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

F2Q08 Earnings Call

August 21, 2008 4:30 pm ET

Executives

Sally Frame Kasaks - Chief Executive Officer

Michael Henry - Chief Financial Officer

Analysts

Adrienne Tennant - Friedman, Billings

Janet Kloppenburg - JJK Research

John Morris - Wachovia

Paul Lejuez - Credit Suisse

Crystal Kallik - D. A. Davidson

Dana Telsey - Telsey Advisory Group

Liz Dunn - Thomas Weisel Partners

Jeff Van Sinderen - B. Riley

Paula Schwartz - Needham & Company

Shaun Knotin - Piper Jaffray

Alicia Reese - Wedbush Morgan Securities

Operator

Welcome to the Pacific Sunwear of California conference call announcing the company’s fiscal second quarter 2008 financial results. (Operator Instructions)

Your speakers today are Sally Frame Kasaks, Chief Executive Officer and Mike Henry, Chief Financial Officer.

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 forecast of future financial performance and estimates of amounts not yet determinable as well as our future prospects and proposed developments or business strategies.

Actual results could differ materially from those projected or reflected in our forward-looking statements and reported results should not be considered an indication of future performance. Pacific Sunwear’s future financial condition and results of operations as well as any forward-looking statements are subject to change and to 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 represents 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 economic conditions generally, changes in consumer spending, demands and preferences, lower-than-anticipated comparable store sales, higher-than-anticipated markdowns, higher than estimated selling, general and administrative cost, competition from other retailers and other uncertainties generally associated with apparel retailing.

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 2, 2008 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 results. Investors are encouraged to review these non-GAAP financial measures as well as the reconciliation in our press release of these measures to the comparable GAAP.

Our press release was attached to 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 re-broadcast or use by any other party without the 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 will now turn the call over to Ms. Kasaks.

Sally Frame Kasaks

I will begin with an overview of our second quarter and will then hand the call over to Mike Henry, our Chief Financial Officer to discuss the financial results. We will then open the line for questions.

During the quarter we continue to move forward with our strategy to grow our apparel business to enhance the productivity of our real estate portfolio and to reduce and exist on profitable product classifications. We continue to make progress and remain focused on our objective of being a leading lifestyle specialty apparel retailer with a limited offering of trend-right accessories and footwear rooted in the youth culture and the fashion vibe of Southern California.

Overall our earnings per share of $0.06 for the quarter were inline with our expectations. However, we have faced significant challenges particularly in certain regional markets and we are concerned with the sales acceleration that we have experienced in recent weeks. To the first 2.5 weeks of August, same-store sales were down 8%; unfortunately the economic environment does not appear to be approving especially in California, Florida and the Desert Southwest where we have 24% of our store base.

Turning now to our second quarter results; our second quarter sales were $313 million up slightly versus $312 million last year. Total company same-store sales decreased 1% during the period. Our apparel business showed a solid 13% same-store sales increase during the quarter and now represents 81% of our total sales. We expect to end the year with apparel representing approximately 85% of our sales mix. We believe that by concentrating on apparel and reducing our emphasis on lower margin footwear and accessories we can improve our merchandise margins overtime.

Junior apparel achieved same-store sales growth of 26% during the quarter and now represents 51% of our apparel sales. We believe that there is additional opportunity to grow juniors business and have set our next target milestone to be 55% of our apparel sales. At this level we would still be below many of our peer groups as junior mix is typically greater than 60% of sales.

Within our junior category, Bullhead denim, tops and dresses were the primary drivers this quarter partially offset by weakness in shorts. Though swimwear was weak during the quarter we were able to liquidate this inventory through promotions at lower margins. We ended the quarter with our propitiatory brands representing 50% of our junior’s apparel sales. In this value driven environment our proprietary brands; Bullhead, Lilu, Nollie and Kirra Girl allow us to offer compelling price points while maintaining stronger gross margins.

Our young men’s apparel business achieved 2% same-store sales growth during the quarter. Bullhead denim and tops were the primary drivers to swim causing the largest drag on young men’s apparel business. Through successful clearance sales, short ended the quarter flat on a comp basis, although they did not produce the merchandised margins we had originally planned.

