Pacific Sunwear of California, Inc.

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

(Mark One)


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

For the quarterly period ended: May 5, 2007


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

Commission file number 0-21296

PACIFIC SUNWEAR OF CALIFORNIA, INC.

(Exact name of registrant as specified in its charter)


California (State of incorporation)		95-3759463 (I.R.S. Employer Identification No.)

3450 East Miraloma Avenue, Anaheim, CA 92806
(Address of principal executive offices and zip code)

(714) 414-4000
(Registrant’s telephone number)

•		Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o

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

Large Accelerated Filer þ Accelerated Filer o Non-Accelerated Filer o

•

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

On June 6, 2007, the registrant had 70,414,727 shares of Common Stock outstanding.

PACIFIC SUNWEAR OF CALIFORNIA, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(unaudited, all amounts in thousands except share amounts)


	May 5, 2007			February 3, 2007
ASSETS
CURRENT ASSETS:
Cash and cash equivalents	$	23,089		$	52,267
Marketable securities		19,600			31,500
Merchandise inventories		210,229			205,213
Other current assets		48,782			46,255

Total current assets		301,700			335,235

PROPERTY AND EQUIPMENT, NET:
Gross property and equipment		741,375			708,774
Less accumulated depreciation and amortization		(302,614	)		(287,888	)

Total property and equipment, net		438,761			420,886

Other Assets		18,158			17,122


TOTAL ASSETS	$	758,619		$	773,243


LIABILITIES AND SHAREHOLDERS’ EQUITY
CURRENT LIABILITIES:
Accounts payable	$	68,515		$	66,581
Other current liabilities		62,521			73,952

Total current liabilities		131,036			140,533

LONG-TERM LIABILITIES:
Deferred lease incentives		86,402			89,371
Deferred rent		30,107			30,619
Other long-term liabilities		11,189			9,367

Total long-term liabilities		127,698			129,357

Commitments and contingencies (Note 5)

SHAREHOLDERS’ EQUITY:
Preferred stock, $.01 par value; 5,000,000 shares authorized; none issued		—			—
Common stock, $.01 par value; 170,859,375 shares authorized; 69,608,546 and 69,560,077 shares issued and outstanding, respectively		696			696
Additional paid-in capital		7,996			5,783
Retained earnings		491,193			496,874

Total shareholders’ equity		499,885			503,353


TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY	$	758,619		$	773,243

See accompanying footnotes

PACIFIC SUNWEAR OF CALIFORNIA, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
AND COMPREHENSIVE INCOME
(unaudited)
(in thousands, except share and per share amounts)


	First Quarter Ended
	May 5, 2007			April 29, 2006
Net sales	$	320,585		$	299,888
Cost of goods sold, including buying, distribution and occupancy costs		237,717			202,606


Gross margin		82,868			97,282
Selling, general and administrative expenses		92,035			79,939


Operating (loss)/income		(9,167	)		17,343
Interest income		969			1,795


(Loss)/Income before income tax (benefit)/expense		(8,198	)		19,138
Income tax (benefit)/expense		(3,140	)		7,273


Net (loss)/ income	$	(5,058	)	$	11,865

Comprehensive (loss)/income	$	(5,058	)	$	11,865


Net (loss)/income per share, basic	$	(0.07	)	$	0.16

Net (loss)/income per share, diluted	$	(0.07	)	$	0.16


Weighted average shares outstanding, basic		69,578,259			73,144,277
Weighted average shares outstanding, diluted		69,578,259			73,711,710

See accompanying footnotes

PACIFIC SUNWEAR OF CALIFORNIA, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited, in thousands)


	First Quarter Ended
	May 5, 2007			April 29, 2006
CASH FLOWS FROM OPERATING ACTIVITIES:
Net (loss)/income	$	(5,058	)	$	11,865
Adjustments to reconcile net (loss)/income to net cash provided by operating activities:
Depreciation and amortization		18,736			16,905
Stock-based compensation		1,536			1,944
Tax benefits related to stock-based compensation		98			1,149
Excess tax benefits related to stock-based compensation		(81	)		—
Loss on disposal of property and equipment		464			6
Change in operating assets and liabilities:
Merchandise inventories		(5,016	)		(7,064	)
Other current assets		(2,527	)		413
Other assets		(1,036	)		(192	)
Accounts payable		1,934			(2,142	)
Other current liabilities		(16,123	)		(17,244	)
Deferred lease incentives		(2,969	)		690
Deferred rent		(512	)		487
Other long-term liabilities		1,198			(5,388	)

Net cash (used in)/provided by operating activities		(9,356	)		1,429

CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment		(32,358	)		(29,096	)
Purchases of available-for-sale marketable securities		(78,400	)		(163,150	)
Sales of available-for-sale marketable securities		90,300			177,750
Maturities of held-to-maturity marketable securities		—			10,516

Net cash used in investing activities		(20,458	)		(3,980	)

CASH FLOWS FROM FINANCING ACTIVITIES:
Repurchase and retirement of common stock		—			(38,162	)
Proceeds from exercise of stock options		579			3,637
Excess tax benefits related to stock-based compensation		81			—
Principal payments under capital lease obligations		(24	)		(242	)

Net cash provided by/(used in) financing activities		636			(34,767	)


NET (DECREASE) IN CASH AND CASH EQUIVALENTS:		(29,178	)		(37,318	)
CASH AND CASH EQUIVALENTS, beginning of period		52,267			95,185

CASH AND CASH EQUIVALENTS, end of period	$	23,089		$	57,867


SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid for interest	$	1		$	2
Cash paid for income taxes	$	10,882		$	18,032

SUPPLEMENTAL DISCLOSURES OF NON-CASH TRANSACTIONS:
Increase in non-cash property and equipment accruals	$	4,717		$	8,635

See accompanying footnotes

PACIFIC SUNWEAR OF CALIFORNIA, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
For the quarterly period ended May 5, 2007
(unaudited, all amounts in thousands except share and per share amounts unless otherwise indicated)

1. NATURE OF BUSINESS

Pacific Sunwear of California, Inc. and its subsidiaries (collectively, the “Company”) is a leading specialty retailer of everyday casual apparel, footwear and accessories designed to meet the needs of active teens and young adults. The Company operates three nationwide, primarily mall-based chains of retail stores, under the names “Pacific Sunwear” (as well as “PacSun”), “Pacific Sunwear Outlet” (as well as “PacSun Outlet”), and “demo.” Pacific Sunwear and Pacific Sunwear Outlet stores specialize in board-sport inspired casual apparel, footwear and related accessories catering to teens and young adults. demo specializes in fashion-focused street wear, including casual apparel, footwear and related accessories catering to teens and young adults. The Company also operates a new specialty footwear concept, One Thousand Steps, which currently has nine stores. One Thousand Steps stores specialize in fashion-forward footwear and accessories catering to young adults. In addition, the Company operates two e-commerce websites (www.pacsun.com and www.demostores.com) which sell PacSun and demo merchandise online, respectively, provide content and a community for its target customers, and provide information about the Company. The Company also operates a third website (www.onethousandsteps.com) that provides store location and product information for One Thousand Steps.

2. 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 Rules 5-02 and 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.). All intercompany transactions have been eliminated in consolidation.

In the opinion of management, all adjustments consisting only of normal recurring entries necessary for a fair presentation have been included. The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the 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 5, 2007 are not necessarily indicative of the results that may be expected for the fiscal year ending February 2, 2008 (“fiscal 2007”). 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 fiscal year ended February 3, 2007 (“fiscal 2006”).

