UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

 

1. NATURE OF BUSINESS

2. BASIS OF PRESENTATION

The accompanying Condensed Consolidated Financial Statements are unaudited and have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Accordingly, certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) have been condensed or omitted.

3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Information regarding significant accounting policies is contained in Note 1, “Nature of Business and Summary of Significant Accounting Policies,” of the Consolidated Financial Statements in the Company’s Annual Report on Form 10-K for fiscal 2013. Presented below in the following notes is supplemental information that should be read in conjunction with “Notes to Consolidated Financial Statements” included in that Report.

The Company calculates its interim income tax provision in accordance with Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 270, “Interim Reporting” (“ASC 270”) and ASC Topic 740, “Accounting for Income Taxes” (“ASC 740”). At the end of each interim period, the Company estimates the annual effective tax rate and applies that rate to its ordinary quarterly earnings. The tax expense or benefit related to significant, unusual, or extraordinary items is recognized in the interim period in which those items occur. In addition, the effect of changes in enacted tax laws, rates or tax status is recognized in the interim period in which the change occurs. The computation of the annual estimated effective tax rate at each interim period requires certain estimates and significant judgment including the expected operating income for the year, permanent and temporary differences as a result of differences between amounts measured and recognized in accordance with tax laws and financial accounting standards, and the likelihood of recovering deferred tax assets generated in the current fiscal year. The accounting estimates used to compute the provision for income taxes may change as new events occur, additional information is obtained or the tax environment changes.

Basic earnings per share is computed using the weighted-average number of common shares outstanding. Diluted earnings per share is computed using the weighted-average number of common shares outstanding adjusted for the incremental shares attributed to outstanding options to purchase common stock and nonvested restricted stock using the treasury stock method, if dilutive. In periods where a net loss is reported, incremental shares are excluded as their effect would be anti-dilutive. In such circumstances, the weighted-average number of shares outstanding in the basic and diluted earnings per common share calculations will be the same. Anti-dilutive options and nonvested shares are excluded from the computation of diluted earnings per share because either the option exercise price or the grant date fair value of the nonvested share is greater than the market price of the Company’s common stock. Options to purchase 7.61.3 million shares of common stock in the secondthird quarter of fiscal 2013,2014, and 5.24.2 million and 6.26.6 million shares of common stock in the first halfthree quarters of fiscal 2014 and 2013, respectively, were excluded from the computation of diluted earnings per share as their effect would have been anti-dilutive.

The table below sets forth the reconciliation of the denominator of each net (loss) income (loss) per share calculation for the secondthird quarter and first halfthree quarters of fiscal years 2014 and 2013:

4. IMPAIRMENT OF LONG-LIVED ASSETS

The Company assesses 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 the Company’s stores, the Company determined that certain stores would not be able to generate sufficient cash flows over the remaining term of the related leases to recover the Company’s investment in the respective stores. As a result, the Company recorded the following non-cash impairment charges related to its retail stores within the accompanying Condensed Consolidated Statements of Operations and Comprehensive Operations, to write-down the carrying value of its long-lived store assets to their estimated fair values.

5. DERIVATIVE LIABILTY

6. OTHER CURRENT LIABILITIES

Other current liabilities consisted of the following:

7. DEBT

The original note executed by Miraloma (the "Miraloma Note") is secured by a deed of trust on the building and land comprising the Company’s principal executive offices in Anaheim, California and is non-recourse to the Company. The Miraloma Note does not contain any financial covenants. In connection with this transaction, the Company transferred the building and related land securing the Miraloma Note to Miraloma and entered into a lease for the building and land with Miraloma. The original note executed by PacSun Stores (the "PacSun Stores Note") is secured by a mortgage on the Company’s leasehold interest in the building and land comprising the Company’s distribution center in Olathe, Kansas, and is unconditionally guaranteed by the Company. The PacSun Stores Note does not contain any financial covenants.

8. INCOME TAXES

9. SHAREHOLDERS’ EQUITY

Preferred Stock

Stock-Based Compensation

There were noneno and 4,62510,375 stock options exercised during the first halfthree quarters of fiscal 2014 and 2013, respectively. The total intrinsic value of options exercised during the first halfthree quarters of fiscal 2013 was immaterial.