We ended the quarter with branded goods representing approximately 77% of our apparel assortment and continue to believe that brands are the primary driver for our young men’s business. Our young men’s proprietary brands; the Bullhead, Kirra and Vurt provide opportunities primarily in denim and T-s.

Our accessory business was disappointing. Accessory same-store sales were down 19% and represented approximately 14% of our sales mix. We believe that accessories are typically incremental purchases and are not traffic drivers. We intend to continue to reduce our accessory inventory and would anticipate ending the year with accessories representing a low double-digit percentage of our sales mix and lastly our footwear category.

We remain on plan with our sneaker liquidation and anticipate being largely out of this category by the end of the year. Footwear comps were down 56% and represented approximately 5% of second quarter sales. Once we complete the sneaker liquidation, footwear will account for approximately 2% to 3% of our total business and will consist primarily of sandals.

In closing, I remain confident in our belief that we are taking the appropriate action to improve the areas of the business where we have direct control. 2008 remains very challenging, but we believe that we are doing the right things to position PacSun for success when the environment improves. In the meantime we will continue to manage expenses and capital needs prudently for the remainder of the year.

We are committed to managing through the near-term challenges with the convincing and compelling product assortment, disciplined and a clear focus on delivering improved results and increase shareholder value over the long-term. I appreciate your continued support and will now turn the call over to Mike Henry.

Mike Henry

Our discussion of financial results today reflects earnings from continuing operations, which excludes any financial statement impacts from our former demo and One Thousand Steps businesses. Pacific Sunwear financial results for the second quarter of fiscal 2008 versus the second quarter of fiscal 2007 were as follows.

Total sales were $313 million this year versus $312 million last year. We ended the quarter with 938 stores versus 957 stores last year. Same-store declined 1%, with transactions up 3% and the average sale down 4%. As Sally mentioned, we faced a very challenging retail environment particularly in California, Florida and the Desert Southwest, which collectively represented 24% of our store base and 26% of our sales for the quarter.

Same-store sales in these regions were down 10% for the second quarter following an 8% decline in the first quarter. Outside of these regions same-store sales were up 3% for the second quarter. E-commerce sales grew 60% during the second quarter to $8 million this year from $5 million last year.

Gross margin declined 220 basis points to $95 million or 30.5% of sales this year from $102 million or 32.7% sales last year. Merchandized gross margins declined 190 basis points due to higher markdowns associated with increased sale promotions. Non-merchandized gross margin costs were up 30 basis points. Occupancy was up 70 basis points as a result of de-leveraging these costs on the negative 1% same-store sales results.

Distribution expenses were down 30 basis points due to the consolidation of our distribution functions in the first quarter; buying costs were down 10 basis points. SG&A expenses increased 90 basis points to $90 million or 28.8% of sales this year from $87 million or 27.9% of sales last year. On a dollar basis SG&A for the second quarter was up less than 4% over the last year.

Depreciation increased 80 basis points due to the impact of accelerated depreciation associated with the store closures and relocations and new depreciation on existing stores from our store refresh program. Store impairment charges increased 70 basis points. All other SG&A expenses were down 60 basis points, led by reductions in payroll related expenses.

Our income tax rate for the quarter was 27.2% this year versus 40.1% last year. We currently expect our effective rate for the year to be approximately 43%. Net income from continuing operations was $3.7 million or $0.06 per diluted share versus $9.3 million or $0.13 per diluted share last year.

Turning to the balance sheet, we ended the quarter with $103 million in working capital. Inventories were up 5% per square foot year-over-year primarily due to our increased investment in denim. We currently expect inventories to be up low double-digits on a per square foot basis at the end of the third quarter due primarily to timing of receipt flows and expect in the year with inventories flat to up slightly per square foot.

We ended the quarter with $11 million in borrowings under our $150 million credit facility that was used to finance a portion of our $43 million in share repurchases during the quarter. These borrowings have since been repaid. We currently expect to end the quarter in a similar net borrowing position and end the year with approximately $50 million to $60 million in cash.

Year-to-date capital expenditures were $49 million and depreciation was $41 million. We have reduced our planned capital expand for the year by $10 million, resulting in a full year capital expectation of approximately $80 million to $85 million. During the second quarter we open six new stores and closed 10 stores.

