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

Q2 2014 Results Earnings Conference Call

August 28, 2014, 04:30 PM ET

Executives

Craig Gosselin - Senior VP, General Counsel and Head of HR

Gary Schoenfeld - President and CEO

Michael Kaplan - SVP and CFO

Analysts

Eddy Yruma - KeyBanc Capital Markets

Dorothy Lakner - Topeka Capital Markets

Betty Chen - Mizuho Securities

Jeff Van Sinderen - B. Riley & Company

Andrew Burns - D.A. Davidson

Joe Bess - Roth Capital

Operator

Good afternoon. My name is Diaz, and I will be your conference operator today.

At this time, I would like to welcome everyone to the Second Quarter 2014 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks there will be a question-and-answer session. (Operator Instructions)

Thank you. Craig Gosselin you may now begin your conference.

Craig Gosselin

Good afternoon and welcome to the Pacific Sunwear of California conference call announcing our fiscal second quarter 2014 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 September 4, 2014. It can be accessed at (855) 859-2056, or (404) 537-3406, passcode 89445780. The call will be archived on the PacSun website at pacsun.com through midnight on December 4, 2014.

The speakers today are Gary Schoenfeld, Chief Executive Officer; and Michael Kaplan, 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 and 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 2013 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 also be found in the Investor Relations section on our website at pacsun.com. All information discussed on the call is as of today, August 28, 2014. PacSun 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 PacSun.

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

Gary Schoenfeld

Good afternoon, everyone and thanks for joining us on our Q2 earnings call. As previously stated in our release at the end of July, sales trends improved as the quarter progressed led by continued growth in our Men’s business resulting in positive comps in both June and July and non-GAAP EPS at the higher end of our initial guidance.

Total sales for the quarter were $212 million with comp store sales of 0.3% and non-GAAP loss per share for the quarter was $0.03 loss.

Following a particularly strong Q1, our Men’s business achieved a 3% comp in Q2. Men’s tops and footwear in particular performed well with what I believe continues to be a very compelling product assortment and brand mix featuring both our emerging as well as heritage brands.

Our Women’s business ends up with a negative comp of 3% largely due to challenging performance in non-apparel consistent with what we had discussed on our last call at the end of Q1. Excluding footwear and accessories, we actually had a positive comp for Women’s apparel in Q2.

Our emerging brands including Brandy Melville and Kendall & Kylie continue to perform well and overall we’re pleased with the growth in key tops and shorts categories.

In terms of fixing our Women’s non-apparel segment, we’re making key changes to our merchandising strategies, which now include brands as a bigger and more distinctive part of our assortment for this category.

Some of these initiatives will begin to affect holiday in a bigger way by next spring. During the first quarter call, I also mentioned the recent launch of our Golden State of Mind summer campaign. This was the biggest initiative to date for the GSOM brand positioning and our team did a pretty great job of capturing the true essence of PacSun.

For Men’s store activities to in-city events, we were able to demonstrate to our customers how the creativity, diversity and optimism of California are relevant and live in the backyards of our customers across the country as well as find ways to have two way engagement in today’s fast paced digital world.

As we look at Q3, back-to-school has gotten off to a pretty good start even in the face of a highly promotional denim market. We’re continuing to see strong responses to several of our key brands and I’m optimistic that we can continue to attract new customers and gain market share based upon the increasing distinctiveness of our brands and merchandising assortments.

So as I turn the call over to Michael, I will reiterate that our core strategies aimed to reestablishing PacSun’s leadership position in this very competitive marketplace are unchanged.

We remain keenly focused on differentiating and elevating PacSun through the best branded assortment and specialty retail, continuously elevating our merchandising mix to appeal to our trend and style savvy 17 to 24 year old guys and girls and connecting our customers to the creativity, diversity and as I like to say, the optimism that is so uniquely California lifestyle and synonymous with PacSun.

Michael Kaplan

Thanks Gary and good afternoon, everyone. Today I will discuss our Q2 2014 operating results our Q3 financial outlook.

Our fiscal 2014 second quarter financial results were as follows. Total net sales from continuing operations were $212 million for the second quarter versus $210 million for the same period last year.

Comparable store sales were up 0.3%. Average unit sales for the quarter were up 7%, while total transactions were down 6%. Ecommerce sales increased 9% in Q2 2014 versus Q2 2013, and represented 6% of total sales.

Gross margin as a percentage of net sales was approximately 29% compared to 30% for the same period last year. Contributing to the decline in gross margin was a 70 basis points decrease in merchandized margin.

