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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 1934For the quarterly period ended May 1, 2004ORo
    
    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 o Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x      No o The number of shares outstanding of the registrants Common Stock, par value
$.01 per share, at May 18, 2004, was 76,660,850.




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PACIFIC SUNWEAR OF CALIFORNIA, INC. FORM 10-Q For the Quarter Ended May 1, 2004 Index PART I.
    
    FINANCIAL INFORMATION
    
    PageItem 1.
    
    Condensed Consolidated Financial Statements (unaudited):Condensed Consolidated Balance
Sheets as of May 1, 2004 and January 31, 2004
    
    
    3Condensed Consolidated Statements
of Income and Comprehensive Income for thefirst quarters ended May 1, 2004 and May 3, 2003
    
    
    4Condensed Consolidated Statements
of Cash Flows for the first quarters endedMay 1, 2004 and May 3, 2003
    
    
    5Notes to Condensed Consolidated Financial Statements
    
    
    6-11Item 2.
    
    Managements Discussion and
Analysis of Financial Conditionand Results of Operations
    
    
    12-22Item 3.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    22Item 4.
    
    Controls and Procedures
    
    
    22PART II.
    
    OTHER INFORMATIONItem 1.
    
    Legal Proceedings
    
    
    23Item 2.
    
    Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities
    
    
    23Item 3.
    
    Defaults Upon Senior Securities
    
    
    23Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    23Item 5.
    
    Other Information
    
    
    23Item 6.
    
    Exhibits and Reports on Form 8-K
    
    
    23SIGNATURE PAGE
    
    
    24EXHIBIT 31EXHIBIT 32EXHIBIT 99.1EXHIBIT 99.2EXHIBIT 99.3
  2




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PACIFIC SUNWEAR OF CALIFORNIA, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(unaudited)
(in thousands, except share amounts) ASSETS May 1,
    
    January 31,2004
    
    2004CURRENT ASSETS:Cash and cash equivalents
    
    $
    76,428
    
    
    $
    142,840Short-term investments
    
    
    50,104
    
    
    
    33,035Accounts receivable
    
    
    6,676
    
    
    
    5,194Merchandise inventories
    
    
    157,912
    
    
    
    147,751Prepaid expenses, includes $10,840 and $10,711 of prepaid rent, respectively
    
    
    16,861
    
    
    
    16,492Deferred income taxes
    
    
    8,224
    
    
    
    8,224Total current assets
    
    
    316,205
    
    
    
    353,536PROPERTY AND EQUIPMENT:Land
    
    
    12,156
    
    
    
    12,156Buildings and building improvements
    
    
    26,686
    
    
    
    26,686Leasehold improvements
    
    
    121,701
    
    
    
    119,210Furniture, fixtures and equipment
    
    
    182,537
    
    
    
    173,222Total property and equipment
    
    
    343,080
    
    
    
    331,274Less accumulated depreciation and amortization
    
    
    (134,091
    )
    
    
    (127,630
    )Net property and equipment
    
    
    208,989
    
    
    
    203,644OTHER ASSETS:Goodwill
    
    
    6,492
    
    
    
    6,492Deferred compensation and other assets
    
    
    12,801
    
    
    
    11,589Total other assets
    
    
    19,293
    
    
    
    18,081Total assets
    
    $
    544,487
    
    
    $
    575,261LIABILITIES AND SHAREHOLDERS EQUITYCURRENT LIABILITIES:Accounts payable
    
    $
    42,829
    
    
    $
    38,668Accrued liabilities
    
    
    51,187
    
    
    
    54,966Current portion of capital lease obligations
    
    
    1,018
    
    
    
    1,008Current portion of long-term debt
    
    
    892
    
    
    
    878Income taxes payable
    
    
    5,326
    
    
    
    15,024Total current liabilities
    
    
    101,252
    
    
    
    110,544LONG-TERM LIABILITIES:Long-term debt, net of current portion
    
    
    
    
    
    
    228Long-term capital lease obligations, net of current portion
    
    
    968
    
    
    
    1,227Deferred compensation
    
    
    12,041
    
    
    
    10,925Deferred rent
    
    
    12,281
    
    
    
    12,046Deferred income taxes
    
    
    11,529
    
    
    
    11,529Total long-term liabilities
    
    
    36,819
    
    
    
    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; 76,652,973 and
78,351,302 shares issued and outstanding, respectively
    
    
    767
    
    
    
    784Additional paid-in capital
    
    
    101,574
    
    
    
    138,877Retained earnings
    
    
    304,075
    
    
    
    289,101Total shareholders equity
    
    
    406,416
    
    
    
    428,762Total liabilities and shareholders equity
    
    $
    544,487
    
    
    $
    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 First Quarter EndedMay 1, 2004
    
