Pacific Sunwear, Inc. – Valuation Analysis Valuation Method | Weight | Implied Value | Relative Valuation | 30% | $2.69; Range of $2.04 - $3.06 | Regression | 35% | $2.30; Range of $2.10 - $2.50 | Discounted Cash Flow | 15% | $2.37; Range of $1.92 - $3.18 | Precedent Transaction Analysis | 20% | $2.30; Range of $1.47 - $3.66 | | Value Range | $1.47 - $3.66 | | Estimated Price | $2.43 | | Market Price (04/19/13) | $2.40 | | Conclusion | Slightly Undervalued* | | Recommendation | Hold |
* It should be noted that since the analysis was completed the stock price has risen to $2.76; however, certain data used in the analysis that is affected by price was pulled as of 04/19/13.
Summary: Based on the weighted valuations that I performed, Pacific Sunwear’s stock is somewhat undervalued. Because of the company’s cash flow struggles and changing business, the DCF analysis was considered to be the poorest indicator of value, followed by the precedent transaction analysis. The regression and relative valuation methods were thought to be the best indicators. Based on this, I concluded a fair value of $2.43 using various weights for the method as each method is based on certain assumptions that may result in a flawed value. For example, the regression and relative valuation, which were given the highest weights, are based on the assumption that the companies chosen for the peer group are comparable to Pacific Sunwear, despite differences in their financial performance and/or business model and size. Based on the concluded price of $2.43, the stock appears to be slightly undervalued, and it should be noted that the stock price has increased to $2.76 since the analysis was completed. I chose a “Hold” recommendation as the concluded price is close to the current stock price, and the stock is very risky. The price going forward will likely be contingent on the company’s ability to leverage cost reductions, store closures, and a new marketing strategy into increased profitability and improved financial condition.
Relative Valuation: For the relative valuation, I used the peer group I selected, consisting of Aeropostale, American Eagle Outfitters, Tilly’s, Wet Seal, and Zumiez, and used the price/book ratio to estimate a price range. The average price/book ratio yielded a price of $2.69 with a range of $2.04 - $3.06 based on the min and max price/book ratios. Based on the relative valuation, the stock appears to be overvalued.
Regression Analysis: For the regression analysis, I used the price/book ratio as my dependent variable with beta, sales growth, total debt/equity, and number of stores as the independent variables. This yielded a price/book ratio of 2.64 and implied price of $2.50. I also ran a regression using price/sales as the dependent variable and the same dependent variables, which yielded an implied price of $2.10. The average of these yields a value of $2.30. Based on the regression analysis, the stock appears to be slightly undervalued.
Discounted Cash Flow Analysis: For the DCF, I estimated 5 years of projections for the company’s operations and valued the company using both the exit multiple & perpetuity growth models. I relied on the exit multiple value of $2.37/share for the DCF; however, the DCF was thought to be the least accurate measure of the stock’s value due to the company’s changing business and uncertain future, and is thus given the smallest weight. Based on the DCF, the company appears to be slightly undervalued. However this model is very sensitive to the variety of assumptions made in the analysis.
Precedent Transaction Analysis: For the precedent transactions, I chose three recent retail acquisitions to arrive at a fair value estimate of $2.30/share. I estimated the price based on three metrics, price/book, price/sales, and EV/Sales, adjusted for the deal premiums 4 weeks before the sale, which yielded a range of values from $1.47 - $3.66. Based on this, the stock appears to be slightly undervalued.
Business Description:
PacSun is a specialty retailer of proprietary and branded casual clothing, accessories, and footwear marketed to teens and young adults. The products sold at the stores are meant to reflect the California lifestyle. The company operates mall-based chain stores under the “PacSun” and “Pacific Sunwear” names. The target customers are teens and young adults or their parents. The company sells directly to the consumers from their stores, which are located in shopping malls in all 50 of the United States and Puerto Rico. Additionally, products can be purchased from their website, www.pacificsunwear.com. The company has a total of 644 stores comprised of 2.5 million square feet.
Sales Mix:
For the most recent three years, sales revenues can be further broken down as follows:

Fiscal Year* | 2012 | 2011 | 2010 | Men’s Apparel | 48% | 49% | 49% | Women’s Apparel | 37% | 37% | 38% | Footwear & Accessories | 15% | 14% | 13% | Total | 100% | 100% | 100% | | | | | % of Sales – Stores | 93% | 94% | 95% | % of Sales – Online | 7% | 6% | 5% |

