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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

For the quarterly period ended August 2, 2003

OR

Commission file number 0-21296

PACIFIC SUNWEAR OF CALIFORNIA, INC.

(714) 414-4000
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports); and (2) has been subject to such filing requirements for the past 90 days.

Yes   x    No   __

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes   x    No   __

     The number of shares outstanding of the registrant’s Common Stock, par value $.01 per share, at August 25, 2003, was 51,770,519.

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PACIFIC SUNWEAR OF CALIFORNIA, INC.

FORM 10-Q
For the Quarter Ended August 2, 2003

Index

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PACIFIC SUNWEAR OF CALIFORNIA, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(unaudited)
(in thousands, except share amounts)

ASSETS

See accompanying notes

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PACIFIC SUNWEAR OF CALIFORNIA, INC.
CONDENSED CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME
(unaudited)
(in thousands, except share and per share amounts)

See accompanying notes

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PACIFIC SUNWEAR OF CALIFORNIA, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
(in thousands)

Supplemental disclosures of non-cash transactions (in thousands): During the first half ended August 2, 2003 and August 3, 2002, the Company recorded an increase to additional paid-in capital of $10,127 and $649, respectively, related to tax benefits associated with the exercise of non-qualified stock options. Also, during the first half ended August 3, 2002, the Company recorded an increase to additional paid-in capital of $291 related to the issuance of restricted stock to satisfy certain deferred compensation liabilities. In addition, during the first half ended August 3, 2002, the Company purchased a prepaid three-year computer maintenance agreement under a long-term debt obligation for $2,413.

See accompanying notes

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PACIFIC SUNWEAR OF CALIFORNIA, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited, all amounts in thousands unless otherwise indicated)

NOTE 1 – BASIS OF PRESENTATION

The accompanying condensed consolidated financial statements are unaudited and have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. The condensed consolidated financial statements include the accounts of Pacific Sunwear of California, Inc. and its wholly owned subsidiaries (the “Company”). All intercompany transactions have been eliminated in consolidation.

The Company’s fiscal year is the 52- or 53-week period ending on the Saturday closest to January 31. “Fiscal 2003” is the 52-week period ending January 31, 2004. “Fiscal 2002” was the 52-week period ended February 1, 2003. “Fiscal 2001” was the 52-week period ended February 2, 2002.

In the opinion of management, all adjustments consisting only of normal recurring entries necessary for a fair presentation have been included. The preparation of the condensed consolidated financial statements in conformity with GAAP necessarily requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the condensed consolidated financial statements and reported revenues and expenses during the reporting period. Actual results could differ from these estimates. The results of operations for the second quarter and first half ended August 2, 2003, are not necessarily indicative of the results that may be expected for fiscal 2003. For further information, refer to the Company’s consolidated financial statements and notes thereto on Form 10-K as of and for the years ended February 1, 2003, February 2, 2002, and February 4, 2001.

NOTE 2 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation —The consolidated financial statements include the accounts of Pacific Sunwear of California, Inc. and its wholly owned subsidiaries, Pacific Sunwear Stores Corp. and ShopPacSun.com Corp. All intercompany transactions have been eliminated in consolidation.

Use of Estimates — The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America necessarily requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the consolidated financial statements as well as the reported revenues and expenses during the reporting period. Actual results could differ from these estimates.

Revenue Recognition — Sales are recognized upon purchase by customers at the Company’s retail store locations or upon shipment for orders received through the Company’s website. The Company has accrued $.7 million as of August 2, 2003 to estimate sales returns by customers based on historical sales return results. Actual return rates have historically been within management’s expectations and the accruals established.

Inventory Valuation — Merchandise inventories are stated at the lower of cost (first-in, first-out method) or market. Cost is determined using the retail inventory method. At any one time, inventories include items that have been marked down to management’s best estimate of their fair market value. Management bases the decision to mark down merchandise upon the age of the item and its current rate of sale.

Goodwill and Other Intangible Assets — On February 3, 2002, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Intangible Assets,” which revised the accounting for purchased goodwill and intangible assets. Under SFAS No. 142, goodwill and intangible assets with indefinite lives are no longer amortized but are tested for impairment annually and also in the

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event of an impairment indicator. The Company completed the required transitional impairment test and the annual test and determined that no impairment existed. Any subsequent impairment losses will be reflected in operating income. With the adoption of SFAS No. 142, the Company discontinued amortization of goodwill.

The Company evaluates the recoverability of goodwill at least annually based on a two-step impairment test. The first step compares the fair value of each reporting unit with its carrying amount, including goodwill. If the carrying amount exceeds fair value, then the second step of the impairment test is performed to measure the amount of any impairment loss. Fair value is determined based on estimated future cash flows, discounted at a rate that approximates the Company’s cost of capital. Such estimates are subject to change and the Company may be required to recognize impairment losses in the future.