3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Information regarding the Company’s significant accounting policies is contained in Note 1, “Nature of Business and Summary of Significant Accounting Policies,” to the consolidated financial statements in the Company’s annual report on Form 10-K for fiscal 2006. 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.

New Accounting Pronouncements — The Company adopted Financial Accounting Standards Board (“FASB”) Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes,” effective February 4, 2007. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in the financial statements in accordance with Statement of Financial Accounting Standards (“SFAS”) 109, “Accounting for Income Taxes.” This pronouncement prescribes a recognition threshold and measurement

process for recording in the financial statements uncertain tax positions taken or expected to be taken in the Company’s tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods and disclosure requirements for uncertain tax positions. For a discussion of the financial statement impacts resulting from the adoption of FIN 48, please see Note 10, “Income Taxes.”

The Company adopted Emerging Issues Task Force Issue No. 06-03 (“EITF 06-03”), “How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (that is, Gross versus Net Presentation),” effective February 4, 2007. The EITF reached a consensus that the presentation of taxes on either a gross or net basis is an accounting policy decision that requires disclosure. Sales taxes collected from the Company’s customers are and have been recorded on a net basis. The adoption of EITF 06-03 did not have an effect on the Company’s consolidated financial position or results of operations.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”). This new standard provides guidance for using fair value to measure assets and liabilities and information about the extent to which companies measure assets and liabilities at fair value, the information used to measure fair value, and the effect of fair value measurements on earnings. This framework is intended to provide increased consistency in how fair value determinations are made under various existing accounting standards which permit, or in some cases require, estimates of fair market value. SFAS 157 also expands financial statement disclosure requirements about a company’s use of fair value measurements, including the effect of such measures on earnings. The provisions of SFAS 157 are effective for financial statements issued for fiscal years beginning after November 15, 2007. While the Company is currently evaluating the provisions of SFAS 157, the adoption is not expected to have a material impact on its consolidated financial statements.

Marketable Securities — At May 5, 2007, marketable securities consisted of auction rate securities of $20 million, classified as available for sale.

4. CLOSURE OF UNDERPERFORMING DEMO STORES

On February 2, 2007, the Board of Directors of the Company approved management’s recommendation to close 74 underperforming demo stores (hereafter, referred to as the “demo closures”). The Company began inventory liquidation sales in the demo closures on March 4, 2007. As of May 5, 2007, 14 of these stores had been closed. As of the date of this filing, all 74 stores had been closed.

The operational results reported in the condensed consolidated financial statements for the quarter ended May 5, 2007 include the operations of the demo closures. A condensed summary of the operational results of the demo closures since the commencement of the inventory liquidation sales on March 4, 2007 and through the end of the Company’s first quarter ended May 5, 2007 is provided below:


Net sales	$	11,269
Gross margin, including occupancy		(339	)
Selling, general & administrative expenses		2,903
Pre-tax operating loss		(3,242	)

The operational results in the condensed summary above include only those expenses directly associated with the operations of the demo closures, including all related lease termination, agency fee and severance expenses. These results do not include any allocation of corporate expenses associated with demo merchandising or other corporate functions. Gross margin reported in the table above includes approximately $2 million in accrued lease termination obligations and approximately $1 million in additional inventory impairment charges associated with discounted inventory. Selling, general and administrative expenses also include approximately $1 million in agency fees incurred to the Company’s agent conducting the liquidation process, Hilco Merchant Resources LLC.

The Company expects to incur total lease termination and agency fee charges of approximately $15-18 million in the first half of fiscal 2007 as lease termination negotiations are finalized related to the demo closures. Actual charges could be significantly higher than the Company’s estimates. See “Litigation” within Note 11, “Commitments and Contingencies.”

5. SEGMENT REPORTING

The Company operates exclusively in the retail apparel industry in which the Company distributes, designs and produces clothing, accessories, footwear and related products catering to the teenage/young adult demographic through primarily mall-based retail stores. The Company has identified four operating segments (PacSun, PacSun Outlet, demo, and One Thousand Steps) as defined by SFAS 131, “Disclosures about Segments of an Enterprise and Related Information.” E-commerce operations for PacSun and demo are included in their respective operating segments. The four operating segments have been aggregated into three reportable segments (PacSun, demo and One Thousand Steps). Store counts for demo as of May 5, 2007 include 60 stores that have subsequently been closed (see Note 4). Information for the first quarters of each of fiscal 2007 and 2006 concerning each of the three reportable segments is set forth below (all amounts in thousands except store counts):


							One
First Quarter Ended							Thousand
May 5, 2007:	PacSun			demo			Steps			Corporate			Total
Net Sales	$	268,080		$	51,244		$	1,261			n/a		$	320,585
% of Total Sales		84	%		16	%		0	%		n/a			100	%
Comparable Store Sales %		0.5	%		(12.1	)%		1.8	%		n/a			(1.2	)%
Income/(Loss) before Income Taxes	$	31,492		$	(3,040	)	$	(847	)	$	(35,803	)	$	(8,198	)
Total Assets	$	428,133		$	89,508		$	13,325		$	227,653		$	758,619
Number of Stores		962			212			9			n/a			1,183
Square Footage (in 000s)		3,650			600			24			n/a			4,274


							One
First Quarter Ended							Thousand
April 29, 2006:	PacSun			demo			Steps			Corporate			Total
Net Sales	$	251,614		$	48,099		$	175			n/a		$	299,888
% of Total Sales		84	%		16	%		0	%		n/a			100	%
Comparable Store Sales %		(2.2	)%		1.0	%		n/a			n/a			(1.8	)%
Income/(Loss) before Income Taxes	$	44,899		$	4,221		$	(347	)	$	(29,635	)	$	19,138
Total Assets	$	418,361		$	98,354		$	6,089		$	249,986		$	772,790
Number of Stores		917			200			5			n/a			1,122
Square Footage (in 000s)		3,437			554			13			n/a			4,004

In the tables above, the “PacSun” reportable segment includes net sales generated from PacSun stores, PacSun Outlet stores and PacSun e-commerce. The “demo” reportable segment includes net sales generated from demo stores and demo e-commerce. The “One Thousand Steps” reportable segment includes net sales generated solely from One Thousand Steps stores. The “Corporate” column is presented solely to allow for reconciliation of store contribution and total asset amounts to consolidated income before income taxes and total assets. Store contribution amounts include only net sales, merchandise gross margins, and direct store expenses with no allocation of corporate overhead or distribution and merchandising costs.

6. STOCK-BASED COMPENSATION

The Company accounts for stock-based compensation in accordance with the provisions of SFAS 123(R), “Share-Based Payment.” Forfeitures are estimated at the date of grant based on historical rates and reduce the compensation expense to be recognized. The expected terms of options granted are derived from historical data on employee exercises. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the date of grant. Expected volatility is based primarily on the historical volatility of the Company’s stock. The Company records stock-based compensation expense using the graded vesting method over the vesting period, which is generally three to four years. The Company’s stock-based awards generally begin vesting one year after the grant date and, for stock options, expire in seven to ten years or three months after termination of employment with the Company. For the first quarter of fiscal 2007 and 2006, the fair value of the Company’s stock-based compensation awards, which includes stock options, non-vested shares, share appreciation rights and shares purchased under the Company’s employee stock purchase plan (“ESPP”), was determined using the following weighted average assumptions:


	First Quarter
	2007						2006
	Stock Awards			ESPP			Stock Awards			ESPP
Expected Life	4 years			0.5 years			5 years			0.5 years
Stock Volatility		35.6	%		31.9	%		46.6% — 48.7	%		35.4	%
Risk-free Interest Rates		4.5	%		5.0	%		4.6% — 4.9	%		4.5	%
Expected Dividends	None			None			None			None

Stock-based compensation expense for each of the first quarters of fiscal 2007 and 2006 was included in costs of goods sold for the Company’s buying and distribution employees ($0.5 million in both years) and in selling, general and administrative expense for all other employees ($0.9 million and $1.4 million, respectively).

