2006 compared to $77 million in fiscal 2005. The effective income tax rate was 38.3% and 37.8% in fiscal 2006 and 2005, respectively. The increase in the effective income tax rate was primarily attributable to stock-based compensation (see Note 10 to the consolidated financial statements). Our weighted average effective state income tax rate will vary over time depending on a number of factors, such as differing income tax rates and net income in the respective states. Our effective income tax rate may continue to change in the future due to our second distribution center and other planned business events.
Fiscal 2005 Compared to Fiscal 2004
Net Sales
Net sales increased to $1.4 billion in fiscal 2005 from $1.2 billion in fiscal 2004, an increase of $162 million, or 13.1%. The components of this $162 million increase in net sales are as follows:
Of the 3.2% increase in comparable store net sales in fiscal 2005, PacSun and PacSun Outlet comparable store net sales increased a combined 3.5% and demo comparable store net sales increased 1.1%. The average sale in a comparable store was up mid single digits, primarily driven by a mid single digit increase in average retail prices per unit partially offset by a low single digit decrease in total transactions per comparable store. The increases in average retail prices were focused in merchandise categories where we believed we had strategic opportunities that allowed for such increases.
Within PacSun and PacSun Outlet, comparable store net sales of guys’ and girls’ merchandise increased 5% and 2%, respectively. Guys’ comparable store net sales results were characterized by strength in denim, polos, tees and sneakers. Girls’ comparable store net sales results were characterized by strength in knits, short-sleeve tees and accessories, partially offset by weakness in long-sleeve tees and casual pants.
Within demo, comparable store net sales of girls’ merchandise increased 15% while guys’ merchandise decreased 10%. Girls’ comparable store net sales results were characterized by strength in accessories, knits, capris and denim. Guys’ comparable store net sales results were characterized by weakness in wovens and tees, partially offset by strength in polos and denim. The sales trend within demo was primarily driven by expanded product offerings for girls, including accessories and footwear.
Gross Margin
Gross margin, after buying, distribution and occupancy costs, increased to $507 million in fiscal 2005 from $448 million in fiscal 2004, an increase of $59 million, or 13.1%. As a percentage of net sales, gross margin was 36.4% for each of fiscal 2005 and 2004. Higher initial markups were offset by higher occupancy and buying expenses and shrinkage as a percentage of net sales during fiscal 2005. Occupancy and buying expenses were higher as a percentage of net sales
22 Pacific Sunwear of California, Inc. Annual Report 2006
primarily due to deleveraging these expenses against the lower comparable store net sales increase experienced in fiscal 2005.
Selling, General and Administrative Expenses
Selling, general and administrative expenses increased to $309 million in fiscal 2005 from $278 million in fiscal 2004, an increase of $31 million, or 11.3%. As a percentage of net sales, these expenses decreased to 22.2% from 22.6%. The components of this 0.4% net decrease in selling, general and administrative expenses as a percentage of net sales were as follows:
Net Interest Income
Net interest income was $6 million in fiscal 2005 compared to $2 million in fiscal 2004, an increase of $4 million. This increase was primarily the result of higher average cash and investment balances as well as increasing interest rates in fiscal 2005 as compared to fiscal 2004. Average cash and investment balances were higher in fiscal 2005 primarily due to cash generated from operations and higher net income driven by the comparable store net sales increase in fiscal 2004.
Income Tax Expense
Income tax expense was $77 million in fiscal 2005 compared to $65 million in fiscal 2004. The effective income tax rate was 37.8% in each of fiscal 2005 and 2004. Our weighted average effective state income tax rate will vary over time depending on a number of factors, such as differing income tax rates and net income in the respective states.
Liquidity and Capital Resources
We have historically financed our operations primarily from internally generated cash flow, with occasional short-term and long-term borrowings and equity financing in past years. Our primary capital requirements have been for the construction of newly opened, remodeled, expanded or relocated stores, the financing of inventories and, in the past, construction of corporate facilities. We believe that our working capital and cash flows from operating activities will be sufficient to meet our operating and capital expenditure requirements without borrowing under our credit facility for at least the next twelve months.
Pacific Sunwear of California, Inc. Annual Report 2006 23
Operating Cash Flows
Net cash provided by operating activities for each of fiscal 2006, 2005 and 2004 (in millions) was $162, $184 and $143, respectively. The $22 million decrease in cash provided by operations in fiscal 2006 as compared to fiscal 2005 was attributable to the following:
Working Capital
Working capital at the end of each of fiscal 2006, 2005 and 2004 (in millions) was $195, $304 and $258, respectively. The $109 million decrease in working capital at February 3, 2007 compared to January 28, 2006 was attributable to the following:
Investing Cash Flows
Net cash used in investing activities in each of fiscal 2006, 2005 and 2004 (in millions) was $114, $105 and $95, respectively. Investing cash flows for fiscal 2006 were comprised of capital expenditures of $158 million, partially offset by $44 million in net maturities of marketable securities. Capital expenditures were predominantly for the opening of new, relocated and expanded stores and improving the visual presentation of our stores. Due to the increasing interest rate environment during fiscal 2006, the Company has liquidated longer-term marketable securities (original maturity period of 3 months to one year) as they matured in favor of shorter-term marketable securities (original maturity of less than 3 months) in order to take advantage of the increasing interest rates.
Fiscal 2006 New Store Costs
Our average cost to build a new or relocated store in fiscal 2006, including leasehold improvements and furniture and fixtures was approximately $0.7 million. We expect the average cost to build new and relocated stores in fiscal 2007 to remain fairly consistent with the 2006 cost. The average total cost to build new stores and relocate or expand stores will
24 Pacific Sunwear of California, Inc. Annual Report 2006
vary in the future depending on various factors, including square footage, changes in store design, and local construction costs. The average landlord allowance, which is shown in the consolidated financial statements as a deferred lease incentive, was approximately $0.2 million in fiscal 2006. Our average cost for initial inventory for new stores opened in fiscal 2006 was approximately $160 thousand. Our initial inventory for new stores will vary in the future depending on various factors, including store concept and square footage.
Fiscal 2007 Store Opening Plans
Given the current trend in our business, we feel it is prudent to slow the pace of our store openings for fiscal 2007. As a result, we currently anticipate opening approximately 20 new stores, consisting of a mixture of PacSun, PacSun Outlet and demo locations. We also plan to expand or relocate approximately 20-25 of our most productive stores to larger locations during fiscal 2007, primarily within the PacSun concept. In addition, we plan to remodel approximately 50 of our existing PacSun stores and approximately 15 of our existing demo stores to an updated store design package. This will result in total square footage growth for fiscal 2007 of approximately four percent.
In fiscal 2007, we expect capital expenditures to be approximately $104 million, broken down as follows:
We currently expect similar total annual capital expenditure requirements for the near future.
We expect cash flows from operations to be sufficient to provide the liquidity and resources necessary to achieve our stated store opening, relocation/expansion goals and the construction of a new distribution center. Cash flows from operations for fiscal 2006, 2005 and 2004 (in millions) were $162, $184 and $143, respectively. We have not entered into any material purchase commitments for capital expenditures related to our store opening or relocation/expansion plans.
Financing Cash Flows
Net cash used by financing activities in each of fiscal 2006, 2005, and 2004 (in millions) was $90, $49 and $93, respectively. In each of the last three fiscal years (in millions), the Company repurchased and retired common stock of $99, $66 and $110, respectively. Proceeds from employee exercises of stock options were $10 million lower in fiscal 2006 ($9 million) than in fiscal 2005 ($19 million).
Information regarding the Company’s common stock repurchase program is contained in Note 9 to the condensed consolidated financial statements, which note is incorporated herein by this reference.
