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Pacific Sunwear (NASDAQ:PSUN)

Q3 2010 Earnings Call

November 22, 2010 4:30 p.m. ET

Executives

Craig Gosselin – Senior Vice President of Human Resources and General Counsel

Gary Schoenfeld – Chief Executive Officer

Michael Henry – Chief Financial Officer

Analysts

Adrienne Tennant – Janney Capital

Paul Lejuez - Nomura

Janet Kloppenburg – JJK Research

Bill Romano

Christine Chen – Needham & Company

David Griffith - Roth Capital Partners

Mitch Kummetz – Robert W. Baird

Marni Shapiro - The Retail Tracker

Dorothy Lakner – Caris & Company

Jeff Van Sinderen – B. Riley & Company

Linda Tsai – MKM Partners

Betty Chen - Wedbush Securities

Charu Sharma – KeyBanc

Sean Naughton - Piper Jaffray

Operator

At this time I would like to welcome everyone to the third quarter 2010 earnings conference call. [Operator Instructions.] At this time I would like to turn the conference over to Mr. Craig Gosselin. Sir, you may begin.

Craig Gosselin

Thank you. Good afternoon, and welcome to the Pacific Sunwear of California conference call announcing the company’s fiscal third quarter 2010 financial results. This is Craig Gosselin, senior vice president, general counsel and head of human resources.

This call is being recorded and the playback will be available starting today approximately two hours after the call through midnight on November 29, 2010. It can be accessed at (800) 642-1687 or (706) 645-9291, pass code 23412284. The call will also be archived on the Pac Sun website at www.pacsun.com through midnight on March 9, 2011.

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 about our future financial performance and prospects. Our actual results could differ materially from those contained in our forward-looking statements. Risks and uncertainties that could cause our business and financial results to differ materially from those in the forward-looking statements are included in our fiscal 2009 Form 10-K and in subsequent filings we made with the SEC, as well as in the earnings press release we issued today.

These documents can be found in the Investor Relations section on our website at pacsun.com. All information discussed on the call is as of today, November 22, 2010. Pacific Sunwear undertakes no duty to update this information to reflect future events or circumstances. This call, the web cast, and its replay are the property of Pac Sun. It is not for rebroadcast or use by any other party without the prior written consent of Pac Sun. With that said, I'll now turn the call over to Gary.

Gary Schoenfeld

Good afternoon, and thank you for joining us today. I'm generally pleased with the progress we're making, as evidenced by our third quarter results, which exceeded our sales and earnings expectations for the quarter.

Total sales for the third quarter were $258 million, reflecting a comp store sales decline of 3% and continuing our sequential quarterly comp improvement that we outlined at the beginning of the year. Our GAAP EPS loss was $0.11 for the third quarter. On a comparable non-GAAP basis, using a normalized tax rate, our EPS loss would have been $0.07 versus a GAAP loss of $0.17 a year ago.

Highlights during the quarter were the continued progress of our men's business, which has now improved its trending for five consecutive quarters, including positive comps for the last two quarters. Our women's business similarly improved its trending, from what had been declines in excess of 20% for the last several quarters, to a decline of 10% in the third quarter.

At the beginning of this fiscal year, our primary financial goals that we outlined were to achieve sequential quarterly improvement in the trending of our same-store sales, hopefully leading to a positive comp in Q4, with a positive comp for the full year in men's, coupled with improvements in margins and further reductions in SG&A expenses. I'd like to comment briefly on each of these.

In terms of total comp sales, we've come from a decline of 15% in Q1, 10% in Q2, to -3% in Q3. We believe we can continue this trend of sequential improvement in the fourth quarter, yet we're off to a slower start than anticipated through the first three weeks of November, with improved AURs being offset by lower transactions, hence our current guidance of -5[%] to flat comp for Q4.

We saw somewhat of a similar slowdown last year at this time before the real traffic of the holiday season began in earnest. We think our stores and our assortments are compelling, and are eagerly awaiting Black Friday later this week. Several weeks ago I was asked to appear on CNBC early next Monday morning following Black Friday weekend and we will know more about how the holiday season is starting out at that time.

Regarding our second objective on men's, I'm pleased to say that our men's comp is now positive year-to-date, and continue to be enthused about the direction of our men's business and the brands we are working with as we finish the year and look ahead to 2011.

With regards to merchandise margins for Q3, they were not as strong in two categories as we would have liked, in denim and wovens, which caused us to be more promotional during the back to school period, yet we remain on track for significant improvement in margins in Q4.

And lastly, with regard to SG&A for the year, we continue to be mindful in managing expenses and expect to end the year at $300-$305 million in SG&A expenses versus our initial guidance of $310-$320 million and compared to $340 million last year.

Stepping back to when I joined Pac Sun in the summer of 2009, we knew we had a lot of work to do to reestablish Pac Sun as a leader in the teen space in a challenging economic environment and a very competitive marketplace. I talked about the importance of reestablishing our relationships with brands, improving our merchandising and selling culture within our stores, connecting with our customers, and reigniting a culture of passion and creativity within Pac Sun.

We still have a lot to do, but I'm very pleased with the progress we've made thus far in each of the critical areas. As I turn to the status of our leadership team and the organizational transformation that we are working to effect, I continue to be very confident in the talent we're attracting and the creativity and passion the team is demonstrating.

Over the past 11 months we've hired eight new vice presidents and promoted a ninth. Regrettably, one of these new hires didn't end up being the right fit, but as a whole I am delighted with the team we are building.

To that end, I'm pleased to announce that Eric Fong joined us in September as vice president of merchandise planning and allocation, and brings 19 years of experience in inventory management. Eric comes to us from Old Navy, where he held the position of vice president of inventory management and most recently as the project lead for Old Navy's category management initiative.