A summary of stock option activity, including share appreciation rights, under the Company’s 2005 Performance Incentive Plan for the first quarter of fiscal 2007 is presented below:

Weighted-

Average

Aggregate

Average

Remaining

Intrinsic

Exercise

Contractual

Value

Stock Options/SARs

Shares

Price

Term (Yrs.)

($000s)

Outstanding at February 3, 2007

2,931,920

19.43

Granted

390,000

20.87

Exercised

(48,469

)

11.96

Forfeited or expired

(89,215

)

24.08

Outstanding at May 5, 2007

3,184,236

19.59

5.37

9,132

Vested and expected to vest at May 5, 2007

2,624,228

19.08

5.19

9,007

Exercisable at May 5, 2007

1,779,086

17.36

4.73

8,852

The weighted-average grant-date fair value of options granted during the first quarters of fiscal 2007 and 2006 was $7.18 and $10.96, respectively. The total intrinsic value of options exercised during the first quarters of fiscal 2007 and 2006 was $0.4 million and $3.8 million, respectively.

A summary of the status of the Company’s non-vested share awards during the first quarter of fiscal 2007 is presented below:


				Weighted-
				Average Grant-
Non-vested Shares	Shares			Date Fair Value
Outstanding at February 3, 2007		327,387		$	19.85
Granted		352,464			21.00
Vested		—			—
Forfeited		(21,240	)		19.95

Outstanding at May 5, 2007		658,611		$	20.47

As of May 5, 2007, the Company had approximately $18 million of compensation cost related to non-vested stock option and non-vested share awards, net of estimated forfeitures, not yet recognized. This compensation expense is expected to be recognized over a weighted average period of approximately 3.0 years.

7. NET (LOSS)/INCOME PER SHARE, BASIC AND DILUTED

The following table summarizes the computation of earnings per share (“EPS”):


	May 5, 2007								April 29, 2006
	Net								Net
First Quarter Ended:	Loss			Shares		EPS			Income		Shares		EPS
Basic EPS:	$	(5,058	)		69,578,259	$	(0.07	)	$	11,865		73,144,277	$	0.16
Diluted EPS:
Effect of dilutive stock options		—			—		(0.00	)		—		567,433		(0.00	)


	$	(5,058	)		69,578,259	$	(0.07	)	$	11,865		73,711,710	$	0.16

Options to purchase 1,958,122 and 1,856,067 shares of common stock in the first quarter of fiscal 2007 and 2006, 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.

8. OTHER CURRENT ASSETS

As of the dates presented, other current assets consisted of the following:


	May 5,		February 3,
	2007		2007
Prepaid expenses	$	28,844	$	27,748
Deferred income taxes		7,291		7,291
Non-trade accounts receivable		6,636		11,216
Income taxes receivable		6,011		—

Total other current assets	$	48,782	$	46,255

9. OTHER CURRENT LIABILITIES

As of the dates presented, other current liabilities consisted of the following:


	May 5,		February 3,
	2007		2007
Accrued capital expenditures	$	18,519	$	13,802
Accrued gift cards		10,415		14,007
Accrued compensation and benefits		9,608		15,529
Sales taxes payable		3,803		4,771
Income taxes payable		—		8,706
Other		20,176		17,137

Total other current liabilities	$	62,521	$	73,952

10. INCOME TAXES

Effective February 4, 2007, the Company adopted FIN 48, “Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement No. 109.” Upon adoption of FIN 48, the Company recorded additional income tax liabilities of $1.8 million, additional deferred income tax assets of $1.2 million, and a charge against retained earnings of $0.6 million representing the cumulative effect of the change in accounting principle. As of February 4, 2007, unrecognized income tax benefits totaled approximately $2.4 million. Of that amount, approximately $1.2 million represents the amount of unrecognized tax benefits that would, if recognized, favorably affect the Company’s effective income tax rate in any future periods. The Company does not anticipate that total unrecognized tax benefits will change significantly in the next twelve months.

Estimated interest and penalties related to the underpayment of income taxes are included in income tax expense and totaled less than $0.1 million for the first quarter of fiscal 2007. Accrued interest and penalties was approximately $0.7 million at both May 5, 2007 and February 4, 2007.

The Company files income tax returns in the U.S. federal jurisdiction and multiple other state and local jurisdictions. The Company is no longer subject to U.S. federal examinations for years prior to 2004 and, with few exceptions, is no longer subject to state and local examinations for years before 2002.

11. COMMITMENTS AND CONTINGENCIES

Litigation — The Company is involved from time to time in litigation incidental to its business. In connection with the Company’s recent closure of 74 demo stores, landlords have, in some instances, threatened or initiated actions alleging breach of the underlying store leases and seeking to recover remaining lease payments for the duration of the underlying leases. The Company is undertaking to reach agreements with landlords of the stores being closed to address its underlying lease obligations. The Company estimates that it will incur total lease termination and agency fee charges of approximately $15-18 million associated with the demo closures. Actual lease termination charges could be significantly higher than the Company’s estimates. The Company believes that the outcome of current and threatened litigation, including litigation relating to the demo store closures, will not likely have a material adverse effect on its results of operations or financial condition.

Letters of Credit — The Company has issued guarantees in the form of commercial letters of credit, of which there were approximately $25 million outstanding at May 5, 2007, as security for merchandise shipments from overseas. All in-transit merchandise covered by letters of credit is accrued for in accounts payable.

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 operations (“MD&A”) should be read in conjunction with the Company’s condensed consolidated financial statements and notes thereto included elsewhere in this Form 10-Q.

Cautionary Note Regarding Forward-Looking Statements

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 we intend that such forward-looking statements be subject to the safe harbors created thereby. We are hereby providing cautionary statements identifying important factors that could cause our 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 identifiable by the use of words or phrases such as “will result,” “expects to,” “will continue,” “anticipates,” “plans,” “intends,” “estimated,” “projects” and “outlook”) are not historical facts and may be forward-looking and, accordingly, such statements involve estimates, assumptions and uncertainties which could cause actual results to differ materially from those expressed in the forward-looking statements. All forward-looking statements included in this report, including forecasts of fiscal 2007 planned store closures and estimates of lease termination charges associated with the recent closure of 74 demo closure stores, are based on information available to us as of the date hereof, and we assume no obligation to update or revise any such forward-looking statements to reflect events or circumstances that occur after such statements are made.

Executive Overview

We consider the following items to be key 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. We consider 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 generally 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 our total net sales, cash, and working capital.

