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Pacific Sunwear of California, Inc. (NASDAQ:PSUN)

F3Q09 Earnings Call

November 16, 2009 4:30 pm ET

Executives

Gar Jackson – Vice President of Investor Relations

Gary H. Schoenfeld – Chief Executive Officer

Michael L. Henry – Chief Financial Officer

Analysts

Jeffrey Klinefelter - Piper Jaffray & Co.

Adrienne Tennant - Friedman, Billings, Ramsey

Christine Chen - Needham and Company

Paul Lejuez - Credit Suisse First Boston

Janet Kloppenburg - JJK Research

Jeffrey Van Sinderen - B. Riley & Co.

Liz Dunn - Thomas Weisel Partners

Mitch Kummetz - Robert W. Baird

Stacy Peck - SP Research

Connie Wong - Wedbush Morgan Securities

Liz Pierce - Roth Capital

Elizabeth Montgomery - Longbow

Dorothy Lakner - Caris & Company

Roxanne Meyer - UBS

Operator

Good afternoon. My name is Maggie and I will be your conference operator today. At this time I would like to welcome everyone to the Pacific Sunwear of California third quarter 2009 earnings conference call. (Operator Instructions) Thank you. Mr. Gar Jackson, you may begin your conference.

Gar Jackson

Thank you. Good afternoon and welcome to the Pacific Sunwear of California conference call announcing the company’s fiscal third quarter financial results. This is Gar Jackson, Vice President of Investor Relations. This call is being recorded and the playback will be available starting today approximately two hours after the call through midnight on November 23, 2009. It can be accessed at 800-642-1687 or 706-645-9291, pass code 38667329. The call will also be archived on the PacSun website at www.pacsun.com through midnight on March 11, 2010.

Your speakers today are Gary Schoenfeld, Chief Executive Officer and Mike Henry, Chief Financial Officer. Today’s call will be limited to one hour and questions will be limited to one per participant.

Before I turn the call over to Gary, I’d like to note that statements and discussions during today’s call will contain forward-looking information including forecasts of future financial performance and statements about our future prospects and proposed developments or business strategies. Actual results could differ materially from those projected or reflected in our forward-looking statements and reported results should not be considered an indication of future performance. The potential risks and uncertainties that could cause the company’s business and financial results to differ materially from those in the forward-looking statements are included in the company’s Form 10-K for the fiscal year ended January 30, 2009, and in subsequent filings with the SEC, as well as in the earnings press release included as an exhibit to the Form 8-K that we furnished to the SEC today. These documents can also be found in the Investor Relations section on our corporate website at pacsun.com.

All information discussed on the call is as of today, November 16, 2009. Pacific Sunwear does not intend and undertakes no duty to update this information to reflect future events or circumstances.

This call, the webcast and its replay are the property of Pacific Sunwear. It is not for rebroadcast or use by any other party without the prior written consent of Pacific Sunwear.

With that said, I will now turn the call over to Gary.

Gary H. Schoenfeld

Thank you. Good afternoon, everybody and thank you for joining us. It’s been a little over four months since I took over as CEO and as a turnaround situation I knew there would be a number of issues we would need to tackle simultaneously and would like to give you an update as to how we are proceeding against our key strategic initiatives and then I will speak briefly about current business trends, after which Mike will give more detail on our Q3 results and Q4 outlook.

We are attacking our business with four essential priorities. First is people and culture -- the question was asked of me on my first call in August, was I going to make any changes to the leadership team. For obvious reasons, that was not something I could speak to publicly at that time, yet affecting a transformation in leadership, accountability, teamwork, and an absolute commitment to wow our customers every day are among my highest priorities.

In terms of leadership, we have five key positions that we are looking to fill with great talent and experience -- a GMM to drive our juniors business, a head of stores to lead our team of 11,000 store managers and brand reps who touch our customers every day, a Chief Marketing Officer that can help reconnect our customers with PacSun and our brands, an SVP of Operations and a Vice President of Merchandise Planning and Allocation.

I am quite excited about the caliber of candidates that share our vision for reestablishing PacSun as the leader in the teen market and look forward to hopefully announcing some key additions to our team as we go into the early part of next year. And yet at the same time, I can assure you we are not waiting to fill these key positions in order to affect change.

From a teamwork perspective, our team broadly defined has to include all functions here at headquarters, our field team across all 50 states, our more than 200 associates in our distribution center in Kansas, as well as each of the key brands that we work with and all of our key suppliers in Asia and other parts of the world. Each person and each function has to recognize its inter-dependencies and we have huge potential if we can truly collaborate, which I am quite confident this team is embracing.

Second is product -- historically Pac’s strength -- PacSun's strengths have been pretty narrowly in tees, fleece, swim, and footwear and to a certain degree PacSun has always had a denim business. I think it’s fair to say that fashion has only more recently become a focal point and with somewhat mixed results so far but certainly something that we feel like we can be a major player in as we go forward.

With respect to t-shirts, it’s simply a category that we have to lead and I know that we can. As it relates to footwear, I spoke last time on the importance of branded footwear and I am pleased to say we will be rolling out to 300 stores by Spring for young men’s and 200 stores for juniors.

Fleece is a category that has fallen off over the last two years, both in part due to fashion trends as well as much more competitive pricing, yet we still see certain brands even at higher price points performing but this is a category that has been challenging and we certainly have to broaden our business to outerwear and other layering pieces to reflect the move beyond the historical fleece business.

Our swim business had a tough year in both juniors and young men’s but this also is a category that PacSun can and must again lead. As we look ahead to the spring, I am quite excited about the technical story that we will be telling in board shorts that I think will be impactful in terms of the overall presence in the stores, as well as an opportunity to have higher price points and equally important is that it is planned with the proper seasonal rollout to become meaningful in different parts of the country as the customer really gets ready for spring and summer.