I'm also happy to announce that Mondy Beller joined us in October as vice president of ecommerce. Mondy comes to us from shop.com, where she was the SVP of marketing and business development. With her 15 years of online marketing and ecommerce experience, Mondy brings the kind of experience and talent that we need to pursue the many opportunities that exist for us to further improve both the sales and marketing dimensions of our online business.

Beyond our leadership team, I see improvement in nearly every aspect of our business, including the brand reps in our stores and the efforts they're making every day to create greater connections with our customers.

Turning to some initial thoughts on next year, we continue to believe that we're making important strides. Our men's business is getting back on solid footing, and I believe we will see growth in our women's business starting in Q1.

Like any apparel manufacturer-retailer, there are going to be some very real challenges in sourcing and product costs that we are going to have to deal with that will have an adverse impact on our merchandise margins and in today's environment we are not expecting that these cost increases can simply be passed along to consumers across the board. We're going to have to be creative and diligent throughout the supply chain, from factories to brands, to achieve reasonable solutions that can mitigate these pressures.

It is still too early to know the full effect of these changes, but we are committed to working aggressively to try to maintain our gross margins next year through better product assortments, localization initiatives, detailed review of product specs, and refined pricing strategies.

So in closing, we continue to believe we're on the right track towards fixing this business. In the beginning of the year, I had hoped we could get to a positive comp by this Q4, and while this still might happen, I think our first quarterly positive comp is probably a more realistic expectation for Q1 of 2011.

That said, we are just 80 hours or so away from the biggest shopping day of the year, and we're eager to see what this holiday season brings.

I will now turn the call over to Mike.

Michael Henry

Thanks Gary, and good afternoon everyone. Our fiscal 2010 third quarter financial results were as follows. Total sales were $258 million this year versus $268 million last year.

Same-store sales declined 3%, with trend improvement in both genders. Our men's business posted a mid-single-digit comp, marking its fifth consecutive quarter of sales trend improvement and second consecutive quarter with positive comps. Our women's business declined 10%, a significant improvement in trend from what had been declines in excess of 20% in recent quarters. We ended the quarter with 877 stores, versus 904 a year ago at this time.

Gross margins, including buying, distribution, and occupancy costs, declined 240 basis points to 25% this year versus 27.4% last year. Merchandise margins declined 250 basis points, primarily due to higher markdowns as a percent of sales and lower initial markups. Occupancy costs improved $1 million, but deleveraged 30 basis points on a lower sales base. Buying and distribution costs improved $1.6 million, and 40 basis points, to last year.

SG&A expenses improved 570 basis points to 27.6% of sales this year, versus 33.3% last year. In dollars, SG&A declined $18 million, to $71 million this year from $89 million last year. Of the $18 million in SG&A reductions, $7 million came from lower impairment charges, $6 million was due to reduced payroll costs, and $5 million was from lower depreciation expenses.

Our income tax benefit for the quarter was just shy of $200,000 as a result of the continuing impact of a valuation allowance against our deferred tax assets. Our GAAP net loss for the quarter was $7 million, or $0.11 per share. On a comparable non-GAAP basis, using a normalized income tax rate of 39%, our net loss for the quarter was $4.3 million, or $0.07 per share, versus a loss of $10.9 million, or $0.17 per share last year. We ended the quarter with $44 million in cash and no borrowings under our credit facility. Total inventories were down low single digits to LY at the end of the third quarter.

Turning to fourth quarter guidance, we're anticipating same-store sales to be in the range of flat to a decline of 5% versus last year, gross margin rate improvement of 100-400 basis points versus last year's 22.6%, and SG&A in the range of $82-84 million versus last year's $94 million.

This translates to an earnings range of a loss of $0.10 to $0.29 per share, including the continuing impact of having a very low tax provision. On a comparable non-GAAP basis, using a normalized income tax rate of approximately 37%, this translates to an earnings range of a loss of $0.07 to $0.18 per share for the quarter.

We expect to end the year with cash in the range of $75-85 million, total capital expenditures at around $20 million, and with approximately 850 stores, subject to negotiations on expiring leases.

Operator, we'll now take questions.

Question-and-Answer Session

Operator

[Operator Instructions.] The first question will come from Adrienne Tennant with Janney Capital.

Adrienne Tennant – Janney Capital

My first question is last year I think you gave us a comp quarter to date at the conference call. I think it was -27% for the first two weeks of November. I was wondering if you could give us a similar number month to date November. And then can you just remind us what the remaining cadence is for December and January. And then secondly, a little bit more color on the average unit cost pressure that you're seeing. What quarter should we start to see that come in, and if you can help us quantify in percentage growth rate how much do you think it's going up next year?

Gary Schoenfeld

As to the first part, I'm relieved to tell you that while acknowledging the first few weeks of November have been below our expectations, it's nothing nearly as ghastly as what was taking place last year, and it's something much closer to about a negative 10. But recognizing we saw quite a shift from what we saw early in November, and then what began on Black Friday. So we're optimistic about seeing improvement starting this weekend, but still factored that into the guidance that we've given for the quarter.

In terms of average unit cost pressure for 2011, it still is early to comment on that, and we're not in a different situation than others that you've been hearing over the last few weeks. I think reading what different people have been saying on the Street, I think people have got a reasonable grasp of the range of impacts and I think on our next call we'll be able to give more guidance as to 2011 as to what that is. As I said in my opening remarks, we have a number of things that we think we can improve upon from a margin perspective, so we're hopeful that we can offset that, but it's really too early to be more specific as it continues to be quite volatile, as you know.

Adrienne Tennant – Janney Capital

Have you bought product through Q1? Through what quarter have you bought product?

Gary Schoenfeld

Yes, we've bought a substantial portion of Q1 at this point, and certainly have made fabric commitments in key categories into Q2 and in some cases portions of Q3 at this point.