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

Operating margin — We view operating margin as a key indicator of our success. The key drivers of operating margins are comparable store net sales, net merchandise margins, and our ability to control operating expenses. During the first half of fiscal 2007, we expect to incur total estimated lease termination and agency fee charges of approximately $15-18 million associated with the 74 demo store closures, approximately $3 million of which was recognized as expense in the first quarter of fiscal 2007. These charges will continue to be recognized and paid as each lease termination is negotiated. Actual lease termination charges could differ materially from our estimates and could adversely affect results of operations for any or all fiscal quarters during fiscal 2007. For a discussion of the changes in the components comprising operating margins during the first quarter of fiscal 2007 and 2006, see “Results of Operations” in this section.

Store sales trends — We evaluate store sales trends in assessing the operational performance of our 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 millions) for fiscal 2006, 2005 and 2004 were $1.24, $1.31 and $1.29, respectively, and average net sales per square foot were $346, $371 and $374, respectively.

Cash flow and liquidity (working capital) — We evaluate cash flow from operations, liquidity and working capital to determine our short-term operational financing needs. Cash flows from operations for fiscal 2006, 2005 and 2004 (in millions) were $162, $184 and $143, respectively. We expect cash flows from operations will be sufficient to finance operations without borrowing under our credit facility during fiscal 2007.

Critical Accounting Policies

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

Recognition of Revenue — Sales are recognized upon purchase by customers at our retail store locations or upon delivery to and acceptance by the customer for orders placed through our websites. We accrue for estimated sales returns by customers based on historical sales return results. Actual return rates have historically been within our expectations and the reserves established. However, in the event that the actual rate of sales returns by customers increased significantly, our operational results could be adversely affected. We record the sale of gift cards as a current liability and recognize a sale when a customer redeems a gift card. The amount of the gift card liability is determined taking into account our estimate of the portion of gift cards that will not be redeemed or recovered (“gift card breakage”). Gift card breakage is recognized as revenue after 24 months, at which time the likelihood of redemption is considered remote based on our historical redemption data.

Valuation of Inventories — Merchandise inventories are stated at the lower of average cost or market utilizing the retail method. At any given time, inventories include items that have been marked down to management’s best estimate of their fair market value. We base 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 our estimates differ from actual results, additional markdowns may have to be recorded, which could reduce our gross margins and operating results.

Determination of Stock-Based Compensation Expense — Under the fair value recognition provisions of SFAS 123(R), “Share-Based Payment,” we recognize stock-based compensation net of an estimated forfeiture rate and only recognize compensation cost for those shares expected to vest using the graded vesting method over the requisite service period of the award.

Determining the appropriate fair value model and calculating the fair value of stock-based compensation awards require the input of highly subjective assumptions, including the expected life of the stock-based compensation awards and stock price volatility. We use the Black-Scholes option-pricing model to determine compensation expense. The assumptions used in calculating the fair value of stock-based compensation awards represent management’s best estimates, but the estimates involve inherent uncertainties and the application of management judgment. As a result, if factors change and we use different assumptions, our stock-based compensation expense could be materially different in the future.

Store Operating Lease Accounting — Rent expense from store operating leases represents one of the largest expenses incurred in operating our stores. We account for store rent expense in accordance with SFAS 13, “Accounting for Leases,” and FASB Technical Bulletin 85-3, “Accounting for Operating Leases with Scheduled Rent Increases.” Accordingly, rent expense under our store operating leases is recognized on a straight-line basis over the original term of each store’s lease, inclusive of rent holiday periods during store construction and excluding any lease renewal options. We expense pre-opening rent in accordance with

FASB Staff Position 13-1, “Accounting for Rental Costs Incurred during a Construction Period.” The Company accounts for landlord allowances received in connection with store operating leases in accordance with SFAS 13, “Accounting for Leases,” and FASB Technical Bulletin 88-1, “Issues Relating to Accounting for Leases.” Accordingly, all amounts received from landlords to fund tenant improvements are recorded as a deferred lease incentive liability, which is then amortized as a credit to rent expense over the related store’s lease term.

Evaluation of Long-Lived Assets — In the normal course of business, we acquire tangible and intangible assets. We periodically evaluate the recoverability of the carrying amount of our 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. The amount of impairment loss recognized is equal to the difference between the carrying value and the estimated fair value of the asset, with such estimated fair values determined using the best information available, generally the discounted future cash flows of the assets using a rate that approximates the Company’s weighted average cost of capital. Impairments are recognized in operating earnings. We use our best judgment based on the most current facts and circumstances surrounding our 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 our assessment of recoverability. Numerous factors, including changes in our business, industry segment, and the global economy, could significantly impact our decision to retain, dispose of, or idle certain of our long-lived assets.

The estimation of future cash flows from operating activities requires significant estimates of factors that include future sales growth and gross margin performance. If our sales growth, gross margin performance or other estimated operating results are not achieved at or above our forecasted level, the carrying value of certain of our retail stores may prove unrecoverable and we may incur additional impairment charges in the future.

Evaluation of Insurance Reserves — We are responsible for workers’ compensation and medical insurance claims up to a specified aggregate stop loss amount. We maintain reserves 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 our expectations and the reserves established. To the extent claims experience or our estimates change, additional charges may be recorded in the future up to the aggregate stop loss amount for each policy year.

Evaluation of Income Taxes — Current income tax expense is the amount of income taxes expected to be payable for the current reporting period. 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. We consider future taxable income and ongoing prudent and feasible tax planning in assessing the value of our deferred tax assets. Evaluating the value of these assets is necessarily based on our judgment. If we determined that it was more likely than not that the carrying value of these assets would not be realized, we would reduce the value of these assets to their expected realizable value through a valuation allowance, thereby decreasing net income. If we subsequently determined that the carrying value of these 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.

Evaluation of Litigation Matters — We are involved from time to time in litigation incidental to our business. We believe that the outcome of current litigation will not likely have a material adverse effect on our results of operations or financial condition and, from time to time, may make provisions for probable litigation losses. Depending on the actual outcome of pending litigation, charges in excess of any provisions could be recorded in the future, which may have an adverse effect on our operating results.

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:


	First Quarter Ended
	May 5,			April 29,
	2007			2006
Net sales		100.0	%		100.0	%
Cost of goods sold, including buying, distribution and occupancy costs		74.2			67.6

Gross margin		25.8			32.4
Selling, general and administrative expenses		28.7			26.6

Operating (loss)/income		(2.9	)		5.8
Interest income		0.3			0.6

(Loss)/Income before income tax (benefit)/expense		(2.6	)		6.4
Income tax (benefit)/expense		(1.0	)		2.4

Net (loss)/income		(1.6	)%		4.0	%

The following table sets forth the Company’s number of stores (by store concept and in total) and total square footage as of the dates indicated:


	May 5, 2007		April 29, 2006
PacSun stores		845		820
Outlet stores		117		97
demo stores		212		200
One Thousand Steps stores		9		5

Total stores		1,183		1,122

Square footage (in 000’s)		4,274		4,004

The store counts above include 60 remaining demo stores that we closed subsequent to May 5, 2007 (see Note 4 to the condensed consolidated financial statements).