    May 3, 2003Net sales
    
    $
    245,131
    
    
    $
    198,331Cost of goods sold, including buying, distribution and occupancy costs
    
    
    161,559
    
    
    
    134,476Gross margin
    
    
    83,572
    
    
    
    63,855Selling, general and administrative expenses
    
    
    59,951
    
    
    
    50,962Operating income
    
    
    23,621
    
    
    
    12,893Interest income, net
    
    
    457
    
    
    
    61Income before income tax expense
    
    
    24,078
    
    
    
    12,954Income tax expense
    
    
    9,104
    
    
    
    4,975Net income
    
    $
    14,974
    
    
    $
    7,979Comprehensive income
    
    $
    14,974
    
    
    $
    7,979Net income per share, basic
    
    $
    0.19
    
    
    $
    0.11Net income per share, diluted
    
    $
    0.19
    
    
    $
    0.10Weighted average shares outstanding, basic
    
    
    78,157,771
    
    
    
    74,524,548Weighted average shares outstanding, diluted
    
    
    80,146,144
    
    
    
    76,472,511
 See accompanying notes 4




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PACIFIC SUNWEAR OF CALIFORNIA, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
(in thousands) For the First Quarter EndedMay 1, 2004
    
    May 3, 2003CASH FLOWS FROM OPERATING ACTIVITIES:Net income
    
    $
    14,974
    
    
    $
    7,979Adjustments to reconcile net income to net cash provided by operating
activities:Depreciation and amortization
    
    
    9,475
    
    
    
    8,783Loss on disposal of equipment
    
    
    1,528
    
    
    
    326Tax benefits related to exercise of stock options
    
    
    2,488
    
    
    
    1,276Change in operating assets and liabilities:Accounts receivable
    
    
    (1,482
    )
    
    
    1,050Merchandise inventories
    
    
    (10,161
    )
    
    
    (11,450
    )Prepaid expenses
    
    
    (369
    )
    
    
    (614
    )Deferred compensation and other assets
    
    
    (96
    )
    
    
    666Accounts payable
    
    
    4,161
    
    
    
    (2,017
    )Accrued liabilities
    
    
    (2,129
    )
    
    
    (2,589
    )Income taxes payable and deferred income taxes
    
    
    (9,698
    )
    
    
    (4,262
    )Deferred rent
    
    
    235
    
    
    
    358Net cash provided by/(used in) operating activities
    
    
    8,926
    
    
    
    (494
    )CASH FLOWS FROM INVESTING ACTIVITIES:Purchases of property and equipment
    
    
    (16,348
    )
    
    
    (8,717
    )Increase in accrued capital expenditures
    
    
    3,203
    
    
    
    1,486Purchases of short-term investments
    
    
    (18,069
    )
    
    
    Maturities of short-term investments
    
    
    1,000
    
    
    
    Net cash used in investing activities
    
    
    (30,214
    )
    
    
    (7,231
    )CASH FLOWS FROM FINANCING ACTIVITIES:Repurchases of common stock
    
    
    (49,995
    )
    
    
    Proceeds from exercise of stock options
    
    
    5,334
    
    
    
    5,425Principal payments under capital lease obligations
    
    
    (249
    )
    
    
    (360
    )Principal payments under long-term debt obligations
    
    
    (214
    )
    
    
    (202
    )Net cash (used in)/provided by financing activities
    
    
    (45,124
    )
    
    
    4,863NET DECREASE IN CASH AND CASH EQUIVALENTS:
    
    
    (66,412
    )
    
    
    (2,862
    )CASH AND CASH EQUIVALENTS, beginning of period
    
    
    142,840
    
    
    
    36,438CASH AND CASH EQUIVALENTS, end of period
    
    $
    76,428
    
    
    $
    33,576SUPPLEMENTAL DISCLOSURES OF CASH FLOW
INFORMATION:Cash paid during the period for:Interest
    
    $
    38
    
    
    $
    78Income taxes
    
    $
    16,314
    
    
    $
    7,961
 Supplemental disclosures of non-cash transactions (in thousands): During the
first quarter ended May 1, 2004, the Company recorded an increase to additional
paid-in capital of $4,853 related to the issuance of restricted stock to
satisfy certain deferred compensation liabilities (see Note 6). See accompanying notes 5