In juniors, I think we have taken some steps to address the shift to lower price points, acknowledging that retailers like Target have become a leader amongst girls in this category and we are actively having conversations with our key heritage brands to recognize that there probably are some changes that need to further be made for all of us to regain this critical segment.

As we talked about denim, there’s no question that this is a critical category for PacSun on a year-around basis and we have to get to the point where our customers learn to truly love our assortment of Bull Head branded denim and become a true destination for them knowing that they can find the latest trends in denim. I tell you, over the last two years PacSun has certainly had some big wins, being out in front certainly on skinny denim and this time last year delivering some exciting color into juniors denim but at the same time as we look out at 2009, we have been behind on two key trends in both destructed and boyfriend, and we are seeing some softness as a result of frankly being behind those critical trends in juniors denim.

But overall, we’d say that with the brands that we work with, the strength of the Bull Head denim, and not just our heritage brands but brands like Levi’s as well, I very much believe that we can make denim a growth category again for PacSun in 2010.

Beyond these specifics by category, when we step back, we need to get back to PacSun's old ways of testing product and moving faster on winters. Additionally, I feel we need to narrow some of our assortments and do a better job of bringing newness to a market where wear now has clearly become the mantra for teen shoppers.

I was in Hong Kong for two days last week and had meetings with each of our most important suppliers, all of which are committed to supporting our needs to be even more on trend and react quicker in what continues to be a very price competitive market.

A third key area for us is customer connection, both through in-store experience and marketing. In the current environment, it is more important than ever that our store associates are able to communicate effectively about the brands and fashion that we carry and able to clearly articulate the latest promotions to customers looking for value. We believe that through improved education and training, and frankly more selective hiring and promotion, our store teams will become much more effective engaging with customers and the critical role that they play in driving sales.

I also spoke on our last call about the opportunity to partner much more closely with our key heritage brands in terms of product, marketing, customer connection, and in-store experience and I am delighted with the progress we are making with most all of our key brands as we plan ahead for 2010.

The strength of these brands that we feature has to be a key point of different at PacSun. You are seeing in our stores the beginning of branded assortment presentations and will continue to see our marketing efforts evolve this next year as we leverage upon our brands’ unique personalities.

A fourth key area for then for us ties directly to margins and profitability, which we know we have to turn from where the trends have been. I believe we can have a very successful profit model with our unique combination of higher margin proprietary brands combined with the much stronger presence of branded apparel, footwear, and accessories. One of our biggest internal initiatives that we have launched over the last 60 days is to move towards a much more thoughtful localized store assortment and allocation process in order to make this happen.

We simply cannot be successful without a much deeper understanding of our different customers and how their style and brand preferences vary across 900 stores in 50 states. Simply put, we are missing sales, hurting our margins, and damaging the customer experience by having had too much of a one-size-fits-all approach to merchandising. This will absolutely be a key initiative for us to implement in 2010 and with more details to follow on our next call, we will include the migration away from value stores as a distinct store grouping within PacSun.

Turning to current business trends, through the first 11 weeks of Q3, we were performing at the higher end of our internal expectations and poised for what we thought would be a significant improvement in fourth quarter. I know we are not alone yet for reasons that still aren’t easily explained, we have seen a dramatic fall-off over the past four weeks that has left us little choice but to lower our internal expectations for holiday. We’ve tested some different pricing strategies for denim, which are encouraging. We are modifying product and promotion strategies, given what we see in the marketplace, and our field team is committed to maximizing each opportunity with every customer. We are also chasing a few items in juniors fashion that we have missed but at this point, our overarching commitment is to sell through our seasonal goods and avoid any substantial carryovers of inventory into spring. Thus while we still expect to improve our bottom line compared to Q4 last year, retail and team spending on apparel continues to be far from recovered and seems likely to result in what would still be a pretty challenging period for our business.

So as I turn the call over to Mike, I will sum up by saying, as I did the first day I walked in, our mission is for PacSun to once again become a teen’s favorite place to shop. With our unique combination of brands coupled with the scale and capabilities to design and source great proprietary product, we can have the unique and compelling proposition for our targeted 16 to 19 year old customer. A turnaround of this magnitude is never easy and we still have a lot of work to do but with a commitment to both teamwork and individual excellence and a culture grounded in trust and [knowing and loving] our customers, we remain focused on our ability to reclaim PacSun's rightful position at the top of teen retailers across the country.

Mike.

Michael L. Henry

Thanks, Gary. Good afternoon, everyone. I will now cover highlights of our third quarter performance and then discuss our fourth quarter guidance. Total sales for the third quarter were $268 million this year versus $324 million last year. Same-store sales declined 18% for the quarter, primarily due to a decrease in total transactions. We ended the quarter with 904 stores versus 940 stores a year ago. Gross margin was $73 million, or 27.4% of sales this year versus $93 million or 28.7% of sales last year.

Merchandise margins improved 170 basis points. Distribution costs declined by $2 million and 20 basis points due to improved operating efficiencies in our [Alathea] distribution center.

Buying costs decreased by $400,000 but deleveraged 20 basis points on lower sales.

Occupancy costs declined $100,000 but deleveraged 300 basis points on lower sales.

SG&A expenses declined to $89 million, or 33.3% of sales this year from $95 million, or 29.5% of sales last year. The $6 million improvement in SG&A expenses was primarily due to store payroll savings. Non-cash store asset impairment charges were $9 million this year versus $10 million last year. Our income tax rate for the quarter was 31.6%. Net loss for the quarter was $10.9 million, or $0.17 per share, versus a loss of $3.5 million or $0.05 per share last year.

