e10vq

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington D.C 20549

FORM 10-Q


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

For the quarterly period ended July 30, 2005


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.


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 þ No o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes þ No 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

The number of shares outstanding of the registrant’s Common Stock, par value $.01 per share, at August 30, 2005, was 74,601,458.

PACIFIC SUNWEAR OF CALIFORNIA, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(unaudited, all amounts in thousands except share amounts)


	July 30, 2005			January 29, 2005
ASSETS
CURRENT ASSETS:
Cash and cash equivalents	$	92,227		$	64,308
Marketable securities		70,366			79,223
Merchandise inventories		242,631			175,081
Other current assets		37,146			34,206

Total current assets		442,370			352,818

PROPERTY AND EQUIPMENT, NET:
Gross property and equipment		551,039			503,745
Less accumulated depreciation and amortization		(223,165	)		(199,523	)

Total property and equipment, net		327,874			304,222

Other Assets		22,063			20,738


TOTAL ASSETS	$	792,307		$	677,778


LIABILITIES AND SHAREHOLDERS’ EQUITY
CURRENT LIABILITIES:
Accounts payable	$	106,695		$	38,753
Other current liabilities		56,534			56,557

Total current liabilities		163,229			95,310

LONG-TERM LIABILITIES:
Deferred lease incentives		75,873			67,683
Deferred rent		27,717			26,826
Deferred income taxes		16,132			16,132
Other long-term liabilities		14,946			13,793

Total long-term liabilities		134,668			124,434

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; 75,041,904 and 74,916,773 shares issued and outstanding, respectively		750			749
Additional paid-in capital		58,966			61,310
Retained earnings		434,694			395,975

Total shareholders’ equity		494,410			458,034


TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY	$	792,307		$	677,778

See accompanying notes

PACIFIC SUNWEAR OF CALIFORNIA, INC.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME

(unaudited, all amounts in thousands except share and per share amounts)


	For the Second Quarter Ended				For the First Half Ended
	July 30, 2005		July 31, 2004		July 30, 2005		July 31, 2004
			(as restated, see				(as restated, see
			Note 3)				Note 3)
Net sales	$	309,064	$	272,164	$	589,049	$	517,665

Cost of goods sold, including buying, distribution and occupancy costs		198,707		177,525		381,342		336,821


Gross margin		110,357		94,639		207,707		180,844

Selling, general and administrative expenses		77,592		66,865		147,714		129,457


Operating income		32,765		27,774		59,993		51,387

Interest income, net		1,180		316		2,265		773


Income before income tax expense		33,945		28,090		62,258		52,160

Income tax expense		12,833		10,623		23,539		19,724


Net income	$	21,112	$	17,467	$	38,719	$	32,436


Comprehensive income	$	21,112	$	17,467	$	38,719	$	32,436


Net income per share, basic	$	0.28	$	0.23	$	0.51	$	0.42


Net income per share, diluted	$	0.28	$	0.22	$	0.51	$	0.41


Weighted average shares outstanding, basic		75,125,782		76,322,161		75,209,185		77,239,966

Weighted average shares outstanding, diluted		76,118,501		77,911,595		76,338,599		79,035,717

See accompanying notes

PACIFIC SUNWEAR OF CALIFORNIA, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited, all amounts in thousands)


	For the First Half Ended
				July 31, 2004
				(as restated,
	July 30, 2005			see Note 3)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	38,719		$	32,436
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		31,081			24,423
Tax benefits related to exercise of stock options		5,737			2,906
Loss on disposal of equipment		—			2,839
Change in operating assets and liabilities:
Merchandise inventories		(67,550	)		(66,082	)
Other current assets		(2,940	)		(5,204	)
Other assets		(1,325	)		(665	)
Accounts payable		67,942			37,274
Other current liabilities		(2,917	)		(15,350	)
Deferred lease incentives		7,809			5,727
Deferred rent		(658	)		(904	)
Other long-term liabilities		1,444			1,229

Net cash provided by operating activities		77,342			18,629


CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment		(48,173	)		(39,950	)
Purchases of held-to-maturity marketable securities		(26,493	)		(19,829	)
Maturities of held-to-maturity marketable securities		20,625			2,640
Purchases of available-for-sale marketable securities		(442,350	)		(637,450	)
Sales of available-for-sale marketable securities		457,075			635,300

Net cash used in investing activities		(39,316	)		(59,289	)


CASH FLOWS FROM FINANCING ACTIVITIES:
Repurchase and retirement of common stock		(19,978	)		(74,931	)
Proceeds from exercise of stock options		10,756			6,883
Principal payments under long-term debt and capital lease obligations		(885	)		(932	)

Net cash used in financing activities		(10,107	)		(68,980	)


NET INCREASE/(DECREASE) IN CASH AND CASH EQUIVALENTS		27,919			(109,640	)
CASH AND CASH EQUIVALENTS, beginning of period		64,308			109,640

CASH AND CASH EQUIVALENTS, end of period	$	92,227		$	0


SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid for interest	$	32		$	81
Cash paid for income taxes		21,659			23,781

SUPPLEMENTAL DISCLOSURES OF NON-CASH TRANSACTIONS:
Increase to additional paid-in capital related to the issuance of stock to satisfy certain deferred compensation liabilities (Note 6)	$	1,142		$	4,853
Increase in non-cash property and equipment accruals		6,179			5,200

See accompanying notes

PACIFIC SUNWEAR OF CALIFORNIA, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

For the Quarterly Period Ended July 30, 2005
(unaudited, all amounts in thousands except share and per share amounts unless otherwise indicated)

1. BASIS OF PRESENTATION AND NATURE OF BUSINESS

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. (the “Company”). 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 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 second quarter and first half ended July 30, 2005 are not necessarily indicative of the results that may be expected for fiscal 2005. 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 29, 2005.

