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Why Reaction to Pacific Sunwear's Earnings Could Be a Buying Opportunity

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On Tuesday, traders were focusing on the fits and selling the stock. But this was creating an opportunity for long-term investors who focus on the positives.

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Editor's Note: Michael Brush is the editor of the stock newsletter Brush Up on Stocks and a weekly market columnist for MSN Money.

In the typical fashion of a long-term turnaround, teen apparel retailer Pacific Sunwear of California (PSUN) is making progress in fits and starts.

On Tuesday, traders were focusing on the fits, and selling the stock.

But this was creating an opportunity for long-term investors who focus on the positives and buy now for a possible double or more, as long as they have the patience to wait out a turnaround in progress.

Let's take a look at four "negatives" which came to light Monday as the company announced third-quarter earnings, and consider why they aren't really so bad.

First, Pacific Sunwear had been hoping that sales at stores open more than a year (same-store sales) would turn positive in the fourth quarter. It revised this down to project flat sales at best, and a possibly 5% decline for the fourth quarter. Investors don't like this kind of surprise. But it's not really a big deal, because turnarounds rarely play out smoothly. The company merely pushed a return to positive sales growth out to the first quarter.
Next, Pacific Sunwear revealed that sales in the first three weeks of November were slower than expected. This sounds bad. The beginning of a new trend? Such worries naturally make investors nervous. But a look at history suggests it might not be so ominous.

Last year, the same slowdown happened in November, but then sales gains after Thanksgiving were strong. Using that as a guide, we could see the same thing happen this year, especially given that consumer surveys show a lot of people intend to hit the stores this Black Friday and afterward, and certainly more than last year. The problem may be that Pacific Sunwear isn't really the kind of store consumers flock to when the weather turns colder in the autumn. So November can be weak. But it does have a history of posting strong holiday sales. So the early November slowdown is probably not a sign of lasting problems. "We think our stores and our assortments are compelling, and are eagerly awaiting Black Friday later this week," CEO Gary Schoenfeld told investors in a conference call Monday.

Third, the company had to cut prices to move denim and sweaters in the third quarter, and this hurt gross margins. But Pacific Sunwear thinks it is on track for "significant" margin improvements in the fourth quarter of one to four percentage points above last year's 22.6%, as discounting eases and the effects of cutting continue to kick in.

Finally, the company said that production costs are going up -- most likely due to higher cotton prices and wage inflation in countries where its goods are made. But it believes it can cut enough costs to offset this problem, by doing things like adjusting its product mix and production specs.

Now let's look at some of three outright positive signs from the third quarter that this turnaround is actually progressing well.

First, the company beat sales guidance for the quarter. It reported a sales decline of 3%, to $258 million, much better than guidance of 4%-9% sales declines. In other words, the turnaround continued to bring sales improvement throughout the year -- and remember, the trend is your friend as an investor. That 3% sales decline last quarter was preceded by a 10% decline in the second quarter, and a 15% in the quarter before that.

Second, the men's business has improved for five straight quarters now, and same store sales were positive in the past two quarters -- including gains in the mid-single digit last quarter. That's a big change. The women's clothing and accessories business has been improving as well, and the company now projects a return to sales growth there next quarter.

Third, the company guided down on overhead costs for the year. It now expects overhead to be around $300 million to $305 million, compared to earlier projections as high as $320 million. That's also much lower than the $340 million in overhead costs the year before. Progress in cutting costs is always a good thing in any turnaround.

All of these positive changes are happening because this turnaround is in the capable hands of Schoenfeld, who joined the Pacific Sunwear as CEO in June 2009. Schoenfeld successfully managed a turnaround at the shoe company Vans in the late 1990s. There, he helped produce a four-fold increase in sales and transform the company into a leading youth lifestyle brand.

It's important to note that the company is still tweaking its management team. This tells us there's plenty of room for improvement and upside in the stock, because the turnaround is still in the fairly early innings. The company just hired a new supply chain manager in September, and last month it hired a manager for its online efforts.

Now all eyes are on the spring season for a simple reason: Christine Lee, who is in charge of juniors' merchandising and design, only came on board early this year. So the spring season is really the first one where she will have an impact on the women's line-up. In other words, the spring's the thing for Pacific Sunwear investors, and if that turns out well I'd continue to hold the stock for another year or two for significant gains.


No positions in stocks mentioned.

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