Focus Article: Hot Topic Inc. (HOTT)

Hot Topic Inc. (HOTT) $9.12

The Company:

Hot Topic is a mall-based retailer that specifically targets teens with music, movies and pop culture inspired clothing and accessories. It has also become one of the leading retailers catering to plus size women through its Torrid line of stores. According to NPD, the plus size women’s category is growing with 32% of women considering themselves as plus size. The plus size category is expected to grow 5.2% annually over the next five years to $9.7 billion, nearly twice the 2.7% annual growth expected from regular apparel sales according to research firm Ibis World.

The first Hot Topic Store opened in 1988 with music inspired accessories for teens. As of September 6, 2012, the company operated 620 Hot Topic stores and 178 Torrid stores. A CFO who starts off an earnings conference call by informing analysts that they were listening to “Smells Like Teen Spirit by Nirvana” while on hold is cool. Hot Topic is in the business of cool and constantly updates its products based on the latest hot movie or best selling artist.

The company hired Lisa Harper as its CEO last year. Ms. Harper previously served as the Chairman and CEO of children’s clothing retailer Gymboree from 2001 until she retired in 2006. Hot Topic has taken several shareholder friendly steps including paying out a $1/share special dividend in 2010, instituting a 28 cents/share annual dividend and increasing that to an annualized rate of 32 cents/share in 2012 as well as the announcement of a $15 million share buyback program on June 6, 2012. The current yield on the stock is an attractive 3.5%, which provides some returns while investors wait for the 20+% long-term growth analysts expect. Despite the performance of their Torrid line, long-term growth of 20% appears to be a far stretch.

Business Statistics & Financials:

During the second quarter, comparable same store sales were up 3.9% year-over-year for the company with Hot Topic stores posting a 3.9% gain and its Torrid brand of stores posting a 4% gain. Apparel sales accounted for 56% of total sales at Hot Topic and 83% of sales at Torrid. The company increased its gross margins to 34.1% from 32.2% last year and managed to narrow its net loss for the quarter to $800,000 or 2 cents per share when compared to $3.6 million or 8 cents per share last year. Capital expenses increased to $19 million this year on account of new store openings and investments in IT systems. The company also generated $10 million more in operating cash flow this year, when compared to the first six months of last year.

The company opened 10 new Torrid stores in Q2 and closed 3 in the quarter. It expects to open 18 new Torrid stores in Q3 and 3 more in Q4. The company expects to earn between 8 to 10 cents per share in Q3 on sales of $181 to $185 million. As is usually the case with retailers, Hot Topic’s strongest quarter is Q4. The company has met or exceeded earnings expectations in each of the last three quarters. The average analyst earnings expectation for the full fiscal year ended January 2013 is 42 cents per share and 50 cents per share for fiscal 2015.

The company has a strong balance sheet with $64 million in net cash and investments. While Hot Topic might appear to be expensive on a P/E basis, as you can see from the competitors table below, it trades for less than 5 times EBITDA despite a 39% increase in the stock price since the start of the year.

Competitors:

Insider Buying:

One insider purchased stock on the open market over the last six months as listed below. These shares were acquired indirectly through Becker Drapkin Partners. Dallas-based Becker Drapkin Partners is an activist firm that focuses on small cap stocks. Their previous purchase was on January 10, 2012 when they picked up 33,200 shares at an average price of $7.03. It is good to see them pick up even more shares at substantially higher prices. As some of you may recall, we have written about Becker Drapkin Partners several times in the past following their purchases of Hot Topic and one of our portfolio holdings, Glu Mobile (GLUU). You can view a list of all insider transactions for Hot Topic Inc. here.

Risk Factors:

Hot Topic operates in a segment of the market that is known for its fickle tastes. The company has managed to find manufacturers that can produce its products in a matter of weeks to address short-term demand but this still requires the company to correctly anticipate trends and position itself accordingly. This is a tough act to pull off on a consistent basis.

While the U6 unemployment rate is 14.6%, teen unemployment is 23.8% and directly affects Hot Topic’s target market. That said, Hot Topic managed to weather the recession by posting positive earnings in fiscal 2009 and fiscal 2010 before posting a loss in fiscal 2011.

Conclusion:

Hot Topic is a turn around story that appears to have turned the corner. A strong balance sheet, a growing brand in Torrid and a 3.5% dividend yield provide additional incentives for considering the company for a long investment. The purchase by Becker Drapkin Partners is encouraging but the 39% gain in the stock since the start of the year gives me pause. The stock trades for less than 5 times EBITDA but it also trades for 15 times fiscal 2014 earnings (after removing $1.51/share in cash).