The first quarter (thirteen weeks) ended May 5, 2007 as compared to the first quarter (thirteen weeks) ended April 29, 2006

Net Sales

Net sales increased to $321 million for the first quarter of fiscal 2007 from $300 million for the first quarter of fiscal 2006, an increase of $21 million, or 7%. The components of this $21 million increase in net sales are as follows:


$millions			Attributable to
$	21		Net sales from stores opened in fiscal 2006 not yet included in the comparable store base
	4		Other non-comparable sales (net sales from expanded or relocated stores not yet included in the comparable store base and internet net sales)
	(1	)	20 closed stores in fiscal 2007 and 3 closed stores in fiscal 2006
	(3	)	1.2% decrease in comparable store net sales in the first quarter of fiscal 2007 compared to the first quarter of fiscal 2006

$	21		Total

Of the (1.2)% decrease in comparable store net sales in the first quarter of fiscal 2007, PacSun and PacSun Outlet comparable store net sales increased a combined 0.5% while demo comparable store net sales decreased (12.1)%. In percentage terms, the average sale transaction in a comparable store was down mid-single digits, driven by a mid-single digit decrease in average unit retail prices and a low-single digit decrease in average units per transaction. Total transactions in a comparable store were up mid-single digits.

Within PacSun and PacSun Outlet, comparable store net sales of girls’ merchandise were up high-single digits while guys’ merchandise was down mid-single digits. Girls’ comparable store net sales results were characterized by strength in shorts, a new dress assortment, and woven and camisole tanks. Guys’ comparable store net sales results were characterized by weakness in accessories and footwear due to exiting various product categories, partially offset by strength in tees.

Within demo, comparable store net sales of guys’ merchandise were down mid-teens while net sales of girls’ merchandise were down high-single digits. Guys’ comparable store net sales results were characterized by weakness in denim and tees. Girls’ comparable store net sales results were characterized by weakness in accessories, capris and denim.

Gross Margin

Gross margin, after buying, distribution and occupancy costs, was $83 million for the first quarter of fiscal 2007 versus $97 million for the first quarter of fiscal 2006. As a percentage of net sales, gross margin was 25.8% for the first quarter of fiscal 2007 compared to 32.4% for the first quarter of fiscal 2006. The 6.6% decrease in gross margin as a percentage of net sales was primarily attributable to a higher markdown rate due to slower than expected net sales activity, particularly in the month of April, and a deleveraging of occupancy expenses as a result of the negative comparable store net sales result for the first quarter of fiscal 2007.

Selling, General and Administrative Expenses

Selling, general and administrative expenses increased to $92 million for the first quarter of fiscal 2007, up from $80 million for the first quarter of fiscal 2006, an increase of $12 million, or 15%. These expenses increased to 28.7% as a percentage of net sales in the first quarter of fiscal 2007 from 26.6% in the first quarter of fiscal 2006. The components of this 2.1% net increase in selling, general and administrative expenses as a percentage of net sales were as follows:


%		Attributable to
	0.9	Increase in store payroll of approximately $6 million, primarily due to the 104 new store additions during fiscal 2006 and the first quarter of fiscal 2007 and deleveraging these costs against the negative comparable store net sales result in the first quarter of fiscal 2007. In total, these payroll costs increased in absolute dollars to $44 million for the first quarter of fiscal 2007 from $38 million during the first quarter of fiscal 2006.
	0.5	Increase in depreciation expenses of approximately $3 million for the first quarter of fiscal 2007 compared to the first quarter of fiscal 2006, primarily due to the 104 new store additions during fiscal 2006 and the first quarter of fiscal 2007, as well as the impact of the Company’s store remodeling program in the first quarter of fiscal 2007.
	0.3	Increase in other selling expenses of $1 million attributable to the demo store closure activities previously announced (see Note 4 to the condensed consolidated financial statements).
	0.3	Increase in consulting expenses of $1 million associated with an ongoing strategic branding study in the first quarter of fiscal 2007.
	0.1	Net increase in all other selling, general and administrative expenses.

	2.1	Total

Net Interest Income

Net interest income was $1 million in the first quarter of fiscal 2007 compared to $2 million in the first quarter of fiscal 2006. This decrease was primarily the result of lower average cash and short-term investment balances in the first quarter of fiscal 2007 as compared to the first quarter of fiscal 2006 due to the negative same store sales and net loss sustained in fiscal 2007.

Income Tax (Benefit)/Expense

The Company recognized an income tax benefit of $3 million for the first quarter of fiscal 2007 compared to income tax expense of $7 million for the first quarter of fiscal 2006 due to the net loss sustained in the first quarter of fiscal 2007. The effective income tax rate was 38.3% in the first quarter of fiscal 2007 versus 38.0% in the first quarter of fiscal 2006. The increase in the effective income tax rate was primarily attributable to the expected stock-based compensation expense impacts of SFAS 123(R) and the impairment expenses recognized during the fourth quarter of fiscal 2006 associated with the demo closures. Our weighted average effective state income tax rate will vary over time depending on a number of factors, such as differing average income tax rates and net incomes in the respective states.

Liquidity and Capital Resources

We have historically financed our operations primarily from internally generated cash flow, with occasional short-term and long-term borrowings and equity financing in past years. Our primary capital requirements have been for the construction of newly opened, remodeled, expanded or relocated stores, the financing of inventories and, in the past, construction of corporate facilities. We believe that our working capital and cash flows from operating activities will be sufficient to meet our operating and capital expenditure requirements without borrowing under our credit facility for at least the next twelve months.

Operating Cash Flows

Net cash used in operating activities was $9 million for the first quarter of fiscal 2007 compared to cash provided of $1 million for the first quarter of fiscal 2006. The $10 million decrease in cash provided by operations in the first quarter of fiscal 2007 as compared to the first quarter of fiscal 2006 was attributable to the following:


$millions			Attributable to
$	(17	)	Decrease in net income.
	(4	)	Decrease in cash flows from deferred lease incentives due to fewer new store openings in the first quarter of fiscal 2007 (4) compared to the first quarter of fiscal 2006 (20).
	(3	)	Decrease in cash flows related to non-inventory current assets, primarily due to increased income tax receivable accruals, partially offset by quicker collection of other non-trade receivables.
	2		Increase in cash flows from all other assets and liabilities
	6		Increase in cash flows from accounts payable, net of inventory, due to timing of payments and reductions in overall inventory levels versus the first quarter of last year.
	6		Increase in cash flows related to deferred compensation liabilities due to lower cash disbursements in the first quarter of fiscal 2007 compared to the first quarter of fiscal 2006.

$	(10	)	Total

Working Capital

Working capital at May 5, 2007 was $171 million compared to $195 million at February 3, 2007, a decrease of $24 million. The changes in working capital were as follows:


$millions			Description
$	195		Working capital at February 3, 2007
	(28	)	Decrease in cash and marketable securities, net of income taxes and accounts payable, primarily due to capital expenditures and income tax payments, among other items (see cash flow statement).
	4		Net increase in working capital attributable to all other current assets and liabilities.

$	171		Working capital at May 5, 2007

Investing Cash Flows

Net cash used in investing activities in the first quarter of fiscal 2007 was $20 million compared to $4 million for the first quarter of fiscal 2006, an increase in cash used of $16 million. Investing cash flows for the first quarter of fiscal 2007 were comprised of capital expenditures of $32 million, partially offset by $12 million in net maturities of marketable securities. In the first quarter of fiscal 2006, the Company had capital expenditures of $29 million and net maturities of marketable securities of $25 million. The Company expects total capital expenditures for fiscal 2007 to be in the range of $100 million to $110 million.

Financing Cash Flows

Net cash provided by financing activities in the first quarter of fiscal 2007 was $0.6 million compared to cash used of $35 million in the first quarter of fiscal 2006. Substantially all of the cash provided in the first quarter of fiscal 2007 came from employee exercises of stock options. In the first quarter of fiscal 2006, the Company repurchased and retired common stock in the amount of approximately $38 million, partially offset by approximately $3 million in proceeds received from employee exercises of stock options.

