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

F4Q07 Earnings Call

March 13, 2008 4:30 pm ET

Executives

Sally Frame Kasaks - Chairwoman of the Board, Chief Executive Officer

Michael L. Henry - Chief Financial Officer, Senior Vice President, Secretary

Analysts

Lauren Levitan - SG Cowen & Co.

Liz Pierce - Roth Capital

Jeffrey Van Sinderen - B. Riley & Co.

Christine Chen - Needham and Company

John Morris - Wachovia Capital Markets

Marni Shapiro - The Retail Tracker

Janet Kloppenburg - JJK Research

Julie Bryan - Jennifer Black & Associates

Liz Dunn - Thomas Weisel Partners

Paul Lejuez - Credit Suisse

Operator

Ladies and gentlemen, welcome to the Pacific Sunwear of California conference call announcing the company’s fiscal fourth quarter and year-end 2007 financial results. This call is being recorded and the play-back will be available starting today approximately two hours after the call through midnight, March 20, 2008. It can be accessed at 800-642-1687, or 706-645-9291, passcode 36639660. The call will also be archived on the Pac-Sun website at www.pacsun.com through midnight March 12, 2009.

Your speakers today are Ms. Sally Frame Kasaks, Chief Executive Officer; and Mr. 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 Ms. Kasaks, I’d like to note that during this earnings conference call, certain statements and responses to questions may contain forward-looking information, including forecasts of future financial performance and estimates of amounts not yet determinable, as well as our future prospects and proposed developments or business strategies, including with respect to our Demo and One Thousand Steps concepts. 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.

Pacific Sunwear's future financial condition and results of operations, as well as any forward-looking statements, are subject to change and inherent known and unknown risks and uncertainties. Pacific Sunwear does not intend and undertakes no obligation to update its forward-looking statements to reflect future events or circumstances.

All forward-looking statements made in this conference call reflect Pacific Sunwear's current analysis of existing trends and information and represent Pacific Sunwear's judgment only as of today.

You should not assume later in the quarter or year that the comments Pacific Sunwear makes today are still valid. Actual results may differ materially from current expectations based on a number of factors affecting Pacific Sunwear's businesses, including changes in consumer demands and preferences, lower than anticipated comparable store sales, higher than anticipated markdowns, competition from other retailers, and uncertainties generally associated with apparel retailing. In particular, the timing and amount of actual charges and expenses relating to the company’s Demo and One Thousand Steps stores may differ from our initial estimates as plans and activities are finalized.

More information on factors that could affect Pacific Sunwear's business and financial results are included in its annual report on Form 10-K for the fiscal year ended February 3, 2007 and other public filings made with the Securities and Exchange Commission.

In addition, please note that during this call today, additional references may be made to non-GAAP financial measures. Investors are encouraged to review these non-GAAP financial measures, as well as the reconciliation of these measures to the comparable GAAP results in our 8-K filed with the SEC today, a copy of which can be found on our website at www.pacsun.com.

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 prior written consent of Pacific Sunwear. If you do not agree with these terms, please disconnect now. By remaining on the line, you agree to be bound by these terms.

With that said, I’ll now turn the call over to Ms. Kasaks.

Sally Frame Kasaks

Good afternoon and thank you for joining us. This is Sally Frame Kasaks, Chief Executive Officer of Pacific Sunwear. With me on this call today is Mike Henry, our Chief Financial Officer.

During today’s call, I will review the initiatives we pursued in fiscal 2007 to improve our business and the progress we have made. I will then outline our priorities and areas of focus for fiscal 2008. When I conclude my remarks, Mike will discuss the financial results and provide guidance for the coming year. We will then take your questions.

Before I get started though, let me take a moment to update you on the three key strategic initiatives that we undertook over the course of last year. First we announced our intent to close our Demo and One Thousand Steps divisions. Second, we announced that we would consolidate our distribution operation to our single existing facility in Olathe, Kansas during the first quarter of 2008. And third, we announced our plan to exit the sneaker and fashion footwear business in order to provide an edited fashion right assortment in these categories.

So where do we stand now? We completed the wind down of One Thousand Steps with the closing of the division at the end of the fourth quarter. We expect the closure of Demo to be completed by the end of the first quarter. We are also transitioning all distribution operations to our Olathe, Kansas facility and also expect this move to be completed by the end of the first quarter.

Finally, the reduction of the footwear business is underway and will be substantially completed by the time we get into the back to school season. Importantly, these actions now permit us to focus our on core Pac-Sun business.

Let’s now turn to what we are doing at Pac-Sun to improve performance and take advantage of the opportunities we have identified. As you may recall, our efforts have been focused on four key objectives; growing our juniors business, reconnecting with our customer, improving our customer shopping experience, and investing in the company to improve operating efficiencies. Each of these objectives supports our overarching goal of achieving results through improved store productivity.

Turning first to juniors, during 2007 our juniors apparel business grew by $76 million over the prior year, an increase of 20% on a comp basis. Although this is significant growth year over year, our juniors penetration at 46% of total apparel sales for the year still remains far below that of our competitive peer group, that on average exceeds 60%. We are focused on this opportunity in fiscal 2008, as I will address a bit later.

Let me also point out that our young men’s business continues to show steady growth, although at a lesser comp rate. Looking forward, we are focused on growing both young men’s and juniors to achieve long-term operating improvement.

Next I will address our customer and the shopping experience. An important element here is having store associates who relate to our customer. We believe that more attention to the fashion savvy customers from associates who can better relate to them will lead to improved sales and greater store productivity. Training and development of this team has been identified as a key objective in our continuing effort to attract new customers.

The implementation of our monthly floor set permitted us to align product newness and flow with improved in-store presentation and marketing. Though execution remains inconsistent, we have seen the benefits of this effort with improved product sell-through.