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PACIFIC SUNWEAR OF CALIFORNIA, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited, all amounts in thousands unless otherwise indicated) NOTE 1  BASIS OF PRESENTATION The accompanying condensed consolidated financial statements are unaudited and
have been prepared in accordance with accounting principles generally accepted
in the United States of America (GAAP) for interim financial information and
with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X.
Accordingly, they do not include all of the information and footnotes required
by GAAP for complete financial statements. The condensed consolidated
financial statements include the accounts of Pacific Sunwear of California,
Inc. and its subsidiaries, Pacific Sunwear Stores Corp. and 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 first quarter of fiscal 2004 was the
13-week period ended May 1, 2004. The first quarter of fiscal
2003 was the 13-week period ended May 3, 2003. 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
first quarter ended May 1, 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
May 1, 2004, the market value of the Companys portfolio was $49.6 million,
consisting of corporate debentures of $23.4 million, U.S. agency debentures of
$17.8 million, corporate commercial paper of $4.4 million and U.S. Treasury
notes of $4.0 million. Stock Split  In August 2003, the Company effected a three-for-two stock
split. All share and per share amounts have been restated to give effect to
the stock split in prior periods. Stock-Based Compensation  The Company accounts for stock-based compensation in
accordance with Accounting Principles Board Opinion No. 25 (APB 25) and,
accordingly, does not currently include compensation expense related to stock
options in reported net income. The Company follows the disclosure provisions
of SFAS 148, Accounting 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
financials statements. The Company is required to follow the prescribed
disclosure format and has provided the additional disclosures required by SFAS
148 for the quarterly period ended May 1, 2004 below. 6




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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 weighted average assumptions: expected life, 5 years; stock
volatility, 37.8% for the first quarter of fiscal 2004 and 53.7% for the first
quarter of fiscal 2003; risk-free interest rates, 3.6% for fiscal 2004 and 2.9%
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 first quarter ended May
1, 2004 and May 3, 2003 would have been reduced to the pro forma amounts
indicated below: For the First Quarter EndedMay 1, 2004
    
    May 3, 2003Net IncomeAs reported
    
    $
    14,974
    
    
    $
    7,979Deduct: Total stock-based employee
compensation expense determined under fair
value based method for all awards, net of
related tax effects
    
    
    (1,558
    )
    
    
    (1,499
    )Pro forma
    
    $
    13,416
    
    
    $
    6,480Net Income Per Share, BasicAs reported
    
    $
    0.19
    
    
    $
    0.11Deduct: Total stock-based employee
compensation expense determined under fair
value based method for all awards, net of
related tax effects
    
    
    (0.02
    )
    
    
    (0.02
    )Pro forma
    
    $
    0.17
    
    
    $
    0.09Net Income Per Share, DilutedAs reported
    
    $
    0.19
    
    
    $
    0.10Deduct: Total stock-based employee
compensation expense determined under fair
value based method for all awards, net of
related tax effects
    
    
    (0.02
    )
    
    
    (0.01
    )Pro forma
    
    $
    0.17
    
    
    $
    0.09
 New Accounting Pronouncements  In January 2003, the 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 Accounting Research
Bulletin No. 51, Consolidated Financial Statements (ARB 51), 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 7




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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 December 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 Company believes that the adoption of FIN 46 and FIN 46(R) will not have a
material impact on its financial position or results of operations because the
Company has no interest in variable interest entities. 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, which is represented by the
deferred compensation liability of $12,041 and $10,925 in long-term liabilities
as of May 1, 2004 and January 31, 2004, respectively. May 1,
    
    January 31,2004
    
    2004Deferred compensation
    
    $
    12,201
    
    
    $
    10,919Long-term computer maintenance contracts
    
    
    420
    
    
    
    502Other assets
    
    
    180
    
    
    
    168$
    12,801
    
    
    $
    11,589
 NOTE 4  ACCRUED LIABILITIES Accrued liabilities consist of the following: May 1,
    
    January 31,2004
    
    2004Accrued compensation and benefits
    
    $
    11,349
    
    
    $
    17,578Accrued capital expenditures
    
    
    9,692
    
    
    
    6,489Accrued stock repurchase trades pending settlement
    
    
    7,121
    
    
    
    Accrued sublease loss charges (Note 8)
    
    
    5,159
    
    
    
    5,543Accrued sales tax payable
    
    
    4,047
    
    
    
    6,189Accrued gift cards and store merchandise credits
    
    
    2,389
    
    
    
    4,618Accrued restricted stock compensation (Note 6)
    
    
    670
    
    
    
    5,118Other
    
    
    10,760
    
    
    
    9,431$
    51,187
    
    
    $
    54,966
 NOTE 5  COMMON STOCK REPURCHASE AND RETIREMENT 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 plan, but as of May 1, 2004, the Company had
completed its repurchase and retirement of shares pursuant to this plan as
follows: # of Shares
    
    Maximum Value ofPurchased as Part
    
    Shares that May Yet# of Shares
    
    Average
    
    of Publicly
    
    be Purchased UnderPeriod
    
    Purchased
    
    Price/Share
    
    Announced Plan
    
    the PlanFebruary 2004
    
    
    75,000
    
    
    $
    23.99
    
    
    
    75,000
    
    
    $
    48,200,750April 2004
    
    
    2,148,700
    
    
    $
    22.43
    
    
    
