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PACIFIC SUNWEAR OF CALIFORNIA INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.(Edgar Glimpses Via Acquire Media NewsEdge) The following management's discussion and analysis of financial condition and results of operations ("MD&A") should be read in conjunction with our Condensed Consolidated Financial Statements and notes thereto included elsewhere in this Report. Cautionary Note Regarding Forward-Looking Statements This Report contains "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), and we intend that such forward-looking statements be subject to the safe harbors created thereby. In Item 1A, Risk Factors, in our Annual Report on Form 10-K for the year ended February 1, 2014 (our "2013 Annual Report"), we provide cautionary statements identifying important factors that could cause our actual results to differ materially from those projected in the forward-looking statements contained herein. Any statements that express, or involve discussions as to, expectations, beliefs, plans, objectives, assumptions, future events or performance (often, but not always, identifiable by the use of words or phrases such as "will result," "expects to," "will continue," "anticipates," "plans," "intends," "estimated," "projects" and "outlook") are not historical facts and may be forward-looking and, accordingly, such statements involve estimates, assumptions and uncertainties which could cause actual results to differ materially from those expressed in the forward-looking statements. Examples of forward-looking statements in this Report include, but are not limited to, the following categories of expectations about: • the sufficiency of operating cash flows, working capital and available credit to meet our operating and capital expenditure requirements; • our capital expenditure plans for fiscal 2014; and • potential recording of non-cash impairment charges for underperforming stores in future quarters. All forward-looking statements included in this Report are based on information available to us as of the date hereof, and are subject to risks and uncertainties that could cause actual results to differ materially from those expressed in the forward-looking statements. See Item 1A, Risk Factors, in our 2013 Annual Report, which are hereby incorporated by reference in this Report for a discussion of these risks and uncertainties. We assume no obligation to update or revise any such forward-looking statements to reflect events or circumstances that occur after such statements are made. Executive Overview We consider the following items to be key indicators in evaluating our 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. We include sales from our e-commerce business in same store sales. Net merchandise margin 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, average net sales per square foot and number of transactions. Cash flow and liquidity (working capital) 15-------------------------------------------------------------------------------- Table of Contents We evaluate cash flow from operations, liquidity and working capital to determine our short-term operational financing needs. Based on current forecasts, we believe that cash flows from operations and working capital, along with the availability under the Wells Credit Facility, will be sufficient to meet our operating and capital expenditure needs for the next twelve months. We currently anticipate that we will borrow under the Wells Credit Facility in the third quarter in order to finance inventory purchases for the holiday season. Critical Accounting Policies There have been no material changes to our critical accounting policies and estimates from the information provided in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" included in our 2013 Annual Report on Form 10-K for the year ended February 1, 2014. 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 periods indicated. The table excludes discontinued operations and the discussion that follows should be read in conjunction with the table: For the Second Quarter Ended For the First Half Ended August 2, 2014 August 3, 2013 August 2, 2014 August 3, 2013 Net sales 100.0 % 100.0 % 100.0 % 100.0 % Cost of goods sold, including buying, distribution and occupancy costs 70.9 70.2 72.3 72.3 Gross margin 29.1 29.8 27.7 27.7 Selling, general and administrative expenses 28.6 27.0 29.4 29.1 Operating income (loss) 0.5 2.8 (1.7 ) (1.4 ) (Gain) loss on derivative liability (4.9 ) 10.1 (3.0 ) 8.1 Interest expense, net 1.9 1.6 2.0 1.8 Income (loss) from continuing operations before income taxes 3.5 (8.9 ) (0.7 ) (11.3 ) Income tax expense - - 0.1 - Income (loss) from continuing operations 3.5 % (8.9 )% (0.8 )% (11.3 )% 16-------------------------------------------------------------------------------- Table of Contents The second quarter (13 weeks) ended August 2, 2014 as compared to the second quarter (13 weeks) ended August 3, 2013 Net Sales Net sales were $211.7 million for the second quarter of fiscal 2014 versus $210.1 million for the second quarter of fiscal 2013. The components of this $1.6 million increase in net sales are as follows: $ millions Attributable to $ 0.4 Increase in comparable store sales. 