Nature of Business – Pacific Sunwear of California, Inc. and its subsidiaries (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 (PacSun) Outlet” and “d.e.m.o.” Pacific Sunwear and Pacific Sunwear Outlet stores specialize in board-sport inspired casual apparel, footwear and related accessories catering to teens and young adults. d.e.m.o. specializes in hip-hop inspired casual apparel, footwear and related accessories catering to teens and young adults. In addition, the Company operates two websites (www.pacsun.com and www.demostores.com) which sell PacSun and d.e.m.o. merchandise online, respectively, provide content and community for its target customers, and provide information about the Company. Additionally, the Company has announced its plans to begin operating a new mall-based chain of specialty retail footwear stores under the name “One Thousand Steps” beginning in fiscal 2006.

The Company’s fiscal year is the 52- or 53-week period ending on the Saturday closest to January 31. “Fiscal 2005” is the 52-week period ending January 28, 2006. “Fiscal 2004” was the 52-week period ended January 29, 2005. The second quarter and first half of fiscal 2005 were the 13-week and 26-week periods ended July 30, 2005, respectively. The second quarter and first half of fiscal 2004 were the 13-week and 26-week periods ended July 31, 2004, respectively.

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 annual report on Form 10-K for the fiscal year ended January 29, 2005. 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.

Marketable Securities – Marketable securities consists of auction rate securities of $36 million, classified as available for sale, and other short-term investments of $34 million, classified as held-to-maturity.

Auction rate securities have long-term stated contractual maturities, but have variable interest rates that reset at each auction period (typically 7 days, or as long as 28 or 35 days in some cases). These securities trade in a broad, highly liquid market and the Company has never had difficulty being able to liquidate any such investment at the end of a given auction period. The Company typically reinvests these securities multiple times during each reporting period at each new auction date. As a result of the resetting variable rates, the Company had no cumulative gross unrealized or realized gains or losses from these investments. All income from these investments was recorded as interest income for each period presented.

Marketable securities, other than auction rate securities, 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. At July 30, 2005, the fair value of the Company’s held-to-maturity portfolio was $34 million, consisting of corporate debentures of $23 million and U.S. treasury/agency debentures of $11 million. Cost is determined by specific identification, which approximates fair value at July 30, 2005 due to the relatively short maturity period of such investments.

Customer Loyalty Programs – The Company accounts for its customer loyalty programs in accordance with EITF 00-22, “Accounting for ‘Points’ and Certain Other Time-Based or Volume-Based Sales Incentive Offers, and Offers for Free Products or Services to Be Delivered in the Future.” The Company’s primary customer loyalty programs are referred to as “PacBucks” for PacSun and PacSun Outlet stores and “d.e.m.o. Dollars” for d.e.m.o. stores. The Company also has a customer loyalty discount program related to its private label credit card. These programs offer customers dollar-for-dollar discounts on future merchandise purchases within stated redemption periods if they purchase specified levels of merchandise in a current transaction. The impact of these programs is recognized ratably as a direct reduction in net sales over the series of transactions required to both earn and redeem the customer discounts. Redemptions generally occur within 30 days of original issuance. See Note 3, “Restatement of Prior Period Financial Statements.”

Stock-Based Compensation – The Company accounts for stock-based compensation in accordance with Accounting Principles Board Opinion No. 25 and related interpretations. Accordingly, no compensation expense has been recognized related to employee stock options for the periods presented. The Company follows the disclosure provisions of Statement of Financial Accounting Standards No. 123 (“SFAS 123”), “Accounting for Stock-Based Compensation,” as amended by SFAS 148, “Accounting for Stock-Based Compensation – Transition and Disclosure.” The Company will expense stock options in accordance with SFAS 123(R) beginning January 29, 2006 (see “New Accounting Pronouncements”). The Company has provided the pro-forma disclosures required by SFAS 123 and SFAS 148 for the second quarter and first half of each of fiscal 2005 and fiscal 2004 below.


	For the Second Quarter Ended						For the First Half Ended
	July 30,			July 31,			July 30,			July 31,
	2005			2004			2005			2004
Net Income

As reported	$	21,112		$	17,467		$	38,719		$	32,436
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		(2,170	)		(1,673	)		(3,991	)		(3,231	)

Pro forma	$	18,942		$	15,794		$	34,728		$	29,205


Earnings per Share
Basic, as reported	$	0.28		$	0.23		$	0.51		$	0.42
Basic, pro forma	$	0.25		$	0.21		$	0.46		$	0.38

Diluted, as reported	$	0.28		$	0.22		$	0.51		$	0.41
Diluted, pro forma	$	0.25		$	0.20		$	0.46		$	0.37

Pro-forma net income and earnings per share related to the fair value of the Company’s stock option awards were determined using the Black-Scholes option-pricing model with the following weighted average assumptions:


	Fiscal Year
	2005			2004
Expected Option Life	5 years			5 years
Stock Volatility		56.7% - 62.8	%		37.0 – 37.8	%
Risk-free Interest Rates		3.9 – 4.1	%		3.6 – 3.7	%
Expected Dividends	None			None

New Accounting Pronouncements – In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS 123(R), “Share-Based Payment.” SFAS 123(R) requires that companies recognize compensation expense equal to the fair value of stock options or other share-based payments over the requisite service period. The standard is effective for the Company at the beginning of its next fiscal year, which starts on January 29, 2006. The Company’s net income will be reduced as a result of the recognition of the remaining amortization of the fair value of existing options (similar to what is disclosed as pro-forma expense above in this Note 2) as well as the recognition of the fair value of all newly issued stock options, which is contingent upon the number of future options granted and other variables. The adoption of this standard will have no impact on the Company’s cash flows.