    2,148,700
    
    
    $
    Total
    
    
    2,223,700
    
    
    $
    22.48
    
    
    
    2,223,700
 8




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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 plan. As of the date of this filing, the Company had
not made any repurchases of shares pursuant to this plan. 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 is 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 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 final
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 84,375 shares. The remaining 25%, or 28,125 shares, will
become fully vested and be delivered to the CEO on September 17, 2004. As a
result of the delivery of 84,375 shares to the CEO during the first quarter of
fiscal 2004, the Company reclassified previously recognized compensation expense
of $1.9 million from accrued liabilities to additional paid-in capital. At May
1, 2004, the Company had accrued $.5 million to recognize the cumulative vested
fair value of the remaining 28,125 shares to be delivered on September 17,
2004. This amount is included in accrued liabilities (see Note 4) on the
balance sheet. The Company will be required to account for these final 28,125
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 closing market price of the Companys stock at May 1, 2004 of
$21.60, the Company would be required to record additional compensation expense
of approximately $.1 million per quarter based on additional vesting of the
shares until September 17, 2004. 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. 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 May 1, 2004, the Company had accrued $.2 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 9




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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 May 1, 2004 of $21.60, the Company would
be required to record additional compensation expense of approximately $.2
million per quarter based on additional vesting of the shares until 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. NOTE 7  NET INCOME PER SHARE, BASIC AND DILUTED The following table summarizes the computation of EPS (all amounts in thousands
except share and per share amounts): First Quarter Ended:
    
    May 1, 2004
    
    May 3, 2003NetIncome
    
    Shares
    
    Per ShareAmount
    
    NetIncome
    
    Shares
    
    Per ShareAmountBasic EPS:
    
    $
    14,974
    
    
    
    78,157,771
    
    
    $
    0.19
    
    
    $
    7,979
    
    
    
    74,524,548
    
    
    $
    0.11Diluted EPS:Effect of dilutive stock options
    
    
    
    
    
    
    1,988,373
    
    
    
    (0.00
    )
    
    
    
    
    
    
    1,947,963
    
    
    
    (0.01
    )$
    14,974
    
    
    
    80,146,144
    
    
    $
    0.19
    
    
    $
    7,979
    
    
    
    76,472,511
    
    
    $
    0.10
 Options to purchase 735,152 and 291,366 shares of common stock in the first
quarter of fiscal 2004 and fiscal 2003, respectively, were not included in the
computation of diluted earnings per share because the option exercise price was
greater than the average market price of the Companys 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 August 2, 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. 10




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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 standby letters of credit as
security for merchandise shipments from overseas. There were $21.8 million of
these letters of credit outstanding at May 1, 2004. The Company has also
issued a guarantee within a sublease on one of its store locations under which
the Company remains secondarily liable on the sublease should the sublessee
default on its lease payments. The term of the sublease ends December 31,
2014. The Company has recorded $.4 million in accrued liabilities to recognize
the estimated fair value of this guarantee, assuming that another sublessee
would be found within one year should the original sublessee default. The
aggregate rental payments remaining on the master lease agreement at May 1,
2004, were $5.8 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  The Company remains liable under two operating leases
covering its former corporate offices and a former store location. These
facilities remain vacant at May 1, 2004. At May 1, 2004, the Company had $5.2
million recorded in accrued liabilities as compared to $5.5 at January 31,
2004, to account for the difference between the Companys remaining contractual
lease obligations and the rate and timeframe within which the Company expected
to be able to sublease these properties. As of May 1, 2004, the Company had
executed a sublease for the remaining term of the Companys lease covering
3,200 of the total 5,200 square feet of the former store location that
contained more favorable terms than the Companys estimated assumptions at the
end of fiscal 2003. 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 May
1, 2004, the aggregate remaining obligations under these leases were
approximately $5.1 million for the former corporate offices and approximately
$6.6 million for the former store location. These amounts are included in the
contractual obligations table within Management's Discussion and
Analysis of Financial Condition and Results of Consolidated
Operations. See Contractual Obligations within
Liquidity and Capital Resources. 11




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ITEM 2  MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF CONSOLIDATED OPERATIONS The following discussion should be read in conjunction with the Condensed
Consolidated Financial Statements and Notes thereto of the Company included
elsewhere in this Form 10-Q. The following Managements Discussion and
Analysis of Financial Condition and Results of Operations 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 for the first quarter of fiscal 2004 was
9.6% as compared to 6.5% for the first quarter of fiscal 2003. Full fiscal
year operating margins for fiscal 2003, 2002 and 2001, were 12.3%, 9.6% and
6.5%, respectively. The Companys first quarter historically accounts for the
smallest percentage of annual net sales and operating margin. 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, average net sales per
square foot, and average trend sales for new stores. 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. Cash flows from operations were significantly
higher in the first quarter of fiscal 2004 as compared to the first quarter of
fiscal 2003, primarily due to higher net income driven by the 12.7% comparable
store net sales increase in the first quarter of fiscal 2004. Management
expects cash flows from operations will be sufficient to finance operations
without borrowing under the Companys credit facility during fiscal 2004. 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 12




