| Pacific Sunwear (PSUN) operates two mall based | | | | Sunwear needs someplace to put all the cash it's |
| retail chains: PacSun and d.e.mo. PacSun is a | | | | generating, and a new concept may be a better |
| nationwide surf and skate themed chain with about | | | | long-term bet than continuing to expand the PacSun |
| 900 locations comprising approximately 3.25 million | | | | chain. |
| square feet. d.e.m.o. is a hip hop themed chain with | | | | There is a real danger of overexpansion at PacSun. If |
| about 200 stores comprising approximately 500,000 | | | | things turn negative, Pacific Sunwear will suffer |
| square feet. Both chains target the "teen" market | | | | mightily. But, that's the nature of retail. Between the |
| (specifically, guys and girls ages 12-24). | | | | operating leases and the fixed costs associated with |
| Locations | | | | each store, specialty retailers are highly leveraged. |
| Nationwide, PacSun operates approximately 800 | | | | Sales increases produce spectacular profit growth; |
| PacSun stores and 100 PacSun Outlets. Unlike PacSun | | | | sales decreases cause a rapid erosion of those |
| stores, which are very evenly distributed on the basis | | | | profits. It is not realistic to assume that a retailer can |
| of population, PacSun Outlets are skewed towards | | | | get out from under the burden of its stores in the |
| highly populous states with large areas of | | | | same way marketers and manufacturers can exit a |
| extraordinarily high population density ("suburban | | | | particular line of business. The biggest difference is |
| sprawl"). The only exceptions are Virginia, North | | | | the speed at which profits evaporate. A specialty |
| Carolina, and Louisiana. While the number of stores in | | | | retailer has little time to adjust course. |
| any one state is small enough that the | | | | One Thousand Steps has promise. Pacific Sunwear |
| disproportionate concentration of PacSun Outlets in | | | | has demonstrated its ability to manage the growth |
| these states may be purely coincidental, I doubt it. | | | | of mall-based chains. The target audience for One |
| More likely, PacSun Outlets in these states are meant | | | | Thousand Steps is part of the same age group |
| to benefit from the expected population growth in | | | | targeted by Pacific Sunwear's other two chains. Like |
| their surrounding communities, and were developed | | | | d.e.m.o., One Thousand Steps will target a very |
| because of the danger of saturation in states such | | | | different segment from existing Pacific Sunwear |
| as New York, New Jersey, Maryland, Michigan, Illinois, | | | | stores. One Thousand Steps is unlikely to attract the |
| and California. I have not heard management discuss | | | | same customers who frequent PacSun or d.e.m.o. |
| this matter. So, it is pure conjecture on my part. It | | | | Therefore, it should be another non-cannibalizing |
| will be interesting to see where the new PacSun and | | | | growth vehicle. |
| PacSun Outlets are located. | | | | Footwear is a good choice for a new mall-based |
| For the most part, PacSun stores are not unusually | | | | chain. Generally, most malls have underserved the |
| concentrated in any state or region. In fact, they are | | | | teen footwear market. Although there are some |
| eerily evenly distributed relative to state populations. | | | | notable footwear chains, a nationwide comparison by |
| It is likely management has intentionally acted to | | | | store count suggests there is plenty of room for a |
| ensure an even distribution of PacSun stores across | | | | new mall-based teen footwear retailer. Teen |
| the U.S. As a result, regional economic and | | | | footwear stores are very scarce relative to teen |
| demographic trends will have no material effect on | | | | apparel stores. |
| PacSun's operations.d.e.m.o. stores are not (yet) as | | | | The margins on both shoes and accessories are |
| evenly distributed. They are disproportionately | | | | good. Just as important, Pacific Sunwear has |
| located in Northeastern states, Southeastern states, | | | | demonstrated its ability to successfully sell both |
| and California. There are relatively few d.e.m.o. stores | | | | types of merchandise. One particularly appealing |
| west of the Appalachians and east of the Sierra | | | | aspect of selling footwear is the strong appeal of |
| Nevadas. The number of stores in the d.e.m.o. chain is | | | | name brands. Obviously, customers form stronger |
| still growing at about 20-25% a year; so, a more | | | | attachments to footwear brands than to apparel |
| even distribution may be achieved in the future. | | | | brand. This is not surprising given the limited number |
| Among teens, hip hop clothing is not limited to the | | | | of footwear items purchased relative to apparel |