Reclassifications – Certain prior year amounts have been reclassified related to e-commerce shipping and handling revenues and expenses (as disclosed in Note 3) to conform to the current year presentation.

3. RESTATEMENT OF PRIOR PERIOD FINANCIAL STATEMENTS

As disclosed in the Company’s Form 10-K for the fiscal year ended January 29, 2005, the Company restated its prior year financial statements to reflect the impact of certain lease accounting corrections and certain other reclassifications related to auction rate securities (“ARS”) and e-commerce shipping revenues and expenses. Additionally, as previously announced in the Company’s Form 8-K dated August 11, 2005, the Company has corrected its July 2004 accounting for PacBuck issuances. A summary of the impact of those corrections to the Company’s financial statements for the second quarter and first half of fiscal 2004 is as follows:


	Second Quarter Ended July 31, 2004
	As		Lease and E-
	Previously		Commerce			PacBucks			As
	Reported		Corrections			Corrections			Restated
Consolidated Income Statement
Net Sales	$	274,797	$	342		$	(2,975	)	$	272,164
Cost of Sales		179,977		(2,452	)		—			177,525

Gross Margin		94,820		2,794			(2,975	)		94,639
SG&A Expenses		64,061		2,804			—			66,865

Operating Income		30,759		(10	)		(2,975	)		27,774
Income Tax Provision		11,750		(2	)		(1,125	)		10,623
Net Income		19,325		(8	)		(1,850	)		17,467
Earnings Per Share, diluted		0.25		(0.00	)		(0.03	)		0.22


	First Half Ended July 31, 2004
	As		Lease and E-
	Previously		Commerce			PacBucks			As
	Reported		Corrections			Corrections			Restated
Consolidated Income Statement
Net Sales	$	519,928	$	712		$	(2,975	)	$	517,665
Cost of Sales		341,537		(4,716	)		—			336,821

Gross Margin		178,391		5,428			(2,975	)		180,844
SG&A Expenses		124,011		5,446			—			129,457

Operating Income		54,380		(18	)		(2,975	)		51,387
Income Tax Provision		20,854		(5	)		(1,125	)		19,724
Net Income		34,299		(13	)		(1,850	)		32,436
Earnings Per Share, diluted		0.43		(0.00	)		(0.02	)		0.41


	First Half Ended July 31, 2004
	As			Lease and
	Previously			ARS
	Reported			Corrections			As Restated
Consolidated Cash Flow Statement
Net Cash Provided by Operating Activities	$	7,256		$	11,373		$	18,629
Net Cash Used in Investing Activities		(46,572	)		(12,717	)		(59,289	)
Net Cash Used in Financing Activities		(68,980	)		—			(68,980	)

Net Decrease in Cash and Cash Equivalents		(108,296	)		(1,344	)		(109,640	)
Cash and Cash Equivalents, Beginning		142,840			(33,200	)		109,640

Cash and Cash Equivalents, Ending		34,544			(34,544	)		0

4. OTHER CURRENT LIABILITIES

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


	July 30,		January 29,
	2005		2005
Accrued capital expenditures	$	10,853	$	6,223
Accrued compensation and benefits		9,434		13,284
Sales taxes payable		6,650		6,647
Accrued gift cards		6,255		10,386
Income taxes payable		3,364		5,993
Other		19,978		14,024

	$	56,534	$	56,557

5. COMMITMENTS AND CONTINGENCIES

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 duration of these indemnities, commitments and guarantees varies, and in certain cases, is indefinite. The majority of these indemnities, commitments and guarantees do not provide for any limitation of the maximum potential future payments the Company could be obligated to make. The Company has not recorded any liability for these indemnities, commitments and guarantees in the accompanying consolidated balance sheets other than as disclosed below in this Note 5.

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 likely 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 probable litigation losses. Depending on the actual outcome of pending litigation, charges in excess of any provisions could be recorded in the future, which may have a material adverse affect on the Company’s operating results.

Letters of Credit – The Company has issued guarantees in the form of commercial letters of credit, of which there were approximately $27 million outstanding at July 30, 2005, as security for merchandise shipments from overseas.

Accrued Sublease Loss Charges – The Company remains liable under an operating lease covering a former store location. The term of the lease ends December 31, 2012. The Company has subleased this location to third parties at rates that are less than the Company’s required lease payments. Accordingly, the Company had approximately $1.5 million recorded in other current liabilities to recognize its net remaining contractual lease obligation related to these premises at July 30, 2005. To the extent any sublessee defaults upon its sublease obligations, the Company may incur additional charges related to this lease in the future. The Company’s remaining contractual obligation under the original lease, exclusive of any sublease income, was approximately $6 million at July 30, 2005.

Lease Guarantee – The Company remains secondarily liable under a guarantee issued related to the assignment of an operating lease covering another former store location. The term of the lease ends December 31, 2014. The Company had approximately $0.4 million recorded in other current liabilities to recognize the remaining estimated fair value of this guarantee, assuming that another assignee would be found within one year should the original assignee default. The aggregate payments remaining on the master lease agreement at July 30, 2005, were approximately $5 million.