Our continued sponsorship of the U.S.A. Surf Team and the U.S.A. Amateur Snowboarding Association reflects our commitment to the action sports industry and provides in-store visual cues that are rooted in our heritage. During the quarter, we debuted the Pac-Sun lounge at the Winter X Games in Aspen, inviting our customers to be a part of a major action sports event at the VIP level.

In our stores, we have started doing tie-ins with leading brands and athletes and have just completed a successful tour with Ryan Sheckler representing Volcom. During the quarter, we also launched the PAC Tour, a 26 in-store and club music tour allowing us to connect with our customers through music. Pacsun.com also remains an important way of communicating with our customers.

In terms of investments, our store refresh program is the principal long-term driver for improving our operating performance and productivity. We now have updated approximately 15% of the Pac-Sun fleet, including 75 refreshed stores in fiscal 2007. Investment in this program has created an enhanced store environment to improve lighting, fixtures, sitting rooms, and music, allowing for better merchandise presentation and an improved shopping experience for our customer. Our goal is to continue to refresh approximately 70 or 75 stores a year.

A second area of capital investment is information technology. As I have noted in the past, we have operated with inadequate systems for the size and complexity of this business. Under new leadership, the goal of this team is to implement systems that provide more detailed merchandise information, improve store productivity, and provide operating efficiencies.

Recent system implementations include TradeStone for merchandise sourcing, QuantiSense for business intelligence and data warehousing, and Lawson as the new backbone of our financial systems. We believe improved efficiency and data gathering and analysis will help us better manage our business in many aspects.

Over the past two years, we have made significant investments in our design, merchandising, sourcing, and marketing talent. We believe that the $115 million growth in our apparel business achieved in 2007 demonstrates that these initiatives are beginning to impact the business. Now we are expanding our focus to improving operating efficiencies.

In the latter half of 2007, we turned more attention towards supply chain. The primary goal for the supply chain team is to develop a customer focused model that improves the way we get product to market. One of the first recommendations of this team was the consolidation of our distribution operations into our existing Olathe, Kansas facility. This move will facilitate shorter average time to market for our merchandise, provide necessary space to implement additional cross-stocking functionality, and should achieve certain cost reductions.

Another goal of the team is to increase shipments of store ready merchandise by processing goods at the factory level prior to delivery to the distribution center and ultimately our stores. Our Pac-Sun store teams will be able to focus their efforts on customers rather than on tasks related to receiving and processing.

With 2007 behind us, let’s turn to our objectives for 2008. Building on the initiatives of 2007, our objectives for 2008 are to focus on apparel, drive store productivity, strengthen internal talent, and continue to invest capital in store refreshes and technology.

During 2008, we expect apparel will continue to be the primary growth driver and will account for approximately 80% of our sales for the year. Our objective is to have apparel growth for the year offset the sales declines caused by our planned exit of sneakers and fashion footwear. February sales were an encouraging indicator as we delivered a strong comp result that more than offset the significant planned decreases in footwear and accessories.

We have stated in the past our objective for junior apparel sales to be at least 50% of our total apparel mix. We are encouraged that with our current floorset, we are off to a solid start to achieve this balance between juniors and young men.

We have continued to validate that our junior customer is primarily driven by fashion, while our young men’s customer is predominantly driven by brands. Our objective going forward is to have trend right fashion for our junior customer and the most coveted brands for our young men’s customer. Within this mix, we anticipate our juniors business to be equally balanced between branded and proprietary goods and our young men’s business to be approximately 70% to 75% branded goods.

The successful relaunch of juniors denim under our proprietary Bullhead brand and the success of Bullhead, Kirra, and Vurt in young men’s, and Kirra Girl and Lilu in juniors confirms that we are achieving the right brand mix between proprietary and national brands.

Finally, we have altered our perspective on how we will select the brands that we include in our mix. Historically, we’ve focused only on brands that have the ability to quickly scale to all stores. We now also seek opportunities to partner with smaller, under-distributed brands that may have regional or smaller distribution benefit, in addition to our longstanding foundation of strong national brands.

In terms of store productivity, with limited new square footage expansion opportunities within Pac-Sun and the closing of approximately 30 to 40 stores a year in the normal course of business, our priority is to grow sales and earnings to our existing real estate portfolio over the next three to four years.

To put this in perspective, we achieved sales per square foot of approximately $350 in 2007. This level of productivity is significantly below our competitive peer set that on average exceeds sales of $500 per square foot. We believe the opportunity to increase sales per square foot to $500 over time is a reasonable objective. We believe that our focus on apparel, market positioning, and business strategies will lead to both increased store productivity and margin improvement.

Clearly business strategies and [change] require a focus on talent. We are committed to building internal talent in all areas of the business. We have invested in buying, design, marketing, and planning and allocation, as well as other support functions in the business.

This year, we will strengthen our focus on our stores organization as we go beyond store refresh initiatives and floorsets to strengthen our connection with our customers. Our store associates and our field teams are all a critical part of this effort.

During 2008, we will also continue to make capital investments focused on our store refresh program and the renovation of our footwear walls to accommodate more productive categories. We will also continue with investments in information technology that are an integral part of our go-forward business strategies.

In conclusion, 2007 was a year of change and progress at Pac-Sun. In 2008, we are taking steps to build on this momentum and drive sales and margin improvement through our merchandising efforts and through ongoing investments in our stores, people, and infrastructure.

Underlying our strategy is a clear focus on our mission, which is to be an apparel focused teen lifestyle retailer with an accessories and footwear component. Our objective is to be a branded house of brands, where youth culture, fashion, and the Southern California vibe come together.

At this point, I would like to turn the call over to Mike Henry, our Chief Financial Officer.