Total inventory was down approximately 5% on a comparable store basis. SG&A expenses were approximately $61 million versus $57 million or 29% of net sales for Q2, an increase from 27% of net sales for the same period a year ago.

The $4 million increase above last year consistent primarily of $2 million attributable to timing of marketing and spend during the quarter, although we anticipate that full year marketing spend should be relatively in line with the prior year, consulting cost supporting our long-term strategies and store impairment charges.

We recorded an income tax benefit of $0.2 million for the quarter. On a GAAP basis we reported income from continuing operations of $8 million or $0.10 per diluted share for the second quarter compared to a loss from continuing operations of $19 million or $0.27 per diluted share for this same period a year ago.

On a non-GAAP basis, excluding the financial impact of the derivate liability and using a normalized income tax benefit of approximately $1.3 million, our loss from continuing operations for the quarter was approximately $2 million or $0.03 per diluted share versus non-GAAP income of $2 million or $0.02 per diluted share on a similar basis last year.

We opened one new store and closed another store in the second quarter resulting in 618 core and outlet stores versus 637 a year ago. We plan to open three new stores during the remainder of fiscal ’14 and close approximately 10 to 20 with the majority of closures occurring in Q4 2014.

I will now talk about the financial outlook for the third quarter of 2014. Our guidance range for Q3 ’14 contemplates a non-GAAP loss per diluted share from continuing operations of between negative $0.09 and negative $0.04. Our forecast for the third quarter non-GAAP guidance range is based on the following assumptions.

Comparable store sales from flat to plus 3%, net sales from $203 million to $208 million, a gross margin rate including buying, distribution and occupancy cost of 25% to 27%, compared to 25% last year.

SG&A expenses in the range of $54 million to $56 million and applicable non-GAAP adjustments or tax affected using a normalized tax rate. Consistent with prior quarters, our guidance for non-GAAP loss per share from continuing operations excludes the quarterly impact of any change in the fair value of the derivative liability due to the inherently variable nature of this financial instrument.

Operator, we will now open up the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) And your first question is from Eddy Yruma from KeyBanc Capital Markets. Your line is now open.

Eddy Yruma - KeyBanc Capital Markets

Hi guys. Thanks very much for taking my question. In terms of reorienting the Women’s business toward brands, I guess at what point do you feel like you’ll have that mix stabilized and I guess is there a margin implication longer term by moving toward more branded products. Thank you.

Gary Schoenfeld

So the comment was pretty specific to non-apparel, although overall, we’re seeing brands be a key differentiator for PacSun in today’s crowded marketplace. So we do see brands overall being a more significant part of the overall women’s business but specifically in addressing non-apparel that has been underperforming, there’s some bigger retailers that have really kind of commoditized some key categories and we think we need to replicate the focus on brands.

So as I said, I think you’ll see some of that affect Q4, but I think in a bigger way it will be spring of next year where you’ll see that be even more prominent.

From a margin standpoint, we think there’s opportunity to improve our overall ending margin in non-apparel. So we don’t see a shift to brands as a threat to one of our clear objectives, which is to continue to increase our overall merchandise margins.

Eddy Yruma - KeyBanc Capital Markets

Great. Thanks so much.

Operator

Your next question comes from the line of Dorothy Lakner at Topeka Capital Markets. Your line is open.

Dorothy Lakner - Topeka Capital Markets

Thanks. Good afternoon, everyone. Just I wonder if Gary could give us a little bit more color on the success that you’re seeing or continued success I should say in the Men’s business and then secondarily just some comment on the denim part of the business, both Men’s and Women’s if you’re seeing any difference in performance there and also on the new trend towards jogger pants. However you want to call them? Thanks.

Gary Schoenfeld

Sure. I’ll take the second part first. Denim is not a very fun business to be in right now. I don’t think that comes as new news. So promotions are pretty aggressive out in the marketplace and I think overall it is a down-trending category for the moment in both Men’s and Women’s.

You’re right. Offsetting that is a lot that’s happening to some degree in joggers and other things in the bottoms business and we’ve certainly been pleased by the strength of our assortment particularly in Men’s that we’ve done in joggers and we think that there’s a lot of interest with consumers in that area.

To the bigger question, in terms of the continued I think strong performance in Men’s, it just ties back to our strategy, which is building a great portfolio, of both emerging and heritage brands that really are relevant to the consumer.

