e10vq

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: November 3, 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 November 29, 2007, the registrant had 70,728,304 shares of Common Stock outstanding.

PACIFIC SUNWEAR OF CALIFORNIA, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(unaudited, all amounts in thousands except share amounts)


	November 3,			February 3,
	2007			2007
ASSETS
CURRENT ASSETS:
Cash and cash equivalents	$	37,179		$	52,267
Marketable securities		—			31,500
Merchandise inventories		242,210			205,213
Other current assets		71,604			46,255

Total current assets		350,993			335,235

PROPERTY AND EQUIPMENT, NET:
Gross property and equipment		692,070			708,774
Less accumulated depreciation and amortization		(297,285	)		(287,888	)

Total property and equipment, net		394,785			420,886

Other Assets		43,515			17,122


TOTAL ASSETS	$	789,293		$	773,243


LIABILITIES AND SHAREHOLDERS’ EQUITY
CURRENT LIABILITIES:
Accounts payable	$	106,351		$	66,581
Other current liabilities		66,113			73,952

Total current liabilities		172,464			140,533

LONG-TERM LIABILITIES:
Deferred lease incentives		78,201			89,371
Deferred rent		28,408			30,619
Other long-term liabilities		35,411			9,367

Total long-term liabilities		142,020			129,357

Commitments and contingencies (Note 12)

SHAREHOLDERS’ EQUITY:
Preferred stock, $.01 par value; 5,000,000 shares authorized; none issued		—			—
Common stock, $.01 par value; 170,859,375 shares authorized; 69,809,959 and 69,560,077 shares issued and outstanding, respectively		698			696
Additional paid-in capital		13,457			5,783
Retained earnings		460,654			496,874

Total shareholders’ equity		474,809			503,353


TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY	$	789,293		$	773,243

See accompanying notes

PACIFIC SUNWEAR OF CALIFORNIA, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

AND COMPREHENSIVE (LOSS)/INCOME

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


	For the Third Quarter Ended					For the Three Quarters Ended
	November 3,			October 28,		November 3,			October 28,
	2007			2006		2007			2006
Net sales	$	373,148		$	375,427	$	1,037,951		$	988,996

Cost of goods sold, including buying, distribution and occupancy costs		262,049			269,085		752,963			687,947


Gross margin		111,099			106,342		284,988			301,049

Selling, general and administrative expenses		148,849			92,562		350,491			255,355


Operating (loss)/income		(37,750	)		13,780		(65,503	)		45,694

Interest income, net		652			709		2,162			3,594

(Loss)/Income before income tax (benefit)/expense		(37,098	)		14,489		(63,341	)		49,288

Income tax (benefit)/expense		(17,061	)		5,506		(27,744	)		18,729


Net (loss)/income	$	(20,037	)	$	8,983	$	(35,597	)	$	30,559


Comprehensive (loss)/income	$	(20,037	)	$	8,983	$	(35,597	)	$	30,559


Net (loss)/income per share, basic	$	(0.29	)	$	0.13	$	(0.51	)	$	0.43


Net (loss)/income per share, diluted	$	(0.29	)	$	0.13	$	(0.51	)	$	0.43


Wtd. avg. shares outstanding, basic		69,765,113			69,344,402		69,678,733			71,274,716

Wtd. avg. shares outstanding, diluted		69,765,113			69,561,420		69,678,733			71,657,385

See accompanying notes

PACIFIC SUNWEAR OF CALIFORNIA, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited, in thousands)


	Three Quarters Ended
	Nov. 3, 2007			Oct. 28, 2006
CASH FLOWS FROM OPERATING ACTIVITIES:
Net (loss)/income	$	(35,597	)	$	30,559
Adjustments to reconcile net (loss)/income to net cash provided by operating activities:
Depreciation and amortization		58,295			52,632
Stock-based compensation		5,119			5,392
Tax benefits related to stock-based compensation		320			1,556
Excess tax benefits related to stock-based compensation		(292	)		(963	)
Loss on disposal/impairment of property and equipment		63,001			373
Change in operating assets and liabilities:
Merchandise inventories		(36,997	)		(37,540	)
Other current assets		(25,349	)		12,237
Other assets		(3,093	)		8,668
Accounts payable		39,770			30,361
Other current liabilities		(8,047	)		(18,879	)
Deferred lease incentives		(11,170	)		4,937
Deferred rent		(2,211	)		1,969
Other long-term liabilities		2,115			(6,687	)

Net cash provided by operating activities		45,864			84,615


CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment		(94,939	)		(107,087	)
Purchases of available-for-sale marketable securities		(171,400	)		(226,503	)
Sales of available-for-sale marketable securities		202,900			286,803
Purchases of held-to-maturity marketable securities (Note 11)		(23,300	)		—
Maturities of held-to-maturity marketable securities		—			14,611

Net cash used in investing activities		(86,739	)		(32,176	)


CASH FLOWS FROM FINANCING ACTIVITIES:
Borrowing under long-term financing obligation (Note 11)		23,300			—
Proceeds from exercise of stock options		2,237			6,532
Excess tax benefits related to stock-based compensation		292			963
Principal payments under capital lease obligations		(42	)		(319	)
Repurchase and retirement of common stock		—			(99,347	)

Net cash provided by/(used in) financing activities		25,787			(92,171	)


NET DECREASE IN CASH AND CASH EQUIVALENTS:		(15,088	)		(39,732	)
CASH AND CASH EQUIVALENTS, beginning of period		52,267			95,185

CASH AND CASH EQUIVALENTS, end of period	$	37,179		$	55,453


SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid for interest	$	5		$	4
Cash paid for income taxes	$	10,635		$	34,941

SUPPLEMENTAL DISCLOSURES OF NON-CASH TRANSACTIONS:
Increase in non-cash property and equipment accruals	$	247		$	9,492
Capital lease transaction for property and equipment	$	9		$	—

See accompanying notes

PACIFIC SUNWEAR OF CALIFORNIA, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

For the quarterly period ended November 3, 2007

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

1. NATURE OF BUSINESS

Pacific Sunwear of California, Inc., together with 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.” The Company also operates a specialty footwear concept, One Thousand Steps, which has nine stores. 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. 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. Please see Note 4 for a discussion concerning the Company’s immediate future plans regarding its demo and One Thousand Steps stores.

