PACIFIC SUNWEAR OF CALIFORNIA INC - FORM 10-Q

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EXCEL - IDEA: XBRL DOCUMENT - PACIFIC SUNWEAR OF CALIFORNIA INC	Financial_Report.xls
EX-31.1 - EX-31.1 - PACIFIC SUNWEAR OF CALIFORNIA INC	d371069dex311.htm
EX-32.1 - EX-32.1 - PACIFIC SUNWEAR OF CALIFORNIA INC	d371069dex321.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

(Mark One)

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended: July 28, 2012

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission file number 0-21296

PACIFIC SUNWEAR OF CALIFORNIA, INC.

(Exact name of registrant as specified in its charter)

California

95-3759463

(State of incorporation)

(I.R.S. Employer

Identification No.)

3450 East Miraloma Avenue, Anaheim, CA 92806

(Address of principal executive offices and zip code)

(714) 414-4000

(Registrant’s telephone number)

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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definition of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x

On August 27, 2012, the registrant had 67,823,841 shares of Common Stock outstanding.

PACIFIC SUNWEAR OF CALIFORNIA, INC.

FORM 10-Q

For the Quarter Ended July 28, 2012

Index


	Page
PART I. FINANCIAL INFORMATION

Item 1. Financial Statements (unaudited):
Condensed Consolidated Balance Sheets—July 28, 2012 and January 28, 2012		3
Condensed Consolidated Statements of Operations and Comprehensive Operations—Second quarter (13 weeks) and first half (26 weeks) ended July 28, 2012 and July 30, 2011, respectively		4
Condensed Consolidated Statements of Cash Flows—First half (26 weeks) ended July 28, 2012 and July 30, 2011, respectively		5
Notes to Condensed Consolidated Financial Statements		6
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		15
Item 3. Quantitative and Qualitative Disclosures about Market Risk		23
Item 4. Controls and Procedures		24

PART II. OTHER INFORMATION

Item 1. Legal Proceedings		24
Item 1A. Risk Factors		24
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		24
Item 3. Defaults Upon Senior Securities		24
Item 4. Mine Safety Disclosures		24
Item 5. Other Information		24
Item 6. Exhibits		25
SIGNATURE PAGE		26
EX-31.1
EX-32.1
EX-101 INSTANCE DOCUMENT
EX-101 SCHEMA DOCUMENT
EX-101 CALCULATION LINKBASE DOCUMENT
EX-101 LABELS LINKBASE DOCUMENT
EX-101 PRESENTATION LINKBASE DOCUMENT

PART I — FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

PACIFIC SUNWEAR OF CALIFORNIA, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited, All Amounts in Thousands Except Share and Per Share Amounts)


	July 28, 2012		January 28, 2012
ASSETS
CURRENT ASSETS:
Cash and cash equivalents	$	34,830	$	50,306
Restricted cash		405		8,593
Merchandise inventories		144,797		88,740
Prepaid expenses		17,165		15,506
Other current assets		6,366		6,272

Total current assets		203,563		169,417

Property and equipment, net		137,440		149,716
Deferred income taxes		6,643		6,643
Other assets		28,487		29,355

TOTAL ASSETS	$	376,133	$	355,131

LIABILITIES AND SHAREHOLDERS’ EQUITY

CURRENT LIABILITIES:
Accounts payable	$	85,852	$	38,914
Other current liabilities		74,891		68,369

Total current liabilities		160,743		107,283

LONG-TERM LIABILITIES:
Deferred lease incentives		16,728		17,681
Deferred rent		16,517		16,602
Long-term debt		74,414		73,910
Other long-term liabilities		26,201		26,558

Total long-term liabilities		133,860		134,751

Commitments and contingencies (Note 10)

SHAREHOLDERS’ EQUITY:
Preferred stock, $0.01 par value; 5,000,000 shares authorized; 1,000 issued and outstanding		—		—
Common stock, $0.01 par value; 170,859,375 shares authorized; 67,823,617 and 67,511,468 shares issued and outstanding, respectively		678		675
Additional paid-in capital		18,357		16,766
Retained earnings		62,495		95,656

Total shareholders’ equity		81,530		113,097

TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY	$	376,133	$	355,131

See accompanying footnotes

PACIFIC SUNWEAR OF CALIFORNIA, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

AND COMPREHENSIVE OPERATIONS

(Unaudited, All Amounts in Thousands Except Share and Per Share Amounts)


	For the Second Quarter Ended						For the First Half Ended
	July 28, 2012			July 30, 2011			July 28, 2012			July 30, 2011
Net sales	$	210,305		$	200,915		$	384,129		$	372,796
Cost of goods sold, including buying, distribution and occupancy costs		152,506			153,578			285,344			292,267

Gross margin		57,799			47,337			98,785			80,529

Selling, general and administrative expenses		63,508			63,842			122,774			124,798

Operating loss		(5,709	)		(16,505	)		(23,989	)		(44,269	)

Loss on derivative liability		8,219			—			1,886			—
Other expense, net		3,454			571			6,763			1,113

Loss from continuing operations before income taxes		(17,382	)		(17,076	)		(32,638	)		(45,382	)

Income taxes		156			376			523			726

Loss from continuing operations		(17,538	)		(17,452	)		(33,161	)		(46,108	)
Loss from discontinued operations, net of income taxes		—			(1,807	)		—			(4,621	)

Net loss	$	(17,538	)	$	(19,259	)	$	(33,161	)	$	(50,729	)

Comprehensive loss	$	(17,538	)	$	(19,259	)	$	(33,161	)	$	(50,729	)

Loss from continuing operations per share:
Basic and Diluted	$	(0.26	)	$	(0.26	)	$	(0.49	)	$	(0.70	)

Loss from discontinued operations per share:
Basic and Diluted	$	—		$	(0.03	)	$	—		$	(0.07	)

Net loss per share:
Basic and Diluted	$	(0.26	)	$	(0.29	)	$	(0.49	)	$	(0.77	)

Weighted-average shares outstanding:
Basic and Diluted		67,738,453			66,343,761			67,661,643			66,273,810

See accompanying footnotes

PACIFIC SUNWEAR OF CALIFORNIA, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited, All Amounts in Thousands)


	For the First Half Ended
	July 28, 2012			July 30, 2011
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss	$	(33,161	)	$	(50,729	)
Adjustments to reconcile net loss to net cash from operating activities:

Depreciation and amortization		17,765			22,437
Asset impairment		3,540			5,785
Loss on disposal of property and equipment		118			63
Loss on derivative liability		1,886			—
Amortization of debt discount		787			—
Non-cash stock-based compensation		1,466			1,736
Change in operating assets and liabilities:
Merchandise inventories		(56,057	)		(67,631	)
Other current assets		(2,060	)		(6,428	)
Other assets		869			124
Accounts payable		46,938			56,383
Other current liabilities		5,562			(573	)
Deferred lease incentives		(953	)		(3,872	)
Deferred rent		(86	)		(736	)
Other long-term liabilities		(163	)		(276	)

Net cash used in operating activities		(13,549	)		(43,717	)

CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment		(9,068	)		(6,938	)
Restricted cash		8,188			—
Proceeds from insurance settlement		653			300

Net cash used in investing activities		(227	)		(6,638	)

CASH FLOWS FROM FINANCING ACTIVITIES:
Payments for credit facility borrowings		(1,254	)		—
Principal payments under mortgage borrowings		(265	)		(248	)
Principal payments under capital leases		(362	)		(169	)
Proceeds from exercise of stock options		181			314

Net cash used in financing activities		(1,700	)		(103	)

NET DECREASE IN CASH AND CASH EQUIVALENTS		(15,476	)		(50,458	)
CASH AND CASH EQUIVALENTS, beginning of period		50,306			63,710

CASH AND CASH EQUIVALENTS, end of period	$	34,830		$	13,252

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid for interest	$	1,741		$	1,047
Cash paid for income taxes	$	483		$	932
SUPPLEMENTAL DISCLOSURES OF NON-CASH TRANSACTIONS:
Property and equipment purchases accrued at period end	$	314		$	345
Capital lease borrowings for property and equipment	$	111		$	—

See accompanying footnotes

PACIFIC SUNWEAR OF CALIFORNIA, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. NATURE OF BUSINESS

Pacific Sunwear of California, Inc. (together with its wholly-owned subsidiaries, the “Company” or “PacSun”) is a leading specialty retailer rooted in the action sports, fashion and music influences of the California lifestyle. The Company sells a combination of branded and proprietary casual apparel, accessories and footwear designed to appeal to teens and young adults. It operates a nationwide, primarily mall-based chain of retail stores under the names “Pacific Sunwear” and “PacSun.” In addition, the Company operates an e-commerce website at www.pacsun.com which sells PacSun merchandise online, provides content and community for its target customers and provides information about the Company. The Company, a California corporation, was incorporated in August 1982. As of July 28, 2012, the Company leased and operated 727 stores in each of the 50 states and Puerto Rico.