Now turning to earnings guidance; as you know we are in a very difficult and unpredictable economic and retail environment. Same-store sales are down 8% through the first 2.5 weeks of August. The particularly core economic climate in California, Florida and the Desert Southwest continues to adversely effect nearly 25% of our stores and we do not expect conditions in these regions to improve in the near-term.

In consideration of these factors assuming same-store sales were to remain in the negative high single-digit range and SG&A dollar growth of no more than 5% year-over-year, we would anticipate earnings per share from continuing operations in the range of $0.00 to $0.05 per diluted share for the third quarter and $0.11 to $0.16 per diluted share for the fourth quarter. The earnings range for the fourth quarter excludes the anticipated gain of $0.23 per diluted share from the sale of our closed Anaheim distribution center expected to close during the fourth quarter.

In closing we continue to believe that the actions we have taken are the correct ones for the long-term health and profitability of our business. We have closed under performing businesses, reduced under productive product categories and continue to improve the productivity of our real estate portfolio by closing under performing locations, all of which designed are improve our profitability overtime.

We remain committed to improving our sales and margin results over the long-term via our increased focus on apparel, containing the rate of SG&A growth year-over-year, reassessing the productivity of our real estate portfolio at each opportunity and prioritizing our capital spending in ways that improve returns to our business and shareholders. Operator we will now take questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Adrienne Tennant with Friedman, Billings.

Adrienne Tennant – Friedman, Billings

Question on the inventory; I mean the comp trend obviously for the back half of the year, negative high single-digit, it seems as though there is obviously a shift going on in the third quarter but then at the end of the fourth quarter its still seems there is a pretty big gap between where you are going to be comping? How should we think about that and if sales were just slow further, how should we think about the additional margin head to kind of liquidate that as we go into ’09?

Mike Henry

Well the guidance certainly contemplates that we’re anticipating a more promotional environment for the back half and at this sales level we certainly will have to promote our way through goods that do not sale. That being said, there are variety of tactics that we’re taking; we’re re-looking at receipt flows, re-looking at orders and we’re taking a variety of steps to make sure we keep our inventories contained. I think we’ve demonstrated over the last year and a half to two years a strong ability to make sure that we do that and plan to continue that efforts throughout the back half.

Sally Frame Kasaks

I just want to jump in also along this. Some of that inventory too is staying focused on a lot of our denim and certainly there’s a certain amount of size and backstop and fulfillment that needs to be done. So we also look at what proportion would be in our denim business which is certainly one of the business drivers of the business today.

Adrienne Tennant – Friedman, Billings

If comps through the back half are trending kind of in negative high single-digit range, one would think that as we go into ’09 they are trending negative mid-singles. So at what point should we expect the inventory to be kind of down inline with where the comps are trending?

Mike Henry

Well at this stage we’ve said inventory would be flat per square foot to up slightly by the end of the year and one of the things you have to remember as we have been shrinking footwear and shrinking accessories we have been funding that with the increased penetration of denim and certainly the key product categories that are working within our apparel assortment particularly in junior’s but also denim on the guys side. So there are certain investments in inventory that we need to make to be able to drive better business going forward as we become more apparel focused.

Adrienne Tennant – Friedman, Billings

What exactly is the shift for the third quarter?

Sally Frame Kasaks

It’s just some timing delivery shifts.

Michael Henry

Yes, there are certain receipts for the holiday season that will be coming in right there towards the end of the third quarter.

Adrienne Tennant – Friedman, Billings

Can you cancel anything at this point?

Sally Frame Kasaks

We are always manipulating, I mean our inventory. This is the planned discussion to get us into Q4, but honestly we are shifting, maneuvering, we do that on an ongoing basis.

Operator

Your next question comes from Janet Kloppenburg of JJK Research.

Janet Kloppenburg - JJK Research

Sal I was wondering if you could give us some information on maybe how the rest of the country is doing versus some of these trouble markets. When I talked to you guys about it before it’s sort of relieving to hear that some major parts of the country are doing quite well and maybe if there is anything you can do to sort of move inventory around into some of the better markets and I was also wondering if you thought that the young men’s business was where you wanted it to be in the strong market for the back-to-school season. Thank you.