| Northeast, Southeast, and California. Therefore, it is | | | | items and the frequency with which any one shoe is |
| unlikely the d.e.m.o. chain will be permanently limited to | | | | worn. |
| these regions. | | | | There are important differences between Pacific |
| Strategy | | | | Sunwear's two existing chains and the One Thousand |
| Pacific Sunwear's strategy is to operate two | | | | Steps concept. Both PacSun and d.e.m.o. sell entire |
| separate, non-cannibalizing chains. Management claims | | | | outfits. They offer everything needed to dress in the |
| each chain is focused on a different teen "subculture". | | | | style of the particular "subculture" they serve. One |
| I would say subculture is too strong a term (and | | | | Thousand Steps will not sell entire outfits. So, the |
| academics are as guilty as retail executives for | | | | new chain is unlikely to enjoy the same kind of |
| stretching the term to the point where it loses its | | | | customer stickiness that PacSun and d.e.m.o. enjoy. |
| meaning). However, it is true that the two styles, | | | | One Thousand Steps will not be as distinctive as |
| and indeed, the two sets of customers are distinct. | | | | PacSun and d.e.m.o. For now, it is difficult to say how |
| There is virtually no overlap between PacSun | | | | distinctive One Thousand Steps will be. However, it is |
| customers and d.e.m.o. customers. | | | | safe to say the new chain will be less distinct in the |
| In April, the company plans to introduce One | | | | minds of customers than either PacSun or d.e.m.o. |
| Thousand Steps, a new mall-based footwear and | | | | That isn't surprising. Very few stores are as distinct |
| accessories chain targeting 18-24 year olds. It is very | | | | as PacSun or d.e.m.o. None of Pacific Sunwear's major |
| unlikely this chain will prove to be cannibalizing. | | | | competitors operates stores that have as well |
| Tactics | | | | defined an image as PacSun or d.e.m.o. |
| Pacific Sunwear locates stores in high-traffic malls. | | | | Pacific Sunwear will manage the One Thousand Steps |
| The company actively seeks to locate its stores in | | | | chain better than any other company possible could. |
| malls frequented by large numbers of teens, despite | | | | If you first described the One Thousand Steps |
| the fact that this puts the company in direct | | | | concept and then asked what company would be |
| competition with rivals such as Abercrombie & | | | | best suited to manage it, I would need only a |
| Fitch (ANF), American Eagle (AEOS), Aeropostale | | | | fraction of a second to say Pacific Sunwear. No |
| (ARO), Hot Topic (HOTT), and Gap (GPS). There are | | | | company is more knowledgeable about selling |
| malls in which one can find PacSun, Abercrombie | | | | footwear to young customers. |
| & Fitch, Aeropostale, and Hot Topic stores all | | | | The PacSun chain has done a tremendous job selling |
| under the same roof. | | | | name brand footwear to teens. PacSun is directly |
| PacSun's footwear offerings have been particularly | | | | responsible for the lasting success of several of the |
| effective in keeping young men coming back. Shoes, | | | | brands it carries. Although brand name footwear was |
| particularly the kind PacSun sells, are a good lure for | | | | already an important part of many skaters' lives (and |
| young men, because men tend to frequent their | | | | more importantly their spending habits), PacSun |
| favorite stores far less often than women do. Even | | | | greatly magnified that importance. Without PacSun, |
| where there are no fashion concerns, shoes must be | | | | the value of the major skate shoe brands would be |
| regularly replaced. Furthermore, males between the | | | | significantly less than it is today. Very few retailers |
| ages of 12-24 must buy new shoes, even if there | | | | have had this kind of positive influence on the brands |
| are no aesthetic considerations involved, because old | | | | they carry. |
| shoes will simply stop fitting their feet. | | | | It is impossible to evaluate the One Thousand Steps |
| There is anecdotal evidence for this; but, | | | | concept at this point. I will be watching the chain |
| unfortunately I could not find a study describing the | | | | carefully to see how it distinguishes itself from its |
| annual change in shoe size for different segments of | | | | competition, how it increases customer stickiness, |
| this age group. There is plenty of data on changes in | | | | and how it selects the brands it carries. The more |
| height for males within this age group. However, it is | | | | different One Thousand Steps is, the more |
| very unlikely changes in height are concurrent with | | | | successful it will be. |
| changes in shoe size. Anecdotal evidence suggests | | | | Pacific Sunwear plans to open 8-10 One Thousand |