Other Long-Lived Assets – On February 3, 2002, the Company adopted SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” which superseded previous guidance on financial accounting and reporting for the impairment or disposal of long-lived assets and for segments of a business to be disposed of. Upon adoption of SFAS No. 144, the Company reviewed long-lived assets and determined that no impairment existed. Under SFAS No. 144, long-lived assets, including amortizing intangible assets, will be tested for impairment whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable.

Income Taxes — Current income tax expense is the amount of income taxes expected to be payable for the current year. A deferred income tax asset or liability is established for the expected future consequences of temporary differences in the financial reporting and tax bases of assets and liabilities. The Company considers future taxable income and ongoing prudent and feasible tax planning in assessing the value of its deferred tax assets. If the Company determines that it is more likely than not that these assets will not be realized, the Company would reduce the value of these assets to their expected realizable value through a valuation allowance, thereby decreasing net income. Evaluating the value of these assets is necessarily based on the Company’s judgment. If the Company subsequently determined that the deferred tax assets, which had been written down, would be realized in the future, the value of the deferred tax assets would be increased, thereby increasing net income in the period when that determination was made.

Litigation — The Company is involved from time to time in litigation incidental to its business. Management believes that the outcome of current litigation will not have a material adverse effect upon the results of operations or financial condition of the Company and, from time to time, may make provisions for potential litigation losses. Depending on the actual outcome of pending litigation, charges in excess of any provisions could be recorded in the future which may have an adverse effect on the Company’s operating results (see Note 9).

Stock Split — On December 18, 2002, the Company effected a three-for-two stock split. All share and per share amounts have been restated to give retroactive recognition to the stock split in prior periods.

Stock-Based Compensation — The Company accounts for stock-based compensation in accordance with Accounting Principles Board (“APB”) Opinion No. 25. In March 2000, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 44 of APB Opinion No. 25, “Accounting for Certain Transactions Involving Stock Compensation,” which, among other things, addressed accounting consequences of a modification that reduces the exercise price of a fixed stock option award (otherwise known as repricing). The adoption of this interpretation did not impact the Company’s consolidated financial statements.

SFAS No. 123 (SFAS 123), “Accounting for Stock-Based Compensation,” requires the disclosure of pro forma net income and earnings per share. Under SFAS 123, the fair value of stock-based awards to employees is calculated through the use of option-pricing models, even though such models were developed to estimate the fair value of freely tradable, fully transferable options without vesting restrictions, which significantly differ from the Company’s stock option awards. These models also require subjective assumptions, including future stock price volatility and expected time to exercise, which greatly affect the calculated values. The Company’s calculations were made using the Black-Scholes option-

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pricing model with the following weighted average assumptions: expected life, 5 years; stock volatility, 45.3% for fiscal 2003 and 60.9% for fiscal 2002; risk-free interest rates, 3.3% for fiscal 2003 and 4.7% for fiscal 2002; and no dividends during the expected term. The Company’s calculations are based on a single-option valuation approach and forfeitures are recognized as they occur. If the computed fair values of the fiscal 2003 and fiscal 2002 awards had been amortized to expense over the vesting period of the awards, net income and earnings per share for the second quarter and first half ended August 2, 2003 would have been reduced to the pro forma amounts indicated below:

New Accounting Pronouncements — In April 2002, the FASB issued SFAS No. 145 (SFAS 145), “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections.” SFAS 145 amended certain provisions of SFAS 13 and requires the fair value recognition of guarantee obligations under which the Company may become secondarily liable. The Company adopted SFAS 145 during fiscal 2002. The adoption of SFAS 145 resulted in the recognition of a $.5 million liability related to the Company’s guarantee of an assignee’s performance under a lease obligation (see Note 9).

In June 2002, the FASB issued SFAS No. 146 (SFAS 146), “Accounting for Costs Associated with Exit or Disposal Activities,” which addresses financial accounting and reporting for costs associated with exit or disposal activities and supersedes Emerging Issues Task Force Issue 94-3 (EITF 94-3), “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” SFAS 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. Under EITF 94-3, a liability for an exit cost, as defined in EITF 94-3, was recognized at the date of an entity’s commitment to an exit plan. SFAS 146 also establishes that the liability should initially be measured and recorded at fair value. The Company adopted the provisions of SFAS 146 for exit or disposal activities initiated after December 31, 2002. The adoption of SFAS 146 has not had a material impact on the Company’s financial position or results of operations.