Prior to FY 2007, footwear & accessories accounted for over 30% of net sales but had decreased to 12% by 2009 due to a de-emphasis on non-apparel items. However, beginning in 2010, the company began re-focusing on non-apparel items by reintroducing footwear to 420 stores as of 02/02/13. In FY 2012, the sales of men’s footwear rose by 33%, while women’s footwear sales rose by 4%.
Store Closings: Prior to FY 2008, the company was expanding rapidly, opening 50 to 100 new stores per year. Before the economic downturn, there were 950 PacSun stores. However in FY 2008, the company began closing stores, closing 38 stores during FY 2008, 40 stores during FY 2009, 33 in FY 2010, and 119 in FY 2011, followed by 92 closures in FY 2012. In the next fiscal year, the company plans to close an additional 20 to 30 of the remaining 644 stores. |
SWOT Analysis
Strengths:
* The company offers a mix of company-owned brands as well as heritage brands such as Hurley, O’Neill, Vans, and Nike, resulting in a unique mix of products. * Merchandise assortment is customized to the clientele of each store. * The company purchases merchandise from a variety of vendors, with no proprietary brand representing more than 10% of net sales.
Weaknesses:
* The company has struggled with declining sales and profitability, which has led to store closures and a debt restructure in 2011. * The company is currently involved in two lawsuits regarding labor law violations in the state of California. The outcome of the litigation could have a negative effect on the company’s image and reputation and could potentially be costly. * The company has levered up over the past several years to finance cash flow shortfalls and now have a high level of leverage compared to other retailers. Additionally, they have put off improvements to their stores, many of which are in need of upgrading, to save on capital expenditures. * The company relies on a mall-based strategy; however, brick-and-mortar locations have lost popularity as the internet retail market has expanded.
Opportunities:
* The online market for apparel is growing, which may present an opportunity to increase market share despite store closures. * Apparel and footwear markets in the United States declined during the economic recession; as the economy continues to recover, retail sales should see further improvement. * The company could potentially expand into new product lines such as hard goods relating to surfing, skateboarding, and other activities that relate to the clothing carried in stores.
Threats:
* Intense competition in the retail industry, particularly from similar stores such as Zumiez and Tilly’s, may erode market share. * Rising cotton prices pose a threat to the apparel industry. Cotton prices have been rising steadily for the past several years and are expected to continue to increase in 2014 due to expected decreases in output coupled with rising demand. * Performance in the retail industry is highly correlated to the overall economy. A decline in the economy as a whole would negatively affect sales and profitability. * The company’s sales are affected by changing tastes and trends, which change frequently in the young demographic that the store targets. * Rising gas prices contribute to reduced foot traffic in malls as consumers tend to drive less when gas is more costly. Additionally, high gas prices contribute to a higher cost of living and reduce discretionary income.
Financial Condition
Overall, Pacific Sunwear’s financial condition is poor. The company has recorded net losses since FY 2006 due to declining sales and profitability margins. As noted above, the company continues to close stores to control cost levels. In addition, the company has been forced to increase their leverage, restructuring their debt in 2011 to include a term loan/PIK loan from Golden Gate Capital, under which debt taken out under the PIK does not amortize and accrues interest which is added to the balance of the term loan annually. In connection with the term loan, the company issued 1,000 shares of convertible Series B Preferred stock, the fair value of which is treated as a derivative liability. The company also has mortgage debt with American National Insurance Company which is secured by various real estate owned by the company. Additionally, the company has a line of credit with Wells Fargo; there was no balance outstanding as of FY 2012.

Performance over the past several years is summarized below:

As the chart indicates, sales have declined since their peak in 2007, bottoming out in 2010 with a slight recovery in FY 2011 & 2012. The company has made strides to improve their appeal to customers, such as increasing their selection of footwear & accessories, introducing new collections such as the recent collaboration by Kendall & Kylie Jenner, and their “California State of Mind” marketing campaign, which emphasizes the many different California lifestyles that the brand seeks to embody and features a fully integrated web and mobile experience. The smaller store base also allows the company to introduce smaller boutique brands were quantities and fulfillment capabilities may not be sufficient to supply product to a larger number of stores, reinforcing the boutique model that the company is now emphasizing. As a result, the company has gained higher interest from their target demographics and restored their spot as the most preferred action sports brand for males and females per a Spring 2013 survey (Piper Jaffray, 2013).
Liquidity Ratios:

