Description

Pacific Sunwear of California, Inc.

NASDAQ: PSUN

Date: 7/28/06

Price per share: $17.00

f/d shares outstanding: 76.3mm

f/d market cap: $1,215mm

Net cash: $108mm

***Thesis***

Pacific Sunwear of California (PSUN) is one of the cheapest specialty retailers in the market, trading at 4.3 LTM EBITDA and 7.7x after-tax free cash flow.  As merchandising gets fixed and growth initiatives take hold, we think the shares are likely to more than double over the next three years, with minimal downside risk.  Management realizes the shares are a bargain and PSUN has been buying back stock at an accelerating pace.  In fiscal 2005, PSUN bought back 2.8mm shares for $66mm, and has repurchased 2.7mm shares for $59mm year-to-date.  Approximately $90mm remains on their current repurchase authorization, over 7% of the fully-diluted shares outstanding.

***Business Description***

PSUN is a specialty retailer of everyday casual apparel, accessories and footwear designed for active teens and young adults.  PSUN operates three nationwide, primarily mall-based chains: Pacific Sunwear (PacSun), Pacific Sunwear Outlet (Outlet), and d.e.m.o.  PacSun and Outlet specialize in board-sport inspired products while d.e.m.o specializes in hip-hop inspired products.  PSUN recently launched a fourth concept, One Thousand Steps, which will feature a wide selection of shoes and accessories targeted at young adults.  Management believes the One Thousand Steps concept can reach 600-800 stores in the future.  Current stores and potential stores for each concept are listed below.

                                    Stores   Potential

PacSun & Outlet           920       1,000               

d.e.m.o.                        201        400

One Thousand Steps     9            700

Total                            1,130      2,100

Unlike its competitors, PSUN offers a selection of popular name brands supplemented by proprietary brands.  Name brands make up close to 70% of sales and include Quiksilver, Billabong, Hurley, Ecko, Phat Farm, and Sean John, among others.  We think this is an important competitive advantage, allowing the company to actively manage merchandise trends by identifying and stocking emerging brand names.  Once identified, PSUN can capitalize on brand fashion trends by developing higher margin proprietary products.

Historical financial results are presented below:

$ millions                       2003     2004     2005     LTM

Net Sales                      $1,041   $1,230   $1,391   $1,411

EBIT                            $128     $175     $199     $191

EBITDA                      $173     $227     $262     $255

Maintenance CapX        -$2       -$13      -$22      -$22

Pre-Tax FCF                $171     $214     $240     $233

After-tax FCF   (1)        $106     $132     $149     $145

EBIT Margin                12%     14%     14%     13%

EBITDA Margin           17%     18%     19%     18%

After-tax FCF Margin   10%     11%     11%     10%

After-tax ROIC (2)       30%     34%     32%     18%

Avg Sales/ Sq Ft           $363     $374     $371     $374

Gross Sq Ft                   2,997    3,448    3,931    4,004   

***The Opportunity***

After several years of impressive growth, PSUN’s recent sales and earnings trends have been disappointing.  For the first 22 weeks of fiscal 2006, same-store sales declined by about 2% for the PacSun and d.e.m.o. concepts.  A weak overall market combined with Wall Street’s obsession with same-store sales has not been kind to the share price, now at a 52-week low.  We believe the recent weakness in the shares presents a compelling long-term investment opportunity.

Near-term business challenges include: sneakers (especially PacSun) and girl’s tees and denim.  Excluding the sneaker drag on same-store sales, PacSun comps would have been positive.  Given the high margins in footwear, the impact on profits is significant.  In tees, the stores got over-penetrated in novelty tees and colors, and under-penetrated in core colors like white and black.  Denim SKUs were all stretch and over-dependent on a single silhouette.  Management is taking steps to address these problems with new product assortments.  While we cannot predict exactly when PSUN will emerge from its current merchandising issues, we are confident that the problems will be fixed.

In brief, the flagship PSUN concept is maturing, d.e.m.o. is currently faltering, and One Thousand Steps is just getting started.  For long-term investors, now is the time to buy!

First, these are great operators.  The CEO, Seth Johnson, has been running the company for the past two years but more importantly spent the prior 12 years at ANF.  We believe that his experience at ANF is very valuable as he was present for the almost three years of same-store sales declines they experienced, all the while doing a great job managing their margins and brand.  Moreover, as evidenced by the impressive detail in PSUN’s public filings, we believe management has a strong handle on operations.    

Second, these are sharp and disciplined capital allocators.  Normalized after-tax returns on invested capital are very high at around 30%.  PSUN has no debt, plenty of borrowing capacity, and the ability to fund growth from cash flow from operations.  Excess cash is being returned to shareholders through share buybacks. 

Finally, the shares are fundamentally very cheap.  At $17, PSUN is trading at under 4.3x LTM EBITDA and 7.7x after-tax free cash flow.  This is well below historical ranges.  To quote Piper Jaffray’s recent downgrade: “On both a P/E and EV/ EBITDA basis, PSUN shares are trading near historical trough levels, we believe supporting potential private equity consideration.  Shares are trading below 10x FY08 EPS of $1.80, a 50% discount to the company’s 10-year mean P/E.”

***Valuation***

PSUN is a well-run specialty retailer with normalized EBIT margins in the 13-14% range and after-tax free cash flow margins in the 10-11% range.  We believe sales will grow from $1.5bn this year to approximately $1.8bn in three years.  After-tax free cash flow will be approaching $200mm.  Applying a conservative 12x multiple, the enterprise value will be $2.4bn, more than double the current $1.1bn enterprise value.  This ignores One Thousand Steps, which could become very valuable in the future.

***Notes***

(1) After-tax free cash flow = (EBITDA-Maintenance CapX)(1-T)

(2) After-tax ROIC is defined as After-tax free cash flow / Average Invested Capital.  Invested Capital is Total Assets – Excess Cash & Investments – Goodwill – Non-Interest Bearing Current Liabilities. 

***Risks***

- Failure to identify fashion trends and emerging brands.

- Weak consumer spending.

- Ill-conceived acquisition.

Catalyst