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 notes 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 three quarters ended November 3, 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.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”), which permits companies to choose to measure certain financial instruments and other items at fair value that are not currently required to be measured at fair value. SFAS 159 is effective for fiscal years beginning after November 15, 2007. The Company has not determined the effect that the adoption of SFAS 159 will have on its consolidated financial statements.

4. PENDING DISPOSITION OF DEMO AND ONE THOUSAND STEPS STORES

On October 22, 2007, the Board of Directors of the Company approved management’s recommendation to explore strategic alternatives for the Company’s demo stores and to close its One Thousand Steps stores. The Company has engaged an investment banker, Financo, Inc., to assist in identifying and evaluating strategic alternatives for the Company’s remaining 154 demo stores (which excludes the 74 demo stores already closed earlier in fiscal 2007). The Company anticipates closing its nine One Thousand Steps stores by the end of fiscal 2007.

The determination to take these actions resulted from a comprehensive review and evaluation of the profit performance as well as the real estate portfolio of the Company’s demo and One Thousand Steps stores. The demo and One Thousand Steps stores collectively generated a total pre-tax operating loss of approximately $49 million during the first nine months of fiscal 2007 (including previously announced lease termination and asset impairment charges related to demo and One Thousand Steps).

As a result of these actions, the Company recognized non-cash store asset impairment charges associated with demo of approximately $49 million (included in selling, general and administrative expenses) and inventory reserve charges for demo and One Thousand Steps aggregating approximately $5 million (included in cost of goods sold) in its third quarter ended November 3, 2007. The Company will likely incur additional charges, both cash and non-cash, in the future related to potential lease terminations and related costs, inventory liquidation costs, employee retention and severance obligations, and/or agency fees associated with the evaluation or implementation of potential strategic alternatives. The actual amounts and timing of such charges, if any, will not be known until various strategic alternatives are evaluated and a definitive course of action is determined.

In accordance with the provisions of SFAS 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” and EITF 03-13, “Applying the Conditions in Paragraph 42 of FASB Statement No. 144 in Determining Whether to Report Discontinued Operations,” demo and One Thousand Steps are not yet considered discontinued operations as the Company continues to receive direct cash flows from operating these stores and does not yet know what the ultimate disposition or divestiture of the demo stores will be.

As of November 3, 2007, the Company had approximately $4 million in accrued liabilities for estimated lease terminations yet to be finalized from 19 of the 74 previously closed demo stores. Additional lease termination charges may be incurred in future periods as any of the remaining 154 demo stores or nine One Thousand Steps stores cease operations and/or lease termination negotiations are finalized for any remaining demo or One Thousand Steps stores.

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). Information for the first three 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
Three Quarters Ended							Thousand
November 3, 2007:	PacSun			demo			Steps			Corporate			Total
Net Sales	$	921,677		$	112,343		$	3,931			n/a		$	1,037,951
% of Total Sales		89	%		11	%		0	%		n/a			100	%
Comparable Store Sales %		4.0	%		(13.7	)%		(14.4	)%		n/a			2.0	%
Income/(Loss) before Income Taxes	$	149,688		$	(80,821	)	$	(14,066	)	$	(118,142	)	$	(63,341	)
Total Assets	$	489,597		$	40,916		$	1,621		$	257,159		$	789,293
Number of Stores		957			154			9			n/a			1,120
Square Footage		3,667			439			24			n/a			4,130


							One
Three Quarters Ended							Thousand
October 28, 2006:	PacSun			demo			Steps			Corporate			Total
Net Sales	$	855,402		$	130,790		$	2,804			n/a		$	988,996
% of Total Sales		87	%		13	%		0	%		n/a			100	%
Comparable Store Sales %		(4.6	)%		(6.9	)%		n/a			n/a			(4.9	)%
Income/(Loss) before Income Taxes	$	148,341		$	(1,547	)	$	(2,007	)	$	(95,501	)	$	49,288
Total Assets	$	461,263		$	118,052		$	15,577		$	181,107		$	775,999
Number of Stores		945			215			9			n/a			1,169
Square Footage		3,582			603			24			n/a			4,209

In the tables above, the “PacSun” reportable segment includes only the operations of PacSun stores, PacSun Outlet stores and PacSun e-commerce. The “demo” reportable segment only includes the operations of demo stores and demo e-commerce. The “One Thousand Steps” reportable segment includes only the

operations of 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 three quarters of each 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:


	Fiscal Three Quarters
	2007						2006
	Stock Awards			ESPP			Stock Awards			ESPP
Expected Life	4 years			0.5 years			5 years			0.5 years
Stock Volatility		34.7% - 36.6	%		31.9	%		41.3% - 48.7	%		35.4	%
Risk-free Interest Rates		4.3% - 4.9	%		5.0	%		4.6% – 5.1	%		4.5	%
Expected Dividends	None			None			None			None

Stock-based compensation expense for the three quarters of each of fiscal 2007 and 2006 was included in costs of goods sold for the Company’s buying and distribution employees ($1.8 million and $1.5 million, respectively) and in selling, general and administrative expense for all other employees ($3.1 million and $3.8 million, respectively).

