ITEM 1. BUSINESS
Pacific Sunwear of California, Inc. (together with its wholly owned subsidiaries, the “Company,” “Registrant,” “PacSun,” “we,” “us,” or “our”) is a leading specialty retailer rooted in the action sports, fashion and music influences of the California lifestyle. We sell casual apparel with a limited selection of accessories and footwear designed to meet the needs of teens and young adults. We operate a nationwide, primarily mall-based chain of retail stores under the names “Pacific Sunwear” and “PacSun.”
The Company, a California corporation, was incorporated in August 1982. As of January 30, 2010, we leased and operated 894 stores among all 50 states and Puerto Rico, comprised of 3,457,171 square feet.
Our executive offices are located at 3450 East Miraloma Avenue, Anaheim, California, 92806; our telephone number is (714) 414-4000; and our Internet address is www.pacsun.com. Through our website, 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:
Our Mission and Strategies
Our mission is to be the favorite place for teens to shop in the mall. Our objective is to provide our customers with a compelling merchandise assortment and great shopping experience that together highlight a great mix of heritage brands, proprietary product and emerging brands that speak to the action sports, fashion and music influences of the California lifestyle. We offer a targeted assortment of apparel, accessories and footwear for Young Men and Juniors (Girls) designed to meet the fashion needs of our customers. We believe the following items are the key strategic elements in executing our stated mission:
Strong Emphasis on Brands. PacSun’s foundation has traditionally been built upon a great collection of powerful brands. Today, that mix of brands includes heritage brands, our own proprietary brands and a mix of up-and-coming, emerging brands. Our heritage brands have been partnered with us for many years and include some of the most well known names in the action sports industry, including Fox Racing, DC Shoes, Roxy, Quiksilver, Hurley, Billabong, Element and Volcom, among others. In recent years, we have also built our own proprietary labels, including Bullhead®,
Kirra®,
Kirra Girl™, On The Byas™, and Nollie®,
to complement our heritage brands and give us added flexibility within certain categories. Additionally, we continually seek emerging brands to bring newness to our stores that speak to the ever-changing tastes of our customers. Taken together, we believe that this mix of brands gives us the capability to offer our customers an unmatched selection of fashionable and authentic products.
We are working with our heritage brands to reinvigorate the PacSun shopping experience. We have changed our in-store merchandise presentations to feature heritage brands exclusively on particular fixtures throughout our store with their own brand signage. Within certain stores, we have also begun allowing particular brands to create “brand shops”
2 Pacific Sunwear of California, Inc. Form 10-K 2009
that offer them the opportunity to create their own selling space within our stores and display their product in a unique manner.
Localized Assortment Planning. We believe there is a significant opportunity to improve both our sales and merchandise margin performance by redefining our merchandise assortment planning strategies. We have traditionally taken a “one size fits all” approach to merchandise assortments in our stores in terms of the timing of product flows and brand or category presentation. This approach generally resulted in all stores receiving seasonal categories (i.e., swim in spring or fleece in autumn) at the same time and in the same magnitude. In recent months, we have commenced implementation of an initiative we call “localization.” Under this initiative, we have grouped our stores into a number of store clusters based on customer segmentations, brand performance, differences in weather, and demographics, among other characteristics. In conjunction with this clustering, we are beginning to implement certain changes in our allocation strategies designed to distribute what we believe to be the right product to the right stores for the right customers. We expect the full impact of these new strategies to begin to take effect in the second half of fiscal 2010 when seasonal differences in weather are more pronounced than in spring and summer.
New Strategic Marketing Initiatives. In the past, our marketing efforts have been fairly limited to in-store creative content, relatively few in-store promotional events, and some national print advertising in major magazines that target teens and young adults. In fiscal 2010, we plan to launch a marketing strategy that we believe embraces the full capabilities of the brands we carry and will communicate to consumers that PacSun is the authentic retailer for action sports and California lifestyle brands. We are working cooperatively with key heritage brands to create new programs and approaches to generate excitement around PacSun and the California lifestyle we embody. We have continued our sponsorship of the U.S. Amateur Surf and Snowboarding Teams that reflect our commitment to the action-sports industry.
Elimination of “Value” Store Designation. During the latter half of fiscal 2008 and through fiscal 2009, we attempted to improve the operating performance of approximately 300 of our poorest performing stores by converting at least a portion of their merchandise assortments to a more value-oriented focus. This decision did not result in improved performance for such stores. As a result, we plan to return these stores to carrying the core PacSun assortment by June 2010. We believe this decision should help recover lost average unit retails in these stores, leading to improved sales and merchandise margin performance versus fiscal 2009. This decision has already enabled us to streamline our merchandising, buying and allocation decisions and processes and we believe that it can improve overall business performance.
Merchandising
Merchandise. Our stores offer a broad selection of casual apparel, related accessories and footwear for Young Men and Juniors, with the goal of being viewed by our customers as the dominant retailer for their lifestyle. The following tables set forth our merchandise assortment as a percentage of net sales for the most recent three fiscal years for our business:
Between fiscal 2007 and fiscal 2009, our sales productivity per square foot fell from $350 to $275. Prior to fiscal 2007, the combination of accessories and footwear accounted for more than 30% of total net sales versus only 12% in fiscal 2009. In retrospect, we believe we may have lost sales opportunities as a result of our previous decisions to de-
Pacific Sunwear of California, Inc. Form 10-K 2009 3
emphasize accessories and footwear during fiscal 2008 and 2009. We believe there is a significant opportunity to begin improving sales as we re-introduce certain categories of accessories and footwear. During the fourth quarter of fiscal 2009, we began re-introducing footwear into a limited number of stores and we currently plan to expand the number of stores in which we carry footwear during fiscal 2010. We plan to analyze the sales performance of these categories during fiscal 2010 in order to determine the appropriate mix of accessories and footwear as a percentage of our total net sales.
Brands. We offer a wide selection of well-known action-sport inspired heritage brands, such as Fox Racing, Billabong, Element, DC Shoes, Roxy, Quiksilver, Hurley and Volcom, among others. In addition, we continually cultivate relationships to add and support up-and-coming brands, even if they are not of sufficient size to deliver to our stores on a nationwide basis. During fiscal 2009, no vendor accounted for more than 10% of total sales.
We supplement our name brand offerings with our proprietary brands, including Bullhead®,
Kirra®,
Kirra Girl™, On The Byas™, and Nollie®.
Proprietary brands provide us with an opportunity to broaden our customer base by offering merchandise of comparable quality to brand name merchandise, capitalize on emerging fashion trends when branded merchandise is not available in sufficient quantities, and 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. Our sourcing organization oversees the manufacture and delivery of our proprietary brand merchandise, with manufacturing sourced both domestically and internationally. Our proprietary brand merchandise accounted for approximately 48%, 38%, and 30% of total net sales in fiscal 2009, 2008, and 2007, respectively. Branded merchandise accounted for approximately 52%, 62%, and 70% of total net sales in fiscal 2009, 2008, and 2007, respectively.
Vendor and Contract Manufacturer Relationships. In fiscal 2009, we believe we strengthened our relationships with our branded vendors. We generally purchase merchandise from vendors that target distribution through specialty retailers, small boutiques and, in some cases, particular department stores, rather than distribution 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 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 shorter lead times associated with domestic manufacturing and the lower costs associated with off-shore manufacturing.
Merchandising, Planning, Allocation and Distribution. Our merchants 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 team 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 Technology.”
All merchandise is delivered to our distribution facility in Olathe, Kansas 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 both national and regional carriers to ship merchandise to our stores and Internet customers. We may occasionally use air freight to ship merchandise to stores when necessary.
4 Pacific Sunwear of California, Inc. Form 10-K 2009
E-commerce. Our Internet sales continued to grow in fiscal 2009 and represented approximately 5% of our total sales for the year. We sell a combination of the same selection of merchandise carried in our stores along with online exclusives at www.pacsun.com. We maintain a database of e-mail addresses that we use for marketing and product promotion purposes. We also advertise our website as a shopping destination on certain Internet portals and search engines and market our website in our stores. Our Internet strategy benefits from the nationwide retail presence of our stores, brand recognition of PacSun, an Internet-savvy customer base, and the participation of our key brands.
Stores
Locations. We operate stores in each of the 50 states and Puerto Rico. For a geographical breakdown of stores by state, see Item 2, “Properties.”
Real Estate Strategy. Prior to fiscal 2007, the Company grew rapidly, with more than 50 new store openings per year since fiscal 1997. Given the economic environment and our sales performance over the past two years, our focus has shifted from continuing to open new stores to optimizing our existing fleet of stores. In order to improve our overall profitability, we intend to close under-performing stores and/or renegotiate existing lease terms to achieve more appropriate occupancy structures within our store operating leases. We closed 40 stores in fiscal 2009 and 38 stores in fiscal 2008. We currently expect to close approximately 25 to 50 stores in fiscal 2010 depending on our ability to negotiate acceptable lease terms as leases come up for renegotiation at lease expiration or at any earlier lease kick-out opportunity. A kick-out clause relieves 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. We have in excess of 100 lease expirations currently scheduled for each of fiscal 2010, 2011 and 2012. While there is a mixture of productive and non-productive stores to address each year, we are likely to continue closing more stores than we open in each of the next three years. Specifically for fiscal 2010, we currently plan to open less than five new stores and expand/relocate less than ten stores.
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 store locations of approximately 3,500 to 4,500 square feet.
Store Operations. Our stores are open for business during mall shopping hours. Each store has a manager, one or more assistant managers, and approximately six to twelve part-time sales associates. District managers supervise approximately 11 stores and approximately 10 district managers report to a regional director. District and store managers participate in a bonus program based on achieving predetermined metrics, including sales and inventory shrinkage targets. We have store operating policies and procedures and in-store training for new managers. We place an 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 2% of net sales at retail (1% at cost).