2. BASIS OF PRESENTATION

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

These Condensed Consolidated Financial Statements should be read in conjunction with the Consolidated Financial Statements and notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended January 28, 2012 (“fiscal 2011”) filed with the SEC. The Condensed Consolidated Financial Statements include the accounts of Pacific Sunwear of California, Inc. and its wholly-owned subsidiaries (Pacific Sunwear Stores Corp., a California corporation (“PacSun Stores”) and Miraloma Borrower Corporation, a Delaware corporation (“Miraloma”)). All intercompany transactions have been eliminated in consolidation.

In the opinion of management, all adjustments consisting only of normal recurring entries necessary for a fair presentation have been included. The preparation of Condensed Consolidated Financial Statements in conformity with GAAP 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 Condensed Consolidated Financial Statements as well as the reported revenues and expenses during the reporting period. Actual results could differ from these estimates. The results of operations for the Company’s fiscal quarter ended July 28, 2012 are not necessarily indicative of the results that may be expected for the fiscal year ending February 2, 2013 (“fiscal 2012”).

The results of continuing operations for all periods presented in these Condensed Consolidated Financial Statements exclude the financial impact of discontinued operations. See Note 12, “Discontinued Operations” for further discussion related to discontinued operations presentation.

3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Information regarding significant accounting policies is contained in Note 1, “Nature of Business and Summary of Significant Accounting Policies,” of the Consolidated Financial Statements in the Company’s Annual Report on Form 10-K for fiscal 2011. Presented below in the following notes is supplemental information that should be read in conjunction with “Notes to Consolidated Financial Statements” included in that Report.

Income Taxes

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

4. IMPAIRMENT OF LONG-LIVED ASSETS

The Company assesses long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying value of such assets (or asset group) may not be recoverable. Based on management’s review of the historical operating performance, including sales trends, gross margin rates, current cash flows from operations and the projected outlook for each of the Company’s stores, the Company determined that certain stores would not be able to generate sufficient cash flows over the remaining term of the related leases to recover the Company’s investment in the respective stores. As a result, the Company recorded the following non-cash impairment charges related to its retail stores within the accompanying Condensed Consolidated Statements of Operations and Comprehensive Operations, to write-down the carrying value of its long-lived store assets to their estimated fair values.


	For the Second Quarter Ended				For the First Half Ended
	(In thousands)
	July 28, 2012		July 30, 2011		July 28, 2012		July 30, 2011
Impairment charges from continuing operations	$	1,142	$	3,100	$	2,676	$	5,118
Impairment charges from discontinued operations		—		295		—		667

Total impairment charges	$	1,142	$	3,395	$	2,676	$	5,785


	July 28, 2012		July 30, 2011
	(In thousands)
Carrying value of assets tested for impairment	$	9,016	$	27,688

Carrying value of assets with impairment	$	1,955	$	4,949

Fair value of assets impaired	$	813	$	1,554

Number of stores tested for impairment		166		187

Number of stores with impairment		23		28

The long-lived assets disclosed above that were written down to their respective fair values consisted primarily of leasehold improvements, furniture, fixtures and equipment. The Company recognized impairment charges of $1.1 million and $3.4 million, respectively, during the quarters ended July 28, 2012 and July 30, 2011 and $2.7 million and $5.8 million, respectively, during the first half ended July 28, 2012 and July 30, 2011. The decrease in the number of stores tested for impairment year-over-year was primarily related to the Company’s recent closure of certain underperforming stores. Based on historical operating performance and the projected outlook for these stores, the Company believes that the remaining asset value of approximately $8 million as of July 28, 2012, is recoverable. Additionally, the Company wrote off approximately $1 million of excess store fixtures in the second quarter of fiscal 2012.

5. OTHER CURRENT LIABILITIES

Other current liabilities consisted of the following:


	July 28, 2012		January 28, 2012
	(In thousands)
Derivative liability	$	21,962	$	20,076
Accrued gift cards		7,701		10,776
Accrued compensation and benefits		14,484		10,687
Sales taxes payable		4,227		3,983
Deferred tax liability		2,201		2,201
Accrued capital expenditures		1,599		1,281
Other		22,717		19,365

Total other current liabilities	$	74,891	$	68,369

As disclosed in Note 8, the Company issued 1,000 shares of its Convertible Series B Preferred Stock (the “Series B Preferred”) in connection with the five-year, $60 million senior secured term loan (the “Term Loan”), funded by an affiliate of Golden Gate Capital. The fair value of the Series B Preferred at issuance was approximately $15.0 million which was recorded as a derivative liability. As of July 28, 2012, the fair value of the derivative liability was approximately $22.0 million. See Note 9, “Fair Value Measurements – Recurring Fair Value Measurements” for further discussion on the derivative liability.

6. DEBT

Credit Facility

On December 7, 2011, the Company entered into a new five-year, $100 million revolving credit facility with Wells Fargo Bank, N.A (the “New Credit Facility”), which replaced the Company’s previous revolving credit facility with JPMorgan Chase (the “Former Credit Facility”). Borrowings under the New Credit Facility bear interest at a floating rate which, at the Company’s option, may be determined by reference to a LIBOR Rate or a Base Rate (as defined in the New Credit Facility, 4.0% as of July 28, 2012). Extensions of credit under the New Credit Facility are limited to a borrowing base consisting of specified percentages of eligible categories of assets. The New Credit Facility is available for direct borrowings and allows for the issuance of letters of credit, and up to $12.5 million is available for swing-line loans. The New Credit Facility is secured by liens and security interests with (a) a first priority security interest in the current and certain related assets of the Company including cash, cash equivalents, deposit accounts, securities accounts, credit card receivables and inventory, and (b) a second priority security interest in all assets and properties of the Company that are not secured by a first lien and security interest. The New Credit Facility also contains covenants that, subject to specified exceptions, restrict the Company’s ability to, among other things, incur additional indebtedness, incur liens, liquidate or dissolve, sell, transfer, lease or dispose of assets, or make loans, investments or guarantees. The New Credit Facility is scheduled to mature on December 7, 2016. Based on current forecasts and plans for the year, the Company believes that cash flows from operating activities, working capital, borrowing availability under the New Credit Facility, and cash on hand resulting from the closing of the Term Loan and the two mortgage transactions discussed below will be sufficient to meet its operating and capital expenditure needs for the next twelve months. However, if the Company were to experience same-store sales declines similar to those that occurred in fiscal 2010 and 2009, it may be required to access most, if not all, of the New Credit Facility and would potentially require other sources of financing to fund its operations, which sources might not be available. At July 28, 2012, the Company had no direct borrowings and $28 million in letters of credit outstanding under the New Credit Facility. The remaining availability under the New Credit Facility at July 28, 2012 was $62 million. The Company is not subject to any financial covenant restrictions under the New Credit Facility.

Term Loan

On December 7, 2011, the Company obtained the Term Loan funded by an affiliate of Golden Gate Capital. The Term Loan bears interest at a rate of 5.5% per annum to be paid in cash, due and payable quarterly in arrears, and 7.5% per annum, due and payable in kind (“PIK”) annually in arrears, with such PIK interest then due and payable being added to the outstanding principal balance of the Term Loan at the end of each fiscal year, and with adjustments to the cash and PIK portion of the interest rate in accordance with the Term Loan agreement, following principal prepayments. Annual cash interest for fiscal 2012 is expected to be approximately $3 million. The Term Loan is guaranteed by each of the Company’s subsidiaries and will be guaranteed by any future domestic subsidiaries of the Company. The Term Loan is secured by liens and security interests with (a) a first priority security interest in all long-term assets of the Company and PacSun Stores and all other assets not subject to a first lien and security interest pursuant to the New Credit Facility, (b) a first priority pledge of the equity interests of Miraloma and (c) a second priority security interest in all assets of the Company and PacSun Stores subject to a first lien and security interest pursuant to the New Credit Facility. The Term Loan also contains covenants substantially identical to those in the New Credit Facility. The principal balance and any unpaid interest related to the Term Loan is due on December 7, 2016. The Company is not subject to any financial covenant restrictions under the Term Loan.