Credit Facility

We have an unsecured $200 million credit agreement with a syndicate of lenders which expires September 14, 2010. The credit facility provides for a $200 million revolving line of credit that can be increased to up to $275 million at our option under certain circumstances. The credit facility is available for direct borrowing and the issuance of letters of credit with a portion also available for swing-line loans. Direct borrowings under the credit facility bear interest at the Administrative Agent’s alternate base rate (as defined, 5.8% at May 5, 2007) or at optional interest rates that are primarily dependent upon LIBOR for the time period chosen. We had no direct borrowings outstanding under the credit facility at May 5, 2007. The credit facility requires us to maintain certain financial covenants, all of which we were in compliance with as of May 5, 2007.

Contractual Obligations

We have minimum annual rental commitments under existing store leases and leases for computer equipment. We lease all of our retail store locations under operating leases and lease computer equipment predominantly under operating leases. In addition, at any time, we are contingently liable for commercial letters of credit with foreign suppliers of merchandise. The table below includes the lease agreements covering the 74 demo stores that we recently closed. In connection with the lease termination negotiations associated with these closures, we expect to incur total estimated lease termination and agency fee charges of approximately $15-18 million during the first half of fiscal 2007 in exchange for a release from all future obligations under the related leases. These charges will be recognized and paid as each lease termination is negotiated. Actual lease termination charges could differ materially from our estimates and could adversely affect results of operations for any or all fiscal quarters during fiscal 2007. At May 5, 2007, our future financial commitments under all existing contractual obligations were as follows:


	Payments Due by Period
Contractual Obligations			Less than						More than
(in millions)	Total		1 year		1-3 years		3-5 years		5 years
Operating lease obligations	$	720	$	111	$	213	$	178	$	218
Letters of credit		25		25		—		—		—

Total	$	745	$	136	$	213	$	178	$	218

The contractual obligations table above does not include common area maintenance (CAM) charges, which are also a required contractual obligation under our store operating leases. In many of our leases, CAM charges are not fixed and can fluctuate significantly from year to year for any particular store. Total store rental expenses, including CAM for fiscal 2006, 2005 and 2004 were $180 million, $161 million, and $138 million, respectively. We expect total CAM expenses to continue to increase as the number of stores increases from year to year.

Operating Leases — We lease our retail stores and certain equipment under operating lease agreements expiring at various dates through January 2019. Substantially all of our retail store leases require us to pay CAM 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 8 to 10 years, many of which contain renewal options exercisable at our discretion. Most leases also contain rent escalation clauses that come into effect at various times throughout the lease term. Rent expense is recorded under the straight-line method over the life of the lease. Other rent escalation clauses can take effect based on changes in primary mall tenants throughout the term of a given lease. Most leases also contain cancellation or kick-out clauses in our favor that relieve us of any future obligation under a lease if specified sales levels are not achieved by a specified date. None of our retail store leases contain purchase options.

We review the operating performance of our stores on an ongoing basis to determine which stores, if any, to expand, relocate or close. We closed six stores in fiscal 2006 and currently anticipate closing approximately 90-100 stores in fiscal 2007, including the 74 demo stores recently closed.

Indemnifications

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

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

New Accounting Pronouncements

Information regarding new accounting pronouncements is contained in Note 3 to the condensed consolidated financial statements for the quarter ended May 5, 2007, which note is incorporated herein by this reference.

Inflation

We do not believe that inflation has had a material effect on the results of operations in the recent past. There can be no assurance that our business will not be affected by inflation in the future.

Seasonality and Quarterly Results

Our business is seasonal by nature. Our first quarter historically accounts for the smallest percentage of annual net sales with each successive quarter contributing a greater percentage than the last. In recent years, excluding sales generated by new and relocated/expanded stores, approximately 44% of our net sales have occurred in the first half of the fiscal year and approximately 56% have occurred in the second half, with the Christmas and back-to-school selling periods together accounting for approximately 30% of our annual net sales and a higher percentage of our operating income. Our 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.

ITEM 3 — QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are susceptible to market value fluctuations with regard to our short-term investments. However, due to the relatively short maturity period of those investments and our intention and ability to hold those investments until maturity, the risk of material market value fluctuations is not expected to be significant.

To the extent we borrow under our credit facility, we are exposed to market risk related to changes in interest rates. At May 5, 2007, there were no borrowings outstanding under our credit facility and we did not borrow under the credit facility at any time during fiscal 2007 or 2006. Based on the interest rate of 5.8% on our credit facility at May 5, 2007, if interest rates on the credit facility were to increase by 10%, and to the extent borrowings were outstanding, for every $1 million outstanding on our credit facility, net income would be reduced by approximately $4 thousand per year. We are not a party with respect to derivative financial instruments.

ITEM 4 — CONTROLS AND PROCEDURES

Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934, as amended (the Exchange Act). These disclosure controls and procedures are designed to provide reasonable assurance 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. Our disclosure controls and procedures are also designed to provide reasonable assurance that information required to be disclosed in the periodic reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our principal executive officer and principal financial officer, in order to allow timely decisions regarding required disclosures. Based on this evaluation, our principal executive officer and our principal financial officer concluded that our disclosure controls and procedures were effective at a reasonable assurance level as of May 5, 2007.

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

PART II — OTHER INFORMATION

Item 1 — Legal Proceedings

For information on legal proceedings, see “Litigation” within Note 11 of Notes to Condensed Consolidated Financial Statements, which is incorporated by reference in response to this Item 1.

Item 1A — Risk Factors

We have updated the risk factors discussed in Item 1A of our Annual Report on Form 10-K for the year ended February 3, 2007. We do not believe any of the updates constitute material changes from the risk factors previously disclosed in that report. For convenience, our risk factors, as updated, are included below in this Item 1A.

Our comparable store net sales results will fluctuate significantly, which can cause volatility in our operating performance and stock price. Our comparable store net sales results have fluctuated significantly on a monthly, quarterly, and annual basis, and are expected to continue to fluctuate in the future. For example, over the past five years, monthly comparable store net sales results have varied from a low of minus 16% to a high of plus 20%. A variety of factors affect our comparable store net sales results, including changes in fashion trends and customer preferences, changes in our merchandise mix, calendar shifts of holiday periods, actions by competitors, weather conditions and general economic conditions. Our

comparable store net sales results for any particular fiscal month, quarter or year may decrease. As a result of these or other factors, our comparable store net sales results, both past and future, are likely to have a significant effect on the market price of our common stock and our operating performance, including our use of markdowns and our ability to leverage operating and other expenses that are somewhat fixed.

Our failure to identify and respond appropriately to changing consumer preferences and fashion trends in a timely manner could have a material adverse impact on our profitability. Our success is largely dependent upon our ability to gauge the fashion tastes of our customers and to provide merchandise at competitive prices and in adequate quantities that satisfies customer demand in a timely manner. Our failure to anticipate, identify or react appropriately in a timely manner to changes in fashion trends could have a material adverse effect on our same store sales results, gross margins, operating margins, financial condition and results of operations. Misjudgments or unanticipated fashion changes could also have a material adverse effect on our image with our customers. Some of our vendors have limited resources, production capacities and operating histories and some have intentionally limited the distribution of their merchandise. The inability or unwillingness on the part of key vendors to expand their operations to keep pace with the anticipated growth of our store concepts, or the loss of one or more key vendors or proprietary brand sources for any reason, could have a material adverse effect on our business.