1.2 Increase in non-comparable sales. $ 1.6 Total For the second quarter of fiscal 2014, comparable store net sales increased 0.3%, average sales transactions increased 7% and total transactions decreased 6%, as compared to the same period a year ago. The comparable store net sales increase resulted from a 3% increase in Men's sales, while Women's sales decreased 3%. The increase in Men's sales was driven primarily by sales of bottoms and footwear. The decline in Women's sales was primarily due to a decrease in sales of non-apparel. Apparel represented 81% of total Men's sales for the second quarter of fiscal 2014 versus 83% in the second quarter of fiscal 2013, while Women's apparel represented 91% of total Women's sales for the second quarter of fiscal 2014 versus 87% in the second quarter of fiscal 2013. Combined accessories and footwear was 14% of total sales for the second quarter of fiscal 2014 versus 15% in the second quarter of fiscal 2013. Gross Margin Gross margin, after buying, distribution and occupancy costs, was $61.5 million for the second quarter of fiscal 2014 versus $62.6 million for the second quarter of fiscal 2013. As a percentage of net sales, gross margin was 29.1% for the second quarter of fiscal 2014 compared to 29.8% for the second quarter of fiscal 2013. The components of this 0.7% decrease in gross margin as a percentage of net sales were as follows: % Attributable to (0.7 ) Decrease in merchandise margin to 52.3% from 53.0%. (0.3 ) Increase in occupancy costs. 0.3 Decrease in buying and distribution costs. (0.7 ) Total Selling, General and Administrative Expenses Selling, general and administrative ("SG&A") expenses were $60.6 million for the second quarter of fiscal 2014 compared to $56.7 million for the second quarter of fiscal 2013. As a percentage of net sales, these expenses increased to 28.6% in the second quarter of fiscal 2014 from 27.0% in the second quarter of fiscal 2013. The components of this 1.6% increase in SG&A as a percentage of net sales were as follows: % Attributable to 0.8 Increase in marketing costs related to timing of expenditures. Incurrence of consulting costs supporting long-term strategies and store impairment charges, partially offset by a decrease instore 0.8 payroll and payroll-related expenses. 1.6 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 $1 million during each of the second quarters of fiscal 2014 and 2013, respectively, to write-down the carrying value of certain long-lived store assets to their estimated fair values. 17-------------------------------------------------------------------------------- Table of Contents Gain on Derivative Liability We recorded a non-cash gain of approximately $10 million related to our derivative liability in the second quarter of fiscal 2014, compared to a non-cash loss of approximately $21 million for the second quarter of fiscal 2013. See Note 10 to the Condensed Consolidated Financial Statements "Fair Value Measurements - Recurring Fair Value Measurements-Derivative Liability" for further discussion of the derivative liability. Interest Expense, Net Interest expense, net, was approximately $4 million and $3 million in the second quarters of fiscal 2014 and 2013, respectively. Interest expense, net, for the second quarters of fiscal 2014 and 2013 was primarily related to interest costs associated with the Term Loan and mortgage debt described in Note 7 to the Condensed Consolidated Financial Statements. Income Taxes We recognized an income tax benefit of $0.2 million and $0.1 million for the second quarters of fiscal 2014 and 2013 respectively. For fiscal 2014, 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 8 to the Condensed Consolidated Financial Statements. Income (Loss) from Continuing Operations Our income from continuing operations for the second quarter of fiscal 2014 was approximately $8 million, or $0.10 per diluted share, versus a loss from continuing operations of approximately $19 million, or $(0.27) per diluted share, for the second quarter of fiscal 2013. Included in income from continuing operations for the second quarter of fiscal 2014 was a non-cash gain of (10.4) million, or $0.14 per diluted share related to our derivative liability, versus a non-cash loss of $21.2 million, or $(0.31) per diluted share, for the same period a year ago. The first half (26 weeks) ended August 2, 2014 as compared to the first half (26 weeks) ended August 3, 2013 Net Sales Net sales were $382.9 million for the first half of fiscal 2014 versus $376.4 million for the first half of fiscal 2013. The components of this $6.5 million increase in net sales are as follows: $ millions Attributable to $ 4.9 Increase in comparable store sales. 