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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington D.C 20549
 FORM 10-Q [X]
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
EXCHANGE ACT OF 1934
 For the quarterly period ended October 30, 2004 OR [  ]
    
    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. CALIFORNIA
(State of Incorporation)
    
    95-3759463
(I.R.S Employer Identification No.)3450 East Miraloma Avenue
Anaheim, California
(Address of principal executive offices)
    
    92806
(Zip code)
 (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 December 6, 2004, was 74,237,339.




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PACIFIC SUNWEAR OF CALIFORNIA, INC.
FORM 10-Q
For the Quarter Ended October 30, 2004 Index PagePART I.
    
    FINANCIAL INFORMATIONItem 1.
    
    Condensed Consolidated Financial Statements (unaudited):Condensed Consolidated Balance Sheets as of October 30, 2004 and January 31, 2004
    
    
    3Condensed Consolidated Statements of Income and Comprehensive Income for the
third quarter and nine months ended October 30, 2004 and November 1, 2003
    
    
    4Condensed Consolidated Statements of Cash Flows for the nine months ended
October 30, 2004 and November 1, 2003
    
    
    5Notes to Condensed Consolidated Financial Statements
    
    
    6-13Item 2.
    
    Managements Discussion and Analysis of Financial Condition
and Results of Operations
    
    
    14-27Item 3.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    27Item 4.
    
    Controls and Procedures
    
    
    27-28PART II.
    
    OTHER INFORMATIONItem 1.
    
    Legal Proceedings
    

    
    28Item 2.
    
    Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    28Item 3.
    
    Defaults Upon Senior Securities
    
    
    28Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    28Item 5.
    
    Other Information
    
    
    28Item 6.
    
    Exhibits
    
    
    28SIGNATURE PAGE
    
    
    29EXHIBIT 10.1EXHIBIT 10.2EXHIBIT 10.3EXHIBIT 31EXHIBIT 32
  2




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PACIFIC SUNWEAR OF CALIFORNIA, INC. 
 CONDENSED CONSOLIDATED BALANCE SHEETS
 (unaudited)
(in thousands, except share amounts)
 October 30,
    
    January 31,2004
    
    2004ASSETSCURRENT ASSETS:Cash and cash equivalents
    
    $
    45,951
    
    
    $
    142,840Short-term investments
    
    
    38,573
    
    
    
    33,035Accounts receivable
    
    
    8,097
    
    
    
    5,194Merchandise inventories
    
    
    201,010
    
    
    
    147,751Prepaid expenses, includes $11,810 and $10,711 of prepaid rent, respectively
    
    
    20,818
    
    
    
    16,492Deferred income taxes
    
    
    8,224
    
    
    
    8,224Total current assets
    
    
    322,673
    
    
    
    353,536PROPERTY AND EQUIPMENT:Land
    
    
    12,156
    
    
    
    12,156Buildings and building improvements
    
    
    26,691
    
    
    
    26,686Leasehold improvements
    
    
    134,232
    
    
    
    119,210Furniture, fixtures and equipment
    
    
    198,920
    
    
    
    173,222Total property and equipment
    
    
    371,999
    
    
    
    331,274Less accumulated depreciation and amortization
    
    
    (151,155
    )
    
    
    (127,630
    )Net property and equipment
    
    
    220,844
    
    
    
    203,644OTHER ASSETS:Goodwill
    
    
    6,492
    
    
    
    6,492Deferred compensation and other assets
    
    
    12,730
    
    
    
    11,589Total other assets
    
    
    19,222
    
    
    
    18,081Total assets
    
    $
    562,739
    
    
    $
    575,261LIABILITIES AND SHAREHOLDERS EQUITYCURRENT LIABILITIES:Accounts payable
    
    $
    58,619
    
    
    $
    38,668Accrued liabilities
    
    
    47,225
    
    
    
    54,966Current portion of capital lease obligations
    
    
    1,309
    
    
    
    1,008Current portion of long-term debt
    
    
    453
    
    
    
    878Income taxes payable
    
    
    12,007
    
    
    
    15,024Total current liabilities
    
    
    119,613
    
    
    
    110,544LONG-TERM LIABILITIES:Long-term debt, net of current portion
    
    
    
    
    
    
    228Long-term capital lease obligations, net of current portion
    
    
    736
    
    
    
    1,227Deferred compensation
    
    
    12,289
    
    
    
    10,925Deferred rent
    
    
    12,345
    
    
    
    12,046Deferred income taxes
    
    
    11,529
    
    
    
    11,529Other long-term liabilities
    
    
    92
    
    
    
    Total long-term liabilities
    
    
    36,991
    
    
    
    35,955Commitments and contingencies (Note 8)SHAREHOLDERS EQUITY:Preferred stock, $.01 par value; 5,000,000 shares authorized; none issued and
outstanding
    
    
    
    
    
    
    Common stock, $.01 par value; 170,859,375 shares authorized; 74,156,155 and
78,351,302 shares issued and outstanding, respectively
    
    
    742
    
    
    
    784Additional paid-in capital
    
    
    50,096
    
    
    
    138,877Retained earnings
    
    
    355,297
    
    
    
    289,101Total shareholders equity
    
    
    406,135
    
    
    
    428,762Total liabilities and shareholders equity
    
    $
    562,739
    
    
    $
    575,261
 See accompanying notes 3




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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)
 For the Third Quarter Ended
    
    For the Nine Months EndedOctober 30,
    
    November 1,
    
    October 30,
    
    November 1,2004
    
    2003
    
    2004
    
    2003Net sales *
    
    $
    329,447
    
    
    $
    281,541
    
    
    $
    850,086
    
    
    $
    714,672Cost of goods sold, including
buying, distribution and
occupancy costs *
    
    
    210,827
    
    
    
    181,041
    
    
    
    553,197
    
    
    
    470,587Gross margin *
    
    
    118,620
    
    
    
    100,500
    
    
    
    296,889
    
    
    
    244,085Selling, general and
administrative expenses *
    
    
    67,733
    
    
    
    61,241
    
    
    
    191,621
    
    
    
    170,279Operating income
    
    
    50,887
    
    
    
    39,259
    
    
    
    105,268
    
    
    
    73,806Interest income, net
    
    
    404
    
    
    
    213
    
    
    
    1,176
    
    
    
    342Income before income tax expense
    
    
    51,291
    
    
    
    39,472
    
    
    
    106,444
    
    
    
    74,148Income tax expense
    
    
    19,394
    
    
    
    14,963
    
    
    
    40,248
    
    
    
    28,281Net income
    
    $
    31,897
    
    
    $
    24,509
    
    
    $
    66,196
    
    
    $
    45,867Comprehensive income
    
    $
    31,897
    
    
    $
    24,509
    
    
    $
    66,196
    
    
    $
    45,867Net income per share, basic
    
    $
    0.43
    
    
    $
    0.32
    
    
    $
    0.87
    
    
    $
    0.60Net income per share, diluted
    
    $
    0.42
    
    
    $
    0.31
    
    
    $
    0.85
    
    
    $
    0.59Weighted average shares
outstanding, basic
    
    
    74,415,403
    
    
    
    77,685,516
    
    
    
    76,298,445
    
    
    
    76,031,944Weighted average shares
outstanding, diluted
    
    
    75,919,451
    
    
    
    79,876,426
    
    
    
    77,996,056
    
    
    
    78,322,218
 * See Note 2, Shipping and Handling Revenues and Expenses for a
reconciliation of net sales, gross margins, and selling, general and
administrative expenses as reported herein to the corresponding amounts for
such items as reported in the Companys third quarter press release as
furnished on Form 8-K dated November 8, 2004. See accompanying notes 4




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PACIFIC SUNWEAR OF CALIFORNIA, INC. 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
 (unaudited)
(in thousands)
 For the Nine Months EndedOctober 30,
    
    November 1,2004
    
    2003CASH FLOWS FROM OPERATING ACTIVITIES:Net income
    
    $
    66,196
    
    
    $
    45,867Adjustments to reconcile net income to net cash provided by operating
activities:Depreciation and amortization
    
    
    29,661
    
    
    
    26,939Loss on disposal of equipment
    
    
    2,474
    
    
    
    1,492Tax benefits related to exercise of stock options
    
    
    4,429
    
    
    
    14,449Change in operating assets and liabilities:Accounts receivable
    
    
    (2,903
    )
    
    
    (972
    )Merchandise inventories
    
    
    (53,259
    )
    
    
    (45,751
    )Prepaid expenses
    
    
    (4,326
    )
    
    
    (1,661
    )Deferred compensation and other assets
    
    
    223
    
    
    
    5,959Accounts payable
    
    
    19,951
    
    
    
    9,108Accrued liabilities
    
    
    (5,677
    )
    
    
    3,796Income taxes payable and deferred income taxes
    
    
    (3,017
    )
    
    
    (550
    )Deferred rent
    
    
    299
    
    
    
    1,234Other long-term liabilities
    
    
    92
    
    
    
    Net cash provided by operating activities
    
    
    54,143
    
    
    
    59,910CASH FLOWS FROM INVESTING ACTIVITIES:Purchases of property and equipment
    
    
    (45,286
    )
    
    
    (27,721
    )Purchases of short-term investments
    
    
    (23,374
    )
    
    
    (10,410
    )Maturities of short-term investments
    
    
    17,836
    
    
    
    Net cash used in investing activities
    
    
    (50,824
    )
    
    
    (38,131
    )CASH FLOWS FROM FINANCING ACTIVITIES:Repurchases of common stock
    
    
    (109,502
    )
    
    
    Proceeds from exercise of stock options
    
    
    10,779
    
    
    
    27,111Principal payments under capital lease obligations
    
    
    (832
    )
    
    
    (1,186
    )Principal payments under long-term debt obligations
    
    
    (653
    )
    
    
    (614
    )Cash paid in-lieu of fractional shares due to 3-for-2 stock split
    
    
    
    
    