The current ratio has declined from levels near the peer average in FY 2006 (which includes the comparable companies listed below) to levels much lower than the peer group by FY 2012. This has been due to a decrease in inventory levels, which may be because of the reduced number of stores, and an increase in payables. One addition to current liabilities is the derivative liability, which was recorded at $20.1M as of 02/02/13. The derivative liability is related to the issue of 1,000 shares of Convertible Series B Preferred Stock in connection with the term loan
Liquidity Analysis: Cash Cycle | | | | | | | | | Days Inventory | 2012 | 2011 | 2010 | | Operating Cycle | 2012 | 2011 | 2010 | Pacific Sunwear | 54 | 56 | 56 | | Pacific Sunwear | 27 | 29 | 32 | Peer Group Average | 46 | 46 | 48 | | Peer Group Average | 25 | 27 | 28 | | | | | | | | | | Days Payable | 2012 | 2011 | 2010 | | Cash Conversion Cycle | 2012 | 2011 | 2010 | Pacific Sunwear | 27 | 27 | 24 | | Pacific Sunwear | 28 | 28 | 32 | Peer Group Average | 25 | 23 | 23 | | Peer Group Average | 25 | 28 | 28 | | | | | | | | | | Payable Conversion Days | 2012 | 2011 | 2010 | | | | | | Pacific Sunwear | 27 | 28 | 24 | | | | | | Peer Group Average | 25 | 22 | 23 | | | | | |
* Data used is from SEC filings. Peer group averages include the average figures for American Eagle Outfitters, Aeropostale, Tilly’s, Wet Seal, & Zumiez. Accounts receivable is not included in the table as the majority of the companies included did not report A/R. However, for it is included in the average operating cycle and average cash conversion cycle numbers as applicable. Tilly’s went public in 2012 and thus is not included in the 2011 & 2010 averages.
Benchmark Analysis
For the benchmark analysis, I selected the most comparable companies in the retail industry based on PacSun’s strategy and target demographic, comparing the company to American Eagle Outfitters, Aeropostale, Hot Topic, Wet Seal, and Zumiez, described below (in no particular order): 1. American Eagle Outfitters – American Eagle Outfitters is a global specialty retailer that operates stores under the American Eagle Outfitters and aerie brands. The brand offers trendy clothing, accessories, and personal care products at affordable prices, targeting young men and women. The company operates 893 AE Outfitters stores and 151 aerie stores; 49 additional franchises are operated by franchise partners abroad. Merchandise is also available through their websites, www.ae.com and www.aerie.com. It should be noted that the company is significantly larger than PacSun with over $3B in sales in FY 2012, and is in much better financial condition. However, the companies have similar target demographics, price points, and products. 2. Aeropostale – Aeropostale is a mall-based specialty retail or casual apparel and accessories. The target demographic is 14 to 17 year-old young men & women through their primary brand (Aeropostale) and 4 to 12 year-old children through the “P.S. from Aeropostale” stores. The company focuses on offering quality clothing at a competitive price point at their store locations and online at aeropostale.com and www.ps4u.com. The company’s merchandise is proprietary and is designed, sourced, marketed, and sold by Aeropostale. The company has a total of 1,062 Aeropostale stores in all 50 states, Puerto Rico, and Canada, 100 P.S. from Aeropostale stores in 20 states, and 26 licensed stores operating in the Middle East, Asia & Europe. Similar to American Eagle, the company is significantly larger than PacSun and is in healthier financial condition, but has similar products, price point, and target demographics. 3. Tilly’s – Tilly’s is a specialty retailer of West Coast inspired apparel, footwear, and accessories. The company targets male & female teens and young adults and operates 168 stores in 28 states, selling a mix of proprietary and third-party merchandise at mid-level price points. Stores are primarily located in malls. The company went public in 2012 and is growing rapidly, with at least 25 new stores planned for 2013. Merchandise is also available for sale online at www.tillys.com. The company is significantly smaller than Pacific Sunwear in terms of store locations and is in a different stage of the lifecycle, as it is a newer company experiencing rapid growth. However, it is used as it is a direct competitor for market share in the action sports brand market, catering to the same tastes and demographics. 4. Wet Seal – Wet Seal is a specialty retailer that sells apparel and accessories through their two nationwide mall-based retail stores, Wet Seal and Arden B. Wet Seal offers juniors apparel for girls age 13-23 while Arden B. offers affordable women’s clothing targeted to women ages 21-39. The company operates 468 Wet Seal stores and 62 Arden B. stores in 47 states and Puerto Rice. Merchandise is also available for purchase online at www.wetseal.com and www.ardenb.com. Wet Seal is similar in size to Pacific Sunwear in terms of store locations and has also struggled with profitability in the past few years. However, the company has a somewhat lower price point and caters to female customers only. 5. Zumiez - Zumiez is a specialty retailer of action sports related apparel, footwear, accessories and sports equipment. The company focuses on selling to young men and women interested in skateboarding, snowboarding, surfing, and motocross. The company operates 500 stores, with 472 in the U.S., 20 in Canada, and 8 in Europe, under the names Zumiez and Blue Tomato (which was acquired during 2Q12). Products are also available online at www.zumiez.com and www.blue-tomato.com. The company is a direct competitor of Pacific Sunwear in the action sports brand market. Like Tilly’s, Zumiez is growing rapidly and poses a threat to the market share of Pacific Sunwear.
One of the challenges faced in selecting comparable companies is that Pacific Sunwear is in poor financial condition, with higher leverage, continued net losses and store closures, whereas many of its’ competitors, such as Zumiez and Tilly’s, are in the growth stage and others have seen a stronger recovery in financial metrics than Pacific Sunwear.
Additionally, many of the direct competitors of Pacific Sunwear, such as Diamond Supply Co., Van’s, Volcom, Fox Racing, LRG, and Obey, are privately held and/or only have online stores. This may be another reason for the continued financial struggles of the company, as many of the brands they carry, which were previously available only in boutiques such as Pacific Sunwear, are now available online and are a source of additional competition.
Relative Valuation
The companies that I chose represent a mix of companies within the retail industry that have a similar product mix and target demographic to Pacific Sunwear, as well as a strong mall presence. The challenge in selecting comparable firms for Pacific Sunwear was finding companies with a similar risk profile. Due to the increasing leverage and continued losses, the company has a very high beta of 2.59x, which is significantly higher than the majority of the companies in the retail sector. The ratio I used to value the firm for the relative valuation was the Price/Book ratio. This ratio was chosen because earnings, EBITDA, and EBITDAR for the firm are negative, making many of the more common valuation ratios irrelevant. Additionally, using average top line sales as an isolated variable did not seem to be an accurate way to value the company due to large differences in profit margins in the comparable set. I calculated the implied share price value using the mean value of the comparable Price/Book ratio as shown below: Company | # of Stores | 2012 Revenue | 2012 Sales Growth YoY | 2012 Net Margin | 2012 Total D/E | 2012 ROE | 2012 ROA | Price/Book | EV | Pacific Sunwear | 644 | 803,071 | 3.31% | -6.48% | 3.88 | Negative | Negative | 2.63 | 194.97M | | | | | | | | | | | Comps: | | | | | | | | | | American Eagle | 1,093 | 3,475,802 | 11.40% | 6.68% | 0.44 | 17.60% | 12.52% | 2.91 | 2.98B | Aeropostale | 1188 | 2,386,178 | 1.84% | 1.38% | 0.81 | 8.03% | 4.73% | 2.46 | 790.89M | Tilly's | 168 | 467,291 | 16.64% | 5.11% | 0.75 | 20.37% | 11.63% | 3.22 | 323.95M | Wet Seal | 530 | 580,397 | -6.40% | 19.51% | 0.76 | Negative | Negative | 2.15 | 269.95M | Zumiez | 500 | 669,393 | 20.42% | 6.30% | 0.35 | 13.90% | 10.31% | 2.66 | 787.51M |
* Data used is from Research Insight, Yahoo! Finance and SEC filings. Relative Value Calculation | Book Value – PacSun | 64,360 | BV/Share - PacSun | $0.95 | Times: Avg. Price/Book | 2.68x | Implied Share Price | $2.54 | Range (Min-Max) | $2.04 - $3.06 |

The implied share price using the comparable valuation indicates that the stock may be undervalued based on the current price of $2.40 (price as of close on 04/19/13). Potential sources of error with this method include the quality of the comparable companies chosen, including differences in size, risk, and profitability. The price of the stock falls within the range of implied values using the minimum and maximum values from the peer group.
Regression Analysis
For the regression analysis, I once again used the price/book ratio to estimate the value of the stock. For the regression, I used the comparable companies set discussed above and used beta, sales growth, number of stores and total debt to equity as my independent variables. I chose these variables in an attempt to capture some of the differences between Pacific Sunwear and the comparable companies in order to take leverage, performance, and risk into account. The regression yielded the following results: | Coefficients | Standard Error | Intercept | 3.73 | 0.73 | Beta | -1.41 | 0.72 | 2012 YoY Sales Growth | 6.93 | 2.27 | # of Stores | 0.00 | 0.00 | 2012 Total D/E | 0.66 | 0.33 | Price/Book Value Estimate | 2.64 | | Implied Price | $2.50 | |
* Date for the regression analysis was taken from Research Insight & Yahoo! Finance.