Credit Facility
We have an unsecured $200 million credit agreement with a syndicate of lenders which expires September 14, 2010. The credit facility provides for a $200 million revolving line of credit that can be increased to up to $275 million at our option under certain circumstances. The credit facility is available for direct borrowing and the issuance of letters of credit with a portion also available for swing-line loans. Direct borrowings under the credit facility bear interest at the Administrative Agent’s alternate base rate (as defined, 5.8% at February 3, 2007) or at optional interest rates that are primarily dependent upon LIBOR for the time period chosen. We had no direct borrowings outstanding under the credit facility at February 3, 2007. The credit facility requires us to maintain certain financial covenants, all of which we were in compliance with as of February 3, 2007.
A significant decrease in our operating results could adversely affect our ability to maintain the required financial ratios under our credit facility. Required financial ratios include a rolling four-quarter minimum fixed charge coverage ratio as well as a maximum leverage ratio. If these financial ratios are not maintained, the lenders will have the option to terminate
Pacific Sunwear of California, Inc. Annual Report 2006 25
the facility and require immediate repayment of all amounts outstanding under the credit facility, if any. The alternatives available to us if in default of our covenants would include renegotiating certain terms of the credit agreement, obtaining waivers from the lenders, or obtaining a new credit agreement with another bank or group of lenders, which may contain different terms. If we were unable to obtain waivers or renegotiate acceptable lending terms, there can be no guarantee that we would be able to obtain a new credit agreement with another bank or group of lenders on similar terms or at all.
Contractual Obligations
We have minimum annual rental commitments under existing store leases as well as a minor amount of capital leases for computer equipment. Our financial obligations under these arrangements are approximately $111 million in fiscal 2007 and similar lower amounts annually thereafter. We lease all of our retail store locations under operating leases. We lease equipment, from time to time, under both capital and operating leases. In addition, at any time, we are contingently liable for commercial letters of credit with foreign suppliers of merchandise. The table below includes the lease agreements covering the 74 demo stores planned to be closed during fiscal 2007. In connection with the lease termination negotiations associated with these closures, we expect to incur total estimated lease termination charges of approximately $8-12 million during fiscal 2007 in exchange for a release from all future obligations under the related leases. These charges will be recognized and paid as each lease termination is negotiated. We are not able to determine the actual amount and specific timing of these lease termination charges at this time. As a result, actual lease termination charges could differ materially from our estimates and could adversely affect results of operations for any or all fiscal quarters during fiscal 2007. At February 3, 2007, our future financial commitments under all existing contractual obligations were as follows:
The contractual obligations table above does not include common area maintenance (CAM) charges, which are also a required contractual obligation under our store operating leases. In many of our leases, CAM charges are not fixed and can fluctuate significantly from year to year for any particular store. Total store rental expenses, including CAM for fiscal 2006, 2005 and 2004 were $180 million, $161 million, and $138 million, respectively. We expect total CAM expenses to continue to increase as the number of stores increases from year to year.
Operating Leases - We lease our retail stores and certain equipment under operating lease agreements expiring at various dates through January 2019. Substantially all of our retail store leases require us to pay CAM charges, insurance, property taxes and percentage rent ranging from 5% to 7% based on sales volumes exceeding certain minimum sales levels. The initial terms of such leases are typically 8 to 10 years, many of which contain renewal options exercisable at our discretion. Most leases also contain rent escalation clauses that come into effect at various times throughout the lease term. Rent expense is recorded under the straight-line method over the life of the lease (see “Straight-Line Rent” in Note 1). Other rent escalation clauses can take effect based on changes in primary mall tenants throughout the term of a given lease. Most leases also contain cancellation or kick-out clauses in our favor that relieve us of any future obligation under a lease if specified sales levels are not achieved by a specified date. None of our retail store leases contain purchase options.
We review the operating performance of our stores on an ongoing basis to determine which stores, if any, to expand, relocate or close. We closed six stores in fiscal 2006 and currently anticipate closing approximately 90-100 stores in fiscal 2007,
26 Pacific Sunwear of California, Inc. Annual Report 2006
including the 74 demo stores previously announced. See “Store Closures” within the “Stores” discussion of Part I, Item 1. “Business” of this report.
Indemnifications
In the ordinary course of business, we may provide indemnifications of varying scope and terms to customers, vendors, lessors, business partners and other parties with respect to certain matters, including, but not limited to, losses arising out of our breach of such agreements, services to be provided by us, or intellectual property infringement claims made by third parties. In addition, we have entered into indemnification agreements with our directors and certain of our officers that will require us, among other things, to indemnify them against certain liabilities that may arise by reason of their status or service as directors or officers. We maintain director and officer insurance, which may cover certain liabilities arising from our obligation to indemnify our directors and officers in certain circumstances.
It is not possible to determine our maximum potential liability under these indemnification agreements due to the limited history of prior indemnification claims and the unique facts and circumstances involved in each particular agreement. Such indemnification agreements may not be subject to maximum loss clauses. Historically, we have not incurred material costs as a result of obligations under these agreements.
New Accounting Pronouncements
Information regarding new accounting pronouncements is contained in Note 1 to the consolidated financial statements for the year ended February 3, 2007, which note is incorporated herein by this reference.
Inflation
We do not believe that inflation has had a material effect on the results of operations in the recent past. There can be no assurance that our business will not be affected by inflation in the future.
Seasonality and Quarterly Results
Our business is seasonal by nature. Our first quarter historically accounts for the smallest percentage of annual net sales with each successive quarter contributing a greater percentage than the last. In recent years, excluding sales generated by new and relocated/expanded stores, 44% of our net sales have occurred in the first half of the fiscal year and 56% have occurred in the second half, with the Christmas and back-to-school selling periods together accounting for approximately 30% of our annual net sales and a higher percentage of our operating income. Our quarterly results of operations may also fluctuate significantly as a result of a variety of factors, including the timing of store openings; the amount of revenue contributed by new stores; the timing and level of markdowns; the timing of store closings, expansions and relocations; competitive factors; and general economic conditions.
ITEM 7A.
ITEM 7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are susceptible to market value fluctuations with regard to our marketable securities. However, due to the relatively short maturity period of those investments and/or our intention and ability to hold those investments until maturity, the risk of material market value fluctuations is not expected to be significant.
To the extent we borrow under our credit facility, we are exposed to market risk related to changes in interest rates. At February 3, 2007, there were no borrowings outstanding under our credit facility and we did not borrow under the credit facility at any time during fiscal 2006 or 2005. Based on the interest rate of 5.8% on our credit facility at February 3, 2007, if interest rates on the credit facility were to increase by 10%, and to the extent borrowings were outstanding, for every $1 million outstanding on our credit facility, net income would be reduced by approximately $4 thousand per year. See “Summary of Significant Accounting Policies” and “Nature of Business.” We are not a party with respect to derivative financial instruments.
ITEM 8.
ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Information with respect to this item is set forth in “Index to Financial Statements,” which appears immediately following the “Signature” section of this report.
27 Pacific Sunwear of California, Inc. Annual Report 2006
ITEM 9.
ITEM 9.
CHANGES IN, AND DISAGREEMENTS WITH, ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A.
CONTROLS AND PROCEDURES
Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures
Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934, as amended (the Exchange Act). These disclosure controls and procedures are designed to provide reasonable assurance that the information required to be disclosed by the Company in its periodic reports filed with the Commission is recorded, processed, summarized and reported within the time periods specified by the Commission’s rules and forms. Our disclosure controls and procedures are also designed to provide reasonable assurance that information required to be disclosed in the periodic reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our principal executive officer and principal financial officer, in order to allow timely decisions regarding required disclosures. Based on this evaluation, our principal executive officer and our principal financial officer concluded that our disclosure controls and procedures were effective at a reasonable assurance level as of February 3, 2007.