Mortgage Debt

On August 20, 2010, the Company, through its wholly-owned subsidiaries, Miraloma and PacSun Stores, executed two promissory notes pursuant to which borrowings in an aggregate amount of $29.8 million from American National Insurance Company (“Anico”) were incurred. The note executed by Miraloma (the “Miraloma Note”) is in the amount of $16.8 million and bears interest at the rate of 6.50% per annum. Monthly principal and interest payments under the Miraloma Note commenced on October 1, 2010, and are $113,435. The principal and interest payments are based on a 25-year amortization schedule. The remaining principal balance of the Miraloma Note, and any accrued but unpaid interest thereon (estimated to be $14.4 million), will be due in full on September 1, 2017. The Miraloma Note is secured by a deed of trust on the building and land comprising the Company’s principal executive offices in Anaheim, California and is non-recourse to the Company. The Miraloma Note does not contain any financial covenants. In connection with this transaction, the Company transferred the building and related land securing the Miraloma Note to Miraloma and entered into a lease for the building and land with Miraloma. Miraloma paid a prepayment fee to Anico equal to 1% of the principal amount of the Miraloma Note on the closing date of the transaction. As a result, Miraloma may prepay the Miraloma Note, in whole, but not in part, at any time without penalty upon 30 days prior written notice to Anico.

The note executed by PacSun Stores (the “PacSun Stores Note”) is in the amount of $13.0 million and bears interest at the rate of 6.50% per annum. Monthly principal and interest payments under the PacSun Stores Note commenced on October 1, 2010, and are $87,777. The principal and interest payments are based on a 25-year amortization schedule. The remaining principal balance of the PacSun Stores Note, and any accrued but unpaid interest thereon (estimated to be $11.2 million), will be due in full on September 1, 2017. The PacSun Stores Note is secured by a mortgage on the Company’s leasehold interest in the building and land comprising the Company’s distribution center in Olathe, Kansas, and is unconditionally guaranteed by the Company. The PacSun Stores Note does not contain any financial covenants. PacSun Stores paid a prepayment fee to Anico equal to 1% of the principal amount of the PacSun Stores Note on the closing date of the transaction. As a result, PacSun Stores may prepay the PacSun Stores Note, in whole, but not in part, at any time without penalty upon 30 days prior written notice to Anico.

The Company recorded interest expense of $3.5 million and $0.6 million during the second quarter of fiscal 2012 and 2011, respectively, and $6.8 million and $1.1 million during the first half of fiscal 2012 and 2011, respectively.

7. INCOME TAXES

The provisions codified within ASC 740 require companies to assess whether valuation allowances should be established against their deferred tax assets based on consideration of all available evidence using a “more likely than not” standard. In accordance with ASC 740, a full valuation allowance was established during the fourth quarter of fiscal 2009 and continues to be maintained on all federal and the majority of state deferred tax assets. Remaining net state deferred tax assets of approximately $5 million were not reserved as the Company concluded it is more likely than not that these net deferred tax assets would be utilized before expiration. The Company has discontinued recognizing federal and certain state income tax benefits until it is determined that it is more likely than not that the Company will generate sufficient taxable income to realize the deferred income tax assets.

The Company continues to monitor whether an ownership change has occurred under Internal Revenue Code Section 382 (“Section 382”). Based on available information at the reporting date, the Company believes it has not experienced an ownership change through the quarter ended July 28, 2012. The determination of whether or not an ownership change under Section 382 has occurred requires the Company to evaluate certain acquisitions and dispositions of ownership interests over a rolling three-year period. As a result, future acquisitions and dispositions could result in an ownership change of the Company under Section 382. If an ownership change were to occur, the Company’s ability to utilize federal net operating loss carryforwards could be severely limited.

8. SHAREHOLDERS’ EQUITY

Common Stock

In connection with certain lease modifications during fiscal 2011, the Company issued 900,000 shares of its common stock to one of its landlords. The fair value on the date of issuance was approximately $1.6 million, which is being amortized on a straight-line basis as a component of occupancy costs over the respective rent reduction period.

Preferred Stock

In conjunction with the Term Loan, the Company issued the Series B Preferred to an affiliate of Golden Gate Capital which, based on the initial conversion ratio, gives that affiliate the right to purchase up to 13.5 million shares of the Company’s common stock. The Series B Preferred shares have an exercise price initially equal to $1.75 per share of the Company’s underlying common stock. The initial holder of the Series B Preferred is entitled to customary registration rights with respect to the underlying common stock. See Note 9, “Fair Value Measurements – Recurring Fair Value Measurements” for further discussion on the accounting treatment of the Series B Preferred.

Stock-Based Compensation

The Company maintains two stock-based incentive plans: (1) the 2005 Performance Incentive Plan (the “Performance Plan”) and (2) the amended and restated Employee Stock Purchase Plan (the “ESPP”). The types of awards that may be granted under the Performance Plan include stock options, stock appreciation rights, restricted stock, and other forms of awards granted or denominated in the Company’s common stock or units of the Company’s common stock. Persons eligible to receive awards under the Performance Plan include officers or employees of the Company or any of its subsidiaries, directors of the Company and certain consultants and advisors to the Company or any of its subsidiaries. The vesting of awards under the Performance Plan is determined at the date of grant. Each award expires on a date determined at the date of grant; however, the maximum term of options and stock appreciation rights under the Performance Plan is ten years after the grant date of the award. As of July 28, 2012, the maximum number of shares of the Company’s common stock that was available for award grants under the Performance Plan was 2.1 million shares. Any shares subject to awards under prior stock plans that are canceled, forfeited or otherwise terminate without having vested or been exercised, as applicable, will become available for other award grants under the Performance Plan. The Performance Plan will terminate on March 22, 2015, unless terminated earlier by the Company’s Board of Directors.

Stock Options

The Company accounts for stock-based compensation expense in accordance with ASC Topic 718, “Stock Compensation” (“ASC 718”). The Company uses the Black-Scholes option-pricing model to estimate the grant date fair value of its stock-based compensation expense. Forfeitures are estimated at the date of grant based on historical rates and reduce the compensation expense to be recognized during the vesting period. The expected term of options granted is derived primarily from historical data on employee exercises adjusted for expected changes to option terms, if any. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the date of grant. Expected volatility is based primarily on the historical volatility of the Company’s common stock. The Company records stock-based compensation expense using the straight-line method over the vesting period, which is generally three to four years. The Company’s stock-based awards generally begin vesting one year after the grant date and, for stock options, expire in seven to ten years or three months after termination of employment with the Company. The Company’s stock-based compensation expense resulted from awards of stock options, restricted stock, and stock appreciation rights, as well as from shares issued under the ESPP.

The fair value of the Company’s stock-based compensation activity was determined using the following weighted- average assumptions:


	For the First Half Ended
	July 28, 2012						July 30, 2011
	Stock Options			ESPP			Stock Options			ESPP
Expected life		4 years			0.5 years			4 years			0.5 years
Expected volatility		87% - 88	%		71	%		83	%		54	%
Risk-free interest rate		0.53% - 0.92	%		0.15	%		1.24% - 1.61	%		0.20	%
Expected dividends	$	—		$	—		$	—		$	—

Under the Performance Plan, incentive and nonqualified stock options have been granted to employees and directors to purchase common stock at prices equal to the fair value of the Company’s shares at the respective grant dates. A summary of stock option (incentive and nonqualified) activity for the first half of fiscal 2012 is presented below:


	Shares			Weighted- Average Exercise Price		Weighted- Average Remaining Contractual Term (Yrs.)		Aggregate Intrinsic Value ($000s)
Outstanding at January 28, 2012		2,990,501		$	6.61
Granted		20,500			1.71
Exercised		—			—
Forfeited or expired		(315,414	)		12.86

Outstanding at July 28, 2012		2,695,587		$	5.85		4.0	$	178

Vested and expected to vest at July 28, 2012		2,512,390		$	6.01		4.0	$	169

Exercisable at July 28, 2012		1,346,857		$	7.83		3.4	$	143

The weighted-average grant-date fair value per share of options granted during the first half of fiscal 2012 and 2011 was $1.71 and $1.96, respectively. There were no stock options exercised during the first half of fiscal 2012 and the total intrinsic value of options exercised during the first half of fiscal 2011 was $0.1 million.

