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Thousand Steps concept. Both PacSun and d.e.m.o. sell entire outfits. They offer everything needed to dress in the style of the particular “subculture” they serve. One Thousand Steps will not sell entire outfits. So, the new chain is unlikely to enjoy the same kind of customer stickiness that PacSun and d.e.m.o. enjoy. One Thousand Steps will not be as distinctive as PacSun and d.e.m.o. For now, it is difficult to say how distinctive One Thousand Steps will be. However, it is safe to say the new chain will be less distinct in the minds of customers than either PacSun or d.e.m.o. That isn’t surprising. Very few stores are as distinct as PacSun or d.e.m.o. None of Pacific Sunwear’s major competitors operates stores that have as well defined an image as PacSun or d.e.m.o. Pacific Sunwear will manage the One Thousand Steps chain better than any other company possible could. If you first described the One Thousand Steps concept and then asked what company would be best suited to manage it, I would need only a fraction of a second to say Pacific Sunwear. No company is more knowledgeable about selling footwear to young customers. The PacSun chain has done a tremendous job selling name brand footwear to teens. PacSun is directly responsible for the lasting success of several of the brands it carries. Although brand name footwear was already an important part of many skaters’ lives (and more importantly their spending habits), PacSun greatly magnified that importance. Without PacSun, the value of the major skate shoe brands would be significantly less than it is today. Very few retailers have had this kind of positive influence on the brands they carry. It is impossible to evaluate the One Thousand Steps concept at this point. I will be watching the chain carefully to see how it distinguishes itself from its competition, how it increases customer stickiness, and how it selects the brands it carries. The more different One Thousand Steps is, the more successful it will be. One obvious mark against the chain is the name. One Thousand Steps is a terrible name. A store name should be short, simple, distinct, and memorable. PacSun and d.e.m.o. both succeed in that respect. Actually, those two names are much better than most, because they happen to be (in spoken form at least) made up of actual words. Of course, if the chain does succeed, it’s unlikely Pacific Sunwear will have any shot at preventing it from being widely known as “Steps”. There may be some reason why the chain couldn’t be operated under that name. If not, I’d say management made a mistake. One Thousand Steps sounds like something that came out of marketing meeting. It’s far too cute for use in real world. Pacific Sunwear plans to open 8-10 One Thousand Steps stores during the first half of 2006. Management believes the chain could grow to 600 ?800 stores. At an average size of 2,500 square feet, that would mean the chain could grow to between 1.5 million and 2 million square feet. Upon announcing the new concept (last year), Pacific Sunwear CEO Seth Johnson made the following statement: Footwear has been a highly successful part of our assortment in PacSun stores. One Thousand Steps will enable us to leverage our brand management skills in what we believe is an underserved market. This new concept gives us an exciting growth vehicle that adds a new and distinct customer base to our business. Combined with out existing PacSun and d.e.m.o. businesses, we will have the opportunity to achieve significant sales and profit growth in the future. I am cautiously optimistic about One Thousand Steps. The concept is more promising than d.e.m.o. However, I will have to wait until I see an actual store before I can offer any assessment of the chain’s profit potential. Estimates Analysts are optimistic about Pacific Sunwear’s future earnings, but pessimistic about Pacific Sunwear’s shares. Wall Street is estimating 16-17% earnings growth over the next five years. That’s lower than the growth rate Pacific Sunwear achieved over the last ten years. However, it’s higher than the growth rate I would predict. The average 5-year earnings estimate from analysts is in the 16-17% range; but, the average recommendation is a hold. These two opinions are mutually exclusive. They are utterly incompatible. You can not predict a 16-17% earnings growth rate for Pacific Sunwear without also predicting the company’s shares will outperform the S&P. Well, actually you can, because a great many analysts have done exactly that. But, you shouldn’t. PSUN is trading at a P/E of about 14. The argument for a significant multiple contraction is very weak. What company is going to grow earnings at 16-17% a year and sport a P/E well below 12? The obvious answer would be a company weighed down by a tremendous debt burden. So, how much debt does Pacific Sunwear have? None. The company’s total liabilities are about equal to current inventory levels. Current assets (ex other) are about $350 million; total liabilities are about $250 million. The company has about $125 million