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In November 2002, the FASB issued FASB Interpretation No. 45 (FIN 45), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees and Indebtedness of Others.” FIN 45 elaborates on the disclosures to be made by the guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also requires that a guarantor recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The initial recognition and measurement provisions of this interpretation are applicable on a prospective basis to guarantees issued or modified after December 31, 2002; while the provisions of the disclosure requirements are effective for financial statements of interim or annual reports ending after December 15, 2002. The adoption of FIN 45 has not had a material impact on the Company’s financial position or results of operations upon adoption.

In December 2002, the FASB issued SFAS No. 148 (SFAS 148), “Accounting for Stock-Based Compensation – Transition and Disclosure.” SFAS 148 amends SFAS 123, “Accounting for Stock-Based Compensation,” to provide alternative methods for voluntary transition to SFAS 123’s fair value method of accounting for stock-based employee compensation (“the fair value method”). SFAS 148 also requires disclosure of the effects of an entity’s accounting policy with respect to stock-based employee compensation on reported net income (loss) and earnings (loss) per share in annual and interim financials statements. The Company is required to follow the prescribed disclosure format and has provided the additional disclosures required by SFAS 148 for the quarterly period ended August 2, 2003 elsewhere in this Note 2.

In January 2003, the FASB issued FASB Interpretation No. 46 (FIN 46), “Consolidation of Variable Interest Entities.” In general, a variable interest entity is a corporation, partnership, trust, or any other legal structure used for business purposes that either (a) does not have equity investors with voting rights or (b) has equity investors that do not provide sufficient financial resources for the entity to support its activities. FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. The consolidation requirements of FIN 46 apply immediately to variable interest entities created after January 31, 2003. The consolidation requirements apply to older entities in the first fiscal year or interim period beginning after June 15, 2003. Certain of the disclosure requirements apply in all financial statements issued after January 31, 2003, regardless of when the variable interest entity was established. Since the Company does not currently have any variable interest entities, the adoption of the provisions of FIN 46 did not have a material impact on the Company’s financial position or results of operations.

On February 2, 2003, the Company adopted the Financial Accounting Standards Board’s Emerging Issues Task Force (EITF) Issue No. 02-16 “Accounting by a Reseller for Cash Consideration Received from a Vendor” (EITF 02-16). The consensus reached by the EITF addressed the accounting for cash consideration received from a vendor, which includes vendor allowances, rebates, cooperative advertising payments, etc. The consensus of the EITF establishes an overall presumption that cash received from a vendor is a reduction in the price of a vendor’s products and should be recognized accordingly as a reduction in cost of sales at the time the related inventory is sold. Some consideration could be characterized as a reduction of expense if the cash received represents a reimbursement of specific, incremental, identifiable costs incurred by the retailer to sell the vendor’s products. The adoption of EITF 02-16 did not have a material impact on the Company’s financial position or results of operations.

Reclassifications — Certain prior year amounts have been reclassified to conform to the current year presentation.

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NOTE 3 – CASH AND CASH EQUIVALENTS

Cash and cash equivalents include cash on hand and marketable securities with original maturities of three months or less.

NOTE 4 – DEFERRED COMPENSATION AND OTHER ASSETS

Deferred compensation and other assets consist of the following:

NOTE 5 – CREDIT FACILITY

The Company has a credit facility with a bank, which expires March 31, 2004. The credit facility provides for a $45.0 million line of credit (the “Credit Line”) to be used for cash advances, commercial letters of credit and shipside bonds. Interest on the Credit Line is payable monthly at the bank’s prime rate (4.25% at August 2, 2003) or at optional interest rates that are primarily dependent upon the London Inter-bank Offered Rates for the time period chosen. The Company did not borrow under the Credit Line at any time during the first half ended August 2, 2003. The Company had $20.7 million outstanding in letters of credit at August 2, 2003. The credit facility subjects the Company to various restrictive covenants, including maintenance of certain financial ratios, and prohibits payment of cash dividends on common stock. At August 2, 2003, the Company was in compliance with all of the covenants.

NOTE 6 – ACCRUED LIABILITIES

Accrued liabilities consist of the following:

NOTE 7 – FEDERAL AND STATE INCOME TAX EXPENSE

The combined federal and state income tax expense was calculated using estimated effective annual tax rates.

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NOTE 8 – NET INCOME PER SHARE, BASIC AND DILUTED

The following table summarizes the computation of EPS (all amounts in thousands except share and per share amounts):

Options to purchase 2,500 and 2,543,660 shares of common stock in the second quarter of fiscal 2003 and fiscal 2002, respectively, and 92,044 and 1,426,356 shares of common stock in the first half of fiscal 2003 and fiscal 2002, respectively, were not included in the computation of diluted earnings per common share because the option exercise price was greater than the average market price of the common stock.