Michael L. Henry

Thank you, Sally. During this call, references will be made to both GAAP and non-GAAP financial results. We strongly encourage investors to review the company’s Form 8-K filed today with the Securities and Exchange Commission, which provides reconciliations between the GAAP and non-GAAP financial measures and also provides quarter by quarter financial results for our go-forward PacSun business on a standalone basis for the last eight quarters, similar to what we provided back in November with our third quarter earnings release.

This 8-K is accessible through the investor relations page of our website at www.pacsun.com.

First I’ll cover the GAAP based results, which exclude the impact of One Thousand Steps from both 2007 and 2006. One Thousand Steps was designated as a discontinued operation in the fourth quarter of fiscal 2007. Accordingly, GAAP based results are provided on a continuing operations basis, which includes both PacSun and Demo as of the end of fiscal 2007. As a reminder, we expect that Demo will be designated as a discontinued operation in the first quarter of fiscal 2008 ending May 3, 2008. Our non-GAAP results, which I will discuss later during this call, will exclude both Demo and One Thousand Steps.

On a GAAP continuing operations basis, total company sales for the fourth quarter of fiscal 2007, which was a 13-week period ended February 2, 2008, were $420 million, a decrease of nearly 8% from total sales of $456 million for the fourth quarter of fiscal 2006, which was a 14-week period ending February 3, 2007.

On a GAAP basis, total company gross margin, including buying, distribution, and occupancy costs, decreased 370 basis points in the fourth quarter to $119 million, or 28.4% of sales from $146 million, or 32.1% of sales in the fourth quarter last year.

Merchandise gross margins decreased 90 basis points, primarily due to increased markdowns associated with Demo and our PacSun footwear business, partially offset by improved IMUs.

Non-merchandise margin categories, which include buying, distribution, and occupancy costs, were up 280 basis points. Occupancy was up 150 basis points, buying costs were up 90 basis points, and distribution costs were up 40 basis points.

On a GAAP basis, SG&A expenses decreased 300 basis points during the fourth quarter to $106 million, or 25.1% of sales from $128 million, or 28.1% of sales in the fourth quarter last year.

Asset impairment charges were $22 million, or 480 basis points lower in the fourth quarter this year versus the fourth quarter last year, primarily due to impairments associated with the 74 Demo stores closed early in fiscal 2007. As a reminder, we had announced our intention to close those 74 stores at the end of fiscal 2006 and took the impairment charge at that time.

Depreciation increased 80 basis points, primarily due to both new depreciation associated with our store refresh program and accelerated depreciation associated with increased store closures.

General and administrative expenses were up 80 basis points, primarily due to severance charges and planned increased in e-commerce and consulting expenses in descending order of impact. The remaining 20 basis points of SG&A increase was primarily due to credit authorization expenses due to having a higher penetration of credit card purchases in the current year.

On a GAAP basis, our income tax rate for the quarter increased to 47.2% from 39.5% last year. This increase was primarily due to lower net income for the year due to the impairment charges associated with Demo.

On a GAAP basis, net income was $7.6 million for the quarter, or $0.11 per diluted share, compared to $11.5 million or $0.16 per diluted share last year.

Now I’ll discuss certain non-GAAP measures for comparisons on our go-forward PacSun business. These measures exclude the financial impact to both the current and prior year of Demo and One Thousand Steps. We expect Demo to be designated as a discontinued operation in the first quarter of fiscal 2008. One Thousand Steps was designated as a discontinued operation in the fourth quarter of fiscal 2007. Accordingly, we believe that a discussion of comparative results on a PacSun standalone basis represents a more relevant view for the potential performance of our business going forward.

For 2007 and 2006 comparative purposes, we also believe it is helpful to present results as if both fourth quarters and fiscal years were comprised of the same number of weeks -- 13 weeks and 52 weeks respectively.

Again, we strongly encourage investors to review our Form 8-K filed with the Securities and Exchange Commission today. This 8-K contains reconciliations of these non-GAAP measures and also includes historical operating results for our PacSun business on a standalone basis for each of the last eight quarters. This information is accessible through the investor relations page of our website.

Net sales of our PacSun business for the fourth quarter were $384 million, an increase of 4.5% over net sales of $368 million for the fourth quarter last year. The prior year result excludes $18 million of sales attributable to the extra week in last year’s fiscal fourth quarter, which contained 14 weeks versus the customary 13 weeks.

PacSun same-store sales during the fourth quarter for like weeks ended February 2, 2008 increased 2%. Total transactions for PacSun were down low single digits, offset by low single digit increases in average unit retail and average items per transaction.

On a non-GAAP basis, gross margin for our PacSun business was $128 million for the GAAP this year versus $123 million in the fourth quarter last year. As a percent of PacSun sales, PacSun gross margins declined 20 basis points to 33.2% of sales for the fourth quarter this year versus 33.4% in the fourth quarter last year.

Merchandise margins increased 100 basis points due to lower markdowns and higher IMUs. Non-merchandise margin categories, which include buying, distribution, and occupancy costs, were up 120 basis points. Occupancy was up 60 basis points, buying and distribution costs were each up 30 basis points. Occupancy was deleveraged versus the low single digit comp. Buying costs were up due to our investments in this function. Distribution costs were up primarily due to operating two distribution facilities in the fourth quarter this year versus one in the fourth quarter last year.

On a non-GAAP basis, SG&A expenses increased 100 basis points to $94 million, or 24.5% of sales for the fourth quarter this year versus $86 million, or 23.5% of sales for the fourth quarter last year.

Depreciation increased 60 basis points -- excuse me, primarily due to both new depreciation, such as our store refresh program, and accelerated depreciation associated with increased store closures.

General and administrative expenses were up 70 basis points, primarily due to planned increases in home office headcount, e-commerce, and consulting expenses, in descending order of impact. Credit authorization expenses increased 20 basis points. Offsetting these increases was a 50 basis point decrease in asset impairment expenses.