No change in our internal control over financial reporting occurred during the last fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Management’s Report on Internal Control Over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our evaluation under the framework in Internal Control - Integrated Framework, our management concluded that our internal control over financial reporting was effective as of February 3, 2007.
Our management’s assessment of the effectiveness of our internal control over financial reporting as of February 3, 2007 has been audited by Deloitte & Touche LLP, an independent registered public accounting firm, as stated in their report which is included herein.
Our management, including our principal executive officer and principal financial officer, does not expect that our disclosure controls and procedures or our internal controls will prevent all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected.
Pacific Sunwear of California, Inc. Annual Report 2006 28
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
Pacific Sunwear of California, Inc.
Anaheim, California
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting appearing above, that Pacific Sunwear of California, Inc. and subsidiaries (the “Company”) maintained effective internal control over financial reporting as of February 3, 2007, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers or persons performing similar functions, and effected by the Company’s Board of Directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America (“generally accepted accounting principles”). A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the Company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the financial statements.
Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management’s assessment that the Company maintained effective internal control over financial reporting as of February 3, 2007, is fairly stated, in all material respects, based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of February 3, 2007, based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year ended February 3, 2007 of the Company and our report dated March 28, 2007, which report expressed an unqualified opinion and includes an explanatory paragraph relating to the adoption of Statement of Financial Accounting Standards No. 123(R), Share Based Payment, in fiscal year 2006.
DELOITTE & TOUCHE LLP
Costa Mesa, California
March 28, 2007
Pacific Sunwear of California, Inc. Annual Report 2006 29
ITEM 9B.
ITEM 9B.
OTHER INFORMATION
None.
PART III
ITEM 10.
ITEM 10.
DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information with respect to this item is incorporated by reference from the Registrant’s definitive Proxy Statement to be filed with the Commission not later than 120 days after the end of the Registrant’s fiscal year.
ITEM 11.
ITEM 11.
EXECUTIVE COMPENSATION
Information with respect to this item is incorporated by reference from the Registrant’s definitive Proxy Statement to be filed with the Commission not later than 120 days after the end of the Registrant’s fiscal year.
ITEM 12.
ITEM 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
Information with respect to this item is incorporated by reference from the Registrant’s definitive Proxy Statement to be filed with the Commission not later than 120 days after the end of the Registrant’s fiscal year.
ITEM 13.
ITEM 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information with respect to this item is incorporated by reference from the Registrant’s definitive Proxy Statement to be filed with the Commission not later than 120 days after the end of the Registrant’s fiscal year.
ITEM 14.
ITEM 14.
PRINCIPAL ACCOUNTANT FEES AND SERVICES
Information with respect to this item is incorporated by reference from the Registrant’s definitive Proxy Statement to be filed with the Commission not later than 120 days after the end of the Registrant’s fiscal year.
PART IV
ITEM 15.
ITEM 15.
EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) 1.
The financial statements listed in the “Index to Consolidated Financial Statements” at page are filed as a part of this report.
2.
Financial statement schedules are omitted because they are not applicable or the required information is shown in the consolidated financial statements or notes thereto.
3.
Exhibits included or incorporated herein: See “Index to Exhibits” at end of consolidated financial statements.
Pacific Sunwear of California, Inc. Annual Report 2006 30
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed, on March 28, 2007, on its behalf by the undersigned, thereunto duly authorized.
PACIFIC SUNWEAR OF CALIFORNIA, INC.
By:
/s/ Sally Frame Kasaks
Sally Frame Kasaks
Interim Chief Executive Officer and Director
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
31 Pacific Sunwear of California, Inc. Annual Report 2006
PACIFIC SUNWEAR OF CALIFORNIA, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
CONSOLIDATED FINANCIAL STATEMENTS FOR THE FISCAL Years Ended:
FEBRUARY 3, 2007 (“Fiscal 2006”)
JANUARY 28, 2006 (“Fiscal 2005”)
JANUARY 29, 2005 (“Fiscal 2004”)
Pacific Sunwear of California, Inc. Annual Report 2006
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
Pacific Sunwear of California, Inc.
Anaheim, California
We have audited the accompanying consolidated balance sheets of Pacific Sunwear of California, Inc. and subsidiaries (the “Company”) as of February 3, 2007 and January 28, 2006, and the related consolidated statements of income and comprehensive income, shareholders’ equity, and cash flows for each of the three years in the period ended February 3, 2007. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Pacific Sunwear of California, Inc. and subsidiaries as of February 3, 2007 and January 28, 2006, and the results of their operations and their cash flows for each of the three years in the period ended February 3, 2007, in conformity with accounting principles generally accepted in the United States of America.
As discussed in Notes 1 and 10 to the consolidated financial statements, the Company changed its method of accounting for stock-based compensation as a result of adopting Statement of Financial Accounting Standards No. 123R, Share-Based Payment, as of January 29, 2006.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of February 3, 2007, based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report, dated March 28, 2007, expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
DELOITTE & TOUCHE LLP
Costa Mesa, California
March 28, 2007
Pacific Sunwear of California, Inc. Annual Report 2006
PACIFIC SUNWEAR OF CALIFORNIA, INC.
CONSOLIDATED BALANCE SHEETS
See notes to consolidated financial statements
Pacific Sunwear of California, Inc. Annual Report 2006
PACIFIC SUNWEAR OF CALIFORNIA, INC.
CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME
See notes to consolidated financial statements
Pacific Sunwear of California, Inc. Annual Report 2006
PACIFIC SUNWEAR OF CALIFORNIA, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
(1) Share repurchases in the first and second quarters of fiscal 2006 exceeded the value of additional paid-in capital. Accordingly, at the end of each of those quarters, negative additional paid-in capital was reclassified against retained earnings.
See notes to consolidated financial statements
Pacific Sunwear of California, Inc. Annual Report 2006
PACIFIC SUNWEAR OF CALIFORNIA, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
See notes to consolidated financial statements
Pacific Sunwear of California, Inc. Annual Report 2006
PACIFIC SUNWEAR OF CALIFORNIA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
For the Fiscal Years Ended February 3, 2007, January 28, 2006 and January 29, 2005
(all amounts in thousands, except share and per share amounts, unless otherwise indicated)
1.
NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Nature of Business - Pacific Sunwear of California, Inc. and its subsidiaries (collectively, the “Company”) is a leading specialty retailer of everyday casual apparel, footwear and accessories designed to meet the needs of active teens and young adults. The Company operates three nationwide, primarily mall-based chains of retail stores, under the names “Pacific Sunwear” (as well as “PacSun”), “Pacific Sunwear Outlet” (as well as “PacSun Outlet”), and “demo.” Pacific Sunwear and Pacific Sunwear Outlet stores specialize in board-sport inspired casual apparel, footwear and related accessories catering to teens and young adults. demo specializes in fashion-focused street wear, including casual apparel, footwear and related accessories catering to teens and young adults. The Company launched operations for a new specialty footwear concept, One Thousand Steps, in April 2006 and currently operates nine One Thousand Steps stores. One Thousand Steps stores specialize in fashion-forward footwear and accessories catering to young adults. In addition, the Company operates two e-commerce websites (www.pacsun.com and www.demostores.com) which sell PacSun and demo merchandise online, respectively, provide content and a community for its target customers, and provide information about the Company. The Company also operates a third website (www.onethousandsteps.com) that provides store location and product information for One Thousand Steps.
