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PSUN > SEC Filings for PSUN > Form 10-K on 5-Apr-2013All Recent SEC Filings

Show all filings for PACIFIC SUNWEAR OF CALIFORNIA INC | Request a Trial to NEW EDGAR Online Pro

Form 10-K for PACIFIC SUNWEAR OF CALIFORNIA INC


5-Apr-2013

Annual Report


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") should be read in conjunction with the Consolidated Financial Statements and Notes thereto of the Company included elsewhere in this Annual Report on Form 10-K. The MD&A excludes the financial statement impact of discontinued operations, as described in Note 14 to the Consolidated Financial Statements. The MD&A contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including those set forth under "Risk Factors" within Item 1A.

The Company's fiscal year is the 52- or 53-week period ending on the Saturday closest to January 31. Fiscal 2012 includes 53-weeks while fiscal 2011 and fiscal 2010 each included 52-weeks. For purposes of the MD&A, the 53-week period ended February 2, 2013 is compared to the 52-week periods ended January 28, 2012 and January 29, 2011. Comparable stores sales, however, compare the 52-week period ended January 26, 2013 to the 52-week periods ended January 28, 2012, and January 29, 2011.

Executive Overview

We consider the following items to be key performance indicators in evaluating Company performance:

Comparable (or "same store") sales

Stores are deemed comparable stores on the first day of the fiscal month following the one-year anniversary of their opening or expansion/relocation. We consider same store sales to be an important indicator of current Company performance. Same store sales results are important in achieving operating leverage of certain expenses such as store payroll, store occupancy, depreciation, general and administrative expenses and other costs that are somewhat fixed. Positive same store sales results usually generate greater operating leverage of expenses while negative same store sales results generally have a negative impact on operating leverage. Same store sales results also have a direct impact on our net sales, cash and working capital.

Net merchandise margins

We analyze the components of net merchandise margins, specifically initial markups, discounts and markdowns as a percentage of net sales. Any inability to obtain acceptable levels of initial markups or any significant increase in our use of discounts or markdowns could have an adverse impact on our gross margin results and results of operations.

Operating margin

We view operating margin as a key indicator of our success. The key drivers of operating margins are comparable store net sales, net merchandise margins, and our ability to control operating expenses. For a discussion of the changes in the components comprising operating margins, see "Results of Operations" in this section.

Store sales trends

We evaluate store sales trends in assessing the operational performance of our stores. Important store sales trends include average net sales per store and average net sales per square foot. Average net sales per store were $1.2 million for fiscal 2012, and $1.1 million during fiscal 2011 and 2010. Average net sales per square foot were $292 for fiscal 2012, and $284 during fiscal 2011 and 2010.

Cash flow and liquidity (working capital)

We evaluate cash flow from operations, liquidity and working capital to determine our short-term operational financing needs. Although we made progress with respect to our comparable store net sales and gross margins in fiscal 2012, if we were to experience a substantial decline in same-store sales and gross margins in the future, we may be required to access most, if not all, of the Wells Credit Facility and would potentially require other sources of financing to fund our operations, which sources might not be available. Based on current forecasts, we believe that cash flows from operations and working capital will be sufficient to meet our operating and capital expenditure needs for the next twelve months.


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Critical Accounting Policies

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America necessarily requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements as well as the reported revenues and expenses during the reported period. Actual results could differ from these estimates. Our significant accounting policies can be found in Note 1 to the Consolidated Financial Statements included in this Annual Report on Form 10-K. The accounting policies that we believe are the most critical to aid in fully understanding and evaluating reported financial results, and the most significant estimates and assumptions used by us in applying such accounting policies, are described below:

Recognition of Revenue

Sales are recognized upon purchase by customers at our retail store locations or upon delivery to and acceptance by the customer for orders placed through our website. We accrue for estimated sales returns by customers based on historical sales return results. Actual return rates have historically been within our expectations and the reserves established. However, in the event that the actual rate of sales returns by customers increased significantly, our operational results could be adversely affected. We record the sale of gift cards as a current liability and recognize a sale when a customer redeems a gift card. The amount of the gift card liability is determined taking into account our estimate of the portion of gift cards that will not be redeemed or recovered ("gift card breakage"). Gift card breakage is recognized as revenue after 24 months, at which time the likelihood of redemption is considered remote based on our historical redemption data.