Sally Frame Kasaks

Thank you, Janet. I think there is one thing we have to understand; we’re going into our biggest weekend this week, so I don’t really want to talk about markets because with this back-to-school some of our stronger markets are the latter markets quite honestly. So, we’re sort of balancing a lot here, so I really can’t speak to that in any informed way sitting here to-date even if I were to look at the numbers.

I think in the young men’s, yes we’ve been very pleased with denim and aspects of our top’s business. I think as the margins probably a little bit more in the top’s area we would have felt a little bit better, just a little bit more in denim, but quite honestly generally where we would want it to be, but maybe a couple of styles that probably we’d like to change.

Janet Kloppenburg - JJK Research

Okay and just a follow-on from your comment Sally, we are early in the season; wouldn’t you expect that comps should improve everywhere, including the South West and Florida market as we move deeper into the season and therefore could your guidance be viewed as conservative?

Michael Henry

It’s possible they could improve. As we sit here, we are down eight and from a peer compared perspective; actually we have tougher compares next week than we do this week. So, for every comment one way about certain markets, there are other data points that can go the other way and it remains to be seen. We positioned our guidance to say basically if things don’t get better, this is where it looks like we would land and we are certainly making every effort to incentives our business to perform better than that level.

Janet Kloppenburg - JJK Research

I just want you to know that other people and their guidance Sally have assumed that business will grows a bit from these levels. So, I’m going to be cautiously optimistic good luck.

Operator

Your next question comes from John Morris with Wachovia.

John Morris – Wachovia

Maybe it’s a little bit of a follow up on Janet’s question but is there way you cam quantify for us how the comps did excluding California, Arizona, Nevada and Florida either on the quarter or even particularly as it relates to the first two weeks of August. Is that turning it down by a couple of points or several points or just give some order of magnitude?

Mike Henry

I’m not going to get into particular’s for August; we’ll give all that when we announce the month. As Sally said there are still certain markets that are the late back-to-school markets so we don’t want to get too much into that. In the script I did mention that outside of California, Florida and Desert Southwest, outside of those regions we are actually up three comp points for the second quarter.

Operator

Your next question comes from Paul Lejuez with Credit Suisse.

Paul Lejuez - Credit Suisse

What has taken the place of footwear in the stores and what’s happening in the productivity of that product; how is it performing and second Mike just any initial thoughts on CapEx for next year?

Sally Frame Kasaks

Let me speak to the product. Certainly we’ve put product categories where shoes were presented on the floor. So what you used to see was anyway between 65,120 skews of footwear, somewhere in that ballpark. Today we have our Backpacks; I think the broader discussion really is the backroom, where in point of fact the shelving might have been significantly driven by footwear, today we had denim back there. So forgetting where the square footage on the selling floor is, from an inventory management, from a staying in business on sizes and so forth I’d have say denim is really picking up the inventory as well as the space and we do see the kind of sales results that we would want there.

Mike Henry

And then Paul just the CapEx in future years; my initial thoughts are that it will probably be in the $70 million to $75 million range, next year and for the next couple of years. One thing to realize is that where we opened 100 plus stores back in the late 90’s, early 2000, those leases will be coming up for renewal.

We have almost 100 leases coming up for renewal next year, about 120 the year after that and nearly 140 the following year and in each of those leases a good number of them have clauses and they are going to require us to do someone on the refresh to the store and so in contemplation of that much of our refreshed program in future years will be driven just strictly off of the lease terms.

It requires us to do something in the store and our job obviously in that regard is to make sure we’re making prudent decisions of what we’re spending, in which locations and making sure that we’re getting an appropriate return on those investments, but broadly at this stage I would think around the $70 million to $75 million range makes sense for each of the next three years probably.

Paul Lejuez - Credit Suisse

Mike could you just remind us of what the average refresh costs?

Mike Henry

This year the current average per square foot is $129 per square foot. We have been working on bringing that down, there is certain decisions we’re making in flooring in the store fronts and what avenue that we are targeting to get that down.

Operator

Your next question comes from Crystal Kallik with D. A. Davidson.

Crystal Kallik - D. A. Davidson

It’s just a bit of a clarification on the guidance; you’ve give us pretty specific as far as where the SG&A percentage rate is for the second half and so certainly implying a fair amount of deteriorations to the gross margin, Mike could you walk us through how much of that you’re thinking as far as occupancy de-leverage, certainly a fair amount with the comp, but markdowns, just how we should think about the order of magnitude when we’re thinking about the gross margin in the second half?