10. FAIR VALUE MEASUREMENTS

The Company measures its financial assets and liabilities at fair value on a recurring basis and measures its nonfinancial assets and liabilities at fair value as required or permitted.

The Series B Preferred shares are required to be measured at fair value each reporting period. The fair value of the Series B Preferred shares was estimated using an option-pricing model that requires Level 3 inputs, which are highly subjective and determined using the following significant assumptions as of:

Non-Recurring Fair Value Measurements

On a non-recurring basis, using a discounted cash flow model, the Company measures certain of its store-level long-lived assets at fair value based on Level 3 inputs including, but not limited to, comparable store sales and margin growth, projected operating costs based primarily on historical trends, and an estimated weighted-average cost of capital rate. During each of the first halfthree quarters of fiscal 2014 and 2013 the Company recorded $1.7 million and $1.42.0 million of impairment charges respectively, in the accompanying Condensed Consolidated Statements of Operations and Comprehensive Operations. In addition, during the third quarter of 2014, the Company determined that certain software previously capitalized for internal use was abandoned. As a result, the Company recorded an impairment charge of $1.1 million and accrued approximately $0.4 million related to future software maintenance costs.

11. COMMITMENTS AND CONTINGENCIES

Litigation

Indemnities, Commitments and Guarantees

During the normal course of business, the Company agreed to certain indemnities, commitments and guarantees under which it may be required to make payments in relation to certain transactions. These indemnities, commitments and guarantees include those given to various lessors in connection with facility leases for certain claims arising from such facility or lease and indemnities to directors and officers of the Company to the maximum extent permitted under the laws of the State of California. The duration of these indemnities, commitments and guarantees varies, and in certain cases, is indefinite. The majority of these indemnities, commitments and guarantees do not provide for any limitation of the maximum potential future payments the Company could be obligated to make. The Company has not recorded any liability for these indemnities, commitments and guarantees in the accompanying Condensed Consolidated Balance Sheets other than as disclosed below.

Letters of Credit

12. SEGMENT REPORTING

13. DISCONTINUED OPERATIONS

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:

Executive Overview

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

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. Closed stores or stores that experience closure during a relocation or remodel are removed from the store base for that period and for the same period in comparable periods. We include sales from our e-commerce business in same store sales. 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.

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.

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.

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.

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 FacilityConsistent with our previous expectations, in the thirdfourth quarter in orderof fiscal 2014 we borrowed $15 million on our Wells Fargo Credit Facility to finance inventory purchases for the holiday season. We expect to repay such borrowings prior to the end of the fourth quarter of fiscal 2014.

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

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:

Net sales were $211.7$212.3 million for the secondthird quarter of fiscal 2014 versus $210.1$202.8 million for the secondthird quarter of fiscal 2013. The components of this $1.6$9.5 million increase in net sales are as follows:

For the secondthird quarter of fiscal 2014, comparable store net sales increased 0.3%4%, average sales transactions increased 7%9% and total transactions decreased 6%5%, as compared to the same period a year ago. The comparable store net sales increase resulted from a 3%6% increase in Men’s sales, while Women’s sales decreased 3%.were flat. The increase in Men’s sales was driven primarily by sales of bottoms, footwear and footwear. The decline in Women’stops. Women's sales was primarily due toof tops increased, offset by a decrease in sales of non-apparel. Apparel represented 81%82% of total Men’s sales for the secondthird quarter of fiscal 2014 versus 83% in the secondthird quarter of fiscal 2013, while Women’s apparel represented 91%89% of total Women's sales for the secondthird quarter of fiscal 2014 versus 87% in the secondthird quarter of fiscal 2013. Combined accessories and footwear was 14%15% of total sales for each of the second quarterthird quarters of fiscal 2014 versus 15% in the second quarter of fiscaland 2013.