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


						Weighted-
				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
Granted		334,000			19.16
Exercised		(86,047	)		9.83
Forfeited or expired		(161,790	)		23.62

Outstanding at August 4, 2007		3,270,399		$	19.61		5.24	$	4,219
Granted		59,000			14.68
Exercised		(50,763	)		6.72
Forfeited or expired		(125,894	)		23.76

Outstanding at November 3, 2007		3,152,742		$	19.56		5.02	$	3,717


Vested and expected to vest at November 3, 2007		2,636,355		$	19.34		4.82	$	3,678


Exercisable at November 3, 2007		1,820,125		$	18.43		4.32	$	3,638

The weighted-average grant-date fair value of options granted during the first three quarters of each of fiscal 2007 and 2006 was $6.70 and $9.36, respectively. The total intrinsic value of options exercised during the first three quarters of each of fiscal 2007 and 2006 was $1.8 million and $5.2 million, respectively.

A summary of the status of the Company’s non-vested share awards during the first three quarters 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
Granted		34,450			19.74
Vested		(35,615	)		20.05
Forfeited		(39,429	)		20.29

Outstanding at August 4, 2007		618,017		$	20.46
Granted		211,150			16.28
Vested		(2,313	)		15.35
Forfeited		(38,092	)		20.18

Outstanding at November 3, 2007		788,762		$	19.37

The fair value of shares vested during the first three quarters of fiscal 2007 was approximately $0.7 million.

As of November 3, 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 2.81 years.

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

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


	November 3, 2007								October 28, 2006
	Net								Net
Third Quarter Ended:	(Loss)			Shares		EPS			Income		Shares		EPS
Basic EPS:	$	(20,037	)		69,765,113	$	(0.29	)	$	8,983		69,344,402	$	0.13
Diluted EPS:
Effect of dilutive equivalents		—			—		(0.00	)		—		217,018		(0.00	)

	$	(20,037	)		69,765,113	$	(0.29	)	$	8,983		69,561,420	$	0.13


	November 3, 2007								October 28, 2006
	Net								Net
Three Quarters Ended:	(Loss)			Shares		EPS			Income		Shares		EPS
Basic EPS:	$	(35,597	)		69,678,733	$	(0.51	)	$	30,559		71,274,716	$	0.43
Diluted EPS:
Effect of dilutive equivalents		—			—		(0.00	)		—		382,669		(0.00	)

	$	(35,597	)		69,678,733	$	(0.51	)	$	30,559		71,657,385	$	0.43

Options to purchase 2,405,831 and 2,476,923 shares of common stock in the third quarter of fiscal 2007 and 2006, respectively, and 2,293,894 and 2,480,699 shares of common stock in the first three quarters 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:


	November 3,		February 3,
	2007		2007
Income taxes receivable	$	30,589	$	—
Prepaid expenses		27,871		27,748
Deferred income taxes		7,291		7,291
Non-trade accounts receivable		5,853		11,216

Total other current assets	$	71,604	$	46,255

9. OTHER CURRENT LIABILITIES

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


	November 3,		February 3,
	2007		2007
Accrued capital expenditures	$	14,049	$	13,802
Accrued compensation and benefits		10,974		15,529
Accrued gift cards		8,644		14,007
Sales taxes payable		3,943		4,771
Accrued lease terminations (Note 4)		3,624		—
Income taxes payable		—		8,706
Other		24,879		17,137

Total other current liabilities	$	66,113	$	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 half of fiscal 2007. Accrued interest and penalties was approximately $0.7 million at both November 3, 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. INDUSTRIAL REVENUE BOND TRANSACTION – OLATHE, KANSAS

On July 17, 2007, Pacific Sunwear Stores Corp., a wholly-owned subsidiary of the Company, completed an industrial revenue bond financing transaction with the city of Olathe, Kansas (the “City”) that will provide property tax savings for 10 years on the Company’s new distribution center located in the City. In the transaction, the City purchased the land and building from the Company through the issuance to the Company of approximately $23.3 million in industrial revenue bonds due January 1, 2018 (“Bonds”) and contemporaneously leased the land and building to the Company for an identical term. The Company can call the Bonds at any time it chooses, but would lose its property tax benefit in the event this transaction was to be canceled. In the Company’s consolidated balance sheet, the land and building remain a component of property and equipment, the investment in the Bonds is included in other assets, and the related long-term lease is included in other long-term liabilities.

The Company, as holder of the Bonds, is due interest at 7% per annum with interest payable semi-annually in arrears on January 1 and July 1. This interest income is directly offset by the interest-only lease payments on the distribution center, which are due at the same time and in the same amount as the interest income. Both the Bonds and the corresponding lease have 10-year terms. If, at any time, the Company chooses to call the Bonds, the proceeds from the Bonds would be required to immediately terminate the lease. The Company’s intention is to maintain the property tax benefit related to the Olathe facility. Accordingly, both the Bonds and the lease are classified as long-term due to the Company’s intent to hold the Bonds until maturity and the structure of the lease, which includes a balloon principal payment and bargain purchase requirement at the end of the lease term.