NOTE 9 – COMMITMENTS AND CONTINGENCIES

The Company has minimum annual rental commitments under existing store leases, the lease for its former corporate offices and distribution center, capital leases for computer equipment, and other long-term debt obligations for multi-year computer maintenance contracts. The Company leases all of its retail store locations under operating leases. The Company leases equipment, from time to time, under capital leases. In addition, at any time, the Company is contingently liable for open letters of credit with foreign suppliers of merchandise. There were $20.7 million of open letters of credit outstanding as of August 2, 2003. As of August 2, 2003, the Company’s future financial commitments under these arrangements are as follows:

Litigation – During the first quarter ended May 3, 2003, the Company reached an agreement, subject to court approval, to settle all claims related to two lawsuits concerning overtime pay for a total of $4.0 million. The Company had accrued $3.9 million related to these matters at February 1, 2003. The suits are Auden v. Pacific Sunwear of California, Inc., which was filed September 17, 2001, and Adams v. Pacific Sunwear of California, Inc., which was filed August 2, 2002. The complaints allege that the Company improperly classified certain California-based employees as “exempt” from overtime pay. The Company

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denies the allegations underlying the suits, but has agreed to settle the suits to avoid the cost, distraction and uncertainty associated with protracted litigation. The court has granted preliminary approval of the settlement and is expected to conduct final fairness hearings regarding the settlement in September or October 2003. The settlement did not have a material impact on results of operations for the second quarter or first half ended August 2, 2003.

The Company is involved from time to time in litigation incidental to its business. Management believes that the outcome of current litigation will not have a material adverse effect upon the results of operations or financial condition of the Company.

Indemnities, Commitments, and Guarantees – During its normal course of business, the Company has made certain indemnities, commitments and guarantees under which it may be required to make payments in relation to certain transactions. These indemnities include those given to various lessors in connection with facility leases for certain claims arising from such leases and indemnification undertakings to directors and officers of the Company to the maximum extent permitted under the laws of the State of California. The Company has issued guarantees in the form of standby letters of credit as security for merchandise shipments from overseas. There were $20.7 million of these letters of credit outstanding at August 2, 2003. The Company has also issued a guarantee of a sublease on one of its store locations under which the Company remains secondarily liable on the sublease should the sublessee default on its lease payments. The term of the sublease ends December 31, 2014. The Company has recorded $.5 million in accrued liabilities to recognize the estimated fair value of this guarantee. The aggregate rental payments remaining on the master lease agreement at August 2, 2003, were $6.2 million. 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 above indemnities, commitments and guarantees in the accompanying consolidated balance sheets other than as noted.

The Company maintains a private label credit card through a third party to promote the PacSun brand image and lifestyle. The third party services the customer accounts and retains all risk and financial obligation associated with any outstanding balances on customer accounts. The Company has no financial obligation and does not provide any guarantee related to any outstanding balances resulting from the use of these private label credit cards by its customers.

Reserve for Corporate Rent – Former Corporate Facilities – During fiscal 2001, the Company recorded a $1.4 million charge to accrue for rent expense associated with the Company’s former corporate offices, which remain unused as of August 2, 2003. The current accrual of $1.2 million is approximately the amount of rent expense for one year, within which time the Company currently believes a tenant will be identified to sublease the premises. To the extent management’s estimates relating to the Company’s ability to sublease these facilities changes or is incorrect, additional charges may be recorded in the future up to the net remaining obligation under the lease. As of August 2, 2003, the aggregate net remaining obligation under this lease was approximately $5.8 million. This amount is included in the contractual obligations table above.

NOTE 10 – RESTRICTED STOCK

During the year ended January 30, 2000, the Company granted a restricted stock award of 75,000 shares with a purchase price of $0.01 per share to its Chief Executive Officer. The 75,000 share award vests 25% on each of September 17, 2001, 2002, 2003 and 2004, if, in each instance, certain cumulative annual earnings per share growth targets have been satisfied. The Company recorded $229 of deferred compensation expense associated with this award during the year ended February 4, 2001. During fiscal 2001, the Company reversed all previously recognized expenses of $317 associated with this award because the cumulative annual earnings per share growth targets had not then been satisfied. No additional expenses have been recognized for this award because the cumulative annual earnings per share growth targets had not been met as of February 1, 2003. Under the award agreement, shares that do not vest at a given vesting date due to the cumulative annual earnings per share growth targets not being met remain

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available for future vesting if the cumulative annual earnings per share growth targets are met as of a subsequent vesting date. It is possible that the cumulative annual earnings per share growth target for this award may be achieved in fiscal 2003 and, if that target is met, the Company will be required to record compensation expense during the year ending January 31, 2004. If the target is met, the compensation expense to be recognized will be based on the closing market price of the Company’s stock as of January 31, 2004 minus the purchase price of $.01 per share. For example, based on the closing market price of the Company’s stock at August 2, 2003 of $29.92, the Company would, assuming the cumulative annual earnings per share growth target is met, record $2.1 million in compensation expense related to this award in the year ending January 31, 2004.