6. COMMON STOCK REPURCHASES

At the beginning of fiscal 2005, the maximum value of Company shares that could yet be repurchased under previously authorized and publicly announced share repurchase plans was approximately $15.5 million. On May 12, 2005, the Company announced that its Board of Directors had authorized the Company to repurchase up to an additional $100 million of the Company’s common stock in open market transactions. There is no expiration date specified for this plan. During fiscal 2005, the Company has made the following repurchases of shares subject to this plan:


									Maximum
					# of Shares				Value of
					Purchased				Shares that
			Average		as Part of				May Yet be
			Price		Publicly		Value of		Purchased
	# of Shares		Paid Per		Announced		Shares		Under the
Period	Purchased		Share		Plan		Purchased		Plan
									$	115,499
May 2005		490,000	$	21.26		490,000	$	10,415	$	105,084
July 2005		417,500	$	22.90		417,500	$	9,563	$	95,521
August 2005		528,100	$	23.28		528,100	$	12,296	$	83,225

7. NET INCOME PER SHARE, BASIC AND DILUTED

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


	Second Quarter Ended
	July 30, 2005							July 31, 2004
								Net
	Net Income		Shares		EPS			Income		Shares		EPS
Basic EPS:	$	21,112		75,125,782	$	0.28		$	17,467		76,322,161	$	0.23
Diluted EPS:
Effect of dilutive stock options		—		992,719		(0.00	)		—		1,589,434		(0.00	)

	$	21,112		76,118,501	$	0.28		$	17,467		77,911,595	$	0.22


	First Half Ended
	July 30, 2005							July 31, 2004
								Net
	Net Income		Shares		EPS			Income		Shares		EPS
Basic EPS:	$	38,719		75,209,185	$	0.51		$	32,436		77,239,966	$	0.42
Diluted EPS:
Effect of dilutive stock options		—		1,129,414		(0.00	)		—		1,795,751		(0.00	)

	$	38,719		76,338,599	$	0.51		$	32,436		79,035,717	$	0.41

Options to purchase 2,180,576 and 1,221,266 shares of common stock in the second quarter of fiscal 2005 and fiscal 2004, respectively, and 1,676,170 and 915,644 shares of common stock in the first half of fiscal 2005 and fiscal 2004, respectively, were not included in the computation of diluted earnings per common share because the option exercise price was greater than the average market price of the Company’s common stock.

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 condensed consolidated financial statements and notes thereto of the Company included elsewhere in this Form 10-Q. As discussed in Note 3 to the condensed consolidated financial statements included at Item 1, the fiscal 2004 financial statements have been restated. This MD&A gives effect to the restatements.

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 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 2005 planned new store openings, capital expenditures and the Company’s plans to begin operating its new retail concept, One Thousand Steps, in fiscal 2006, are based on information available to us as of the date hereof, and we do not intend, or assume any obligation, to update or revise any such forward-looking statements to reflect events or circumstances that occur after such statements are made. See “Risk Factors” within this section.

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 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 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. Operating margin as a percentage of net sales for fiscal 2004, 2003 and 2002, was 13.8%, 12.3% and 9.6%, respectively. The 13.8% operating margin result for fiscal 2004 was our highest historical annual operating margin. Operating margin as a percentage of sales for each of the first halves of fiscal 2005 and 2004 was 10.2% and 9.9%, respectively. For a discussion of the changes in the components comprising operating margins, see “Results of Operations” in this section.

Store sales trends – We evaluate store sales trends in assessing the operational performance of our 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 for fiscal 2004, 2003 and 2002 were $1.3 million, $1.2 million and $1.1 million, respectively. Average net sales per square foot were $374, $363 and $330, 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 2004, 2003 and 2002 were approximately $143 million, $161 million and $89 million, respectively. We expect cash flows from operations will be sufficient to finance operations without borrowing under our credit facility during fiscal 2005.

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:

Revenue Recognition – 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 website. 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.

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. 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.

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 capitalize rent expense incurred during the build-out period of our stores as a component cost of construction and amortize this amount over the life of the related store’s lease term once construction has completed, generally upon the commencement of store operations. 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. 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.

Evaluation of Insurance Reserves – We are responsible for workers’ compensation insurance claims up to a specified aggregate stop loss amount. We maintain 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 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 determine that it is more likely than not that these assets will 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 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.

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 tables set forth selected income statement data of the Company expressed as a percentage of net sales for the periods indicated as well as a summary of the Company’s number of stores and total square footage as of the dates presented. The discussion that follows should be read in conjunction with these tables:


	Second Quarter Ended						First Half Ended
	July 30,			July 31,			July 30,			July 31,
	2005			2004			2005			2004
Net sales		100.0	%		100.0	%		100.0	%		100.0	%
Cost of goods sold, including buying, distribution and occupancy costs		64.3			65.2			64.7			65.1

Gross margin		35.7			34.8			35.3			34.9
Selling, general and administrative expenses		25.1			24.6			25.1			25.0

Operating income		10.6			10.2			10.2			9.9
Interest income, net		0.4			0.1			0.4			0.2

Income before income tax expense		11.0			10.3			10.6			10.1
Income tax expense		4.2			3.9			4.0			3.8

Net income		6.8	%		6.4	%		6.6	%		6.3	%


	July 30, 2005		July 31, 2004
PacSun stores		780		717
Outlet stores		91		82
d.e.m.o. stores		183		148

Total stores		1,054		947

Square footage (in 000’s)		3,720		3,266

The second quarter (thirteen weeks) ended July 30, 2005 as compared to the second quarter (thirteen weeks) ended July 31, 2004

Net Sales

Net sales increased to $309 million for the second quarter of fiscal 2005 from $272 million for the second quarter of fiscal 2004, an increase of $37 million, or 14%. The components of this $37 million increase in net sales are as follows:


$millions		Attributable to
$16		Net sales from stores opened in fiscal 2004 not yet included in the comparable store base
12		73 new stores opened in fiscal 2005 not yet included in the comparable store base
8		3.2% increase in comparable store net sales in the second quarter of fiscal 2005 compared to the second quarter of fiscal 2004
3		Other non-comparable sales (net sales from expanded or relocated stores not yet included in the comparable store base and internet net sales)
(2)		9 closed stores in fiscal 2005 and 5 closed stores in fiscal 2004
$37		Total

Of the 3.2% increase in comparable store net sales in the second quarter of fiscal 2005, PacSun and PacSun Outlet comparable store net sales increased a combined 3.5% and d.e.m.o. comparable store net sales increased 0.4%. In percentage terms, the average sale transaction in a comparable store was up mid single digits, driven by a high single digit increase in average retail prices. The increases in average retail prices were primarily due to a lower markdown rate as well as changes in sales mix towards higher priced merchandise. Total transactions per comparable store were down mid single digits.