On a non-GAAP basis, our income tax rate for the fourth quarter was 37.2% compared to 38.9% last year. The lower non-GAAP tax rates are primarily attributable to the exclusion of the GAAP losses associated with impairment and other reserve charges associated with Demo and One Thousand Steps.

On a non-GAAP basis, PacSun net income was $22 million, or $0.31 per diluted share for the fourth quarter this year compared to $23 million, or $0.33 per diluted share during the fourth quarter last year.

We ended the quarter with a strong balance sheet, including approximately $188 million in working capital, of which $98 million was cash. Inventory per square foot at the end of the year was down 7% versus the prior year on a PacSun standalone basis. We carry no [borrowing] base debt and have zero exposure to auction rate securities.

Cash flows from operations were $116 million for the year. Capital expenditures were $106 million. Depreciation was $80 million.

During the quarter, we opened four new PacSun stores and closed seven PacSun stores. For the full year as a total company, we opened 18 new stores and closed 110 stores; 76 of those were Demo and nine were One Thousand Steps.

Now turning to earnings guidance for fiscal 2008, these earnings ranges are presented on a GAAP continuing operations basis, which includes only the PacSun business. We expect Demo to be designated as a discontinued operation during the first quarter of fiscal 2008. Therefore, these earnings ranges will not include any lease termination, severance, or other charges associated with the liquidation of the Demo business.

For the full 2008 fiscal year, based on a 3% to 4% comp increase scenario, the company would expect earnings from continuing operations in the range of $0.73 to $0.77 per diluted share. For the year, we expect to improve gross margins by approximately 100 to 150 basis points and to leverage SG&A by approximately 50 to 100 basis points at this comp level.

In order to begin leveraging SG&A for the year, we would need a comp of approximately 5% to 6%. Obviously we would need significant larger comps in the first half of the year to leverage SG&A due to the relative size of the quarters as we progress through the year.

We currently expect our effective income tax rate to be 39% for the year.

For the first quarter of fiscal 2008, also based on a 3% to 4% comp increase scenario, the company would expect to incur a loss from continuing operations in the range of $0.06 to $0.08 per diluted share. At this comp level, we expect to improve gross margins for the first quarter by less than 100 basis points versus the first quarter last year due to specific charges we expect to incur, as follows.

First, we expect to incur additional footwear inventory reserves of approximately $2 million associated with our pending reductions in this category. Next, we’ll also incur approximately $1 million in severance and other transition charges associated with the pending consolidation of our distribution function to our existing Olathe, Kansas facility, which we expect to complete in April.

Within SG&A, we expect to deleverage for the quarter by approximately 250 to 300 basis points versus the first quarter last year.

We expect to incur approximately $2.5 million in increased depreciation versus last year’s first quarter, due primarily to our ongoing store refresh program and accelerated depreciation associated with increased store closures.

Other SG&A variances expected for the quarter include store payroll of approximately $2.4 million, due primarily to the impact of minimum wage increases and home office payroll of approximately $1.5 million, due to important investments we have made over the past year in particular areas expected to help drive the business toward improved store productivity and operating efficiencies.

For fiscal 2008, we expect total capital expenditures to be approximately $90 million to $95 million and depreciation to be approximately $75 million to $80 million. We expect total square footage for the PacSun business to decline 1% to 2% over the course of the year due to closing approximately 35 stores in the normal course of business, opening approximately 15 to 20 new stores, and relocating or expanding approximately 15 to 20 stores.

We will also refresh approximately 60 to 70 stores this year, including 22 stores that will go dark in April to begin the refresh process.

Expected closures by quarter are estimated to be 15, 10, 5, and 5 as you progress through the four quarters. We expect new openings to be spread fairly equally across quarters. The number and timing of stores to be closed, opened, relocated, or refreshed are subject to change at any time and we undertake no obligation to update these numbers in the future.

With regard to the Demo liquidation process that we expect to complete during the first quarter, we currently anticipate incurring approximately $35 million to $40 million in lease termination charges, approximately $5 million in operating losses and agency fees associated with the inventory liquidation process, and approximately $2.5 million in severance and retention charges during the first quarter, upon closure of the stores.

The timing and amount of actual charges and expenses related to the Demo liquidation may differ materially from our initial estimates as plans and activities are finalized.

Operator, we’ll now take questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Lauren Levitan, Cowen & Co.

Lauren Levitan - SG Cowen & Co.

Thanks. Good afternoon. Sally, I was hoping you could give us your thoughts on the strategies that will enable you to drive the higher productivity target that you talked about. Should we be watching for a different approach in terms of additional categories, density approach, pricing approach? Give us some sense of what we should be watching for as the possible drivers of the higher productivity that you talk about relative to your peers. Thanks very much.

Sally Frame Kasaks

Thanks, Lauren. Probably a couple of fronts we’ll be looking at. First of all, I think the issue of density is probably one that you’ll begin to see a little bit -- some greater quantities, particularly as we’ve gotten more and more confident in the junior business but also in young men’s, so I think that’s part of it. In addition, we will be expanding a category such as dorm wear, for example. During the holiday season we had some really strong success there.

We are not looking to add a lot of new categories but we think we have plenty of opportunity to build within our existing denim business, particularly in young men’s, where we probably left some money on the table. We also think in young men’s we may have been a little conservative in some of the fleece hoodie categories.

Probably too we will see a little greater emphasis on certain dimensions of outerwear in certain parts of the country, particularly in the November/December period, so we are looking at very targeted opportunities over the next few months.