| changes in shoe size are more common and more | | | | Steps stores during the first half of 2006. |
| pronounced among males than among females within | | | | Management believes the chain could grow to 600 - |
| this age group. | | | | 800 stores. At an average size of 2,500 square feet, |
| It also suggests changes in shoe size would be more | | | | that would mean the chain could grow to between |
| common and more pronounced within the youngest | | | | 1.5 million and 2 million square feet. |
| segment of this group. This has important | | | | Upon announcing the new concept (last year), Pacific |
| psychological implications, because, if true, selling | | | | Sunwear CEO Seth Johnson made the following |
| footwear would tend to cause young men to | | | | statement: |
| frequent a particular store at a time when they are | | | | Footwear has been a highly successful part of our |
| more likely to form a habit of shopping there | | | | assortment in PacSun stores. One Thousand Steps |
| regularly. For instance, one would expect that a male | | | | will enable us to leverage our brand management |
| shopper has formed more attachments and stronger | | | | skills in what we believe is an underserved market. |
| attachments to particular stores by the time he is 17 | | | | This new concept gives us an exciting growth vehicle |
| than he had by the time he was 13. | | | | that adds a new and distinct customer base to our |
| Pacific Sunwear's stores offer a broad selection of | | | | business. Combined with out existing PacSun and |
| items within each brand. In fact, the company has | | | | d.e.m.o. businesses, we will have the opportunity to |
| been responsible for the expansion of some of the | | | | achieve significant sales and profit growth in the |
| brands it carries into new products (particularly | | | | future. |
| footwear and accessories). Pacific Sunwear has | | | | I am cautiously optimistic about One Thousand Steps. |
| encouraged the owners of some of its best known | | | | The concept is more promising than d.e.m.o. |
| brands to expand beyond their original product and | | | | However, I will have to wait until I see an actual |
| leverage the prominence their brand enjoys within | | | | store before I can offer any assessment of the |
| Pacific Sunwear's stores into nationwide sales of new | | | | chain's profit potential. |
| products. | | | | Estimates |
| Pacific Sunwear is able to effect such changes, | | | | Analysts are optimistic about Pacific Sunwear's future |
| because the company is usually one of the largest | | | | earnings, but pessimistic about Pacific Sunwear's |
| customers for each of its vendors. In several cases, | | | | shares. Wall Street is estimating 16-17% earnings |
| Pacific Sunwear is the largest customer. The | | | | growth over the next five years. That's lower than |
| company has more influence over vendors than | | | | the growth rate Pacific Sunwear achieved over the |
| would be suggested by the size of its total sales, | | | | last ten years. However, it's higher than the growth |
| because the products it sells tend to have a more | | | | rate I would predict. |
| limited distribution than the products carried by some | | | | The average 5-year earnings estimate from analysts |
| of Pacific Sunwear's larger competitors. | | | | is in the 16-17% range; but, the average |
| The brands carried in PacSun and d.e.m.o. stores | | | | recommendation is a hold. These two opinions are |
| benefit from a greatly enhanced image among the | | | | mutually exclusive. They are utterly incompatible. You |
| "subculture" they target. These are niche brands that | | | | can not predict a 16-17% earnings growth rate for |
| become even more closely associated with their | | | | Pacific Sunwear without also predicting the company's |
| particular niche when they are featured prominently in | | | | shares will outperform the S&P. Well, actually |
| PacSun and d.e.m.o. stores. | | | | you can, because a great many analysts have done |
| There is anecdotal evidence that a few of the name | | | | exactly that. But, you shouldn't. |
| brands carried in PacSun stores have become so | | | | PSUN is trading at a P/E of about 14. The argument |
| closely associated with the chain, that, within the | | | | for a significant multiple contraction is very weak. |
| customer's mind, the brand's image and the store's | | | | What company is going to grow earnings at 16-17% |
| image have fused. Where a brand carried in PacSun | | | | a year and sport a P/E well below 12? The obvious |
| stores is also carried elsewhere, it is almost always | | | | answer would be a company weighed down by a |
| much more visible in the PacSun stores, because the | | | | tremendous debt burden. So, how much debt does |