Within PacSun and PacSun Outlet, comparable store net sales of guys’ and girls’ merchandise increased 3.8% and 3.2%, respectively. Guys’ comparable store net sales results were characterized by strength in denim, board shorts, sneakers and tees, partially offset by weakness in fleece and wovens. Girls’ comparable store net sales results were characterized by strength in swimwear, skate tees, board shorts and skirts, partially offset by weakness in knits, sandals and casual pants.

Within d.e.m.o., comparable store net sales of girls’ merchandise increased 20.9%, while guys’ merchandise decreased 12.0%. Girls’ comparable store net sales results were characterized by strength in tops, capris and accessories. Guys’ comparable store net sales results were characterized by weakness in tees and accessories.

Gross Margin

Gross margin, after buying, distribution and occupancy costs, increased to $110 million for the second quarter of fiscal 2005 from $95 million for the second quarter of fiscal 2004, an increase of $15 million, or 16%. As a percentage of net sales, gross margin was 35.7% for the second quarter of fiscal 2005 compared to 34.8% for the second quarter of fiscal 2004. The 0.9% increase in gross margin as a percentage of net sales was primarily attributable to a lower markdown rate associated with less promotional activity in the second quarter of fiscal 2005 as compared to the second quarter of fiscal 2004 as well as an improved initial markup rate.

Selling, General and Administrative Expenses

Selling, general and administrative expenses increased to $78 million for the second quarter of fiscal 2005, up from $67 million for the second quarter of fiscal 2004, an increase of $11 million, or 16%. These expenses increased to 25.1% as a percentage of net sales in the second quarter of fiscal 2005 from 24.6% in the second quarter of fiscal 2004. The components of this 0.5% net increase in selling, general and administrative expenses as a percentage of net sales were as follows:


%		Attributable to
0.5		Increase in general and administrative expenses as a percentage of net sales to 5.9% ($18 million) for the second quarter of fiscal 2005 from 5.4% ($15 million) for the second quarter of fiscal 2004, primarily due to design expenses attributable to the development of our new large store prototype and new third store concept (One Thousand Steps).
0.4		Increase in store closing expenses to $0.9 million for the second quarter of fiscal 2005 as compared to a credit of $0.2 million for the second quarter of fiscal 2004, primarily due to a credit recognized in the second quarter of fiscal 2004 due to the execution of a lease termination agreement related to our former corporate offices.
(0.4)		Decrease in direct store expenses as a percentage of net sales to 6.7% ($21 million) for the second quarter of fiscal 2005 from 7.1% ($19 million) for the second quarter of fiscal 2004 as a result of small improvements in several expense categories.
0.0		Store payroll expenses as a percentage of net sales were 12.2% in the second quarter of each of fiscal 2005 and fiscal 2004. In absolute dollars, store payroll expenses were $38 million for the second quarter of fiscal 2005 versus $33 million for the second quarter of fiscal 2004, primarily due to the addition of 43 net new stores during the second half of fiscal 2004 and 64 net new stores during the first half of fiscal 2005.
0.5		Total

Net Interest Income

Net interest income was $1.2 million in the second quarter of fiscal 2005 compared to $0.3 million in the second quarter of fiscal 2004, an increase of $0.9 million. This increase was primarily the result of higher average cash and short-term investment balances as well as higher interest rates in the second quarter of fiscal 2005 as compared to the second quarter of fiscal 2004.

Income Tax Expense

Income tax expense was $13 million for the second quarter of fiscal 2005 compared to $11 million for the second quarter of fiscal 2004. The effective income tax rate was 37.8% in the second quarter of each of fiscal 2005 and fiscal 2004. Our weighted 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.

The first half (26 weeks) ended July 30, 2005 as compared to the first half (26 weeks) ended July 31, 2004

Net Sales

Net sales increased to $589 million for the first half of fiscal 2005 from $518 million for the first half of fiscal 2004, an increase of $71 million, or 14%. The components of this $71 million increase in net sales are as follows:


$millions		Attributable to
$39		Net sales from stores opened in fiscal 2004 not yet included in the comparable store base
15		3.1% increase in comparable store net sales in the first half of fiscal 2005 compared to the first half of fiscal 2004
14		Net sales from 73 new stores opened in fiscal 2005 not yet included in the comparable store base
6		Other non-comparable sales (net sales from expanded or relocated stores not yet included in the comparable store base and internet net sales)
(3)		9 closed stores in fiscal 2005 and 5 closed stores in fiscal 2004
$71		Total

Of the 3.1% increase in comparable store net sales in the first half of fiscal 2005, PacSun and PacSun Outlet comparable store net sales increased 3.3% and d.e.m.o. comparable store net sales increased 1.8%. In percentage terms, the average sale transaction in a comparable store was up mid single digits, driven by a high single digit increase in average retail prices. The increases in average retail prices were primarily due to changes in sales mix towards higher priced merchandise, primarily denim and swim, in relation to other merchandise. Total transactions per comparable store were down mid single digits.

Within PacSun and PacSun Outlet, comparable store net sales of guys’ and girls’ merchandise increased 3.9% and 2.6%, respectively. Guys’ comparable store net sales results were characterized by strength in denim, sneakers, tees and board shorts, partially offset by weakness in casual pants and fleece. Girls’ comparable store net sales results were characterized by strength in swimwear, denim , skirts and board shorts, partially offset by weakness in casual pants, capris and sandals.