The Company’s fiscal year is the 52- or 53-week period ending on the Saturday closest to January 31. Fiscal year-end dates for all periods presented or discussed herein are as follows:
Principles of Consolidation - The consolidated financial statements include the accounts of Pacific Sunwear of California, Inc. and its subsidiaries, Pacific Sunwear Stores Corp. and Miraloma Corp. All intercompany transactions have been eliminated in consolidation.
Basis of Presentation - The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”).
Use of Estimates - The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America necessarily requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the consolidated financial statements as well as the reported revenues and expenses during the reporting period. Actual results could differ from these estimates.
Fair Value of Financial Instruments - Statement of Financial Accounting Standards No. 107 (“SFAS 107”), “Disclosures about Fair Value of Financial Instruments,” requires management to disclose the estimated fair value of certain assets and liabilities defined by SFAS 107 as financial instruments. Financial instruments are generally defined by SFAS 107 as cash, evidence of ownership interest in an entity, or a contractual obligation that both conveys to one entity a right to receive cash or other financial instruments from another entity and imposes on the other entity the obligation to deliver cash or other financial instruments to the first entity. At February 3, 2007, management believes that the carrying amounts of cash, short-term investments, receivables and payables approximate fair value because of the short maturity of these financial instruments.
Pacific Sunwear of California, Inc. Annual Report 2006
Cash and Cash Equivalents - The Company considers all highly liquid financial instruments purchased with an original maturity of three months or less to be cash equivalents. Cash and cash equivalents consist primarily of investment-grade asset-backed debt obligations, commercial paper and money market funds.
Marketable Securities - At February 3, 2007, marketable securities consisted of auction rate securities of approximately $32 million, classified as available for sale. At January 28, 2006, marketable securities consisted of auction rate securities of approximately $60 million, classified as available for sale, and other short-term investments of approximately $15 million, classified as held-to-maturity.
Auction rate securities have long-term stated contractual maturities, but have variable interest rates that reset at each auction period (typically 7 to 28 days). These securities trade in a broad, highly liquid market and the Company has never had difficulty liquidating part or all of its investment at the end of a given auction period. The Company typically reinvests these securities multiple times during each reporting period at each new auction date. As a result of the resetting variable rates, the Company had no cumulative gross unrealized or realized gains or losses from these investments. All income from these investments was recorded as interest income for each period presented.
Merchandise Inventories - Merchandise inventories are stated at the lower of cost (first-in, first-out method) or market. Cost is determined using the retail inventory method. At any given time, inventories include items that have been marked down to management’s best estimate of their fair market value. Management bases the decision to mark down merchandise primarily upon the current rate of sale and age of a specific item, among other factors.
Property and Equipment - All property and equipment are stated at cost. Depreciation is recognized on a straight-line basis over the following estimated useful lives:
Goodwill and Other Intangible Assets - The Company accounts for goodwill and other intangible assets in accordance with SFAS 142, “Goodwill and Intangible Assets.” The Company evaluates the recoverability of goodwill at least annually based on a two-step impairment test. The first step compares the fair value of each reporting unit with its carrying amount, including goodwill. If the carrying amount exceeds fair value, then the second step of the impairment test is performed to measure the amount of any impairment loss. Fair value is determined based on estimated future cash flows, discounted at a rate that approximates the Company’s cost of capital. Such estimates are subject to change and the Company may be required to recognize impairment losses in the future. At February 3, 2007, goodwill of $6 million was included in other assets. No impairment losses were required to be recognized related to goodwill in any of the fiscal years covered by this report.
Other Long-Lived Assets - The Company evaluates the carrying value of long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable in accordance with SFAS 144, “Accounting for the Impairment of Long-Lived Assets.” Factors that are considered important and that could trigger an impairment review include a current-period operating or cash flow loss combined with a history of operating or cash flow losses and a projection or forecast that demonstrates continuing losses or insufficient income associated with the use of a long-lived asset or asset group. Other factors include a significant change in the manner of the use of the asset or a significant negative industry or economic trend. This evaluation is performed based on estimated undiscounted future cash flows from operating activities compared with the carrying value of the related assets. If the undiscounted future cash flows are less than the carrying value, an impairment loss is recognized, measured by the difference between the carrying value and the estimated fair value of the assets, with such estimated fair values
Pacific Sunwear of California, Inc. Annual Report 2006
determined using the best information available, generally the discounted future cash flows of the assets using a rate that approximates the Company’s weighted average cost of capital. See Note 2, “Store Closures and Impairment of Long-Lived Assets,” for a discussion of asset impairment charges recognized in fiscal 2006.
Insurance Reserves - The Company uses a combination of third-party insurance and self-insurance for workers’ compensation, employee medical and general liability insurance. For each type of insurance, the Company has defined stop-loss or deductible provisions that limit the Company’s maximum exposure to claims. The Company maintains reserves for estimated claims associated with these programs, both reported and incurred but not reported, based on historical claims experience and other estimated assumptions.
Income Taxes - Current income tax expense is the amount of income taxes expected to be payable for the current year. The combined federal and state income tax expense was calculated using estimated effective annual tax rates. A deferred income tax asset or liability is established for the expected future consequences of temporary differences in the financial reporting and tax bases of assets and liabilities. The Company considers future taxable income and ongoing prudent and feasible tax planning in assessing the value of its deferred tax assets. Evaluating the value of these assets is necessarily based on the Company’s judgment. If the Company determines that it is more likely than not that these assets will not be realized, the Company would reduce the value of these assets to their expected realizable value through a valuation allowance, thereby decreasing net income. If the Company subsequently determined that the deferred tax assets, which had been written down, would be realized in the future, the value of the deferred tax assets would be increased, thereby increasing net income in the period when that determination was made.
Litigation - The Company is involved from time to time in litigation incidental to its business. Management believes that the outcome of current litigation will not likely have a material adverse effect upon the results of operations or financial condition of the Company and, from time to time, may make provisions for probable litigation losses. At February 3, 2007, litigation reserves were not material to the consolidated financial statements taken as a whole (see Note 8).
Deferred Lease Incentives - The Company accounts for landlord allowances in accordance with SFAS 13, “Accounting for Leases,” and Financial Accounting Standards Board (“FASB”) Technical Bulletin (“FTB”) 88-1, “Issues Relating to Accounting for Leases.” Accordingly, all incentives received from landlords to fund tenant improvements are recorded as deferred liabilities and then amortized over the related store’s lease term.
Revenue Recognition - Sales are recognized upon purchase by customers at the Company’s retail store locations or upon delivery to and acceptance by the customer for orders placed through the Company’s website. The Company records the sale of gift cards as a current liability and recognizes a sale when a customer redeems a gift card. The amount of the gift card liability is determined taking into account our estimate of the portion of gift cards that will not be redeemed or recovered (“gift card breakage”). Gift card breakage is generally recognized as revenue after 24 months, at which time the likelihood of redemption is considered remote based on our historical redemption data. Gift card breakage has never been more than 0.4% of sales in any fiscal year. The Company accrues for estimated sales returns by customers based on historical sales return results. Sales return accrual activity for each of the three fiscal years in the period ended February 3, 2007 is as follows:
E-commerce Shipping and Handling Revenues and Expenses - The Company accounts for shipping and handling revenues and expenses in accordance with Emerging Issues Task Force Issue (“EITF”) 00-10, “Accounting for Shipping and Handling Fees and Costs.” All shipping and handling revenues and expenses relate to sales activity generated from the Company’s websites. Amounts charged to the Company’s internet customers for shipping and handling revenues are
Pacific Sunwear of California, Inc. Annual Report 2006
included in net sales. Amounts paid by the Company for internet shipping and handling expenses are included in cost of goods sold and encompass payments to third party shippers and costs to store, move and prepare merchandise for shipment.