Competition
The retail apparel, accessory and footwear business is highly competitive. Our stores compete on a national level with certain leading specialty retail chains as well as certain department stores that offer the same or similar brands and styles of merchandise including: Abercrombie and Fitch, Aéropostale, American Eagle Outfitters, Buckle, Forever 21, Hollister, J.C. Penney, Kohl’s, Macy’s, Old Navy, Target, Urban Outfitters, and Zumiez as well as a wide variety of regional and local specialty stores. Many of our competitors are larger than we are and have significantly greater resources available to them than we do. We believe the principal competitive factors in our industry are fashion, merchandise assortment, quality, price, store location, environment and customer service.
Pacific Sunwear of California, Inc. Form 10-K 2009 5
Trademarks and Service Marks
We are the owner in the United States of the marks “Pacific Sunwear of California®,”
“PacSun®,”
and “Pacific Sunwear®.”
We also use and have registered, or have a pending registration on, a number of other marks, including those attributable to our proprietary brands such as Bullhead®,
Kirra®,
Kirra Girl™, Nollie®
and On The Byas™. 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.
Information Technology
Our merchandise, financial and store computer systems operate using primarily IBM equipment. Our information systems provide Company management, merchants and planners with data that helps them identify emerging trends and manage inventories. These systems include purchase order management, open order reporting, open-to-buy, receiving, distribution, merchandise allocation, basic stock replenishment, inter-store transfers, and inventory and price management. Company management uses daily and weekly item sales reports to make purchasing and markdown decisions. Merchandise purchases are generally based on planned sales and inventory levels.
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 office. Each of the regional directors and district managers uses a laptop computer and can access appropriate or relevant Company-wide information, including actual and budgeted sales by store, district and region, transaction information and payroll data.
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, as amended, 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 providing cautionary statements identifying important factors that could cause our actual results to differ materially from those projected in the forward-looking statements contained 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. Examples of forward-looking statements in this report include, but are not limited to, the following categories of expectations about:
•
our branding and merchandising strategies, including our plans to work with our heritage brands to reinvigorate the PacSun shopping experience and our plans to expand the number of stores in which we carry footwear during fiscal 2010,
•
our “localization” strategies, including our belief that redefining our merchandise assortment planning strategies could improve both our sales and merchandise margin performance and our expectations that the full impact of our “localization” strategies will begin to take effect in the second half of fiscal 2010,
•
our plans to eliminate our “value” store designations and our belief that such plans will lead to improved sales and merchandise margin performance versus fiscal 2009,
•
forecasts of future sales activity, inventory levels and selling, general and administrative expenses,
•
the sufficiency of working capital, operating cash flows and available credit to meet our operating and capital expenditure requirements,
•
our capital expenditure plans for fiscal 2010,
•
forecasts of future store closures, expansions, relocations and store refreshes, including planned fiscal 2010 activities,
•
future borrowings and repayments under our credit facility, and
•
future increases in occupancy expenses
All forward-looking statements included in this report are based on information available to us as of the date hereof, and are subject to risks and uncertainties that could cause actual results to differ materially from those expressed in the forward-looking statements. 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 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 business and 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
8 Pacific Sunwear of California, Inc. Form 10-K 2009
operations to accommodate our merchandising requirements, 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.
We face significant competition from both vertically-integrated and brand-based competitors which could have a material adverse effect on our business. The retail apparel business is highly competitive. All of our stores 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 and off-price retailers 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 failure to reverse declining sales in our Juniors business would have a material adverse impact on our business and profitability. In fiscal 2009, our Juniors business accounted for approximately 49% of total net sales. Juniors’ sales experienced a same store decline of 19% in fiscal 2009. The failure to reverse this negative trend would have a material adverse impact on our business, financial condition, results of operations and stock price.
We have previously changed certain of our merchandising and real estate strategies with the goal of improving our operating results. We may continue to modify our strategies going forward and we cannot be certain that our existing or modified strategies will be successful in improving our store productivity or profitability. We recently eliminated the distinction between our “Core” PacSun stores and our “Value” PacSun stores as this distinction has not resulted in improved operating results. We have also reintroduced selected footwear and accessory merchandise in an effort to recapture sales within these product categories. We are also restructuring existing occupancy terms for underperforming stores and closing a number of stores that are unprofitable. All of these strategy decisions are aimed at improving our operating results. However, there can be no assurance that these new strategies, or any future modification of our strategies, will be successful or result in improved operating results. The failure of these strategies to improve our operating results could have a material adverse impact on our business, financial condition, results of operations and stock price.
Our comparable store net sales results fluctuate significantly, which can cause volatility in our operating performance and stock price. Our comparable store net sales results have fluctuated significantly over time, and are expected to continue to fluctuate in the future. For example, over the past five years, quarterly comparable store net sales results for our stores have varied from a low of minus 24% to a high of plus 8%. A variety of factors affect our comparable store net sales results, including unfavorable economic conditions and decreases in consumer spending, changes in fashion trends and customer preferences, changes in our merchandise mix, calendar shifts of holiday periods, actions by competitors, and weather conditions. Our comparable store net sales results for any fiscal period 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 the market price of our common stock and our operating performance, including our use of markdowns and our ability to leverage operating and other expenses that are somewhat fixed.
Our net sales, operating income and inventory levels fluctuate on a seasonal basis. We experience major seasonal fluctuations in our net sales and operating income, with a significant portion of our operating income typically realized during the third quarter back-to-school and fourth quarter holiday season. Any decrease in sales or margins during these periods could have a disproportionately adverse effect on our financial condition and results of operations. Seasonal fluctuations also affect our inventory levels, since we usually order merchandise in advance of peak selling periods and sometimes before new fashion trends are confirmed by customer purchases. We generally carry a significant amount of inventory, especially before the back-to-school and holiday season selling periods. If we are not successful in selling inventory during these periods, we may have to sell the inventory at significantly reduced prices, which would adversely affect our profitability.
Our customers may not prefer our proprietary brand merchandise, which may negatively impact our profitability. Sales from proprietary brand merchandise accounted for approximately 48%, 38%, and 30% of net
Pacific Sunwear of California, Inc. Form 10-K 2009 9
sales in fiscal 2009, 2008 and 2007, respectively. There can be no assurance that any change in the sales penetration of proprietary brand merchandise will improve our operating results. 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 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 do not own or operate any manufacturing facilities and therefore depend upon independent third-party vendors for the manufacture of our merchandise. 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 , and competition with other companies for import quota capacities; (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; (vii) local business practice and political issues, including issues relating to compliance with domestic or international labor standards which may result in adverse publicity; and (viii) acts of terrorism. 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.
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. In this regard, we have historically used stock awards as a component of our total employee compensation program in order to align employees’ interests with the interests of our shareholders, encourage employee retention and provide competitive compensation and benefit packages. As a result of the decline in our stock price in recent periods, the ability to retain present, or attract prospective employees has been adversely affected. 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.
We operate our business from one corporate headquarters facility and one distribution facility which exposes us to significant operational risks. All of our corporate headquarters functions reside within a single facility in Anaheim, California. Our distribution function resides within a single facility in Olathe, Kansas. Any significant interruption in the availability or operation of our corporate headquarters or distribution facility 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.
Our business depends on our ability to operate existing stores that achieve acceptable levels of profitability. Any failure to do so may negatively impact our stock price and operational performance. Our stores are located principally in enclosed regional shopping malls. PacSun is a relatively mature concept with limited domestic
10 Pacific Sunwear of California, Inc. Form 10-K 2009
opportunities to open new stores in such malls. The rate of our new store openings has declined significantly over recent years, and we expect to open no more than five stores per year going forward. There can be no assurance, however, that we will be able to successfully operate existing stores in a manner that will enable us to achieve acceptable levels of profitability. Any inability to profitably operate our existing stores will have a material adverse impact on our business, stock price, financial condition and results of operations.
We have stated our intention to pursue a merchandise assortment planning strategy based on localization, which may not be successful in improving our store productivity or profitability. We have implemented a strategic initiative to improve the productivity of our stores in terms of sales per square foot and the profitability of our business as a whole by placing a greater emphasis on grouping our stores into a number of store clusters based on customer segmentations, brand performance, differences in weather and demographics, among other characteristics. See Part I, Item I, “Business” for further discussion of this initiative. In conjunction with this initiative, we are beginning to implement certain changes in our allocation strategies designed to achieve better delivery of product to our customers. It is uncertain whether this shift in merchandising strategy will result in higher sales per square foot in our stores or improved operating margins for our business as a whole. Moreover, implementation of this strategy could increase costs and place a strain on our management, operational and financial resources, as well as our information systems. The failure of this strategy to improve sales per square foot and profitability could have a material adverse impact on our business, financial condition, results of operations and stock price.
The continued volatility in the U.S. economy has adversely affected consumer spending, which could negatively impact our business, operating results and stock price. Our business operations and financial performance depend significantly on general economic conditions and their impact on levels of consumer spending. Consumer spending is impacted by a number of factors, including consumer confidence in the strength of the general economy, fears of economic recession or depression, the availability and cost of consumer credit, the cost of basic necessities such as food, fuel and housing, inflation, salary and wage levels, levels of taxation and unemployment levels. Recent unfavorable economic conditions in the U.S. have resulted in an overall slowing in the retail sector because of decreased consumer spending, which may continue to decline for the foreseeable future. The cost of purchased merchandise may increase as economies of scale are eroded by decreased global demand, and as other costs increase. These and other economic factors could continue to have a material adverse effect on demand for our merchandise and on our financial condition and results of operations.
We are also dependent upon the continued popularity of malls as a shopping destination and the ability of shopping mall anchor tenants and other attractions within the vicinity of our stores to generate customer traffic. Unfavorable economic conditions, particularly in certain regions, have adversely affected mall traffic and resulted in the closing of certain anchor tenants. A continued slowdown in the U.S. economy or an uncertain economic outlook could continue to lower consumer spending levels and cause a decrease in shopping mall traffic, each of which would adversely affect our sales results and financial performance.
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 dependent 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. 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. In addition, the raw materials used by our vendors to manufacture our products may become subject to availability constraints and price volatility caused by high demand for fabrics, weather, economic conditions, government regulations or other factors affecting supply conditions. There can be no assurance that we will be able to acquire sufficient quantities of quality merchandise at
Pacific Sunwear of California, Inc. Form 10-K 2009 11
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.