    
    (33
    )Net cash (used in)/provided by financing activities
    
    
    (100,208
    )
    
    
    25,278NET (DECREASE)/INCREASE IN CASH AND CASH EQUIVALENTS:
    
    
    (96,889
    )
    
    
    47,057CASH AND CASH EQUIVALENTS, beginning of period
    
    
    142,840
    
    
    
    36,438CASH AND CASH EQUIVALENTS, end of period
    
    $
    45,951
    
    
    $
    83,495SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:Cash paid during the period for:Interest
    
    $
    105
    
    
    $
    185Income taxes
    
    $
    38,836
    
    
    $
    14,382
 Supplemental disclosures of non-cash transactions (in thousands): During the
nine months ended October 30, 2004, the Company recorded an increase to
additional paid-in capital of $5,471 related to the issuance of restricted
stock to satisfy certain deferred compensation liabilities (see Note 6).
During the nine months ended October 30, 2004 and November 1, 2003, the
Companys accrued capital expenditures increased by $3,407 and $2,960,
respectively. See accompanying notes 5




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PACIFIC SUNWEAR OF CALIFORNIA, INC. 
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
  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 subsidiaries, Pacific Sunwear Stores Corp. and Miraloma Corp.
(formerly ShopPacSun.com Corp.) (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 2004 is the 52-week period ending January 29,
2005. Fiscal 2003 was the 52-week period ended January 31, 2004. The third
quarter and first nine months of fiscal 2004 were the 13- and 39-week periods
ended October 30, 2004, respectively. The third quarter and first nine months
of fiscal 2003 were the 13- and 39-week periods ended November 1, 2003,
respectively. In the opinion of management, all adjustments consisting only of normal
recurring entries necessary for a fair presentation have been included. The
preparation of 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 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. The results of operations for the
third quarter and nine months ended October 30, 2004 are not necessarily
indicative of the results that may be expected for fiscal 2004. For further
information, refer to the Companys consolidated financial statements and notes
thereto included in the Companys annual report on Form 10-K for the year ended
January 31, 2004. NOTE 2  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Information regarding the Companys significant accounting policies is
contained in Note 1, Summary of Significant Accounting Policies and Nature of
Business, to the consolidated financial statements in the Companys Form 10-K
for the fiscal year ended January 31, 2004. Presented below in this and the
following notes is supplemental information that should be read in conjunction
with Notes to Consolidated Financial Statements included in that report. Short-term Investments  Short-term investments are classified as
held-to-maturity and consist of marketable corporate and U.S. agency debt
instruments with original maturities of three months to one year and are
carried at amortized cost, less other than temporary impairments in value.
Cost is determined by specific identification. At October 30, 2004, the fair
value of the Companys portfolio was $38.5 million, consisting of corporate
debentures of $21.5 million, U.S. agency debentures of $10.0 million, U.S.
Treasury notes of $4.0 million and corporate commercial paper of $3.0 million. Property and Equipment  Leasehold improvements and furniture, fixtures and
equipment are stated at cost. Amortization of leasehold improvements is
computed on the straight-line method over the lesser of an assets estimated
useful life or the life of the related stores lease (generally 10 years).
Depreciation on furniture, fixtures and equipment is computed on the
straight-line method over five years. Depreciation on buildings and building
improvements is computed on the straight-line method over the estimated useful
life of the asset (generally 39 years). Revenue Recognition  Sales are recognized upon purchase by customers at the
Companys retail store locations or upon delivery to and acceptance by the
customer for orders placed through the Companys website. The Company accrues
for estimated sales returns by customers based on historical sales return 6




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results. The Company records the sale of gift cards as a current liability and
recognizes a sale when a customer redeems a gift card. The amount of the gift
card liability is determined taking into account the Companys estimate of the
portion of gift cards that will not be redeemed or recovered (see Note 4). Shipping and Handling Revenues and Expenses  The Company accounts for shipping
and handling revenues and expenses in accordance with Emerging Issues Task
Force (EITF) Issue 00-10, Accounting for Shipping and Handling Fees and
Costs. All shipping and handling revenues and expenses relate to sales
activity generated from the Companys website. These amounts, which were
previously netted within selling, general and administrative expenses (SG&A) in
our third quarter earnings press release as filed on Form 8-K dated November 8,
2004, have been reclassified for purposes of this quarterly report on Form 10-Q
in accordance with EITF 00-10. Accordingly, amounts charged to the Companys
internet customers for shipping and handling revenues have been reclassified to
net sales. Amounts paid by the Company for internet shipping and handling
expenses have been reclassified to cost of goods sold and encompass payments to
third party shippers and costs to store, move and prepare merchandise for
shipment. A reconciliation of the reclassifications of shipping and handling
revenues and expenses for the periods presented is provided below: For the Third Quarter Ended
    
    For the Nine Months EndedOctober 30,
    
    November 1,
    
    October 30,
    
    November 1,2004
    
    2003
    
    2004
    
    2003Net sales per 8-K
    
    $
    329,083
    
    
    $
    281,253
    
    
    $
    849,011
    
    
    $
    713,976E-commerce shipping revenues
    
    
    364
    
    
    
    288
    
    
    
    1,075
    
    
    
    696Net sales as reported
    
    $
    329,447
    
    
    $
    281,541
    
    
    $
    850,086
    
    
    $
    714,672Gross margins per 8-K
    
    $
    118,880
    
    
    $
    100,617
    
    
    $
    297,272
    
    
    $
    244,305E-commerce net shipping costs
    
    
    (260
    )
    
    
    (117
    )
    
    
    (383
    )
    
    
    (220
    )Gross margins as reported
    
    $
    118,620
    
    
    $
    100,500
    
    
    $
    296,889
    
    
    $
    244,085SG&A per 8-K
    
    $
    67,993
    
    
    $
    61,358
    
    
    $
    192,004
    
    
    $
    170,499E-commerce net shipping costs
    
    
    (260
    )
    
    
    (117
    )
    
    
    (383
    )
    
    
    (220
    )SG&A as reported
    
    $
    67,733
    
    
    $
    61,241
    
    
    $
    191,621
    
    
    $
    170,279
 Customer Loyalty Programs -The Companys primary customer loyalty programs are
referred to as PacBucks for PacSun and PacSun Outlet stores and d.e.m.o.
Dollars for d.e.m.o. stores. The Company also has a customer loyalty discount
program related to its private label credit card. These programs offer
customers dollar-for-dollar discounts on future merchandise purchases within
stated redemption periods if they purchase specified levels of merchandise in a
current transaction. These programs are recorded as a direct reduction in net
sales upon redemption, which is generally within 30 days of the original
issuance. Cost of Goods Sold, including Buying, Distribution and Occupancy Costs  Cost
of goods sold includes the landed cost of merchandise and all expenses incurred
by the Companys buying and distribution functions. These costs include
inbound freight, purchasing and receiving costs, inspection costs, warehousing
costs, internal transfer costs, and any other costs borne by the Companys
buying department and distribution center. Occupancy costs include store
rents, common area charges, as well as store expenses related to telephone
service, supplies, repairs and maintenance, insurance, loss prevention, and
taxes and licenses. Selling, General and Administrative Expenses  Selling, general and
administrative expenses include payroll, depreciation and amortization,
advertising, credit authorization charges, expenses associated with the
counting of physical inventories, and all other general and administrative
expenses not directly related to merchandise or operating the Companys stores. Stock-Based Compensation  The Company accounts for stock-based compensation in
accordance with Accounting Principles Board (APB) Opinion No. 25 and,
accordingly, does not currently include compensation expense related to stock
options in reported net income. The Company follows the disclosure provisions
of Statement of Financial Accounting Standards No. 148 (SFAS 148),
Accounting 7




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for Stock-Based Compensation  Transition and Disclosure. SFAS 148 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 financial statements. The Company is
required to follow the prescribed disclosure format and has provided the
additional disclosures required by SFAS 148 for the third quarter and nine
months ended October 30, 2004 below. 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-pricing model
with the following ranges of weighted average assumptions: expected life, 5
years; stock volatility of 37.0% to 37.8% for fiscal 2004 and 40.4% to 53.7%
for fiscal 2003; risk-free interest rates of 3.3% to 3.7% for fiscal 2004 and
2.9% to 3.3% for fiscal 2003; 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 2004 and fiscal 2003 awards had been amortized to expense over the
vesting period of the awards, net income and earnings per share for the third
quarter and nine months ended October 30, 2004 and November 1, 2003,
respectively, would have been reduced to the pro forma amounts indicated below: For the Third Quarter Ended
    
    For the Nine Months EndedOctober 30,
    
    November 1,
    
    October 30,
    
    November 1,2004
    
    2003
    
    2004
    
    2003Net IncomeAs reported
    
    $
    31,897
    
    
    $
    24,509
    
    
    $
    66,196
    
    
    $
    45,867Deduct: Total stock-based
employee compensation
expense determined under
fair value based method for
all awards, net of related
tax effects
    
    
    (1,530
    )
    
    
    (1,437
    )
    
    
    (4,758
    )
    
    
    (4,515
    )Pro forma
    
    $
    30,367
    
    
    $
    23,072
    
    
    $
    61,438
    
    
    $
    41,352Net Income Per Share, BasicAs reported
    
    $
    0.43
    
    
    $
    0.32
    
    
    $
    0.87
    
    
    $
    0.60Deduct: Total stock-based
employee compensation
expense determined under
fair value based method for
all awards, net of related
tax effects
    
    
    (0.02
    )
    
    
    (0.02
    )
    
    
    (0.06
    )
    
    
    (0.06
    )Pro forma
    
    $
    0.41
    
    
    $
    0.30
    
    
    $
    0.81
    
    
    $
    0.54Net Income Per Share, DilutedAs reported
    
    $
    0.42
    
    
    $
    0.31
    
    
    $
    0.85
    
    
    $
    0.59Deduct: Total stock-based
employee compensation
expense determined under
fair value based method for
all awards, net of related
tax effects
    