And then secondly, supporting that with style and trends that a 17, 19, 22, 24 year old guy is going to be excited about wearing and I think in pretty singly we’re differentiating ourselves because of that two pronged approach to our merchandising and guys are responding well.

That strategy is similar in Women’s, although brands play a lesser role, but even so as I alluded to on to the previous question, we see brands continuing to be of important distinction to our Women’s business and looking to continue to grow that on the Women’s side as well.

Dorothy Lakner - Topeka Capital Markets

Great. Thank you.

Operator

And your next question comes from the line of Betty Chen from Mizuho Securities. Your line is now open.

Betty Chen - Mizuho Securities

Thank you. Good afternoon and a nice job in controlling the business in a tough environment.

Gary Schoenfeld

Appreciated.

Betty Chen - Mizuho Securities

I was wondering if you can talk a little bit about the non-apparel business in Women’s. Give us a sense, if you could. What percent of the Women’s business that is can you quantify what was the positive comp number in the apparel business so we can get a sense of the strength there.

And then my other question is regarding SG&A. It sounds like or it looks like SG&A growth in the second quarter kicked up a little bit. Is part of that due to the store impairment charge that you alluded to and is that also part of the increase in SG&A dollar guidance for the third quarter? Thanks.

Gary Schoenfeld

So you touched on a few different things, SG&A, a few different factors, store impairment is a portion of it and as we look right now, the store impairment probably comes in a bitter higher in Q3.

I think as people are recognizing top performing models are continuing to win and dry traffic and the important destinations, secondary malls are finding the marketplace more competitive and with a portfolio of 600 stores like we have, we are seeing a few stores just because of that shift pop up and hit the impairment limitations.

So we’re seeing a bit of that in that regard and as Michael also talked about part of Q2’s SG&A was a shift in timing around marketing spend, but for the year, we still expect marketing to be pretty close to where it was last year.

To your first question about the women’s business, I’m not going to get as specific as to what percentage. We are first and foremost a apparel destination and non-apparel was the bigger part of Men’s business because of the branded part of Men’s snickers and Men’s hats being two significant parts of our Men’s non-apparel business.

But more specifically within Women’s across the different classifications that we carry in our stores, if you walk in the stores so far during 2014, there’s not a real prominence of brands and historically if you go back with heritage brands PacSun used to have strong branded non-apparel business as the heritage brand business has gotten tougher in the Women’s side.

That’s also had impact on non-apparel and we’ve taken on our non-apparel business in the last couple of years to a more private label and trying to compete on price with some of the more aggressive fast passion retailers. The reality is I don’t think that strategy is proving successful. We don’t have the space to have as broad of assortment as they do and I think we’re increasingly recognizing that for PacSun, who we are, what we stand for and what our strategy is.

We think the right way to be successful in non-apparel in Women’s similar as in Men’s is to make brands a bigger part of what differentiates us from a lot of the vertical retailers and fast passion retailers that customers are obviously also shopping. So more to come on that, but I think that’s the right direction for us to move forward.

Betty Chen - Mizuho Securities

That sounds great. Gary; In terms of the least the legacy product in Women’s non-apparel, were you able to maybe move some of that during the second quarter or it’d be so entering the third quarter with some that you want to clear through before the new presentation starts to roll in the fourth quarter.

Gary Schoenfeld

Unfortunately, it’s more of the latter and I would tell you unfortunately even some stuff is bought for Q4 that currently I wish wasn’t. The dollar amount’s not that significant, but that’s why I say you’ll see some of this affected for holiday but in a much more complete way as we look ahead to spring.

Betty Chen - Mizuho Securities

Okay, great. Thanks so much. Best of look.

Operator

And your next question comes from the line of Jeff Van Sinderen at B. Riley. Your line now open.

Jeff Van Sinderen - B. Riley & Company

Good afternoon. Gary, can you talk a little bit about how you’re evolving the Women’s merchant team since Kristine left and then maybe you could just give us a sense of maybe how your real estate plans, any touch on that or evolving longer term with the stores you’re closing,

I guess the way I’m looking at it looks like revenues, which shrink if comps ran flat at least this year. So I guess I’m just wondering about revenues growing or shrinking over the next couple of years based on how you’re looking at real estate and then maybe you can also just touch on SG&As related to revenues, if your revenues grew could you SG&A down, hold revenue growth that sort of thing.

Gary Schoenfeld

Unfortunately our comps dropped through the first half of the year and you’ve seen our guidance of 0 to 3 for Q3 that we’re optimistic about continuing positive comps through the third quarter.