in cash and marketable securities. Pacific Sunwear can probably generate over $150 million in cash from operations each year. It is unlikely the company can open new stores fast enough to keep free cash flow from reaching 50 – $75 million a year. This is a fast growing company that is generating cash much faster than it can spend it. There is a good chance that, five years from now, there will be fewer shares outstanding than there are today. Therefore, whatever multiple contraction these analyst are expecting would have to bring Pacific Sunwear’s stock down to a P/E rarely seen by healthy, growing U.S. companies. The company’s PEG ratio is well below 1, and its forward P/E is about 12. I don’t pay any attention to these numbers, but analysts seem to. So, why don’t they rate PSUN a buy? I don’t know and I don’t care. It probably has something to do with the industry. Compared to analysts, I’m less optimistic about Pacific Sunwear’s earnings growth, but more optimistic about the company’s shares. Profitability Pacific Sunwear has consistently earned high returns on equity while employing very little debt. Over the past 10 years, the company has achieved returns on equity of about 17%. Returns in recent years have been higher than returns at the beginning of the ten year period. However, the company’s return on equity has been above average throughout the period, and the difference between the ROE of recent years and the ROE of the more distant past is not particularly significant. Basically, this has been a business with a 17% return on equity for some time. Pacific Sunwear scores well on every profitability metric. The company has a high free cash flow margin ?and an even higher owner’s earnings margin, because the company has invested much more in capital expenditures than required for maintenance alone. Pacific Sunwear’s return on retained earnings has ranged from 25-50% and its pre-tax return on non-cash assets has ranged from 20-30%. Both of these numbers are quite healthy, especially considering the consistency with which they have been achieved. Pacific Sunwear, like most of its rivals, leases its retail stores under long-term operating leases. The initial term of each lease is usually ten years. The use of operating leases makes it difficult to compare the profitability of companies like Pacific Sunwear with the profitability of companies that do not have any such long-term obligations. Pacific Sunwear has about $700 million in minimum future rental commitments. The present value of these commitments should be estimated at well under $500 million for purposes of comparison. So, even if one were to compare Pacific Sunwear’s capital structure with that of non-retailers, PSUN would not appear to be unduly leveraged. Price Shares of Pacific Sunwear currently sell at a relatively modest price-to-sales ratio of 1.2. The stock’s (trailing) P/E ratio is about 14. The stock’s price-to-book ratio is not all that different from the P/B of the general market, despite the fact that PSUN is expected to grow earnings faster and achieve a higher return on equity than the general market. The price-to-book ratio is not a particularly useful measure for an operator of leased retail stores. The price-to-sales ratio is somewhat more useful, but still questionable, because Pacific Sunwear has a different merchandising mix than many of its rivals. Pacific Sunwear has an enterprise value-to-EBITDA ratio of under 6 and an EV/sales ratio of just over 1. This is a bit cheaper than comparable peers. A few of Pacific Sunwear’s more troubled rivals trade at lower EBITDA multiples, but they have much poorer growth prospects and more of a mixed record of sustaining high returns on equity. Most of Pacific Sunwear’s rivals are selling at much more reasonable prices than they had once traded at. The group does not appear overvalued relative to the market. Conclusions I don’t like owning retailers, and I don’t like valuing retailers. If I had to pick an expected 10-year annual return for the investor who buys shares of PSUN at tomorrow’s opening price, I would pick 12-13%. This rate of return should be enough to beat the market, but is short of the magical 15% rate of return that I believe will lead to a 3-5% real after-tax return for the buy and hold investor. It is conceivable Pacific Sunwear will perform much better than I expect. If everything goes the way management hopes, and each of the three chains is expanded to the stated goals, the 10-year return could be closer to 15-17%. However, I believe such a high rate of return is unlikely. I’m sticking with 13%. If I had to choose between being 100% invested in the S&P 500 or being 100% invested in PSUN, I would probably choose PSUN. If I had to choose between being 25-50% invested in S&P 500 or 25-50% invested in PSUN, I would definitely choose PSUN. Regardless, I expect shares of Pacific Sunwear will beat the market over the next ten years. If you own more than a handful of stocks, PSUN would probably make a fine addition to your portfolio (if acquired at the $22.50 or so at which the stock last traded).