    
    (0.02
    )
    
    
    (0.02
    )
    
    
    (0.06
    )
    
    
    (0.06
    )Pro forma
    
    $
    0.40
    
    
    $
    0.29
    
    
    $
    0.79
    
    
    $
    0.53
 Segment Reporting  The Company operates exclusively in the retail apparel
industry in which the Company distributes, designs and produces clothing,
accessories and related products catering to the teenage/young adult
demographic through primarily mall-based retail stores. The Company has
identified four operating segments (PacSun stores, PacSun Outlet stores,
d.e.m.o. stores, and e-commerce) as defined by SFAS 131, Disclosures about
Segments of an Enterprise and Related Information. The four operating
segments have been aggregated into one reportable segment based on the similar
nature of products sold, 8




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production, merchandising and distribution processes involved, target
customers, and economic characteristics among the four operating segments. New Accounting Pronouncements  In January 2003, the Financial Accounting
Standards Board (FASB) issued FIN 46, Consolidation of Variable Interest
Entities and in December 2003, issued FIN 46(R) (revised December 2003)
Consolidation of Variable Interest Entities  An Interpretation of ARB No.
51. 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 in the
entity 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. FIN
46(R) clarifies the application of ARB No. 51, Consolidated Financial
Statements, to certain entities in which equity 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 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. FIN
46(R) applies immediately to variable interest entities created after December
31, 2003, and to variable interest entities in which an enterprise obtains an
interest after that date. It applies no later than the first reporting period
ending after March 15, 2004, to variable interest entities in which an
enterprise holds a variable interest (other than special purpose) that it
acquired before January 1, 2004. FIN 46(R) applies to public enterprises as of
the beginning of the applicable interim or annual period. The adoption of FIN
46 and FIN 46(R) did not have a material impact on the Companys financial
position or results of operations because the Company has no interest in
variable interest entities. In March 2004, the Emerging Issues Task Force (EITF) reached a consensus on
EITF Issue No. 03-1 (EITF 03-1), The Meaning of Other-Than-Temporary
Impairment and Its Application to Certain Investments, for which the
measurement and recognition provisions are effective for reporting periods
beginning after June 15, 2004. EITF 03-1 provides a three-step process for
determining whether investments, including debt securities, are other than
temporarily impaired and requires additional disclosures in annual financial
statements. An investment is impaired if the fair value of the investment is
less than its cost. EITF 03-1 outlines that an impairment would be considered
other-than-temporary unless: a) the investor has the ability and intent to
hold an investment for a reasonable period of time sufficient for the recovery
of the fair value up to (or beyond) the cost of the investment, and b) evidence
indicating that the cost of the investment is recoverable within a reasonable
period of time outweighs evidence to the contrary. Although not presumptive, a
pattern of selling investments prior to the forecasted recovery of fair value
may call into question the investors intent. In addition, the severity and
duration of the impairment should also be considered in determining whether the
impairment is other-than-temporary. The adoption of EITF 03-1 did not have a
material impact on the Companys financial position or results of operations
because the Company has the ability and intent to hold all of its
held-to-maturity marketable securities until maturity. Reclassifications  Certain prior year amounts have been reclassified to
conform to the current year presentation. NOTE 3- DEFERRED COMPENSATION AND OTHER ASSETS The Company maintains an Executive Deferred Compensation Plan (the Executive
Plan) covering Company officers that is funded by participant contributions
and periodic Company discretionary contributions. The deferred compensation
asset balance represents the investments held by the Company to cover the
vested participant balances in the Executive Plan of $12,289 and $10,925
included in long-term liabilities as of October 30, 2004 and January 31, 2004,
respectively. 9




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##### Table of Contents



October 30,
    
    January 31,2004
    
    2004Deferred compensation
    
    $
    12,471
    
    
    $
    10,919Long-term computer maintenance contracts
    
    
    128
    
    
    
    502Other assets
    
    
    131
    
    
    
    168$
    12,730
    
    
    $
    11,589
 NOTE 4  ACCRUED LIABILITIES Accrued liabilities consist of the following: October 30,
    
    January 31,2004
    
    2004Accrued compensation and benefits
    
    $
    13,917
    
    
    $
    17,578Accrued capital expenditures
    
    
    9,245
    
    
    
    5,838Accrued sales tax payable
    
    
    5,608
    
    
    
    6,189Accrued gift cards and store merchandise credits
    
    
    2,703
    
    
    
    4,618Accrued medical expenses
    
    
    2,196
    
    
    
    1,260Accrued sublease loss charges (Note 8)
    
    
    1,700
    
    
    
    5,543Accrued restricted stock compensation (Note 6)
    
    
    659
    
    
    
    5,118Other
    
    
    11,197
    
    
    
    8,822$
    47,225
    
    
    $
    54,966
 NOTE 5  COMMON STOCK REPURCHASE AND RETIREMENT The CompanyBoard of Directors has authorized a common stock repurchase plan
in three separate authorizations. The Companys stock repurchase activity
under this plan is as follows: Maximum# of Shares
    
    
    
    
    
    Value ofPurchased
    
    
    
    
    
    Shares thatAverage
    
    as Part of
    
    
    
    
    
    May Yet bePrice
    
    Publicly
    
    Value of
    
    Purchased# of Shares
    
    Per Paid
    
    Announced
    
    Shares
    
    Under thePeriod
    
    Purchased
    
    Share
    
    Plan
    
    Purchased
    
    PlanAuthorization #1 (1)February 2004
    
    
    75.0
    
    
    $
    23.99
    
    
    
    75.0
    
    
    $
    1,799.3
    
    
    $
    48,200.7April 2004
    
    
    2,148.7
    
    
    $
    22.43
    
    
    
    2,148.7
    
    
    $
    48,195.4
    
    
    $
    5.3Total
    
    
    2,223.7
    
    
    $
    22.48
    
    
    
    2,223.7
    
    
    $
    49,994.7Authorization #2 (2)June 2004
    
    
    482.1
    
    
    $
    19.70
    
    
    
    482.1
    
    
    $
    9,495.3
    
    
    $
    15,504.7July 2004
    
    
    812.4
    
    
    $
    19.01
    
    
    
    812.4
    
    
    $
    15,440.6
    
    
    $
    64.1Total
    
    
    1,294.5
    
    
    $
    19.26
    
    
    
    1,294.5
    
    
    $
    24,935.9Authorization #3 (3)August 2004
    
    
    1,746.0
    
    
    $
    19.80
    
    
    
    1,746.0
    
    
    $
    34,570.8
    
    
    $
    15,429.2Grand Total
    
    
    5,264.2
    
    
    $
    20.80
    
    
    
    5,264.2
    
    
    $
    109,501.4
    
    
    $
    15,498.6
 (1) On January 28, 2004, the Company announced that the Board of Directors had
authorized the Company to purchase up to $50 million or 2.5 million shares of
the Companys common stock in open market transactions. There was no
expiration date specified for this authorization. During the first quarter of
fiscal 10




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##### Table of Contents



2004, the Company had substantially completed its repurchase and retirement of
shares pursuant to this authorization. (2) On May 10, 2004, the Company announced that the Board of Directors had
authorized the Company to purchase up to an additional $25 million of the
Companys common stock in open market transactions. There was no expiration
date specified for this authorization. During the second quarter of fiscal
2004, the Company had substantially completed its repurchase and retirement of
shares pursuant to this authorization. (3) On August 18, 2004, the Companys Board of Directors authorized the Company
to purchase up to an additional $50 million of the Companys common stock in
open market transactions. There was no expiration date specified for this
authorization. NOTE 6  RESTRICTED STOCK During the year ended January 30, 2000, 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 (CEO). The award was scheduled to vest 25% on each of
September 17, 2001, 2002, 2003 and 2004, if, in each instance, certain
cumulative annual earnings per share growth targets had been satisfied. Under
the award agreement, shares that did not vest at a given vesting date due to
the cumulative annual earnings per share growth targets not being met remained
available for future vesting if the cumulative annual earnings per share growth
targets were met as of a subsequent vesting date. During fiscal 2004, the
Companys Board of Directors verified that the final cumulative annual earnings
per share growth target for this award had been met. Accordingly, the CEO
became vested in and received the total share award of 112,500 shares during
fiscal 2004 and, as a result, the Company reclassified previously recognized
compensation expense of $2.6 million from accrued liabilities to additional
paid-in capital. During the year ended February 4, 2001, the Company granted a restricted stock
award of 168,750 shares with a purchase price of $0.01 per share to its CEO.
The award is scheduled to vest 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. 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 first quarter of fiscal 2004, the Companys Board of
Directors verified that the third cumulative annual earnings per share growth
target for this award had been met. Accordingly, the CEO became immediately
vested in and received 75% of the total share award, or 126,563 shares. The
remaining 25%, or 42,187 shares, will vest and be received by the CEO in March
2005 upon confirmation by the Board of Directors that the fiscal 2004
cumulative annual earnings per share growth target has been met by the Company.
As a result of the delivery of 126,563 shares to the CEO during the first
quarter of fiscal 2004, the Company reclassified previously recognized
compensation expense of $2.9 million from accrued liabilities to additional
paid-in capital. At October 30, 2004, the Company had accrued $0.7 million to
recognize the cumulative vested fair value of the remaining 42,187 shares.
This amount is included in accrued liabilities (see Note 4) on the balance
sheet. The Company will be required to account for these final 42,187 shares
under variable accounting rules, which will require adjustments to compensation
expense until the delivery date based on additional vesting of the shares and
changes in the market price of the Companys stock. For example, based on the
market price of the Companys stock at October 30, 2004 of $23.44, the Company
would be required to record additional compensation expense of approximately
$0.3 million through March 15, 2005. Additionally, based on any change in the
market price of the Companys stock until the delivery date, the cumulative
compensation expense recognized for this portion of this award will continue to
be adjusted. 11




