Newsletter Value Investor Insight carried an interview September 29th with Stephen Roseman, who runs Thesis Capital. Since 2000,his portfolios – at three different firms, but assuming the fee structure of Thesis Capital – have returned an average 15.9% per year after fees, vs. 7.2% for the Russell 2000, according to Value Investor Insight. Here's the excerpt from the interview in which he discusses Pacific Sunwear (NASDAQ:PSUN), which was trading at $15.44 at the time of the interview:
Tell us about one of your favorite retail ideas today, Pacific Sunwear (PSUN).
SR: Pacific Sunwear is a mall-based retailer selling surfing- and skateboardinginspired apparel and accessories to teenagers and kids in their early 20s. They sell their own brands, as well as proprietary third-party brands.
The company is suffering from both external and self-inflicted problems. The CEO, chief merchant and CFO all retired – not a great combination – and the new management team made some early merchandising mistakes, particularly in footwear. They also haven’t communicated well their plan to become more vertically integrated and sell more companyowned brands. I think that’s smart and should eventually be great for margins, but the transition has been tough on comparable sales, which has disappointed the market.
Fashion cycles tend to last three to five years. Starting in the fourth quarter of 2003, we went from a decidedly nonpreppy look at the mall to more of a preppy one. Such shifts don’t affect the buying behavior of core customers of a particular look or style, but they do affect the large number of marginal customers who kind of move with the wind. This is particularly true with teens, who exhibit the unique dynamic of wanting to be different … just like the rest of their friends.
When preppy started working again in 2003, you saw companies like Abercrombie & Fitch and American Eagle start to take off, while those that offered a different look, such as Pacific or Hot Topic, started to suffer.
So is part of the thesis that preppy is going back out?
SR: We’re starting to see evidence of the beginning of the end of the preppy cycle, yes. Retailing is mostly a zero-sum game, so as the marginal customer moves away from stores like American Eagle – which hasn’t had a negative comp in three years – they’re going to rediscover places like Pacific Sunwear and Hot Topic.
On the operating side, we believe they’re doing the right thing to build up their own brands and we can be patient for it to show up in better numbers. We’re also confident they’ll turn around the merchandising problems while managing the business to generate excellent cash flow.
How bargain-priced are the shares, at a recent $15.44?
SR: If they pull back on store openings and only spend on maintenance capital expenditures, the company generates $100 million or better of free cash flow, on an enterprise value of $1 billion. The shares trade at only 5x what we estimate to be normalized annual earnings before interest, taxes and depreciation. I think I can safely say that I’ve never lost money – and typically do very well – in buying companies at 5x EBITDA.
Valuing it on either a private-market basis – I think a sale is a possibility – or on a turnaround, the company is trading for 50% of what I think it’s worth.
Isn’t there a real risk the next trend after preppy is something other than what Pacific sells?
SR: That’s always a risk, but I think a very remote one in this case. Pacific basically sells the staples of kids’ wardrobes – jeans, T-shirts, shoes. The California-influenced look has been around a long time and has come in and out of favor, but I don’t think it’s in any danger of going away.
Related: More long stock picks here.