Gross margin, after buying, distribution and occupancy costs, was $61.5$56.7 million for the secondthird quarter of fiscal 2014 versus $62.6$51.2 million for the secondthird quarter of fiscal 2013. As a percentage of net sales, gross margin was 29.1%26.7% for the secondthird quarter of fiscal 2014 compared to 29.8%25.2% for the secondthird quarter of fiscal 2013. The components of this 0.7% decrease1.5% increase in gross margin as a percentage of net sales were as follows:

We recorded a non-cash gain of approximately $10$5 million related to our derivative liability in the secondthird quarter of fiscal 2014, compared to a non-cash lossgain of approximately $21$23 million for the secondthird 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, was approximately $4 million and $3 million in each of the secondthird quarters of fiscal 2014 and 2013, respectively.2013. Interest expense, net, for the secondthird 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.

We recognized an income tax benefitexpense of $0.2$0.1 million and $0.1$0.4 million for the secondthird 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.

Net sales were $382.9$595.2 million for the first halfthree quarters of fiscal 2014 versus $376.4$579.2 million for the first halfthree quarters of fiscal 2013. The components of this $6.5$16.0 million increase in net sales are as follows:

For the first halfthree quarters of fiscal 2014, comparable store net sales increased 1%2%, average sales transactions increased 6%7% 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%2%. The increase in Men’s sales was driven primarily by sales of footwear, tops, bottoms and bottoms.footwear. The decline in Women’s sales was primarily due to a decrease in sales of non-apparel. Apparel represented 80%81% of total Men’s sales for the first halfthree quarters of fiscal 2014 versus 82% in the first halfthree quarters of fiscal 2013, while Women’s apparel represented 91% of total Women's sales for the first halfthree quarters of fiscal 2014 versus 86%87% in the first halfthree quarters of fiscal 2013. Combined accessories and footwear was 15% of total sales for the first halfthree quarters of fiscal 2014 versus 16% in the first halfthree quarters of fiscal 2013.

Gross margin, after buying, distribution and occupancy costs, was $106.2$162.9 million for the first halfthree quarters of fiscal 2014 versus $104.4$155.5 million for the first halfthree quarters of fiscal 2013. As a percentage of net sales, gross margin was flat at 27.7%27.4% for both the first halfthree quarters of fiscal 2014 andcompared to 26.9% for the first halfthree quarters of fiscal 2013. The activitycomponents of this 0.5% increase in gross margin as a percentage of net sales was as follows:

We recorded a non-cash gain of approximately $12$17 million related to our derivative liability in the first halfthree quarters of fiscal 2014, compared to a non-cash loss of approximately $30$7 million for the first halfthree quarters 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, was approximately $8$12 million and $7$11 million for the first halfthree quarters of fiscal 2014 and 2013, respectively. Interest expense, net, for the first halfthree 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.

We recognized income tax expense of $0.2$0.4 million and $0.5 million for the first halfthree quarters of fiscal 2014 and $0.1 million for the first half of fiscal 2013.2013, 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.

Our loss from continuing operations for the first halfthree quarters of fiscal 2014 was approximately $3 million, or $(0.04)$(0.05) per diluted share, versus a loss from continuing operations of approximately $43$25 million, or $(0.62)$(0.36) per diluted share, for the first halfthree quarters of fiscal 2013. Included in the loss from continuing operations for the first halfthree quarters of fiscal 2014 was a non-cash gain of $12approximately $17 million or $0.17$0.24 per diluted share related to our derivative liability, versus a non-cash loss of $30$7.0 million, or $(0.45)$(0.10) 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 FacilityConsistent with our previous expectations, in the thirdfourth quarter in orderof fiscal 2014 we borrowed $15 million on our Wells Fargo Credit Facility to finance inventory purchases for the holiday season. We expect to repay such borrowings prior to the end of the fourth quarter of fiscal 2014.

Information regarding the Wells Credit Facility is contained in Note 7 to the Condensed Consolidated Financial Statements and is incorporated herein by reference.

Information regarding the Term Loan is contained in Note 7 to the Condensed Consolidated Financial Statements and is incorporated herein by reference.

Information regarding our mortgage debt is contained in Note 7 to the Condensed Consolidated Financial Statements and is incorporated herein by reference.

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.

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.

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 halfthree quarters 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.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

ITEM 4. CONTROLS AND PROCEDURES.