12. 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 earlier in fiscal 2007, 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. Similar actions may take place with regard to the Company’s remaining 154 demo stores and nine One Thousand Steps stores (see Note 4). The Company is undertaking to reach agreements with landlords of the 74 closed stores to address its underlying lease obligations. As of November 3, 2007, lease terminations have been executed covering 55 of the 74 total demo closures. The Company has accrued estimated lease termination obligations related to the 19 remaining active leases from the original 74 closures and has included that amount in accrued liabilities (see Note 4). Actual lease termination charges could be significantly higher than the Company’s estimates. Any additional charges will be recognized at the time any of the remaining lease termination negotiations are finalized and/or when new information causes the Company to revise its estimates. The Company believes that the outcome of current and threatened litigation, including litigation relating to any remaining demo or One Thousand Steps stores, 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 $27 million outstanding at November 3, 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 consolidated 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 the forward-looking statements contained 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. Examples of forward-looking statements in this report include, but are not limited to, the following categories of expectations about:

	•		forecasts of future store closures, including planned fiscal 2007 closures

	•		estimates of remaining lease termination charges associated with the recent closure of 74 demo stores

	•		the sufficiency of working capital and operating cash flows to meet our operating and capital expenditure requirements without borrowing significantly under our credit facility

	•		the outcome of litigation matters

	•		expectations regarding future increases in CAM expenses

All forward-looking statements included in this report are based on information available to us as of the date hereof, and are subject to risks and uncertainties that could cause actual results to differ materially from those expressed in the forward-looking statements. See Item 1A, Risk Factors, in this report for a discussion of these risks and uncertainties. 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 three quarters of fiscal 2007, the Company incurred total estimated lease termination charges of approximately $18 million associated with the 74 demo closures, approximately $4 million of which remains in accrued liabilities for lease terminations not yet finalized with 19 of the original 74 demo closures. Actual lease termination charges could differ materially from our estimates and could adversely affect results of operations for the remainder of fiscal 2007. For a discussion of the changes in the components comprising operating margins during the first half 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 that our cash flows from operations and working capital will be sufficient to finance operations without significant borrowing under our credit facility over the next twelve months. However, in the event we were required to negotiate lease terminations with any or all of the 154 remaining demo stores and nine One Thousand Steps stores, we could be required to draw on our credit facility in order to pay expenses associated with such closures.

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 reported revenues and expenses during the reporting 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 increases 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 is 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 the carrying value of these assets will not be realized, we will reduce the value of these assets to their expected realizable value through a valuation allowance, thereby decreasing net income. If we subsequently determine 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:


	Third Quarter Ended						Three Quarters Ended
	Nov. 3,			Oct. 28,			Nov. 3,			Oct. 28,
	2007			2006			2007			2006
Net sales		100.0	%		100.0	%		100.0	%		100.0	%
Cost of goods sold, including buying, distribution and occupancy costs		70.2			71.7			72.5			69.6

Gross margin		29.8			28.3			27.5			30.4
Selling, general and administrative expenses		39.9			24.7			33.8			25.8

Operating (loss)/income		(10.1	)		3.6			(6.3	)		4.6
Interest income, net		0.2			0.3			0.2			0.4

(Loss)/Income before income tax (benefit)/expense		(9.9	)		3.9			(6.1	)		5.0
Income tax (benefit)/expense		(4.5	)		1.5			(2.7	)		1.9

Net (loss)/income		(5.4	)%		2.4	%		(3.4	)%		3.1	%

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:


	November 3,		October 28,
	2007		2006
PacSun stores		838		835
Outlet stores		119		110
demo stores		154		215
One Thousand Steps stores		9		9

Total stores		1,120		1,169

Square footage (in 000’s)		4,130		4,209

The third quarter (thirteen weeks) ended November 3, 2007 as compared to the third quarter (thirteen weeks) ended October 28, 2006

Net Sales

Net sales were $373 million for the third quarter of fiscal 2007, a slight decrease from $375 million for the third quarter of fiscal 2006. The components of this $2 million decrease in net sales are as follows:


$millions			Attributable to
$	(18	)	Decrease in other non-comparable sales, which include net sales from expanded or relocated stores not yet included in the comparable store base, internet net sales, and the impact of lost sales from our refreshed stores while the stores are closed for renovation.
	(15	)	93 closed stores in fiscal 2007 and 6 closed stores in fiscal 2006.
	16		5% increase in comparable store net sales in the third quarter of fiscal 2007 compared to the third quarter of fiscal 2006.
	13		Net sales from stores opened in fiscal 2006 not yet included in the comparable store base.
	2		13 new stores opened in fiscal 2007 not yet included in the comparable store base.
$	(2	)	Total

Of the 5.0% increase in comparable store net sales in the third quarter of fiscal 2007, PacSun and PacSun Outlet comparable store net sales increased a combined 7.7% and demo comparable store net sales decreased (18.3)%. In percentage terms, total transactions were up high-single digits while the average unit retail and average number of units per sale transaction in a comparable store were both down low-single digits. The decrease in average unit retail was primarily driven by weakness in the footwear business, which experienced a comparable store decrease in the mid-twenties for sneakers. Sneakers carry higher average unit retail prices than our non-sneaker footwear categories.

Within PacSun and PacSun Outlet, comparable store net sales of girls’ and guys’ merchandise increased 18.4% and 0.4%, respectively. Girls’ comparable store net sales results were characterized by strength in denim, tank tops, dresses, handbags, and shorts, partially offset by weakness in tees and sneakers. Guys’ comparable store net sales results were characterized by strength in tees, fleece and shorts, offset by weakness in accessories and sneakers. Accessory comparable sales were down for guys primarily due to our exiting certain prior year classifications such as wallets, belt buckles and body jewelry.

Within demo, comparable store net sales of girls’ and guys’ merchandise decreased (11.3)% and (25.1)%, respectively. Girls’ comparable store net sales results were characterized by weakness in accessories and bottoms, partially offset by strength in tops. Guys’ comparable store net sales results were primarily characterized by weakness in tees, wovens and denim.