Consolidation in the commercial retail industry may affect our ability to successfully negotiate favorable rent terms for our stores in the future. As a mall-based retailer, the success of our business is dependent upon developing and maintaining good relationships with our landlords. Potential consolidation in the commercial retail industry could limit our ability in the future to negotiate favorable rent terms or potentially close unprofitable stores. Should significant consolidation occur, a large proportion of our store base could be concentrated with one or a few entities that control premium mall space. These entities could then be in a position to dictate unfavorable terms to us due to the significant leverage they would possess. If we are unsuccessful in negotiating favorable rent terms with these entities and are therefore unable to profitably operate our existing stores, there would be a material adverse impact on our business, financial condition, results of operations and stock price.
Any reinvestment in our existing store base may not result in improved operating performance. Conversely, the lack of any reinvestment may cause many of our stores to appear less attractive to customers. 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 in comparison. Due to the current economic environment and store performance, we have significantly scaled back our store refresh program. 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.
Any material failure, interruption or security breach of our computer systems or information technology may adversely affect the operation of our business and our financial results. We are dependent on our computer systems and information technology to properly conduct business. A failure or interruption of our computer systems or information technology could result in the loss of data, business interruptions or delays in our operations. Also, despite our considerable efforts and technological resources to secure our computer systems and information technology, security breaches, such as unauthorized access and computer viruses, may occur resulting in system disruptions, shutdowns or unauthorized disclosure of confidential information. Any security breach of our computer systems or information technology may result in adverse publicity, loss of sales and profits, damages, fines or other loss resulting from misappropriation of information.
In addition, 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 the existing or future needs of our business. 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.
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. Decreased sales would have a material adverse effect on our business, financial condition and results of operations. As we source our product globally, any threat or actual act of terrorism or war could cause a disruption to our inventory supply which could have a material adverse effect on our business, results of operations and financial condition.
12 Pacific Sunwear of California, Inc. Form 10-K 2009
Adverse outcomes of litigation matters or failure to comply with federal or state regulations could significantly affect our operating 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. In addition to SEC rules and regulations, Sarbanes-Oxley requirements and other U.S. public company regulations, there are various other requirements mandated for the textiles and apparel industries such as the Consumer Product Safety Improvement Act of 2008, California’s Proposition 65 and similar state laws. Failure to comply with these laws could have a material adverse impact on our business, financial condition, results of operations and stock price.
Our inability or failure to protect our intellectual property or our infringement of other’s intellectual property could have a negative impact on our operating results. We believe that our trademarks and domain names are valuable assets that are critical to our success. The unauthorized use or other misappropriation of our trademarks or domain names could diminish the value of our brands and cause a decline in our net sales. Although we have secured or are in the process of securing protection for our trademarks and domain names in the United States and a number of other countries, there are certain countries where we do not currently have or where we do not currently intend to apply for protection for certain trademarks or at all. Also, the efforts we have taken to protect our trademarks may not be sufficient or effective. Therefore, we may not be able to prevent other persons from using our trademarks or domain names, which also could adversely affect our business. We are also subject to the risk that we or the third-party brands we carry may infringe on the intellectual property rights of other parties. Any infringement or other intellectual property claim made against us or the third-party brands we carry, whether or not it has merit, could be time-consuming, result in costly litigation, cause product delays or require us to pay additional royalties or license fees. As a result, any such claim could have a material adverse effect on our business, financial condition, results of operations and stock price.
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 traffic and 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.
While we have installed privacy protection systems, devices and activity monitoring on our network, if unauthorized parties gain access to our networks or databases, they may be able to steal, publish, delete or modify our private and sensitive third-party information. In such circumstances, we could be held liable to our customers or other parties or be subject to regulatory or other actions for breaching privacy rules. This could result in costly investigations and litigation, civil or criminal penalties and adverse publicity that could adversely affect our financial condition, results of operations and reputation. Further, if we are unable to comply with security standards established by banks and the credit card industry, we may be subject to fines, restrictions and expulsion from card acceptance programs, which could adversely affect our retail operations.
Pacific Sunwear of California, Inc. Form 10-K 2009 13
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 market price of the common stock will not continue to fluctuate significantly. Future announcements or management discussions concerning us or our 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, our failure to meet analysts’ estimates, changes in accounting policies, or unfavorable economic conditions, among other factors, could cause the market price of our common stock to fluctuate substantially. In addition, the recent distress in the financial markets has resulted in extreme price and volume volatility. This volatility has had, and similar events in the future could have, 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.
*************
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.
ITEM 2.
ITEM 2.
PROPERTIES
We operate retail apparel stores in all 50 states and Puerto Rico. We lease our retail stores under operating lease agreements with initial terms of approximately ten years that expire at various dates through February 2021. For more information concerning our store operating lease commitments, see Note 12 to the consolidated financial statements included in this Annual Report on Form 10-K.
We own our corporate office which is located in Anaheim, California and encompasses a total of approximately 150,000 square feet. We operate a distribution center in Olathe, Kansas, which comprises approximately 400,000 square feet. For more information concerning our distribution center, see Note 7 to the consolidated financial statements included in this Annual Report on Form 10-K. We believe these facilities are capable of servicing our operational needs through fiscal 2010.
14 Pacific Sunwear of California, Inc. Form 10-K 2009
At the end of fiscal 2009, the geographic distribution of our 894 stores was as follows:
ITEM 3.
ITEM 3.
LEGAL PROCEEDINGS
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, we 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.
ITEM 4.
ITEM 4.
RESERVED
Pacific Sunwear of California, Inc. Form 10-K 2009 15
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 26, 2010, the number of holders of record of common stock of the Company was 442. We have never declared or paid any dividends on our common stock as our credit facility prohibits the payment of dividends.
16 Pacific Sunwear of California, Inc. Form 10-K 2009
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 NASDAQ Stock Market (“NASDAQ Composite Index”) and the CRSP Total Return Industry Index for the NASDAQ Retail Trade Stocks (“NASDAQ Retail Trade Index”) for the period commencing on January 29, 2005 and ending on January 30, 2010.
COMPARISION OF 5 YEAR CUMULATIVE TOTAL RETURN(1)
Among Pacific Sunwear of California, Inc., the NASDAQ Composite Index
and the NASDAQ Retail Trade Index
(1) Returns are calculated based on the premise that $100 is invested in each of PacSun stock, the NASDAQ Composite Index and the NASDAQ Retail Index on January 29, 2005, and that all dividends (if any) were reinvested. 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 - The Company did not repurchase shares of common stock in fiscal 2009. Our Board of Directors authorized a stock repurchase plan in July 2008 as a means to reduce our overall number of shares outstanding, thereby providing greater value to our shareholders through increased earnings per share. The Company ended fiscal 2009 with approximately $48 million available under the stock repurchase plan. The repurchase authorization does not expire until all authorized funds have been expended. The Company does not currently plan to repurchase any shares during fiscal 2010.
Pacific Sunwear of California, Inc. Form 10-K 2009 17
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The selected consolidated income statement data for each of fiscal 2009, 2008 and 2007, and consolidated balance sheet data as of the end of fiscal 2009 and 2008, 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 all years presented excludes the financial impact of the Company’s former demo and One Thousand Steps concepts due to the designation of these operations as discontinued operations during the first quarter of fiscal 2008 and the fourth quarter of fiscal 2007, respectively. The consolidated income statement data for fiscal 2006 and 2005, as well as the consolidated balance sheet data as of the end of fiscal 2007, 2006 and 2005, 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) 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.
(2) 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.
(3) The Company repurchased and retired common stock of $53 million, $99 million, and $66 million million during fiscal 2008, 2006, and 2005, respectively. The Company did not repurchase any common stock during fiscal 2009 or 2007.
18 Pacific Sunwear of California, Inc. Form 10-K 2009
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 (“MD&A”) should be read in conjunction with the Consolidated Financial Statements and Notes thereto of the Company included elsewhere in this Annual Report on Form 10-K. This MD&A excludes the financial statement impact of the discontinued demo and One Thousand Steps concepts (see Note 15 to the consolidated financial statements included in this Annual Report on Form 10-K). The MD&A 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 fiscal 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 usually generate greater operating leverage of expenses while negative same store sales results generally have a negative impact on operating leverage. Same store sales results also have a direct impact on our total net sales, cash and working capital.
Net merchandise margins - We analyze the components of net merchandise margins, specifically initial markups, discounts 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 discounts or markdowns could have an adverse impact on our gross margin results and results of operations.
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. For a discussion of the changes in the components comprising operating margins, see “Results of Operations” in this section.
Store sales trends - We evaluate store sales trends in assessing the operational performance of our stores. Important store sales trends include average net sales per store and average net sales per square foot. Average net sales per store were $1.1 million for fiscal 2009 and $1.3 million for each of fiscal 2008 and 2007. Average net sales per square foot were $275, $339 and $350 in fiscal 2009, 2008 and 2007, 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. We currently believe that our working capital, cash flows from operating activities and credit facility availability will be sufficient to meet our operating and capital expenditure requirements for at least the next twelve months. For a discussion of the changes in operating cash flows and working capital, see “Liquidity and Capital Resources” in this section.
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
Pacific Sunwear of California, Inc. Form 10-K 2009 19
reported financial results, and the most significant estimates and assumptions used by us in applying such accounting policies, are described below:
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. These estimates are based on a combination of factors, including current selling prices, current and projected inventory levels, current and projected rates of sell-through, known markdown and/or promotional events expected to create a permanent decrease in inventory value, estimated inventory shrink and aging of specific items. Reserves established for such items have historically been adequate. While we do not expect actual results to differ materially from our estimates, to the extent they do differ for any of these factors, we may have to record additional reserves in subsequent periods, which could reduce our gross margins and operating results.
Store Operating Lease Accounting - Rent expense from store operating leases represents one of the largest expenses incurred in operating our stores. 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 exclusive of any lease renewal options. Accordingly, we expense all pre-opening rent. 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 our 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.
The estimation of future cash flows from operating activities requires significant estimates of factors that include future sales and gross margin performance. If our sales or 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.