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##### Table of Contents



NOTE 7  NET INCOME PER SHARE, BASIC AND DILUTED The following table summarizes the computation of earnings per share: Third Quarter Ended: October 30, 2004
    
    November 1, 2003Per Share
    
    
    
    
    
    
    
    
    
    Per ShareNet Income
    
    Shares
    
    Amount
    
    Net Income
    
    Shares
    
    AmountBasic EPS:
    
    $
    31,897
    
    
    
    74,415,403
    
    
    $
    0.43
    
    
    $
    24,509
    
    
    
    77,685,516
    
    
    $
    0.32Diluted EPS:Effect of dilutive stock options
    
    
    
    
    
    
    1,504,048
    
    
    
    (0.01
    )
    
    
    
    
    
    
    2,190,910
    
    
    
    (0.01
    )$
    31,897
    
    
    
    75,919,451
    
    
    $
    0.42
    
    
    $
    24,509
    
    
    
    79,876,426
    
    
    $
    0.31
 Nine Months Ended: October 30, 2004
    
    November 1, 2003Per Share
    
    
    
    
    
    
    
    
    
    Per ShareNet Income
    
    Shares
    
    Amount
    
    Net Income
    
    Shares
    
    AmountBasic EPS:
    
    $
    66,196
    
    
    
    76,298,445
    
    
    $
    0.87
    
    
    $
    45,867
    
    
    
    76,031,944
    
    
    $
    0.60Diluted EPS:Effect of dilutive stock options
    
    
    
    
    
    
    1,697,611
    
    
    
    (0.02
    )
    
    
    
    
    
    
    2,290,274
    
    
    
    (0.01
    )$
    66,196
    
    
    
    77,996,056
    
    
    $
    0.85
    
    
    $
    45,867
    
    
    
    78,322,218
    
    
    $
    0.59
 Options to purchase 1,128,234 and 2,073 shares of common stock in the third
quarter of fiscal 2004 and fiscal 2003, respectively, and 961,022 and 14,335
shares of common stock in the first nine months of fiscal 2004 and fiscal 2003,
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 8  COMMITMENTS AND CONTINGENCIES Litigation  During fiscal 2003, the Company reached an agreement to settle all
claims related to two lawsuits concerning overtime pay for a total of $4.0
million. The suits were Auden v. Pacific Sunwear of California, Inc., which
was filed September 17, 2001, and Adams v. Pacific Sunwear of California, Inc.,
which was filed November 1, 2002. The complaints alleged that the Company
improperly classified certain California based employees as exempt from
overtime pay. In the first quarter of fiscal 2004, the Company paid
substantially all amounts due pursuant to the terms of the settlement
agreement. The settlement did not have a material impact on the Companys
results of operations for fiscal 2004 or fiscal 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 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
Company has issued guarantees in the form of commercial letters of credit as
security for merchandise shipments from overseas. There were $32.7 million of
these letters of credit outstanding at October 30, 2004. The Company remains
secondarily liable under a guarantee within a sublease on one of its former
store locations should the sublessee default on its lease payments. The term
of the sublease ends December 31, 2014. At October 30, 2004, the Company had
$0.4 million recorded in accrued liabilities to recognize the estimated fair
value of this guarantee assuming that another sublessee would be found within
one year 12




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##### Table of Contents



should the original sublessee default. The aggregate rental payments remaining
on the master lease agreement at October 30, 2004, were $5.6 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 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. Sublease Loss Charges  During the second quarter of fiscal 2004, the Company
executed a lease termination agreement related to the Companys former
corporate offices and distribution center that resulted in the Company
reversing $0.9 million in previously accrued liabilities. The Company retains
no future obligations regarding these premises. The Company remains liable under an operating lease covering a former store
location. The Company has subleased 3,200 of a total 5,200 square feet of
these premises. At October 30, 2004, the Company had $1.7 million recorded in
accrued liabilities to account for the Companys net remaining contractual
lease obligations for this location, which includes estimated sublease
assumptions for the remaining 2,000 square feet. The Company continues to
update its sublease assumptions on a quarterly basis based on its review of
current real estate market conditions and any on-going negotiations. To the
extent managements estimates relating to the Companys ability to sublease
these facilities at the assumed rates or within the assumed timeframes changes
or is incorrect, additional charges or reversals of previous charges may be
recorded in the future. At October 30, 2004, the gross remaining obligations
under the Companys original lease, exclusive of any sublease income, were
approximately $6.3 million. 13




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##### Table of Contents



ITEM 2  MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF CONSOLIDATED OPERATIONS The following Managements Discussion and Analysis of Financial Condition and
Results of Consolidated Operations should be read in conjunction with the
Condensed Consolidated Financial Statements and Notes thereto of the Company
included elsewhere in this Form 10-Q. This discussion contains forward-looking
statements that involve risks and uncertainties. The Companys actual results
could differ materially from those anticipated in these forward-looking
statements as a result of certain factors, including those set forth under
Cautionary Note Regarding Forward-Looking Statements and Risk Factors in this
section. Executive Overview Management of the Company considers the following items to be key performance
indicators in evaluating Company performance: Comparable (or same store) sales- Stores are deemed comparable stores on the
first day of the month following the one-year anniversary of their opening or
expansion/relocation. Management of the Company considers same store sales to
be an important indicator of current Company 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 generate greater operating leverage of expenses while negative same
store sales results negatively impact operating leverage. Same store sales
results also have a direct impact on the Companys total net sales, cash, and
working capital. Net merchandise margins- Management analyzes the components of net merchandise
margins, specifically initial markups and markdowns as a percentage of net
sales. Any inability to obtain acceptable levels of initial markups or any
significant increase in the Companys use of markdowns could have an adverse
impact on the Companys gross margin results and results of operations. Operating margin- Management views operating margin as a key indicator of the
Companys success. The key drivers of operating margins are comparable store
net sales, net merchandise margins, and the Companys ability to control
operating expenses. Operating margin as a percentage of net sales for the
first nine months of fiscal 2004 was 12.4% as compared to 10.3% for the first
nine months of fiscal 2003. For a discussion of the changes in the components
comprising operating margins, see Results of Operations in this section.
Full fiscal year operating margins for fiscal 2003, 2002 and 2001, were 12.3%,
9.6% and 6.5%, respectively. The first half of the Companys fiscal year
historically accounts for a smaller percentage of annual net sales and
operating margin as compared to the second half. The Companys highest
historical operating margin was 12.9% for fiscal 1999. Store sales trends- Management evaluates store sales trends in assessing the
operational performance of the Companys store expansion strategies. Important
store sales trends include average net sales per store and average net sales
per square foot. Average net sales per store (in thousands) for fiscal 2003,
2002 and 2001 were $1,229, $1,102 and $1,031, respectively. Average net sales
per square foot for the same years were $363, $330 and $321, respectively. Cash flow and liquidity (working capital)- Management evaluates cash flow from
operations, liquidity and working capital to determine the Companys short-term
operational financing needs. Management expects cash flows from operations
will be sufficient to finance operations without borrowing under the Companys
credit facility during the next twelve months. 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 14




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##### Table of Contents



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 delivery to and acceptance by the
customer for orders placed through the Companys website. The Company accrues
for estimated 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 event that the
actual rate of sales returns by customers increased significantly, the
Companys operational results could be adversely affected. The Company records
the sale of gift cards as a current liability and recognizes a sale when a
customer redeems a gift card. The amount of the gift card liability is
determined taking into account the Companys estimate of the portion of gift
cards that will not be redeemed or recovered. 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 primarily upon its
current rate of sale and the age of the item, among other factors. To the
extent that managements estimates differ from actual results, additional
markdowns may have to be recorded, which could reduce the Companys gross
margins and operating results. Evaluation of 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 the global economy, could
significantly impact managements decision to retain, dispose of, or idle
certain of its long-lived assets. Evaluation of Insurance Reserves- The Company is responsible for workers
compensation insurance claims up to a specified aggregate stop loss amount.
The Company maintains a reserve for estimated claims, both reported and
incurred but not reported, based on historical claims experience and other
estimated assumptions. Actual claims activity has historically been within
managements expectations and the reserves established. To the extent claims
experience or managements estimates change, additional charges may be recorded
in the future up to the aggregate stop loss amount for each policy year. Accrued Sublease Loss Charges- The Company remains liable under an operating
lease covering a former store location. The Company executed a sublease
covering 3,200 of the total 5,200 square feet of this location during the first
quarter of fiscal 2004. At October 30, 2004, the Company had $1.7 million
recorded in accrued liabilities to account for the Companys net remaining
contractual lease obligations for this location, which includes estimated
sublease assumptions for the remaining 2,000 square feet. The Company
continues to update its sublease assumptions on a quarterly basis based on its
review of current real estate market conditions and any on-going negotiations.
To the extent managements estimates relating to the Companys ability to
sublease these facilities at the assumed rates or within the assumed timeframes
changes or is incorrect, additional charges or reversals of previous charges
may be recorded in the future. At October 30, 2004, the gross remaining
obligations under the Companys original lease, exclusive of any sublease
income, were approximately $6.3 million. This amount is included in the
contractual obligations table within Managements Discussion and Analysis of
Financial Condition and 15




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##### Table of Contents



Results of Consolidated Operations. See Contractual Obligations within
Liquidity and Capital Resources. Income Taxes- Current income tax expense is the amount of income taxes
expected to be payable for the current year. The combined federal and state
income tax expense was calculated using estimated effective annual tax rates.
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. Evaluating the value of these assets is necessarily based
on the Companys judgment. 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. 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 8 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 this table: Third Quarter Ended
    
    Nine Months EndedOctober 30,
    
    November 1,
    
    October 30,
    
    November 1,2004
    
    2003
    
    2004
    
    2003Net sales
    
    
    100.0
    %
    
    
    100.0
    %
    
    
    100.0
    %
    
    
    100.0
    %Cost of goods sold, including
buying, distribution and
occupancy costs
    