Gross Margin

Gross margin, after buying, distribution and occupancy costs, increased to $111 million for the third quarter of fiscal 2007 from $106 million for the third quarter of fiscal 2006, an increase of $5 million, or 4%. As a percentage of net sales, gross margin was 29.8% for the third quarter of fiscal 2007 compared to 28.3% for the third quarter of fiscal 2006. The 1.5% increase in gross margin as a percentage of net sales was primarily attributable to the following:


%			Attributable to
	2.0		Increase in merchandise margins as a percentage of net sales, primarily due to a decreased markdown rate and improved initial markups.
	(0.4	)	Increase in buying costs as a percentage of net sales, primarily due to planned increases in our merchandise design and planning departments.
	(0.2	)	Increase in occupancy expenses as a percentage of net sales, primarily due to common area maintenance expenses.
	0.1		Decrease in distribution costs as a percentage of net sales.
	1.5		Total

Selling, General and Administrative Expenses

Selling, general and administrative expenses increased to $149 million for the third quarter of fiscal 2007, up from $93 million for the third quarter of fiscal 2006, an increase of $56 million, or 61%. These expenses increased to 39.9% as a percentage of net sales in the third quarter of fiscal 2007 from 24.7% in the third quarter of fiscal 2006. The components of this 15.2% net increase in selling, general and administrative expenses as a percentage of net sales were as follows:


%		Attributable to
	13.7	Asset impairment and write-off charges of $51 million during the third quarter of fiscal 2007, primarily due to $49 million in store asset impairment charges attributable to the Company’s 154 demo stores (see Note 4 to the condensed consolidated financial statements).
	1.2	Increase in general and administrative expenses as a percentage of net sales to 6.8% ($25 million) for the third quarter of fiscal 2007 from 5.6% ($21 million) for the third quarter of fiscal 2006. In absolute dollars, these expenses were up primarily due to strategic consulting expenses and planned payroll increases in the Company’s home office and within its field management team. The Company also incurred planned expense increases associated with its e-commerce operation.
	0.3	Increase in all other direct store expenses as a percentage of net sales to 19.3% ($72 million) in the third quarter of fiscal 2007 as compared to 19.0% ($71 million) in the third quarter of fiscal 2006. The primary increase in other direct store expenses was attributable to depreciation expenses associated with our PacSun store refresh program.
	15.2	Total

Net Interest Income

Net interest income was $0.7 million in the third quarter of each of fiscal 2007 and fiscal 2006.

Income Tax Benefit/Expense

The Company had a net income tax benefit of approximately $17 million for the third quarter of fiscal 2007 compared to income tax expense of approximately $6 million for the third quarter of fiscal 2006 due to the net loss sustained by the Company during the third quarter of fiscal 2007. The effective income tax rate was 46.0% in the third quarter of fiscal 2007 as compared to 38.0% in the third quarter of fiscal 2006. The increase in the effective income tax rate was primarily attributable to the Company’s projected net loss for fiscal 2007 as a result of the store asset impairment charges associated with demo stores (see Note 4 to the condensed consolidated financial statements). As a result of the forecasted loss, permanent tax benefits related to investment tax credits associated with our Olathe, Kansas distribution center result in an increase to the effective tax rate. 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.

Three quarters (39 weeks) ended November 3, 2007 as compared to the three quarters (39 weeks) ended October 28, 2006

Net Sales

Net sales increased to $1,038 million for the first three quarters of fiscal 2007 from $989 million for the first three quarters of fiscal 2006, an increase of $49 million, or 5%. The components of this $49 million increase in net sales are as follows:


$millions			Attributable to
$	53		Net sales from stores opened in fiscal 2006 not yet included in the comparable store base
	18		2.0% increase in comparable store net sales in the first three quarters of fiscal 2007 compared to the first three quarters of fiscal 2006
	10		Other non-comparable sales (net sales from expanded or relocated stores not yet included in the comparable store base and internet net sales)
	3		13 new stores opened in fiscal 2007 not yet included in the comparable store base
	(35	)	93 closed stores in fiscal 2007 and 6 closed stores in fiscal 2006
$	49		Total

Of the 2.0% increase in comparable store net sales in the first three quarters of fiscal 2007, PacSun and PacSun Outlet comparable store net sales increased 4.0% and demo comparable store net sales decreased (13.7)%. In percentage terms, total transactions were up high-single digits while the average unit retail and average number of units per sale transaction in a comparable store were both down low-single digits. The decrease in average unit retail was primarily driven by the footwear business, which experienced a comparable store decrease in the mid-twenties for sneakers. Sneakers carry higher average unit retail prices than our non-sneaker footwear categories.

Within PacSun and PacSun Outlet, comparable store net sales of girls’ merchandise increased 11.1% while guys’ merchandise decreased (1.2)%. Girls’ comparable store net sales results were characterized by strength in denim, tank tops, dresses, shorts and handbags, partially offset by weakness in tees and sneakers. Guys’ comparable store net sales results were characterized by strength in tees, fleece, and shorts, but were more than offset by weakness in accessories, sneakers and pants. Accessory comps were down for guys primarily due to our exiting certain prior year classifications such as wallets, belt buckles and body jewelry.

Within demo, comparable store net sales of girls’ and guys’ merchandise decreased (10.2)% and (17.3)%, respectively. Girls’ comparable store net sales results were characterized by weakness in accessories and denim, partially offset by strength in tops. Guys’ comparable store net sales results were primarily characterized by weakness in tops and denim.