On the balance sheet, we ended the quarter with $96 million in working capital and no borrowing base debt. Our inventories are lower by 26% per square foot on a dollar basis versus a year ago.

Now turning to our fourth quarter outlook, through the first 11 weeks of the third quarter, our same-store sales had declined 17%. Over the last four weeks since then, our run-rate had dropped off by approximately 10 points. Although we do not expect this run-rate to continue throughout the fourth quarter, we are clearly off to a slow start. We are also seeing signs of increased promotional activity among our peers that we expect will create additional competitive challenges as we progress through the quarter. As a result of these factors, and assuming same-store sales decline in the low 20s for the quarter, we expect to report a loss of $0.28 to $0.35 per share. We currently expect SG&A dollars to be in the mid $90 million range for the quarter, which includes $5 million in estimated non-cash store asset impairment charges.

Any non-cash tax valuation allowance charges or additional store asset impairment charges that we may incur in the fourth quarter would increase our losses. As a reminder, we ended last fiscal year with inventories down 30% per square foot. Due to that significant reduction, we would anticipate ending inventories to be roughly flat versus last year on a per square foot basis as we close this year.

Operator, we will now take questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of Jeffrey Klinefelter with Piper Jaffray.

Jeffrey Klinefelter - Piper Jaffray & Co.

Just a couple of questions for you, Gary, in addressing your sales trends, maybe in total for Q3 but also the change in trend here recently, are there any geographic differences or divergences that you could point out that would help depreciate where the business is deteriorating or is it just a national phenomenon?

Gary H. Schoenfeld

It’s generally been national. There have been some regions actually out here that’s been a little bit better than the rest of the country but it has been fairly broad.

Jeffrey Klinefelter - Piper Jaffray & Co.

Okay. In terms of your store base, Gary, now that you have been there for a little while looking at your stores by market and thinking about the marketplace, the consumption trends, what -- how do you feel about right-sizing your store base? You know, given your preference, is there an appropriate number of stores to fit the current sales trend in your current concept? Do you still think that you can just eliminate the roughly 30 to 35 a year or would you need to get more aggressive with that given the current cycle?

Gary H. Schoenfeld

We have more stores than we need, so to be direct about your question, I think -- I don’t know that the world ever needed 900 domestic PacSun stores and if you had a perfect sheet of paper, that number might be closer to 600, 700 stores. I think we will end this year under 900 and as we look at 30 to 40 leases coming up over each of the next three years, it probably puts us to where we are -- in three years time we are probably somewhere in 750 to 800, and that probably puts us in a pretty good position. So at this point in time, we don’t have any plans to do anything particularly aggressive above and beyond what I just outlined.

Jeffrey Klinefelter - Piper Jaffray & Co.

Okay, and just lastly for me, on the store impairment charges here in Q4, Mike, could you address what that charge was directed toward, how many stores and how will we see this pattern of impairment through the next several quarters?

Michael L. Henry

It was $9 million in this particular quarter. I apologize. I don’t have the exact number of stores that that was, but I can get that for you and get back to you. This quarter we are anticipating $5 million based on what we have seen in recent trends and what we are projecting for this current quarter. As we go forward, it’s all going to hinge on what we see coming out of holiday and what that makes us think about 2010 business and the number can span quite significantly so I can't give you a specific number at this stage.

Operator

Our next question comes from the line of Adrienne Tennant with Friedman, Billings, Ramsey.

Adrienne Tennant - Friedman, Billings, Ramsey

My question is for Gary -- what is the biggest difference that you have seen as you were looking at the company from the outside now that you are there and you are doing your market research and visiting the stores -- how do you feel PacSun is viewed by your customer and can you talk about the strategic repositioning and what you want to get back to.

Gary H. Schoenfeld

That’s a great question. I think much as I felt when I came on board was PacSun has lost its way over the last two, three, four, almost five years. And the things that made PacSun a leader, the energy of the stores, the newness that -- what I call heritage brands were projecting, really has been kind of overtaken by the vertical retailers during that time. And so I think our challenge continues to be to find the right combination of our own designed and sourced product matched with and complemented by the right assortment of branded product in both young men’s and junior’s, apparel predominantly but also footwear, accessories, to round that our.

So I think at the moment, PacSun doesn’t offer a clear point of different and that is what we need to go about addressing and when I talk about becoming their favorite place to shop, I choose those words particularly because I think that’s what we need to do. We need to be a place where they are excited to go, they love the brands that we carry, the marketing that the brands do and the excitement that creates in our stores complemented by things that we can design and develop ourselves that gives us the flexibility to move quicker and to hit key price points that may be dictated by our competitors.

Adrienne Tennant - Friedman, Billings, Ramsey

In your experience though, how long should it take you to get, knowing that that’s where you need to go, how long should it take you to get back there if the kind of deterioration has happened over the past two to four years?

Gary H. Schoenfeld

I would love to answer that but I am going to resist answering because I don’t have the perfect answer. Obviously I am hoping -- you know, every day we move the dial a bit and certainly as we look ahead to 2010, there’s a lot that I hope that we can accomplish. By the same token, the customer has got a lot of choices out there right now so to win them back is going to take some time.

Adrienne Tennant - Friedman, Billings, Ramsey

Okay, great. And then my last question for Mike, can you give us some color on why shouldn’t we think that SG&A has more opportunity in it as the sales are declining this quickly?

Michael L. Henry

Well, excluding impairments from the conversation, we’ve certainly narrowed SG&A this year by $30 million in total and we are always looking for additional opportunities to be able to reduce SG&A further. It does get more challenging in certain respects, store payroll being a good example where you have to have minimum coverage to be able to operate a store but suffice it to say, we are still looking at a lot of different opportunities as we plan 2010 and do believe there are other things that we can do to continue to improve that SG&A number.