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##### Table of Contents



and liabilities at the date of the financial statements as well as the reported
revenues and expenses during the reported period. Actual results could differ
from these estimates. The accounting policies that the Company believes are
the most critical to aid in fully understanding and evaluating reported
financial results include the following: Revenue Recognition- Sales are recognized upon purchase by customers at the
Companys retail store locations or upon shipment for orders placed through the
Companys website. 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. 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. 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 estimates differ from actual results, additional
markdowns may have to be recorded, which could reduce the Companys gross
margins and operating results. Long-Lived Assets- In the normal course of business, the Company acquires
tangible and intangible assets. The Company periodically evaluates the
recoverability of the carrying amount of its long-lived assets (including
property, plant and equipment, and other intangible assets) whenever events or
changes in circumstances indicate that the carrying amount of an asset may not
be fully recoverable. Impairment is assessed when the undiscounted expected
future cash flows derived from an asset or asset group are less than its
carrying amount. Impairments are recognized in operating earnings. The
Company uses its best judgment based on the most current facts and
circumstances surrounding its business when applying these impairment rules to
determine the timing of the impairment test, the undiscounted cash flows used
to assess impairments, and the fair value of a potentially impaired asset.
Changes in assumptions used could have a significant impact on the Companys
assessment of recoverability. Numerous factors, including changes in the
Companys business, industry segment, and the global economy, could
significantly impact managements decision to retain, dispose of, or idle
certain of its long-lived assets. Goodwill and Other Intangible Assets- The Company evaluates the recoverability
of goodwill at least annually based on a two-step impairment test. The first
step compares the fair value of each reporting unit with its carrying amount,
including goodwill. If the carrying amount of a reporting unit exceeds fair
value, then the second step of the impairment test is performed to measure the
amount of any impairment loss. Fair value is determined based on estimated
future cash flows, discounted at a rate that approximates the Companys cost of
capital. Such estimates are subject to change and the Company may be required
to recognize impairment losses in the future. 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 two operating
leases covering its former corporate offices and a former store location.
These facilities remain vacant at May 1, 2004. At May 1, 2004, the Company had
$5.2 million recorded in accrued liabilities as compared to $5.5 million at
January 31, 2004, to account for the difference between the Companys remaining
contractual lease obligations and the rate and timeframe within which the
Company expected to be able to sublease these 13




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##### Table of Contents



properties. As of May 1, 2004, the Company had executed a sublease for the
remaining term of the Companys lease covering 3,200 of the total 5,200 square
feet of the former store location that contained more favorable terms than the
Companys estimated assumptions at the end of fiscal 2003. 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 May 1, 2004, the aggregate remaining
obligations under these leases were approximately $5.1 million for the former
corporate offices and approximately $6.6 million for the former store location.
These amounts are included in the contractual obligations table
within Liquidity and Capital Resources. See
Contractual Obligations therein. 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 for the quarter
ended May 1, 2004). 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: May 1,
    
    May 3,For the first quarter ended:
    
    2004
    
    2003Net sales
    
    
    100.0
    %
    
    
    100.0
    %Cost of goods sold (including buying, distribution
and occupancy costs)
    
    
    65.9
    
    
    
    67.8Gross margin
    
    
    34.1
    
    
    
    32.2Selling, general and administrative expenses
    
    
    24.5
    
    
    
    25.7Operating income
    
    
    9.6
    
    
    
    6.5Interest income, net
    
    
    0.2
    
    
    
    0.0Income before income tax expense
    
    
    9.8
    
    
    
    6.5Income tax expense
    
    
    3.7
    
    
    
    2.5Net income
    
    
    6.1
    %
    
    
    4.0
    %
 14




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##### Table of Contents



The following table sets forth the Companys number of stores and total square
footage as of the dates indicated: May 1,
    
    May 3,2004
    
    2003PacSun stores
    
    
    689
    
    
    
    625Outlet stores
    
    
    81
    
    
    
    74d.e.m.o. stores
    
    
    137
    
    
    
    109Total stores
    
    
    907
    
    
    
    808Square footage (in 000s)
    
    
    3,117
    
    
    
    2,721
 The first quarter (thirteen weeks) ended May 1, 2004 as compared to the first
quarter (thirteen weeks) ended May 3, 2003 Net Sales Net sales increased to $245.1 million for the first quarter of fiscal 2004 from
$198.3 million for the first quarter of fiscal 2003, an increase of $46.8
million, or 23.6%. The components of this $46.8 million increase in net sales
are as follows: Amount($million)
    