During the year ended February 4, 2001, the Company granted a restricted stock award of 112,500 shares with a purchase price of $0.01 per share to its Chief Executive Officer. The 112,500 share award vests 25% on each of March 15, 2002, 2003, 2004 and 2005, if, in each instance, certain cumulative annual earnings per share growth targets have been satisfied. The Company recorded $38 of deferred compensation expense associated with this award during the year ended February 4, 2001. During fiscal 2001, the Company reversed all previously recognized expenses of $38 associated with this award because the cumulative annual earnings per share growth targets had not then been satisfied. Under the award agreement, shares that do not vest at a given vesting date due to the cumulative annual earnings per share growth targets not being met remain available for future vesting if the cumulative annual earnings per share growth targets are met as of a subsequent vesting date. During the second quarter of fiscal 2003, the Company determined that it is probable that the cumulative annual earnings per share growth target for this award will be achieved in fiscal 2003 and, accordingly, the Company recorded compensation expense of $2.1 million to recognize the cumulative value of the award. This expense has been accrued within deferred compensation liabilities on the balance sheet. The Company will be required to recognize additional compensation expense related to this award in each future quarter based on additional vesting of the shares and the market price of the Company’s stock. For example, based on the market price of the Company’s stock at August 2, 2003 of $29.92, the Company would be required to record additional compensation expense of approximately $.2 million in each quarter based on additional vesting of the shares until the shares are delivered to the Chief Executive Officer. Additionally, based on any change in the market price of the Company’s stock in future quarters, the cumulative compensation expense recognized for this award will continue to be adjusted until the shares are delivered to the Chief Executive Officer.

NOTE 11 – SUBSEQUENT EVENT – STOCK SPLIT

On August 7, 2003, the Company announced a three-for-two stock split. The record date for the split is August 25, 2003. Shareholders of record as of that date will receive one new share of common stock for every two shares they owned on the record date. The additional shares will be mailed on or about September 5, 2003. Cash will be paid in lieu of issuing fractional shares based on the closing market price of the Company’s common stock on August 25, 2003.

The disclosures of proforma net income per share, both basic and diluted, as well as proforma weighted shares outstanding, both basic and diluted, are presented as if the stock split had taken effect as of the balance sheet date. Currently, the Company’s common stock is not yet trading on a post-split basis. The Company’s common stock will begin trading on a post-split basis on September 8, 2003.

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ITEM 2 — MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF CONSOLIDATED OPERATIONS

Critical Accounting Policies

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America necessarily requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements as well as the reported revenues and expenses during the reported period. Actual results could differ from these estimates. The accounting policies that the Company believes are the most critical to aid in fully understanding and evaluating reported financial results include the following:

Revenue Recognition - Sales are recognized upon purchase by customers at the Company’s retail store locations or upon shipment for orders received through the Company’s website. The Company has accrued $.7 million as of August 2, 2003 to estimate sales returns by customers based on historical sales return results. Actual return rates have historically been within management’s expectations and the reserves established. However, in the unlikely event that the actual rate of sales returns by customers increased significantly, the Company’s operational results could be adversely affected.

Inventory Valuation - Merchandise inventories are stated at the lower of cost (first-in, first-out method) or market. Cost is determined using the retail inventory method. At any one time, inventories include items that have been marked down to management’s best estimate of their fair market value. Management bases the decision to mark down merchandise upon the age of the item and its current rate of sale. To the extent that management estimates differ from actual results, additional markdowns may have to be recorded, which could reduce the Company’s gross margins and operating results.

Long-Lived Assets - In the normal course of business, the Company acquires tangible and intangible assets. The Company periodically evaluates the recoverability of the carrying amount of its long-lived assets (including property, plant and equipment, and other intangible assets) whenever events or changes in circumstances indicate that the carrying amount of an asset may not be fully recoverable. Impairment is assessed when the undiscounted expected future cash flows derived from an asset or asset group are less than its carrying amount. Impairments are recognized in operating earnings. The Company uses its best judgment based on the most current facts and circumstances surrounding its business when applying these impairment rules to determine the timing of the impairment test, the undiscounted cash flows used to assess impairments, and the fair value of a potentially impaired asset. Changes in assumptions used could have a significant impact on the Company’s assessment of recoverability. Numerous factors, including changes in the Company’s business, industry segment, and global economy, could significantly impact management’s decision to retain, dispose of, or idle certain of its long-lived assets.