Operator

Our next question comes from the line of Christine Chen with Needham.

Christine Chen - Needham and Company

You talked about your heritage brands. I guess ideally, where would you like the penetration of heritage brands to be versus your own brands in both girls as well as in guys? Thank you.

Gary H. Schoenfeld

Not locked in on a hard number at this point in time. We need to drive sales increases in both. I think that’s the overarching opportunity and secondly, we need to leverage more of the marketing and things that make those brands compelling and give them a chance to stand out and give us a real point of difference in the mall, so at this point I am not wedded to, as I say, any particular split in percentage or targets but we definitely can do a better job of projecting and working with brands in both apparel and footwear and accessories, but I see quite opportunities to grow our own brands as well.

Operator

Our next question comes from the line of Paul Lejuez with Credit Suisse First Boston.

Paul Lejuez - Credit Suisse First Boston

Mike, based on your earnings guidance, where do you see year-end cash? And I’m wondering if you are anticipating using your credit facility in first half of ’10? And then also I guess Mike, Gary, it seems like a lot of time was spent getting out of footwear over the last couple of years and reconfiguring the store to have apparel take that space. I’m just wondering if there is a CapEx increase that comes with getting back into that category in a bigger way.

Gary H. Schoenfeld

We’re not anticipating any major CapEx in terms of bringing footwear back into the stores. We are not going to start with a huge slat wall and as broad of a presentation as what PacSun used to have and we’ve also got partners that would be interested in doing some of the in-store fixturing and the like, so to the extent there is some CapEx that we incur, it won't be a really material number in that regard.

As to the first part, I’ll just -- in terms of cash, as Mike and company have said previously, we continue to expect to end the year with cash above where we were a year ago and we will also add that we have applied for a tax refund as a result of new legislation that was signed by the President about 10, 12 days ago and that refund could potentially add another $20 million to $25 million of cash, assuming everything unfolds as it appears to be and as we have been learning about this in the last week-and-a-half. So that’s where we are from a cash perspective.

Paul Lejuez - Credit Suisse First Boston

Would that refund keep you from needing to borrow?

Gary H. Schoenfeld

Can’t say for sure -- we are glad we have the line to support working capital if we need it but at this point, it’s hard for us to comment for sure on 2010 but we are continuing to track cash wise where we thought we would end the year and we will comment more about 2010 after we end the fourth quarter.

Paul Lejuez - Credit Suisse First Boston

And Gary, could you just explain what you said about the value concept? You made a comment that -- I missed it earlier.

Gary H. Schoenfeld

Sure, no, happy to -- I think a big opportunity for us around localized assorting and a better understanding first off who are -- the differences between our different customers. Clearly not every 17-year old is walking in with the same tastes in fashion and brands and we have the ability to speak to not every customer and every fashion trend that is out there but certainly recognize two or three or four different groups of customers that we have.

And then secondly recognize that both for fashion and brand preferences, as well as climate and other criteria, that a one-size-fits-all approach to merchandising is resulting in both lost sales as well as mismatched inventory, bigger markdowns, so the whole focus around merchandise planning and allocation, we are going through a pretty dramatic shift.

As part of that, the value concept which was one way of trying to address that and saying let’s take our lowest 30% performing stores and let’s try and deliver lower price point product, that model really hasn’t worked and as we transition towards a combination or criteria driving what a store assortment should look like, the notion of having distinct value stores will go away.

So that transition will happen some time during 2010. We are still ironing out kind of the details and the timing and the internal communication of that, so I can't be a lot more specific about it other than to say that changeover will take place sometime during 2010.

Paul Lejuez - Credit Suisse First Boston

So you are saying that you are not just going to try to put low priced product in that store, you are going to try to put the right product based on some other customer preferences that you are picking up on?

Gary H. Schoenfeld

That’s exactly right and we’ve done some pretty good analytical work and regression analyses and other things that are pretty convincing that that was too simplistic of an approach and frankly has really not resulted in any higher traffic count and just largely has lowered our average transaction price and sales per transaction that hasn’t benefited us in any other way.

Operator

Our next question comes from the line of Janet Kloppenburg with JJK Research.

Janet Kloppenburg - JJK Research

Gary, I was wondering if you could spend a minute and talk a little bit about PacSun's heritage focus on sort of extreme sports or skate, other things -- is that still an important aspect of the brand’s identity and is that something that will be of a greater focus as you try and differentiate the brand and make it the place that kids want to shop.

And with that, does that mean that the universal brands will change, depending on what the focus is? What does that mean for the universal brands? Thanks.

Gary H. Schoenfeld

Sure. The answer is yes, action sports, extreme sports, however you want to refer to it, definitely is an important part of our heritage and definitely there is a substantial segment of our customer base that connects with those brands on a national level and they look to PacSun to be a leader in providing again not just apparel but footwear and accessories as well with those brands. So most definitely that is an important part of our business and will be going forward.

At the same time and to the comments a moment ago about localized assortments, across our 900 stores in 50 states, there is also a significant segment of the teen population that doesn’t relate to those brands in the same way but likes the California heritage of PacSun and the fact that we can carry a mix of brands rather than just being a single branded vertical retailer and that we are a teen targeted specialty store rather than a department store that if we can create the right environment and have the right trend oriented product, that that also is an important part of our customer base in PacSun.

So we feel like we have an opportunity to speak much more effectively to both of those and they are not the same customer, they are not looking for quite the same things and as I mentioned a moment ago, I think we are beginning to really understand A, the distinction between those customers, both on the young men’s as well as the junior side, and as a result of that setting ourselves up this next year to do a much better job of assorting product into those stores and weighted between those stores based on the preferences between those customer types.

