Hip-Hop Investing

I've long admired teen retailer Pacific Sunwear (Nasdaq: PSUN  ) . The company's differentiated in its approach to reaching America's young shoppers, and consistently stands out among a crowded field of contenders for Generation Y's dollars. I also believe it's uniquely positioned to benefit from two trends that will likely keep influencing our culture.

Pacific Sunwear's namesake stores are loaded with board sport (skateboarding, surfing, snowboarding) fashions from the best established and new brands around. And its d.e.m.o. chain of shops are beacons of urban style, boasting fashions backed by hip-hip royalty. Pacific Sunwear offers branded merchandise, as well as private label clothes and accessories, in all its locations.

Surfin', skatin', and rappin'
Surfing and skateboarding have enjoyed a revival of sorts in popular culture over the past few years, with movies, television, and music capitalizing on the inherent coolness of ripping a wave or perfecting a backside ollie. Kids in middle America, closer to cornfields than ocean, have embraced the California lifestyle as much as any resident with a 90210 zip code. And that's thanks, in part, to retailers like Pacific Sunwear, which have introduced landlocked teens to clothes from Billabong, O'Neill, Hurley, Quiksilver (NYSE: ZQK  ) , and Vans (Nasdaq: VANS  ) .

While this free-flowing surf-and-skate trend has been flowering, another grittier trend -- hip-hop culture -- has been steadily making its way from the inner-city to the suburbs. The immense mainstream popularity of rappers like Jay-Z, Snoop Dogg, Eminem, 50 Cent, and P. Diddy has transformed urban experiences into suburban success. Flip on MTV and watch for 15 minutes to see what I mean. (That is, if MTV's not showing a lame Real World rerun for the hundredth time.)

If you think there's no money to be made in (or from) hip-hop, you must have missed the recent BusinessWeek cover showcasing rap godfather Russell Simmons, founder of Def Jam records and Phat Farm Fashions. Or perhaps Gap's (NYSE: GPS  ) hiring of rapper Missy Elliott for its fall marketing campaign passed you by. Gap, in fact, likes hip-hop so much that it also just launched an Old Navy ad campaign featuring extravagant 4'11" rapper Lil' Kim. Shoe company Reebok (NYSE: RBK  ) also understands how profitable hip-hop can be, and has launched shoe lines designed by and named after rappers Jay-Z and 50 Cent.

PacSun's unique advantage
Though these two trends -- surf/skate and hip-hop -- may seem incredibly disparate, Pacific Sunwear benefits from both like no other company out there. Through its two chains of stores, PacSun reaches two very different audiences, with little to no overlap between them. I find this brand separation appealing, with none of the same cannibalization threats that Old Navy presented to Gap or Abercrombie & Fitch (NYSE: ANF  ) currently faces from Hollister. PacSun's able to grow its business by effectively operating two totally independent chains.

The company's Pacific Sunwear stores are obviously more established, with a base of 664 locations and 78 outlets to d.e.m.o.'s 121 stores. They've been around longer, too -- Pacific Sunwear's a 22-year-old company, and it just introduced the d.e.m.o. concept five years ago. However, a chunk of the firm's future growth is contingent on d.e.m.o. and its continued success.

d.e.m.o.'s market
d.e.m.o. stores sell clothes from hip-hop labels like Phat Farm, Enyce, Rocawear, Sean John, Baby Phat, Ecko, and J. Lo. Brands dominate more in d.e.m.o. than private label clothes (clothes designed, tagged, and sold by Pacific Sunwear), with about 85% of sales coming from branded offerings. In Pacific Sunwear stores, its private label clothes and accessories make up 35% of sales. That means d.e.m.o.'s merchandise margins are below Pacific Sunwear's, but the smaller chain's sales growth has been outstanding.

d.e.m.o. also gives Pacific Sunwear access to an older demographic, and one that's willing to pay more for clothes. The company has said that when it was rolling out its Pacific Sunwear stores, it knew that there was a different shopper out there they weren't reaching at all, and -- voilà -- d.e.m.o. was born.

Back in the second quarter of its current fiscal year, Pacific Sunwear doubled its store target numbers for d.e.m.o., from 200 locations to 400. That's significant, and reflects the possibilities that the company sees for this brand. The lack of competition from another national chain is glaring, and with d.e.m.o.'s comparable-store sales up 12% in 2002 and up 25.5% through the first nine months of fiscal 2003, you can hardly blame Pacific Sunwear for deciding to build out the brand more aggressively.

Pacific Sunwear ultimately envisions operating 1300-1400 stores by fiscal 2007, with more PacSun and PacSun outlets making up the bulk of that. The future for additional Pacific Sunwear locations looks bright, too, with one competitor recently closing up shop altogether and another exiting the men's business.

While both Vans and Quiksilver have had strong results over the past year thanks to a renewed attraction to board sports and old-school fashions, there's an inherent risk to owning a single brand (even if it's a really cool one). With Pacific Sunwear, the threat of teenage fickleness is spread out over lots of brands, and that gives the company an advantage over other teen retailers. Fellow standout Hot Topic (Nasdaq: HOTT  ) has followed a similar formula, but with a different fashion focus, and has also been successful doing so.

Of course, there's always the risk that surfing will suddenly become as cool as pocket protectors, and that hip-hoppers will stop taking their street message to the masses (or that the masses will stop listening). Both of those possibilities seem highly unlikely to me, though, given that Pacific Sunwear's been profiting from surf and skate wear for 22 years, and that people have been predicting the death of hip-hop since the first time the Sugar Hill Gang's lyrical rhymes reached the airwaves in 1979.

Next week, I'll break down Pacific Sunwear's financials, revealing a company that's as sound as its prospects are strong. I'll also talk more about the risks and opportunities it faces in its quest for growth. Please come back then for more.

Of the companies listed, LouAnn Lofton owns shares of Gap and Abercrombie & Fitch. She also recommends that anyone interested in hip-hop run out and buy a copy of Outkast's latest CD, which is so innovative and excellent that she can't turn it off. The Motley Fool is investors writing for investors.

Want to talk about Pacific Sunwear with other Fools? Check out the company's discussion board.


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