Customer Loyalty Programs - The Company accounts for its customer loyalty programs in accordance with EITF 00-22, “Accounting for ’Points’ and Certain Other Time-Based or Volume-Based Sales Incentive Offers, and Offers for Free Products or Services to Be Delivered in the Future.” Generally, these programs offer customers dollar-for-dollar discounts on future merchandise purchases within stated redemption periods if they purchase specified levels of merchandise in a current transaction. The impact of these programs is recognized ratably as a direct reduction in net sales over the series of transactions required to both earn and redeem the customer discounts. Redemptions generally occur within 30 days of original issuance.
Cost of Goods Sold, including Buying, Distribution and Occupancy Costs - Cost of goods sold includes the landed cost of merchandise and all expenses incurred by the Company’s buying and distribution functions. These costs include inbound freight, purchasing and receiving costs, inspection costs, warehousing costs, internal transfer costs, and any other costs borne by the Company’s buying department and distribution center. Occupancy costs include store rents, common area charges, as well as store expenses related to telephone service, supplies, repairs and maintenance, insurance, loss prevention, and taxes and licenses.
Vendor Allowances - The Company accounts for allowance money received from vendors in accordance with EITF 02-16, “Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor.” Cash consideration received from a vendor includes vendor allowances, rebates, cooperative advertising payments, etc. The Company recognizes cash received from vendors as a reduction in the price of the vendor’s products and accordingly, as a reduction in cost of sales at the time the related inventory is sold.
Straight-Line Rent - The Company accounts for rent expense in accordance with SFAS 13, “Accounting for Leases,” and FTB 85-3, “Accounting for Operating Leases with Scheduled Rent Increases.” Accordingly, rent expense under the Company’s store operating leases is recognized on a straight-line basis over the original term of each store’s lease, inclusive of rent holiday periods during store construction and excluding any lease renewal options. As of January 29, 2006, the Company adopted FASB Staff Position (“FSP”) 13-1, “Accounting for Rental Costs Incurred During a Construction Period,” which requires the Company to expense rental costs incurred during store construction periods as rent expense. Prior to the adoption of FSP 13-1, the Company capitalized rent expense attributable to the build-out period of its stores as a component cost of construction and amortized this amount over the life of the related store’s lease term once construction had completed, generally upon the commencement of store operations.
Selling, General and Administrative Expenses - Selling, general and administrative expenses include payroll, depreciation and amortization, advertising, credit authorization charges, expenses associated with the counting of physical inventories, and all other general and administrative expenses not directly related to merchandise or operating the Company’s stores.
Advertising Costs - Costs associated with the production or placement of advertising, such as photography, design, creative talent, editing, magazine insertion fees and other costs associated with such advertising, are expensed the first time the advertising appears publicly. Advertising costs were $17 million, $15 million, and $11 million in fiscal 2006, 2005, and 2004, respectively.
Stock-Based Compensation - On January 29, 2006, the Company adopted the fair value recognition provisions of SFAS 123(R), “Share-Based Payment,” under the modified prospective method. Prior to January 29, 2006, the Company had accounted for stock-based compensation under the recognition and measurement provisions of Accounting Principles Board Opinion 25 (“APB 25”) and related interpretations, as permitted by SFAS 123, “Accounting for Stock-Based Compensation.” In accordance with APB 25, no compensation expense was required to be recognized
Pacific Sunwear of California, Inc. Annual Report 2006
for options granted to employees that had an exercise price equal to the market value of the underlying common stock on the date of grant.
As a result of adopting SFAS 123(R), the Company’s net income and earnings per share for fiscal 2006 were $4 million and $0.05 lower, respectively, than if it had continued to account for stock-based compensation under APB 25 as it did during fiscal 2005. Stock-based compensation expense for fiscal 2006 was included in costs of goods sold for the Company’s buying and distribution employees ($2 million) and in selling, general and administrative expense for all other employees ($4 million). The adoption of SFAS 123(R) had no impact on the Company’s cash flows.
A reconciliation of reported net income and earnings per share for fiscal 2005 and 2004 to that which would have been reported if SFAS 123(R) had been in place for that period is presented in the following table:
Earnings per Share - The Company reports earnings per share in accordance with the provisions of SFAS 128, “Earnings Per Share.” Basic earnings per common share is computed using the weighted average number of shares outstanding. Diluted earnings per common share is computed using the weighted average number of shares outstanding adjusted for the incremental shares attributed to outstanding options to purchase common stock. For purposes of calculating diluted earnings per share, incremental shares included in, and anti-dilutive options excluded from, the calculations for each of fiscal 2006, 2005 and 2004 were as follows:
Anti-dilutive options and non-vested shares are excluded from the computation of diluted earnings per share because either the option exercise price or the grant date fair value of the non-vested share is greater than the market price of the Company’s common stock.
Comprehensive Income - The Company reports comprehensive income in accordance with the provisions of SFAS 130, “Reporting Comprehensive Income.” SFAS 130 established standards for the reporting and display of comprehensive income. Components of comprehensive income include net earnings (loss), foreign currency translation adjustments and gains/losses associated with investments available for sale. There was no difference between net income and comprehensive income for any of the periods presented.
Vendor and Merchandise Concentrations - During each of fiscal 2006, 2005 and 2004, Billabong (which incorporates both Billabong and Element brands) accounted for 11.3%, 10.3%, and 9.4% of total net sales, respectively, and Quiksilver (which incorporates the Quiksilver, Roxy, and DC Shoes brands) accounted for 10.6%, 10.4%, and 10.9% of total net
Pacific Sunwear of California, Inc. Annual Report 2006
sales, respectively. No other individual branded vendor accounted for more than 7% of total net sales for any period. The Company’s merchandise assortment as a percentage of net sales for each of fiscal 2006, 2005 and 2004 was as follows:
New Accounting Pronouncements - In June 2006, the FASB issued FASB Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes,” which clarifies the accounting for uncertainty in income taxes recognized in the financial statements in accordance with SFAS 109, “Accounting for Income Taxes.” This pronouncement prescribes a recognition threshold and measurement process for recording in the financial statements uncertain tax positions taken or expected to be taken in the Company’s tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods and disclosure requirements for uncertain tax positions. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company is in the process of evaluating the effect, if any, the adoption of FIN 48 will have on its consolidated financial position, results of operations and cash flows.
In June 2006, the FASB ratified the consensus reached on EITF 06-03, How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (that is, Gross versus Net Presentation). The EITF reached a consensus that the presentation of taxes on either a gross or net basis is an accounting policy decision that requires disclosure. EITF 06-03 is effective for the first interim or annual reporting period beginning after December 15, 2006. Taxes collected from the Company’s customers are and have been recorded on a net basis. The Company has no intention of modifying this accounting policy. As such, the adoption of EITF 06-03 will not have an effect on the Company’s consolidated financial position or results of operations.
In September 2006, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 108, “Financial Statements - Considering the Effects of Prior Year Misstatements When Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”). This new guidance addresses how a registrant should quantify the effect of errors on the financial statements based on their impact to both the balance sheet and the income statement in order to determine materiality. The guidance provides for a one-time cumulative effect adjustment to correct for misstatements and errors that were not deemed material under a prior approach but are material under the SAB 108 approach. The application of SAB 108 did not have an effect on the Company’s consolidated financial position or results of operations.
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”). This new standard provides guidance for using fair value to measure assets and liabilities and information about the extent to which companies measure assets and liabilities at fair value, the information used to measure fair value, and the effect of fair value measurements on earnings. This framework is intended to provide increased consistency in how fair value determinations are made under various existing accounting standards which permit, or in some cases require, estimates of fair market value. SFAS 157 also expands financial statement disclosure requirements about a company’s use of fair value measurements, including the effect of such measures on earnings. The provisions of SFAS 157 are effective for financial statements issued for fiscal years beginning after November 15, 2007. While the Company is currently evaluating the provisions of SFAS 157, the adoption is not expected to have a material impact on its consolidated financial statements.