Adrienne Tennant – Janney Capital

And what is the lead time on branded versus private label?

Gary Schoenfeld

It varies by category. There's not a short answer to that.

Operator

The next question will come from Paul Lejuez with Nomura.

Paul Lejuez - Nomura

Just wondering what comp level you guys need to see next year to be free cash flow positive, and also wondering if you could maybe update us on what you're feeling on store closings, both at the end of this year and next.

Gary Schoenfeld

So on the real estate piece, as Mike alluded to, we anticipate being around 850 by year end, which is consistent with what we have said in the past. We would anticipate subsequent closings in the following year in 2011, but it would be premature for us to be more specific around that. But we'll speak to that on the next call. And as to the first part of your question, again we're not prepared to get into 2011 discussions beyond what we've already indicated, which is we are setting our sights for a positive comp in the first quarter, and seeing a positive comp for the first time in quite some time in our women's business, but not prepared to comment beyond that with regards to 2011.

Paul Lejuez - Nomura

Any update on the shop-in-shops? Are you seeing a lift on those stores yet?

Gary Schoenfeld

As I've said in the past, it's not our expectation that they individually create a material change in terms of the one store. Those tend to be opportunities to really highlight brands and learn some opportunities about those brands, but we're not expecting a big shift in terms of lifting the store. It's more about giving individual brands attention, and then how do we merchandise around that. So we continue to be pleased. We have opened our first two with Nike this past week and looking at the first few days of that's been kind of fun. But there isn't more to comment on with regards to shop-in-shops overall.

Operator

The next question will come from Janet Kloppenberg with JJK Research.

Janet Kloppenburg – JJK Research

Mike, could you clarify for us, your guidance for the third quarter was a loss of $0.09 to $0.16. Was that a taxed number or an untaxed range?

Michael Henry

That was a comparable non-GAAP, so that would have incorporated a normalized tax rate.

Janet Kloppenburg – JJK Research

Okay, so then the $0.07 is the number we should be looking at, right?

Michael Henry

The $0.07-$0.18, yes, would be presented on a comparable basis.

Janet Kloppenburg – JJK Research

No, the $0.07 loss that you just reported for the third quarter.

Michael Henry

Understood. Yes.

Janet Kloppenburg – JJK Research

So actually you beat your range, correct?

Michael Henry

Yes.

Janet Kloppenburg – JJK Research

And when I look at it it's because your SG&A came in about $3 million below the low end of your range, which was $74 million. So maybe you could help us understand that.

Michael Henry

We were a little bit better on our sales. Our sales guidance for the quarter was a decline of four to nine. We landed at a decline of three, and then we were a little bit better in SG&A than we anticipated -

Janet Kloppenburg – JJK Research

I know. The SG&A is what I'm focused on. How did you save there?

Michael Henry

It's exactly the things that I mentioned. We had $7 million in lower impairment charges. That came in a little better than we were expecting. We had $6 million from payroll costs, which was also a little bit better than we were expecting, and then depreciation was $5 million lower than expected, and that came in as we would have thought.

Janet Kloppenburg – JJK Research

And because those are significant differences, have you contemplated those differences in your guidance for the fourth quarter, or could there be opportunity for further SG&A savings in the fourth quarter?

Michael Henry

We always target our SG&A guidance at what we realistically expect to happen. Could there potentially be things that break our way? Sure. But that $82-84 million range is what we realistically expect to achieve for the fourth quarter. We don't intentionally try to sandbag any of the line items.

Janet Kloppenburg – JJK Research

No, that's not the point. I was just wondering. These are bigger differences than we expected, and than we've seen historically. There's no sandbagging here. That wasn't something I was thinking about at all. I was just thinking about whether there's a shift going on in the number of store closings you've had, etc., that would influence your impairment and depreciation charges, and perhaps there could be another shift in the fourth quarter. I'm really not thinking you're sandbagging.

Michael Henry

That aggregate, $82-84 million represents our best thinking on what we think's going to happen in impairments and depreciation and payroll and all manner of other expenses. Invariably there are differences between individual store performance and what we're projecting at any point in time that moves that impairment number around a bit, but in the aggregate that's really where we're expecting to be is $82-84 million.

Janet Kloppenburg – JJK Research

Okay great. And then on the sales trend, you came in so much better than expected. Then November seems a little odd, the trend. We had heard around the industry that sales trends actually strengthened as October concluded. Did you see that trend, and therefore is this a surprise? Or was the trend starting to slow as you went through October?

Gary Schoenfeld

I think what we're seeing in our business and I'm hearing frankly September's pretty mixed, and I know American Eagle deferred on giving their guidance until they're doing their monthly -

Janet Kloppenburg – JJK Research

You said September but I think you meant you're hearing November's pretty mixed.

Gary Schoenfeld

Hearing November - so what I think is going on in Pac Sun's business is I think we're a significant holiday destination, but we're not a big fall destination, and the distinction that I make in that is as the weather breaks we're not like North Face or some other retail that's an obvious destination when it gets cold. And the other thing I would say is we're not like Gap. We didn't run 40% off the whole store on Saturday, and we're not like Aeropostale, that's 50-70% off the entire store right now. So I think as a result, we've now seen this two years in a row. Again, not nearly as severe as we thought a year ago, but still seeing where the beginning of November, candidly, a bit quieter than we'd like it to be. But still very hopeful that we're going to have a pretty robust Black Friday, which I think begins to be indicative of what the holiday season's going to be like.

Janet Kloppenburg – JJK Research

Okay great. And then just one last question on inventories. Are they as lean as you'd like them to be? And how should we be thinking about where they'd be coming out of the fourth quarter?