Goodwill and Other Intangible Assets - The Company evaluates the recoverability of goodwill at least annually based on a two-step impairment test. The first step compares the fair value of each reporting unit with its carrying amount, including goodwill. If the carrying amount exceeds fair value, then the second step of the impairment test is performed to measure the amount of any impairment loss. Fair value is determined based on estimated future cash flows, discounted at a rate that approximates the Company’s cost of capital. Such estimates are subject to change and the Company may be required to recognize impairment losses in the future.

Income Taxes - Current income tax expense is the amount of income taxes expected to be payable for the current year. A deferred income tax asset or liability is established for the expected future consequences of temporary differences in the financial reporting and tax bases of assets and liabilities. The Company considers future taxable income and ongoing prudent and feasible tax planning in assessing the value of its deferred tax assets. If the Company determines that it is more likely than not that these assets will not be realized, the Company would reduce the value of these assets to their expected realizable value through a valuation allowance, thereby decreasing net income. Evaluating the value of these assets is necessarily based on the Company’s judgment. If the Company subsequently determined that the deferred tax assets,

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which had been written down, would be realized in the future, the value of the deferred tax assets would be increased, thereby increasing net income in the period when that determination was made.

Litigation - The Company is involved from time to time in litigation incidental to its business. Management believes that the outcome of current litigation will not have a material adverse effect upon the results of operations or financial condition of the Company and, from time to time, may make provisions for potential litigation losses. Depending on the actual outcome of pending litigation, charges in excess of any provisions could be recorded in the future that may have an adverse effect on the Company’s operating results (see Note 9 to the condensed consolidated financial statements).

Results of Operations

The following table sets forth selected income statement data of the Company expressed as a percentage of net sales for the periods indicated. The discussion that follows should be read in conjunction with the table below:

The following table sets forth the Company’s number of stores and total square footage as of the dates indicated:

The thirteen weeks ended August 2, 2003 (second quarter) as compared to the thirteen weeks ended August 3, 2002 (second quarter)

Net Sales

Net sales increased to $234.4 million for the second quarter of fiscal 2003 from $190.9 million for the second quarter of fiscal 2002, an increase of $43.5 million, or 22.8%. Of this $43.5 million increase, $25.0 million was attributable to a 13.9% increase in comparable store net sales in the second quarter of fiscal 2003 as compared to the second quarter of fiscal 2002, $7.9 million was attributable to net sales generated by 23 new stores opened in fiscal 2002 and not yet included in the comparable store base, $7.6 million was attributable to net sales generated by 51 new stores opened in fiscal 2003 and not yet included in the comparable store base, and $4.1 million was attributable to other non-comparable store net sales.

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Offsetting these increases was a $1.1 million decrease attributable to the closing of three stores during fiscal 2003 and twelve stores during fiscal 2002. Other non-comparable store net sales consist primarily of sales from stores that have been expanded or relocated and not yet included in the comparable store base as well as merchandise sold over the internet. Of the 13.9% increase in comparable store net sales in the second quarter of fiscal 2003, PacSun and PacSun Outlet comparable store net sales increased 13.2% and d.e.m.o. comparable store net sales increased 21.9%. The increase in comparable store net sales within PacSun and PacSun Outlet was primarily attributable to increases in comparable store net sales of footwear, juniors and accessories. The increase in comparable store net sales within d.e.m.o. was attributable to increases in comparable store net sales of young men’s, juniors and accessories. Stores are deemed comparable stores on the first day of the first month following the one-year anniversary of their opening or expansion/relocation. Retail prices of the Company’s merchandise remained relatively unchanged in the second quarter of fiscal 2003 compared to the second quarter of fiscal 2002 and had no significant impact on the net sales increase for the second quarter of fiscal 2003.

Gross Margin

Gross margin, after buying, distribution and occupancy costs, increased to $79.8 million for the second quarter of fiscal 2003 from $60.6 million for the second quarter of fiscal 2002, an increase of $19.2 million, or 31.7%. As a percentage of net sales, gross margin was 34.0% for the second quarter of fiscal 2003 compared to 31.8% for the second quarter of fiscal 2002. Of this 2.2% increase, occupancy costs decreased 1.5% as a percentage of net sales compared to the second quarter of fiscal 2002, primarily due to the 13.9% comparable store net sales increase which leveraged these costs, net merchandise margins increased .6% as a percentage of net sales due to a higher initial markup partially offset by a slightly higher markdown rate, and distribution costs as a percentage of net sales decreased .2% due to freight and labor efficiencies in the new distribution center as well as leveraging these costs over higher total sales. Offsetting these increases was a .1% increase in buying costs as a percentage of net sales.