I think on balance though, we do see though the junior business, as we’ve said, continuing to grow at a higher rate and I think there you’ll see a combination of slight price point discussion but more a matter of just density and maybe the addition of a half a dozen styles. I mean, we’re not talking about adding a lot of new categories to do this. We still feel we’re under penetrated in those units.

Operator

Thank you. Your next question comes from the line of Liz Pierce, Roth Capital Partners.

Liz Pierce - Roth Capital

Good afternoon. Sally, in your comment about talent in terms of design and marketing, I wonder if you could just elaborate on what kind of things that you are thinking about. And then also, in terms of the store organization, kind of the same -- really basically the same question.

Sally Frame Kasaks

Well, our young men’s design team has been pretty well-established over the past year. We have now a new design director in juniors and we have really begun to put some muscle behind the whole design talent for our proprietary brands. We also made some additions in our sourcing areas, so I think we are at least for that part of the business, which is our proprietary, we are in much better shape in terms of being more efficient, faster to market on new styles and so forth.

So that’s really where that effort is there. In fact, we’re actually starting to build a space here for our designers. In the past, they were sitting in cubicles that looked more like Mike’s accounting area, so what we are trying to do is give them the space and create an environment where the design talent can work. We’ve also started -- we’re starting to add more to our marketing arena as well.

In terms of stores, I think I’d also touch -- the supply chain initiatives are really important because so many of our store associates have been engaged in a lot of tasks day-in, day-out tasks and I think once we begin to remove footwear from the stores and begin to organize our back room so that the floor ready product can be housed properly instead of in cartons throughout the back room, on shelves, tagged, labeled -- a lot of things we can do to make the back room more efficient. We can spend more time with them. They will spend more time on the selling floor.

In the past there were just too many tasks and these are the things we’re looking to eliminate. We’re also looking for technology improvements, which will start, speed up transactions, for example, get information to our store associates on a more timely basis. So there’s a whole series of initiatives where frankly last year, we were more focused on product, planning, allocation and those aspects. Our focus is much more going to be directed towards stores -- hiring, recruiting. I think this will be kind of exciting out there over the next 12 months.

Operator

Thank you. Your next question comes from the line of Jeff Van Sinderen, B. Riley.

Jeffrey Van Sinderen - B. Riley & Co.

Actually, I wanted to ask you -- your guys business, right now you guys have a great polo shirt display from Volcom and I’m just wondering, can you give us anymore color on how your business with Volcom is evolving in both genders?

Sally Frame Kasaks

Volcom is -- you know, is one of our key vendors and we’ve started working with them, that polo was an example. We also have a great short in the young men’s business. I think this season the young men’s is a bit stronger than our juniors but we’ve worked -- I think we found the center of gravity with them and I must say that polo program, and particularly that short and polo program has been strong, and the Ryan Sheckler in-store events has been strong.

So we are continuing to forge our business with them. I know it was a little difficult for a couple of years as we were sorting through things but I think we’re on pretty steady ground right now.

Operator

Thank you. Your next question comes from the line of Christine Chen, Needham and Company.

Christine Chen - Needham and Company

Thank you. I wanted to ask -- are you doing your floorsets on a different timeframe this year because of the earlier Easter? I noticed that Pac Bucks was moved up because of Easter. Can you just go through that for Q2 and maybe back to school?

Sally Frame Kasaks

No, those are -- there’s a certain cadence that was moved up because Easter and spring break is a key driver, so clearly our marketing efforts do align around those key holiday or those key activities, so yes, those are always moved in relationship. You sort of count the days and work it.

On the other hand, last year we were just trying to get caught up with floorsets. Our goal now is to do one at the beginning of almost every month. Every month will have a floorset and then some kind of mid-month update from time to time because we are flowing goods. We’re much more in control of the flow of product. We’re much more in control of the unit sales planning we’re doing, so our floor sets, yeah, they are different from last year but only because last year we were just trying figure it out. We were initiating a new effort. This year we finally are in a cadence that allows us to receive, process, get goods into the store, and achieve our sales goals.

Operator

(Operator Instructions) Your next question comes from the line of John Morris, Wachovia.

John Morris - Wachovia Capital Markets

Thanks. A couple of questions, Sally, I think first of all for you; you mentioned the men’s business getting up to about 75% branded product. What would that be up from last year? And how does the breadth of the vendor base change in as much as you talked about and we’ve seen in the stores, to your credit, a lot of newness in terms of some of the new names and new vendors. How would that vendor base change and will those deliveries of that new unique product, new vendors, go to all stores?

Sally Frame Kasaks

Actually, our men’s branded business has been pretty much at 70% to 75% range, so we would imagine growth commensurate with the comp growth, but that’s been about the center of gravity for us. Juniors may have been more branded but the growth is coming from the blend also, so it’s 50-50 proprietary to national brand.

We would -- we’re not looking to roll out brands, particularly some of these new emerging brands to all stores at this point. We see that there are some regional variations and we think that by providing some of the smaller brands, a showcase without trying to put too much burden on their growth. I mean, we want them because they are selective, because they have an emerging trend, for example.

So as I said, in the old days we would try to scale them all out. You come in, we get a sell-through and we try to run them to all stores. I think along the way that did create some problems with our relationships with our brands and it’s not the right way to do it anymore. So yes, I’m sure over time some will become all stores but that’s not our efforts as we start off cultivating and curating these new brands.

Brand mix, by the way to that question in terms of total number of brands, John, is hard to say. I mean, I think we’ve tightened up so much that on inventory and we’ve tightened up so much, so we can afford to have a little flexibility where it doesn’t have to fit into a particular number of brands.

Operator

Thank you. Your last question comes from the line of Marni Shapiro, The Retail Tracker.