    Attributable to$23.4
    
    12.7% increase in comparable store net sales in the first quarter of fiscal 2004
compared to the first quarter of fiscal 200317.5
    
    Net sales from stores opened in fiscal 2003 not yet included in the comparable store base4.3
    
    Other non-comparable sales (net
sales from expanded or relocated stores not yet included in the comparable store base and internet net sales)1.9
    
    31 new stores opened in fiscal 2004 not yet included in the comparable store base(.3)
    
    1 closed store in fiscal 2004 and 4 closed stores in fiscal 2003$46.8
    
    Total
 Of the 12.7% increase in comparable store net sales in the first quarter of
fiscal 2004, PacSun and PacSun Outlet comparable store net sales increased
13.6% and d.e.m.o. comparable store net sales increased 6.0%. The increase in
comparable store net sales within PacSun and PacSun Outlet was primarily
attributable to increases in comparable store net sales of footwear,
accessories, young mens apparel and, to a lesser extent, juniors apparel. The
increase in comparable store net sales within d.e.m.o. was attributable to
increases in comparable store net sales of juniors apparel and accessories merchandise.
Retail prices of the Companys merchandise remained relatively unchanged in
the first quarter of fiscal 2004 compared to the first quarter of fiscal 2003
and had no significant impact on the net sales increase for the first quarter
of fiscal 2004. Gross Margin Gross margin, after buying, distribution and occupancy costs, increased to
$83.6 million for the first quarter of fiscal 2004 from $63.9 million for the
first quarter of fiscal 2003, an increase of $19.7 million, or 30.8%. As a
percentage of net sales, gross margin was 34.1% for the first quarter of fiscal
2004 compared to 32.2% for the first quarter of fiscal 2003. The components of
this 1.9% increase in gross margin as a percentage of net sales are as follows: %
    
    Attributable to1.3%
    
    Decrease in occupancy costs, primarily due to leveraging these costs over higher total sales.7%
    
    Increase in net merchandise margins, primarily due to a higher initial markup rate
partially offset by a higher markdown rate(.1)%
    
    Increase in distribution costs1.9%
    
    Total
 15




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##### Table of Contents



Selling, General and Administrative Expenses Selling, general and administrative expenses increased to $60.0 million for the
first quarter of fiscal 2004 from $51.0 million for the first quarter of fiscal
2003, an increase of $9.0 million, or 17.6%. These expenses decreased to 24.5%
as a percentage of net sales in the first quarter of fiscal 2004 from 25.7% in
the first quarter of fiscal 2003. The components of this 1.2% net decrease in
selling, general and administrative expenses as a percentage of net sales were
as follows: %
    
    Attributable to(.9)%
    
    Decrease in depreciation and other store expenses, primarily due to leveraging these
costs over higher total sales(.5)%
    
    Decrease in store payroll, primarily due to leveraging these costs over higher total sales(.1)%
    
    Net decrease in all other general and administrative expenses.3%
    
    Increase in store closing, expansion and relocation expenses(1.2)%
    
    Total
 Net Interest Income Net interest income was $.5 million in the first quarter of fiscal 2004
compared to $.1 million in the first quarter of fiscal 2003, an increase of $.4
million. This increase was primarily the result of higher average cash
balances in the first quarter of fiscal 2004 as compared to the first quarter
of fiscal 2003, primarily due to higher net income driven by the comparable
store net sales increases in the first quarter of fiscal 2004 and
last three quarters of fiscal 2003. Income Tax Expense Income tax expense was $9.1 million for the first quarter of fiscal 2004
compared to $5.0 million for the first quarter of fiscal 2003. The effective
income tax rate was 37.8% in the first quarter of fiscal 2004 and 38.4% in the
first quarter of fiscal 2003. The lower effective income tax rate for the
first 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. 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, net of landlord allowances, of newly opened,
remodeled, expanded or relocated stores as well as for the financing of
inventories. 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. 16




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##### Table of Contents



Operating Cash Flows Net cash provided by operating activities was $8.9 million for the first
quarter of fiscal 2004 compared to cash used of $.5 for the first quarter of fiscal
2003. The $9.4 million increase in cash provided by operations in the first
quarter of fiscal 2004 as compared to the first quarter of fiscal 2003 was
attributable to the following: Amount($million)
    
    Attributable to$7.5
    
    Increase in accounts payable leverage compared to the first quarter of fiscal 2003 (1)7.0
    
    Increase in net income.3
    
    Other items netting to a cash flow increase(5.4)
    
    Decrease in accrued income taxes primarily due to income tax payments, partially
offset by fiscal 2004 income tax accruals$9.4
    