Selling, General and Administrative Expenses

Selling, general and administrative expenses increased to $58.2 million for the second quarter of fiscal 2003 from $48.5 million for the second quarter of fiscal 2002, an increase of $9.7 million, or 20.0%. These expenses decreased to 24.8% as a percentage of net sales in the second quarter of fiscal 2003 from 25.4% in the second quarter of fiscal 2002. Of this .6% net decrease as a percentage of net sales, 1.0% was due to a decrease in store payroll expenses as a percentage of net sales and .3% was due to a decrease in depreciation and other store selling expenses as a percentage of net sales, primarily due to the 13.9% comparable store net sales increase which leveraged these costs. Store closing expenses decreased .4% as a percentage of net sales. These decreases were partially offset by a 1.1% increase in general and administrative expenses as a percentage of net sales, primarily due to recording $2.1 million in restricted stock expense in the second quarter of fiscal 2003 related to the Company’s determination in this quarter that the cumulative annual earnings per share growth target for the year ending January 31, 2004 of a restricted stock award made to the Chief Executive Officer during the year ended February 4, 2001 will most likely be met (see Note 10 to the condensed consolidated financial statements).

Income Tax Expense

Income tax expense was $8.3 million for the second quarter of fiscal 2003 compared to $4.5 million for the second quarter of fiscal 2002. The effective income tax rate was 38.4% in each of the second quarters of fiscal 2003 and fiscal 2002.

The twenty-six weeks ended August 2, 2003 (first half) as compared to the twenty-six weeks ended August 3, 2002 (first half)

Net Sales

Net sales increased to $432.7 million for the first half of fiscal 2003 from $352.6 million for the first half of fiscal 2002, an increase of $80.1 million, or 22.7%. Of this $80.1 million increase, $44.6 million was

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attributable to a 13.6% increase in comparable store net sales in the first half of fiscal 2003 compared to the first half of fiscal 2002, $21.1 million was attributable to net sales generated by 23 new stores opened in fiscal 2002 and not yet included in the comparable store base, $9.3 million was attributable to net sales generated by 51 new stores opened in fiscal 2003 and not yet included in the comparable store base, and $7.8 million was attributable to other non-comparable store net sales. Offsetting these increases was a $2.7 million decrease attributable to the closing of three and twelve stores during fiscal 2003 and fiscal 2002, respectively. Other non-comparable store net sales consist primarily of sales from stores that have been expanded or relocated and not yet included in the comparable store base as well as merchandise sold over the internet. Of the 13.6% increase in comparable store net sales in the first half of fiscal 2003, PacSun and PacSun Outlet comparable store net sales increased 11.9% and d.e.m.o. comparable store net sales increased 29.1%. The increase in comparable store net sales within PacSun and PacSun Outlet was primarily attributable to increases in comparable store net sales of footwear, juniors and accessories. The increase in comparable store net sales within d.e.m.o. was attributable to increases in comparable store net sales of young men’s, juniors and accessories. Stores are deemed comparable stores on the first day of the first month following the one-year anniversary of their opening or expansion/relocation. Retail prices of the Company’s merchandise remained relatively unchanged in the first half of fiscal 2003 compared to the first half of fiscal 2002 and had no significant impact on the net sales increase for the first half of fiscal 2003.

Gross Margin

Gross margin, after buying, distribution and occupancy costs, increased to $143.7 million for the first half of fiscal 2003 from $109.8 million for the first half of fiscal 2002, an increase of $33.9 million, or 30.9%. As a percentage of net sales, gross margin was 33.2% for the first half of fiscal 2003 compared to 31.1% for the first half of fiscal 2002. Of this 2.1% increase as a percentage of net sales, 1.5% was due to a decrease in occupancy costs as a percentage of net sales, primarily due to the 13.6% comparable store net sales increase which leveraged these costs over higher total sales, .3% was due to a decrease in distribution costs as a result of freight and labor efficiencies in the new distribution center as well as leveraging these costs over higher total sales, and .3% was due to an increase in net merchandise margins as a percentage of net sales due to a higher initial markup partially offset by a higher markdown rate.