1.6 Increase in non-comparable sales. $ 6.5 Total For the first half of fiscal 2014, comparable store net sales increased 1%, average sales transactions increased 6% and total transactions decreased 5%, as compared to the same period a year ago. The comparable store net sales increase was due to a 6% increase in Men's sales, while Women's sales decreased 4%. The increase in Men's sales was driven primarily by sales of footwear, tops and bottoms. The decline in Women's sales was primarily due to a decrease in sales of non-apparel. Apparel represented 80% of total Men's sales for the first half of fiscal 2014 versus 82% in the first half of fiscal 2013, while Women's apparel represented 91% of total Women's sales for the first half of fiscal 2014 versus 86% in the first half of fiscal 2013. Combined accessories and footwear was 15% of total sales for the first half of fiscal 2014 versus 16% in the first half of fiscal 2013. Gross Margin Gross margin, after buying, distribution and occupancy costs, was $106.2 million for the first half of fiscal 2014 versus $104.4 million for the first half of fiscal 2013. As a percentage of net sales, gross margin was flat at 27.7% for both the first half of fiscal 2014 and the first half of fiscal 2013. The activity in gross margin as a percentage of net sales was as follows: % Attributable to 0.2 Increase in merchandise margin to 53.1% from 52.9%. (0.2 ) Increase in buying and occupancy costs, partially offset by reductions in distribution costs. - Total Selling, General and Administrative Expenses Selling, general and administrative ("SG&A") expenses were $112.6 million for the first half of fiscal 2014 compared to $109.4 million for the first half of fiscal 2013. As a percentage of net sales, these expenses increased to 29.4% in the first half of fiscal 2014 18-------------------------------------------------------------------------------- Table of Contents from 29.1% in the first half of fiscal 2013. The components of this 0.3% increase in SG&A as a percentage of net sales were as follows: % Attributable to 0.2 Increase in marketing costs related to timing of expenditures. Incurrence of consulting costs supporting long-term strategies and store impairment charges, partially offset by decreases in depreciation and amortization and store payroll andpayroll-related 0.1 expenses. 0.3 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 $1.7 million during the first half of fiscal 2014 and approximately $1.4 million during the first half of fiscal 2013 to write-down the carrying value of certain long-lived store assets to their estimated fair values. Gain on Derivative Liability We recorded a non-cash gain of approximately $12 million related to our derivative liability in the first half of fiscal 2014, compared to a non-cash loss of approximately $30 million for the first half of fiscal 2013. See Note 10 to the Condensed Consolidated Financial Statements "Fair Value Measurements - Recurring Fair Value Measurements-Derivative Liability" for further discussion of the derivative liability. Interest Expense, Net Interest expense, net, was approximately $8 million and $7 million for the first half of fiscal 2014 and 2013, respectively. Interest expense, net, for the first half of fiscal 2014 and 2013 was primarily related to interest costs associated with the Term Loan and mortgage debt described in Note 7 to the Condensed Consolidated Financial Statements. Income Taxes We recognized income tax expense of $0.2 million for the first half of fiscal 2014 and $0.1 million for the first half of fiscal 2013. For fiscal 2014, 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 8 to the Condensed Consolidated Financial Statements. Loss from Continuing Operations Our loss from continuing operations for the first half of fiscal 2014 was approximately $3 million, or $(0.04) per diluted share, versus a loss from continuing operations of approximately $43 million, or $(0.62) per diluted share, for the first half of fiscal 2013. Included in the loss from continuing operations for the first half of fiscal 2014 was a non-cash gain of $12 million or $0.17 per diluted share related to our derivative liability, versus a non-cash loss of $30 million, or $(0.45) per diluted share, for the same period a year ago. Liquidity and Capital Resources We have historically financed our operations primarily from internally generated cash flow and with short-term and long-term borrowings. Our primary cash requirements have been for the financing of inventories and construction of newly opened, remodeled, expanded or relocated stores. Based on current forecasts, we believe that cash flows from operations and working capital, along with the availability under the Wells Credit Facility, will be sufficient to meet our operating and capital expenditure needs for the next twelve months. We currently anticipate that we will borrow under the Wells Credit Facility in the third quarter in order to finance inventory purchases for the holiday season. 