Valuation of Inventories

Merchandise inventories are stated at the lower of average cost or market utilizing the retail method. At any given time, inventories include items that have been marked down to management's best estimate of their fair market value. These estimates are based on a combination of factors, including current selling prices, current and projected inventory levels, current and projected rates of sell-through, known markdown and/or promotional events expected to create a permanent decrease in inventory value, estimated inventory shrink and aging of specific items. Reserves established for such items have historically been adequate. While we do not expect actual results to differ materially from our estimates, to the extent they do differ for any of these factors, we may have to record additional reserves in subsequent periods, which could reduce our gross margins and operating results.

Store Operating Lease Accounting

Rent expense from store operating leases represents one of the largest expenses incurred in operating our stores. Rent expense under our store operating leases is recognized on a straight-line basis over the original term of each store's lease, inclusive of rent holiday periods during store construction and exclusive of any lease renewal options. Accordingly, we expense all pre-opening rent. All amounts received from landlords to fund tenant improvements are recorded as a deferred lease incentive liability, which is then amortized on a straight line basis as a credit to rent expense over the related store's lease term.

Evaluation of Long-Lived Assets

In the normal course of business, we acquire tangible and intangible assets. We periodically evaluate the recoverability of the carrying amount of our long-lived assets on a store-by-store basis (including property, plant and equipment, and other intangible assets) whenever events or changes in circumstances indicate that the carrying amount of an asset may not be fully recoverable. Impairment is assessed when the undiscounted expected future cash flows derived from an asset or asset group are less than its carrying amount. The amount of impairment loss recognized is equal to the difference between the carrying value and the estimated fair values of the asset, with such estimated fair values determined using a discounted cash flow model consisting of, but not limited to projected sales growth, estimated gross margins, projected operating costs and an estimated weighted-average cost of capital rate. Impairments are recognized in operating earnings. We use our best judgment based on the most current facts and circumstances surrounding our business when applying these impairment rules to determine the timing of the impairment test, the undiscounted cash flows used to assess impairments, and the fair value of a potentially impaired asset. Changes in assumptions used could have a significant impact on our assessment of recoverability. Numerous factors, including changes in our business, industry segment and the global economy, could significantly impact our decision to retain, dispose of or idle certain of our long-lived assets.


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During fiscal 2012, fiscal 2011, and fiscal 2010, we recorded impairment charges of $5 million, $15 million, and $16 million, respectively. The impairment charges recorded during these periods resulted primarily from a variety of factors affecting our net sales, including unfavorable economic conditions and decreases in consumer spending, changes in fashion trends and customer preferences. The estimation of future cash flows from operating activities requires significant estimations of factors that include future sales and gross margin performance. If our sales or gross margin performance or other estimated operating results are not achieved at or above our forecasted level, the carrying value of certain of our retail stores may prove unrecoverable and we may incur additional impairment charges in the future. For more information concerning the evaluation of impairment of long-lived assets, see Note 3 to the Consolidated Financial Statements.

Stock-Based Compensation Expense

We recognize stock-based compensation expense based on the fair value on the grant date, net of an estimated forfeiture rate, and only recognize compensation cost for those shares expected to vest. Stock-based compensation is recognized on a straight-line basis over the requisite service period of the respective award. Determining the appropriate fair value model and calculating the fair value of stock-based compensation awards require the input of highly subjective assumptions, including the expected life of the stock-based compensation awards and stock price volatility. We use the Black-Scholes option-pricing model to determine compensation expense for all stock options. The assumptions used in calculating the fair value of stock-based compensation awards represent management's best estimates, but those estimates involve inherent uncertainties and the application of management judgment. As a result, if factors change and we use different assumptions, our stock-based compensation expense could be materially different in the future. See "Stock-Based Compensation" in Notes 1 and 8 to the Consolidated Financial Statements for a further discussion on stock-based compensation.