Marni Shapiro - The Retail Tracker

Congratulations because the stores really do look great. If you could talk a little bit about two things; the first was the smaller brands that you talked about, and I thought I saw one of these brands in footwear that you brought in that I had seen in a bunch of skate and surf stores, but if you are bringing in these smaller brands and I appreciate the diversity that it will offer the store, but is there risk in their delivery? Because some of these companies are not used to selling a chain as large as yours and if they commit to a date, that date isn’t always necessarily that date in-store.

And then the other question is with more branded goods in your store, especially on the boy’s side, what does that say for the overall -- what should we be thinking about the overall PacSun merchandise margin? And then how do you reconcile this as you renegotiate leases?

Sally Frame Kasaks

First of all, we’re not adding more brands. This is -- our mix has been typically in young men’s at 70% to 75%. That’s been out there. The growth we are getting is in fact in our own -- and by the way, don’t forget, one of our major proprietary brands is Bullhead, which is denim for guys and gals, so don’t read too much into this. I think we are taking this in a direction that might lead us to say and ascertain things that aren’t correct, so our margin goals remain consistent with over time what we’ve, you know, we’re talking about. And we’re seeing improvement there.

What we are -- and also by having less inventory, we’re getting more productive, better sell-through, so there are many ways to skin this margin gain, so please don’t anybody think that because we just restated what we’ve been doing that this is a significant change. I think the significant change to our business totally is that 50-50 guys, juniors, and young men’s. That’s reducing the footwear, which did not have the margin we needed and tightening up on accessories, so let’s understand margin is not just about branded goods. It’s about a range of initiatives.

I think the other thing though is we are not trying to scale these smaller brands to all stores. That’s a very important point. That was the old model. The new model is if they are smaller brands, we want to cultivate them, we want to help them grow. We recognize that some of them may miss a delivery but it’s not going to impact our business and we certainly don’t want to hurt them.

But these are small buys. These are not the -- they are going to be well-managed buys. They are bought as tightly as we would buy our core assortments and there is a lot of discipline and rigor around this, so please I don’t want people to see this as a risk. We see it as an opportunity to remain relevant and connected with our customer.

And in terms of our margin goals and working with our landlords, I think our -- if our sales per square foot can begin to achieve the numbers we know they can, I think our landlords will be happy, we’ll be happy, and the margins will be absolutely where they need to be. And as I’ve indicated, we’re very encouraged initially in February by what’s happening in apparel. I think when we get that 80-20 mix and kind of put the complexity of footwear behind us, we’ll have a much simpler model with higher margin potential all the way around.

Operator

Thank you. We do have another question from Janet Kloppenburg, JJK Research.

Janet Kloppenburg - JJK Research

There’s something wrong with the question-and-answer. I think there’s other people that are queued up, Sally. You might just want to ask them to let other people back in.

Sally Frame Kasaks

We’re seeing that there’s only one and suddenly now we’ve seen more come through. Thank you.

Janet Kloppenburg - JJK Research

There’s something wrong with the whole process but my first question, Sally, is if you could reiterate what you said -- you thought that the branded product in women’s would get to -- what did you say that would be?

Sally Frame Kasaks

We were saying that our proprietary national brands and juniors would be 50-50.

Janet Kloppenburg - JJK Research

Okay, 50% would be branded and 50% would be your proprietary labels. Now --

Sally Frame Kasaks

Which are Lilu, Kirra Girl, and Bullhead.

Janet Kloppenburg - JJK Research

And do you see an opportunity for those brands to go into different categories than they are now, or just for deeper penetration of those brands within their existing categories?

Sally Frame Kasaks

For the time being, we think that Kirra Girl really speaks more to the surf lifestyle, if you want to use it that way, and will pretty much stay there. But I think over the next year, certainly some of that will evolve. We don’t have a plan to go that much -- we see maybe slightly broader assortments. Particularly in Lilu, there tends to be more top driven. We think that we may be able to add a few more SKUs there but we’re not talking about building a much, much larger assortment.

Janet Kloppenburg - JJK Research

Okay. And when you say that the junior apparel is going to become -- I think you said apparel is going to be 80% of the sales. Is junior apparel going to be 50% of that number?

Sally Frame Kasaks

Of that 80%, yes, so it really becomes 80% of divided by two gives you our apparel, guys to gals.

Janet Kloppenburg - JJK Research

And that’s for this year -- you’ll get to that level in ’08?

Sally Frame Kasaks

We are so close right now that there’s no reason to see that that would not happen. By month, it might shift slightly but there’s no reason not to expect that.

Janet Kloppenburg - JJK Research

And does that change in mix do anything to change the cadence of product flows? Is it more frequent? Is there newness coming in every week? How will that change, Sally?

Sally Frame Kasaks

I think the flow will remain essentially as it is, though we probably will be able -- but this is what we are learning now, Janet, because we are getting a better sense of sell-throughs. We now have -- we’re beginning to look at sales productivity per table and we are bringing a lot of metrics that a lot of us are familiar with and we think that over the next few months, we’ll have a better sense of that. But we are moving up deliveries earlier because we feel we may be a little light out there, so we are playing with what is the right level of inventory and number of SKUs. But I would imagine that over -- you know, over this next period of time, we might see more frequent delivery of certain styles, certain colors, maybe a print here and there. We are not talking about moving up goods that much more though. It might be just additives as the month goes on.

Don’t forget too we do hold goods back in the DC for replenishment as well, so there’s a combination of things at work here.

Operator

Thank you. Your next question comes from the line of Julie Bryan, Jennifer Black.

Julie Bryan - Jennifer Black & Associates

Good afternoon and nice quarter. Sally, in the past you have talked about the company being immersed in the youth culture and at the beginning of the call, I heard you mention, talking about the relationship with the Amateur Snowboarding Association and the U.S. Surf Team and then you talked about music as a tie to youth. I was wondering if you could add on to that a little bit and talk about to what extent do those relationships turn into tangible sales and what are maybe some specific things that you are doing so that does turn into sales?