Mike Henry

The great order of magnitude is going to be in the merchandized gross margins. We are contemplating that the promotional environment will continue and certainly for a negative high-single comp we are going to have to spur certain promotions to make sure that inventories do stay clean, so the great majority of it is within merchandised margins. At this comp level occupancy would likely deliver 150 to 200 basis points per quarter.

We will continue to have distribution leverage. I can recall at this time last year, we would have had two distribution functions in operation; we just have the single Olathe center in operation at this stage. So, we expect to have anywhere from 30 to 50 basis points of distribution leverage in the back half even considering this comp rate. So, again just leading off merchandised margins are the great majority of it; occupancy will probably de-lever 150 to 200 and then you’ll have distribution offsetting in that just a bit.

Crystal Kallik - D. A. Davidson

And then would you just talk a little bit about year end thought process; looking at a buybacks, you’ve certainly just made aggressive buybacks in Q2, but it sounds like in general you’re taking a much more cautious tone, so should we assume with the cash balance where it is that you’ll probably tamper the buyback activity for a while.

Mike Henry

I think that’s fair; we do have the $50 million buyback authorization out there. Certainly, as we look at potential comp performance being in the negative high single-digit range, we do plan to be cognizant of what our cash needs are and trying to protect that cash balance, so that we can ahead into next year in a healthy position and the assumption that we would end the year with $50 million to $60 million in cash does not contemplate buybacks in the back half of the year.

Crystal Kallik - D. A. Davidson

Iis there has been any surprise findings in the market researches you’ve done lately, certainly the volatile environment, anything that’s particularly enlightening that you’re seeing out there recently over the past few weeks as the environment seems to have shifted even more so?

Sally Frame Kasaks

I’m not sure with the question means; I don’t want to answer the wrong question here. I guess on balance I mean what we’re doing is as I said I think we’ve particularly been watching certain regions and its really the regional sales right now and I feel as you look at the assortments and so forth from an assortments point of view, yes there is always shift we’re making, but there is nothing profound that’s jumped out. Of course over the next few weeks we’ll able to see as the back-to-school roads and we can’t handle the people that are shopping, there has been a lot of speculation but we have no research that would guide us at this point, it’s just all too new.

Operator

Your next question comes from Dana Telsey with Telsey Advisory Group.

Dana Telsey - Telsey Advisory Group

Can you talk a little bit about the performance of the remodels, how those are performing relative to the base level of stores and also the impact of private label, Bullhead or whatever versus the brand and how you see the mix transitioning or how you want it to transition over the next year or so and Sally given your background, what’s different about this period of weakness compared to the other apparel retailers that you’ve lead? How is it different? How is it similar? Thank you.

Michael Henry

Dana I’ll start off with the refresh question and then we’ll go from there. The refreshes continue to outperform the rest of the chain by 10 to 12 comp points on average and they continue to deliver 200 to 250 basis points improved gross margin performance that remains true versus the chain as a whole. It also remains true even within the difficult regions when you look at some of those initial refreshes that we did in California in particular or Arizona and Nevada, even within the depressed economic area the refreshes still outperform the other stores in those regions by 10 comp points, that’s been a pretty consistent data point as we’ve gone quarter-to-quarter and it remains true.

Sally Frame Kasaks

Let me just say to our proprietary versus national brands; our denim business is strong, we called it right, it’s a strong business. Therefore Bullhead, which is our own brands is fairly doing very well and though we do have some national brands mixed in with the assortment, Bullhead is being a win for us both in young men’s and in juniors’.

As I said, our objective is to continue to grow proprietary in the junior business, attended margins, speed, fashion, all of that aspect that we’re committed to and in young men its just certain items and categories that we will build on there and our men’s mix is pretty much where it’s going to be; we’ve got a couple of points that we might switch by season. So, I think on balance we will continue to grow penetration of our junior proprietary. Quite honestly denim is really one of the major drivers right now in that area and we’re generally pleased with that.

I just reminded myself, I’ve been asked this more than a couple of years, I have to tell you I’ve worked through the 70’s; my career got started, it did very well thank you, so we got through that. I must say that in the early 80s and the early 90’s I didn’t even know there was a recession because we were turning businesses around, so there were always opportunities. I think the difference here though for me is this is a very well established business.