    
    64.0
    %
    
    
    64.3
    %
    
    
    65.1
    %
    
    
    65.9
    %Gross margin
    
    
    36.0
    %
    
    
    35.7
    %
    
    
    34.9
    %
    
    
    34.1
    %Selling, general and
administrative expenses
    
    
    20.5
    %
    
    
    21.8
    %
    
    
    22.5
    %
    
    
    23.8
    %Operating income
    
    
    15.5
    %
    
    
    13.9
    %
    
    
    12.4
    %
    
    
    10.3
    %Interest income, net
    
    
    0.1
    %
    
    
    0.1
    %
    
    
    0.1
    %
    
    
    0.1
    %Income before income tax expense
    
    
    15.6
    %
    
    
    14.0
    %
    
    
    12.5
    %
    
    
    10.4
    %Income tax expense
    
    
    5.9
    %
    
    
    5.3
    %
    
    
    4.7
    %
    
    
    4.0
    %Net income
    
    
    9.7
    %
    
    
    8.7
    %
    
    
    7.8
    %
    
    
    6.4
    %
 The following table sets forth the Companys number of stores and total square
footage as of the dates indicated: October 30,
    
    November 1,2004
    
    2003PacSun stores
    
    
    734
    
    
    
    664Outlet stores
    
    
    84
    
    
    
    78d.e.m.o. stores
    
    
    159
    
    
    
    121Total stores
    
    
    977
    
    
    
    863Total square footage (in 000s)
    
    
    3,391
    
    
    
    2,937
 16




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##### Table of Contents



The third quarter (13 weeks) ended October 30, 2004 as compared to the third
quarter (13 weeks) ended November 1, 2003 Net Sales Net sales increased to $329.4 million for the third quarter of fiscal 2004 from
$281.5 million for the third quarter of fiscal 2003, an increase of $47.9
million, or 17.0%. The components of this $47.9 million increase in net sales
are as follows: Amount($million)
    
    Attributable to$20.8
    
    Net sales from 105 new stores opened in fiscal 2004 not yet included in the comparable store base16.9
    
    6.6% increase in comparable store net sales in the third quarter of fiscal 2004 compared
to the third quarter of fiscal 20036.9
    
    Net sales from stores opened in fiscal 2003 not yet included in the comparable store base4.2
    
    Other non-comparable sales (net sales from expanded or relocated stores not yet included
in the comparable store base and internet net sales, including shipping and handling
revenues)(0.9)
    
    5 closed stores in fiscal 2004 and 4 closed stores in fiscal 2003$47.9
    
    Total
 Of the 6.6% increase in comparable store net sales in the third quarter of
fiscal 2004, PacSun and PacSun Outlet comparable store net sales increased 6.8%
and d.e.m.o. comparable store net sales increased 4.8%. Total transactions per
comparable store were up 1% and the average sale transaction in a comparable
store was up 5%, primarily driven by a 4% increase in average retail prices per
unit. The increases in average retail prices were focused in
particular merchandise categories wherein the Company believed it had
strategic opportunities that allowed for such increases. Within PacSun and PacSun Outlet, comparable store net sales of girls and guys
merchandise increased 8% and 5%, respectively. Girls comparable store net
sales results were characterized by strength in sneakers, denim, skirts,
accessories, tees, knits, and fleece. Guys comparable store net sales results
were characterized by strength in sneakers, wovens, denim, tees, and fleece. Within d.e.m.o., comparable store net sales of girls merchandise increased 17%
while guys merchandise decreased 3%. Girls comparable store net sales
results were characterized by strength in denim, outerwear, knits, and tees.
Guys comparable store net sales results were characterized by weakness in
knits, fleece, and active hookups, partially offset by strength in wovens and
denim. The sales trend within d.e.m.o. was primarily driven by expanded
product offerings for girls, including accessories and footwear. Gross Margin Gross margin, after buying, distribution and occupancy costs, increased to
$118.6 million for the third quarter of fiscal 2004 from $100.5 million for the
third quarter of fiscal 2003, an increase of $18.1 million, or 18.0%. As a
percentage of net sales, gross margin was 36.0% for the third quarter of fiscal
2004 compared to 35.7% for the third quarter of fiscal 2003. The 0.3% increase
in gross margin as a percentage of net sales was attributable to leverage of
non-merchandise margin costs over higher total sales and improved merchandise
margins. Selling, General and Administrative Expenses Selling, general and administrative expenses increased to $67.7 million for the
third quarter of fiscal 2004 from $61.2 million for the third quarter of fiscal
2003, an increase of $6.5 million, or 10.6%. These expenses decreased to 20.5%
as a percentage of net sales in the third quarter of fiscal 2004 from 21.8% in
the third quarter of fiscal 2003. The components of this 1.3% net decrease in
selling, general and administrative expenses as a percentage of net sales were
as follows: 17




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%
    
    Attributable to(0.9) %
    
    Decrease in restricted stock expense to $0.4 million (0.1% of net
sales) for the third quarter of fiscal 2004 from $2.7 million
(1.0% of net sales) for the third quarter of fiscal 2003. During
the third quarter of fiscal 2003, a grant of restricted stock to
the Chief Executive Officer was reinstated in the amount of $2.1
million upon the Companys determination that the fiscal 2003
cumulative earnings per share growth target would be met (see Note
6 to the condensed consolidated financial statements). The
Company adjusts the amount of restricted stock expense quarterly
based on additional vesting of the restricted stock and changes in
the Companys stock price.(0.3) %
    
    Decrease in store closing expenses to $0.5 million (0.2% of net
sales) for the third quarter of fiscal 2004 from $1.4 million
(0.5% of net sales) for the third quarter of fiscal 2003,
primarily due to executing fewer store
relocations/expansions/closures in the third quarter of fiscal
2004 (3) versus the third quarter of fiscal 2003 (18)(0.1) %
    
    Decrease in other selling, general and administrative expenses as
a percentage of net sales to 20.2% for the third quarter of fiscal
2004 from 20.3% for the third quarter of fiscal 2003, primarily
due to leveraging these expenses over higher total sales. Other
selling, general and administrative expenses increased in absolute
dollars to $66.8 million for the third quarter of fiscal 2004
compared to $57.1 million for the third quarter of fiscal 2003,
primarily due to the addition of 105 new stores in fiscal 2004 as
well as increased sales volume(1.3)%
    
    Total
 Net Interest Income Net interest income was $0.4 million in the third quarter of fiscal 2004
compared to $0.2 million in the third quarter of fiscal 2003, an increase of
$0.2 million. Income Tax Expense Income tax expense was $19.4 million for the third quarter of fiscal 2004
compared to $15.0 million for the third quarter of fiscal 2003. The effective
income tax rate was 37.8% in the third quarter of fiscal 2004 and 37.9% in the
third quarter of fiscal 2003. The lower effective income tax rate for the
third quarter of fiscal 2004 was primarily attributable to a lower weighted
effective state income tax rate for the Company. The weighted effective state
income tax rate for the Company will vary depending on a number of factors,
such as differing income tax rates and net sales in the respective states. The nine months (39 weeks) ended October 30, 2004 as compared to the nine
months (39 weeks) ended November 1, 2003 Net Sales Net sales increased to $850.1 million for the first nine months of fiscal 2004
from $714.7 million for the first nine months of fiscal 2003, an increase of
$135.4 million, or 18.9%. The components of this $135.4 million increase in
net sales are as follows: Amount($million)
    
    Attributable to$55.1
    
    8.4% increase in comparable store net sales in the first nine months of fiscal 2004
compared to the first nine months of fiscal 200336.2
    
    Net sales from stores opened in fiscal 2003 not yet included in the comparable store base33.7
    
    Net sales from 105 new stores opened in fiscal 2004 not yet included in the comparable store baseOther non-comparable sales (net sales from expanded or relocated stores not yet included
in the comparable store base and internet net sales, including shipping and handling
revenues)(1.9)
    
    5 closed stores in fiscal 2004 and 4 closed stores in fiscal 2003$135.4
    
    Total
 18




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Of the 8.4% increase in comparable store net sales in the first nine months of
fiscal 2004, PacSun and PacSun Outlet comparable store net sales increased 8.8%
and d.e.m.o. comparable store net sales increased 4.7%. Total transactions per
comparable store were up 2% and the average sale transaction in a comparable
store was up 6%, due to 3% increases in average retail prices per unit as well
as the number of items per sale transaction. The increases in average retail prices were focused in
particular merchandise categories wherein the Company believed it had
strategic opportunities that allowed for such increases. Within PacSun and PacSun Outlet, comparable store net sales of guys and girls
merchandise increased 9% and 8%, respectively. Guys comparable store net
sales results were characterized by strength in sneakers, wovens, tees, denim,
accessories, and swimwear. Girls comparable store net sales results were
characterized by strength in sneakers, accessories, denim, knits, skirts,
shorts, swim, and tees. Within d.e.m.o., comparable store net sales of girls merchandise increased 20%
while guys merchandise decreased 4%. Girls comparable store net sales
results were characterized by strength in denim, outerwear, knits, tees, and
accessories. Guys comparable store net sales results were characterized by
weakness in knits, fleece, active hookups, and shorts, partially offset by
strength in wovens, denim, and active knits. The sales trend within d.e.m.o.
was primarily driven by expanded product offerings for girls, including
accessories and footwear. Gross Margin Gross margin, after buying, distribution and occupancy costs, increased to
$296.9 million for the first nine months of fiscal 2004 from $244.1 million for
the first nine months of fiscal 2003, an increase of $52.8 million, or 21.6%.
As a percentage of net sales, gross margin was 34.9% for the first nine months
of fiscal 2004 compared to 34.1% for the first nine months of fiscal 2003. The
0.8% increase in gross margin as a percentage of net sales was approximately
equally attributable to improved merchandise margins and leverage of
non-merchandise margin costs over higher total sales. Selling, General and Administrative Expenses Selling, general and administrative expenses increased to $191.6 million for
the first nine months of fiscal 2004 from $170.3 million for the first nine
months of fiscal 2003, an increase of $21.3 million, or 12.5%. These expenses
decreased to 22.5% as a percentage of net sales in the first nine months of
fiscal 2004 from 23.8% in the first nine months of fiscal 2003. The components
of this 1.3% net decrease in selling, general and administrative expenses as a
percentage of net sales were as follows: %
    