2.
STORE CLOSURES AND IMPAIRMENT OF LONG-LIVED ASSETS
As previously announced in a report on Form 8-K, on February 2, 2007, the Board of Directors of the Company approved management’s recommendation to close 74 underperforming demo stores. The determination to take this action resulted from a comprehensive review and evaluation of the real estate portfolio and profit performance of the Company’s demo
Pacific Sunwear of California, Inc. Annual Report 2006
stores. The stores to be closed, which in total generated a pre-tax operating loss of approximately $9 million in fiscal 2006, are expected to be closed during the first half of fiscal 2007. Accordingly, the Company recognized an impairment charge of approximately $22 million related to the fixed assets associated with these stores. This non-cash charge is recorded within selling, general and administrative expenses in the consolidated statements of operations. The Company has retained Hilco Merchant Resources, LLC to assist it in connection with the orderly liquidation of the inventory in these stores and Hilco Real Estate, LLC to assist it in connection with the disposition of the Company’s real estate operating leases covering these stores. The fair value of the inventory at these stores was determined based on the liquidation agreement between Hilco Merchant Resources, LLC and the Company. As a result of this agreement, a $2 million inventory liquidation charge was included in cost of goods sold for fiscal 2006. The Company estimates that additional lease termination, severance and related charges of approximately $10-15 million will be incurred throughout fiscal 2007 as lease termination negotiations are finalized related to these demo closures. The specific timing of such charges on a quarterly basis is not determinable and actual charges could be significantly higher than the Company’s estimates.
In addition, the Company assesses whether events or changes in circumstances have occurred that potentially indicate the carrying value of long-lived assets may not be recoverable. The Company’s evaluations during fiscal 2006 indicated that impairments existed at 11 retail stores. As such, the Company recorded non-cash charges of $2 million during fiscal 2006 within selling, general and administrative expenses in the consolidated statements of operations to write-down the carrying value of these stores’ long-lived assets to their estimated fair values. The following is a breakdown of asset impairment charges taken during fiscal 2006 by reportable segment:
3.
OTHER CURRENT ASSETS
As of the dates presented, other current assets consisted of the following:
4.
PROPERTY AND EQUIPMENT, NET
As of the dates presented, property and equipment consisted of the following categories:
Pacific Sunwear of California, Inc. Annual Report 2006
5.
CREDIT FACILITY
The Company has an unsecured $200 million credit agreement with a syndicate of lenders (the “Credit Facility”) which expires September 14, 2010. The Credit Facility provides for a $200 million revolving line of credit that can be increased to up to $275 million at the Company’s option under certain circumstances. The Credit Facility is available for direct borrowing and the issuance of letters of credit with a portion also available for swing-line loans. Direct borrowings under the Credit Facility bear interest at the Administrative Agent’s alternate base rate (as defined, 5.8% at February 3, 2007) or at optional interest rates that are primarily dependent upon LIBOR for the time period chosen. The Company had no direct borrowings outstanding under the Credit Facility at February 3, 2007. The Credit Facility requires the Company to maintain certain financial covenants. The Company was in compliance with all such covenants as of February 3, 2007.
6.
OTHER CURRENT LIABILITIES
As of the dates presented, other current liabilities consisted of the following:
7.
INCOME TAXES
The components of income tax expense for the periods presented were as follows:
A reconciliation of income tax expense to the amount of income tax expense that would result from applying the federal statutory rate to income before income taxes for the periods presented was as follows:
Pacific Sunwear of California, Inc. Annual Report 2006
The major components of the Company’s overall net deferred tax asset of $7 million and overall net deferred tax liability of $6 million at February 3, 2007 and January 28, 2006, respectively, were as follows:
8.
COMMITMENTS AND CONTINGENCIES
Operating Leases - The Company leases its retail stores and certain equipment under operating lease agreements expiring at various dates through January 2019. Substantially all of the Company’s retail store leases require the Company to pay common area maintenance charges, insurance, property taxes and percentage rent ranging from 5% to 7% based on sales volumes exceeding certain minimum sales levels. The initial terms of such leases are typically ten years, many of which contain renewal options exercisable at the Company’s discretion. Most leases also contain rent escalation clauses that come into effect at various times throughout the lease term. Rent expense is recorded under the straight-line method over the life of the lease (see “Straight-Line Rent” in Note 1). Other rent escalation clauses can take effect based on changes in primary mall tenants throughout the term of a given lease. Most leases also contain cancellation or kick-out clauses in the Company’s favor that relieve the Company of any future obligation under a lease if specified sales levels are not achieved by a specified date. None of the Company’s retail store leases contain purchase options.
The table below includes the lease agreements covering the 74 demo stores planned to be closed during fiscal 2007 (see Note 2). In connection with the lease termination negotiations associated with these closures, the Company expects to incur total estimated lease termination charges of approximately $8-12 million during fiscal 2007 in exchange for a release from all future obligations under the related leases. These charges will be recognized and paid as each lease termination is negotiated. The Company is not able to determine the actual amount and specific timing of these lease termination charges at this time. As a result, actual lease termination charges could differ materially from the Company’s estimates and could adversely affect results of operations for any or all fiscal quarters during fiscal 2007.
As of February 3, 2007, minimum future rental commitments under non-cancelable operating leases were as follows:
Pacific Sunwear of California, Inc. Annual Report 2006
The rental commitments table above does not include common area maintenance (CAM) charges, which are also a required contractual obligation under the Company’s store operating leases. In many of the Company’s leases, CAM charges are not fixed and can fluctuate significantly from year to year for any particular store. Store rental expenses, including CAM, were $180 million, $161 million, and $138 million, of which $7 million was paid as percentage rent based on sales volume for each of fiscal 2006, 2005 and 2004. The Company expects total CAM expenses to continue to increase as the number of stores increases from year to year.
Litigation - The Company is involved from time to time in litigation incidental to its business. In connection with the Company’s undertakings to close 74 demo stores, landlords have, in some instances, threatened or initiated actions alleging breach of the underlying store leases and seek to recover remaining lease payments for the duration of the underlying leases. The Company is undertaking to reach agreements with landlords of the stores being closed to address its underlying lease obligations. As previously announced, the Company estimates that it will incur lease termination charges of approximately $8-12 million associated with the lease termination negotiations associated with these demo closures. Actual lease termination charges could be significantly higher than the Company’s estimates. The Company believes that the outcome of current and threatened litigation, including litigation relating to the demo store closures, will not likely have a material adverse effect on its results of operations or financial condition.
Indemnities, Commitments, and Guarantees - During its normal course of business, the Company has made certain indemnities, commitments and guarantees under which it may be required to make payments in relation to certain transactions. These indemnities include those given to various lessors in connection with facility leases for certain claims arising from such facility or lease and indemnities to directors and officers of the Company to the maximum extent permitted under the laws of the State of California. The duration of these indemnities, commitments and guarantees varies, and in certain cases, is indefinite. The majority of these indemnities, commitments and guarantees do not provide for any limitation of the maximum potential future payments the Company could be obligated to make. The Company has not recorded any liability for these indemnities, commitments and guarantees in the accompanying consolidated balance sheets other than as disclosed below in this Note 8.
Letters of Credit - The Company has issued guarantees in the form of commercial letters of credit, of which there were approximately $17 million outstanding at February 3, 2007, as security for merchandise shipments from overseas. All in-transit merchandise covered by letters of credit is accrued for in accounts payable.