Gary Schoenfeld

Inventories were down modestly, and consistent with our expectations in terms of how we were planning the quarter. And so I don't know if they're ever completely as lean as you'd like them to be. I'd love to never have a markdown in the back of the store. But directionally they're in line with where we wanted to be for the quarter. And in terms of ending the year, part of that will be dependent, certainly, on our expectations for Q1. So I think it's about inventory being in line with expectations for Q1, and so that probably is in the - modest increase is probably a realistic expectation for inventory based on what we've said in terms of at this point in time looking forward to positive comps for Q1.

Operator

The next question will come from Jeffrey Klinefelter with Piper Jaffray & Co.

Bill Romano

Hi, this is Bill Romano. I'm an individual shareholder. You had mentioned in October you hired Ms. Biller, head of ecommerce, obviously you have a big ecommerce vision going forward. Can you let us know on the call what is your vision for ecommerce going forward over the next couple of years, and how are you and the company - Ms. Biller - plan to help the company sell more products online to customers?

Gary Schoenfeld

So, again, I think there's two facets to Mondy joining us. One is with respect to driving online sales, and the second is what everybody is obviously keenly sensitive to, which is the world of social media and how powerful of a marketing tool the online world is. Both are super important to us, and in terms of online sales initiatives it's roughly 5% of our business currently and we think that there are a number of things that drive the online business that we can become much more effective at. So there's no one silver bullet per se, but we have high expectations in terms of - our customer clearly shops online, and there's a lot we can do in a number of different aspects of it. So I'm not going to speak to the details of search engine optimization and all the different things that can be done in terms of making a web page more productive, but suffice it to say we've got a lot of initiatives that we're embarking on, and look forward to reporting growth in the online business over the next few years.

Bill Romano

You said it's right now 5% of sales. In a perfect world, in the next couple of years, where do you see that trend headed? Where would you like - [I know you don't ever] give forward guidance, but where would you like to be in a perfect world?

Gary Schoenfeld

There isn't a perfect world answer, as everybody talks about it being really multi-channel. It is. So in my mind it's not necessarily dot com versus in stores. But certainly there's the potential for it being considerably bigger than 5%. You hear many in the industry talk about online being 10% or more. I don't think that's an unrealistic expectation, but it's not necessarily a target that we've committed ourselves to at this time. But we do look for meaningful growth in this channel.

Bill Romano

Are you guys building any type of mobile apps for the new iPhones, Androids, so customers can now have more accessibility on the go to your website and buy products wherever they are?

Gary Schoenfeld

We do look forward to adding that capability, yes.

Bill Romano

And final question going forward, what would you like to tell the shareholders on the call today and obviously you've been on board for about a year and a half. It's been a very successful tenure so far. What would you like to do - your number one goal in 2011, to take Pacific Sunwear to the next level?

Gary Schoenfeld

That's a good question.

Bill Romano

No right or wrong answer here.

Gary Schoenfeld

It's hard distilling down to one, and I don't want to be just flip and say well, gross sales and margins, but if I was going to give one, it would be gross sales and margins is what we're really aiming for. [Laughter.] And it's guys and girls, it's building our brands as well as our proprietary brands, and making the Pac Sun brand in and of itself that much more compelling and connected to our target customers. So probably wrapped about four things into that long sentence.

Operator

The next question will come from Christine Chen with Needham & Company.

Christine Chen – Needham & Company

Wondering if you could talk a little bit about the drivers in the improvement in your girls business, from a product category perspective? And certainly, the stores seem to be emphasizing brands a lot more, and I'm wondering if you're happy with the performance of branded merchandise in both sexes?

Gary Schoenfeld

Sure. I think driving the women's business is a combination of factors, and I think it just starts with a more tasteful aesthetic and fashion execution, targeted toward an older teen customer that better matches the guys who shop our stores. Within specific categories, [bare] is certainly a category that performed well for us in the summer and into the third quarter. Some of the other seasonal things that we did in shorts and carrying that through added as well. Pleased with what we're seeing in terms of trends in fleece and what we think the opportunity is for that in the fourth quarter. And as to the question around brands, continue to be very pleased with the way that we're working with our brands. Those relationships were not great 16 or 17 months ago, and we're hugely appreciative of the way those relationships are today and the kinds of product and marketing initiatives that we're working with our brands on. And yes, it certainly is a conscious effort to have more brand visibility in the stores, which is certainly executed this holiday season.

Christine Chen – Needham & Company

And just as a follow up, you had mentioned in the past you'd like the average age of the girl to trend a little bit older to match up with the average age of your guy customer. I feel like the assortment certainly is trending a little bit older. Have you seen the customer base follow?

Gary Schoenfeld

Yes we have, and some of the market research we did in the fall is certainly confirming that.

Operator

The next question will come from David Griffith with Roth Capital Partners

David Griffith - Roth Capital Partners

Gary, on the last call you talked about footwear and some of the challenges there. I wonder if you could kind of update us on where you see your position with accessories and footwear and I know that's a focus for next year for Christine as well. But could you give us an update there?

Gary Schoenfeld

Sure. I certainly feel better about the way we show up for footwear this holiday season, and in our top stores we've paid an even more significant merchandising assortment in roughly our top 200 stores that I think is considerably more impactful and begins to help customers see that we're seriously back in the business. As I spoke to last time, I was not very pleased with the way we were supporting footwear in terms of our in-store selling and field execution and we're about to find out if that's improved. But I have every hope and expectation that the field team is much better equipped to support selling this category.

David Griffith - Roth Capital Partners

And accessories?