We are currently evaluating store design alternatives for all of our retail concepts, which may not result in improved operational performance. We believe that store design is an important element in the customer shopping experience. Many of our stores have been in operation for many years and have not been updated or renovated since opening. Some of our competitors are in the process of updating, or have updated, their store designs, which may make our stores appear less attractive visually. We have been testing or plan to test new store design alternatives for all of our retail concepts in an attempt to update the look of our stores and improve their productivity. This process carries additional risks such as higher than anticipated construction costs, lack of customer acceptance, and lower store productivity than planned or anticipated, among others. There can be no assurance that this process will prove successful in improving operational results or that we can achieve meaningful results in an adequate timeframe. Any inability on our part to successfully implement new store designs in a timely manner could have a material adverse effect on our business, financial condition and results of operations.

Our continued growth depends, in part, on our ability to develop new store concepts and/or open new stores that achieve acceptable levels of profitability. Any failure to do so may negatively impact our stock price and operational performance. Our store concepts are located principally in enclosed regional shopping malls. Our PacSun concept is a relatively mature concept with limited domestic opportunities to open new stores in such malls. Our two newest store concepts, demo and One Thousand Steps, have yet to achieve acceptable levels of profitability. We recently closed 74 underperforming demo stores and do not plan to open any new One Thousand Steps stores during fiscal 2007. There can be no assurance that the operational performance of these two concepts will improve and a failure to improve could result in additional store closures, asset impairment charges, and lease termination and other related expenses being incurred in the future. There can also be no assurance that we will be able to successfully develop new store concepts that will enable us to continue to grow profitably. Any inability to sustain future long-term growth opportunities could have a material adverse impact on our business, stock price, financial condition and results of operations.

We launched operations of a new retail concept, One Thousand Steps, in fiscal 2006, which could divert attention from existing operations. We launched operations for One Thousand Steps in fiscal 2006 through the opening of the first nine test stores. This new concept is at a very early stage and is not yet proven. Our ability to make this new retail concept successful is subject to numerous risks, including, but not limited to, (i) lower productivity (in terms of sales per square foot) than anticipated or required to make the concept profitable and expandable, (ii) higher than anticipated construction costs, (iii) unanticipated operating problems, (iv) lack of customer acceptance, (v) new vendor relationships, (vi) competition from existing and new retailers, and (vii) lack of sufficient product differentiation. There can be no assurance that this new retail concept will achieve sales and profitability levels that justify the Company’s investment in it. Additionally, the expansion of this new retail concept involves other risks that could have a material adverse effect on the Company, including, but not limited to, (i) diversion of

management’s attention from the Company’s core businesses, (ii) inability to attract, train and retain qualified personnel, including management and product designers, and (iii) difficulty in locating and obtaining favorable store sites and negotiating acceptable lease terms. Any inability to succeed in developing this new retail concept could have a material adverse effect on our continued growth and results of operations.

We face significant competition from both vertically-integrated and brand-based competitors that are growing rapidly, which could have a material adverse effect on our business. The retail apparel, footwear and accessory business is highly competitive. All of our store concepts compete on a national level with a diverse group of retailers, including vertically-integrated and brand-based national, regional and local specialty retail stores and certain leading department stores that offer the same or similar brands and styles of merchandise as we do. Many of our competitors are larger and have significantly greater resources than we do. We believe the principal competitive factors in our industry are fashion, merchandise assortment, quality, price, store location, environment and customer service.

Our customers may not prefer our proprietary brand merchandise, which may negatively impact our profitability. Sales from proprietary brand merchandise accounted for approximately 28%, 31%, and 30% of net sales in fiscal 2006, 2005, and 2004, respectively. There can be no assurance that we will be able to achieve increases in proprietary brand merchandise sales as a percentage of net sales. Because our proprietary brand merchandise generally carries higher merchandise margins than our other merchandise, our failure to anticipate, identify and react in a timely manner to fashion trends with our proprietary brand merchandise, particularly if the percentage of net sales derived from proprietary brand merchandise changes significantly (up or down), may have a material adverse effect on our same store sales results, operating margins, financial condition and results of operations.

Our current or prospective vendors may be unable or unwilling to supply us with adequate quantities of their merchandise in a timely manner or at acceptable prices, which could have a material adverse impact on our business. The success of our business is dependant upon developing and maintaining good relationships with our vendors. We work very closely with our vendors to develop and acquire appropriate merchandise at acceptable prices for our stores. However, we do not have any contractual relationships with our vendors. In addition, some of our vendors are relatively unsophisticated or underdeveloped and may have difficulty in providing adequate quantities or quality of merchandise to us in a timely manner. Also, certain of our vendors sell their merchandise directly to retail customers in direct competition with us. Our vendors could discontinue their relationship with us or raise prices on their merchandise at any time. There can be no assurance that we will be able to acquire sufficient quantities of quality merchandise at acceptable prices in a timely manner in the future. Any inability to do so, or the loss of one or more of our key vendors, could have a material adverse impact on our business, results of operations and financial condition.

Our foreign sources of production may not always be reliable, which may result in a disruption in the flow of new merchandise to our stores. We purchase merchandise directly in foreign markets for our proprietary brands. In addition, we purchase merchandise from domestic vendors, some of which is manufactured overseas. We do not have any long-term merchandise supply contracts and our imports are subject to existing or potential duties, tariffs and quotas. We face competition from other companies for production facilities and import quota capacity. We also face 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 within which we do 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 we do business with. Any inability on our part to rely on our foreign sources of production due to any of the factors listed above could have a material adverse effect on our business, financial condition and results of operations.

The loss of key personnel could have a material adverse effect on our business at any time. Our continued success is dependent to a significant degree upon the services of our key personnel, particularly our executive officers. The loss of the services of any member of our senior management team could have a material adverse effect on our business, financial condition and results of operations. Our success in the future will also be dependent upon our ability to attract and retain qualified personnel. Our inability to attract and retain qualified personnel in the future could have a material adverse effect on our business, financial condition and results of operations.

Our information systems may not be adequate to support future growth, which could disrupt business operations. We have experienced periods of rapid growth in the past. While we regularly evaluate our information systems capabilities and requirements, there can be no assurance that our existing information systems will be adequate to support future growth or will remain adequate to support the existing needs of our business. In order to support future growth, we may have to undertake significant information system implementations, modifications and/or upgrades in the future at significant cost to us. Such projects involve inherent risks associated with replacing and/or changing existing systems, such as system disruptions and the failure to accurately capture data, among others. Information system disruptions, if not anticipated and appropriately mitigated, could have a material adverse effect on our business, results of operations and financial condition.

Adverse outcomes of litigation matters could significantly affect our operational results. We are involved from time to time in litigation incidental to our business. We believe that the outcome of current litigation will not have a material adverse effect upon our results of operations or financial condition. However, our assessment of current litigation could change in light of the discovery of facts with respect to legal actions pending against us not presently known to us or determinations by judges, juries or other finders of fact which do not accord with our evaluation of the possible liability or outcome of such litigation.

Our dependence on a single distribution facility exposes us to significant business disruption risks. As of May 5, 2007, all of our distribution functions resided within a single facility in Anaheim, California. During May 2007, the Company began operating a second distribution center in Olathe, Kansas on a limited basis. Any significant interruption in the operation of the existing distribution facility or delay in the ramp up of operations in our second distribution center due to natural disasters, accidents, system failures or other unforeseen causes would have a material adverse effect on our business, financial condition and results of operations. There can be no assurance that our distribution centers will be adequate to support our future growth.