Derivative Liability

In December 2011, we issued 1,000 shares of convertible Series B Preferred Stock (the "Series B Preferred") in connection with the Term Loan. The Series B Preferred is convertible into approximately 13.5 million shares of our common stock at a conversion price initially equal to $1.75 per share. The fair value of the Series B Preferred at issuance was approximately $15 million which was recorded as a derivative liability. This derivative liability is remeasured at fair value at each reporting period. Changes in the related fair value are recorded in loss on derivative liability, in the consolidated statements of operations and comprehensive operations.

Evaluation of Income Taxes

We account for income taxes under the asset and liability method, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements. Under this method, deferred tax assets and liabilities are determined based on the temporary differences between the financial statements and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in income in the period that includes the enactment date.

Deferred income tax assets are reduced by a valuation allowance if, in the judgment of our management, it is more likely than not that all or a portion of a deferred tax asset will not be realized. In making such determination, we consider all available positive and negative evidence, including recent financial operations, projected future taxable income, scheduled reversals of deferred tax liabilities, tax planning strategies and the length of tax asset carryforward periods. The realization of deferred tax assets is primarily dependent upon our ability to generate sufficient future taxable earnings in certain jurisdictions. If we subsequently determine that the carrying value of these assets, which had been written down, would be realized in the future, the value of the deferred tax assets would be increased, thereby increasing net income in the period when that determination was made. See "Income Taxes" in Notes 1 and 9 to the Consolidated Financial Statements for further discussion regarding the realizability of our deferred tax assets and our assessment of a need for a valuation allowance.


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Results of Operations

Continuing Operations

The following table sets forth selected income statement data from our
continuing operations expressed as a percentage of net sales for the fiscal
years indicated. The table excludes discontinued operations and the discussion
that follows should be read in conjunction with the table:



                                                                   Fiscal Year
                                                     2012             2011             2010
Net sales                                             100.0 %          100.0 %          100.0 %
Cost of goods sold, including buying,
distribution and occupancy costs                       75.0             78.1             77.4

Gross margin                                           25.0             21.9             22.6
Selling, general and administrative expenses           29.7             31.1             32.5

Operating loss                                         (4.7 )           (9.2 )           (9.9 )
Loss on derivative liability                              -              0.6                -
Interest expense, net                                   1.7              0.6              0.1

Loss before income taxes                               (6.4 )          (10.4 )          (10.0 )
Income taxes                                            0.1              0.1              0.1

Loss from continuing operations                        (6.5 )%         (10.5 )%         (10.1 )%

Fiscal 2012 Compared to Fiscal 2011

Net Sales

Net sales increased to $803 million in fiscal 2012 from $777 million in fiscal
2011. The components of this $26 million increase in net sales were as follows:



$millions                                   Attributable to
   $    21        2% increase in comparable store net sales in fiscal 2012 and the
                  impact of a 53rd fiscal week. The increase in comparable store net
                  sales was due to an increase of 6% in average sale dollars,
                  partially offset by a decrease in total sales transactions of 4%.
         4        Increase due to non-comparable sales from new, expanded or
                  relocated stores not yet included in the comparable store base.
         1        Increase in other sales.

   $    26        Total

For fiscal 2012, comparable store net sales of Men's and Women's each increased by 2%. The increase in both Men's and Women's was driven by increases in sales of bottoms and non-apparel, partially offset by reduced demand in tops as compared to fiscal 2011. Apparel represented 85% of total Men's sales for fiscal 2012 versus 86% in fiscal 2011, while Women's apparel was flat at 86% of total Women's sales for fiscal 2012 and fiscal 2011. Total accessories and footwear represented a combined 15% of total sales for fiscal 2012 versus 14% in fiscal 2011.