Gary Schoenfeld

And accessories as a whole, you'll see we've added branded sunglasses into those same top 200 stores, or roughly the same stores, and that's a category that I think adds good energy than other categories. We're doing a little bit of different merchandising approach on hats, so those are key on the guy's business. On the girl's business, a much more compelling jewelry presentation with depth as well as elevated product, again more consistent with where we want to take the women's customer. So as a whole, we view accessories as an important sales contributor, but also an important contributor to the overall environment of the store for both men's and women's. Men's, a couple key categories that are branded that guys expect to find in Pac Sun, and on women's, it's categories like jewelry, but then also seasonal categories like scarves or bags that also help complete outfits and are important to the women's segment as well. So liking how we're starting to execute that this holiday season and look forward to further growing that segment of the business next year.

Operator

The next question will come from Mitch Kummetz with Robert Baird.

Mitch Kummetz – Robert W. Baird

A couple questions. First, on your Q4 comp guidance, the midpoint of that range is essentially in line with where you guys came in for Q3, so if you think about your business by gender are you expecting guys to continue to be up mid-singles, girls down ten in terms of your Q4 comp outlook?

Gary Schoenfeld

Honestly, I can't be more specific than kind of where we said. I do expect guys to remain positive and that implicitly says women's in the negative range. So what you said probably isn't way far off. The one category that's challenging for us is denim, which has been a very significant category for Pac Sun for the last several years. It still is, but that's the one category where it was below plan in Q3 and the first few weeks have continued to be a bit soft. Excluding denim, I'd be very confident that we will be positive comp the rest of the business. There aren't a lot of real catalysts in denim right now, and our expectation is that it's going to be another fairly promotional denim season. Some of the new product we've brought in in terms of non-indigo denim and some of the twills - we're pleased with how those are performing. Similarly, a much stronger leggings presentation on the women's side. We're encouraged with what we see there. So overall our basic denim is generally performing, but in terms of the more fashion component there's not a couple of clear winners that we're confident are going to drive the holiday business for us.

Mitch Kummetz – Robert W. Baird

Okay. Let me ask you about that. So what was your comp in girls if you exclude denim? And then also, I'm guessing as you go from the back half of this year into the first half of next year denim shrinks as a percentage of mix going from fall to spring. Is that one of the reasons why you become more confident in a positive comp in girls by Q1?

Gary Schoenfeld

There's a number of factors. I think first off is the changes we've made organizationally with Christine coming on last February, and then a number of other changes we've made in the team underneath her really meant that spring of 2011 would be the first season that she and the direction we want to take the business we could plan from the beginning. So that's kind of the first point. Second is spring and summer is on the women's side where our brands even have more opportunity to shine around swim and shorts and sandals and feel like what we've got lined up there is really compelling. So I'd say those are some of the bigger drivers, although you are correct. Denim doesn't play as big of a role in the first half of the year. We still see actually opportunities year-over-year to improve denim, notwithstanding the comments that I just made. But I'd just say it's in total we've had the opportunity to plan spring from the beginning and we continue to like how it looks and where that plan sits.

Mitch Kummetz – Robert W. Baird

And then a quick question for Mike. On your gross margin guidance for Q4, up 1-4 points, what kind of merchandise margin is baked into that?

Michael Henry

With the range of sales that we have, projecting a five point comp range and so as you slide one way or the other in the range we're targeting to try to keep inventory at an acceptable level heading into next year and so there's a range there of what's contemplated in the guidance of about 300 basis points of movement just based on additional markdowns needing to keep inventory in line as you move to the more negative end of that scale.

Mitch Kummetz – Robert W. Baird

And how much is AUR up through the first three weeks?

Gary Schoenfeld

I don't think we can be specific on answering that, but it's been a nice increase in AUR, but it's not so nice when you see transactions lagging.

Operator

The next question will come from Marni Shapiro with Retail Tracker.

Marni Shapiro - The Retail Tracker

Could you talk a little bit about the juniors business? If you wouldn't mind, just a little bit more detail there? It feels like the men's side does feel very clear, and there are pockets of the juniors business that feel very clear to me, the vision. And then there are parts that feel less clear. Sometimes during the quarter it felt a little of a hodgepodge in a season where there were some very good styles that could have felt very Pac Sun and very California. And I guess I'm curious what your focus is there on the juniors side. Are we going back to that true California surfy heritage with color and comfortable looks and layers and sheer knits and things like that that feel very right now and right for Pac Sun? Or do you have a different vision in mind? And then along the same lines on the juniors side, are you getting in a new shopper? Who is shopping juniors today? Is it the core shopper who's coming in and buying, or are you getting a new shopper who's maybe coming in to buy for her boyfriend and finding something she likes? Just any kind of better clarity on it?

Gary Schoenfeld

I think fair observations and fair questions and I don't have great answers for you. I don't know that I'm going to be able to add a lot of clarity, just given how recent the transformation is that we're beginning to effect. So as I alluded to earlier, we did some market research in stores and intercepts as well as online during back to school to understand what's different and how she perceives us and where we see the strengths are as we reformulate the strategy around the women's part of the business. As I say, what was certainly confirmed out of that was we're getting credit with that older teen, 16-20 year old, rather than what I believe was much more of a 12-15 year old customer when I walked in the door last summer, of '09. So that we've got some pretty good evidence that we've made that change and are making that change. In terms of is she a new customer, is she a prior customer? I think to a fair degree she's a prior customer, but she certainly is seeing us show up a bit different. We think one of our opportunities in 2011 is to put more effort behind introducing Pac Sun to that new customer and we felt though, that we didn't want to begin really that effort in any meaningful way until we felt we had the product assortment right. And so just in line with the previous question, again part of our optimism around turning to a positive comp in Q1 is I think your critique is fair in that the entire assortment hasn't necessarily sat fully complementary, and part of that is because we weren't able to start day one in developing the line with a very clear vision. So I think the best answer I can give you is we think there is a very clear position that will be evident as we move into spring, and that yes, we think our positioning is around that fun California lifestyle. Does she want fashion as part of the assortment? Yes, but she's not looking for Pac Sun to be at the forefront of fashion, but certainly wants us to take what are the fashionable trends and then translate that to a maybe a little bit more California casual execution. So as you walk into stores during the holiday and an example would be you'll see shine translated to some of our women's tank tops in the [bare] category. We're not taking shine all the way to sweaters or dresses, per se, in a meaningful way, but we certainly feel like that's a fashion trend that needs to be part of what we're doing. And she's certainly looking for more than just a traditional ribbed or striped tank top from us. And so maybe that gives a little bit of clarity. But I think your comments are perceptive and I think clarity of focus and trend influence will become much more evident as we get into spring.