19-------------------------------------------------------------------------------- Table of Contents For the First Half Ended August 2, 2014 August 3, 2013 (In thousands)Net cash provided by (used in) operating activities $ 1,105 $ (17,090 ) Net cash used in investing activities (7,919 ) (4,484 ) Net cash provided by (used in) financing activities 360 (291 ) Net decrease in cash and cash equivalents $ (6,454 ) $ (21,865 ) Operating Cash Flows Net cash provided by operating activities in the first half of fiscal 2014 was $1.1 million, compared to $17.1 million of cash used for the first half of fiscal 2013. This increase of $18.2 million was due primarily to increases in accounts payable and other current liabilities. Our primary use of cash in the first half of fiscal 2014 and 2013 was to purchase merchandise inventories. Non-cash adjustments to reconcile our net loss to net cash used in operating activities were approximately $5 million in the first half of fiscal 2014 and $48 million in the first half of fiscal 2013, and were primarily related to depreciation expense, asset impairment charges and the (gain) loss on our derivative liability in both periods. Working Capital Working capital at August 2, 2014, was $19 million compared to $16 million at February 1, 2014, an increase of $3 million. The changes in working capital were as follows: $ millions Description $ 16 Working capital at February 1, 2014. (6 ) Decrease in cash and cash equivalents. 2 Increase in inventories, net of accounts payable. 7 Increase in other current assets, net of other current liabilities. $ 19 Working capital at August 2, 2014. Investing Cash Flows Net cash used in investing activities in the first half of fiscal 2014 was $7.9 million compared to $4.5 million used in investing activities for the first half of fiscal 2013, an increase in cash outflow of $3.4 million. Investing cash outflows in the first half of fiscal 2014 and 2013 were comprised of capital expenditures for refreshing existing stores and information technology investments at the store level. We expect total capital expenditures for fiscal 2014 to be approximately $18 million to $20 million. Financing Cash Flows Net cash provided by financing activities in the first half of fiscal 2014 was $0.4 million compared to net cash used in financing activities of $0.3 million for the first half of fiscal 2013. The primary sources of cash from financing activities in the first half of fiscal 2014 were proceeds from mortgage borrowings and stock option exercises, offset by principal payments under our mortgage debt and capital lease obligations. The primary uses of financing activities in the first half of 2013 were principal payments under our mortgage debt and capital lease obligations. Wells Credit Facility Information regarding the Wells Credit Facility is contained in Note 7 to the Condensed Consolidated Financial Statements and is incorporated herein by reference. Term Loan Information regarding the Term Loan is contained in Note 7 to the Condensed Consolidated Financial Statements and is incorporated herein by reference. Mortgage Transactions Information regarding our mortgage debt is contained in Note 7 to the Condensed Consolidated Financial Statements and is incorporated herein by reference. 20-------------------------------------------------------------------------------- Table of Contents Contractual Obligations We have minimum annual rental commitments under existing store leases as well as a minor amount of capital leases for computer equipment. We lease all of our retail store locations under operating leases. We lease equipment, from time to time, under both capital and operating leases. In addition, at any time we are contingently liable for commercial letters of credit with foreign suppliers of merchandise. At August 2, 2014, our future financial commitments under all existing contractual obligations were as follows: Payments Due by Period Less More than 1 1-3 3-5 than 5 Total year years years years (In millions) Operating lease obligations $ 316 $ 73 $ 111 $ 75 $ 57 Term loan 97 4 93 - - Mortgage debt 38 2 4 4 28 Letters of credit 11 11 - - -Guaranteed minimum royalties 6 2 2 1 1 Capital lease obligations 1 1 - - - Total $ 469 $ 93 $ 210 $ 80 $ 86 Operating lease obligations consist primarily of future minimum lease commitments related to store operating leases. The contractual obligations table above does not include common area maintenance ("CAM") charges, insurance, or tax obligations, which are also required contractual obligations under our store operating leases. In many of our leases, CAM charges are not fixed and can fluctuate significantly from year to year for any particular store. Total store rental expenses, including CAM, for the first half of fiscal 2014 and fiscal 2013 were approximately $69 million and $68 million, respectively. Total CAM expenses could fluctuate from year-to-year as long-term leases come up for renewal at current market rates in excess of original lease terms and as we continue to close stores. Additional information regarding operating leases can be found below under the caption "Operating