Stock-Based Compensation Expense - We recognize stock-based compensation expense based on the fair value on the grant date. Under fair value method, we recognize stock-based compensation net of an estimated forfeiture rate
20 Pacific Sunwear of California, Inc. Form 10-K 2009
and only recognize compensation cost for those shares expected to vest using the graded vesting method over the requisite service period of the award. 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 Notes 1 and 11 to the consolidated financial statements included in this Annual Report on Form 10-K for a further discussion on stock-based compensation.
Evaluation of Income Taxes - We account for income taxes under the asset and liability method, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements. Under this method, deferred tax assets and liabilities are determined based on the temporary differences between the financial statements and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in income in the period that includes the enactment date.
Deferred income tax assets are reduced by a valuation allowance if, in the judgment of our management, it is more likely than not that all or a portion of a deferred tax asset will not be realized. In making such determination, we consider all available positive and negative evidence, including recent financial operations, projected future taxable income, scheduled reversals of deferred tax liabilities, tax planning strategies, and the length of tax asset carryforward periods. The realization of deferred tax assets is primarily dependent upon our ability to generate sufficient future taxable earnings in certain jurisdictions. If we subsequently determine 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. See “Income Taxes” in Notes 1 and 10 to the consolidated financial statements for further discussion regarding the realizability of our deferred tax assets and our assessment of a need for a valuation allowance.
Results of Operations
The following table sets forth selected income statement data from our continuing operations expressed as a percentage of net sales for the fiscal years indicated. The table and discussion that follows excludes the operations of the discontinued demo and One Thousand Steps concepts (see Note 15 to the consolidated financial statements). The discussion that follows should be read in conjunction with the following table:
Pacific Sunwear of California, Inc. Form 10-K 2009 21
Fiscal 2009 Compared to Fiscal 2008
Net Sales
Net sales decreased to $1.03 billion in fiscal 2009 from $1.25 billion in fiscal 2008, a decrease of $228 million, or 18.2%. The components of this $228 million decrease in net sales were as follows:
For fiscal 2009, comparable store net sales of Juniors apparel decreased 19% and Young Mens apparel decreased 11%. For the fourth quarter of 2009, the Young Mens apparel sales trend improved to minus (9)% while the Juniors apparel sales trend decreased to minus (26)%. For fiscal 2009, comparable store net sales of accessories and footwear decreased 43%. The decline in sales of accessories and footwear was primarily due to our decisions in fiscal 2008 to exit or significantly reduce our emphasis on these categories. Apparel represented 88% of total sales for fiscal 2009 versus 83% in fiscal 2008. Accessories and footwear represented a combined 12% of total sales for fiscal 2009 versus 17% in fiscal 2008. As we reintroduce certain categories of footwear and accessories during fiscal 2010, the combined sales penetration of these categories may begin to increase.
Gross Margin
Gross margin, after buying, distribution and occupancy costs, decreased to $259 million in fiscal 2009 from $320 million in fiscal 2008, a decrease of $61 million, or 19.2%. As a percentage of net sales, gross margin was 25.2% in fiscal 2009, a 0.3% decrease from 25.5% in fiscal 2008. The primary components of this 0.3% net decrease in gross margin as a percentage of net sales were as follows:
We ended fiscal 2009 with total inventories 16% below the ending level of fiscal 2008 in anticipation of continued negative same store sales results in the first quarter of 2010.
Selling, General and Administrative Expenses
Selling, general and administrative (“SG&A”) expenses decreased to $340 million in fiscal 2009 from $381 million in fiscal 2008, a decrease of $41 million, or 10.8%. As a percentage of net sales, these expenses increased to 33.1% in
22 Pacific Sunwear of California, Inc. Form 10-K 2009
fiscal 2009 from 30.4% in fiscal 2008. The components of this 2.7% net increase in SG&A expenses as a percentage of net sales were as follows:
We evaluate the recoverability of the carrying amount of long-lived assets for all stores (primarily property, plant and equipment) whenever events or changes in circumstances indicate that the carrying amount of an asset may not be fully recoverable. Should comparable store net sales and gross margin continue to decline, we may record additional non-cash impairment charges for underperforming stores in fiscal 2010.
Other (Expense)/Income, net
Other expense was $0.3 million for fiscal 2009 compared to other income of $2 million in fiscal 2008. In fiscal 2009, we recorded a $0.3 million cash surrender charge upon liquidation of deferred compensation assets partially offset by interest income. For fiscal 2008, we recorded a gain on the sale of our former Anaheim distribution center of approximately $9 million, offset by a non-cash impairment charge of $5 million associated with a reduction in the fair value of land available for sale less estimated selling costs and a charge of $2 million to reflect the decline in fair value associated with deferred compensation assets.
Income Taxes
We recognized an income tax benefit of $11 million for fiscal 2009 compared to $19 million for fiscal 2008. Our effective income tax rate was 13.6% for fiscal 2009 and 33.0% for fiscal 2008. The difference in the effective income tax rate is primarily attributable to the valuation allowance charges recorded in fiscal 2009. For fiscal 2010, we expect to continue to maintain a valuation allowance against deferred tax assets resulting in minimal income tax expense for the year. Information regarding the realizability of our deferred tax assets and our assessment of a need for a valuation allowance is contained in Note 10 to the consolidated financial statements included in this Annual Report on Form 10-K, which note is incorporated herein by this reference.
Net Loss and Net Loss per Share
Our net loss for fiscal 2009 was $70 million, or $(1.07) per share, versus a net loss from continuing operations of $39 million, or $(0.59) per share, for fiscal 2008. Amounts for fiscal 2009 include the impact of a $19 million tax valuation allowance as discussed above. On a non-GAAP basis, excluding the impact of this valuation allowance, our net loss for fiscal 2009 was $51 million, or $(0.78) per share.
About Non-GAAP Financial Measures
The preceding paragraph contains non-GAAP financial measures, including non-GAAP net loss and non-GAAP net loss per share for fiscal 2009. Non-GAAP financial measures should not be considered as a substitute for, or superior to, measures of financial performance prepared in accordance with GAAP. These non-GAAP financial measures do
Pacific Sunwear of California, Inc. Form 10-K 2009 23
not reflect a comprehensive system of accounting, differ from GAAP measures with the same names, and may differ from non-GAAP financial measures with the same or similar names that are used by other companies. The Company computes non-GAAP financial measures using a consistent methodology from quarter to quarter and year to year. The Company may consider whether other significant items that arise in the future should be excluded from the non-GAAP financial measures.
The Company excluded a deferred tax asset valuation allowance charge in presenting a non-GAAP net loss amount and per share amount above under the caption “Net Loss and Net Loss per Share”. The Company believes that these non-GAAP financial measures provide meaningful supplemental information regarding the Company’s operating results primarily because they exclude amounts that are not considered part of ongoing operating results when planning and forecasting and when assessing the performance of the organization, individual operating segments or its senior management. In addition, the Company believes that non-GAAP financial information is used by analysts and others in the investment community to analyze the Company’s historical results and to provide estimates of future performance versus the results and estimates of others. The Company believes that failure to report these non-GAAP measures excluding the impact of the valuation allowance could result in confusion among investors and analysts by creating a misplaced perception that the Company’s results have underperformed or exceeded expectations.
Fiscal 2008 Compared to Fiscal 2007
Net Sales
Net sales decreased to $1.25 billion in fiscal 2008 from $1.31 billion in fiscal 2007, a decrease of $51 million, or 3.9%. The components of this $51 million decrease in net sales were as follows:
Comparable store net sales of Juniors apparel increased 21% and Young Mens apparel was flat as we shifted the merchandise mix away from accessories and footwear and expanded Juniors apparel. Comparable store net sales of accessories decreased 27% and footwear decreased 76%. The decline in accessory comparable store net sales was primarily due to our decision to exit certain accessory categories during both fiscal 2008 and 2007 such as wallets, watches, belt buckles and home goods. The decline in the footwear business was primarily due to a significant decrease in comparable net store sales of sneakers as we largely exited the sneaker business in fiscal 2008. For fiscal 2008, footwear represented approximately 5% of total sales, a 59% decrease in sales penetration versus the prior year.
Gross Margin
Gross margin, after buying, distribution and occupancy costs, decreased to $320 million in fiscal 2008 from $414 million in fiscal 2007, a decrease of $94 million, or 22.7%. As a percentage of net sales, gross margin was
24 Pacific Sunwear of California, Inc. Form 10-K 2009
25.5% in fiscal 2008, a 6.2% decrease from 31.7% in fiscal 2007. The primary components of this 6.2% net decrease in gross margin as a percentage of net sales were as follows:
At the end of fiscal 2008, inventories per square foot were down 30% in dollars and 19% in total units versus the end of fiscal 2007. We ended fiscal 2008 with average weeks of supply in stores of approximately 17 weeks versus having ended fiscal 2007 with average weeks of supply in stores of approximately 22 weeks, a decline of just over 20%.
Selling, General and Administrative Expenses
Selling, general and administrative (SG&A”) expenses increased to $381 million in fiscal 2008 from $344 million in fiscal 2007, an increase of $37 million, or 10.8%. As a percentage of net sales, these expenses increased to 30.4% from 26.4%. The components of this 4.0% net increase in SG&A expenses as a percentage of net sales were as follows:
%
Attributable to
2.3
Increase in asset impairment charges, including a $15 million increase in store impairments, $8 million related to the materials handling equipment in the Company’s former Anaheim distribution center, and $6 million related to the impairment of goodwill.
0.7
Increase in payroll and payroll-related expenses ($2 million) due to deleveraging these expenses against the (5%) decline in same-store sales results. In dollars, store payroll expenses were down approximately $1 million.
0.5
Increase in depreciation expense ($4 million), primarily due to the impact of accelerated depreciation associated with store closures and relocations, and new depreciation on existing stores from our refresh program.
0.5
Increase in other SG&A expenses.
4.0
Total
Goodwill Impairment
During fiscal 2008, we determined that the goodwill created in connection with our 1986 four-store acquisition in California and our 1997 fifteen-store acquisition in Florida was fully impaired and we recorded a pre-tax, non-cash goodwill impairment charge of approximately $6 million during fiscal 2008.