Marni Shapiro - The Retail Tracker

Without saying it on a public call for your competitors, are there other items in the store today that if I walked in you would see that are from this design team that are go forward ideas?

Gary Schoenfeld

Sure. [Laughter.]

Marni Shapiro - The Retail Tracker

Okay. Because I could rattle off a few of them right now. I just don't want to - [inaudible] reason's I'll take it off line. And I just want to say, in spite of everything that's gone on in your stores over the last couple of years, your sales associates have been really exceptional of late and so congratulations on that.

Gary Schoenfeld

Well, appreciate that. We've made a huge amount of change. I think the field has a great leader in Paula and we've promoted a really great candidate to be her number two on field execution, and frankly our whole regional director team has changed in the last 12 months. So I've got a lot of confidence in that leadership team. We had a great meeting with our district managers a week ago. They're all very geared to deliver Black Friday and holiday the way we'd like to see it done. But I appreciate the feedback.

Operator

The next question will come from Dorothy Lakner with Caris & Company.

Dorothy Lakner – Caris & Company

I wondered if you could maybe talk about, since you've talked about things you're doing in your top 200 stores, I wonder what the comp difference is between the top 200 and the chain on average. And then a little bit more color if you would on the localization strategy, where you are right now and what more there is to accomplish there.

Gary Schoenfeld

So on the top 200, and it segues better to speaking to the localization, I've always had a bit of a walk before we run mentality, so some categories like footwear or even a smaller category like sunglasses, where I know we need to be in those, but just how much do we commit in terms of inventory or fixtures or other things. Those are some things that we want to see demonstrable improvement before we roll them out further. So none of that really applies on a massive scale that really says those stores are going to perform significantly different, but we have questions on a few categories where tactically we're going some things a bit different. So long way of saying there's not a profound gap between how the top 200 stores have comped to date versus the balance. But as I said, with that as a segue to localization, our first step in that was this back to school. You heard me start to speak to it as an important operational initiative this time a year ago, but the actual execution of that didn't begin to materialize towards back to school. But it certainly was a contributing factor towards sales ending up where they did as a minus three comp versus something that could have been more in line with the guidance we'd given. Where we saw some of the highlights was frankly just the differentiation around staying in certain warm weather categories longer and in many markets that was probably the biggest win that came out of localization. Underneath that, there were a number of smaller initiatives and details where we saw on the margins some benefit. But candidly, one of the key initiatives of Eric Fong joining us is now I've got somebody who can truly lead the execution of that full time, and we see it as clearly a really important initiative going forward. So we feel like we've put a stake in the ground that we're seeing some benefit from, and we think it will continue to be an important area of benefit as we go into 2011.

Dorothy Lakner – Caris & Company

And then one other thing. In terms of marketing, obviously you did some events and so forth around back to school, and I guess at this point you're looking for a new head of marketing. Any color on timing for that?

Gary Schoenfeld

Right now you're speaking to the head of marketing and we're kind of having some fun to be honest. So we've already got, I think, some pretty exciting plans for 2011. So to answer your question specifically, yes, I will continue to look for somebody to lead that and yet we've got some talented people within our marketing team and our director of marketing I have a lot of confidence in. Brought onboard a creative director about four months ago who I think quite highly of. I'm pleased with the agency we brought onboard a year ago, with Mondy now heading the dotcom execution. We'll hire the right person when we find them, but we're not going to lose any ground. And in fact, to the opposite, we're going to do some good stuff next year.

Operator

The next question will come Jeff Van Sinderen with B. Riley.

Jeff Van Sinderen – B. Riley & Company

Gary, maybe since we've focused a lot on the girl's business, you can give us a little more color on the guy's business in terms of where the strength was in, let's say core legacy branded product, private label product, versus some of the newer brands that you've brought on in the guy's business.

Gary Schoenfeld

As you know, we've tended not to want to get into the discussion of one brand versus another, so in general I think as we indicated, the day I walked in, I felt the winning proposition for Pac Sun was our mix of what I termed that day heritage brands, proprietary brands, and emerging brands. And the honest answer is it's a combination of those that are fueling the strength in our men's business.

Jeff Van Sinderen – B. Riley & Company

And then merchandise margins in men's, just wondering if those came in kind of as expected, or if those were also impacted somewhat by some of the promotional activity in denim. Or was denim more on the girl's side?

Gary Schoenfeld

No, that was on the guy's side, and candidly the other category that from a margin perspective underperformed in Q3 was wovens, which year-over-year experienced a fairly significant decline as that became a very pervasive category and one where there was a fair bit of promotion on.

Jeff Van Sinderen – B. Riley & Company

And what's your assessment of the denim category? Do you think that there's just a general lack of trends in fashion denim now that's sort of impacting everyone? Or do you think maybe you guys don't have some of the best styles in fashion denim? I know you said the basic part of it's good, but fashion's been a little more challenging.