Janet Kloppenburg - JJK Research

And so as you add more brands on the women side in particular, will we start to see less of a private label focus or will you just leave private label product at its current level and add more brands?

Gary H. Schoenfeld

Again, we are not looking to add a lot more brands. We like a lot of the brands we work with but I would say that yes, on the junior side, there is the opportunity to look for and work with a few more brands. At the same time, what I like about our model, the juniors business is obviously heavily both trend and value influenced and the brands don’t carry as much weight as they do on the young men’s side, so having the ability to move quickly and source direct and be able to hit key price points and still achieve the kinds of margins that we need to achieve, all point to maintaining a significant proprietary business on the junior side as well.

Janet Kloppenburg - JJK Research

Okay, and then my last question is just on what you referred to as the miss in denim in juniors -- has that been corrected, Gary? Should we look for a stronger assortment and a greater competitive edge for the Bullhead brand going into the spring season?

Gary H. Schoenfeld

I think --

Janet Kloppenburg - JJK Research

In denim.

Gary H. Schoenfeld

Yes, I think our denim assortment in spring, yeah, will be stronger than where we sit right now at holiday.

Operator

Our next question comes from the line of Jeffrey Van Sinderen with B. Riley.

Jeffrey Van Sinderen - B. Riley & Co.

Gary, I wonder if you could just give us your thoughts on what you feel is behind the falloff in business after the first 11 weeks? In other words, what do you think are the reasons for that? Do you think it has to do with your assortment? Do you think it has to do with the space? Just any thoughts on that would be helpful and then I did have another question to throw in as well, which is you mentioned hiring a junior GMM -- I was just wondering, is Brad Cunningham still there? And then finally, if you could just give us your thoughts on what you are experiencing in working with your landlords.

Gary H. Schoenfeld

Sure. That was a good job asking three or four questions, which I have no problem with -- they are all good questions. So first is to the decline -- as I said, we don’t have -- I don’t have a great crystal ball to say boy that can really pinpoint and in fact internally I think we’ve discussed fairly atypical without any real exogenous factors at a time when not much has changed to see that kind of decline. So trying to do better understand it, I think some of it is external and I think some of it is internal. The optimistic side would say gee, maybe part of it is just the consumer now as it is getting closer to holiday, we’ve taught them pretty well wait for Black Friday and holiday because really good sales come, so there may be an element of that.

I think there is a very real element of teen unemployment, which doesn’t get much press. But I have seen some figures that indicate teen unemployment is literally at its highest rate in some 60 years. I think that’s real. I think teen spending is challenged right now.

But I also think some of it is internal. I think that some other retailers have been much more aggressive promotionally than where we wanted to be. I wanted to try and position us being less promotional than I think PacSun has been and we have now had to react to that. So I think that that’s been a factor.

And then I think this time of year, denim is obviously a key driver in terms of bottoms and if we are off in trend, then it makes it awfully hard to be that first place with limited dollars that that girl or guy is going to come spend. So I think it’s a combination of all of those factors.

In terms of your other questions, I know one of them was about real estate and in terms of real estate, we continue to have ongoing and active discussions with landlords. I would have liked to have gotten more closure on those discussions than we have been able to at this point, so those conversations continue and I think that we will make some progress in terms of lowering some of our costs. At the same time, landlords are reluctant to make any concessions that they don’t feel that they have to. So we continue to work through that.

And you asked me about one or two other things?

Jeffrey Van Sinderen - B. Riley & Co.

Right, yeah, I was wondering, you mentioned about hiring a junior --

Gary H. Schoenfeld

Oh, sorry, juniors and with regard to Brad. Brad is a good guy and he certainly has helped move the juniors business along here at PacSun but no, he is not here any longer and I didn’t feel it was fair to him or the team to start doing a search -- when you are talking world of merchants, it’s a small universe and I didn’t want him to hear things through some other channel or the team and felt like this was a better way to move forward. But as I say, he’s a good guy, he’s talented, and he certainly has been helpful in his time here.

Operator

Our next question comes from the line of Liz Dunn with Thomas Weisel Partners.

Liz Dunn - Thomas Weisel Partners

Could you just give us some of the metrics that you normally share how much the juniors business was down versus guys, apparel and non-apparel? And then what is leading to what looks like some fairly robust gross margin assumptions for the fourth quarter? I mean, obviously you are up against very easy comparisons but would you anticipate that the environment is much less promotional in your own stores or sort of help us think about that.

Gary H. Schoenfeld

So some of those figures that you are asking for that maybe have been previously shared, I am not as anxious to be as specific from a competitive standpoint. What I am comfortable sharing is, as we said in the press release, our trends in our young men’s business were stronger than our juniors business, and that distinction has increased as of late. And in terms of apparel versus non-apparel, apparel has performed better than non-apparel but that’s not surprising, given the lack of inventory and presence in terms of non-apparel. And thus an important opportunity though for us to re-address that piece.

Liz Dunn - Thomas Weisel Partners

Okay, and then the gross margin?

Gary H. Schoenfeld

In terms of gross margins, we are coming into the quarter in a better position than where the company was a year ago and we are assuming a more promotional quarter for reasons that we have mentioned and what we are seeing in the marketplace right now and trends of the last 30 days than what we would otherwise have thought. But even with those adjustments and a very strong desire on my part to go into spring with a clean inventory position, we do anticipate significant margin improvement versus a year ago in the fourth quarter, from a merchandise margin perspective.

Liz Dunn - Thomas Weisel Partners

Okay, and just one more, if I may -- looking at the strategies that have played out over the last two years, is it your position and the board’s position that you have sort of aggravated the effect of an already bad environment? I mean, you are reversing many of the things that were done under previous management, so can we take it that what has happened to your business is not just the environment but things that, strategies that you have pursued, that the company has pursued that have just been flawed?