Restricted Stock Awards

A summary of service-based restricted stock awards activity under the Performance Plan for the first half of fiscal 2012 is presented in the following table. Except as described below, such restricted stock awards contain a service-based restriction as to vesting. These awards generally vest over four years with 25% of the grant vesting each year on the anniversary of the grant date.


	Shares			Weighted- Average Grant-Date Fair Value
Outstanding at January 28, 2012		765,523		$	3.91
Granted		1,495,782			1.76
Vested		(179,508	)		4.40
Forfeited or expired		(100,207	)		4.06

Outstanding at July 28, 2012		1,981,590		$	2.24

The weighted-average grant-date fair value per share of service-based restricted stock awards granted during the first half of 2012 and 2011 was $1.76 and $3.53, respectively. The total fair value of awards vested during the first half of fiscal 2012 and 2011 was $0.5 million and $0.9 million, respectively.

During the first half of fiscal 2012, the Company granted 675,000 performance-based restricted stock awards which only vest upon the achievement of certain financial targets. The weighted-average grant-date fair value per share of performance-based restricted stock awards granted during the first half of fiscal 2012 was $1.77. There were no performance-based restricted stock awards granted during the first half of fiscal 2011.

Restricted Stock Units

A summary of restricted stock units activity under the Performance Plan for the first half of fiscal 2012 is presented below. Restricted stock units contain a service-based restriction as to vesting. These awards generally vest 100% on the first anniversary of the grant date.


	Shares			Weighted- Average Grant-Date Fair Value
Outstanding at January 28, 2012		150,000		$	3.19
Granted		125,000			1.57
Vested		(125,000	)		3.19
Forfeited or expired		(25,000	)		3.19

Outstanding at July 28, 2012		125,000		$	1.57

Stock-based compensation expense recognized related to nonvested stock options, restricted stock awards and restricted stock units during each of the second quarters of fiscal 2012 and 2011 was $0.6 million and $0.7 million, respectively, and during the first half of fiscal 2012 and 2011, was $1.4 million and $1.7 million, respectively.

At July 28, 2012, the Company had approximately $4.3 million of stock-based compensation cost related to nonvested stock options, service-based restricted stock awards and restricted stock units expected to be recognized over a weighted-average period of approximately 2.6 years, and $0.5 million of stock-based compensation cost related to certain performance-based restricted stock awards, which is expected to be recognized over a weighted-average period of approximately 3.5 years.

Employee Stock Purchase Plan (“ESPP”)

The Company’s ESPP provides a method for Company employees to voluntarily purchase Company common stock at a 10% discount from fair market value as of the beginning or the end of each six-month purchasing period, whichever is lower. The ESPP covers substantially all employees who have three months of service with the Company, excluding senior executives.

The ESPP is intended to constitute an “employee stock purchase plan” within the meaning of Section 423 of the Internal Revenue Code of 1986, as amended.

During the first half of fiscal 2012 and 2011, the Company issued 114,897, and 95,798 shares at an average price of $1.58 and $2.35, respectively, under the ESPP.

9. FAIR VALUE MEASUREMENTS

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

Fair value is defined as the price that would be received pursuant to the sale of an asset or paid to transfer a liability in an orderly transaction between market participants. In order to determine the fair value of certain assets and liabilities, the Company applies the three-level hierarchy of valuation techniques based upon whether the inputs reflect assumptions other market participants would use based upon market data obtained from independent sources (observable inputs) or reflect the Company’s assumptions of market participant valuation (unobservable inputs) and requires the use of observable inputs if such data is available without undue cost and effort. The hierarchy is as follows:

•

Level 1 — quoted prices for identical instruments in active markets.

•

Level 2 — inputs other than Level 1 inputs, which are observable either directly or indirectly.

•

Level 3 — unobservable inputs.

Level 3 assumptions are, by their nature, inherently uncertain and the effect of changes in estimates may result in a significantly lower or higher fair value measurement.

Recurring Fair Value Measurements

Derivative Liability

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


	July 28, 2012			April 28. 2012
Conversion price	$	1.75		$	1.75
Expected volatility		66	%		65	%
Expected term (in years)		9.3			9.6
Risk free interest rate		1.58	%		1.96	%
Expected dividends	$	—		$	—

The following table presents the activity recorded for the derivative liability during the first half ended:


	July 28, 2012
	(In thousands)
Beginning balance as of January 28, 2012	$	20,076
Gain on change in fair value		(6,333	)

Balance as of April 28, 2012		13,743
Loss on change in fair value		8,219

Ending balance as of July 28, 2012	$	21,962

The derivative liability is included in other current liabilities in the accompanying Condensed Consolidated Balance Sheet. Changes in the fair value of the derivative liability are included in gain on derivative liability in the accompanying Condensed Consolidated Statement of Operations and Comprehensive Operations.

Money Market Funds

As of July 28, 2012, and January 28, 2012, the Company had approximately $10.0 million and $19.8 million held in money market funds, respectively. The fair value of money market funds is determined based on Level 1 inputs which consist of quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets. Money market funds are included in cash and cash equivalents in the accompanying Condensed Consolidated Balance Sheet.

Non-Recurring Fair Value Measurements

On a non-recurring basis, using a discounted cash flow model, the Company measures certain of its long-lived assets at fair value based on Level 3 inputs including, but not limited to, moderate comparable store sales and margin growth, projected operating costs based primarily on historical trends, and an estimated weighted-average cost of capital rate. During the first half of fiscal 2012 and 2011 the Company recorded $3.5 million and $5.8 million of impairment charges, respectively, in the accompanying Condensed Consolidated Statements of Operations and Comprehensive Operations.

10. COMMITMENTS AND CONTINGENCIES

Litigation

Charles Pfeiffer, individually and on behalf of other aggrieved employees vs. Pacific Sunwear of California, Inc. and Pacific Sunwear Stores Corp., Superior Court of California, County of Riverside, Case No. 1100527. On January 13, 2011, the plaintiff in this matter filed a lawsuit against the Company alleging violations of California’s wage and hour, overtime, meal break and rest break rules and regulations, among other things. The complaint seeks an unspecified amount of damages and penalties. The Company has filed an answer denying all allegations regarding the plaintiff’s claims and asserting various defenses. The Company is currently in the discovery phase of this case. As the ultimate outcome of this matter is uncertain no amounts have been accrued by the Company as of the date of this report. Depending on the actual outcome of this case, provisions could be recorded in the future which may have a material adverse effect on the Company’s operating results.

Tamara Beeney, individually and on behalf of other members of the general public similarly situated vs. Pacific Sunwear of California, Inc. and Pacific Sunwear Stores Corporation, Superior Court of California, County of Orange, Case No. 30-2011-00459346-CU-OE-CXC. On March 18, 2011, the plaintiff in this matter filed a putative class action lawsuit against the Company alleging violations of California’s wage and hour, overtime, meal break and rest break rules and regulations, among other things. The complaint seeks class certification, the appointment of the plaintiff as class representative, and an unspecified amount of damages and penalties. The Company has filed an answer denying all allegations regarding the plaintiff’s claims and asserting various defenses. The Company is currently in the discovery phase of this case. As the ultimate outcome of this matter is uncertain, no amounts have been accrued by the Company as of the date of this report. Depending on the actual outcome of this case, provisions could be recorded in the future which may have a material adverse effect on the Company’s operating results.

Phillip Gleason, on behalf of himself and others similarly situated vs. Pacific Sunwear of California, Inc., Superior Court of California, County of Los Angeles, Case No. 457654. On March 21, 2011, the plaintiff in this matter filed a putative class action lawsuit against the Company alleging violations of California’s wage and hour, overtime, meal break and rest break rules and regulations, among other things. The complaint sought class certification, the appointment of the plaintiff as class representative, and an unspecified amount of damages and penalties. On May 25, 2012, the Company settled Mr. Gleason’s claims for a nominal sum and the complaint was dismissed with prejudice as to such claims on August 21, 2012.