Gary Schoenfeld

I'm sure there are some that are seeing increases, and by no means are we being complacent and saying well, there's just nothing new. Part of our challenge is to create newness and create excitement and we need to find some better solutions than what we've been able to do. But if I step back from that a bit, then yeah, I do think a part of it also is that there isn't a clear new trend must-have item out there. Leggings and leggings with destruction is probably the most meaningful trend happening on the women's side. On the guy's side there's clearly nice interest in non-indigo denim and twills. And so seeing some of that happening. But again, it's not with just a must have enthusiasm that is driving the business, and therefore yeah, it's a fairly competitive category right now.

Jeff Van Sinderen – B. Riley & Company

And then finally, I know you don't report monthly comps, but just wondering if there was anything that was unusual or that was worth mentioning about the monthly comp progression in Q3 or if it was pretty much as usual or as expected.

Gary Schoenfeld

You're right. We don't usually comment about month. There is some movement one month versus another. Directionally we're pleased where the quarter came out obviously.

Operator

The next question will come from Linda Tsai with MKM Partners.

Linda Tsai – MKM Partners

You discussed some of the weakness in denim, but with the wovens was it more on the branded or on the private label side? Could you just provide a little more color there?

Gary Schoenfeld

It was just in general as a category. It was, as I say, broadly distributed, and very available at a number of different retailers, and with some pretty aggressive promotional pricing attached to it that we had to respond to, hence some margin pressure for us. It wasn't specific to branded or proprietary in that regard.

Linda Tsai – MKM Partners

So what might be the opportunity next year. How could you change that around? Would it be more on the pricing side, or just trying to have more differentiation?

Gary Schoenfeld

I think it's actually both that you mentioned. So I think in terms of what the plaid kinds of wovens and checks that we saw last year and this year, to the extent that the merchant team feels like that trend is continuing I think we will plan on that in terms of what we consider more commodity kind of pricing as that product carries into 2011. And certainly one of the opportunities and challenges is to say, you know, where else can we move wovens into more differentiated and interesting product. That's one of the categories that we will launch some product with Modern Amusement next year that we're excited about, but that by itself won't be the solution and we'll have to find other opportunities for differentiation and creating some excitement with customers.

Operator

The next question will be from Betty Chen with Wedbush Securities.

Betty Chen - Wedbush Securities

I was wondering if you can give us a little bit more color around the composition of the inventory. As I think you mentioned it was down on an absolute basis. Is there any sense you can give us in regard to the carryover inventory and how that compared year-over-year?

Gary Schoenfeld

We tend to not break it out too terribly much between that and part of that don't like to get into a lot of detail in terms of competitors and what we're carrying over in new and all that. In short, we'd say it's reasonably comparable to where it was a year ago would be the short answer in that respect.

Betty Chen - Wedbush Securities

Okay great. Now, in regard to the quarter to date trends you mentioned, it does appear that a lot of your competitors have chosen to be very aggressive on the pricing side, early, even before Black Friday. So I was wondering twofold, related to that, first is have you continued to see the gender performance in early Q4 similar to the third quarter, with the men's still trending positive and the women's maybe in that territory, in the negative 10% territory? And then also, given what you've seen, what are you thinking in terms of promotional cadence year-over-year or how should we think about that? And is that what is embedded in your gross margin guidance for the fourth quarter?

Gary Schoenfeld

Again, what we saw a year ago was the business performance from Black Friday on through Christmas was markedly different than what it had been for the previous 30 days. I don't have a good enough crystal ball to say exactly to what extent that's going to repeat itself. I do know I was reading something over the weekend from ICSC saying that one survey had as many as 31% of Americans planning to shop this Black Friday versus 26% a year ago. And I read another estimate as many as 134 million people intend to - that was specific to the day and then another one saying 134 million people had to leave over the weekend. Those are some staggering numbers, and again, to put that in context and I think we've spoken to this previously, in the time that I've been here at Pac Sun, this buy now, spend now, wear now trend continues to be increasingly exacerbated. So qualitatively, all that points to Black Friday being even more significant than it's been in the past and we're still optimistic about what Black Friday is going to mean for us. We think we're teed up operationally in staffing and inventory flow and promotional strategy to deliver a meaningful Black Friday and hopefully translating to a positive comp. But we're about close to 80 hours away from that kicking off, and eager to see that. And hence the comment in here about my having been asked to be on CNBC next Monday, and if there's a meaningful trend that comes out of Black Friday we'll add some color at that time in terms of what that translates to. And so as far as looking a year from now about the only thing that I can share that is likely is that we will do this earnings release a week later and after Black Friday, because we can have a much better conversation frankly a week from now than we can have today.

Betty Chen - Wedbush Securities

Okay, that's very helpful. I was wondering if you would be willing to comment on the earlier question I had about the quarter to date comp trends by gender. I think you mentioned that it had started off a little bit slow. Has that been the case for both men's and women's, or are you only seeing it maybe in the girl's side of the business?

Gary Schoenfeld

Overall, traffic has been slow.

Betty Chen - Wedbush Securities

And then just lastly, I think you had mentioned in looking out into 2011 certainly I think we've heard from everyone now regarding the sourcing headwinds. For now should we be expecting, I think you said that gross margin will be similar to 2010 or did I hear that incorrectly?

Gary Schoenfeld

To be clear, and you're not far off, I think what I said is number one, it's too early to know, but number two, at least as of the moment it would be our hope that we could maintain this year's gross margin rate into next year and that a series of other operational and product and merchandising initiatives could offset those headwinds. But I don't want to be any more precise than that because it still is quite dynamic and it would be premature to try and be any more specific, no different than just about any of the other retailers or manufacturers I think you've been hearing from over the last week or two.

Operator

The next question will come from Charu Sharma with KeyBanc.

Charu Sharma – KeyBanc

So Gary, I just had a question on the juniors business. In terms of the penetration relative to the rest of the business, so in 2009 I believe it was about 43%. Can you just comment on your comfort level as you're seeing that business develop and grow, do you see that penetration being sustainable, or do you see it changing?