Other (Expense)/Income, net
For fiscal 2008, we recorded a gain on the sale of our former Anaheim distribution center of approximately $9 million. The sale of the distribution center closed in November 2008. In the fourth quarter of fiscal 2008, we committed to a plan to sell a parcel of land that had been held for future development. In connection with the planned sale, we recorded a non-cash impairment charge of $5 million associated with a reduction in the fair value of this land less estimated selling costs. The sale of the land closed in February 2009 and we received approximately $4 million in net cash proceeds.
Pacific Sunwear of California, Inc. Form 10-K 2009 25
At January 31, 2009, we held deferred compensation assets associated with our executive deferred compensation plan that were required to be measured at fair value on a recurring basis. Fair value is determined by the most recent publicly quoted market price of the securities at the balance sheet date. For fiscal 2008, we recorded a charge of $2 million to reflect the decline in fair value associated with these assets.
Net interest income was $0.1 million for fiscal 2008 compared to approximately $3 million for fiscal 2007. Interest income was lower in fiscal 2008 due to the Company having increased direct borrowings under our credit facility and lower average cash balances compared to the prior year due to share repurchases, the payment of demo lease terminations and losses from continuing operations.
Income Taxes
Income tax benefit was $19 million in fiscal 2008 compared to income tax expense of $27 million in fiscal 2007. The effective income tax rate was 33.0% in fiscal 2008 and 36.9% in fiscal 2007, a decrease of 3.9%. The decrease in the effective income tax rate is primarily attributable to operating losses incurred in fiscal 2008 and to the establishment of a valuation allowance of $2.7 million against our state deferred tax assets related to Kansas state investment tax credits that may not be utilized before expiration. Our determination that we would not fully realize this deferred tax asset was based on the significant deterioration in the retail business climate resulting in revisions to our projected future taxable earnings in this jurisdiction. Our weighted average effective income tax rate will vary over time depending on a number of factors, such as differing average state income tax rates and changes in forecasted annual earnings.
Liquidity and Capital Resources
We have typically financed our operations primarily from internally generated cash flow, with occasional short-term and long-term borrowings. Our primary resource requirements have been for the financing of inventories and construction of newly opened, remodeled, expanded or relocated stores. We believe that our working capital, cash flows from operating activities, and credit facility availability will be sufficient to meet our operating and capital expenditure requirements for at least the next twelve months.
Operating Cash Flows
Net cash provided by operating activities for fiscal 2009 was $87 million. We generated $32 million of cash from operations (net of non-cash charges). In addition, we generated $49 million from changes in working capital items and $6 million due to changes in other assets and liabilities. These changes were primarily driven by collection of approximately $54 million of income tax receivables.
Net cash provided by operating activities for fiscal 2008 was $34 million. We generated $45 million of cash from operations (net of non-cash charges). In addition, we generated $22 million from changes in working capital items and used $33 million due to changes in other assets and liabilities. The change in working capital in fiscal 2008 was primarily driven by decreases in merchandise inventories and accounts receivable offset by decreases in accounts payable and accrued liabilities. The change in other assets and liabilities was primarily driven by a reduction in deferred lease incentives.
26 Pacific Sunwear of California, Inc. Form 10-K 2009
Net cash provided by operating activities for fiscal 2007 was $116 million. We generated $121 million of cash from operations (net of non-cash charges). In addition, we generated $28 million from changes in working capital items and used $33 million due to changes in other assets and liabilities. The change in working capital in fiscal 2007 was primarily driven by decreases in merchandise inventories. The change in other assets and liabilities was primarily driven by generation of deferred tax assets and a reduction in deferred lease incentives.
Working Capital
Working capital at the end of fiscal 2009 and 2008 was $117 million and $98 million, respectively. The $19 million increase in working capital was attributable to the following:
Investing Cash Flows
Net cash used in investing activities in each of fiscal 2009, 2008 and 2007 was $20 million, $56 million and $98 million, respectively. Investing cash flows for fiscal 2009 were comprised of capital expenditures of approximately $23 million offset by proceeds from the sale of land of approximately $4 million. Investing cash flows for fiscal 2008 were comprised of capital expenditures of $81 million offset by proceeds from the sale of the Anaheim distribution center of approximately $25 million. Investing cash flows for fiscal 2007 were comprised of capital expenditures of $106 million and purchase of a $23 million long-term investment associated with the Company’s Olathe, Kansas distribution center, partially offset by $31 million in net maturities of short-term marketable securities. Capital expenditures were predominantly for refreshing existing stores and the opening of new, relocated and expanded stores during fiscal 2009, 2008 and 2007. In fiscal 2010, we expect total capital expenditures to be approximately $20 million to $30 million.
Financing Cash Flows
Net cash provided by financing activities in fiscal 2009 was $1 million compared to cash used of $51 million in fiscal 2008 and cash provided of $28 million in fiscal 2007. The primary source of financing inflows in fiscal 2009 was proceeds from employee exercises of stock options. The primary source of financing outflows in fiscal 2008 was the repurchase and retirement of $53 million in common stock. The primary source of financing inflows in fiscal 2007 was a $23 million long-term lease obligation related to the Company’s Olathe, Kansas distribution facility. Proceeds from employee exercises of stock options accounted for the remaining source of financing cash inflows for both fiscal 2008 and 2007.
Credit Facility
Information regarding our credit facility is contained in Note 8 to the consolidated financial statements included in this Annual Report on Form 10-K, which note is incorporated herein by this reference.
Pacific Sunwear of California, Inc. Form 10-K 2009 27
Contractual Obligations
We have minimum annual rental commitments under existing store leases as well as a minor amount of capital leases for computer equipment. 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. At January 30, 2010, our future financial commitments under all existing contractual obligations were as follows:
Over the next three fiscal years through 2012, we will have approximately 45% of our store leases reach the end of their original lease term. These leases will either be renewed or extended, potentially at different rates, or allowed to expire. As a result, depending on market conditions, actual future rental commitments and the time frame of such commitments may differ significantly from those shown in the table above.
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 2009, 2008 and 2007 were $164 million, $165 million and $158 million, respectively. Total CAM expenses may continue to fluctuate significantly from year to year as long-term leases come up for renewal at current market rates in excess of original lease terms and as we continue to close stores.
Operating Leases - We lease our retail stores and certain equipment under operating lease agreements expiring at various dates through February 2021. Substantially all of our retail store leases require us to pay CAM charges, insurance, property taxes and percentage rent ranging from 2% to 20% when sales volumes exceed 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 to the consolidated financial statements included in this Annual Report on Form 10-K). 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 or mall occupancy targets 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 40 PacSun stores in fiscal 2009. We currently anticipate closing approximately 25 to 50 stores in fiscal 2010. See “Real Estate Strategy” within the “Stores” discussion in Part I, Item 1 captioned, “Business,” of this report.
The ASC 740 (FIN 48) obligations shown in the table above represent uncertain tax positions related to temporary differences. The years for which the temporary differences related to the uncertain tax positions will reverse have been estimated in scheduling the obligations within the table.
28 Pacific Sunwear of California, Inc. Form 10-K 2009
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.
Off-Balance Sheet Arrangements
The Company has not entered into any transactions with unconsolidated entities whereby the Company has financial guarantees, subordinated retained interests, derivative instruments, or other contingent arrangements that expose the Company to material continuing risks, contingent liabilities, or any other obligation under a variable interest in an unconsolidated entity that provides financing, liquidity, market risk, or credit risk support to the Company.
Recent Accounting Pronouncements
Information regarding new accounting pronouncements is contained in Note 1 to the consolidated financial statements included in this Annual Report on Form 10-K, which note is incorporated herein by reference.
Inflation
We do not believe that inflation or changing prices 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 or changing prices 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, approximately 45% of our net sales have occurred in the first half of the fiscal year and 55% have occurred in the second half, with the back-to-school and holiday selling periods accounting for approximately 30 to 35% of our annual net sales and a higher percentage of our operating results on a combined basis. Our quarterly results of operations may also fluctuate significantly as a result of a variety of factors, including changes in consumer buying patterns; the timing of store openings; the amount of revenue contributed by new stores; fashion trends; 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
The Company is exposed to interest rate risk from its Credit Facility (see Note 8 to the Company’s Consolidated Financial Statements included in this Annual Report on Form 10-K). Direct borrowings under the Credit Facility bear interest at the Administrative Agent’s alternate base rate (as defined, 1.5% at January 30, 2010) or at optional interest rates that are primarily dependent upon LIBOR or the Federal Funds Effective Rate for the time period chosen. At January 30, 2010, the Company had no direct borrowings outstanding under the Credit Facility.
A sensitivity analysis was performed to determine the impact of unfavorable changes in interest rates on the Company’s cash flows. The sensitivity analysis quantified that the estimated potential cash flow impact would be less than $10,000 in additional interest expense (for each $1 million borrowed) if interest rates were to increase by 10% over a year period. Actual interest charges incurred may differ from those estimated because of changes or differences
Pacific Sunwear of California, Inc. Form 10-K 2009 29
in market rates, differences in amounts borrowed, timing and other factors. The Company is 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 Consolidated Financial Statements,” which appears immediately following the “Signatures” section of this report and which section is incorporated herein by reference.
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 Exchange Act. These disclosure controls and procedures are designed to provide reasonable assurance that the information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act 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 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 January 30, 2010.
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 January 30, 2010.
Deloitte & Touche LLP, our independent registered public accounting firm that audited the financial statements included in this Annual Report on Form 10-K, has issued an attestation report on our internal control over financial reporting, 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 control over financial reporting 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.
Changes in Internal Control Over Financial Reporting
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.
30 Pacific Sunwear of California, Inc. Form 10-K 2009
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders of
Pacific Sunwear of California, Inc.
Anaheim, California
We have audited the internal control over financial reporting of Pacific Sunwear of California, Inc. and subsidiaries (the “Company”) as of January 30, 2010, 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, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on 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, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, 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 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, the Company maintained, in all material respects, effective internal control over financial reporting as of January 30, 2010, 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 January 30, 2010, of the Company, and our report dated March 31, 2010, expressed an unqualified opinion on those consolidated financial statements.
/s/ DELOITTE & TOUCHE LLP
Costa Mesa, California
March 31, 2010
Pacific Sunwear of California, Inc. Form 10-K 2009 31
ITEM 9B.