    Attributable to(0.6) %
    
    Decrease in restricted stock expense to $1.0 million (0.1% of net
sales) for the first nine months of fiscal 2004 from $4.8 million
(0.7% of net sales) for the first nine months of fiscal 2003.
During fiscal 2003, two grants of restricted stock to the Chief
Executive Officer were reinstated upon the Companys determination
that the fiscal 2003 cumulative earnings per share growth targets
would be met (see Note 6 to the condensed consolidated financial
statements)(0.2) %
    
    Decrease in store closing expenses to $1.6 million (0.2% of net
sales) for the first nine months of fiscal 2004 from $3.2 million
(0.4% of net sales) for the first nine months of fiscal 2003,
primarily due to the lease termination agreement related to the
Companys former corporate offices and distribution center; the
lease termination resulted in the Company reversing $0.9 million
in previously accrued liabilities (see Note 8 to the condensed
consolidated financial statements)(0.5) %
    
    Decrease in other selling, general and administrative expenses as
a percentage of net sales to 22.2% for the third quarter of fiscal
2004 from 22.7% for the third quarter of fiscal 2003, primarily
due to leveraging these expenses over higher total sales. Other
selling, general and administrative expenses increased in absolute
dollars to $189.0 million for the third quarter of fiscal 2004
compared to $162.3 million for the third quarter of fiscal 2003,
primarily due to the addition of 105 new stores in fiscal 2004 as
well as increased sales volume(1.3)%
    
    Total
 19




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Net Interest Income Net interest income was $1.2 million in the first nine months of fiscal 2004
compared to $0.3 million in the first nine months of fiscal 2003, an increase
of $0.9 million. This increase was primarily the result of higher average cash
and short-term investment balances as well as higher investment returns in the
first nine months of fiscal 2004 as compared to the first nine months of fiscal
2003. Income Tax Expense Income tax expense was $40.2 million for the first nine months of fiscal 2004
compared to $28.3 million for the first nine months of fiscal 2003. The
effective income tax rate was 37.8% in the first nine months of fiscal 2004 and
38.1% in the first nine months of fiscal 2003. The lower effective income tax
rate for the first nine months of fiscal 2004 was primarily attributable to a
lower weighted effective state income tax rate for the Company. The weighted
effective state income tax rate for the Company will vary depending on a number
of factors, such as differing income tax rates and net sales in the respective
states. Liquidity and Capital Resources The Company has financed its operations primarily from internally generated
cash flow, with occasional short-term and long-term borrowings and equity
financing in past years. The Companys primary capital requirements have been
for the construction costs of newly opened, remodeled, expanded or relocated
stores, net of landlord allowances, the financing of inventories and, in the
past, construction of corporate facilities. Management believes that the
Companys working capital, cash flows from operating activities and credit
facility will be sufficient to meet the Companys operating and capital
expenditure requirements for the next twelve months. Operating Cash Flows Net cash provided by operating activities was $54.1 million for the first
nine months of fiscal 2004 compared to $59.9 million for the first nine months
of fiscal 2003. The $5.8 million decrease in cash provided by operations in
the first nine months of fiscal 2004 as compared to the first nine months of
fiscal 2003 was attributable to the following: Amount($million)
    
    Attributable to$(10.0)
    
    Decrease in tax benefits from stock option exercises,
primarily due to fewer stock option exercises(9.5)
    
    Decrease in accrued liabilities, primarily due to the
payment of the Auden and Adams settlements of $4.0
million (see Note 8 to the condensed consolidated
financial statements), the payment of fiscal 2003
bonuses ($7.6 million) partially offset by fiscal 2004
bonus accruals ($4.4 million), the lease termination
covering the Companys former corporate offices and
distribution center which resulted in the reversal of
$0.9 million in previously recognized expenses (see Note
8 to the condensed consolidated financial statements),
and other items netting to a $1.4 million reduction in
accrued expenses(5.7)
    
    Decrease in deferred compensation accruals, primarily
due to the delivery of restricted stock to the Chief
Executive Officer in the amount of $5.5 million (see
Note 6 to the condensed consolidated financial
statements)(0.9)
    
    Other items netting to a cash flow decrease20.3
    
    Increase in net income$(5.8)
    
    Total
 20




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Working Capital Working capital at October 30, 2004 was $203.1 million compared to $243.0
million at January 31, 2004, a decrease of $39.9 million. The components of
this $39.9 million decrease in working capital were as follows: Amount($million)
    
    
Attributable to$(91.4
    )
    
    Decrease in cash and short-term investments, primarily
due to $109.5 million in common stock repurchases made
in the first nine months of fiscal 200433.3
    
    
    Increase in inventories, net of accounts payable,
primarily due to square footage growth of 15%7.7
    
    
    Decrease in accrued liabilities, primarily due to the
payment of the Auden and Adams settlements of $4.0
million (see Note 8 to the condensed consolidated
financial statements), the payment of fiscal 2003
bonuses ($7.6 million) partially offset by fiscal 2004
bonus accruals ($4.4 million), the lease termination
covering the Companys former corporate offices and
distribution center which resulted in the reversal of
$0.9 million in previously recognized expenses (see Note
8 to the condensed consolidated financial statements),
and other items netting to a $0.4 million increase in
accrued expenses3.0
    
    
    Decrease in accrued income taxes due to payment of
fiscal 2003 and 2004 income taxes and accrual of tax
benefits related to stock option exercises, partially
offset by fiscal 2004 income tax accruals7.5
    
    
    Other items netting to a working capital increase$(39.9
    )
    
    Total
 Investing Cash Flows Net cash used in investing activities in the first nine months of fiscal 2004
was $50.8 million compared to $38.1 million for the first nine months of fiscal
2003, an increase in cash used of $12.7 million. The components of the $50.8
million in cash used in investing activities in the first nine months of fiscal
2004 are as follows: Amount($million)
    
    Attributable to$(35.7)
    
    Construction costs of new, expanded and relocated stores(23.4)
    
    Purchases of short-term investments classified as held-to-maturity(5.0)
    
    Other capital expenditures, including computer hardware and software(4.5)
    
    Maintenance capital expenditures on existing stores17.8
    
    Maturities of short-term investments classified as held-to-maturity$(50.8)
    
    Total
 In the remainder of fiscal 2004, capital expenditures are expected to be
approximately $10-15 million, of which approximately $8-13 million will be for
opening new and relocated/expanded stores, and approximately $2 million will be
used for other capital expenditures, including maintenance capital on existing
stores and computer hardware and software. During the year ended January 28, 2006 (fiscal 2005), the Company plans to
open approximately 120 net new stores, of which approximately 70 will be PacSun
stores, approximately 10 will be PacSun Outlet stores, and approximately 40
will be d.e.m.o. stores. The Company also plans to expand or relocate
approximately 30-35 of its most productive stores to larger locations during
fiscal 2005. Based on the Companys current projected store opening and relocation/expansion
plans through fiscal 2007, the Companys capital resource needs for those
stores will be approximately as follows: 21




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2005
    
    2006
    
    2007
    
    TotalNumber of new and relocated
stores
    
    
    155
    
    
    
    175
    
    
    
    185
    
    
    
    515Estimated capital expenditures
(in 000s)
    
    $
    52,000
    
    
    $
    62,000
    
    
    $
    69,000
    
    
    $
    183,000
 The Company expects cash flows from operations to be sufficient to provide the
liquidity and resources necessary to achieve its stated store opening and
relocation/expansion goals through fiscal 2007. Cash flows from operations (in
thousands) for the first nine months of fiscal 2004 as well as for all of
fiscal 2003 and 2002 were $54,143, $151,647, and $76,623, respectively. The
Company has not entered into any material purchase commitments for capital
expenditures related to its store opening or relocation/expansion plans. The
average total cost to build new stores or expand or relocate stores will vary
in the future depending on various factors, including square footage, changes
in store design, local construction costs and landlord allowances. The Company has previously stated its goal to operate 1,400 stores by the end
of 2007 and that its existing corporate offices and distribution center would
be adequate to support those growth plans. If growth plans were to accelerate
or if the Companys previous assumptions regarding the adequacy of its existing
facilities were to be proven inaccurate, the Company may purchase additional
land and begin construction of a new, additional corporate office and a new,
additional distribution center at any time before the end of fiscal 2007. The
Company has initiated planning efforts to assess this possible future need.
Costs of this possible future construction are currently unknown. Costs to
construct the Companys current corporate offices and distribution center were
approximately $52 million and were incurred during fiscal 2000 and fiscal 2001. Financing Cash Flows Net cash used in financing activities in the first nine months of fiscal
2004 was $100.2 million compared to cash provided of $25.3 million for the
first nine months of fiscal 2003, an increase in cash used of $125.5 million.
The components of the $125.5 million increase in cash used in financing
activities in the first nine months of fiscal 2004 as compared to the first
nine months of fiscal 2003 were as follows: Amount($million)
    
    Attributable to$(109.5)
    
    Repurchases of common stock(16.3)
    
    Decrease in proceeds received from stock option exercises0.3
    
    Decrease in principal payments under long-term debt and capital lease obligations$(125.5)
    