The regression had an R2 of 0.922, indicating that 92.2% of the variation in the price/BV was explained by the independent variables, and a residual of 0.07, which indicates that the stock may be somewhat overpriced. For an additional test, I ran a second regression with the same variable using Price/Sales as the dependent variable.

| Coefficients | Standard Error | t Stat | Intercept | 0.05 | 0.70 | 0.07 | 2012 Revenue | 0.00 | 0.00 | 1.28 | # of Stores | 0.00 | 0.00 | -0.89 | Beta | 0.75 | 0.45 | 1.67 | 2012 Total D/E | -0.43 | 0.18 | -2.31 | Price/Sales Estimate | 0.18 | | | Implied Price | $2.10 | | |
* Date for the regression analysis was taken from Research Insight & Yahoo! Finance.

For this regression, the R2 was 91.1% and the residual was 0.02, again indicating that the stock may be overpriced. A simple average of the values from the two regressions yields a value of $2.30/share.

Using the same methodology for the comparable companies yielded the following results based on the price/book ratio. The 04/19/13 stock prices are used as this was the date of the price/book calculation. Zumiez | | | Wet Seal | | Price/Book Estimate | 2.71 | | Price/Book Estimate | 2.06 | Implied Price | $18.92 | | Implied Price | $2.99 | Price as of 04/19/13 | $26.79 | | Price as of 04/19/13 | $3.08 | Valuation | Overpriced | | Valuation | Overpriced | | | | | | Tilly's | | | Aeropostale | | Price/Book Estimate | 3.08 | | Price/Book Estimate | 2.06054 | Implied Price | $13.87 | | Implied Price | $9.75 | Price as of 04/19/13 | $13.62 | | Price as of 04/19/13 | $13.05 | Valuation | Underpriced | | Valuation | Overpriced | | | | | | American Eagle Outfitters | | | | Price/Book Estimate | 2.93 | | | | Implied Price | $17.12 | | | | Price as of 04/19/13 | $18.62 | | | | Valuation | Overpriced | | | |

DCF Analysis
For the DSC analysis, I developed estimates for the company’s future performance using a combination of factors, including consensus estimates, historical performance, and the company’s strategy going forward.
Sales
As mentioned previously, sales for the company have begun to recover somewhat, growing by 3.3% during FY 2012 and 0.2% during FY 2011. While it appears that there has been some growing interest in their products, their strategy of decreasing store locations should also be taken into account. Additionally, their strongest competitors in the actions sports brand arena, Tilly & Zumiez, are relatively new and growing rapidly, which could affect the market share of the company. For the FY 2013 & 2014 sales, I utilized a report from Piper Jaffray (Piper Jaffray, 2013), which indicated a slight decrease in sales in 2013 followed by a 1.2% increase in 2014. For the remaining three years, I chose a 2.0% growth rate. I feel that is a reasonable long-term growth rate for the company as it is near the inflation rate and sales growth can be expected to stabilize once the company has downsized to the desired number of stores. This resulted in a sales revenue CAGR for the projection periods of 1.4%.
Expenses
Next, I projected the COGS, SG&A and depreciation expenses as a % of sales. I forecast COGS, depreciation, & SG&A to decrease slightly as the company continues to take steps to streamline their cost structure, including store closures. These estimates were also based off of the Piper Jaffray reports in the first two years; for the final three years of the projections, I once again assumed that the company’s expense structure would stabilize somewhat as it returns to a healthier financial condition and is able to maintain their store base. For CAPEX, I also included a slight decrease as a % of sales due to the store closures; however, I didn’t forecast a significant decrease as the company has reportedly deferred store upgrades due to their poor financial health, and the remaining stores may require significant upgrades once the company returns to a better financial condition. Forecasted expenses are shown below. Assumptions | | | | | | | | | | | | | 2010 | 2011 | 2012 | 2013 | 2014 | 2015 | 2016 | 2017 | Sales (% growth) | | NA | 0.19% | 3.31% | -0.65% | 1.20% | 2.00% | 2.00% | 2.00% | Gross Profit (% sales) | | 22.57% | 21.89% | 25.03% | 27.50% | 29.50% | 29.50% | 29.50% | 29.50% | SG&A (% sales) | | 25.29% | 25.64% | 25.57% | 25.40% | 25.30% | 25.20% | 25.20% | 25.20% | Depreciation & Amortization (% sales) | 7.17% | 5.47% | 4.35% | 3.65% | 3.60% | 3.50% | 3.40% | 3.40% | Capital Expenditures (% sales) | 2.19% | 1.67% | 1.87% | 1.80% | 1.70% | 1.60% | 1.60% | 1.60% | Tax Rate | | | 35.00% | 35.00% | 35.00% | 35.00% | 35.00% | 35.00% | 35.00% | 35.00% |