ITEM 9B. OTHER INFORMATION
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS, AND CORPORATE GOVERNANCE
Information with respect to this item is incorporated by reference from the sections captioned “Proposal 1 Election of Directors - Nominees and Continuing Directors,” “Executive Officers,” “Section 16(a) Beneficial Ownership Reporting Compliance,” “Corporate Governance,” and “Board of Directors and Committees of the Board - Committees of the Board of Directors” in our definitive Proxy Statement to be filed with the Commission not later than 120 days after the end of our fiscal year covered by this Annual Report on Form 10-K.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Information with respect to this item is incorporated by reference from the sections captioned “Board of Directors and Committees of the Board - Director Compensation” and “Executive Compensation and Related Matters” in our definitive Proxy Statement to be filed with the Commission not later than 120 days after the end of our fiscal year covered by this Annual Report on Form 10-K.
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 sections captioned “Equity Compensation Plan Information” and “Security Ownership of Principal Shareholders and Management” in our definitive Proxy Statement to be filed with the Commission not later than 120 days after the end of our fiscal year covered by this Annual Report on Form 10-K.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
Information with respect to this item is incorporated by reference from the sections captioned “Related Party Transactions Policy” and “Board of Directors and Committees of the Board - Committees of the Board of Directors” in our definitive Proxy Statement to be filed with the Commission not later than 120 days after the end of our fiscal year covered by this Annual Report on Form 10-K.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
Information with respect to this item is incorporated by reference from the section captioned “Fees Paid to Independent Registered Public Accounting Firm” in our definitive Proxy Statement to be filed with the Commission not later than 120 days after the end of our fiscal year covered by this Annual Report on Form 10-K.
PART IV
ITEM 15.
ITEM 15. EXHIBITS, 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.
32 Pacific Sunwear of California, Inc. Form 10-K 2009
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 its behalf by the undersigned, thereunto duly authorized.
PACIFIC SUNWEAR OF CALIFORNIA, INC.
By:
/s/ Gary H. Schoenfeld
Gary H. Schoenfeld
President, Chief Executive Officer and Director
Date: March 31, 2010
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.
Pacific Sunwear of California, Inc. Form 10-K 2009 33
PACIFIC SUNWEAR OF CALIFORNIA, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
CONSOLIDATED FINANCIAL STATEMENTS FOR THE FISCAL YEARS ENDED:
JANUARY 30, 2010 (“Fiscal 2009”)
JANUARY 31, 2009 (“Fiscal 2008”)
FEBRUARY 2, 2008 (“Fiscal 2007”)
Pacific Sunwear of California, Inc. Form 10-K 2009
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders 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 January 30, 2010 and January 31, 2009, and the related consolidated statements of operations and comprehensive operations, shareholders’ equity, and cash flows for each of the three years in the period ended January 30, 2010. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these 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 the Company as of January 30, 2010 and January 31, 2009, and the results of its operations and its cash flows for each of the three years in the period ended January 30, 2010, in conformity with accounting principles generally accepted in the United States of America.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of January 30, 2010, 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 31, 2010, expressed an unqualified opinion on the Company’s internal control over financial reporting.
/s/ DELOITTE & TOUCHE LLP
Costa Mesa, California
March 31, 2010
Pacific Sunwear of California, Inc. Form 10-K 2009
PACIFIC SUNWEAR OF CALIFORNIA, INC.
CONSOLIDATED BALANCE SHEETS
See notes to consolidated financial statements.
Pacific Sunwear of California, Inc. Form 10-K 2009
PACIFIC SUNWEAR OF CALIFORNIA, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE OPERATIONS
See notes to consolidated financial statements.
Pacific Sunwear of California, Inc. Form 10-K 2009
PACIFIC SUNWEAR OF CALIFORNIA, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
(1) Share repurchases in fiscal 2008 exceeded the value of additional paid-in capital. Accordingly, at the end of the fiscal year, negative additional paid-in capital was reclassified against retained earnings.
See notes to consolidated financial statements.
Pacific Sunwear of California, Inc. Form 10-K 2009
PACIFIC SUNWEAR OF CALIFORNIA, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
See notes to consolidated financial statements.
Pacific Sunwear of California, Inc. Form 10-K 2009
PACIFIC SUNWEAR OF CALIFORNIA, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(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 rooted in the action sports, fashion and music influences of the California lifestyle. The Company sells casual apparel with a targeted selection of accessories and footwear designed to meet the needs of teens and young adults. The Company operates a nationwide, primarily mall-based chain of retail stores, under the names “Pacific Sunwear” and “PacSun.” In addition, the Company operates an e-commerce website at www.pacsun.com which sells PacSun merchandise online, provides content and community for its target customers, and provides information about the Company. As of January 30, 2010, the Company leased and operated 894 stores among all 50 states and Puerto Rico, comprised of 3,457,171 square feet.
The results of operations for all periods presented in these consolidated financial statements excludes the financial impact of the Company’s former demo and One Thousand Steps concepts due to the designation of these operations as discontinued operations during the first quarter of fiscal 2008 and the fourth quarter of fiscal 2007, respectively (see Note 15). During fiscal 2007, the Company closed 74 demo stores, which specialized in fashion-focused streetwear apparel, as well as its nine-store One Thousand Steps footwear concept, which was originally launched in April 2006 and discontinued in January 2008. During fiscal 2008, the Company closed its remaining 153 demo stores.
The Company’s fiscal year is the 52- or 53-week period ending on the Saturday closest to January 31st. 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 - Management is required to disclose the estimated fair value of certain assets and liabilities as financial instruments. Financial instruments are generally defined 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. As of January 30, 2010, management believes that the carrying amounts of cash, receivables and payables approximate fair value because of the short maturity of these financial instruments.
Pacific Sunwear of California, Inc. Form 10-K 2009
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 commercial paper and money market funds.
Merchandise 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. These estimates are based on a combination of factors, including current selling prices, current and projected inventory levels, current and projected rates of sell-through, known markdown and/or promotional events expected to create a permanent decrease in inventory value, estimated inventory shrink and aging of specific items. Reserves of approximately $2 million have been accrued against existing inventory at January 30, 2010 in consideration of these factors. Actual results have historically been within the Company’s expectations and the reserves established for such items.
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:
Property Category
Depreciation Term
Buildings
39 years
Building improvements
Lesser of remaining estimated useful life of the building or estimated useful life of the improvement
Leasehold improvements
Lesser of remaining lease term (at inception, generally 10 years) or estimated useful life of the improvement
Furniture, fixtures and equipment
Generally 5 years (ranging from 3 to 15 years), depending on the nature of the asset
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. 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 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 4, “Impairment of Long-Lived Assets,” for a discussion of asset impairment charges recognized in fiscal 2009, 2008 and 2007.
Income Taxes - The Company accounts for income taxes under the asset and liability method, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements. Under this method, deferred tax assets and liabilities are determined based on the temporary differences between the financial statements and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in income in the period that includes the enactment date.
Deferred income tax assets are reduced by a valuation allowance if, in the judgment of the Company’s management, it is more likely than not that all or a portion of a deferred tax asset will not be realized. In making such determination, the Company considers all available positive and negative evidence, including recent financial operations, projected future taxable income, scheduled reversals of deferred tax liabilities, tax planning strategies, and the length of tax asset carryforward periods. The realization of deferred tax assets is primarily dependent upon our ability to generate sufficient future taxable earnings in certain jurisdictions. If the Company subsequently determines that the carrying
Pacific Sunwear of California, Inc. Form 10-K 2009
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. See Note 10, “Income Taxes,” for further discussion regarding the realizability of our deferred tax assets and our assessment of a need for a valuation allowance.
The Company accounts for uncertain tax positions in accordance with authoritative guidance for Income Taxes. This guidance 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. The literature also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods and disclosure requirements for uncertain tax positions.
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.
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 1.0% 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 January 30, 2010 is as follows:
E-commerce Shipping and Handling Revenues and Expenses - 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 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 - 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.
Pacific Sunwear of California, Inc. Form 10-K 2009
Vendor Allowances - Cash consideration received from vendors primarily includes discounts, vendor allowances and rebates. 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 - 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. Accordingly, the Company expenses pre-opening rent.
Deferred Lease Incentives - Amounts received from landlords to fund tenant improvements are recorded as a deferred lease incentive liability and then amortized as a credit to rent expense over the related store’s lease term.
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 $14 million, $16 million, and $17 million in fiscal 2009, 2008, and 2007, respectively.
Stock-Based Compensation - The Company accounts for stock-based compensation expense under the fair value method. The Company recorded non-cash, stock-based compensation in the consolidated statement of operations for each of fiscal 2009, 2008 and 2007 as follows (in thousands):
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 2009, 2008 and 2007 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.
Vendor and Merchandise Concentrations - In fiscal 2009, no vendor accounted for more than 10% of net sales. During each of fiscal 2008 and 2007, Billabong (which incorporates both Billabong and Element brands) accounted for 11% and 10% of total net sales, respectively, and Quiksilver (which incorporates the DC Shoes, Roxy, and Quiksilver brands) accounted for 10% and 12% of total net sales, respectively. No other individual branded vendor accounted for more than 10% of total net sales for any period presented.
Pacific Sunwear of California, Inc. Form 10-K 2009
The merchandise assortment for the Company as a percentage of net sales for each of fiscal 2009, 2008 and 2007 was as follows:
Recent Accounting Pronouncements - The Company adopted the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC” or “Codification”) Topic 105, “Generally Accepted Accounting Principles,” formerly FASB Statement 168, “The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles.” ASC 105 establishes the FASB Codification as the single source of authoritative GAAP recognized by the FASB to be applied by nongovernmental entities. Rules and interpretive releases of the SEC under authority of the federal securities laws are also sources of authoritative GAAP for SEC registrants. ASC 105 and the Codification are effective for financial statements issued for interim and annual periods ending after September 15, 2009. The Codification supersedes all existing non-SEC accounting and reporting standards. All other non-grandfathered, non-SEC accounting literature not included in the Codification will become non-authoritative. The FASB will not issue new standards in the form of Statements, FASB Staff Positions, or Emerging Issues Task Force Abstracts. Instead, the FASB will issue Accounting Standards Updates (ASUs), which will serve only to: (a) update the Codification; (b) provide background information about the guidance; and (c) provide the basis for conclusions on the change(s) in the Codification. As the Codification does not change GAAP, it does not have a material impact on the Company’s consolidated financial statements. Previous references made to GAAP literature in the notes to the Company’s consolidated financial statements have been updated with references to the new Codification.