We have some fundamental strategic initiatives in the business and we are continuing to adjust that and I think it’s a little bit tougher as you’re going through this; kind of a slight turn in the business in terms of how we’re approaching it. I think as we said the headwinds are probably making it a little more difficult, that part of it I’m not use to because usually if you just get the right product out there it works, but I think there are some difference here, that regionally and just across the board it’s making it a little bit tougher, but I’m fairly optimistic that it does feel tougher than what I’ve experienced in the past.

Operator

Your next question comes from Liz Dunn with Thomas Weisel Partners.

Liz Dunn - Thomas Weisel Partners

First related to the comp, if you are running a negative eight in the first two weeks, I mean August is your most difficult comparison of the year if we don’t look at March, April because that had do with an Easter shift. I mean it’s seems a little extreme to be forecasting high single-digits for the balance of the year, when you’re really facing your most difficult comparison this month and then they get significantly easier through the balance of the year, so that’s my first question.

Second question is just a follow up on footwear. Am I understanding it right that footwear will continue to be a drag for the balance of the year, but it will be over after the fourth quarter and it will be less of a drag as we move into the back half and then this third follow up question relates just to the inventory, the timing of shipments resulting in inventories being up at the end of Q3; can you just help us think about as you look at it from a seasonal planning perspective, what are receipts year-over-year per foot up or down? Thanks.

Mike Henry

Alright, so I guess August is the toughest compared year-over-year, but as we look forward we have 25% of our stores in regions that are comping negative double-digits that was worst than what they were doing in the first quarter. I don’t want to get into any more details about what’s happing thus far, but we are down to eight months to-date in August, we still have even tougher competitors coming up the remainder of this week and next week and August is half the quarter in terms of sales volume.

As we see year-to-date, we essentially know a third of the quarter and it’s down eight, we’ve got a little tougher compared coming ahead. So, if the customer didn’t show up for back-to-school in the way we thought, I’m not really sure what the catalyst is for September or October. So, while certainly I can understand the viewpoint about compares and what have you and maybe this is conservative and maybe it is, I hope you’re right, but we’ve got to position this for our long-term shareholders in a way that says, if it doesn’t get better, here is where it is, make sure we’re very clear about what that could be and position everyone for success going forward and that’s our intent.

With footwear you’re correct, it will continue to be a comp drag through to the rest of this year. We will enter next year with footwear only being about 2% of the total assortment, 2% to 3% as Sally mentioned. We entered ’08 with footwear at 10% of the assortment, so it certainly will continue to be a comp drag, but a much smaller one as we enter ’09.

The bigger issue setting footwear aside is we’re going to enter ’09 roughly 85% in apparel business relative to 71% entering to ’08; that’s the big deal, that’s were our real opportunity is from what we can look at going ahead in ’09 and if the apparel portion of our business has been up double-digits all year along, the juniors business continues to be very strong, denim on both sides of the business continues to be very strong, that’s the nature of our opportunities we think about what ’09 can be.

Then finally, you’d asked about inventory, I don’t have any specific numbers in front of me in terms of amount of receipts or receipts per foot, just stated very simply as we mentioned it very much is a timing of receipt flows for holiday and positioning ourselves to get ready for the fourth quarter and again we fully expect the end of the year to be flat to up slightly per square foot. So, it is a very temporary situation and one that I feel very concerned about at this stage.

Liz Dunn - Thomas Weisel Partners

But is it the timing of shipments issue, can’t you provide us with what inventories would be ex the timing issue?

Mike Henry

No, I mean we’ve given you our plan; that’s what our plan is and I don’t know what the value, I’m trying to slice out of what’s the difference in timing of flows. We’ve give you the expectation of where we expect to be at in the Q3, we’ve given you the expectation of what we expect to be in Q4.

Operator

Your next question comes from Jeff Van Sinderen with B. Riley.

Jeff Van Sinderen - B. Riley

I guess one of the question that I have is as you look at that say 25% or so chunk of your store base that’s in the really difficult geographic real estate markets or whatever you want to attributed to, when you look at those stores at this point, are there a lot of stores in that group that are going to have a negative profitability contribution this year based on the guidance you’ve given or how should we look at that?