Accrued Sublease Loss Charges - The Company remains liable under an operating lease covering a former store location. The term of the lease ends December 31, 2012. The Company has subleased this location to third parties at rates that are less than the Company’s required lease payments. Accordingly, the Company had approximately $1 million accrued to recognize its net remaining contractual lease obligation related to these premises at February 3, 2007. To the extent any sublessee defaults upon its sublease obligations, the Company may incur additional charges related to this lease in the future. The Company’s remaining contractual obligation under the original lease, exclusive of any sublease income, was approximately $5 million at February 3, 2007.
Lease Guarantee - The Company remains secondarily liable under a guarantee issued related to the assignment of an operating lease covering another former store location. The term of the lease ends December 31, 2014. The Company had approximately $0.3 million accrued to recognize the remaining estimated fair value of this guarantee, assuming that another assignee would be found within one year should the original assignee default. The aggregate payments remaining on the master lease agreement at February 3, 2007, were approximately $4 million.
9.
COMMON STOCK
Common Stock Repurchase and Retirement - The Company entered fiscal 2006 with approximately $50 million remaining to be spent under its stock repurchase plan, which was originally approved by its Board of Directors and announced in January 2004. Over time, the Company’s Board of Directors has continued to authorize additional stock repurchases, including an additional $100 million authorized in May 2006. The repurchase authorizations do not expire
Pacific Sunwear of California, Inc. Annual Report 2006
until all authorized funds have been expended. In accordance with California law, all repurchased shares are immediately retired. During fiscal 2006 and 2005, the Company made repurchases of its own common stock of $99 million and $66 million, respectively, under these authorizations. During fiscal 2006 and through March 28, 2007, the Company made the following repurchases of shares subject to this plan:
Shareholder Rights Plan - In December 1998, the Board of Directors approved the adoption of a Shareholder Rights Plan (“the Rights Plan”). The Rights Plan provides for the distribution to the Company’s shareholders of one preferred stock purchase “Right” for each outstanding share of the Company’s common stock. The Rights have an exercise price of $75 per Right, subject to subsequent adjustment. Initially, the Rights will trade with the Company’s common stock, and will not be exercisable until the occurrence of certain takeover-related events, as defined. The Rights Plan provides that if a person or group acquires more than 15% of the Company’s stock without prior approval of the Board of Directors, holders of the Rights will be entitled to purchase the Company’s stock at half of market value. The Rights Plan also provides that if the Company is acquired in a merger or other business combination after a person or group acquires more than 15% of the Company’s stock without prior approval of the Board of Directors, holders of the Rights will be entitled to purchase the acquirer’s stock at half of market value. The Rights were distributed to holders of the Company’s common stock of record on December 29, 1998, as a dividend, and will expire, unless earlier redeemed, on December 29, 2008.
10.
STOCK COMPENSATION PLANS
On January 29, 2006, the Company adopted the fair value recognition provisions of SFAS 123(R) under the modified prospective method. Prior to January 29, 2006, the Company had accounted for stock-based compensation under the recognition and measurement provisions of Accounting Principles Board Opinion 25 (“APB 25”) and related interpretations, as permitted by SFAS 123, “Accounting for Stock-Based Compensation.” In accordance with APB 25, no compensation expense was required to be recognized for options granted to employees that had an exercise price equal to the market value of the underlying common stock on the date of grant.
For fiscal 2006, compensation expense was recognized under the modified prospective method of SFAS 123(R) for all stock-based compensation awards granted prior to, but not yet vested as of, January 29, 2006 based on the grant date fair value estimated in accordance with the original provisions of SFAS 123, and for all stock-based compensation awards granted after January 28, 2006 based on the grant date fair value estimated in accordance with the provisions of SFAS 123(R). The Company’s financial results for prior periods have not been restated.
Pacific Sunwear of California, Inc. Annual Report 2006
Consistent with the valuation method used for the disclosure-only provisions of SFAS 123 prior to fiscal 2006, the Company is using the Black-Scholes option-pricing model to estimate the grant date fair value of its recognized stock-based compensation expense for fiscal 2006. Forfeitures are estimated at the date of grant based on historical rates and reduce the compensation expense to be recognized. The expected term of options granted is derived from historical data on employee exercises. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the date of grant. Expected volatility is based primarily on the historical volatility of the Company’s stock. The Company records stock-based compensation expense using the graded vesting method over the vesting period, which is generally three to four years. The Company’s stock-based awards generally begin vesting one year after the grant date and, for stock options, expire in seven to ten years or three months after termination of employment with the Company. For fiscal 2006, the Company’s stock-based compensation expense resulted from awards of stock options, non-vested shares, and stock appreciation rights, as well as from shares purchased under the Company’s employee share purchase plan.
For each of fiscal 2006, 2005 and 2004, the fair value of the Company’s stock-based compensation activity was determined using the following weighted average assumptions:
The total intrinsic value of options exercised during fiscal 2006, 2005 and 2004 was $6 million, $23 million, and $23 million, respectively.
At February 3, 2007, outstanding incentive and nonqualified options had exercise prices ranging from $3.51 to $28.90 per share, with an average exercise price of $19.43 per share, and generally begin vesting one year after the grant date. Options generally vest over three or four years. The options generally expire seven or ten years from the date of grant or three months after employment or services are terminated.
At February 3, 2007, incentive and nonqualified options to purchase 2,931,920 shares were outstanding and 6,432,723 shares were available for future grant under the Company’s stock compensation plans. During fiscal 2006, 2005 and 2004, the Company recognized tax benefits of $2 million, $8 million, and $8 million, respectively, resulting from the exercise of certain nonqualified stock options.
Under the Company’s stock option plans, incentive and nonqualified options have been granted to employees and directors to purchase common stock at prices equal to the fair value of the Company’s shares at the respective grant dates. A summary of stock option (incentive and nonqualified) activity under the Company’s 2005 Performance Incentive Plan for fiscal 2006 is presented below:
Pacific Sunwear of California, Inc. Annual Report 2006
The weighted-average grant-date fair value of options granted during each of fiscal 2006, 2005 and 2004 was $9.36, $14.38 and $9.26, respectively.
Additional information regarding options outstanding as of February 3, 2007, is as follows:
A summary of the status of the Company’s non-vested shares as of February 3, 2007, and changes during the year then ended, is presented below. Non-vested shares contain a time-based restriction as to vesting. These awards generally vest over four years with 25% of the grant vesting each year on the anniversary of the grant date.
At February 3, 2007, the Company had approximately $15 million of compensation cost related to non-vested stock option and non-vested share awards not yet recognized. This compensation expense is expected to be recognized over a weighted average period of approximately 3.4 years.
During 1999 and 2000, the Company granted restricted stock awards for an aggregate total of 281,250 shares with a purchase price of $0.01 per share to its then Chief Executive Officer (“CEO”). The awards vested 25% per year, if, in each instance, certain cumulative annual earnings per share growth targets had been satisfied. During each of fiscal 2005 and fiscal 2004, the Company’s Board of Directors verified that the scheduled cumulative annual earnings per share growth targets for these awards had been met. Accordingly, the CEO became vested in and received 42,187 shares and 239,063 shares during fiscal 2005 and 2004, respectively, and, as a result, the Company reclassified previously recognized accrued compensation of approximately $1 million and $5 million from accrued liabilities to additional paid-in capital. As of February 3, 2007, the Company has no further obligations remaining related to these awards.