    Total
 Common Stock Repurchase and Retirement  Information regarding the Companys
common stock repurchase plan is contained in Note 5 to the condensed
consolidated financial statements, which note is incorporated herein by this
reference. In its discretion, the Companys Board of Directors authorized the stock
repurchase plan as a means to reduce the Companys overall number of shares
outstanding, thereby providing greater value to the Companys shareholders
through increased earnings per share. The Company does not expect the impact
of stock repurchases to be significant to its overall liquidity needs as it
expects cash flows from operations to continue to be strong in the future. The
Company believes this is a prudent use of a portion of the $175.9 million in
cash and short-term investments available to it as of the end of fiscal 2003 in
order to enhance shareholder value. Credit Facility The Company has a credit facility with a bank, which expires April 1, 2007.
The credit facility provides for a $45.0 million line of credit (the Credit
Line) through March 31, 2005 to be used for cash advances, commercial letters
of credit and shipside bonds. The Credit Line increases to $50.0 million from
April 1, 22




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2005 through March 31, 2006, and $60.0 million from April 1, 2006 through
expiration on April 1, 2007. Interest on the Credit Line is payable monthly at
the banks prime rate (4.75% at October 30, 2004) 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 facility at
any time during the first nine months of fiscal 2004 or during fiscal 2003.
The Company had $32.7 million outstanding in letters of credit at October 30,
2004. 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 October 30, 2004, the Company
was in compliance with all of the credit facility covenants. A significant decrease in the Companys operating results could adversely
affect the Companys ability to maintain the required financial ratios under
the Companys credit facility. Required financial ratios include total
liabilities to tangible net worth, limitations on capital expenditures and
achievement of certain rolling four-quarter EBITDA requirements. If these
financial ratios are not maintained, the bank will have the option to require
immediate repayment of all amounts outstanding under the credit facility, if
any. The most likely result would be that the Company would renegotiate
certain terms of the credit agreement, obtain a waiver from the bank, or obtain
a new credit agreement with another bank, which may contain different terms. Contractual Obligations The Company has minimum annual rental commitments under existing store
operating leases, capital leases for computer equipment, and other long-term
debt obligations for multi-year computer maintenance contracts. In addition,
at any time, the Company is contingently liable for open letters of credit with
foreign suppliers of merchandise. At October 30, 2004, the Companys future
financial commitments under these arrangements were as follows: Payments Due by PeriodContractual Obligations
    
    
    
    Less than
    
    1-3
    
    3-5
    
    More than(in millions)
    
    Total
    
    1 year
    
    years
    
    years
    
    5 yearsOperating lease obligations
    
    $
    635.0
    
    
    $
    89.8
    
    
    $
    177.8
    
    
    $
    167.0
    
    
    $
    200.4Capital lease obligations
    
    
    2.0
    
    
    
    1.3
    
    
    
    0.7
    
    
    
    
    
    
    
    Long-term debt obligations
    
    
    0.5
    
    
    
    0.5
    
    
    
    
    
    
    
    
    
    
    
    Letters of credit
    
    
    32.7
    
    
    
    32.7
    
    
    
    
    
    
    
    
    
    
    
    Total
    
    $
    670.2
    
    
    $
    124.3
    
    
    $
    178.5
    
    
    $
    167.0
    
    
    $
    200.4
 The contractual obligations table above does not include common area
maintenance (CAM) charges, which are also a required contractual obligation
under the Companys store operating leases. In many of the Companys leases,
CAM charges are not fixed and can fluctuate significantly from year to year for
any particular store. Actual CAM expenses for the first nine months of each of
fiscal 2004 and fiscal 2003 were $44.2 million and $37.8 million, respectively.
The Company expects total CAM expenses to continue to increase as the number
of stores increases from year to year. Operating Leases  The Company leases its retail stores, former corporate
offices and distribution facilities, and certain equipment under operating
lease agreements expiring at various dates through December 2016.
Substantially all of the Companys retail store leases require the Company to
pay common area maintenance charges, insurance, property taxes and percentage
rent ranging from 5% to 7% based on sales volumes exceeding certain minimum
sales levels. The initial terms of such leases are typically eight to ten
years, many of which contain renewal options exercisable at the Companys
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. Most leases also contain cancellation or
kick-out clauses in the Companys favor that relieve the Company of any future
obligation under a lease if specified sales levels are not achieved by a
specified date. None of the Companys retail store leases contain purchase
options. 23




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The Company reviews the operating performance of its stores on an ongoing basis
to determine which stores, if any, to expand, relocate or close. The Company
closed four stores in fiscal 2003 and anticipates closing approximately four
stores in fiscal 2004. New Accounting Pronouncements Information regarding new accounting pronouncements is contained in Note 2 to
the condensed consolidated financial statements for the quarter ended October
30, 2004, which note is incorporated herein by this reference. Inflation The Company does not believe that inflation has had a material effect on
the results of operations in the recent past. There can be no assurance that
the Companys business will not be affected by inflation in the future. Seasonality and Quarterly Results The Companys business is seasonal by nature, with the Christmas and
back-to-school periods historically accounting for the largest percentage of
annual net sales. The Companys first quarter historically accounts for the
smallest percentage of annual net sales. In fiscal 2003, excluding sales
generated by new and relocated/expanded stores, the Christmas and
back-to-school periods together accounted for approximately 36% of the
Companys annual net sales and a higher percentage of the Companys operating
income. In fiscal 2003, excluding net sales generated by new and
relocated/expanded stores, approximately 43% of the Companys annual net sales
occurred in the first half of the fiscal year and approximately 57% in the
second half. The Companys quarterly results of operations may also fluctuate
significantly as a result of a variety of factors, including the timing of
store openings; the amount of revenue contributed by new stores; the timing and
level of markdowns; the timing of store closings, expansions and relocations;
competitive factors; and general economic conditions. Cautionary Note Regarding Forward-Looking Statements and Risk Factors This report on Form 10-Q contains forward-looking statements within the
meaning of Section 27A of the Securities Act of 1933 and Section 21E of the
Exchange Act, and the Company intends that such forward-looking statements be
subject to the safe harbors created thereby. The Company is hereby providing
cautionary statements identifying important factors that could cause the
Companys actual results to differ materially from those projected in
forward-looking statements of the Company herein. Any statements that express,
or involve discussions as to, expectations, beliefs, plans, objectives,
assumptions, future events or performance (often, but not always, through 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. All forward-looking statements included in this report, including
forecasts of fiscal 2004 planned new store openings and capital expenditures,
are based on information available to the Company as of the date hereof, and
the Company assumes no obligation to update or revise any such forward-looking
statements to reflect events or circumstances that occur after such statements
are made. Such uncertainties include, among others, the following factors: Merchandising/Fashion Sensitivity.The Companys success is largely dependent
upon its ability to gauge the fashion tastes of its customers and to provide
merchandise that satisfies customer demand in a timely manner. The Companys
failure to anticipate, identify or react appropriately in a timely manner to
changes in fashion trends could have a material adverse effect on the Companys
same store sales results, operating margins, financial condition and results of
operations. Misjudgments or unanticipated fashion changes could also have a
material adverse effect on the Companys image with its customers. 24




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Proprietary Brand Merchandise.Sales from proprietary brand merchandise
accounted for approximately 32% of net sales in fiscal 2003. The Company may
increase the percentage of net sales in proprietary brand merchandise in the
future, although there can be no assurance that the Company will be able to
achieve increases in proprietary brand merchandise sales as a percentage of net
sales. Because the Companys proprietary brand merchandise generally carries
higher merchandise margins than its other merchandise, the Companys failure to
anticipate, identify and react in a timely manner to fashion trends with its
proprietary brand merchandise, particularly if the percentage of net sales
derived from proprietary brand merchandise increases, may have a material
adverse effect on the Companys same store sales results, operating margins,
financial condition and results of operations. Fluctuations in Comparable Store Net Sales Results.The Companys comparable
store net sales results have fluctuated significantly in the past on a monthly,
quarterly, and annual basis, and are expected to continue to fluctuate in the
future. A variety of factors affect the Companys comparable store net sales
results, including changes in fashion trends, changes in the Companys
merchandise mix, calendar shifts of holiday periods, actions by competitors,
weather conditions and general economic conditions. The Companys comparable
store net sales results for any particular fiscal month, fiscal quarter or
fiscal year in the future may decrease. As a result of these or other factors,
the Companys future comparable store net sales results are likely to have a
significant effect on the market price of the Companys common stock. Expansion and Management of Growth.PacSuns continued growth depends to a
significant degree on its ability to open and operate stores on a profitable
basis and on managements ability to manage the Companys planned expansion.
The Company has previously announced plans to operate 1,400 stores by the end
of 2007, of which approximately 900 will be PacSun stores, approximately 100
will be PacSun Outlet stores, and approximately 400 will be d.e.m.o. stores.
The Companys planned expansion is dependent upon a number of factors,
including the ability of the Company to locate and obtain favorable store
sites, negotiate acceptable lease terms, obtain adequate supplies of
merchandise and hire and train qualified management level and other employees.
Factors beyond the Companys control may also affect the Companys ability to
expand, including general economic and business conditions affecting consumer
spending. There can be no assurance that the Company will achieve its planned
expansion, that such expansion will be profitable, or that the Company will be
able to manage its growth effectively. Any failure to manage growth could have
a material adverse effect on the Companys business, financial condition and
results of operations. Reliance on Key Personnel.The continued success of the Company is dependent
to a significant degree upon the services of its key personnel, particularly
its executive officers. The loss of the services of any member of senior
management could have a material adverse effect on the Companys business,
financial condition and results of operations. The Companys success in the
future will also be dependent upon the Companys ability to attract and retain
qualified personnel. The Companys inability to attract and retain qualified
personnel in the future could have a material adverse effect on the Companys
business, financial condition and results of operations. Dependence on Single Distribution Facility.The Companys distribution
functions for all of its stores and for internet sales are handled from a
single facility in Anaheim, California. Any significant interruption in the
operation of the distribution facility due to natural disasters, accidents,
system failures or other unforeseen causes would have a material adverse effect
on the Companys business, financial condition and results of operations.
There can be no assurance that the Companys corporate office and distribution
center will be adequate to support the Companys future growth. Internet Sales. The Companys internet operations are subject to numerous
risks that could have a material adverse effect on the Companys operational
results, including unanticipated operating problems, reliance on third party
computer hardware and software providers, system failures and the need to
invest in additional computer systems. Specific risks include: (i) diversion
of sales from PacSun stores; (ii) rapid technological change; (iii) liability
for online content; and (iv) risks related to the failure of the computer
systems that operate the website and its related support systems, including
computer viruses, telecommunication failures and electronic break-ins and
similar disruptions. In addition, internet operations involve risks which are
beyond the Companys control that could have a material adverse effect 25