WACC Calculation
I calculated the WACC using the following assumptions:
Cost of Equity – For the cost of equity calculation, I used the 10-year T-Bond rate as of 04/19/13 to calculate the risk-free rate. Then, to estimate the market risk premium, I took the 10-year average return on the S&P 500 per Morningstar, less the estimated risk-free rate for a market risk premium of 6.3%. To calculate the levered beta, I used betas from Research Insight for the comparable firms and unlevered them using the D/E equity ratio, then relevered the average beta using PacSun’s leverage ratio. This resulted in a levered beta of 3.44. Overall, my cost of equity was 23.3%.
Cost of Debt: For the cost of debt, I used a blended rate of the company’s current debt. This was complicated by the PIK loan; however, based on 2012 interest expense, I estimated that 50% of the term loan was held in the PIK portion of the note and used that to calculate the average rate of interest. This resulted in a pre-tax cost of debt of 6.4% and a post-tax cost of debt of 4.2% using a 35% tax rate.
WACC Calculation: To calculate the WACC, I used the average of the comparable D/E ratios for the target capital structure as Pacific Sunwear is currently more leveraged than its peers. This resulted in a D/E ratio of 0.62 and a final WACC conclusion of 11.4%.
Net Working Capital Estimate: To estimate working capital, I used inventory, prepaid expenses & other, accounts payable, and other current liabilities. I did not project a significant change in these accounts as % of sales or in the cash cycle and instead used historical averages from 2010 – 2012 to estimate the projected NWC. Pacific Sunwear NWC Projections | | | | | | | | | | Historical Period | Projection Period | | 2010 | 2011 | 2012 | 2013 | 2014 | 2015 | 2016 | 2017 | Sales | $775,867.0 | $777,337.0 | $803,071.0 | $797,851.0 | $807,425.3 | $823,573.8 | $840,045.2 | $856,846.1 | Cost of Goods Sold | 600,775.0 | 607,156.0 | 602,091.0 | 578,442.0 | 569,234.8 | 580,619.5 | 592,231.9 | 604,076.5 | Inventories | 95,701.0 | 88,740.0 | 90,681.0 | 87,731.3 | 86,334.8 | 88,061.5 | 89,822.8 | 91,619.2 | Prepaid Expenses and Other | 16,442.0 | 21,778.0 | 15,727.0 | 17,627.5 | 17,839.1 | 18,195.9 | 18,559.8 | 18,931.0 | Total Current Assets | $112,143.0 | $110,518.0 | $106,408.0 | $105,358.8 | $104,173.9 | $106,257.4 | $108,382.5 | $110,550.2 | Accounts Payable | 41,028.0 | 38,914.0 | 49,994.0 | 43,159.3 | 42,472.3 | 43,321.8 | 44,188.2 | 45,072.0 | Other Current Liabilities | 42,186.0 | 68,369.0 | 63,641.0 | 60,002.3 | 60,722.3 | 61,936.8 | 63,175.5 | 64,439.0 | Total Current Liabilities | $83,214.0 | $107,283.0 | $113,635.0 | $103,161.6 | $103,194.7 | $105,258.5 | $107,363.7 | $109,511.0 | Net Working Capital | $28,929.0 | $3,235.0 | ($7,227.0) | $2,197.2 | $979.3 | $998.8 | $1,018.8 | $1,039.2 | % sales | 3.7% | 0.4% | (0.9%) | 0.3% | 0.1% | 0.1% | 0.1% | 0.1% | | | | | | | | | | (Increase) / Decrease in NWC | $5,321.0 | $25,694.0 | $10,462.0 | ($2,197.2) | $1,218.0 | ($19.6) | ($20.0) | ($20.4) | | | | | | | | | | Assumptions | 2010 | 2011 | 2012 | 2013 | 2014 | 2015 | 2016 | 2017 | Days Inventory Held | 58.1 | 53.3 | 55.0 | 55.4 | 55.4 | 55.4 | 55.4 | 55.4 | Prepaids and Other CA (% of sales) | 2.1% | 2.8% | 2.0% | 2.2% | 2.2% | 2.2% | 2.2% | 2.2% | | | | | | | | | | Days Payable Outstanding | 24.9 | 23.4 | 30.3 | 27.2 | 27.2 | 27.2 | 27.2 | 27.2 | Other Current Liabilities (% of sales) | 5.4% | 8.8% | 7.9% | 7.5% | 7.5% | 7.5% | 7.5% | 7.5% |

DCF Analysis: The historic cash flows are shown as follows: Pacific Sunwear, Inc. | | | | | | (in 000’s) | | | | | | | Mid-Year Convention | N | Historical Period | | | | | 2010 | 2011 | 2012 | CAGR | Sales | | | $775,867.0 | $777,337.0 | $803,071.0 | 1.2% | % growth | | | NA | 0.2% | 3.3% | | COGS | | | 600,775.0 | 607,156.0 | 602,091.0 | | Gross Profit | | | $175,092.0 | $170,181.0 | $200,980.0 | 4.7% | % margin | | | 22.6% | 21.9% | 25.0% | | SG&A | | | 196,252.0 | 199,321.0 | 205,362.0 | | EBITDA | | | ($21,160.0) | ($29,140.0) | ($4,382.0) | | % margin | | | (2.7%) | (3.7%) | (0.5%) | | Depreciation & Amortization | | 55,647.0 | 42,505.0 | 34,915.0 | | EBIT | | | ($76,807.0) | ($71,645.0) | ($39,297.0) | | % margin | | | (9.9%) | (9.2%) | (4.9%) | | Taxes | | | - | - | - | | EBIAT | | | ($76,807.0) | ($71,645.0) | ($39,297.0) | | | | | | | | | Plus: Depreciation & Amortization | 55,647.0 | 42,505.0 | 34,915.0 | | Less: Capital Expenditures | | 17,000.0 | 13,000.0 | 15,000.0 | | Less: Increase in NWC | | 5,321.0 | 25,694.0 | 10,462.0 | | | | | | | | | Unlevered Free Cash Flow | ($43,481.0) | ($67,834.0) | ($29,844.0) | |

Projected cash flows based on the historical results and assumptions outlined above are as follows:

Pacific Sunwear | | | | | | | | DSC (in 000’s) | | | | | | | | | Feb. 2nd FYE | | | | | | | | | Operating Scenario | 1 | | | | | | | Mid-Year Convention | N | Projection Period | | | | | 2013 | 2014 | 2015 | 2016 | 2017 | CAGR | Sales | | | $797,851.0 | $807,425.3 | $823,573.8 | $840,045.2 | $856,846.1 | 1.4% | % growth | | | (0.6%) | 1.2% | 2.0% | 2.0% | 2.0% | | COGS | | | 578,442.0 | 569,234.8 | 580,619.5 | 592,231.9 | 604,076.5 | | Gross Profit | | | $219,409.0 | $238,190.4 | $242,954.3 | $247,813.3 | $252,769.6 | 2.9% | % margin | | | 27.5% | 29.5% | 29.5% | 29.5% | 29.5% | | SG&A | | | 173,532.6 | 175,211.3 | 178,715.5 | 183,129.9 | 186,792.5 | | EBITDA | | | $45,876.4 | $62,979.2 | $64,238.8 | $64,683.5 | $65,977.2 | 7.5% | % margin | | | 5.8% | 7.8% | 7.8% | 7.7% | 7.7% | | Depreciation & Amortization | | 29,121.6 | 29,067.3 | 28,825.1 | 28,561.5 | 29,132.8 | | EBIT | | | $16,754.9 | $33,911.9 | $35,413.7 | $36,121.9 | $36,844.4 | | % margin | | | 2.1% | 4.2% | 4.3% | 4.3% | 4.3% | | Taxes | | | - | 11,869.2 | 12,394.8 | 12,642.7 | 12,895.5 | | EBIAT | | | $16,754.9 | $22,042.7 | $23,018.9 | $23,479.3 | $23,948.8 | 7.4% | | | | | | | | | | Plus: Depreciation & Amortization | 29,121.6 | 29,067.3 | 28,825.1 | 28,561.5 | 29,132.8 | | Less: Capital Expenditures | | 14,361.3 | 13,726.2 | 13,177.2 | 13,440.7 | 13,709.5 | | Less: Increase in NWC | | (2,197.2) | 1,218.0 | (19.6) | (20.0) | (20.4) | | | | | | | | | | | Unlevered Free Cash Flow | $33,712.3 | $36,165.8 | $38,686.4 | $38,620.1 | $39,392.5 | 3.2% |

Enterprise Value | | Implied Equity Value and Share Price | | Implied Perpetuity Growth Rate | PV of FCF | | | $135,361.7 | | Enterprise Value | | $361,296.9 | | Terminal Year FCF (2017E) | | $39,392.5 | | | | | | Less: Total Debt | | 249,452.0 | | WACC | | | 11.4% | Terminal Value | | Less: Preferred Securities | | - | | Terminal Value | | | $387,945.7 | Terminal EBITDA (2017E) | $65,977.2 | | Less: Noncontrolling Interest | | - | | | | | | Exit Multiple | | | 5.9x | | Plus: Cash | | | 48,733.0 | | Implied Perpetuity Growth Rate | 1.1% | Terminal Value | | $387,945.7 | | | | | | | | | | | | | | | | Implied Equity Value | | $160,577.9 | | Implied EV/EBITDA | PV of TV | | | $225,935.2 | | | | | | | Enterprise Value | | $361,296.9 | % of Enterprise Value | | 62.5% | | Shares Outstanding | | 67,815.0 | | 2013 EBITDA* | | | 45,876.4 | | | | | | | | | | | | | | | Enterprise Value | | $361,296.9 | | Implied Share Price - Exit Multiple Method | | $2.37 | | Implied EV/EBITDA | | 7.9x |

To calculate the exit multiple of 5.9x, I used the average EV/EBITDA multiple for the comparable set. The resulting DCF value of $2.37/share is very sensitive to the assumptions made to reach the value. For example, a 1% decrease in sales growth in each period yields a value of $2.15/share. In comparison, a 1% increase in the sales growth in each period yields a value of $2.54/share. The implied EV/EBITDA calculation was calculated using the projected 2013 EBITDA rather than actual FY 2012 EBITDA due to the fact that the 2012 EBITDA was negative. A second calculation of the DCF analysis was performed using the terminal growth method rather than the exit multiple method which yielded a similar value, shown below: Enterprise Value | | Implied Equity Value and Share Price | | Implied Perpetuity Growth Rate | PV of FCF | | | $134,760.3 | | Enterprise Value | | $383,814.2 | | Terminal Year FCF (2017E) | | $39,392.5 | | | | | | Less: Total Debt | | 249,452.0 | | WACC | | | 11.4% | Terminal Value | | Less: Preferred Securities | | - | | Terminal Value | | | $426,609.2 | Terminal FCF (2017E) | $39,083.5 | | Less: Noncontrolling Interest | | - | | | | | | Perpetuity Growth | | | 2.0% | | Plus: Cash | | | 48,733.0 | | Implied Perpetuity Growth Rate | 2.0% | Terminal Value | | $426,609.4 | | | | | | | | | | | | | | | | Implied Equity Value | | $183,095.2 | | Implied EV/EBITDA | PV of TV | | | $248,452.5 | | | | | | | Enterprise Value | | $383,814.2 | % of Enterprise Value | | 64.7% | | Shares Outstanding | | 67,815.0 | | 2013 EBITDA* | | | 45,876.4 | | | | | | | | | | | | | | | Enterprise Value | | $383,814.2 | | Implied Share Price | | $2.70 | | Implied EV/EBITDA | | 8.4x |