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Gross Margin

Gross margin, after buying, distribution and occupancy costs, increased to
$201 million in fiscal 2012 from $170 million in fiscal 2011, an increase of
$31 million, or 18.2%. As a percentage of net sales, gross margin increased to
25.0% in fiscal 2012 from 21.9% in fiscal 2011. The primary components of this
3.1% increase were as follows:



  %                                        Attributable to
  2.2            Increase in merchandise margin to 49.1% in fiscal 2012 from 46.9%
                 in fiscal 2011, primarily due to an increase in initial markups and
                 a decrease in promotions and markdowns in fiscal 2012 compared to
                 fiscal 2011.
  0.7            Leveraging of occupancy costs as a result of the 2% same-store
                 sales increase for fiscal 2012 discussed above and a reduction in
                 rent expense related to negotiations with our landlords. Occupancy
                 costs as a percentage of net sales were 19.4% in fiscal 2012
                 compared to 20.1% in fiscal 2011.
  0.2            Decrease in buying and distribution costs as a percentage of sales
                 to 4.1% in fiscal 2012 compared to 4.3% in fiscal 2011.

  3.1            Total

Selling, General and Administrative Expenses

Selling, general and administrative ("SG&A") expenses decreased to $239 million
in fiscal 2012 from $242 million in fiscal 2011, a decrease of $3 million, or
1.2%. As a percentage of net sales, these expenses decreased to 29.8% in fiscal
2012 from 31.1% in fiscal 2011. The components of this 1.3% decrease in SG&A
expenses as a percentage of net sales were as follows:



  %                                         Attributable to
  (0.8 )          Decrease in depreciation expense as a percentage of sales. Total
                  depreciation was $31 million in fiscal 2012 compared to $36 million
                  in fiscal 2011.
   0.7            Increase in store payroll and payroll-related expenses as a
                  percentage of net sales due primarily to an increase in employee
                  benefits.
  (0.5 )          Decrease in non-cash asset impairment and lease buyout charges in
                  fiscal 2012 to $5 million from $9 million in fiscal 2011.
  (0.7 )          Decrease in all other SG&A expenses as a percentage of sales. Other
                  SG&A decreased $3 million to $58 million in fiscal 2012 from $61
                  million in fiscal 2011, primarily due to a decrease in consulting
                  expenses.

  (1.3 )          Total

We assess long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying value of such assets (or asset group) may not be recoverable. Based on management's review of the historical operating performance, including sales trends, gross margin rates, current cash flows from operations and the projected outlook for each of our stores, we determined that certain stores would not be able to generate sufficient cash flows over the remaining term of the related leases to recover our investment in the respective stores. As a result, we recorded non-cash impairment charges from continuing operations of approximately $5 million and $9 million during fiscal 2012 and 2011, respectively, to write-down the carrying value of certain long-lived store assets to their estimated fair values.

Loss on Derivative Liability

We recorded a $5 million fair market value adjustment in fiscal 2011 related to our derivative liability (see "Derivative Liability" above). The net impact of the fair market value adjustments recorded in fiscal 2012 related to the derivative liability were immaterial to the fiscal 2012 Consolidated Financial Statements.

Interest Expense, net

Interest expense, net, was $13 million for fiscal 2012, compared to $4 million in fiscal 2011. In fiscal 2012, we recorded $8 million of interest expense, of which $5 million was "payable in kind" interest expense, related to the Term Loan. We also recorded $2 million of amortization of the debt discount in relation to the Term Loan and $2 million was interest expense associated with the "Mortgage Debt" (defined below). In fiscal 2011, we recorded $1 million of interest expense, of which $0.7 million was "payable in kind" interest expense, related to the Term Loan. Amortization of the debt discount related to the Term Loan was $0.2 million in fiscal 2011 and there was $2 million of interest expense related to the Mortgage Debt.


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Income Tax Expense

We recognized income tax expense of $0.8 million for fiscal 2012, compared to income tax expense of $1.0 million for fiscal 2011. For fiscal 2013, we expect to continue to maintain a valuation allowance against deferred tax assets resulting in minimal income tax expense for the year. Information regarding the realizability of our deferred tax assets and our assessment of a need for a valuation allowance is contained in Note 9 to the Consolidated Financial Statements.

Loss from Continuing Operations

Our loss from continuing operations for fiscal 2012 was $52 million, or $(0.77) per share, versus a loss from continuing operations of $82 million, or $(1.23) per share, for fiscal 2011.

Fiscal 2011 Compared to Fiscal 2010

Net Sales

Net sales increased to $777 million in fiscal 2011 from $776 million in fiscal
2010. The components of this $1 million increase in net sales were as follows:



$millions                                   Attributable to
  $    (1)        Decrease due to non-comparable sales from new, expanded or
                  relocated stores not yet included in the comparable store base.
        2         Increase in other sales.