So from a revenue standpoint, you’re right that if we close 10 to 20 stores, how does that math affect overall business but overall it is important to recognize first and foremost -- we remain encouraged about the trend of our comp performance relative to a tough marketplace.

What we think that means in terms of gaining market share and what customers are saying and thinking about PacSun. As we look much beyond this year, we don’t see anything right now that is profoundly different than what we’ve indicated in the past other than what I alluded to a few minutes ago, which is I think we’re all recognizing the distinction between top performing models and secondary models, so like everybody else we’ll continue to evaluate that and see how the customer continues to evolve in this Omni channel environment that we have today.

From an SG&A perspective, we remain very diligent in terms of controlling inventory, controlling SG&A, take those things seriously. At the same time as we’ve indicated driving positive comps and driving merchandised margin improvements are the keys that we see in terms of continuing to improve the financial performance of the business. So I hope that is response to your question.

Jeff Van Sinderen - B. Riley & Company

Yeah. The only thing we didn’t hit on was maybe evolving the merchant team since Kristine left?

Gary Schoenfeld

Oh yeah! Glad. Yes. You’ve known me for a long time. I frankly have always kind of embraced the opportunity when somebody leaves to dive deeper into the team and my experience over the last 20 years has been that tends to be a good thing and then as I get to work closer with the team, you get better visibility on top talent. You also get to get more into the weeds and evolve strategies and evolve priorities.

I’m hugely appreciative of what Kristine contributed. Really enjoyed working with her. Her team really enjoyed working with her. At the same time, I have to say that the last 30 days for me working more closely with the Women’s team has really been pretty fantastic and I think also creating appropriately more synergies and more collaboration between our Women’s and Men’s team, which can only be a good thing/

So the long -- the short answer to -- or the short end to a long answer is I’m really confident in the Women’s leadership team that we have in the building today, the strength of the brands, the strength of our creative direction and I am excited about where I think we're going to take the women's business.

As I say, the non-apparel business has been our Achilles' heel in women's for the last few quarters and I think in the last 30 days, we've made -- come to some important decisions about how we want to go about fixing that and I also think we're continuing to see opportunities to make brands a bigger part of our total w women's business.

I think brands are excited about being in PacSun. So I think you're going to continue to see that be a more and more prominent part, which fits our overall strategy for the total business across both genders.

Unidentified Analyst

Thanks and good luck for the rest of the quarter.

Gary Schoenfeld

Appreciate it.

Operator

(Operator Instructions) Your next question comes from Andrew Burns from D.A. Davidson. Your line is now open.

Andrew Burns - D.A. Davidson

Good afternoon. A question on gross margins as it relates to your third quarter guidance. It looks like you it contemplates a flat to 200 basis points improvement in gross margin and second quarter merchandise margins were down 70 basis points.

What would be the change there in terms of what looks to be an improvement in merchandise margin? Is it less promotional activity or strength in private label, just trying to get a sense of the drivers there?

Michael Kaplan

Yes, the highest levels are you’ve heard us say for the last several quarters that improving merchandize margins and inventory productivity has been a very high initiative for this entire organization over the last nine to 12 months and I think as we go into the back half of the year, those initiatives, which have lag time in terms of them beginning to really take effect, I think our guidance reflects optimism about the impact of those initiatives.

So I'll say that number one. Number two is we previously spoke to during spring, summer, some seasonal category swim in particular, men’s tanks being another -- we certainly saw some seasonal categories that experienced a lot of price promotion in the marketplace and therefore put pressure on Q2 margins.

So I would say it's the combination of those two things are the biggest things that address your question of why do we see the improvement Q3 versus Q2 even in the backdrop of a tough denim marketplace, which we've already spoken to.

Andrew Burns - D.A. Davidson

Okay. Thanks. And in terms of the topline guidance, does the comp guidance of flat to plus three factor in any sort of deceleration from current trends given what we've seen in past seasons here that when the traffic drops down from the mall, the peaks and valley seem to be more pronounced.

Gary Schoenfeld

So what I would say is, it's our best thinking as we sit here today and that's probably the best answer that I can give you. We obviously are cognizant to what you're alluding to, which is the shift in patterns towards the peaks and the slower periods tend to be slower. Weather tends to play a role in terms of September, October and when does it start to get cold.

So obviously we take all those things into consideration. Current trends of the business and it leads us to the guidance that we've given of the flat to plus three.