Gary Schoenfeld

As I've said from the get go, I see opportunities in both men's and women's. We're not consciously at this stage trying to manage to a particular split or percentage. So there may come a time where that gets clearer and we have a stronger point of view, but at this point the focus for me is certainly growing both parts of the business. Probably there's a bigger delta in potential in the women's and if we can really get that right there's probably in the near term even some more upside in terms of percentage increase than would translate into a little bit more of the penetration. But specifically, I still believe that men's will be the bigger part of our business at least for the foreseeable future.

Charu Sharma – KeyBanc

And on the sourcing side, I think in the past you've talked about some operational efficiencies and opportunities there in terms of increasing the speed to market, which clearly would be a benefit to the private label juniors business. Can you just comment on in terms of the juniors product, how much of that is benefitting from a faster speed to market pipeline. Any opportunity for improvement that you have on that end of the business?

Gary Schoenfeld

The answer is yes, there certainly is opportunity for improvement, and really it's in tops where I think that's most pronounced and is going to be most significant for us. And were it not for the dynamics in China and Asia right now on a sourcing perspective, I'd probably speak even with more conviction around the benefits and impact to that. Offsetting that is frankly a need and a desire to make fabric commitments and ensure production in the factories that we want to be in. So I think in 2011 speed and supply chain agility will continue to be a premium, but offsetting that a bit will also be some of the aspects that I just spoke of.

Charu Sharma – KeyBanc

And just last question, quickly, on the inventory, I know you don't want to give too much detail in terms of the composition, but in the first quarter I think juniors inventory clearly was down. I think it was about 30% as you were rejuvenating that merchandise. Can you just comment on how that builds up? And if you could, in terms of gender, the composition of your inventory and your comfort level going into 4Q?

Gary Schoenfeld

The decline on women's was really in Q1, and I think now you're asking me how I feel about the composition going into Q4. So do you want to clarify? Is your question about going into Q1, or where we currently sit with regards to Q4?

Charu Sharma – KeyBanc

No, that's correct. Going into Q4. I was just saying that in Q1 clearly you were under-invested in juniors inventory by 30%. So just wanted to get a sense of how that's grown and your comfort level with the juniors composition of inventory now as you head into the fourth quarter.

Gary Schoenfeld

Got it. Short answer is I feel comfortable about where the women's inventory is. It still is negative year-over-year and we think where we were lacking the right inventory we feel good about the flow of that inventory into the holiday season and directionally feel like we will end the year with a much better composition on our women's inventory compared to where it was a year ago.

Operator

The final question will come from Sean Naughton with Piper Jaffray.

Sean Naughton - Piper Jaffray

In terms of the comps, can you talk about any differences between geographies or outlet versus full price. And then maybe secondly, have you experienced any disruptions in your inventory flow for the third quarter and maybe moving into the fourth quarter as capacity has been relatively tight from what we've been hearing?

Gary Schoenfeld

Geographically, I've kind of been consistent in replying to that, which is not much of a reply, and for a couple of reasons: A) we don't see radical disparities between one region of the country or another, and B) as we work on turning around the business from my perspective it isn't not managing the business to one region versus another, therefore I don't feel it's particularly insightful or necessary at this point to get into that detail. Maybe someday that will be different, but that's my feeling currently. While not answering your question, I'll say it's not wildly different in one part of the country versus another.

As to outlet versus the core stores, outlet performed a bit better during the quarter, and as to the question around any supply disruptions, no, we've not experienced anything. There's always a few things that get pushed a few days here and there, but no, we continue to feel good about the supply chain and the factory relationships we have.

Sean Naughton - Piper Jaffray

And is there anything that you're seeing in the action sports industry that are potential catalysts that could help drive traffic to Pac Sun outside of your company's specific marketing?

Gary Schoenfeld

That's a good question. Candidly, I think that we need to reestablish ourselves as the retailer that for 30 years has been an authentic destination around action sports, hence our efforts in footwear and sunglasses and other accessories and the featuring of brands within the stores that somebody else mentioned. We feel like it's more about within our grasp things that we do to tie into that, but I guess to answer your question are there any external catalysts that are apparent on the immediate horizon, I wouldn't say there are any obvious ones other than - I've believed for many years, and I continue to believe, that action sports are a lifestyle and the brands that relate to them and tap into the energy and creativity of action sports continue to have the opportunity to play a bigger and bigger role in the marketplace and obviously excited about Pac Sun's legacy in that regard and more importantly what I think we can claim going forward.

Sean Naughton - Piper Jaffray

And then lastly, I think you talked about being an 850-store chain at the end of this year, so a few more store closures from where we are today. Can you just remind us on your thinking on what the ultimate size or what you think makes sense for this chain moving forward?

Gary Schoenfeld

As we spoke to that in the past, when I first came on board and we were north of 900 stores, I think I said on my very first call, or some time close to that, there are probably 150-200 stores that we really didn't need. I think that assessment has continued to probably prove accurate. As I believe we indicated on a couple of the more recent calls, landlords aren't anxious to have more vacant space, so directionally what we're hearing from landlords is a preference that even in some of those tough malls that we continue to find ways to keep the doors open without those being a drag on cash flow. So we've shown a willingness to do that with key landlords on short-term renewals. So whether we decline by orders of magnitude 100 stores in the next couple years, or something a bit more than that, or half that number, will in part be a function of what I just described and whether or not that continues to be landlords' sentiments 12-24 months from now or if it's something different.

Operator

At this time I would like to turn the conference back over to Mr. Gosselin for any closing remarks.

Gary Schoenfeld

Well, he's going to pass it back to me. Appreciate everybody's interest and certainly you know where we'll be starting about midnight on Thursday night. So thank you very much and wish everybody a good holiday season.

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