Selling, General and Administrative Expenses

Selling, general and administrative expenses increased to $109.1 million for the first half of fiscal 2003 from $92.2 million for the first half of fiscal 2002, an increase of $16.9 million, or 18.3%. These expenses decreased to 25.2% as a percentage of net sales in the first half of fiscal 2003 from 26.1% in the first half of fiscal 2002. Of this .9% net decrease as a percentage of net sales, .9% was due to a decrease in store payroll expenses as a percentage of net sales and .5% was due to a decrease in depreciation and other store selling expenses, primarily due to the 13.6% comparable store net sales increase which leveraged these costs over higher total sales. In addition, .3% was due to a decrease in store closing expenses as a percentage of net sales. Offsetting these decreases was a .8% increase in general and administrative expenses, primarily due to recording $2.1 million in restricted stock expense in the second quarter of fiscal 2003 related to the Company’s determination in this quarter that the cumulative annual earnings per share growth target for the year ending January 31, 2004 of a restricted stock award made to the Chief Executive Officer during the year ended February 4, 2001 will most likely be met (see Note 10 to the condensed consolidated financial statements), as well as higher bonus expense.

Income Tax Expense

Income tax expense was $13.3 million for the first half of fiscal 2003 compared to $6.6 million for the first half of fiscal 2002. The effective income tax rate was 38.4% in each of the first halves of fiscal 2003 and fiscal 2002.

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Liquidity and Capital Resources

The Company has financed its operations from internally generated cash flow, short-term and long-term borrowings and equity financing. The Company’s primary capital requirements have been for the construction of new stores, remodeling, expansion, or relocation of selected stores, financing of inventories, and, in fiscal 2001, construction of the Company’s new corporate offices and distribution center.

Net cash provided by operating activities for the first half of fiscal 2003 was $24.7 million as compared to cash used of $8.8 million for the first half of fiscal 2002. This $33.5 million increase in cash provided was attributable to a $15.3 million increase in accounts payable net of inventory increases, primarily due to timing of payments, an increase in net income of $10.8 million, an increase in accrued income taxes and deferred income taxes of $5.9 million, and other items netting to an increase in cash provided of $1.5 million. Working capital at August 2, 2003, was $165.2 million compared to $109.3 million at February 1, 2003, an increase of $55.9 million. The increase in working capital at August 2, 2003, as compared to February 1, 2003, was attributable to an increase in cash of $26.4 million, an increase in inventories, net of accounts payable, of $16.9 million, a decrease in accrued income taxes of $10.7 million, and other items netting to an increase of $1.9 million. The increase in inventories was related to increases in inventories in comparable stores which generated a 13.6% increase in comparable store net sales during the first half of fiscal 2003 as well as opening 48 net new stores and expanding/relocating 9 stores with over 50% larger average square footage than their previous locations. The Company’s average store inventories vary throughout the year and increase in advance of the peak selling periods of spring break, back-to-school and Christmas.

Net cash used in investing activities was $18.6 million for property and equipment for the first half of fiscal 2003 compared to $22.7 million for property and equipment for the first half of fiscal 2002. Of the $18.6 million of net cash used for investment in property and equipment in the first half of fiscal 2003, $16.9 million was used for new and existing stores and $1.7 million was used for other capital expenditures, including computer hardware and software.

Net cash provided by financing activities for the first half of fiscal 2003 was $20.3 million compared to $12.6 million for the first half of fiscal 2002. Of the $20.3 million of net cash provided by financing activities in the first half of fiscal 2003, $21.5 million was due to proceeds received from the exercise of stock options, offset by $1.2 million of payments under capital lease and long-term debt obligations.

The Company has a credit facility with a bank, which expires March 31, 2004. The credit facility provides for a $45.0 million line of credit (the “Credit Line”) to be used for cash advances, commercial letters of credit and shipside bonds. Interest on the Credit Line is payable monthly at the bank’s prime rate (4.25% at August 2, 2003) or at optional interest rates that are primarily dependant upon the London Inter-bank Offered Rates for the time period chosen. The Company did not borrow under the Credit Line at any time during the first half ended August 2, 2003. The Company had $20.7 million outstanding in letters of credit at August 2, 2003. The credit facility subjects the Company to various restrictive covenants, including maintenance of certain financial ratios, and prohibits payment of cash dividends on common stock. At August 2, 2003, the Company was in compliance with all of the covenants.

The Company has minimum annual rental commitments under existing store leases, the lease for its former corporate offices and distribution center, capital leases for computer equipment, and other long-term debt obligations for multi-year computer maintenance contracts. The Company leases all of its retail store locations under operating leases. The Company leases equipment, from time to time, under capital leases. In addition, at any time, the Company is contingently liable for open letters of credit with foreign suppliers of merchandise. As of August 2, 2003, the Company’s future financial commitments under these arrangements are as follows:

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