Michael Henry

Not a lot of them. I mean anywhere in the country and not just in those regions, there are stores that are less profitable than others, but even in those difficult comp regions are some of our most productive stores on a four wall basis, some of our most productive stores in terms aggregate top line value to us. So, I don’t tend to think of it as those economic regions are going to create anymore impairments or issues to us than any other region or the country strictly because so many other stores are so profitable on our four wall basis even, in this depressed environment.

Jeff Van Sinderen - B. Riley

Okay and then Sally, just wanted to get your thoughts on if you think there is anything in particular in terms of your merchandise assortment that needs work outside of accessories, which I know has been somewhat disappointing?

Sally Frame Kasaks

No, at this point as indicated we are pretty confident where we are in June. As I think in guidance there’s probably some top’s issues that we might rework but that’s just the kind of the normal merchandising that we’d have to be doing day-in and day-out. As I said our big debt was denim, that’s working. I think the other part of it than is just to make sure we get our top’s a little more wide and that’s just a normal jiggering that one has to do, but I think our big call out was denim and that’s important.

Jeff Van Sinderen - B. Riley

And then as you look at your private label business I know everyone’s sort of facing this issue of rising cost; just wondering how you are approaching that? If there’s any changes or any difference in terms of how you are going approaching that or you might find some potentially lower cost associate?

Sally Frame Kasaks

I’m not going to look for lower cost right now, but what we are doing is that as our quantities are increasing, our negotiations are getting better, there are a lot of things that our sourcing group is doing because as we get more important to certain factories and certain countries, we’re sort of leveraging our growth in these categories right now.

Certainly I think so going into spring I’m not going to say that we were less concerned, I think we still haven’t got of full sense of what the back half of next year is going to look like. It’s probably going to be more back half of next year and as we’re going through a lot of imaginations here, I think there will be some increases, but we’re not terribly concerned sitting here today that there will be some increases.

Jeff Van Sinderen - B. Riley

And then Mike, as you look through the P&L I’m sure you go through this process quite often, but are there any areas you’re seeing where you think this room to reduce expenses?

Mike Henry

Sure, we’re always looking at opportunities in a variety of areas, you’re absolutely right, we have been all year. The thing that concerns me about the back half if we do end up performing in a negative high-single digit range, there will be some store impairment risk that can potentially offset some of the savings initiatives that we have put in place and do expect to perform for us. So, I think we demonstrated a pretty decent job of containing expense growth in Q2 and I’d expect that we will continue to do that through 2Q, 3Q, 4Q and into next year. Just in terms of aggregate SG&A the biggest risk to me is the potential for store impairments that may hit us.

Operator

Your next question comes from Paula Schwartz with Needham & Company.

Paula Schwartz - Needham & Company

Hi, this is Paula Schwartz calling in for Christine. I just wanted to talk a little bit about the direction of product. We’ve noticed a lot of newness in stores and think the product has been looking a little edgier and there seems to be more emphasis on brands or styles that we would consider more skate versus surf. So, I was wondering if you could comment on that and is this sort of a test or trend that we should expect to see throughout holiday?

Sally Frame Kasaks

Paula, first and concerning surf versus skate Paula it’s consistently been more skate driven, it’s just the nature of the timing of the year where the spring and summer tends to be more surf. So, the edginess you see has probably been about four years worth, the different style interpretations.

Certainly I think in young men’s and we are speaking to young men’s, the fall is always a bit more skate going into the season; last year we shifted more towards sort of the snowboard aesthetic and then as time moves on it kind of moved back to the beach and surf. So, that’s pretty consistent with what we’ve done and last year we did the same thing, so that’s pretty consistent with our cadence goes. I think that was the primary question, I believe.

Paula Schwartz - Needham & Company

Right; do you just think that we are going to continue to see -- there has been a lot of newness also in the color pallet, do you think we are going to see that going forward in fall and holiday or we’re going to sort of trend.

Sally Frame Kasaks

Yes, color has been important in all parts of the business and so far nothing has come around to replace it, so certainly you have to remember that we always do have to ground that in neutrals and so we see a lot of color but we also are making sure that we get the right balance in neutrals such as grey, bone base colors, black; so we try to balance the color to a grounded neutral in most cases.