Within d.e.m.o., comparable store net sales of girls’ merchandise increased 20.4% while guys’ merchandise decreased 10.6%. Girls’ comparable store net sales results were characterized by strength in denim, capris, tops and accessories. Guys’ comparable store net sales results were characterized by weakness in tees and accessories.

Gross Margin

Gross margin, after buying, distribution and occupancy costs, increased to $208 million for the first half of fiscal 2005 from $181 million for the first half of fiscal 2004, an increase of $27 million, or 15%. As a percentage of net sales, gross margin was 35.3% for the first half of fiscal 2005 compared to 34.9% for the first half of fiscal 2004. The 0.4% increase in gross margin as a percentage of net sales was primarily attributable to a lower markdown rate associated with less promotional activity in the first half of fiscal 2005 as compared to the first half of fiscal 2004.

Selling, General and Administrative Expenses

Selling, general and administrative expenses increased to $148 million for the first half of fiscal 2005 from $129 million for the first half of fiscal 2004, an increase of $19 million, or 15%. These expenses increased to 25.1% as a percentage of net sales in the first half of fiscal 2005 from 25.0% in the first half of fiscal 2004. The components of this 0.1% net increase in selling, general and administrative expenses as a percentage of net sales were as follows:


%		Attributable to
0.3		Increase in general and administrative expenses as a percentage of net sales to 5.8% ($34 million) for the first half of fiscal 2005 from 5.5% ($28 million) for the first half of fiscal 2004, primarily due to design expenses attributable to the development of our new large store prototype and new third store concept (One Thousand Steps).
(0.2)		Decrease in store payroll expenses as a percentage of net sales to 12.3% ($72 million) in the first half of fiscal 2005 from 12.5% ($65 million) for the first half of fiscal 2004, primarily due to leveraging these expenses over higher total sales and tight control of store payroll costs. The increase in absolute dollars was primarily attributable to the addition of 43 net new stores during the second half of fiscal 2004 and 64 net new stores during the first half of fiscal 2005.
0.1		Total

Net Interest Income

Net interest income was $2.3 million in the first half of fiscal 2005 compared to $0.8 million in the first half of fiscal 2004, an increase of $1.5 million. This increase was primarily the result of higher average cash and short-term investment balances as well as higher interest rates in the first half of fiscal 2005 as compared to the first half of fiscal 2004.

Income Tax Expense

Income tax expense was $24 million for the first half of fiscal 2005 compared to $20 million for the first half of fiscal 2004. The effective income tax rate was 37.8% in the first half of each of fiscal 2005 and fiscal 2004. Our weighted 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 in past years. Our primary capital requirements have been for the construction of newly opened, remodeled, expanded or relocated stores, the financing of working capital increases and, in the past, construction of corporate facilities. We believe that our invested cash and cash equivalents, cash flows from operating activities and revolving credit facility will be sufficient to meet our operating and capital expenditure requirements for at least the next twelve months.

Operating Cash Flows

Net cash provided by operating activities was $77 million for the first half of fiscal 2005 compared to $19 million for the first half of fiscal 2004. The $58 million increase in cash provided by operations in the first half of fiscal 2005 as compared to the first half of fiscal 2004 was attributable to the following:


$millions		Attributable to
$29		Increase in cash flows from accounts payable, net of inventory, due to timing of payments.
12		Increase in cash flows from other current liabilities, including $9 million from accrued liabilities and $3 million from accrued income taxes. Cash payments for payroll were lower in the first half of fiscal 2005 as compared to the first half of fiscal 2004, primarily due to the settlement of a litigation matter in the prior year, which resulted in a $4 million cash payment during the first half of fiscal 2004. Cash payments for income taxes were lower primarily due to the timing of fiscal 2005 estimated income tax payments in relation to the actual income tax liability as compared to the same items for fiscal 2004.
7		Increase in depreciation expense, primarily due to the addition of 43 net new stores during the second half of fiscal 2004 and 64 net new stores during the first half of fiscal 2005.
6		Increase in net income.
4		Other items netting to an increase in cash provided by operating activities.
$58		Total

Working Capital

Working capital at July 30, 2005 was $279 million compared to $258 million at January 29, 2005, an increase of $21 million. The changes in working capital were as follows:


$millions		Description

$258		Working capital at January 29, 2005

19		Increase in cash and marketable securities, primarily due to cash provided by operations.

2		Increase in other current assets.


$279		Working capital at July 30, 2005

Investing Cash Flows

Net cash used in investing activities in the first half of fiscal 2005 was $39 million compared to $59 million for the first half of fiscal 2004, a decrease in cash used of $20 million. Of the $39 million in net cash used in investing activities for the first half of fiscal 2005, $48 million was attributable to capital expenditures, partially offset by $9 million in net maturities of marketable securities. Capital expenditures for the first half of fiscal 2005 were categorized as follows:


$millions		Attributable to

$36		Construction costs of new, expanded and relocated stores

7		Capital expenditure improvements on existing stores

5		Other capital expenditures, including computer hardware and software


$48		Total

Total capital expenditures for fiscal 2005 are expected to be approximately $90-95 million, with a significant majority of the spending directed towards opening new and relocated/expanded stores. Other planned uses include maintenance capital for existing stores and computer hardware and software.

We plan to purchase additional land and begin construction of a new, additional corporate office and a new, additional distribution center at any time before the end of fiscal 2007. We have initiated planning efforts to assess these future needs. Costs of this future construction are currently unknown. Costs to construct our current corporate offices and distribution center were approximately $52 million and were incurred during fiscal 2000 and fiscal 2001.

Financing Cash Flows

Net cash used in financing activities in the first half of fiscal 2005 was $10 million compared to $69 million for the first half of fiscal 2004. The components of the $10 million of net cash used in financing activities in the first half of fiscal 2005 were repurchases of common stock of $20 million, repayments made pursuant to capital lease and long-term debt obligations of $1 million, partially offset by $11 million in proceeds from employee exercises of stock options. Information regarding the Company’s common stock repurchase program is contained in Note 6 to the condensed consolidated financial statements, which note is incorporated herein by this reference.