The Company is also involved from time to time in other litigation incidental to its business. The Company believes that the outcome of current litigation will not likely have a material adverse effect on its results of operations or financial condition and, from time to time, the Company may make provisions for probable 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 a material adverse effect on the Company’s operating results.

Indemnities, Commitments and Guarantees

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

Letters of Credit

The Company has issued guarantees in the form of commercial letters of credit, of which there were approximately $28 million outstanding at July 28, 2012, as security for merchandise shipments from overseas. All in-transit merchandise covered by letters of credit is accrued for in accounts payable.

11. SEGMENT REPORTING

The Company operates exclusively in the retail apparel industry. The Company designs, produces and distributes clothing and related products catering to teens and young adults through its primarily mall-based PacSun retail stores. The Company has identified three operating segments: PacSun stores, PacSun Outlet stores and pacsun.com. The three operating segments have been aggregated into one reportable segment based on the similar nature of products sold, production, merchandising and distribution processes involved, target customers, and economic characteristics among the three operating segments.

12. DISCONTINUED OPERATIONS

In accordance with ASC Topic 205, “Presentation of Financial Statements- Discontinued Operations” (“ASC 205”), the Company has presented the results of operations of its closed stores as discontinued operations for all periods presented. The Company closed 3 and 6 underperforming stores in the second quarter of fiscal 2012 and 2011, respectively, and during the first half of fiscal 2012 and 2011, the Company closed 8 and 31 underperforming stores, respectively. If the cash flow of the closed store was determined not to be significant to ongoing operations, and the cash inflows of nearby stores were not expected to increase significantly, the results of operations of the closed store are included in discontinued operations. The following table details the operating results included in discontinued operations for the periods presented:


	For the Second Quarter Ended July 30, 2011			For the First Half Ended July 30, 2011
Net sales	$	13,983		$	27,856
Cost of goods sold, including buying, distribution and occupancy costs		11,840			23,416

Gross margin		2,143			4,440
Selling, general and administrative expenses		3,998			9,183

Operating loss		(1,855	)		(4,743	)
Income taxes		48			122

Loss from discontinued operations	$	(1,807	)	$	(4,621	)

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

The following management’s discussion and analysis of financial condition and results of operations (“MD&A”) should be read in conjunction with our Condensed Consolidated Financial Statements and notes thereto included elsewhere in this Report.

Cautionary Note Regarding Forward-Looking Statements

This Report contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and we intend that such forward-looking statements be subject to the safe harbors created thereby. In Item 1A, Risk Factors, in our Annual Report on Form 10-K for the year ended January 28, 2012 (our “Annual Report”), as amended by Amendment No. 1 to our Annual Report, filed April 10, 2012 (our Annual Report, as amended, our “2011 Annual Report”), we provide cautionary statements identifying important factors that could cause our actual results to differ materially from those projected in the forward-looking statements contained herein. Any statements that express, or involve discussions as to, expectations, beliefs, plans, objectives, assumptions, future events or performance (often, but not always, identifiable by the use of words or phrases such as “will result,” “expects to,” “will continue,” “anticipates,” “plans,” “intends,” “estimated,” “projects” and “outlook”) are not historical facts and may be forward-looking and, accordingly, such statements involve estimates, assumptions and uncertainties which could cause actual results to differ materially from those expressed in the forward-looking statements. Examples of forward-looking statements in this Report include, but are not limited to, the following categories of expectations about:

•

the sufficiency of operating cash flows, working capital and available credit to meet our operating and capital expenditure requirements;

•

our capital expenditure plans for fiscal 2012;

•

potential recording of non-cash impairment charges for underperforming stores in future quarters; and

•

sales trends for the third quarter of fiscal 2012.

All forward-looking statements included in this Report are based on information available to us as of the date hereof, and are subject to risks and uncertainties that could cause actual results to differ materially from those expressed in the forward-looking statements. See Item 1A, Risk Factors, in our 2011 Annual Report, which are hereby incorporated by reference in this Report for a discussion of these risks and uncertainties. We assume no obligation to update or revise any such forward-looking statements to reflect events or circumstances that occur after such statements are made.

Executive Overview

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

Comparable (or “same-store”) sales

Stores are deemed comparable stores on the first day of the fiscal month following the one-year anniversary of their opening or expansion/relocation. We consider same-store sales to be an important indicator of the Company’s current performance. Same-store sales results are important in achieving operating leverage of certain expenses such as store payroll, store occupancy, depreciation, general and administrative expenses and other costs that are somewhat fixed. Positive same-store sales results usually generate greater operating leverage of expenses while negative same-store sales results generally have a negative impact on operating leverage. Same-store sales results also have a direct impact on our net sales, cash and working capital.

Net merchandise margin

We analyze the components of net merchandise margins, specifically initial markups, discounts and markdowns as a percentage of net sales. Any inability to obtain acceptable levels of initial markups or any significant increase in our use of discounts or markdowns could have an adverse impact on our gross margin results and results of operations.

Operating margin

We view operating margin as a key indicator of our success. The key drivers of operating margins are comparable store net sales, net merchandise margins, and our ability to control operating expenses. For a discussion of the changes in the components comprising operating margins, see “Results of Operations” in this section.

Store sales trends

We evaluate store sales trends in assessing the operational performance of our stores. Important store sales trends include average net sales per store and average net sales per square foot.

Cash flow and liquidity (working capital)

We evaluate cash flow from operations, liquidity and working capital to determine our short-term operational financing needs. Based on current forecasts and plans for the year, we believe that cash flows from operating activities, working capital, borrowing availability under the New Credit Facility, and cash on hand resulting from the closing of the Term Loan will be sufficient to meet our operating and capital expenditure needs for the next twelve months. However, if we were to experience same-store sales declines similar to those which occurred in fiscal 2010 and 2009, we may have to access most, if not all, of the New Credit Facility and potentially require other sources of financing to fund our operations, which sources might not be available. For a discussion of the changes in our operating cash flows and working capital, see “Liquidity and Capital Resources” in this section.

Critical Accounting Policies

There have been no material changes to our critical accounting policies and estimates from the information provided in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in our 2011 Annual Report.

Results of Operations

Continuing Operations

The following table sets forth selected income statement data from our continuing operations expressed as a percentage of net sales for the fiscal years indicated. The table excludes discontinued operations and the discussion that follows should be read in conjunction with the table:


	For the Second Quarter Ended						For the First Half Ended
	July 28, 2012			July 30, 2011			July 28, 2012			July 30, 2011
Net sales		100.0	%		100.0	%		100.0	%		100.0	%
Cost of goods sold, including buying, distribution and occupancy costs		72.5			76.4			74.3			78.4

Gross margin		27.5			23.6			25.7			21.6
Selling, general and administrative expenses		30.2			31.8			32.0			33.5

Operating loss		(2.7	)		(8.2	)		(6.3	)		(11.9	)
Loss on derivative liability		3.9			—			0.5			—
Other expense, net		1.6			0.3			1.7			0.3

Loss before income taxes		(8.2	)		(8.5	)		(8.5	)		(12.2	)
Income taxes		(0.1	)		(0.2	)		(0.1	)		(0.2	)

Loss from continuing operations		(8.3	)%		(8.7	)%		(8.6	)%		(12.4	)%

The second quarter (13 weeks) ended July 28, 2012 as compared to the second quarter (13 weeks) ended July 30, 2011

Net Sales

Net sales increased to $210 million for the second quarter of fiscal 2012 from $201 million for the second quarter of fiscal 2011. The components of this $9 million increase in net sales are as follows:


$ millions		Attributable to
$	8	A 5% increase in comparable store net sales in the second quarter of fiscal 2012 and an 8% increase in average sales transactions, partially offset by a decrease in total transactions of 3%.
	1	Increase in other non-comparable sales including sales from expanded, relocated or new stores not yet included in the comparable store base.