Gary H. Schoenfeld

I’m not sure that I want to say it quite as blunt as you just did but your conclusions -- you know, I can't say are way off the mark, and would just say that -- a couple of things. One is this is a company that had an unbelievable 10-year run of success and finally saw a slowdown of its business, saw a dramatic shift in the emergence of vertical retailers, and there are some very smart people on this board and trying to understand what those changes in the marketplace, how they are affecting business -- you know, not easy decisions or judgment calls to make. So having said that, it is fair to say that some of the things that I think were tried haven’t proved successful and the board is 100% aligned that we do put our best thinking with some good analytical rigor and make the necessary changes to fix the business and drive it forward and that is obviously my focus rather than really spending a lot of time looking backwards.

Operator

Our next question comes from the line of Mitch Kummetz with Robert W. Baird.

Mitch Kummetz - Robert W. Baird

Gary, I’ve got a few questions for you on footwear and you made the comment in your prepared remarks that for spring, 300 doors young men’s, 200 for juniors -- can you remind us where it is now? Because I don’t think it ever really went to zero, right?

Gary H. Schoenfeld

We maintained a very small presence in a small number of doors with 10, 12 SKUs of product, so we are looking at assortments that are 30 to 45 SKUs in young men’s, something smaller than that in juniors as we look ahead to spring.

Mitch Kummetz - Robert W. Baird

Okay, and are you going to keep it pretty tight in terms of the brand assortment?

Gary H. Schoenfeld

Yes, initially although we will also begin to test some additional brands as well, but yeah, within that kind of a SKU count, we want to make sure that the brands we do carry have a meaningful presentation and then we will add other brands as we build the business, learn as we get going and build it going forward.

Mitch Kummetz - Robert W. Baird

And do you have any thoughts on your shoe door count beyond spring? I mean, should we anticipate growing for back to school?

Gary H. Schoenfeld

Yes.

Mitch Kummetz - Robert W. Baird

Okay, and then lastly, your predecessor had her reasons for wanting to move out of the footwear business and if I recall correctly, it really kind of centered on profitability, that the footwear business was less profitable for PacSun than the apparel business by a fairly wide margin, if I recall correctly. So as you get back into footwear, I mean, do you think that you could do that business more profitable or is it more that you think that shoe business is part of the action sports uniform and so you feel like it is a necessary category to be in or -- what are your main reasons for wanting to get back into footwear and how do you think you can do it more profitably than where it was a couple of years ago when the company started moving out of it?

Gary H. Schoenfeld

The reason for doing it is both. I think it can be a profitable contributor to sales and I think it is an important part of the selling proposition in PacSun both in terms of the brands as well as a category that is particularly important to guys but also a piece of rounding out outfits for girls and frankly it’s an important differentiator from the vertical retailers that we compete with in the mall.

So for all of those reasons, I think it is something critical that we act on and get back into. Again, I think that what was a great business for PacSun, the marketplace changed, it then got tougher and tougher and as I said a few minutes ago, it’s easy to second-guess something at a different point in time but at that point in time when PacSun's business was challenging and there was a lot of inventory sitting in a lot of back rooms in a lot of stores, there certainly was reason to think the best solution here is just to get out and focus on apparel.

With my background, I am not sure I would have made that decision but it certainly is a decision that was very legitimate at the time. Having said that, sitting here today I am quite confident the path we are on is the right path for us going forward and I am excited what I think it is going to do to add to both our young men’s and juniors business going forward.

Operator

Our next question comes from the line of Stacy Peck with SP Research.

Stacy Peck - SP Research

Just a few questions and Gary, mostly for you -- starting with the localized markets, and it sounded like you were -- you sort of had a path that you were going on and were making maybe some progress on more of a localized assortment. I am wondering is there a systems investment that you need to make to proceed down that path or sort of where are you on that and where can you go on that?

Second of all, I am wanting you to talk more about price and kind of where you see PacSun over time in the mall -- how does PacSun fit in?

Third, how are you figuring out, how are you thinking about where to take owned brands versus fashion? Kind of how are you spending your time thinking about that these days?

And then lastly, just if you would comment on the flat inventory thought for I think you said Q4. I understand it was down a lot last year but your comp and sales are quite a bit as well, so I would think you would want those tighter and I am wondering what happens after Q4 -- is it just that the sales dropped off so you are struggling and trying to cancel or what is the thought there on inventory? Thank you.

Gary H. Schoenfeld

Sure. So first with regard to implementing the localized assortment strategy, the answer is we definitely are intent on moving forward without any major investment in systems. There certainly are some tools and technology that we will explore and consider that may further assist us in maximizing the potential of what localized assortments really can represent in terms of profitability but we are proceeding without making any of those significant investments up front.

Second to your question with regard to pricing in the mall, certainly a good question and I would say that still is one that we are refining. I don’t see us leading with price, which some retailers have certainly done and done rather effectively. At the same time, we have to recognize that at least in the near term, there isn’t a lot of indication that says the consumer is going to let you get away without being pretty sharp in terms of your price value fashion quotient. So we are quite conscious of price and I can speak to that more as he business evolves.

Thirdly, I think you asked in terms of -- I think you said owned versus fashion and I am not sure -- I think you meant the branded part of our business compared to our proprietary, or do you want to clarify -- let me answer the fourth part and then you can clarify that.

Your fourth question was regard to end of the year inventory -- this time last year the company was certainly over inventoried and then I think got very aggressive about moving through inventory and to the point where there were some key items in key ad categories in spring products that were under represented, so as I think you can appreciate it’s not just the overall dollar amount but it’s the mix of carryover product versus new product. And it’s for that reason that being flat year over year is kind of the right place for us to be based on current expectations for next spring and that’s probably as much as I could offer but there was a lot underneath that inventory number a year ago that makes me feel very good about aiming towards a similar dollar figure going into 2010.