    Total
 (1)Accounts payable as a percentage of inventories increased to 27.1% at May
1, 2004, as compared to 19.6% at May 3, 2003, primarily due to timing of
payments. The Companys success is largely dependent upon its ability to gauge the
fashion tastes of its customers and provide merchandise that satisfies customer
demand. Any inability to provide appropriate merchandise in sufficient
quantities in a timely manner could have a material adverse effect on the
Companys business, operating results, cash flows from operations and financial
condition. Any economic downturn that affects the retail industry as a whole
could also adversely affect the Companys business, operating results, cash
flows from operations and financial condition. Working Capital Working capital at May 1, 2004 was $215.0 million compared to $243.0 million at
January 31, 2004, a decrease of $28.0 million. The components of this $28.0
million decrease in working capital were as follows: Amount($million)
    
    Attributable to$(49.3)
    
    Decrease in cash and short-term investments, primarily due
to $50.0 million in stock repurchases in the first quarter
of fiscal 20049.7
    
    Decrease in accrued income taxes due to payment of fiscal
2003 income taxes and accrual of tax benefits related to
stock option exercises, partially offset by fiscal 2004
income tax accruals6.0
    
    Increase in inventories, net of accounts payable, due to
square footage growth of 15% and increases in inventories
in comparable stores4.9
    
    Decrease in accrued liabilities due to the issuance of
restricted stock to satisfy certain deferred compensation
liabilities (see Note 6 to the condensed consolidated
financial statements).7
    
    Other items netting to a working capital increase$(28.0)
    
    Total
 Investing Cash Flows Net cash used in investing activities in the first quarter of fiscal 2004 was
$30.2 million compared to $8.7 million for the first quarter of fiscal 2003, an
increase in cash used of $24.7 million. The components of the $30.2 million of
net cash used in investing activities in the first quarter of fiscal 2004 are
as follows: Amount($million)
    
    Attributable to$(18.1)
    
    Purchases of short-term investments classified as held-to-maturity(11.5)
    
    Construction costs of new, expanded and relocated stores(1.2)
    
    Maintenance capital expenditures on existing stores(.4)
    
    Other capital expenditures, including computer hardware and software1.0
    
    Maturities of short-term investments classified as held-to-maturity$(30.2)
    
    Total
 17




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##### Table of Contents



In the remainder of fiscal 2004, capital expenditures are expected to be
approximately $40 million, of which approximately $33 million will be for
opening new and relocated/expanded stores, and approximately $7 million will be
used for other capital expenditures, including maintenance capital on existing
stores and computer hardware and software. Financing Cash Flows Net cash used in financing activities in the first quarter of fiscal 2004
was $45.1 million compared to cash provided of $4.9 million for the first
quarter of fiscal 2003. The components of the $45.1 million of net cash used
in financing activities in the first quarter of fiscal 2004 were as follows: Amount($million)
    
    Attributable to$(50.0)
    
    Repurchases of common stock(.4)
    
    Principal payments under long-term debt and capital lease obligations5.3
    
    Proceeds received from stock option exercises$(45.1)
    
    Total
 Common Stock Repurchase and Retirement  Information regarding the Companys
common stock repurchase programs is contained in Note 5 to the condensed
consolidated financial statements, which note is incorporated herein by this
reference. 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, 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 (4.0% at May 1, 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 quarter of fiscal 2004 or fiscal 2003. The
Company had $21.8 million outstanding in letters of credit at May 1, 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 May 1, 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 require the Company to 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 leases,
the lease for its former corporate offices and distribution center, capital
leases for computer equipment, and other long-term debt obligations for
multi-year computer maintenance contracts. The Company leases all of its
retail store locations under operating leases. The Company leases equipment,
from time to time, under capital leases. In addition, at any time, the Company
is contingently liable for open letters of credit with foreign suppliers of
merchandise. At May 1, 2004, the Companys future financial commitments under
these arrangements were as follows: Contractual Obligations
(in millions) Payments Due by PeriodLess than
    
    1-3
    
    3-5
    
    More thanTotal
    
    1 year
    
    years
    
    years
    
    5 yearsOperating lease obligations
    
    $
    553.9
    
    
    $
    83.8
    
    
    $
    165.2
    
    
    $
    150.2
    
    
    $
    154.7Capital lease obligations
    
    
    2.0
    
    
    
    1.0
    
    
    
    1.0
    
    
    
    
    
    
    
    Long-term debt obligations
    
    
    0.9
    
    
    
    0.9
    
    
    
    
    
    
    
    
    
    
    
    Letters of credit
    
    
    21.8
    
    
    
    21.8
    
    
    
    
    
    
    
    
    
    
    
    Total
    
    $
    578.6
    
    
    $
    107.5
    
    
    $
    166.2
    
    
    $
    150.2
    
    
    $
    154.7
 18




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##### Table of Contents



The Company reviews the operating performance of its stores on an ongoing basis
to determine which stores, if any, to expand, relocate or close. Most leases
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. The Company closed four stores in fiscal
2003 and anticipates closing approximately five 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 May 1,
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, 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. 19