Gross Margin

Gross margin, after buying, distribution and occupancy costs, decreased to $285 million for the first three quarters of fiscal 2007 from $301 million for the first three quarters of fiscal 2006, a decrease of $16 million, or 5%. As a percentage of net sales, gross margin was 27.5% for the first three quarters of fiscal 2007 compared to 30.4% for the first three quarters of fiscal 2006. The 2.9% decrease in gross margin as a percentage of net sales was primarily attributable to the following:


%			Attributable to
	(1.7	)	Lease termination and other occupancy costs associated with the Company’s closure of 74 underperforming demo stores ($18 million).
	(1.0	)	Decrease in merchandise margins as a percentage of net sales, primarily due to an increased markdown rate (1.1% higher in the current year) partially offset by higher initial markups (0.4% higher in the current year). Other margin items were down 0.3% as a percentage of net sales.
	(0.3	)	Increase in buying costs as a percentage of net sales, primarily due to planned increases in our merchandise design and planning departments.
	(0.1	)	Net increase in distribution expenses.
	0.2		Decrease in occupancy expenses as a percentage of net sales, excluding the demo closure lease termination expenses.
	(2.9	)	Total

Selling, General and Administrative Expenses

Selling, general and administrative expenses increased to $350 million for the first three quarters of fiscal 2007 from $255 million for the first three quarters of fiscal 2006, an increase of $95 million, or 37%. These expenses increased to 33.8% as a percentage of net sales in the first three quarters of fiscal 2007 from 25.8% in the first three quarters of fiscal 2006. The components of this 8.0% net increase in selling, general and administrative expenses as a percentage of net sales were as follows:


%		Attributable to
	6.1	Asset impairment and write-off charges of $64 million during the first three quarters of fiscal 2007, primarily due to $59 million in store asset impairment charges attributable to the Company’s demo and One Thousand Steps stores (see Note 4 to the condensed consolidated financial statements).
	1.0	Increase in general and administrative expenses as a percentage of net sales to 7.0% ($72 million) for the first three quarters of fiscal 2007 from 6.0% ($59 million) for the first three quarters of fiscal 2006. In absolute dollars, these expenses were up primarily due to planned payroll increases in the Company’s home office and within its field management team, strategic consulting expenses and other planned expense increases in the Company’s e-commerce function.
	0.5	Increase in store payroll expenses as a percentage of net sales to 12.9% ($134 million) in the first three quarters of fiscal 2007 as compared to 12.4% ($123 million) in the first three quarters of fiscal 2006. In absolute dollars, these expenses were up primarily due to minimum wage increases in many states across the country and an increased emphasis on the quality of our in-store merchandise presentation. As a percentage of net sales, these expenses were up due to deleveraging them against the low-single digit same-store sales increase in the first three quarters of fiscal 2007.
	0.4	Increase in other direct store expenses as a percentage of net sales to 7.7% ($80 million) in the first three quarters of fiscal 2007 from 7.3% ($73 million) in the first three quarters of fiscal 2006. In absolute dollars, these expenses were up primarily due to $5 million in increased depreciation expenses associated with new store openings and renovations, and $2 million in agency fee expenses associated with the demo store closures.
	8.0	Total

Net Interest Income

Net interest income was $2.2 million in the first three quarters of fiscal 2007 compared to $3.6 million in the first three quarters of fiscal 2006. Interest income was lower in the first three quarters of fiscal 2007 due to the Company having lower average cash and short-term investment balances compared to the prior year.

Income Tax Benefit/Expense

The Company had a net income tax benefit of approximately $28 million for the first three quarters of fiscal 2007 compared to income tax expense of approximately $19 million for the first three quarters of fiscal 2006 due to the net loss sustained by the Company during the first three quarters of fiscal 2007. The effective income tax rate was 43.8% in the first three quarters of fiscal 2007 as compared to 38.0% in the first three quarters of fiscal 2006. The increase in the effective income tax rate was primarily attributable to the Company’s projected net loss for fiscal 2007 as a result of the store asset impairment charges associated with demo stores (see Note 4 to the condensed consolidated financial statements). As a result of the forecasted loss, permanent tax benefits related to investment tax credits associated with our Olathe, Kansas distribution center result in an increase to the effective tax rate. 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.

Pending Disposition of demo and One Thousand Steps Stores

The tables below present the direct, aggregate financial impact of operating demo and One Thousand Steps for each of the previous seven fiscal quarters:


	1^st			2^nd			3^rd
Fiscal 2007	Quarter			Quarter			Quarter
Net sales	$	52,507		$	32,470		$	31,297
Gross margin, including buying and occupancy		7,672			(10,826	)		(3,626	)
Selling, general & administrative expenses		15,332			22,673			60,442
Pre-tax operating loss		(7,660	)		(33,499	)		(64,068	)
After-tax operating loss		(4,726	)		(19,496	)		(37,163	)
Loss per diluted share		(0.07	)		(0.28	)		(0.53	)


	1^st		2^nd			3^rd			4^th
Fiscal 2006	Quarter		Quarter			Quarter			Quarter
Net sales	$	48,274	$	37,104		$	48,216		$	72,368
Gross margin, including buying and occupancy		12,937		2,478			10,373			13,099
Selling, general & administrative expenses		12,196		13,126			14,351			40,923
Pre-tax operating income/(loss)		740		(10,648	)		(3,978	)		(27,825	)
After-tax operating income/(loss)		459		(6,602	)		(2,466	)		(16,893	)
Earnings/(Loss) per diluted share		0.01		(0.09	)		(0.04	)		(0.24	)

The operational results in the condensed summaries above include only those expenses directly associated with the operations of the demo and One Thousand Steps concepts, including corporate overhead functions directly assigned to these concepts such as their merchandising, sourcing, field management, marketing and e-commerce teams. These results also include the operational results of the 74 previously-closed demo stores, the results of which were disclosed separately in previous public filings. These results do not include any allocation of shared functions such as distribution, real estate, construction, information services, human resources, or finance.

In the third quarter of fiscal 2007, selling, general and administrative expenses included approximately $49 million in store asset impairment charges associated with the Company’s remaining 154 demo stores, and gross margin, including buying and occupancy, included approximately $5 million in aggregate inventory reserve charges associated with demo and One Thousand Steps.

In the second quarter of fiscal 2007, gross margin, including buying and occupancy, included approximately $13 million in total lease termination and other occupancy charges associated with the previous 74 demo closures. Selling, general and administrative expenses included $10 million in asset impairment charges associated with One Thousand Steps.