Stacy Peck - SP Research

A couple of follow-ups and then I will clarify my question but just on the inventory then, would you expect flat inventories sort of for the first half of 2010? I.E., that’s going to be the run-rate going forward? And then on the localized assortment, I mean, how excited are you about that and how much of an opportunity is that? And then what I was asking on the third question was just on owned brands versus not owned brands, i.e. proprietary brands and you know, on the girl’s side, the fashion side, how are you thinking about it? How are you approaching it? How are you trying to figure out how much you should have of one versus the other?

Gary H. Schoenfeld

The answer to the first part is yes, I’m actually quite excited about what the whole localized assorting means and again, it starts from understanding our different customer profiles and then doing a better job of understanding where those different customers shop between our stores, and I think you all recognize it’s not just a matter of the customer in the Midwest is different from the customer in Los Angeles -- it’s much more specific than that and I think there is a huge opportunity, as I said, to drive better sales as well as drive better margins, reduce end of season markdowns and thereby create a much better customer experience.

So I think it’s a big deal for us -- a lot of work to implement and it’s been a real priority, as I said, for the last 60 days and will continue to be as we go into 2010. But I think it’s a big deal as it relates to margins and profitability.

In terms of your question about juniors business specifically that I think you are asking, the proprietary part of our business for the reasons I mentioned previously, it will continue to be an important part of our juniors business for sure. To be competitive, we have to be very good at the product we design and develop and create in denim, in shorts, in t-shirts, in bear and in layering pieces.

Having said that, we also think that both some of our heritage brands like Roxy, Billabong, Hurley, that they offer some important opportunities in juniors. Fox has got a very loyal junior customer, so we think several of those brands will be important as we go forward. And we also think that there are other juniors fashion brands, Lucy Love has been a very consistent performer in dresses that we think we can grow with. We are very excited about O’Neal’s dress line for this upcoming spring/summer, so there will be outside brands as an important part of our mix and again an important part of our differentiation.

Operator

Our next question comes from the line of Connie Wong with Wedbush.

Connie Wong - Wedbush Morgan Securities

Gary, I was wondering, and I apologize if I missed this earlier, but did you indicate what the drivers of the improved men’s business by category was earlier in the quarter?

Gary H. Schoenfeld

I didn’t and I would say denim and t-shirts and then the wovens category, those would be the three drivers.

Connie Wong - Wedbush Morgan Securities

Okay, and I know that you did not want to comment specifically on private versus brand penetration but I was curious if you could comment on if the branded penetration in men’s is higher than the women’s side of the business, or are they pretty similar?

Gary H. Schoenfeld

No, it’s definitely higher in the young men’s business and I would expect that to continue.

Connie Wong - Wedbush Morgan Securities

Okay, great. And then you had also mentioned before about wanting more newness in the stores and I think particularly for the juniors side. Are you seeing faster product cycles?

Gary H. Schoenfeld

Yeah, and again it’s part of how we -- we need to do a better job planning our business and it comes back again to this localized assorting and recognizing different stores, different climates, different time of year to roll out product as well as different preferences -- all of that combined with better planning around turning product will set us up for I think doing a better job in 2010 of bringing newness into the stores.

Connie Wong - Wedbush Morgan Securities

Okay, great and then just one last question about some of your core heritage brands -- I was curious to know how you guys go about determining which really are the true core heritage brands. Have they changed from prior years? Are you guys using focus groups to determine what you put into the stores?

Gary H. Schoenfeld

No, they haven’t really changed and Volkom is obviously another one of our key brands and so the brands -- and again, I kind of use the heritage term to say the brands that a customer would expect to find in PacSun. So kind of by definition, then they are not changing an awful lot.

As between them, obviously trends and what they are doing product wise and marketing wise influence this business between those brands but those group of brands will continue to be important for us and as we go into footwear, we’ve got a strong apparel business with DC, adding them and footwear will only strengthen that. And as we add bands to our footwear business, also opens opportunities to start looking at doing more apparel with them. But that universe of brands that a customer has gotten to know and love and expect to find in PacSun over the last 10, 15 years, isn’t changing a whole lot.

Operator

Our next question comes from the line of Liz Pierce with Roth Capital.

Liz Pierce - Roth Capital

I think most of mine have been asked but I did want to circle back to the people and culture, the first thing that you talked about, Gary -- are those positions that you listed, those are all vacant at this point?

Gary H. Schoenfeld

Yes.

Liz Pierce - Roth Capital

And they were vacant -- but they were filled when you came in?

Gary H. Schoenfeld

For the most part, with the exception of a Chief Marketing Officer, hasn’t been as much at the forefront of PacSun's strategy really ever and I think we’ve got great opportunities to work with our brands. We are going to spend the next day-and-a-half at a little company up in Beaverton, Oregon that’s got a few brands that we find interesting and with each of the other brands that I’ve mentioned on this call, we’ve been having I think some really exciting discussions as we look ahead to 2010, and I think we all recognize our -- PacSun really has been the leader of the action sports market. They need us to be better than we’ve been. Collectively the action sports market has lost a lot of market share to some very good vertical retailers and our mission is to lead the charge and get some of that business back.

Liz Pierce - Roth Capital

I guess my question was do you have enough depth underneath those positions that you are not hurting yourself in the interim period?

Gary H. Schoenfeld

I am pleased with the way the team is responding. I know my dad wishes I would get a little bit more sleep and my 42-hour trip to Hong Kong was maybe a little bit brief by necessity last week, but no, I’m excited about the team that is here. I think that we are becoming a more and more focused and effective team every day and every week that goes by and we’ve got the support of the brands out there, we’ve got the support of a great base of suppliers in Asia and other parts of the world. We’ve got a lot of work to do but no, as I said, none of that is getting in the way from us making progress.