Sally Frame Kasaks

Well, I think part of it -- look, I think it’s important to recognize our heritage has been in surf, skate but we are expanding to more of the active styles, just generally the action sports, which is what kids are interested in. You know, for example, the music tour. We actually did have -- they actually happened to be very talented musicians that happened to be working for us. I happened to meet this young man and it turns out he just performed at Staples Center and it turns out that they really are a great band. And they went out and we sponsored them on the tour. We had in-store events and I think it begins to create the buzz and cool factor that over time helped us to be a primary destination for our customer. Certainly the in-store marketing is important.

So we believe that young people -- you know, the youth culture today wants to be at a place where it’s happening, where the store and the environment reflects what they are interested in, and we just believe it’s all one and the same. We’ve done a lot of research work with these kids, and I don’t mean that in a demeaning way. We have style leaders working for us now. We are really trying to understand because none of us is the customer and we happen to believe and we’ve seen that these activities and events just put us on the radar screen with the targeted customer we have, and that’s really what it’s for. I have to believe that’s going to add to that $500 a square foot over time.

Operator

Thank you. Your next question comes from the line of Liz Dunn, Thomas Weisel Partners.

Liz Dunn - Thomas Weisel Partners

Good afternoon. I just had a question regarding denim. Do you see any shift in the relevant fashion coming in 2008? Directionally, where is denim going for 2008, particularly on the girls side?

Sally Frame Kasaks

We have opportunity in young men’s. As I said, I think we left some money on the table this past year. We’re seeing new washes in both guys and gals, young men’s and juniors. We’ve been testing styles out there. I’m not going to tell the world what styles we are going to be selling because that’s our business and everyone is trying to figure that out.

But I will tell you the proportion that is emerging that continues to emerge right up our alley and we just see denim continuing to grow. We’re going to be adding additional SKUs. I think the one thing that in hindsight we might do differently is when we begin to exit styles, we may begin to exit non-performing sooner than we have in the past so that we can create space in our stores to bring in, you know, the right trend a little bit. We may have been a little conservative last year. I think that would be all of our hindsights at this point.

But denim continues to be driven by new washes, a range of dark colors, indigos. Our team has just left for Europe yesterday and Saturday, so I’m sure they’ll be coming back with a lot of new ideas and we are keeping enough of our production open on all categories to be able to respond to trends that we see there now.

Operator

Thank you. Your next question comes from the line of Paul Lejuez, Credit Suisse.

Paul Lejuez - Credit Suisse

Just to follow-up on Liz’s question, can you just remind us what percent of sales denim was in ’06 and ’07, where you expect it to be in ’08? And then second, can you give any color on the outlet stores? How have trends been there versus your non-outlet, regular mall stores? And how many are in true outlet centers?

Sally Frame Kasaks

I think we have 60 that are in true outlet centers. I believe that’s the current number and we can get back to you with the actual number, because we have sort of a hybrid universe out there, Paul.

And we’ve seen, depending on parts of the country, some of the so-called -- and I’m going to call it the value rather than just the outlet business. There have been months where it’s trended slightly better than the core Pac mall business, so we continue to see opportunity. We don’t talk about it much but we are continuing to see opportunity out there, Paul.

In terms of denim, just off the top of my head because it’s a moving number, it’s about 20% of the volume, if I’m not -- I think I’m directionally correct. Just about, pretty close because it changes slightly, about 20% of the volume. And it’s probably -- my sense is that’s somewhat the center of gravity. You might go up a couple of points if in fact the trend is a little bit stronger, it might drop a couple of points if a little weaker, but it’s about 20% of the business. We can get back to you with an exact number.

Michael L. Henry

Yeah, I’m actually looking at a chart here that says it was 16% of ending inventory as of the end of the year and 13% of ending inventory as of the end of the prior year. I don’t have sales --

Sally Frame Kasaks

But that’s about -- but that’s the center of gravity, though.

Operator

Thank you. Your next question comes from the line of John Morris, Wachovia.

Analyst for John Morris - Wachovia Capital Markets

This is Jennifer calling for John Morris. We were just kind of wondering if you could comment on how denim sales are doing outside of Bullhead denim, and is it a good category right now or is it a little bit weaker?

Sally Frame Kasaks

Basically Bullhead is our denim business. We do carry some Levi’s and it’s doing reasonably well but our business is essentially Bullhead with a few -- that’s where it is. I mean, that’s exactly what we’ve targeted. Bullhead is our brand. We do do some work -- you know, we do some things with Levi’s but from a business point of view, Bullhead is our brand.

Analyst for John Morris - Wachovia Capital Markets

Okay, thanks.

Operator

Thank you. Your next question comes from the line of Liz Pierce, Roth Capital Partners.

Liz Pierce - Roth Capital

Just a clarification; so --

Sally Frame Kasaks

Sorry you got cut off. I realize we were -- I’m being told we had some problems. I know Janet said something, so I’m sorry.

Liz Pierce - Roth Capital

Just to clarify on footwear and accessories, so obviously down to 20% right, of total sales?

Sally Frame Kasaks

Correct.

Liz Pierce - Roth Capital

And then, if I remember correctly, footwear is going to be in that low to mid single digits?

Michael L. Henry

We said previously it would be 6 to 8.

Liz Pierce - Roth Capital

Okay. I guess what my real question is, is there any kind of seasonality that we will see in that? I mean, it would just seem -- are you going to -- like flip-flops, obviously a lower ticket price versus something heavier in the winter, or is it just going to be those surf kind of items all year round?