$	9	Total

For the second quarter of fiscal 2012, comparable store net sales of Men’s and Women’s increased 7% and 2%, respectively, which represented the highest Men’s second quarter comparable since fiscal 2004. The increase in Men’s was attributable to increases in sales of tops and non-apparel, partially offset by decreases in sales of bottoms, compared to the second quarter of fiscal 2011. The increase in Women’s was primarily driven by increases in sales of bottoms and non-apparel partially offset by decreases in sales of tops, compared to the second quarter of fiscal 2011. Apparel represented 85% of total Women’s sales for the second quarter of fiscal 2012 versus 86% in the second quarter of fiscal 2011, while Men’s apparel was flat at 85% of total Men’s sales for the second quarters of fiscal 2012 and fiscal 2011. Total non-apparel represented a combined 15% of total sales for the second quarter of fiscal 2012 and 14% of total sales for the second quarter of fiscal 2011. In addition, same-store sales transactions decreased from 4.7 million in the second quarter of fiscal 2011 to 4.6 million in the second quarter of fiscal 2012.

On our quarterly conference call discussing second quarter results, held on August 22, 2012, we provided same-store sales guidance for our third quarter of fiscal 2012 to be in the range of negative 2% to plus 2%.

Gross Margin

Gross margin, after buying, distribution and occupancy costs, was $58 million for the second quarter of fiscal 2012 versus $47 million for the second quarter of fiscal 2011. As a percentage of net sales, gross margin was 27.5% for the second quarter of fiscal 2012 compared to 23.6% for the second quarter of fiscal 2011. The components of this 3.9% increase in gross margin as a percentage of net sales were as follows:


%		Attributable to
	2.6	Increase in merchandise margin to 51.4% in the second quarter of fiscal 2012 from 48.8% in the second quarter of fiscal 2011, primarily due to an increase in initial markups and a decrease in promotions.
	1.1	Leveraging of occupancy costs as a result of the 5% same-store sales increase for the second quarter of fiscal 2012 discussed above and a reduction in rent expense related to negotiations with our landlords.
	0.2	Decrease in distribution costs as compared to the second quarter of fiscal 2011.

	3.9	Total

Selling, General and Administrative Expenses

Selling, general and administrative expenses (“SG&A”) was flat at $64 million for the second quarter of fiscal 2012 compared to the second quarter of fiscal 2011. These expenses decreased to 30.2% as a percentage of net sales in the second quarter of fiscal 2012 from 31.8% in the second quarter of fiscal 2011. The components of this 1.6% decrease in SG&A as a percentage of net sales were as follows:


%		Attributable to
0.8		Increase in payroll and payroll-related expenses as a percentage of net sales. Payroll expense, increased $4 million to $39 million in the second quarter of fiscal 2012 from $35 million in the second quarter of fiscal 2011 due primarily to an increase in bonus accrual.
(0.6)		Decrease in depreciation expense to $8.6 million in the second quarter of fiscal 2012 from $9.4 million in the second quarter of fiscal 2011 due primarily to recent store closures.
(0.6)		Decrease in non-cash asset impairment charges and store closure related charges to $2 million in the second quarter of fiscal 2012 from $3 million in the second quarter of fiscal 2011.
(1.2)		Decrease in all other SG&A expenses as a percentage of sales. Other SG&A expenses decreased $2 million to $14 million in the second quarter of fiscal 2012 from $16 million in the second quarter of fiscal 2011, primarily due to a decrease in credit card authorization fees and consulting fees.

(1.6)		Total

We assess long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying value of such assets (or asset group) may not be recoverable. Based on management’s review of the historical operating performance, including sales trends, gross margin rates, current cash flows from operations and the projected outlook for each of our stores, we determined that certain stores would not be able to generate sufficient cash flows over the remaining term of the related leases to recover our investment in the respective stores. As a result, we recorded non-cash impairment charges of approximately $1 million during the second quarter of fiscal 2012 and approximately $3 million during the second quarter of fiscal 2011 to write-down the carrying value of certain long-lived store assets to their estimated fair values. During the second quarters of fiscal 2012 and 2011, we tested 116 and 187 stores, respectively, for impairment and recorded impairment charges related to 23 and 28 of these stores, respectively. The decrease in the number of stores tested for impairment year-over-year was primarily related to our recent closure of certain underperforming stores. In addition, based on historical operating performance and the projected outlook for these stores, we believe that the remaining asset value of approximately $8 million as of July 28, 2012, is recoverable. Additionally, the Company wrote off approximately $ 1 million of excess store fixtures in the second quarter of fiscal 2012.

Loss on Derivative Liability

We recorded a fair market adjustment of approximately $8 million related to the derivative liability in the second quarter of fiscal 2012. See Note 9 to the Condensed Consolidated Financial Statements “Fair Value Measurements – Recurring Fair Value Measurements-Derivative Liability” for further discussion on the derivative liability.

Other Expense, Net

Other expense was approximately $4 million and $1 million for the second quarters of fiscal 2012 and 2011, respectively. The increase in other expense from fiscal 2011 to fiscal 2012 is primarily related to interest expense associated with the Term Loan described in Note 6 to the Condensed Consolidated Financial Statements.

Income Taxes

We recognized income tax expense of $0.2 million and $0.4 million for the second quarter of fiscal 2012 and 2011, respectively. For fiscal 2012, we expect to continue to maintain a valuation allowance against deferred tax assets resulting in minimal income tax expense for the year. Information regarding the realizability of our deferred tax assets and our assessment of a need for a valuation allowance is contained in Note 7 to the Condensed Consolidated Financial Statements.

Loss from Continuing Operations

Our loss from continuing operations for the second quarter of fiscal 2012 was approximately $18 million, or $(0.26) per share, versus a loss from continuing operations of approximately $17 million, or $(0.26) per share, for the second quarter of fiscal 2011.

The first half (26 weeks) ended July 28, 2012 as compared to the first half (26 weeks) ended July 30, 2011

Net Sales

Net sales increased to $384 million for the first half of fiscal 2012 from $373 million for the first half of fiscal 2011. The components of this $11 million increase in net sales are as follows:


$ millions		Attributable to
$	10	A 3% increase in comparable store net sales in the first half of fiscal 2012 and an increase in average sales transactions of 7%, partially offset by a decrease in total transactions of 4%.
	1	Increase in other non-comparable sales including sales from expanded, relocated or new stores not yet included in the comparable store base and bulk sales.

$	11	Total

For the first half of fiscal 2012, comparable store net sales of Men’s and Women’s increased 4% and 1%, respectively. The increase in Men’s was attributable to increases in sales of tops, bottoms, and non-apparel, compared to the first half of fiscal 2011. The increase in Women’s was driven by increases in sales of bottoms and non-apparel, partially offset by decreases in sales of tops, compared to the first half of fiscal 2011. Apparel represented 85% of total Women’s sales for the first half of fiscal 2012 versus 86% in the first half of fiscal 2011, while Men’s apparel was flat at 85% of total Men’s sales for the first half of fiscal 2012 and fiscal 2011. Total non-apparel represented a combined 15% of total sales for the first half of fiscal 2012 and 14% of total sales for the first half of fiscal 2011. In addition, same-store sales transactions decreased from 8.9 million in the first half of fiscal 2011 to 8.5 million in the first half of fiscal 2012.

Gross Margin

Gross margin, after buying, distribution and occupancy costs, was $99 million for the first half of fiscal 2012 versus $81 million for the first half of fiscal 2011. As a percentage of net sales, gross margin was 25.7% for the first half of fiscal 2012 compared to 21.6% for the first half of fiscal 2011. The components of this 4.1% increase in gross margin as a percentage of net sales were as follows:


%		Attributable to
	2.1	Increase in merchandise margin to 51.2% in the first half of fiscal 2012 from 49.1% in the first half of fiscal 2011, primarily due to an increase in initial markups and a decrease in promotions.
	1.6	Leveraging of occupancy costs as a result of the 3% same-store sales increase for the first half of fiscal 2012 discussed above and a reduction in rent expense related to negotiations with our landlords.
	0.4	Decrease in buying and distribution costs to $15 million in the first half of fiscal 2012 compared to $16 million in the first half of fiscal 2011.