Leases." Obligations under our Executive Deferred Compensation Plan are equal to approximately $2 million as of August 2, 2014, and have been excluded from the contractual obligations table above as we are unable to reasonably determine the amount or the timing of the future payments. Operating Leases We lease our retail stores and certain equipment under operating lease agreements expiring at various dates through August 2025. Many of our retail store leases require us to pay CAM charges, insurance and property taxes. In addition, many of our retail store leases require us to pay percentage rent ranging from 2% to 20% when sales volumes exceed certain minimum sales levels. The initial terms of such leases are typically 8 to 10 years, some of which contain renewal options exercisable at our discretion. Most leases also contain rent escalation clauses that come into effect at various times throughout the lease term. Rent expense is recorded under the straight-line method over the life of the lease (see "Straight-Line Rent" in Note 1 to the Consolidated Financial Statements in our 2013 Annual Report). Other rent escalation clauses can take effect based on changes in primary mall tenants throughout the term of a given lease. Many leases also contain cancellation or kick-out clauses in our favor that relieve us of any future obligation under a lease if specified criteria are met. These cancellation provisions typically apply if annual store sales levels do not exceed $1 million or mall occupancy targets are not achieved within the first 36 months of the lease. Generally, we are not required to make payments to our landlords in order to exercise our cancellation rights under these provisions. The Wells Credit Facility and Term Loan do not preclude the transfer or disposal of assets related to the stores we are projecting to close by the end of fiscal 2014. None of our retail store leases contain purchase options. Indemnifications In the ordinary course of business, we may provide indemnifications of varying scope and terms to customers, vendors, lessors, business partners and other parties with respect to certain matters, including, but not limited to, losses arising out of our breach of such agreements, services to be provided by us, or intellectual property infringement claims made by third parties. In addition, we have entered into indemnification agreements with our directors and certain of our officers that will require us, among other things, to indemnify them against certain liabilities that may arise by reason of their status or service as directors or officers. We maintain director and officer insurance, which may cover certain liabilities arising from our obligation to indemnify our directors and officers in certain circumstances. 21-------------------------------------------------------------------------------- Table of Contents It is not possible to determine our maximum potential liability under these indemnification agreements due to the limited history of prior indemnification claims and the unique facts and circumstances involved in each particular agreement. Such indemnification agreements may not be subject to maximum loss clauses. Historically, we have not incurred material costs as a result of obligations under these agreements. Off-Balance Sheet Arrangements We have not entered into any transactions with unconsolidated entities whereby we have financial guarantees, subordinated retained interests, derivative instruments, or other contingent arrangements that expose us to material continuing risks, contingent liabilities, or any other obligation under a variable interest in an unconsolidated entity that provides financing, liquidity, market risk, or credit risk support to us. Recent Accounting Pronouncements Information regarding recent accounting pronouncements is contained in Note 3 to the Condensed Consolidated Financial Statements and is incorporated herein by reference. Inflation We do not believe that inflation has had a material effect on our results of operations in the recent past, including the first half of fiscal 2014. Seasonality and Quarterly Results Our business is seasonal by nature. Our first quarter historically accounts for the smallest percentage of annual net sales with each successive quarter contributing a greater percentage than the last. In recent years, approximately 45% of our net sales have occurred in the first half of the fiscal year and 55% have occurred in the second half. The six to seven week selling periods for each of the back-to-school and holiday seasons together account for approximately 35% to 40% of our annual net sales and a higher percentage of our operating results on a combined basis. Our quarterly results of operations may also fluctuate significantly as a result of a variety of factors, including changes in consumer buying patterns, fashion trends, the timing and level of markdowns, the timing of store closings, expansions and relocations, competitive factors, and general economic conditions. |