The perpetuity growth model yields a significantly higher value of $2.70; however, the implied EV/EBITDA multiple using a rate of 2.0% is quite high at 7.8x, which is higher than the highest multiple in the comparable set (Zumiez at 7.4x). Thus, this model is not given much weight in the valuation. To further test the assumptions made, a sensitivity analysis as it pertains to WACC, perpetuity growth, and exit multiples is shown below: | | Exit Multiple | | | Exit Multiple | | ###### | | 5.4x | 5.9x | 6.4x | 6.9x | | ###### | 4.9x | 5.4x | 5.9x | 6.4x | 6.9x | WACC | 10.4% | | 314,970 | 314,970 | 335,068 | 375,264 | WACC | 10.4% | 135,385 | 155,500 | 175,615 | 195,730 | 215,845 | | 10.9% | | 309,244 | 309,244 | 328,893 | 368,192 | | 10.9% | 129,187 | 148,853 | 168,518 | 188,184 | 207,849 | | 11.4% | | 303,660 | $303,660 | 322,873 | 361,297 | | 11.4% | 123,143 | 142,371 | $161,599 | 180,828 | 200,056 | | 11.9% | | 298,214 | 298,214 | 317,000 | 354,574 | | 11.9% | 117,248 | 136,051 | 154,853 | 173,656 | 192,458 | | 12.4% | | 292,900 | 292,900 | 311,273 | 348,018 | | 12.4% | 111,499 | 129,887 | 148,275 | 166,662 | 185,050 | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | Implied Share Price | | PV of Terminal Value as % of Enterprise Value | | | Exit Multiple | | | Exit Multiple | | 2.4 | | 5.4x | 5.9x | 6.4x | 6.9x | | 0.6 | 4.9x | 5.4x | 5.9x | 6.4x | 6.9x | WACC | 10.4% | | 2.29 | 2.59 | 2.89 | 3.18 | WACC | 10.4% | 58.6% | 61.0% | 63.1% | 64.9% | 66.6% | | 10.9% | | 2.19 | 2.48 | 2.77 | 3.06 | | 10.9% | 58.9% | 61.2% | 63.3% | 65.2% | 66.8% | | 11.4% | | 2.10 | $2.37 | 2.67 | 2.95 | | 11.4% | 58.9% | 61.2% | 63.3% | 65.2% | 66.8% | | 11.9% | | 2.01 | 2.28 | 2.56 | 2.84 | | 11.9% | 58.6% | 61.0% | 63.1% | 64.9% | 66.6% | | 12.4% | | 1.92 | 2.19 | 2.46 | 2.73 | | 12.4% | 58.2% | 60.5% | 62.6% | 64.5% | 66.2% | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | Implied Perpetuity Growth Rate | | Implied Enterprise Value / LTM EBITDA | | | Exit Multiple | | | Exit Multiple | | 0.0 | | 5.4x | 5.9x | 6.4x | 6.9x | | 7.9 | 4.9x | 5.4x | 5.9x | 6.4x | 6.9x | WACC | 10.4% | | -0.6% | 0.3% | 1.0% | 1.6% | WACC | 10.4% | 7.3x | 7.8x | 8.2x | 8.6x | 9.1x | | 10.9% | | -1.0% | -0.2% | 0.5% | 1.2% | | 10.9% | 7.5x | 7.9x | 8.4x | 8.8x | 9.3x | | 11.4% | | -1.0% | -0.2% | 0.5% | 1.2% | | 11.4% | 7.5x | 7.9x | 8.4x | 8.8x | 9.3x | | 11.9% | | -0.6% | 0.3% | 1.0% | 1.6% | | 11.9% | 7.3x | 7.8x | 8.2x | 8.6x | 9.1x | | 12.4% | | 0.3% | 1.2% | 1.9% | 2.5% | | 12.4% | 7.1x | 7.5x | 7.9x | 8.3x | 8.7x |

For the purpose of valuing Pacific Sunwear, the DCF analysis is not considered to be the preferred method of valuation for several reason. First of all, the company is in the process of reducing their retail footprint with store closures occurring over the past several years and more closures planned for the future. As a result, the cost structure is changing, which is difficult to project, and it is difficult to estimate the impact of closing stores on the top line. This also affects the CAPEX estimate, which may change in unexpected ways as the number of stores to maintain decreases but will likely be impacted by the completion of upgrades to the company’s stores that have been deferred due to insufficient cash flows. The company also changed their marketing strategy in 2012, with a focus on social media efforts through their “California State of Mind” campaign and a boutique feel for their stores, which has met with some success and may not have been fully realized in the top line. Additionally, the company has two strong competitors, Tilly’s & Zumiez, that are rapidly-growing companies in the action sports brand market and may be able to take additional market share from Pacific Sunwear. Although Pacific Sunwear is currently the most recognized brand in the action sports brand market, the impact of Tilly’s and Zumiez may not have been fully realized yet; additionally, they are in better financial health than Pacific Sunwear, which may give them a competitive advantage.
Furthermore, the company has consistently lost money for the past several years. Although there has been some improvement in recent periods, the assumptions made in the DCF assume that the cost restructuring and marketing efforts of the company are successful and that the company is able to recognize profits in the projection periods.
Lastly, the retail industry is very sensitive to macroeconomic factors that affect consumer confidence and disposable income as well as commodities prices for gas and cotton. Unforeseen changes in employment, gas prices, cotton prices, and other factors that contribute to decreased sales and/or higher COGS may affect the price estimated by the DCF.
Overall, I concluded a share price of $2.37 for the company based on the exit multiple method which is dependent on the assumptions made above. A share price range of $1.92 - $3.18 was calculated using varied WACC and exit multiple estimates.
Precedent Transaction Analysis
For the precedent transaction analysis, I chose four recent M&A transactions found via ThomsonOne Investment Research. The transactions are detailed as follows: 1) Hot Topic Acquisition: This is considered to be the most comparable transaction of the three as Hot Topic is a similar company to Pacific Sunwear. The companies are both specialty retailers that cater to a specific segment of the teen & young adult market. The firm has also struggled with profitability in the past several years due to the recession and corresponding decrease in disposable income for their target demographic. However, Hot Topic focuses more on popular culture, music, and gifts, in addition to apparel. In March 2013, Sycamore Partners made an offer to purchase 100% of the company for cash and take the company private. Sycamore also purchased retailer Talbots last year. The deal has been accepted by Hot Topic and is still in process. Due to the similarities in the companies and their financial performance, the deal is considered to be a good comparable. 2) Christopher & Banks Corp. Acquisition: Aria Partners GP, LLC, offered to purchase 96% of Christopher & Banks Corp. in 2012, making their total ownership stake 100%. This was the second offer that the company made, with their first offer (for the same price of $1.75) made in May 2012, which was rejected and represented only a 16% premium at that time. Christopher & Banks operates 2 menswear brands and has 644 locations. As an investor, Aria has argued that the company allowed their value to decrease due to irresponsible management. Like PacSun, the company is in poor financial health and is a mall-based retailer; however, they sell menswear exclusively and cater primarily to an older demographic. The companies are somewhat similar in terms of number of stores and risk, and the deal is thought to be fairly comparable. 3) Charming Shoppes, Inc. Acquisition: Ascena Retail Group, Inc. acquired 100% of Charming Shoppes in 2012. Both companies operate several chains, with Charming Shoppes including Lane Bryant, Fashion Bug (which has now been shut down), Catherine’s, and Figi’s. Ascena’s brands include dressbarn, Maurice’s, and Justice. The combination of the two companies will give them an opportunity to streamline the business as both company’s brands including specialty retailers geared towards women, particularly in the plus-size market. Like Pacific Sunwear, Charming Shoppes is a specialty retailer that has struggled in the past few years; however, it is larger than PacSun and caters to different demographics. The deal was completed in 2012. Due to the differences in size and business model, the deal may not be the best comparable; however, as in the previous transactions used, the reason for the acquisition appears to have been to improve the company’s financial condition and take advantage of potential synergies, which would likely be the reason for a Pacific Sunwear acquisition if one were to take place. Precedent Transactions | | | | | | | | Target: | Hot Topic, Inc. | Christopher & Banks Corp. | Charming Shoppes, Inc. | Country | United States | United States | United States | Acquirer | Sycamore Partners, LLC | Aria Partners GP, LLC | Ascena Retail Group, Inc. | Date Announced | 3/7/2013 | 7/3/2012 | 5/2/2012 | Date Effective | Pending | Intended | 6/15/2012 | Consideration | Cash | Cash (Tender Offer) | Cash (Tender Offer) | % Sought | 100.00% | 96%* | 100.00% | Deal Value | $625.01M | $61.64M | $880.38M | Deal EV/Sales | 0.78 | 0.09 | 0.41 | Initial Offer Price | $14.00/share | $1.75/share | $7.35/share | Premium, Pre Bid 1 Day (%) | 30.23% | 50.86% | 24.58 % | Premium, Pre Bid 1 Week | 29.63% | 48.31% | 24.58 % | Premium, Pre Bid 4 Weeks | 27.27% | 63.55% | 20.49 % | | | | | Target Company: | | | | EV/Sales | 0.7x | 0.5x | 0.4x | Price/Sales | 0.7x | 0.6x | 0.4x | Price/BV | 3.24x | 3.30x | 2.0x | Total D/E | 0.59x | 0.80x | 31.84x | Sales Growth | 6.30% | 1.42% | -4.50% | GP Margin | 36.20% | 29.43% | 49.50% | Net Income Margin | 2.63% | -3.73% | -0.50% | | | | | * The acquiror previously owned 4% of the company. Post-acquisition, it will own 100%. | * Information taken from ThomsonOne. | | |