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Private Label Merchandise.Sales from private label merchandise accounted for
approximately 32% of net sales in fiscal 2003. The Company may increase the
percentage of net sales in private label merchandise in the future, although
there can be no assurance that the Company will be able to achieve increases in
private label merchandise sales as a percentage of net sales. Because the
Companys private label 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 private label
merchandise, particularly if the percentage of net sales derived from private
label 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.
As of May 1, 2004, the Company operated 907 stores, of which 689 were PacSun
stores, 81 were PacSun Outlet stores, and 137 were 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 new 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, 20




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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 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 private label 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; and (vi) 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 require the Company to
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. Stock Options.In March 2004, the FASB issued an exposure draft proposing that
all publicly traded companies begin recording compensation expense related to
all unvested stock options prospectively for fiscal years beginning after
December 15, 2004. The comment period on the exposure draft ends June 30,
2004. 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. If 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 fiscal
year beginning January 30, 2005 and its stock price could decline. 21




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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 May 1, 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 quarter of fiscal 2004. Based on the interest rate of 4.0% 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 $2,500 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 Chief Financial 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. 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. 22




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PART II-OTHER INFORMATION 
 Item 1  Legal Proceedings For information on 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  Changes in Securities, Use of Proceeds and Issuer Purchases of Equity
Securities For information on repurchases made during the first quarter, 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 a) The 2004 Annual Meeting of Shareholders of the Company was held on May 19,
2004. c) At the 2004 Annual Meeting, Sally Frame Kasaks, Thomas Murnane and Peter
Starrett were elected as Class I Directors of the Company for a two-year term
ending in 2006. The shareholders voted on and ratified the appointment of Deloitte & Touche LLP
as independent auditors for the Company for the year ending January 29, 2005. Voting at the 2004 Annual Meeting for the election of directors was as set
forth below. Each of the nominees identified below was elected a director. NAME
    
    VOTESCAST FOR
    
    VOTESWITHHELDClass I Directors:Sally Frame Kasaks
    
    
    69,579,344
    
    
    
    2,753,862Thomas Murnane
    
    
    70,361,933
    
    
    
    1,971,273Peter Starrett
    
    
    70,508,273
    
    
    
    1,824,933
 With respect to the ratification of the appointment of Deloitte & Touche LLP as
independent auditors for the Company for the year ended January 29, 2005,
69,062,159 votes were cast for approval, 1,976,280 votes were cast against,
1,294,767 votes abstained and there were zero broker non-votes. 
 Item 5  Other Information- Not Applicable 
 Item 6  Exhibits and Reports on Form 8-K Exhibit 31
    
    Written statements of Greg H. Weaver and Carl W. Womack pursuant to section 302 of the
Sarbanes-Oxley Act of 2002.Exhibit 32
    
    Written statement of Greg H. Weaver and Carl W. Womack pursuant to section 906 of the
Sarbanes-Oxley Act of 2002.Exhibit 99.1
    
    Amended and Restated Pacific Sunwear of California, Inc. 1999 Stock Award Plan dated March 24, 2004.Exhibit 99.2
    
    Amended and Restated Pacific Sunwear of California, Inc. Employee Stock Purchase Plan dated September 5, 2003.Exhibit 99.3
    
    First Amendment to Business Loan Agreement dated May 7, 2004, between the Company and Bank of America N.A.
 On March 2, 2004, the Company filed an 8-K furnishing a press release
announcing results of operations for the fourth quarter and fiscal year ended
January 31, 2004. 23




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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: May 19, 2004
    /s/   GREG H. WEAVERGreg H. WeaverChairman of the Board
and Chief Executive Officer
(Principal Executive Officer) Date: May 19, 2004
    /s/   CARL W. WOMACKCarl W. WomackSenior Vice President, Chief
Financial Officer and Secretary
(Principal Financial and Accounting Officer) 24




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EXHIBIT INDEX  Exhibit 31
    
    Written statements of Greg H. Weaver and Carl W. Womack pursuant to section 302 of the
Sarbanes-Oxley Act of 2002.Exhibit 32
    
    Written statement of Greg H. Weaver and Carl W. Womack pursuant to section 906 of the
Sarbanes-Oxley Act of 2002.Exhibit 99.1
    
    Amended and Restated Pacific Sunwear of California, Inc. 1999 Stock Award Plan dated March 24, 2004.Exhibit 99.2
    
    Amended and Restated Pacific Sunwear of California, Inc. Employee Stock Purchase Plan dated September 5, 2003.Exhibit 99.3
    
    First Amendment to Business Loan Agreement dated May 7, 2004, between the Company and Bank of America N.A.