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on the Companys operational results, including: (i) price competition
involving the items the Company intends to sell; (ii) the entry of the
Companys vendors into the internet business, in direct competition with the
Company; (iii) the level of merchandise returns experienced by the Company;
(iv) governmental regulation; (v) online security breaches; (vi) credit card
fraud; and (vii) competition and general economic conditions specific to the
internet, online commerce and the apparel industry. Economic Impact of Terrorist Attacks or War/Threat of War.The majority of the
Companys stores are located in regional shopping malls. Any threat of
terrorist attacks or actual terrorist events, particularly in public areas,
could lead to lower customer traffic in regional shopping malls. In addition,
local authorities or mall management could close regional shopping malls in
response to any immediate security concern. Mall closures, as well as lower
customer traffic due to security concerns, could result in decreased sales.
Additionally, war or the threat of war could significantly diminish consumer
spending, resulting in decreased sales for the Company. Decreased sales would
have a material adverse effect on the Companys business, financial condition
and results of operations. Reliance on Foreign Sources of Production.The Company purchases merchandise
directly in foreign markets for its proprietary brands. In addition, the
Company purchases merchandise from domestic vendors, some of which is
manufactured overseas. The Company does not have any long-term merchandise
supply contracts and its imports are subject to existing or potential duties,
tariffs and quotas. The Company faces competition from other companies for
production facilities and import quota capacity. The Company also faces a
variety of other risks generally associated with doing business in foreign
markets and importing merchandise from abroad, such as: (i) political
instability; (ii) enhanced security measures at United States ports, which
could delay delivery of imports; (iii) imposition of new legislation relating
to import quotas that may limit the quantity of goods which may be imported
into the United States from countries in a region that the Company does
business; (iv) imposition of duties, taxes, and other charges on imports; (v)
delayed receipt or non-delivery of goods due to the failure of foreign-source
suppliers to comply with applicable import regulations; (vi) delayed receipt or
non-delivery of goods due to organized labor strikes or unexpected or
significant port congestion at United States ports; and (vii) local business
practice and political issues, including issues relating to compliance with
domestic or international labor standards which may result in adverse
publicity. New initiatives may be proposed that may have an impact on the
trading status of certain countries and may include retaliatory duties or other
trade sanctions that, if enacted, would increase the cost of products purchased
from suppliers in countries that the Company does business with. The inability
of the Company to rely on its foreign sources of production due to any of the
factors listed above could have a material adverse effect on the Companys
business, financial condition and results of operations. Credit Facility Financial Covenants.A significant decrease in the Companys
operating results could adversely affect the Companys ability to maintain
required financial ratios under the Companys credit facility. Required
financial ratios include a rolling four-quarter EBITDA requirement, total
liabilities to tangible net worth ratio, and limitations on capital
expenditures. If these financial ratios are not maintained, the bank will have
the option to require immediate repayment of all amounts outstanding under the
credit facility, if any. The most likely result would be that the Company
would renegotiate certain terms of the credit agreement, obtain a waiver from
the bank, or obtain a new credit agreement with another bank, which may contain
different terms. Expensing of Stock Options.The FASB currently expects to issue a final
standard regarding equity-based compensation in the fourth quarter of 2004.
The FASBs existing exposure draft proposes that all publicly traded companies
begin recording compensation expense related to all unvested and newly granted
stock options prospectively for interim fiscal periods beginning after June 15,
2005. Currently, the Company includes such expenses on a pro forma basis in
the notes to the Companys quarterly and annual financial statements in
accordance with accounting principles generally accepted in the United States
of America and does not include compensation expense related to stock options
in the Companys reported earnings in the financial statements. When
accounting standards are changed to require the Company to expense stock
options, the Companys reported earnings would be lower under the new standard
in the second half of the fiscal year beginning January 30, 2005 and its stock
price could decline. 26




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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. However, managements assessment of the
Companys current litigation could change in light of the discovery of facts
with respect to legal actions pending against the Company not presently known
to the Company or determinations by judges, juries or other finders of fact
which do not accord with managements evaluation of the possible liability or
outcome of such litigation. Volatility of Stock Price.The market price of the Companys common stock has
fluctuated substantially in the past and there can be no assurance that the
market price of the common stock will not continue to fluctuate significantly.
Future announcements or management discussions concerning the Company or its
competitors, net sales and profitability results, quarterly variations in
operating results or comparable store net sales, changes in earnings estimates
by analysts or changes in accounting policies, among other factors, could cause
the market price of the common stock to fluctuate substantially. In addition,
stock markets have experienced extreme price and volume volatility in recent
years. This volatility has had a substantial effect on the market prices of
securities of many smaller public companies for reasons frequently unrelated to
the operating performance of the specific companies. ************* The Company cautions that the risk factors described above could cause actual
results or outcomes to differ materially from those expressed in any
forward-looking statements of the Company made by or on behalf of the Company.
Further, management cannot assess the impact of each such factor on the
Companys business or the extent to which any factor, or combination of
factors, may cause actual results to differ materially from those contained in
any forward-looking statements. 
 ITEM 3  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company is susceptible to market value fluctuations with regard to its
short-term investments. However, due to the relatively short maturity period
of those investments and the Companys intention to hold those investments
until maturity, the risk of material market value fluctuations is not expected
to be significant. To the extent the Company borrows under its credit facility, the Company is
exposed to market risk related to changes in interest rates. At October 30,
2004, there were no borrowings outstanding under the Companys credit facility
and the Company did not borrow under the credit facility at any time during the
first nine months of fiscal 2004. Based on the interest rate of 4.75% on the
Companys credit facility, if interest rates on the credit facility were to
increase by 10%, and to the extent borrowings were outstanding, for every
$1,000,000 outstanding on the Companys credit facility, net income would be
reduced by approximately $3,000 per year. For a discussion of the Companys
accounting policies for financial instruments and further disclosures relating
to financial instruments, see Summary of Significant Accounting Policies and
Nature of Business in the Notes to Consolidated Financial Statements in the
Companys Form 10-K for the year ended January 31, 2004. The Company is not a
party with respect to derivative financial instruments. 
 ITEM 4  CONTROLS AND PROCEDURES As of the end of the period covered by this report, the Chief Executive Officer
and the Principal Financial and Accounting Officer of the Company
(collectively, the certifying officers) evaluated the effectiveness of the
Companys disclosure controls and procedures (as such term is defined in Rules
13a-15(e) and 15d-15(e) under the Exchange Act). These disclosure controls and
procedures are designed to ensure that the information required to be disclosed
by the Company in its periodic reports filed with the Commission is recorded,
processed, summarized and reported within the time periods specified by the
Commissions rules and forms, and that the information is communicated to the
certifying officers on a timely basis. 27




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The certifying officers concluded, based on their evaluation, that the
Companys disclosure controls and procedures were effective for the Company as
of the end of the period covered by this report, taking into consideration the
size and nature of the Companys business and operations. No change in the Companys internal control over financial reporting occurred
during the last fiscal quarter that has materially affected, or is reasonably
likely to materially affect, the Companys internal control over financial
reporting. 
 PART II-OTHER INFORMATION 
 Item 1  Legal Proceedings For information regarding legal proceedings, see Litigation within Note 8 of
Notes to Condensed Consolidated Financial Statements, which is incorporated by
reference in response to this Item 1. 
 Item 2  Unregistered Sales of Equity Securities and Use of Proceeds For information on repurchases made during the first nine months of fiscal
2004, see Note 5 of Notes to Condensed Consolidated Financial Statements, which
is incorporated by reference in response to this Item 2. 
 Item 3  Defaults Upon Senior Securities- Not Applicable 
 Item 4  Submission of Matters to a Vote of Security Holders- Not Applicable 
 Item 5  Other Information- Not Applicable 
 Item 6  Exhibits Exhibit 10.1

Amended and Restated Pacific Sunwear of California, Inc.
Employee Stock Purchase Plan dated November 17, 2004Exhibit 10.2

Form of Performance-Based Bonus Award AgreementExhibit 10.3

Description of 2004 cash bonus arrangementsExhibit 31

Written statements of Greg H. Weaver and Gerald M. Chaney
pursuant to section 302 of the Sarbanes-Oxley Act of 2002.Exhibit 32

Written statement of Greg H. Weaver and Gerald M. Chaney
pursuant to section 906 of the
Sarbanes-Oxley Act of 2002.
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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: December 7, 2004
    
    /s/ GREG H. WEAVERGreg H. WeaverChairman of the Boardand Chief Executive Officer(Principal Executive Officer)Date: December 7, 2004
    
    /s/ GERALD M. CHANEYGerald M. ChaneySenior Vice President, ChiefFinancial Officer and Secretary(Principal Financial and Accounting Officer)
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Exhibit Index Exhibit 10.1

Amended and Restated Pacific Sunwear of California, Inc.
Employee Stock Purchase Plan dated November 17, 2004Exhibit 10.2

Form of Performance-Based Bonus Award AgreementExhibit 10.3

Description of 2004 cash bonus arrangementsExhibit 31

Written statements of Greg H. Weaver and Gerald M. Chaney
pursuant to section 302 of the Sarbanes-Oxley Act of 2002.Exhibit 32

Written statement of Greg H. Weaver and Gerald M. Chaney
pursuant to section 906 of the
Sarbanes-Oxley Act of 2002.
 30