The Company maintains an Employee Stock Purchase Plan (the “ESPP”), which provides a method for Company employees to voluntarily purchase Company common stock at a 10% discount from fair market value as of the beginning or the end of each six-month purchasing period, whichever is lower. The ESPP covers substantially all employees, except officers, who have three months of service with the Company. The ESPP is intended to constitute an “employee stock
Pacific Sunwear of California, Inc. Annual Report 2006
purchase plan” within the meaning of Section 423 of the Internal Revenue Code of 1986, as amended, and therefore the Company has not recognized compensation expense related to the ESPP for fiscal years 2005 and prior. As a result of the adoption of SFAS 123(R), the Company recognized $0.2 million in compensation expense related to the ESPP for fiscal 2006. In fiscal 2006 and 2005, 65,889 and 55,345 shares were issued at an average price of $16.14 and $20.41, respectively, under the ESPP. During fiscal 2006, the Company began recognizing compensation expense for the employee discount provision of the Company’s ESPP in accordance with SFAS 123(R) (see “Stock-Based Compensation” in Note 1).
11.
RETIREMENT PLANS
The Company maintains an Executive Deferred Compensation Plan (the “Executive Plan”) covering Company officers that is funded by participant contributions and periodic Company discretionary contributions. The Company had $9 million and $18 million recorded in other assets at February 3, 2007 and January 28, 2006, respectively, representing investments held by the Company to cover the vested participant balances in the Executive Plan. These deferred compensation asset investments are classified as trading securities and are stated at fair market value in accordance with SFAS 115, “Accounting for Certain Investments in Debt and Equity Securities.” Fair market value is determined by the most recent publicly quoted market price of the securities at the balance sheet date. Vested participant balances are included in other long-term liabilities and were $8 million and $15 million as of February 3, 2007 and January 28, 2006, respectively. The Company made contributions to the Executive Plan of $0.2 million for fiscal 2006 and $0.3 million for each of fiscal 2005 and 2004.
The Company also maintains an Employee Savings Plan (the “401(k) Plan”). The 401(k) Plan is a defined contribution plan covering substantially all employees who have reached age 21 and have one year of service with the Company. The 401(k) Plan is funded by employee contributions and periodic Company discretionary contributions, which are subject to approval by the Company’s Board of Directors. The Company made contributions to the 401(k) Plan, net of forfeitures, of approximately $1 million for each of fiscal 2006, 2005 and 2004.
12.
SEGMENT REPORTING
The Company operates exclusively in the retail apparel industry in which the Company distributes, designs and produces clothing, accessories, footwear and related products catering to the teenage/young adult demographic through primarily mall-based retail stores. The Company has identified four operating segments (PacSun, PacSun Outlet, demo, and One Thousand Steps) as defined by SFAS 131, “Disclosures about Segments of an Enterprise and Related Information.” E-commerce operations for PacSun and demo are included in their respective operating segments. The four operating segments have been aggregated into three reportable segments (PacSun, demo and One Thousand Steps). Information for each of fiscal 2006, 2005 and 2004 concerning each of the three reportable segments is set forth below (all amounts in thousands except store counts):
Pacific Sunwear of California, Inc. Annual Report 2006
In the tables above, “PacSun” reportable segment includes net sales generated from PacSun stores, PacSun Outlet stores and PacSun e-commerce. The “demo” reportable segment includes net sales generated from demo stores and demo e-commerce (demo internet sales began in June 2005). The “One Thousand Steps” reportable segment includes net sales generated solely from One Thousand Steps stores. The “Corporate” column is presented solely to allow for reconciliation of store contribution and total asset amounts to consolidated income before income taxes and total assets. Store contribution amounts include only net sales, merchandise gross margins, and direct store expenses with no allocation of corporate overhead or distribution and merchandising costs. For fiscal 2006, demo Income before Income Taxes includes $24 million of inventory and asset impairment charges associated with the planned closure of 74 underperforming demo stores.
We updated our disclosure of segments in the current year to include three reportable segments due to the launch of our new store concept, One Thousand Steps, in April 2006 and also due to the poor profit performance of the demo concept during fiscal 2006. As a result of these issues, we no longer considered our operating segments to be economically similar under the aggregation criteria of SFAS 131. Data for prior fiscal years has been restated to present all three reportable segments in the updated disclosure format.
The Company expects contribution margins for One Thousand Steps to be negative during at least the first full year of operations due to the significant start-up costs incurred in launching the initial nine stores opened to date. demo’s contribution margin was negative during fiscal 2006 primarily due to significant markdown activity taken due to negative comparable store net sales results.
Pacific Sunwear of California, Inc. Annual Report 2006
13.
QUARTERLY FINANCIAL DATA (UNAUDITED)
Summarized quarterly financial results for fiscal 2006 and 2005 are as follows:
Earnings per basic and diluted share are computed independently for each of the quarters presented based on diluted shares outstanding per quarter and, therefore, may not sum to the totals for the year. Additionally, the sum of the four quarterly amounts for any line item may not agree to the fiscal year total in the consolidated financial statements due to rounding.
Pacific Sunwear of California, Inc. Annual Report 2006
INDEX TO EXHIBITS
Note References
(1) Incorporated by reference from the Company’s Form S-1 Registration Statement (No. 33-57860) as filed with the Securities and Exchange Commission on February 4, 1993.
(2) Incorporated by reference from the Company’s Annual Report on Form 10-K as filed with the Securities and Exchange Commission on March 17, 1995.
(3) Incorporated by reference from the Company’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on December 24, 1998.
(4) Incorporated by reference from the Company’s Form 8-A Registration Statement as filed with the Securities and Exchange Commission on December 24, 1998.
(5) Incorporated by reference from the Company’s Annual Report on Form 10-K as filed with the Securities and Exchange Commission on April 6, 2000.
(6) Incorporated by reference from the Company’s Annual Report on Form 10-K as filed with the Securities and Exchange Commission on March 30, 2001.
(7) Incorporated by reference from the Company’s Quarterly Report on Form 10-Q as filed with the Securities and Exchange Commission on May 21, 2004.
(8) Incorporated by reference from the Company’s Quarterly Report on Form 10-Q as filed with the Securities and Exchange Commission on August 31, 2004.
(9) Incorporated by reference from the Company’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on October 13, 2004.
(10) Incorporated by reference from the Company’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on November 24, 2004.
(11) Incorporated by reference from the Company’s Quarterly Report on Form 10-Q as filed with the Securities and Exchange Commission on December 9, 2004.
(12) Incorporated by reference from the Company’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on December 16, 2004.
(13) Incorporated by reference from the Company’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on March 25, 2005.
(14) Incorporated by reference from the Company’s Annual Report on Form 10-K as filed with the Securities and Exchange Commission on April 12, 2005.
(15) Incorporated by reference from the Company’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on May 6, 2005.
(16) Incorporated by reference from the Company’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on May 24, 2005.
(17) Incorporated by reference from the Company’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on September 19, 2005.
(18) Incorporated by reference from the Company’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on October 6, 2005.
(19) Incorporated by reference from the Company’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on December 6, 2005.
(20) Incorporated by reference from the Company’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on March 20, 2006.
(21) Incorporated by reference from the Company’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on March 21, 2006.
(22) Incorporated by reference from the Company’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on April 4, 2006.
(23) Incorporated by reference from the Company’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on May 23, 2006.
(24) Incorporated by reference from the Company’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on August 2, 2006.
(25) Incorporated by reference from the Company’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on August 21, 2006.
(26) Incorporated by reference from the Company’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on October 2, 2006.
(27) Incorporated by reference from the Company’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on October 18, 2006.
(28) Incorporated by reference from the Company’s Quarterly Report on Form 10-Q as filed with the Securities and Exchange Commission on December 5, 2006.
(29) Incorporated by reference from the Company’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on December 18, 2006.
(30) Incorporated by reference from the Company’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on February 6, 2007.
* Management contract or compensatory plan or arrangement.