Sally Frame Kasaks

Well, the flip-flops will be a part of the assortment much of the year, you know, flexing on seasonality. We also will be carrying a selected number of sneaker type footwear, probably a dozen, 400 to 600 stores, really as -- kind of how it started, quite honestly, a much more edited assortment. So you will see footwear, you will see a very edited assortment of it, but that should be about 6% to 8%. So you’ll see some seasonality because certainly flip-flops outperform sneakers in this time of year in particular. But we will continue to have in young men’s a tight assortment.

Liz Pierce - Roth Capital

On the sneaker side, is it going to be -- how much versus guys versus girls?

Sally Frame Kasaks

It’s almost all guys.

Liz Pierce - Roth Capital

It’s almost all guys? So really, she’s just not going to and you’re not going to bother wasting that square footage?

Sally Frame Kasaks

I would rather put other things on those walls. It will be edited. It will be tight fixture. It won’t even be a wall. So if you look at a dozen styles, there’s ways we can do it but absolutely we know that we can convert that. Frankly in the stores we’ve started to remove footwear from, we’ve seen juniors business escalate, so we are very bullish that this is the right move and as long as for the young men’s business, the sneaker assortment fits to what our apparel is about so we don’t end up looking like some of our sneaker competitors out there.

Liz Pierce - Roth Capital

And when do you -- I mean, just based on some of the numbers that Mike gave out, so when should we see this gets to kind of, to use your words, that center of gravity? When does the assortment become -- if between footwear and accessories, the assortment that you think is perfect? Is that for back to school?

Sally Frame Kasaks

Surely for back to school, though you will begin to see us consolidating, so some of you may be out there and say oh, what are they doing -- well, what we are doing is we are consolidating footwear to a smaller fleet of stores. We’ve begun that and you may see those back walls turning either into swimwear or dorm wear or some category of juniors. In most cases, they are going to go to some category of juniors because in many of our stores, don’t forget, we’re one shop short. Until we get all of these refreshes done, juniors does not have quite the exposure that it does in our new stores, newer stores.

So you will see this, so by back to school, our strategy should become pretty clear to people out there, by August 1st to August 15th.

Operator

Thank you. Your final question comes from the line of Janet Kloppenburg, JJK Research.

Janet Kloppenburg - JJK Research

Mike, I had a question for you but I got cut off there. When you look at the pressure of expenses on the first quarter, which you laid out, the $2.5 million or the $2 million in inventory reserve and the severance and I think there was maybe a higher depreciation, which of those expenses if any, I think maybe severance, will not be -- will be eliminated at the end of Q1?

What I’m trying to get at is in order to get to your annual guidance, your Q2, 3 and 4 quarters are going to be up some and I’m just trying to think about what expenses will not burdening those quarters.

Michael L. Henry

You’re absolutely right in your suspicion that the severance and retention will be contained to Q1 once we complete the transition fully to -- about week three of April is what we’ve targeted as the date. At that time, all the remaining severance and retention obligations will be there. There may be a small amount of expense at the beginning of Q2, relocating some people or something to that effect, but it would be less than $0.5 million is our current estimate of what that might be. But that would be the one category that would not carry through.

In terms of payroll expenses, there’s different --

Janet Kloppenburg - JJK Research

What about the inventory reserve on the footwear? Will we have that cost every quarter?

Michael L. Henry

That should take care of the footwear transition within Q1. I would not expect at this point that we would see repetitive additional significant footwear reserves as we go to Q2, 3, and 4.

Janet Kloppenburg - JJK Research

So that’s about $3 million that you won’t be carrying forward, but the depreciation, will that be up? How much will that be up on the year versus last?

Michael L. Henry

We said it would be 75 to 80 for the year.

Janet Kloppenburg - JJK Research

And how much was it last year?

Michael L. Henry

It was right around -- it was 80 this year.

Janet Kloppenburg - JJK Research

So it’s 80 versus 80 -- 75 to 80 this year versus 80 last year?

Michael L. Henry

Right. It was $80,323,000.

Janet Kloppenburg - JJK Research

But it will be up by $2.5 million in the first quarter versus last year’s first quarter?

Michael L. Henry

Yeah, in the first quarter specifically because you have the carryover impact of all the refreshes that we did last year. You also have the impact of a greater number of store closures than we had relative to the prior year.

Janet Kloppenburg - JJK Research

So should we look for depreciation on a quarter to quarter basis to begin the decline in the second quarter? In other words, will the second quarter ’08 depreciation, could it come in lower than the second quarter ’07?

Michael L. Henry

You know, I don’t have it by quarter here in front of me. I mean, I’ve --

Janet Kloppenburg - JJK Research

Okay, we can deal with it offline. I just wanted to understand the whole expense -- you know, really what I’m getting at, Mike, is why the quarterly loss for the first quarter is at $0.06 to $0.08, and it seems that some of that has to do with the footwear reserve and the higher severance.

Michael L. Henry

Right, $3 million of it absolutely is tied directly to the footwear transition and the other $1 million to the DC transition. The other things are issues that are just attendant to what we’ve done in terms of the refresh program and other investments in different pieces of our business that have a particular impact to Q1 because it’s such a small volume quarter. I would not expect that these types of expenses would continue to have these kinds of variances as we go Q2, 3, and 4 and then we should have much better leverage points as we go further and further into the year.

Janet Kloppenburg - JJK Research

Okay, great, and if you could give me a call later to go over that, that would be great.

Michael L. Henry

Sure.

Janet Kloppenburg - JJK Research

Thanks very much.

Operator

At this time, there are no further questions. Please proceed with any closing remarks.

Sally Frame Kasaks

Thank you and we’ll be here this afternoon if there are any calls you also need to make to us. Thank you. Bye-bye.

Operator

Thank you. This does conclude today’s conference call. You may now disconnect.

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Source: Pacific Sunwear F4Q07 (Qtr End 2/2/08) Earnings Call Transcript
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