Andrew Burns - D.A. Davidson

Okay. Thanks. And good luck.

Gary Schoenfeld

Thank you.

Operator

Your next question comes from Dave King at Roth Capital. Your line is now open.

Joe Bess - Roth Capital

Hey. Good morning. This is Joe Bess on for Dave. My first question is thinking all about, so some of your competitors when we speak with them, they say that they’ve been saying -- noting that post key trends are around at times like back-to-school that traffic tends to slow down a little bit.

But with the improvements that you guys are seeing through the second quarter and into Q3, have you seen in any of your guys’ geographies where back-to-school has already occurred where off peak trends have kind of been a little bit more improved based on kind of year-over-year? Have you guys seen any sort of trends there?

Gary Schoenfeld

Not really in a position to comment on that, that specifically and the world isn’t so precise, it still isn’t even Labor Day yet. So as school calendars keep shifting, as our customer ages up, it's not that I am holding back from it, we're not smart enough to be able to comment on that with any real precision one way or the other.

Joe Bess - Roth Capital

Okay. No problem, and then just another question on denim. Are you able to give us the sense of the size of that as the total versus total revenue and then any sort of commentary on how much joggers could be offsetting the downtrend at this point in time?

Gary Schoenfeld

Yes, I think we've been indicated historically that denim tends to be plus or minus 20% of our business in the back half of the year and so I'll reference that, that we might have said a couple of years ago as it's down trending, then you can assume it's probably end up less than that.

Getting into specifics of joggers versus this, versus that, is not going to get that specific.

Joe Bess - Roth Capital

Okay. Great. Thank you.

Operator

Your next question comes from the line of Dorothy Lakner at Topeka Capital Markets. Your line is now open.

Dorothy Lakner - Topeka Capital Markets

Thanks. Just wanted to follow-up Gary to make sure I understood what you were saying about the branded part of the women's business. I know you talked about more branded on the non-apparel side, but do you also mean that you would like to see more brands on the apparel side of the business?

Gary Schoenfeld

I think it is part of how we are continuing to bring new customers in and grow the business is the strength of our brands. The reality is there is lot of places to just buy trendy apparel in malls and online. I believe since the day I got here and this is what made PacSun successful in its of prior iteration.

The vision here is that brands really be our point of differentiation. I don't think it ever gets close to the same penetration comparing women's to men's, but yes I continue to excite -- be excited about what our distinctive brands mean to our women customers as well and continue to see an interesting pipeline of opportunities there.

Dorothy Lakner - Topeka Capital Markets

Great. Thanks and good luck.

Gary Schoenfeld

Thank you.

Operator

And your next question comes from the line of Betty Chen at Mizuho Securities. Your line is now open.

Betty Chen - Mizuho Securities

Oh! Thank you. I was hoping to follow-up in terms of product cost, whether you are seeing any sort of benefit or pressure for the fall or holiday season and then in terms of the marketing campaign, it sounds like you're pleased with the reaction, any additional color you can share with us in terms of who you may be attracting new or existing and whether you're continuing to see that customer age up as you’ve been targeting over the last several years. Thanks.

Gary Schoenfeld

Yes, I think we continue to believe that we are being successful in really making a college girl and guy, the sweet spot of our customer and I think it's generally agreed if you can really resonate with them in college, you can then hold on to them, well beyond that and if you're confident at college then for junior and seniors and high school that's where they are setting their sight.

So I think that from a customer standpoint, that is largely who is shopping PacSun today and we're pleased about sitting in that position.

As for the first part of your question regarding product cost, we're not seeing that being a material factor in affecting the business right now.

Betty Chen - Mizuho Securities

Okay. And then I guess if I could another follow-up, in terms of branding Kendall & Kylie, I think you mentioned you were pleased -- are you still seeing those brands show growth year-over-year and continue appetite from your customers especially given the exclusivity that you have with those partners?

Gary Schoenfeld

Yes, we are. We continue to be very pleased with how they perform and the relationships we have with both of them and continuing to evolve the merchandizing together I think in smart ways.

Betty Chen - Mizuho Securities

Great. Thanks so much Gary.

Gary Schoenfeld

Thank you.

Operator

This concludes the questions and I would like to return the call to Gary Schoenfeld.

Gary Schoenfeld

Great. I appreciate everybody joining us this afternoon and enjoy the Labor Day weekend. We look forward to speaking with you at the end of Q3. Thank you very much.

Operator

This concludes today’s conference call. You may now disconnect.

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