In the fourth quarter of fiscal 2006, selling, general and administrative expenses included approximately $22 million in store asset impairment charges, and gross margin, including buying and occupancy, included approximately $2 million in inventory reserve charges associated with 74 previously closed demo stores.

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 significantly under our credit facility for at least the next twelve months. However, in the event we were required to negotiate lease terminations with any or all of the 154 remaining demo stores and nine One Thousand Steps stores, we could be required to draw on our credit facility in order to pay expenses associated with such closures.

Operating Cash Flows

Net cash provided by operating activities was $46 million for the first three quarters of fiscal 2007 compared to $85 million for the first three quarters of fiscal 2006. The $39 million decrease in cash provided by operations in the first three quarters of fiscal 2007 as compared to the first three quarters of fiscal 2006 was primarily attributable to the following:


$millions			Attributable to
$	(66	)	Decrease in net income. This amount includes $47 million (after taxes) in store asset impairments, lease termination and other charges related to demo and One Thousand Steps in the first three quarters of fiscal 2007.
	(38	)	Decrease in cash flows from non-inventory current assets, primarily due to accrued income tax receivables of approximately $31 million in the current year versus approximately $3 million in the prior year as a result of the net loss sustained by the Company in the current year and the timing of the payment of fiscal November store rent expenses. November rents were paid in fiscal October in the current year versus in fiscal November in the prior year due to the different quarter-end date (November 3 this year versus October 28 last year).
	(16	)	Decrease in cash flows related to deferred lease incentives due to fewer new store openings in the first three quarters of fiscal 2007 (13) versus the first three quarters of fiscal 2006 (67).
	63		Non-cash asset impairment charges, primarily due to the impairment of the demo and One Thousand Steps stores (see Note 4 to the condensed consolidated financial statements).
	10		Increase in cash flows related to accounts payable, net of inventories, primarily due to a 2% reduction in inventory per square foot and an improved inventory aging position as of the end of the third quarter of fiscal 2007 as compared to the third quarter of fiscal 2006.
	9		Increase in cash flows related to long-term liabilities, primarily due to reduced cash disbursements associated with deferred compensation to former executives in the current year as compared to the prior year.
	(1	)	Net decrease in cash flows from all other operating activities
$	(39	)	Total

Working Capital

Working capital at November 3, 2007 was $179 million compared to $195 million at February 3, 2007, a decrease of $16 million. The changes in working capital were as follows:


$millions			Description
$	195		Working capital at February 3, 2007
	(47	)	Decrease in cash and marketable securities, primarily due to the net loss sustained by the Company during fiscal 2007, among other items (see cash flow statement).
	(5	)	Decrease in non-trade accounts receivable due to cash receipts and fewer landlord allowances in the current year as a result of lower new store openings.
	(3	)	Increase in accounts payable, net of inventory.
	39		Increase in net income tax receivables due to the net loss sustained by the Company during fiscal 2007.
$	179		Working capital at November 3, 2007

Investing Cash Flows

Net cash used in investing activities in the first three quarters of fiscal 2007 was $87 million compared to $32 million for the first three quarters of fiscal 2006, a decrease in cash flows from investing activities of $55 million. Investing cash flows for the first three quarters of fiscal 2007 were comprised of capital expenditures of $95 million and net maturities of marketable securities of $8 million. Capital expenditures were predominantly for the opening of remodeled, relocated and expanded stores. In the first three quarters of fiscal 2006, the Company’s investing activities were comprised of $107 million in capital expenditures and $75 million in net maturities of marketable securities. Due to an increasing interest rate environment in the prior year, the Company had been aggressively liquidating longer-term investments (original maturity of 3 months to one year) in favor of shorter-term investments (original maturity of less than 3 months).

Financing Cash Flows

Net cash provided by financing activities in the first three quarters of fiscal 2007 was $26 million compared to cash used of $92 million for the first three quarters of fiscal 2006. The Company completed an industrial revenue bond transaction associated with its Olathe, Kansas distribution center which resulted in a cash inflow of $23 million during the third quarter of fiscal 2007 (see Note 11 to the condensed consolidated financial statements). Proceeds from employee exercises of stock options were $5 million lower in the first three quarters of fiscal 2007 ($2 million) than in the first three quarters of fiscal 2006 ($7 million). The Company repurchased and retired common stock in the amount of $99 million during the first three quarters of fiscal 2006, but has not made any repurchases during fiscal 2007.

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, 5.2% at November 3, 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 November 3, 2007. The credit facility requires us to maintain certain financial covenants, as amended, all of which we were in compliance with as of November 3, 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 for 19 of the original 74 demo closure stores for which lease termination agreements have not yet been finalized. All 74 stores have been closed by the Company, but the leases remain active for the 19 stores previously mentioned. At November 3, 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	$	107	$	211	$	176	$	226
Letters of credit		27		27		—		—		—
Olathe lease obligation (see Note 11)		23		—		—		—		23

Total	$	770	$	134	$	211	$	176	$	249

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 these leases 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 remodel, expand, relocate or close. We currently anticipate closing approximately 105-115 stores in fiscal 2007, including the 74 demo stores recently closed (see Note 4 to the condensed consolidated financial statements).