To calculate the value based on the transactions chosen, I used the average price/book ratio for each deal adjusted by the premium four weeks prior to the sale in order to find the unaffected price. This yield an implied price/book value of 1.55x, for a share price of $1.47/share. The same process for the price/sales ratio yielded a share price of $3.66/share, and a price of $1.76/share was calculated using the deal EV/sales adjusted for the premium. Averaged together, this resulted in an implied share price of $2.30/share. This would imply that the share is slightly overvalued based on the precedent transaction analysis. Included above are some financial metrics of the acquired companies for comparison to the subject. Although the deals may not be perfectly accurate for estimating the underlying value, they are comparable in that the acquired companies were struggling retail companies. The premiums also give a good indicator of the average premium that would be paid for deals in the retail industry. Premiums are likely due to the control interest received as well as potential synergies, particularly for the Charming Shoppes acquisition.
Conclusion
Pacific Sunwear was hit hard by the recession and seems to have recovered more slowly than many other companies in the industry. The company is in a taste-driven business and runs the risk of falling out of favor with their teen and young adult audience. Currently, the company is re-sizing their business by closing a significant amount of stores to reduce costs and focus on their strongest locations. In addition, they are making an effort to increase their marketing effectiveness with the “California State of Mind” marketing campaign, which is integrated with social media, and emphasizes the many facets of the California lifestyle that the company tries to represent. In addition, they are moving towards a more boutique shopping experience, with the smaller number of stores allowing them to offer smaller brands that may not have the capacity to provide products to a larger chain. All of these efforts are focused around returning to profitability, as the company has reported consecutive losses since FY 2006. However, as of FY 2012, that goal had not yet been achieved despite some improvement over previous years including a 3.3% increase in revenues. The next few years of operations will likely determine if the company is able to stay in business or not.

According to my analysis, the fair value is $2.43, which indicates that the stock may be slightly undervalued but is fairly close to the price of the stock. I recommended a “Hold” for the stock as the price is close to the concluded value and it is a very risky investment. The company is currently making changes to their business in order to improve profitability and the price going forward will be contingent on the success of those measures; additionally, it is likely that the next few years of operations will determine whether the company is able to remain in business or not. Possible flaws in my price conclusion include the appropriateness of comparable firms and precedent transactions, quality of assumptions made in the DCF analysis, the success of the company’s plan to improve profitability, and macroeconomic factors such as a continued or worsened recession, rising gas prices, and rising cotton prices.

Bibliography:

Bloomberg. Various data retrieved April 2013. http://www.bloomberg.com Kumar, Anand. “Industry’s Concern Over Rising Cotton Prices”. Published 03/18/13 by Inpaper Magazine. Retrieved 04/20/13. http://dawn.com/2013/03/18/industrys-concern-over-rising-cotton-prices/ Pacific Sunwear: Evolution As a Crossover Fashion Retailer Evident in Teen Survey; Upgrade to OW (2013). Piper Jaffray, 1-13. Retrieved 04/25/13 from ThomsonOne.

Pacific Sunwear SWOT Analysis. (2012). Pacific Sunwear Corporation SWOT Analysis, 1-8. Retrieved 02/10/13 from Business Source Premier.

Standard & Poor’s Research Insight. Various data retrieved April 2013.

U.S. Securities & Exchange Commission. Various data retrieved April 2013. http://www.sec.gov Yahoo! Finance. Various data retrieved April 2013.
http://www.finance.yahoo.com