| target market for PacSun and the target market for | | | | Pacific Sunwear have? None. |
| the brands it carries are very similar - and the image | | | | The company's total liabilities are about equal to |
| PacSun projects is relatively undiluted. Other retailers | | | | current inventory levels. Current assets (ex other) |
| run a greater risk of striking a discordant note. | | | | are about $350 million; total liabilities are about $250 |
| Merchandise | | | | million. The company has about $125 million in cash |
| Pacific Sunwear's total sales consist of approximately | | | | and marketable securities. Pacific Sunwear can |
| 67% name brand sales and 33% proprietary brand | | | | probably generate over $150 million in cash from |
| sales. Pacific Sunwear's two largest individual branded | | | | operations each year. |
| vendors are Quiksilver (ZQK) and Billabong. Both | | | | It is unlikely the company can open new stores fast |
| companies are probably still best known for their surf | | | | enough to keep free cash flow from reaching 50 - |
| wear; however, they have branched out into other | | | | $75 million a year. This is a fast growing company |
| merchandise such as skateboarding and snowboarding | | | | that is generating cash much faster than it can spend |
| apparel and various accessories. Quiksilver is | | | | it. |
| responsible for sales of the Quiksilver, Roxy, and DC | | | | There is a good chance that, five years from now, |
| Shoes brands; Billabong is responsible for sales of | | | | there will be fewer shares outstanding than there are |
| both the Billabong and Element brands. | | | | today. Therefore, whatever multiple contraction |
| Each company's merchandise accounts for about | | | | these analyst are expecting would have to bring |
| 10% of Pacific Sunwear's total sales or about 15% of | | | | Pacific Sunwear's stock down to a P/E rarely seen by |
| total name brand sales. In other words, about | | | | healthy, growing U.S. companies. |
| twenty cents of every dollar spent at Pacific | | | | The company's PEG ratio is well below 1, and its |
| Sunwear stores is spent on Quiksilver or Billabong | | | | forward P/E is about 12. I don't pay any attention to |
| products. These percentages are based on Pacific | | | | these numbers, but analysts seem to. So, why don't |
| Sunwear's company wide total sales numbers; | | | | they rate PSUN a buy? I don't know and I don't care. |
| therefore, it is safe to say sales of Quiksilver and | | | | It probably has something to do with the industry. |
| Billabong products make up well over one-fourth of all | | | | Compared to analysts, I'm less optimistic about |
| sales at PacSun stores. | | | | Pacific Sunwear's earnings growth, but more |
| Pacific Sunwear's total sales consist of approximately | | | | optimistic about the company's shares. |
| 65% apparel, 20% accessories, and 15% footwear. | | | | Profitability |
| Pacific Sunwear has always sold more guys' apparel | | | | Pacific Sunwear has consistently earned high returns |
| than girls' apparel. In recent years, the gap has | | | | on equity while employing very little debt. Over the |
| narrowed slightly. Currently, apparel sales consist of | | | | past 10 years, the company has achieved returns on |
| approximately 55% guys' apparel and 45% girls' | | | | equity of about 17%. Returns in recent years have |
| apparel. | | | | been higher than returns at the beginning of the ten |
| Apparel sales account for a smaller percentage of | | | | year period. However, the company's return on |
| Pacific Sunwear's total sales than they had in previous | | | | equity has been above average throughout the |
| years, because sales of footwear have been growing | | | | period, and the difference between the ROE of |
| much faster than sales of apparel. Sales of | | | | recent years and the ROE of the more distant past |
| accessories have grown faster than apparel sales, | | | | is not particularly significant. Basically, this has been a |
| but slower than footwear sales. Only relative growth | | | | business with a 17% return on equity for some time. |
| is being discussed here; absolute growth has been | | | | Pacific Sunwear scores well on every profitability |
| positive in all categories. Of course, this is not | | | | metric. The company has a high free cash flow |
| surprising considering the growth in the number of | | | | margin - and an even higher owner's earnings margin, |
| stores operated. | | | | because the company has invested much more in |
| Trends | | | | capital expenditures than required for maintenance |
| Recently, growth in the number of total transactions | | | | alone. |
| per comparable store at both PacSun and d.e.m.o. has | | | | Pacific Sunwear's return on retained earnings has |
| been anemic. However, growth in the average sales | | | | ranged from 25-50% and its pre-tax return on |