	4.1	Total

Selling, General and Administrative Expenses

Selling, general and administrative expenses (“SG&A”) decreased to $123 million for the first half of fiscal 2012 from $125 million for the first half of fiscal 2011, a decrease of $2 million, or 1.5%. These expenses decreased to 32.0% as a percentage of net sales in the first half of fiscal 2012 from 33.5% in the first half of fiscal 2011. The components of this 1.5% decrease in SG&A as a percentage of net sales were as follows:


%		Attributable to
	0.8	Increase in payroll and payroll-related expenses as a percentage of net sales. Payroll expense increased $5 million to $75 million in the first half of fiscal 2012 from $70 million in the first half of fiscal 2011, primarily due to an increase in bonus accrual.
	(0.9)	Decrease in depreciation expense to $17 million in the first half of fiscal 2012 from $19 million in the first half of fiscal 2011 due primarily to recent store closures.
	(0.5)	Decrease in non-cash asset impairment charges and store closure related charges to $4 million in the first half of fiscal 2012 from $5 million in the first half of fiscal 2011.
	(0.9)	Decrease in all other SG&A expenses as a percentage of sales. Other SG&A decrease $3 million to $27 million in the first half of fiscal 2012 from $30 million in the first half of fiscal 2011, primarily due to a decrease in consulting costs and credit card processing fees.

	(1.5)	Total

We assess long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying value of such assets (or asset group) may not be recoverable. Based on management’s review of the historical operating performance, including sales trends, gross margin rates, current cash flows from operations and the projected outlook for each of our stores, we determined that certain stores would not be able to generate sufficient cash flows over the remaining term of the related leases to recover our investment in the respective stores. As a result, we recorded non-cash impairment charges of approximately $3 million and $6 million during the first half of fiscal 2012 and 2011, respectively, to write-down the carrying value of certain long-lived store assets to their estimated fair values. During the first half of fiscal 2012 and 2011, we tested 151 and 240 stores, respectively, for impairment and recorded impairment charges related to 39 and 64 of these stores, respectively. The decrease in the number of stores tested for impairment year-over-year was primarily related to our recent closure of certain underperforming stores. Additionally, the Company wrote off approximately $1 million of excess store fixtures in the second half of fiscal 2012.

Loss on Derivative Liability

We recorded a fair market adjustment of approximately $2 million related to the derivative liability in the first half of fiscal 2012. See Note 9 to the Condensed Consolidated Financial Statements “Fair Value Measurements – Recurring Fair Value Measurements-Derivative Liability” for further discussion on the derivative liability.

Other Expense, Net

Other expense was approximately $7 million and $1 million for the first half of fiscal 2012 and 2011, respectively. The increase in other expense from fiscal 2011 to fiscal 2012 was primarily related to interest expense associated with the Term Loan described in Note 6 to the Condensed Consolidated Financial Statements.

Income Taxes

We recognized income tax expense of $0.5 million and $0.7 million for the first half of fiscal 2012 and 2011, respectively. For fiscal 2012, we expect to continue to maintain a valuation allowance against deferred tax assets resulting in minimal income tax expense for the year. Information regarding the realizability of our deferred tax assets and our assessment of a need for a valuation allowance is contained in Note 7 to the Condensed Consolidated Financial Statements.

Loss from Continuing Operations

Our loss from continuing operations for the first half of fiscal 2012 was approximately $33 million, or $(0.49) per share, versus a loss from continuing operations of approximately $46 million, or $(0.70) per share, for the first half of fiscal 2011.

Liquidity and Capital Resources

We have historically financed our operations primarily from internally generated cash flow and with short-term and long-term borrowings. Our primary cash requirements have been for the financing of inventories and construction of newly opened, remodeled, expanded or relocated stores. Based on current forecasts and plans for the year, we believe that cash flows from operating activities, working capital, borrowing availability under the New Credit Facility, and cash on hand resulting from the closing of the Term Loan will be sufficient to meet our operating and capital expenditure needs for the next twelve months. However, if we were to experience same-store sales declines similar to those which occurred in fiscal 2010 and 2009, we may be required to access most, if not all, of the New Credit Facility and potentially require other sources of financing to fund our operations, which sources might not be available.


	For the First Half Ended
	July 28, 2012			July 30, 2011
	(In thousands)
Net cash used in operating activities	$	(13,549	)	$	(43,717	)
Net cash used in investing activities		(227	)		(6,638	)
Net cash used in financing activities		(1,700	)		(103	)

Net decrease in cash and cash equivalents	$	(15,476	)	$	(50,458	)

Operating Cash Flows

Net cash used in operating activities for the first half of fiscal 2012 was $14 million. We used $8 million of cash in operations (net of non-cash charges). In addition, cash decreased $6 million from changes in working capital items primarily due to increases in merchandise inventories of $56 million partially offset by an increase in accounts payable of $47 million. Such increases resulted from the seasonal variation between the peak back-to-school selling season and the annual low point for inventories at the end of the fiscal year. The remaining working capital change was attributable to an increase in other current liabilities of $6 million, partially offset by an increase in other current assets, primarily due to an increase in prepaid expenses.

Net cash used in operating activities for the first half of fiscal 2011 was $44 million. We used $21 million of cash in operations (net of noncash charges), before working capital changes. In addition, cash decreased $18 million from changes in working capital items, primarily due to increases in merchandise inventories of $68 million, offset by increased accounts payable of $56 million due to the seasonal variation between the peak back-to-school selling season and the annual low point for inventories at the end of the fiscal year. The remaining decrease in cash from working capital items was attributable to an increase in other current assets of $6 million primarily due to an increase in prepaid expenses of $5 million. Additional decreases in operating cash flows were due to changes in other assets and liabilities of $5 million.

Working Capital

Working capital at July 28, 2012, was $43 million compared to $62 million at January 28, 2012, a decrease of $19 million. The changes in working capital were as follows:


$ millions			Description
$	62		Working capital at January 28, 2012.
	(15	)	Decrease in cash and cash equivalents.
	9		Increase in merchandise inventories, net of accounts payable, from fiscal year end due to planned receipt flows.
	(13	)	Increase in other current liabilities, net of other current assets.

$	43		Working capital at July 28, 2012.

Investing Cash Flows

Net cash used in investing activities in the first half of fiscal 2012 was $0.2 million compared to $6.6 million used in investing activities for the first half of fiscal 2011, a decrease in cash outflow of $6.4 million. Investing cash used in the first halves of fiscal 2012 and 2011 were comprised primarily of capital expenditures for refreshing existing stores and information technology investments at the store level. We expect total capital expenditures for fiscal 2012 to be approximately $15 million. Investing cash inflows of $9 million in the first half of fiscal 2012 were primarily related to the receipt of restricted cash that was used as collateral to fund letters of credit outstanding under the Former Credit Facility.

Financing Cash Flows

Net cash used in financing activities in the first half of fiscal 2012 was $1.7 million compared to $0.1 million for the first half of fiscal 2011. The primary source of financing cash outflows in fiscal 2012 was principal payments under the New Credit Facility of $1.3 million. The primary driver of financing cash outflows in fiscal 2011 was payments for mortgage borrowing costs.

New Credit Facility

Information regarding the New Credit Facility is contained in Note 6 to the Condensed Consolidated Financial Statements and is incorporated herein by reference.

Term Loan

Information regarding the Term Loan is contained in Note 6 to the Condensed Consolidated Financial Statements and is incorporated herein by reference.

Mortgage Transactions

Information regarding our mortgage debt is contained in Note 6 to the Condensed Consolidated Financial Statements and is incorporated herein by reference.

Contractual Obligations

We have minimum annual rental commitments under existing store leases as well as a minor amount of capital leases for computer equipment. We lease all of our retail store locations under operating leases. We lease equipment, from time to time, under both capital and operating leases. In addition, at any time, we are contingently liable for commercial letters of credit with foreign suppliers of merchandise. At July 28, 2012, our future financial commitments under all existing contractual obligations were as follows:


	Payments Due by Period
	Total		Less than 1 year		1-3 years		3-5 years		More than 5 years
	(In millions)
Operating lease obligations	$	372	$	77	$	133	$	87	$	75
Term loan		104		3		8		93		—
Mortgage debt		29		1		1		1		26
Letters of credit		28		28		—		—		—
Guaranteed minimum royalties		5		1		4		—		—
Capital lease obligations		1		1		—		—		—

Total	$	539	$	111	$	146	$	181	$	101

Operating lease obligations consist primarily of future minimum lease commitments related to store operating leases. The contractual obligations table above does not include common area maintenance (“CAM”) charges, insurance, or tax obligations, which are also required contractual obligations under our store operating leases. In many of our leases, CAM charges are not fixed and can fluctuate significantly from year to year for any particular store. Total store rental expenses, including CAM, for the first half of fiscal 2012 and fiscal 2011 were approximately $70 million and $80 million, respectively. Total CAM expenses may continue to fluctuate significantly from year-to-year as long-term leases come up for renewal at current market rates in excess of original lease terms and as we continue to close stores. Additional information regarding operating leases can be found below under the caption “Operating Leases.”