Operator

Your next question comes from Shaun Knotin with Piper Jaffray.

Shaun Knotin - Piper Jaffray

I just have a couple of quick question; one is on the marketing side are you guys doing anything differently this year versus last year for back-to-school with something potentially different online or email marketing campaigns; is there any change in the marketing cadence this year?

Sally Frame Kasaks

Shaun we use our e-com for certain things; we have done our pack loop which is something we’ve done every year and we’ve done email blasts and so forth where appropriate. I think we’re still trying to make sure that we stay rooted in the core business vis-à-vis our denim projection and so forth, so that really is a lot of it but from a marketing cadence we’re pretty like-to-like to last year, maybe just doing a few more blasts here and there.

Shaun Knotin - Piper Jaffray

So the overall dollar spend should be relatively similarly?

Sally Frame Kasaks

Yes we’re not looking at this juncture any major change on that front; we’re pretty steady Eddie there.

Shaun Knotin - Piper Jaffray

Okay and then secondly just is there any change in the leverage point you guys are looking for; I mean clearly comps look like they are going to be challenged in the back half; maybe a little conservative right now but is there any change to where you think you need to be in order to leverage SG&A right now?

Mike Henry

No, in consideration of our guidance obviously there isn’t going to be any leverage if we’re going to perform in the negative high singles.

Shaun Knotin - Piper Jaffray

Right and then finally, just a last question quickly on the store impairment process; is that a constant cycle you are doing or is that something you’d do once a year that you’re looking at?

Mike Henry

It is constant; as each quarter flips by we have to make reassessment of our portfolio, it’s something that we do each and every quarter and with each quarter it goes by with disappointing performance, it just brings more stores into question that we have to take a harder look at.

Shaun Knotin - Piper Jaffray

And of those I guess 100 you said that were coming up next year, I mean are there any of those were that you could potentially accelerate the right sizing potentially of the store base that you would be looking at?

Mike Henry

There are always in any chunk of stores, in any particular time, there are stores that certainly come up for consideration in that regard and end up being closure decisions where we have a kick out clause that we can exercise and that’s a continuous process.

Sally Frame Kasaks

We have said and if I can just add some, so we have on an ongoing basis said that we would close stores in the normal course of business which typically would be about 30, 35 per year as we look at it now. So, that’s pretty consistent with what we’ve been saying probably for the better part of the last year.

Operator

Your next question comes from Betty Chen with Wedbush Morgan Securities.

Alicia Reese - Wedbush Morgan Securities

Hi, this is actually [Alicia Reese] on behalf of Betty Chen. I was just wondering real quick when will we start to anniversary the softness that we’ve been seeing in California, Florida and the Desert Southwest?

Mike Henry

It’s really the month of October is the first time we started to see California and the Desert Southwest in particular go into a negative high-single digit territory and it really hasn’t recovered since then. So, October becomes the anniversary point. It will be interesting to see how those areas perform once we start lapping that. In some sense you could question, well does that mean, maybe they’ll moderate a little bit because they are beginning the anniversary, but I can tell you from being positioned out here in Southern California the environment is certainly significantly worst than it was a year ago, so I’m not convinced that that means those regions are going to get any better.

Sally Frame Kasaks

And significantly it has been going back and forth between the East and the West Coast, so I can assure you, it feels tougher out right here than anything I’ve seen back East.

Alicia Reese - Wedbush Morgan Securities

And what sort of comps would we need to see to get leverage there?

Mike Henry

To get leverage where?

Alicia Reese - Wedbush Morgan Securities

Like in California, the Desert Southwest.

Mike Henry

Well, we’ve stated in the past that to get leverage on SG&A, it would take a five to six over the course of this year and that’s from a total chain perspective. All those regions represent about 25% of our stores and for Q2 in the aggregate they were about a 4% comp drag, if that helps to answer your question, because we were up three outside of those regions and the quarter comp was down one, so there is a four point delta there.

Operator

There are no further questions at this time.

Sally Frame Kasaks

Thank you all very much and we’ll be keeping in touch and thank you for your interest.

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Source: Pacific Sunwear of California, Inc. F2Q08 (Qtr End 02/08/08) Earnings Call Transcript
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