In January 2010, the FASB issued ASU 2010-06, new guidance and clarifications for improving disclosures about fair value measurements. This guidance requires enhanced disclosures regarding transfers in and out of the levels within the fair value hierarchy. Separate disclosures are required for transfers in and out of Level 1 and 2 fair value measurements, and the reasons for the transfers must be disclosed. In the reconciliation for Level 3 fair value measurements, separate disclosures are required for purchases, sales, issuances, and settlements on a gross basis. The Company does not anticipate the adoption of this guidance to materially impact the Company. The new disclosures and clarifications of existing disclosures are effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements, which are effective for interim and annual reporting periods beginning after December 15, 2010.
In February 2010, the FASB issued ASU 2010-09, which amends ASC 855 to address certain implementation issues related to an entity’s requirement to perform and disclose subsequent-events procedures. In particular the amendment (i) adds a definition of the term “SEC filer” to the ASC Master Glossary, (ii) exempts SEC filers from disclosing the date through which subsequent events have been evaluated, (iii) removes the definition of a “public entity” from the ASC Glossary and (iv) adds a definition of the term “revised financial statements” to the ASC Master Glossary. The amendment is effective immediately for financial statements for all entities.
Pacific Sunwear of California, Inc. Form 10-K 2009
2.
OTHER CURRENT ASSETS
As of the dates presented, other current assets consisted of the following:
3.
PROPERTY AND EQUIPMENT, NET
As of the dates presented, property and equipment consisted of the following categories:
4.
IMPAIRMENT OF LONG-LIVED ASSETS
Store Assets - 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. As a result of these evaluations during fiscal 2009, 2008 and 2007, the Company recorded non-cash impairment charges of approximately $27 million, $29 million and $1 million in each year, respectively, within selling, general and administrative expenses in the consolidated statements of operations to write-down the carrying value of long-lived store assets to their estimated fair values.
Goodwill - During fiscal 2008, the Company determined that the goodwill created in connection with its 1986 four-store acquisition in California and its 1997 fifteen-store acquisition in Florida was fully impaired and recorded a pre-tax, non-cash goodwill impairment charge of approximately $6 million during the third quarter of fiscal 2008.
5.
ASSETS HELD FOR SALE
During fiscal 2008, the Company’s management committed to a plan to sell a parcel of land that had been held for future development. In connection with the planned sale, the Company recorded a pre-tax, non-cash impairment charge of approximately $5 million associated with a reduction in the fair value of this land less estimated selling costs. The impairment charge is included in other income and expenses in the consolidated statement of operations. The Company had classified the remaining carrying value of this land of approximately $4 million as held for sale on the consolidated balance sheet as of January 31, 2009. The sale of the land closed in February 2009 and the Company received approximately $4 million in net cash proceeds.
6.
FAIR VALUE MEASUREMENTS
The Company’s assets and liabilities are measured and reported on a fair value basis in accordance with ASC 820, “Fair Value Measurements and Disclosures.” ASC 820 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles, and expands disclosure about fair value measurements. ASC 820 enables the reader of the financial statements to assess the inputs used to develop those
Pacific Sunwear of California, Inc. Form 10-K 2009
measurements by establishing a hierarchy for ranking the quality and reliability of the information used to determine fair values. ASC 820 requires that assets and liabilities carried at fair value be classified and disclosed in one of the following three categories:
•
Level 1: Quoted market prices in active markets for identical assets or liabilities
•
Level 2: Observable market based inputs that are corroborated by market data
•
Level 3: Unobservable inputs that are not corroborated by market data
The following table represents our fair value hierarchy for financial assets measured at fair value on a recurring basis as of January 30, 2010 (amounts in millions):
Long-lived store assets (primarily property and equipment) with a carrying amount of $276 million were written down to their fair value of $249 million, resulting in a non-cash impairment charge of $27 million, which was included in the operating results for fiscal 2009. In fiscal 2008, the Company recorded a non-cash impairment charge of $29 million to write down the carrying value of long-lived store assets. Fair value is determined using a discounted cash flow model. The estimation of future cash flows from operating activities requires significant estimates of factors that include future sales and gross margin performance. If the Company’s sales or gross margin performance or other estimated operating results are not achieved at or above the forecasted level, the carrying value of certain store assets may prove unrecoverable and the Company may incur additional impairment charges in the future.
7.
INDUSTRIAL REVENUE BOND TRANSACTION - OLATHE, KANSAS
On July 17, 2007, Pacific Sunwear Stores Corp., a wholly-owned subsidiary of the Company, completed an industrial revenue bond financing transaction with the city of Olathe, Kansas (the “City”) that will provide property tax savings for 10 years on the Company’s new distribution center located in the City. In the transaction, the City purchased the land and building from the Company through the issuance to the Company of approximately $23 million in industrial revenue bonds due January 1, 2018 (“Bonds”) and contemporaneously leased the land and building to the Company for an identical term. The Company can call the Bonds at any time it chooses, but would lose its property tax benefit in the event this transaction was to be cancelled. In the Company’s consolidated balance sheet, the land and building remain a component of property and equipment, the investment in the Bonds is included in other assets, and the related long-term lease is included in other long-term liabilities.
The Company, as holder of the Bonds, is due interest at 7% per annum with interest payable semi-annually in arrears on January 1 and July 1. This interest income is directly offset by the interest-only lease payments on the distribution center, which are due at the same time and in the same amount as the interest income. Both the Bonds and the corresponding lease have 10-year terms. If, at any time, the Company chooses to call the Bonds, the proceeds from the Bonds would be required to immediately terminate the lease. The Company’s intention is to maintain the property tax benefit related to the Olathe facility. Accordingly, both the Bonds and the lease are classified as long-term due to the Company’s intent to hold the Bonds until maturity and the structure of the lease, which includes a balloon principal payment and bargain purchase requirement at the end of the lease term.
8.
CREDIT FACILITY
The Company has an asset-backed credit agreement with a syndicate of lenders (the “Credit Facility”) which expires April 29, 2013 and provides for a secured revolving line of credit of up to $150 million, which can be increased to up to $225 million subject to lender approval. Extensions of credit under the Credit Facility are limited to a borrowing base
Pacific Sunwear of California, Inc. Form 10-K 2009
consisting of specified percentages of eligible categories of assets, primarily cash and inventory (generally, 75% of inventories). The Credit Facility is available for direct borrowing and, subject to borrowing base availability ($103 million at January 30, 2010), up to $75 million is available for the issuance of letters of credit and up to $15 million is available for swing-line loans. The Credit Facility is secured by cash, cash equivalents, deposit accounts, securities accounts, credit card receivables and inventory. Direct borrowings under the Credit Facility bear interest at the Administrative Agent’s alternate base rate (as defined, 1.5% at January 30, 2010) or at optional interest rates that are primarily dependent upon LIBOR or the Federal Funds Effective Rate for the time period chosen. The Company currently believes that the availability under the Credit Facility, working capital and cash flows from operating activities will be sufficient to meet its operating and capital expenditure needs for at least the next twelve months. At January 30, 2010, the Company had no direct borrowings and $9 million in letters of credit outstanding under the Credit Facility. The remaining availability at January 30, 2010 was $94 million.
The Company is not subject to any financial covenant restrictions under the Credit Facility unless, at any point in time, total remaining borrowing availability under the facility falls below $15 million or 10% of the aggregate lender commitments in the event the facility is increased beyond $150 million. The Company is permitted to incur additional indebtedness outside the Credit Facility up to a maximum principal amount at any time outstanding of $150 million. Any such indebtedness may not be secured by any of the collateral designated under the Credit Facility or any other assets of the Company, except that up to $40 million of such indebtedness may be secured by liens on real property and related fixtures. Additionally, the Credit Facility prohibits the payment of dividends and contains specific limits on certain kinds of indebtedness, as defined in the facility agreement.
9.
OTHER CURRENT LIABILITIES
As of the dates presented, other current liabilities consisted of the following:
10.
INCOME TAXES
The components of income tax (benefit)/expense from continuing operations for the fiscal periods presented were as follows:
Pacific Sunwear of California, Inc. Form 10-K 2009
Included in fiscal 2009, 2008 and 2007 current income taxes were tax benefits of approximately $0.4 million, $0.5 million and $0.8 million, respectively, relating to uncertain tax positions.
A reconciliation of income tax (benefit)/expense from continuing operations to the amount of income tax (benefit)/expense that would result from applying the federal statutory rate to income from continuing operations before income taxes for the fiscal periods presented was as follows:
The major components of the Company’s overall net deferred tax asset of approximately $4 million and $21 million at January 30, 2010 and January 31, 2009, respectively, were as follows:
As previously disclosed in the Company’s Annual Report on Form 10-K for fiscal 2008, the Company established a $3 million valuation allowance against deferred tax assets related to Kansas state investment tax credits that more likely than not would not be utilized before expiration. As outlined in the Company’s two most recent Form 10-Q filings with the Securities and Exchange Commission (SEC), dated December 7, 2009 and September 2, 2009, the Company indicated that it might be required to take a charge to record additional valuation allowance related to its deferred tax assets given recent fluctuations in business trends. For the year ended January 30, 2010, in accordance with ASC 740, “Income Taxes,” and as a result of continued pre-tax operating losses, the Company re-evaluated the realizability of all its gross federal and state deferred tax assets. ASC 740 requires that deferred tax assets be reduced by a valuation allowance if it is more likely than not that some or all of the deferred tax assets will not be realized. In
Pacific Sunwear of California, Inc. Form 10-K 2009
assessing the potential need for a valuation allowance, ASC 740 requires an evaluation of both positive and negative evidence. An enterprise must use judgment in considering the relative impact of available evidence. In making such judgment, the weight given to the potential effect of positive and negative evidence should be commensurate with the extent to which it can be objectively verified. The Company’s assessment considered all available positive and negative evidence. Negative evidence included the fact that the Company was in a cumulative three-year pre-tax loss position as of the end of fiscal 2009 and will likely have near term operating losses. Positive evidence included the Company’s strong earnings history prior to fiscal 2008 and various cost cutting efforts that have been implemented to improve future profitability. The Company concluded that based on a weighting of objectively verifiable positive and negative evidence available as of January 30, 2010, a full valuation allowance of $13 million against the Company’s federal deferred tax assets and an $11 million valuation allowance against certain state deferred tax assets was required. Remaining state deferred tax assets of $4 million were not reserved as the Company concluded it is more likely than not these deferred tax assets will be utilized before expiration. In addition, the Company has discontinued recognizing federal and certain state income tax benefits until it is determined that it is more likely than not that the Company will generate sufficient taxable income to realize the deferred income tax assets. As of the year ended January 30, 2010, federal and state valuation allowances against deferred tax assets were $13 million and $14 million, respectively.