   $    1         Total

For fiscal 2011, comparable store net sales of Men's and Women's were flat. Increases in both Men's and Women's were driven by increases in sales of bottoms and non-apparel, partially offset by reduced demand in tops as compared to fiscal 2010. Apparel represented 86% of total Women's sales for fiscal 2011 versus 87% in fiscal 2010, while Men's apparel was flat at 86% of total Men's sales for fiscal 2011 and fiscal 2010. Total accessories and footwear represented a combined 14% of total sales for fiscal 2011 versus 13% in fiscal 2010.

Gross Margin

Gross margin, after buying, distribution and occupancy costs, decreased to
$170 million in fiscal 2011 from $175 million in fiscal 2010, a decline of
$5 million, or 2.8%. As a percentage of net sales, gross margin decreased to
21.9% in fiscal 2011 from 22.6% in fiscal 2010. The primary components of this
0.7% decrease were as follows:



  %                                     Attributable to
(0.5)         Decrease in merchandise margin to 46.9% in fiscal 2011 from 47.4% in
              fiscal 2010, primarily due to an increase in markdowns in fiscal
              2011, compared to fiscal 2010.
(0.3)         Deleverage of occupancy costs as a result of the flat same-store
              sales for fiscal 2011 discussed above. Occupancy costs as a
              percentage of net sales were 20.1% in fiscal 2011 compared to 19.8%
              in fiscal 2010.
 0.2          Decrease in buying and distribution costs as a percentage of sales
              to 4.3% in fiscal 2011 compared to 4.5% in fiscal 2010.
(0.1)         Increase in other gross margin costs.

(0.7)         Total


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Selling, General and Administrative Expenses

SG&A expenses decreased to $242 million in fiscal 2011 from $252 million in
fiscal 2010, a decrease of $10 million, or 4.0%. As a percentage of net sales,
these expenses decreased to 31.1% in fiscal 2011 from 32.5% in fiscal 2010. The
components of this 1.4% decrease in SG&A expenses as a percentage of net sales
were as follows:



  %                                     Attributable to
(1.1)         Decrease in depreciation expense as a percentage of sales. Total
              depreciation was $36 million in fiscal 2011 compared to $44 million
              in fiscal 2010.
(0.5)         Decrease in store payroll and payroll-related expenses as a
              percentage of net sales due to better management of store payroll in
              fiscal 2011 compared to fiscal 2010. Payroll expense decreased $4
              million to $135 million in fiscal 2011 from $139 million in fiscal
              2010.
(0.3)         Decrease in asset impairment and lease buyout charges in fiscal 2011
              to $9 million compared to $12 million in fiscal 2010.
 0.5          Increase in all other SG&A expenses as a percentage of sales. SG&A
              expenses increased $4 million to $61 million in fiscal 2011 from $57
              million in fiscal 2010, primarily due to an increase in consulting
              and advertising expenses.

(1.4)         Total

We assess long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying value of such assets (or asset group) may not be recoverable. Based on management's review of the historical operating performance, including sales trends, gross margin rates, current cash flows from operations and the projected outlook for each of our stores, we determined that certain stores would not be able to generate sufficient cash flows over the remaining term of the related leases to recover our investment in the respective stores. As a result, we recorded non-cash impairment charges from continuing operations of approximately $9 million and $11 million during fiscal 2011 and 2010, respectively, to write-down the carrying value of certain long-lived store assets to their estimated fair values.

Loss on Derivative Liability

We recorded a $5 million fair market adjustment in fiscal 2011 related to our derivative liability (see "Derivative Liability" above).

Interest Expense, net

Interest expense, net, was $4 million for fiscal 2011 compared to approximately $1 million in fiscal 2010. In fiscal 2011, we recorded $3 million of interest expense related to the Term Loan and to the Mortgage Debt. In fiscal 2010, we recorded $0.9 million of interest expense related to the Mortgage Debt.

Income Tax Expense

We recognized income tax expense of $1.0 million for fiscal 2011, compared to . . .

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