Having said that, there’s some very important positions that I look forward to having some great people join our team and the impact over time that those people will be able to make for sure. I look forward to that very much so.

Liz Pierce - Roth Capital

Okay. I’ll follow-up offline on the rest. Thank you.

Operator

Our next question comes from the line of Elizabeth Montgomery with Longbow.

Elizabeth Montgomery - Longbow

My first question would be when you were talking about the comp store sales run-rate, I think you said it had fallen off about 10 points, which would imply something like a down high 20s so far, and you said you didn’t expect that to continue throughout Q4 but I am wondering what are the drivers that you would see improving that? Is it just kind of overall mall traffic picking up and then improvement in your store traffic? That’d be my first one.

Gary H. Schoenfeld

Yes, and I think others were more aggressive on promotions than we’ve been, so we see that as part of it is well.

Elizabeth Montgomery - Longbow

Okay, and then secondly, have you guys looked at the shopping patterns of the Pac Bucks members say over the past four or fiver years to see if there has been a real change in trend? Has that become a smaller part of the business or is it still about the same or is it just proving less effective in the current environment?

Gary H. Schoenfeld

I think the Pac Loot program is meaningful from a mom’s perspective. I don’t think it has as much effect on teens but I can't tell you that definitively or analytically we are able to draw that conclusion. We’ve also launched a loyalty card program that is a bit of an alternative approach to Pac Loot and we are going to continue to test both approaches along with other pricing and promotion strategies.

So if you put all that in a big bucket, I think there is an opportunity for us to be more effective.

Elizabeth Montgomery - Longbow

And when did the loyalty program launch?

Gary H. Schoenfeld

Back to school.

Elizabeth Montgomery - Longbow

Okay. And then if I could ask too, it seems like the website has changed in appearance a little bit and it looks a little bit more sophisticated than it used to, especially on the women’s side which is about the only thing I would know. And I wondered kind of when that had happened and is that a strategy that we could see being translated into the store assortments as well?

Gary H. Schoenfeld

So a couple of things -- I mean, certainly dot.com is an important piece to what we do, obviously don’t need to explain to you all the importance of what is happening online to the teen market for sure. You are correct that from a product perspective, juniors product, we are doing some things beyond what we have done in the stores and we are encouraged by some of the early reads on some of that product and we will be testing some of that in stores and there definitely are some learnings from that that we think will be positive contributors to the juniors business looking ahead to 2010.

Operator

Our next question comes from the line of Dorothy Lakner with Caris & Company.

Dorothy Lakner - Caris & Company

Just a question on this idea of marketing, doing more marketing with the brands. I would assume from what you are saying that this is not going to really happen very much before back to school -- is that fair?

Gary H. Schoenfeld

I wouldn’t be as specific about that for 2010 just yet. There are some things that are in the works certainly for spring, so I’d say it’s an overall initiative for 2010 and probably build it during the year but I am excited about some of the programs that we will be talking about when we are up in Oregon tomorrow that will be certainly evidence in stores come spring break.

Dorothy Lakner - Caris & Company

Okay, and then if I could just add one more on to that, in terms of some of the brands that you talked about, is it fair to say that perhaps you are going to be buying those brands better than has been done in the past? Or would you go so far as to say -- I think so far you avoided saying that they would necessarily increase as a percent of the mix but is it fair to say that maybe they weren’t bought as well as they might have been.

Gary H. Schoenfeld

Yeah, I guess -- yeah, I paused for a moment but yeah, if you think of that in terms of again I keep using this term around localized assorting, so yes, doing a better job of recognizing that maybe a certain brand or maybe certain styles within a brand shouldn’t go to all stores, and assorting it better to the stores that that matches up against that yes, we do think we can buy better and generate more productivity as a result.

Dorothy Lakner - Caris & Company

I guess what I was also thinking is that it seems like some of those brands at least have within their assortments things that on the junior side at least would be more fashion oriented than PacSun's necessarily carried recently?

Gary H. Schoenfeld

I would agree with that also.

Dorothy Lakner - Caris & Company

Okay. All right, great. Thanks and good luck.

Operator

We will take our last question from the line of Roxanne Meyer with UBS.

Roxanne Meyer - UBS

Just a quick one -- in thinking about the key hires that you are going to be making, some of the marketing, changes in store, planning and allocation, just wondering if you can give us an idea directionally about how you are thinking about CapEx and SG&A for 2010 at this point?

Gary H. Schoenfeld

I think we can better comment on that on the next call. As Mike alluded to earlier, we certainly remain sensitive to SG&A but what we need to do is bring customers back into the store and drive profitable sales. So that is going to be the key really to turning this business around. There just is a certain amount of overhead that is required whether it is 750 or 900 stores that is both branded and proprietary across all 50 states and relatively speaking the company is pretty efficient and pretty cost conscious, so from an SG&A perspective, we remain mindful of that and I don’t think it’s going to swing wildly from this year to next year but I don’t think we are prepared to be more specific at this point in time.

Similarly in terms of CapEx, it would be early for us to give you a view on that and -- but we can speak more to that certainly on our end of the year call.

Operator

Thank you. At this time, I will turn it back over to Mr. Jackson for any closing remarks.

Gary H. Schoenfeld

This is Gary and I thank everybody for joining us on the call and encourage your friends and relatives to come shop PacSun and we wish you all a happy and healthy holiday season and we look forward to speaking with you soon. Thank you very much.

Operator

Thank you all for joining today’s conference call. You may now disconnect.

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Source: Pacific Sunwear of California F3Q09 (Qtr End 10/31/09) Earnings Call Transcript
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