Our stock price can fluctuate significantly due to a variety of factors, which can negatively impact our total market value. The market price of our common stock has fluctuated substantially 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 made by management or 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 the past. This volatility has had a substantial effect on the market prices of securities of many public companies for reasons frequently unrelated to the operating performance of the specific companies.

Selling merchandise over the internet carries particular risks that can have a negative impact on our business. Our internet operations are subject to numerous risks that could have a material adverse effect on our 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 our 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 our control that could have a material adverse effect on our operational results, including: (i) price competition involving the items we intend to sell; (ii) the entry of our vendors into the internet business, in direct competition with us; (iii) the level of merchandise returns experienced by us; (iv) governmental regulation; (v) online security breaches involving unauthorized access to Company and/or customer information; (vi) credit card fraud; and (vii) competition and general economic conditions specific to the internet, online commerce and the apparel industry.

Any failure by us to maintain credit facility financial covenants could have a material adverse impact on our business. A significant decrease in our operating results could adversely affect our ability to maintain required financial ratios under our credit facility. Required financial ratios include a rolling four-quarter minimum fixed charge coverage ratio as well as a maximum leverage ratio. If these financial ratios are not maintained, the lenders will have the option to terminate the facility and require immediate repayment of all amounts outstanding under the credit facility, if any. The alternatives available to the Company if in default of its covenants would include renegotiating certain terms of the credit agreement, obtaining waivers from the lenders, or obtaining a new credit agreement with another bank or group of lenders, which may contain different terms. If we were unable to obtain waivers or renegotiate acceptable lending terms, there can be no guarantee that we would be able to obtain a new credit agreement with another bank or group of lenders on similar terms or at all.

The effects of terrorism or war could significantly impact consumer spending and our operational performance. The majority of our stores are located in regional shopping malls. Any threat or actual act of terrorism, 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 our business, financial condition and results of operations.

*************

We caution that the risk factors described above could cause actual results or outcomes to differ materially from those expressed in any forward-looking statements made by us or on behalf of the Company. Further, we cannot assess the impact of each such factor on our 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 2 — Unregistered Sales of Equity Securities and Use of Proceeds

None.

Item 3 — Defaults upon Senior Securities

None.

Item 4 — Submission of Matters to a Vote of Security Holders

None.

Item 5 — Other Information

None.


		Page #
PART I.	FINANCIAL INFORMATION

Item 1.	Condensed Consolidated Financial Statements (unaudited):
	Condensed Consolidated Balance Sheets May 5, 2007 and February 3, 2007		3
	Condensed Consolidated Statements of Operations and Comprehensive Income First quarter (13 weeks) ended May 5, 2007 and April 29, 2006		4
	Condensed Consolidated Statements of Cash Flows First quarter (13 weeks) ended May 5, 2007 and April 29, 2006		5
	Notes to Condensed Consolidated Financial Statements		6-12
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		13-20
Item 3.	Quantitative and Qualitative Disclosures about Market Risk		21
Item 4.	Controls and Procedures		21

PART II.	OTHER INFORMATION
Item 1.	Legal Proceedings		21
Item 1A.	Risk Factors		21-25
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		25
Item 3.	Defaults upon Senior Securities		25
Item 4.	Submission of Matters to a Vote of Security Holders		25
Item 5.	Other Information		25
Item 6.	Exhibits		26

	SIGNATURE PAGE		27
EXHIBIT 10.1
EXHIBIT 10.2
EXHIBIT 31
EXHIBIT 32


Exhibit 10.1		Summary of Named Executive Officers Annual Compensation for fiscal 2007

Exhibit 10.2		Summary of Board Compensation

Exhibit 10.3		Employment Agreement, dated as of May 22, 2007, between the Company and Sally Frame Kasaks (1)

Exhibit 10.4		Form of Stock Appreciation Rights Agreement between the Company and Sally Frame Kasaks (1)

Exhibit 10.5		Form of Restricted Stock Unit Agreement between the Company and Sally Frame Kasaks (1)

Exhibit 31		Written statements of Sally Frame Kasaks and Gerald M. Chaney pursuant to section 302 of the Sarbanes-Oxley Act of 2002.

Exhibit 32		Written statement of Sally Frame Kasaks and Gerald M. Chaney pursuant to section 906 of the Sarbanes-Oxley Act of 2002.


	PACIFIC SUNWEAR OF CALIFORNIA, INC. (Registrant)
Date: June 7, 2007	/s/ SALLY FRAME KASAKS
	Sally Frame Kasaks
	Chairman and Chief Executive Officer (Principal Executive Officer)


Date: June 7, 2007	/s/ GERALD M. CHANEY
	Gerald M. Chaney
	Senior Vice President, Chief Financial Officer and Secretary (Principal Financial and Accounting Officer)


Exhibit 10.1		Summary of Named Executive Officers Annual Compensation for fiscal 2007

Exhibit 10.2		Summary of Board Compensation

Exhibit 10.3		Employment Agreement, dated as of May 22, 2007, between the Company and Sally Frame Kasaks (1)

Exhibit 10.4		Form of Stock Appreciation Rights Agreement between the Company and Sally Frame Kasaks (1)

Exhibit 10.5		Form of Restricted Stock Unit Agreement between the Company and Sally Frame Kasaks (1)

Exhibit 31		Written statements of Sally Frame Kasaks and Gerald M. Chaney pursuant to section 302 of the Sarbanes-Oxley Act of 2002.

Exhibit 32		Written statement of Sally Frame Kasaks and Gerald M. Chaney pursuant to section 906 of the Sarbanes-Oxley Act of 2002.


Named Executive Officer	Title	New Annual Base Salary
Sally Frame Kasaks	Chairman and Chief Executive Officer	$	1,250,000
Wendy E. Burden	Chief Operating Officer	$	548,825
Gerald M. Chaney	Senior Vice President, Chief Financial Officer	$	590,000
Thomas M. Kennedy	Division President, PacSun	$	620,000
Lou Ann Bett	Division President, demo	$	490,000

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Amount		Description
$	50,000	Lead director annual retainer, disbursed in five equal payments for each regularly scheduled Board meeting.

	30,000	Annual retainer for all other non-employee directors, disbursed in five equal payments for each regularly scheduled Board meeting.

	10,000	Audit committee chairman annual retainer, disbursed in same manner as Board member annual retainer (excludes lead director).

	5,000	Non-audit committee chairman annual retainer, disbursed in same manner as Board member annual retainer (excludes lead director).

	3,000	Attendance fee for each in-person Board meeting.

	1,250	Attendance fee for each telephonic Board meeting or committee meeting of any kind.

	a)		Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

	b)		Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

	c)		Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures as of the end of the period covered by this report based on such evaluation; and

	d)		Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

	a)		All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

	b)		Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

	(i)		the Report fully complies with the requirements of section 13(a) or 15(d), as applicable, of the Securities Exchange Act of 1934, as amended; and

	(ii)		the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.



Dated: June 7, 2007	/s/ SALLY FRAME KASAKS
	Sally Frame Kasaks
	Chairman and Chief Executive Officer Pacific Sunwear of California, Inc. (Principal Executive Officer)


Dated: June 7, 2007	/s/ GERALD M. CHANEY
	Gerald M. Chaney
	Senior Vice President and Chief Financial Officer Pacific Sunwear of California, Inc. (Principal Financial Officer)