Credit Facility

We have a credit facility with a bank, which expires April 1, 2007. The credit facility provides for a $45 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 million from April 1, 2005 through March 31, 2006, and $60 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 (6.25% at July 30, 2005) or at optional interest rates that are primarily dependent upon the London Inter-bank Offered Rates for the time period chosen. We did not borrow under the credit facility at any time during fiscal 2005 or 2004. We had approximately $27 million outstanding in letters of credit at July 30, 2005. The credit facility subjects us to various restrictive

covenants, including maintenance of certain financial ratios, and prohibits payment of cash dividends on common stock. At July 30, 2005, we were in compliance with all of the credit facility covenants.

A significant decrease in our operating results could adversely affect our ability to maintain the required financial ratios under our credit facility. Required financial ratios include total liabilities to tangible net worth, limitations on capital expenditures and achievement of certain rolling four-quarter EBITDA (earnings before interest, taxes, depreciation and amortization) 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 alternatives available to the Company if in default of its covenants are 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. At July 30, 2005, we had no borrowings outstanding under our credit facility.

Contractual Obligations

We have minimum annual rental commitments under existing store leases and capital leases for computer equipment as of July 30, 2005. Our financial obligations under these arrangements are approximately $100 million in fiscal 2005 and similar amounts annually thereafter. We lease all of our retail store locations under operating leases. We lease equipment, from time to time, under capital leases. In addition, at any time, we are contingently liable for commercial letters of credit with foreign suppliers of merchandise. At July 30, 2005, our future financial commitments under these arrangements 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	$	650	$	100	$	192	$	168	$	190
Capital lease obligations		1		1		—		—		—
Letters of credit		27		27		—		—		—
Total	$	678	$	128	$	192	$	168	$	190

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 2004, 2003 and 2002 were $138 million, $120 million, and $109 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 December 2018. 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 initial term 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 five stores in fiscal 2004 and anticipate closing approximately 15 stores in fiscal 2005.

New Accounting Pronouncements

Information regarding new accounting pronouncements is contained in Note 2 to the condensed consolidated financial statements for the quarter ended July 30, 2005, 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, with the Christmas and back-to-school periods historically accounting for the largest percentage of annual net sales. 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 each of fiscal 2004 and fiscal 2003, excluding sales generated by new and relocated/expanded stores, the Christmas and back-to-school periods together accounted for approximately 30% of our annual net sales and a higher percentage of our operating income. In fiscal 2004, excluding net sales generated by new and relocated/expanded stores, approximately 44% of our annual net sales occurred in the first half of the fiscal year and approximately 56% in the second half. These results are consistent with prior years. 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.

Risk Factors

The products we sell are subject to significant merchandising/fashion sensitivity. 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, 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 PacSun, PacSun Outlet and d.e.m.o. stores, 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 may not be able to manage our planned expansion effectively. Our continued growth depends to a significant degree on our ability to open and operate stores on a profitable basis and to manage our planned expansion. There can be no assurance that we will achieve our planned expansion, that such expansion will be profitable, or that we will be able to manage our growth effectively. Our planned expansion is dependent upon a number of factors, including our ability 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 our control may also affect our ability to expand, including general economic and business conditions affecting consumer spending. Any failure to manage growth could have a material adverse effect on our business, financial condition and results of operations.

We plan to launch a new retail concept, One Thousand Steps, which could negatively affect existing operations. We have announced plans to launch a new retail store concept, named One Thousand Steps, which will commence operations during fiscal 2006. We are currently in the preliminary planning stage regarding store design, merchandise selection and site selection for this new concept. Our ability to make this new retail concept successful is subject to numerous risks, including, but not limited to, (i)

unanticipated operating problems, (ii) lack of customer acceptance, (iii) new vendor relationships, (iv) competition from existing and new retailers, and (v) 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 a profitable new retail concept could have a material adverse effect on our continued growth and results of operations.

Our customers may not accept our proprietary brand merchandise. Sales from proprietary brand merchandise accounted for approximately 30%, 32% and 33% of net sales in fiscal 2004, 2003 and 2002, respectively. We may increase the percentage of net sales in proprietary brand merchandise in the future, although 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 increases, may have a material adverse effect on our same store sales results, operating margins, financial condition and results of operations.

Our comparable store net sales results can fluctuate significantly. 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. A variety of factors affect our comparable store net sales results, including changes in fashion trends, 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 future fiscal month, quarter or year may decrease. As a result of these or other factors, our future comparable store net sales results are likely to have a significant effect on the market price of our common stock.

We could lose key personnel 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 dependence on a single distribution facility exposes us to significant operational risks. Although we have begun planning efforts to locate a site for the construction of a second distribution center, all of our current distribution functions continue to reside within a single facility in Anaheim, California. Any significant interruption in the operation of the existing distribution facility 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 current distribution center will be adequate to support our future growth.

Selling merchandise over the internet carries particular risks that can distract attention from our core businesses. 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 terrorist attacks or war/threat of war could significantly affect consumer spending. The majority of our 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 our business, financial condition and results of operations.

Our foreign sources of production may not always be reliable. 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.

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 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 us 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.

The expensing of stock options will reduce our future reported earnings. The FASB has issued a new accounting standard requiring companies to begin recording compensation expense related to all unvested and newly granted stock options. This standard will go into effect for us in fiscal 2006. Currently, we include 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 do not include compensation expense related to stock options in our reported earnings in the financial statements. Our reported earnings will be lower under the new standard in fiscal 2006 and our stock price could decline as a result.

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 stock price can fluctuate significantly. The market price of our 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.