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 November 3, 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 November 3, 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 5.2% on our credit facility at November 3, 2007, if interest rates on the credit facility were to increase by 10%, and to the extent borrowings were outstanding, for every $10 million outstanding on our credit facility, net income would be reduced by approximately $30 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 November 3, 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 13 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 continue to modify our existing store design model for our PacSun stores, 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 new store design alternatives for our PacSun stores 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 other store concepts, demo and One Thousand Steps, have yet to achieve acceptable levels of profitability. We are currently seeking strategic alternatives for our 154 remaining demo stores and plan to close our nine One Thousand Steps stores as soon as is practical. There can 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 are in the process of seeking strategic alternatives for our demo stores and plan to close our One Thousand Steps stores as soon as is practical. These processes could divert significant attention from our more successful PacSun and PacSun Outlet operations and we are likely to incur related cash and non-cash charges, the amount of which is not currently known. On October 22, 2007, our Board of Directors approved management’s recommendation to explore strategic alternatives for our demo stores and to close our One Thousand Steps stores. We have engaged an investment banker to assist us in identifying and evaluating strategic alternatives for our remaining 154 demo stores and plan to close our nine One Thousand Steps stores as soon as is practical. For our demo stores, the strategic alternatives to be considered are to sell all or a portion of the demo stores to a third party, negotiate lease terminations directly with landlords, or some combination of these alternatives. This process could result in significant distraction from our go-forward PacSun and PacSun Outlet operations. In addition, the Company will likely incur additional charges, both cash and non-cash, in the future related to potential lease terminations and related costs, inventory liquidation costs, employee retention and severance obligations, and/or agency fees associated with the evaluation or implementation of potential strategic alternatives. The actual amounts and timing of such charges, if any, will not be known until various strategic alternatives are evaluated and a definitive course of action is determined. Any inability to successfully exit these retail concepts in a timely and cost effective manner could have a material adverse effect on our stock price, financial condition 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 stores 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. For our PacSun and PacSun Outlet stores, sales from proprietary brand merchandise accounted for approximately 30%, 34%, and 33% 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 dependent 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.

Any disruption of our distribution activities could have a material adverse impact on our business. We operate two distribution facilities, one in Anaheim, California, that has been in operation for several years and the other in Olathe, Kansas, which began limited operations in May 2007. 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.

Item 6 – Exhibits


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

Exhibit 10.1		Pacific Sunwear of California, Inc. Executive Severance Plan +*

Exhibit 10.2		Amendment No. 1 to Employment Agreement between the Company and Thomas Kennedy +*

Exhibit 10.3		Retention Bonus Agreement between the Company and Lou Ann Bett (1) *

Exhibit 10.4		Amendment No. 4 to Credit Agreement, dated as of October 31, 2007, with JPMorgan Chase Bank, N.A., as Administrative Agent, and a syndicate of other lenders (2)

Exhibit 31.1		Written statements of Sally Frame Kasaks and Michael L. Henry pursuant to section 302 of the Sarbanes-Oxley Act of 2002

Exhibit 32.1		Written statement of Sally Frame Kasaks and Michael L. Henry pursuant to section 906 of the Sarbanes-Oxley Act of 2002

Note References:


(1)		Incorporated by reference from the Company’s Current Report on Form 8-K, as filed with the Securities and Exchange Commission on October 30, 2007

(2)		Incorporated by reference from the Company’s Current Report on Form 8-K, as filed with the Securities and Exchange Commission on November 7, 2007

+		Filed herewith

*		Management contract or compensatory plan or arrangement

EXHIBIT INDEX


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

Exhibit 10.1		Pacific Sunwear of California, Inc. Executive Severance Plan +*

Exhibit 10.2		Amendment No. 1 to Employment Agreement between the Company and Thomas Kennedy +*

Exhibit 10.3		Retention Bonus Agreement between the Company and Lou Ann Bett (1) *

Exhibit 10.4		Amendment No. 4 to Credit Agreement, dated as of October 31, 2007, with JPMorgan Chase Bank, N.A., as Administrative Agent, and a syndicate of other lenders (2)

Exhibit 31.1		Written statements of Sally Frame Kasaks and Michael L. Henry pursuant to section 302 of the Sarbanes-Oxley Act of 2002

Exhibit 32.1		Written statement of Sally Frame Kasaks and Michael L. Henry pursuant to section 906 of the Sarbanes-Oxley Act of 2002

Note References:


(1)		Incorporated by reference from the Company’s Current Report on Form 8-K, as filed with the Securities and Exchange Commission on October 30, 2007

(2)		Incorporated by reference from the Company’s Current Report on Form 8-K, as filed with the Securities and Exchange Commission on November 7, 2007

+		Filed herewith

*		Management contract or compensatory plan or arrangement


	Page #
PART I. FINANCIAL INFORMATION

Item 1. Condensed Consolidated Financial Statements (unaudited):
Condensed Consolidated Balance Sheets November 3, 2007 and February 3, 2007		3
Condensed Consolidated Statements of Operations and Comprehensive (Loss)/Income Third quarter (13 weeks) and three quarters (39 weeks) ended November 3, 2007 and October 28, 2006		4
Condensed Consolidated Statements of Cash Flows Three quarters (39 weeks) ended November 3, 2007 and October 28, 2006		5
Notes to Condensed Consolidated Financial Statements		6-13
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Consolidated Operations		14-26
Item 3. Quantitative and Qualitative Disclosures about Market Risk		26
Item 4. Controls and Procedures		26

PART II. OTHER INFORMATION
Item 1. Legal Proceedings		27
Item 1A. Risk Factors		27-31
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		31
Item 3. Defaults upon Senior Securities		31
Item 4. Submission of Matters to a Vote of Security Holders		31
Item 5. Other Information		31
Item 6. Exhibits		31

SIGNATURE PAGE		32
EXHIBIT 3.1
EXHIBIT 10.1
EXHIBIT 10.2
EXHIBIT 31.1
EXHIBIT 32.1


	PACIFIC SUNWEAR OF CALIFORNIA, INC. (Registrant)
Date: November 30, 2007	/s/ SALLY FRAME KASAKS
	Sally Frame Kasaks
	Chairman and Chief Executive Officer (Principal Executive Officer)


Date: November 30, 2007	/s/ MICHAEL L. HENRY
	Michael L. Henry
	Interim Chief Financial Officer and Secretary (Principal Financial and Accounting Officer)

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