As of January 30, 2010, the Company had tax effected federal net operating losses (“NOLs”) of approximately $15 million available to offset future federal taxable income. In addition, as of January 30, 2010 the Company had tax effected state NOLs of approximately $12 million available to offset future state income taxable income. Federal and state NOLs will expire at various times and in varying amounts in our fiscal tax years 2012 through 2029. The Company also had federal and Kansas credit carryforwards of approximately $0.2 million and $4 million, respectively. The Company’s federal and Kansas carryforwards will begin to expire in 2028 and 2017, respectively.
As of both January 30, 2010 and January 31, 2009, unrecognized income tax benefits accounted for under ASC 740 (FIN 48) totaled approximately $1 million. Of those amounts, approximately $0.5 million and $0.8 million, respectively, represent unrecognized tax benefits that would, if recognized, favorably affect the Company’s effective income tax rate in any future periods. The Company does not anticipate that total unrecognized tax benefits will change significantly in the next twelve months.
The following is a tabular reconciliation of the total amounts of unrecognized tax benefits (including interest) at January 30, 2010, January 31, 2009 and February 2, 2008:
Estimated interest and penalties related to the underpayment of income taxes are included in income tax expense and totaled less than $0.1 million for fiscal 2009. Accrued interest and penalties were approximately $0.2 million at each of January 30, 2010 and January 31, 2009.
The Company files income tax returns in the U.S. federal jurisdiction and multiple other state and local jurisdictions. The Company is no longer subject to U.S. federal examinations for years prior to 2006 and, with few exceptions, is no longer subject to state and local examinations for years before 2005. Our income tax returns for the 2007 and 2008 tax
Pacific Sunwear of California, Inc. Form 10-K 2009
years are currently under examination by the Internal Revenue Service. We do not expect that the results of the examination will have a material effect on our financial condition or results of operations.
11.
STOCK COMPENSATION
The Company accounts for stock-based compensation expense according to the fair value method. The Company uses the Black-Scholes option-pricing model to estimate the grant date fair value of its recognized stock-based compensation expense. 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 primarily from historical data on employee exercises adjusted for expected changes to option terms, if any. 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. 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 2009, 2008 and 2007, the fair value of the Company’s stock-based compensation activity was determined using the following weighted-average assumptions:
Stock Options - There were no options exercised in fiscal 2009. The total intrinsic value of options exercised during fiscal 2008 and 2007 were $0.4 million and $2 million, respectively.
At January 30, 2010, outstanding incentive and nonqualified options had exercise prices ranging from $1.20 to $28.90 per share, with an average exercise price of $9.54 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 January 30, 2010, incentive and nonqualified options to purchase 3,783,728 shares were outstanding and 4,192,469 shares were available for future grant under the Company’s stock compensation plans. During fiscal 2009, 2008 and 2007, the Company recognized tax benefits of $2 million, $2 million and $0.3 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
Pacific Sunwear of California, Inc. Form 10-K 2009
dates. A summary of stock option (incentive and nonqualified) activity under the Company’s 2005 Performance Incentive Plan for fiscal 2009 is presented below:
The weighted-average grant-date fair value per share of options granted during each of fiscal 2009, 2008 and 2007 was $1.70, $4.28 and $6.68, respectively. Additional information regarding options outstanding as of January 30, 2010 is as follows:
Non-vested Shares - A summary of the status of the Company’s non-vested shares as of January 30, 2010, 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.
Pacific Sunwear of California, Inc. Form 10-K 2009
Non-vested Share Units - A summary of non-vested share units activity under the Company’s 2005 Performance Incentive Plan for fiscal 2009 is presented below:
At January 30, 2010, the Company had approximately $6 million of compensation cost related to non-vested stock option, non-vested share awards and non-vested share units not yet recognized. This compensation expense is expected to be recognized over a weighted-average period of approximately 3.0 years.
Employee Stock Purchase Plan (“ESPP”) - The Company maintains an 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, excluding executives, who have three months of service with the Company. The ESPP is intended to constitute an “employee stock purchase plan” within the meaning of Section 423 of the Internal Revenue Code of 1986, as amended. The Company recognized $0.3 million, $0.1 million and $0.2 million in compensation expense related to the ESPP for each of fiscal 2009, 2008 and 2007, respectively. In fiscal 2009, 2008 and 2007, 378,378, 218,851 and 65,825 shares were issued at an average price of $1.92, $2.97 and $14.69, respectively, under the ESPP.
12.
COMMITMENTS AND CONTINGENCIES
Operating Leases - The Company leases its retail stores and certain equipment under operating lease agreements expiring at various dates through February 2021. 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 2% to 20% when sales volumes exceed certain minimum sales levels. The initial terms of such leases are typically ten years, and many of such leases 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 or mall occupancy targets are not achieved by a specified date. None of the Company’s retail store leases contain purchase options.
Pacific Sunwear of California, Inc. Form 10-K 2009
As of January 30, 2010, minimum future rental commitments under non-cancelable operating leases were as follows (in thousands):
The 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. For fiscal 2009, 2008, and 2007, store rental expenses, including CAM, for our stores were $164 million, $165 million, and $158 million, respectively, of which $4 million, $4 million and $5 million, respectively, was paid as percentage rent based on sales volume. The Company expects total CAM expenses to continue to increase from year to year or as long-term leases come up for renewal at current market rates in excess of original lease terms.
Litigation - The Company is involved from time to time in litigation incidental to its business. The Company believes that the outcome of current litigation will not likely have a material adverse effect on its results of operations or financial condition and, from time to time, the Company 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 its operating results.
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.
Letters of Credit - The Company has issued guarantees in the form of commercial letters of credit, of which there were approximately $9 million outstanding at January 30, 2010, as security for merchandise shipments from overseas. All in-transit merchandise covered by letters of credit is accrued for in accounts payable.
13.
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. Vested participant balances are included in other long-term liabilities and were approximately $2 million and $4 million as of January 30, 2010 and January 31, 2009, respectively. The Company made no contributions to the Executive Plan during fiscal 2009, and $0.1 million in each of fiscal 2008 and 2007.
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. The 401(k) Plan is funded by participant
Pacific Sunwear of California, Inc. Form 10-K 2009
contributions and Company matching contributions. The Company made contributions to the 401(k) Plan, net of forfeitures, of approximately $1 million for fiscal 2009 and $1.5 million for each of fiscal 2008 and 2007.
14.
SEGMENT REPORTING
The Company operates exclusively in the retail apparel industry in which the Company distributes, designs and produces clothing and related products catering to teens and young adults through its primarily mall-based PacSun retail stores. The Company has identified three operating segments: PacSun stores, PacSun Outlet stores and pacsun.com. The three operating segments have been aggregated into one reportable segment based on the similar nature of products sold, production, merchandising and distribution processes involved, target customers, and economic characteristics among the three operating segments.
15.
DISCONTINUED OPERATIONS
Financial results of the Company’s former demo and One Thousand Steps concepts are reported as “loss from discontinued operations (net of tax effects)” in the consolidated statements of operations and comprehensive operations due to the designation of these operations as discontinued operations during the first quarter of fiscal 2008 and the fourth quarter of fiscal 2007, respectively. During fiscal 2007, the Company closed 74 demo stores which specialized in fashion-focused streetwear apparel as well as its nine-store One Thousand Steps (“OTS”) footwear concept, which was originally launched in April 2006 and discontinued in January 2008. Subsequently in the first quarter of fiscal 2008, the Company closed its remaining 153 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 and OTS stores and after having exhausted other strategic alternatives.
Total actual cash payments made during fiscal 2008 associated with the discontinuation of demo were approximately $58 million. A tabular reconciliation of the charges incurred, payments made, and reconciling adjustments made during fiscal 2008 to account for the discontinuation of demo is set forth below in millions:
(1) In January 2008, the Company announced its intent to discontinue the demo business. Amounts accrued at February 2, 2008 represent charges incurred during the fourth quarter of fiscal 2007 for stores already closed and severance charges communicated to employees prior to the end of fiscal 2007.
(2) Adjustments to the demo liquidation liabilities were based on settlement amounts that differed from the original estimate as a result of good faith negotiations with individual landlords and actual performance of the liquidation process.
No further cash payments related to the discontinuation of demo are expected. All charges incurred in the discontinuation of demo are included in the financial results of the discontinued operations disclosed above within this note.
The operating results of the discontinued operations are summarized as follows:
Pacific Sunwear of California, Inc. Form 10-K 2009
16.
QUARTERLY FINANCIAL DATA (UNAUDITED)
The table below presents summarized quarterly financial results on a continuing operations basis for each of fiscal 2009 and 2008. The Company designated its former “demo” store concept as a discontinued operation during the first quarter of fiscal 2008 ended May 3, 2008 (see Note 15). Accordingly, the information presented below excludes the operating impact of demo for all periods. All amounts in the table below are expressed in thousands of dollars, except for share and per share amounts:
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. Form 10-K 2009
INDEX TO EXHIBITS
* Management contract or compensatory plan or arrangement
+ Filed herewith