| transaction was up significantly, allowing Pacific | | | | non-cash assets has ranged from 20-30%. Both of |
| Sunwear to post strong same store sales numbers. | | | | these numbers are quite healthy, especially |
| Over the last two years, the number of total | | | | considering the consistency with which they have |
| transaction per comparable store has been virtually | | | | been achieved. |
| flat. Recently, growth in the average sales transaction | | | | Pacific Sunwear, like most of its rivals, leases its retail |
| has been as high as 7-8%. | | | | stores under long-term operating leases. The initial |
| This may be a short-term trend. Unfortunately, I am | | | | term of each lease is usually ten years. The use of |
| not convinced it is. Pacific Sunwear's performance in | | | | operating leases makes it difficult to compare the |
| terms of growth in the number of total transactions | | | | profitability of companies like Pacific Sunwear with |
| and growth in sales per square foot has not been as | | | | the profitability of companies that do not have any |
| strong as the headline numbers suggest. These are | | | | such long-term obligations. |
| two metrics to watch closely in the years ahead. | | | | Pacific Sunwear has about $700 million in minimum |
| The general impression given by these metrics (and | | | | future rental commitments. The present value of |
| by much of the other available data) is that the | | | | these commitments should be estimated at well |
| PacSun chain is more mature than Pacific Sunwear's | | | | under $500 million for purposes of comparison. So, |
| impressive growth rates suggest. The store count | | | | even if one were to compare Pacific Sunwear's |
| alone might lead some to the conclusion that | | | | capital structure with that of non-retailers, PSUN |
| PacSun's past growth rates are unsustainable. Of | | | | would not appear to be unduly leveraged. |
| course, every retailer must face this dilemma at | | | | Conclusions |
| some point - and specialty retailers like PacSun must | | | | I don't like owning retailers, and I don't like valuing |
| confront the problem sooner than most. | | | | retailers. If I had to pick an expected 10-year annual |
| At times, comparable store sales growth at PacSun | | | | return for the investor who buys shares of PSUN at |
| has outpaced comparable store sales growth at | | | | tomorrow's opening price, I would pick 12-13%. This |
| d.e.m.o. The difference has often been small, but that | | | | rate of return should be enough to beat the market, |
| does not make it immaterial. In the most recent | | | | but is short of the magical 15% rate of return that I |
| period, same store sales were stronger at d.e.m.o. | | | | believe will lead to a 3-5% real after-tax return for |
| than at PacSun. Still, d.e.m.o. does not have the same | | | | the buy and hold investor. |
| potential PacSun did. However, management is intent | | | | It is quite conceivable Pacific Sunwear will perform |
| upon adding new d.e.m.o. stores - and, at present, | | | | much better than I expect. If everything goes the |
| there is no good reason not to. | | | | way management hopes, and each of the three |
| Both PacSun and d.e.m.o. have some room for | | | | chains is expanded to the stated goals, the 10-year |
| expansion left - and Pacific Sunwear is generating | | | | return could be closer to 15-17%. However, I believe |
| more than enough free cash flow to fund their | | | | such a high rate of return is unlikely. I'm sticking with |
| expansion. The company already has plenty of cash | | | | 13%. |
| on hand. In fact, it probably has more cash than it | | | | If I had to choose between being 100% invested in |
| can effectively deploy, considering how much free | | | | the S&P 500 or being 100% invested in PSUN, I |
| cash flow Pacific Sunwear will generate next year. | | | | would probably choose PSUN. If I had to choose |
| Growth | | | | between being 25-50% invested in S&P 500 or |
| There is still some growth potential at both PacSun | | | | 25-50% invested in PSUN, I would definitely choose |
| and d.e.m.o. However, the attention of most Pacific | | | | PSUN. Regardless, I expect shares of Pacific Sunwear |
| Sunwear shareholders will likely be fixed on One | | | | will beat the market over the next ten years. |
| Thousand Steps, the company's new mall-based | | | | If you own more than a handful of stocks, PSUN |
| footwear and accessories chain scheduled to launch in | | | | would probably make a fine addition to your portfolio |
| April. One Thousand Steps will target 18-24 year olds. | | | | (if acquired at the $22.50 or so at which the stock |
| I have mixed feelings about One Thousand Steps. | | | | last traded). |
| The concept could be a good growth vehicle. Pacific | | | | |