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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 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 July 30, 2005, there were no borrowings outstanding under our credit facility and we did not borrow under the credit facility at any time during fiscal 2005 or 2004. Based on the interest rate of 6.25% on our credit facility at July 30, 2005, 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) 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. Based on this evaluation, our principal executive officer and our principal financial officer concluded that our disclosure controls and procedures were effective as of July 30, 2005.

In the quarterly period ended July 31, 2004, our Company’s then principal executive and financial officers (collectively, the “certifying officers”) evaluated the effectiveness of our 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 us in our 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 our disclosure controls and procedures were effective as of July 31, 2004.

As a result of the need to restate the financial statements for the second quarter and first half of fiscal 2004 due to lease accounting issues and the impact of our PacBucks promotional program, our certifying officers and management have considered again whether our disclosure controls and procedures were effective on those dates. Based on the corrections required to be made, our certifying officers and management have concluded that a control deficiency existed with respect to lease accounting and PacBucks at July 31, 2004. Our certifying officers and management have concluded that this represents a control deficiency and that our disclosure controls and procedures as of October 30, 2004 and November 1, 2003 were not effective. While assessing its internal control over financial reporting for Sarbanes-Oxley purposes for fiscal 2004, the Company effectively remediated these issues.

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 5 of Notes to Condensed Consolidated Financial Statements, which is incorporated by reference in response to this Item 1.

Item 2 – Unregistered Sales of Equity Securities and Use of Proceeds

For information on repurchases made during fiscal 2005, see Note 6 of Notes to Condensed Consolidated Financial Statements, which is incorporated by reference in response to this Item 2.

Item 3 – Defaults Upon Senior Securities - None

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

a) The 2005 Annual Meeting of Shareholders of the Company was held on May 18, 2005.

b) At the 2005 Annual Meeting, Greg H. Weaver, Julius Jensen III, Pearson C. Cummin III and Michael Goldstein were elected as Class II Directors of the Company for a two-year term ending in 2007. Additionally, Seth R. Johnson was elected as a Class I Director of the Company for a one-year term ending in 2006. Sally Frame Kasaks, Thomas M. Murnane and Peter Starrett continued in office after the meeting.

c) In addition, the shareholders voted on and approved the Pacific Sunwear of California, Inc. 2005 Performance Incentive Plan.

The shareholders also voted on and ratified the appointment of Deloitte & Touche LLP as the Company’s independent registered public accounting firm for the fiscal year ending January 28, 2006.

Voting at the 2005 Annual Meeting for the election of directors is set forth below. Each of the nominees identified below was elected a director.


	VOTES		VOTES
DIRECTOR NAME	CAST FOR		WITHHELD
Class II:
Greg H. Weaver		71,387,172		603,503
Julius Jensen III		70,633,921		1,356,754
Pearson C. Cummin III		71,426,250		564,425
Michael Goldstein		71,379,386		611,289

Class I:
Seth R. Johnson		71,424,112		566,563

With respect to the approval of the Pacific Sunwear of California, Inc. 2005 Performance Incentive Plan, 51,945,963 votes were cast for approval, 7,812,803 votes were cast against approval, 24,929 votes abstained and there were 12,206,980 broker non-votes.

With respect to the ratification of the appointment of Deloitte & Touche LLP as the Company’s independent registered public accounting firm for the year ending January 28, 2006, 71,041,891 votes were cast for approval, 937,903 votes were cast against approval, 10,881 votes abstained and there were no broker non-votes.

Item 5 – Other Information - None

Item 6 – Exhibits


Exhibit 3.1		Third Amended and Restated Bylaws of the Company, as amended

Exhibit 10.1		Summary of Compensation for Timothy M. Harmon

Exhibit 31		Written statements of Seth R. Johnson and Gerald M. Chaney pursuant to section 302 of the Sarbanes-Oxley Act of 2002.

Exhibit 32		Written statement of Seth R. Johnson and Gerald M. Chaney pursuant to section 906 of the Sarbanes-Oxley Act of 2002.


	Page(s)
PART I. FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements (unaudited):
Condensed Consolidated Balance Sheets as of July 30, 2005 and January 29, 2005		3
Condensed Consolidated Statements of Income and Comprehensive Income for the second quarters and first halves ended July 30, 2005 and July 31, 2004 (as restated)		4
Condensed Consolidated Statements of Cash Flows for the first halves ended July 30, 2005 and July 31, 2004 (as restated)		5
Notes to Condensed Consolidated Financial Statements		6-11

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		12-24

Item 3. Quantitative and Qualitative Disclosures About Market Risk		24

Item 4. Controls and Procedures		24-25

PART II. OTHER INFORMATION
Item 1. Legal Proceedings		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		25-26
Item 5. Other Information		26
Item 6. Exhibits		26

SIGNATURE PAGE		27
EXHIBIT 3.1
EXHIBIT 10.1
EXHIBIT 31
EXHIBIT 32


				Pacific Sunwear of California, Inc.
				(Registrant)

Date: August 31, 2005				/s/ SETH R. JOHNSON

				Seth R. Johnson
				Director and Chief Executive Officer
				(Principal Executive Officer)

Date: August 31, 2005				/s/ GERALD M. CHANEY

				Gerald M. Chaney
				Senior Vice President, Chief Financial Officer
				(Principal Financial and Accounting Officer)

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Exhibit No.		Description
Exhibit 3.1		Third Amended and Restated Bylaws of the Company, as amended

Exhibit 10.1		Summary of Compensation for Timothy M. Harmon

Exhibit 31		Written statements of Seth R. Johnson and Gerald M. Chaney pursuant to section 302 of the Sarbanes-Oxley Act of 2002.

Exhibit 32		Written statement of Seth R. Johnson and Gerald M. Chaney pursuant to section 906 of the Sarbanes-Oxley Act of 2002.