Obligations under our Executive Deferred Compensation Plan are equal to approximately $2 million as of July 28, 2012 and have been excluded from the contractual obligations table above as we are unable to reasonably determine the amount or the timing of the future payments.

Operating Leases

We lease our retail stores and certain equipment under operating lease agreements expiring at various dates through January 2023. Many of our retail store leases require us to pay CAM charges, insurance and property taxes. In addition, many of our retail store leases require us to pay percentage rent ranging from 2% to 20% when sales volumes exceed certain minimum sales levels. The initial terms of such leases are typically 8 to 10 years, some of which contain renewal options exercisable at our discretion. Most leases also contain rent escalation clauses that come into effect at various times throughout the lease term. Rent expense is recorded under the straight-line method over the life of the lease. Other rent escalation clauses can take effect based on changes in primary mall tenants throughout the term of a given lease. Many leases also contain cancellation or kick-out clauses in our favor that relieve us of any future obligation under a lease if specified criteria are met. These cancellation provisions typically apply if annual store sales levels do not exceed $1 million or mall occupancy targets are not achieved within the first 36 months of the lease. Generally, we are not required to make payments to our landlords in order to exercise our cancellation rights under these provisions. We are planning to close approximately 100 stores in the fourth quarter of fiscal 2012. The New Credit Facility and Term Loan do not preclude the transfer or disposal of assets related to the closure of such stores. None of our retail store leases contain purchase options.

Indemnifications

In the ordinary course of business, we may provide indemnifications of varying scope and terms to customers, vendors, lessors, business partners and other parties with respect to certain matters, including, but not limited to, losses arising out of our breach of such agreements, services to be provided by us, or intellectual property infringement claims made by third parties. In addition, we have entered into indemnification agreements with our directors and certain of our officers that will require us to, among other things, indemnify them against certain liabilities that may arise by reason of their status or service as directors or officers. We maintain director and officer insurance, which may cover certain liabilities arising from our obligation to indemnify our directors and officers in certain circumstances.

It is not possible to determine our maximum potential liability under these indemnification agreements due to the limited history of prior indemnification claims and the unique facts and circumstances involved in each particular agreement. Such indemnification agreements may not be subject to maximum loss clauses. Historically, we have not incurred material costs as a result of obligations under these agreements.

Off-Balance Sheet Arrangements

We have not entered into any transactions with unconsolidated entities whereby we have financial guarantees, subordinated retained interests, derivative instruments, or other contingent arrangements that expose us to material continuing risks, contingent liabilities, or any other obligation under a variable interest in an unconsolidated entity that provides financing, liquidity, market risk, or credit risk support to us.

Recent Accounting Pronouncements

Information regarding recent accounting pronouncements is contained in Note 3 to the Condensed Consolidated Financial Statements and is incorporated herein by reference.

Inflation

We do not believe that inflation has had a material effect on our results of operations in the recent past, including the first half of fiscal 2012.

Seasonality and Quarterly Results

Our business is seasonal by nature. Our first quarter historically accounts for the smallest percentage of annual net sales with each successive quarter contributing a greater percentage than the last. In recent years, approximately 45% of our net sales have occurred in the first half of the fiscal year and 55% have occurred in the second half. The six to seven week selling periods for each of the back-to-school and holiday seasons together account for approximately 35% to 40% of our annual net sales and a higher percentage of our operating results on a combined basis. Our quarterly results of operations may also fluctuate significantly as a result of a variety of factors, including changes in consumer buying patterns, fashion trends, the timing and level of markdowns, the timing of store closings, expansions and relocations, competitive factors and general economic conditions.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

We are exposed to interest rate risk in connection with the New Credit Facility. Generally, direct borrowings under the New Credit Facility bear interest at a floating rate which, at the Company’s option, may be determined by reference to a LIBOR rate, plus 1.50% (1.74% at July 28, 2012). See Note 6 to the Condensed Consolidated Financial Statements.

A sensitivity analysis was performed with respect to the New Credit Facility to determine the impact of unfavorable changes in interest rates on our cash flows. The sensitivity analysis determined that the estimated potential cash flow impact would be less than $10,000 in additional interest expense (for each $1 million borrowed) if interest rates were to increase by 10% over a three-month period. Actual interest charges incurred may differ from those estimated because of changes or differences in market rates, differences in amounts borrowed, timing and other factors.

We are exposed to market risks related to fluctuations in the market price of our common stock. The derivative liability associated with the Series B Preferred is recorded at fair value using an options pricing model which is dependent on the market price of our common stock. Changes in the value of the derivative are included as a component of earnings in current operations. A sensitivity analysis was performed with respect to the Series B Preferred to determine the impact of fluctuations in the market price of our common stock. The sensitivity analysis determined that the impact of a market price fluctuation of 10% would change the fair value of the derivative liability by approximately $3 million. See Note 9 to the Condensed Consolidated Financial Statements for further discussion of our derivative liability and valuation thereof.

ITEM 4. CONTROLS AND PROCEDURES.

Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) and 15d-15(e) promulgated under the Exchange Act. These disclosure controls and procedures are designed to provide reasonable assurance that the information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified by the Securities and Exchange Commission’s rules and forms. Our disclosure controls and procedures are also designed to provide reasonable assurance that information required to be disclosed in the reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosures. Based on this evaluation, our principal executive officer and our principal financial officer concluded that our disclosure controls and procedures were effective at a reasonable assurance level as of July 28, 2012.

No change in our internal control over financial reporting occurred during the most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II — OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

For information on legal proceedings see “Litigation” within Note 10 to the Condensed Consolidated Financial Statements, which information is incorporated herein by reference.

ITEM 1A. RISK FACTORS

We have included in Part I, Item 1A of our 2011 Annual Report descriptions of certain risks and uncertainties that could affect our business, future performance or financial condition (the “Risk Factors”). We believe there are no material changes from the disclosure provided in our 2011 Annual Report with respect to the Risk Factors. Investors should consider the Risk Factors prior to making an investment decision with respect to the Company’s stock.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES

None.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None.

ITEM 4. MINE SAFETY DISCLOSURES

Not applicable.

ITEM 5. OTHER INFORMATION

None.

ITEM 6. EXHIBITS


		Incorporated by Reference
Exhibit #	Exhibit Description	Form		Filing Date

3.1	Third Amended and Restated Articles of Incorporation of the Company		10-Q		8/31/04

3.2	Certificate of Determination of Preferences of Series A Junior Participating Preferred Stock of the Company		8-K		12/24/98

3.3	Fifth Amended and Restated Bylaws of the Company		8-K		4/3/09

3.4	Certificate of Determination of Preferences of Convertible Series B Preferred Stock of the Company.		8-K		12/7/11

31.1+	Certifications of Gary H. Schoenfeld and Michael W. Kaplan pursuant to section 302 of the Sarbanes-Oxley Act of 2002

32.1+	Certifications of Gary H. Schoenfeld and Michael W. Kaplan pursuant to section 906 of the Sarbanes-Oxley Act of 2002

101.INS**	XBRL Instance Document

101.SCH**	XBRL Taxonomy Extension Schema Document

101.CAL**	XBRL Taxonomy Extension Calculation Linkbase Document

101.LAB**	XBRL Taxonomy Extension Label Linkbase Document

101.PRE**	XBRL Taxonomy Extension Presentation Linkbase Document

+	Filed herewith

**	These interactive files are deemed not filed or a part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933 or Section 18 of the Securities Exchange Act of 1934 and are otherwise not subject to liability under these sections.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


	PACIFIC SUNWEAR OF CALIFORNIA, INC. (Registrant)

Date: August 30, 2012	By:	/s/ GARY H. SCHOENFELD
		Gary H. Schoenfeld
		President, Chief Executive Officer and Director
		(Principal Executive Officer)

Date: August 30, 2012	By:	/s/ MICHAEL W. KAPLAN
		Michael W. Kaplan
		Sr. Vice President and Chief Financial Officer
		(Principal Financial and Accounting Officer)

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