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Sunday, June 26, 2011

Revisiting Hot Topic (HOTT)

Comparing the 10-K for the year ending Jan 29, 2011 with the year ending Feb 1, 2002.

44.6 million shares now.
31.5 million shares then.  Dilution was a problem for them.

ShockHound is a new business for them.  Selling MP3s.  Why buy the cow if the Internet is drowning in free milk?  I wrote that before reading further down that they're discontinuing ShockHound.  Wow, I'm a fricken genius! :-/

I have contact with a number of young quasi anti-hipster counterculture types that are in the age range of Hot Topic.  The store is at least relevant and valid.  In fact, it seems to have swung in that direction a few years ago.

The product mix has gone from mostly apparel with acessories and some gifts mixed in to what is now mostly an even mix of accessories, Music, and "License" (what the hell is "License"?).  Torrid, which had just started in 2002, is mostly apparel.

I'm not sure I like the fact that they have a "Trend Director".  They do still have mostly the same direct channels for getting trends, and the same game-plan.

Now: 657 Hot Topic stores
Then: 352 Hot Topic stores (even then there were signs of some saturation).
They peaked in 2007 with 694 stores!

Now: 153 Torrid stores.

Now: Ave sales per HT store is $800K.  $426 per sq foot.
Then: Ave sales per HT store was $1 million.  $642 per sq foot.

Now: they're closing some stores
Then: they rarely closed a store (typically it was a relocation within the same mall)

Now: $188K to open a new store.
Then: didn't find it, but I recall it might have been less.

Looking at the list of officers, I see a lot of new names.  Interestingly, it's the squares who are still around: Gerald Cook, Jim McGinty, George Wehlitz.  Betsy is gone, she left within the past year or so.

New CEO is Lisa Harper from, gasp, Gymboree!

On to the numbers.  Revenues have been stagnant or falling since 2006.  33% gross margins, yuck.  SG&A then eats up the rest.

Comps have essentially been dropping since 2006.

E&Y auditors.  Nonqualified opinion.

PP&E dominates the assets, plus a lot of inventory.  To their credit, they don't have any debt: they could almost pay off all of their liabilities with cash and short term investments.

Operating cash flow is pretty good.  Earnings are killed by depreciation, which is bad; either all those leasehold improvements etc. start getting old or else they need to be replaced.  Given changing trends, I think I can guess which one it is.  As expected, big capex.

Oddly, they paid cash dividends in 2010; apparently the cash was piling up.  Which may indicate that the business is still quite viable, but they've oversaturated the market and killed their financials.  Perhaps it's time to accept a reasonable low-growth cash cow instead of a fast-growth home run.

If they clean up their act, what will the outcome be?  They should be able to get back to something like 38% gross margins (the fast turnaround nature of the business won't support 50%).  SG&A should come down to something like 24% of revenue, maybe even less if they're clever.  You figure 5.4% taxes and you get a net margin of maybe 8%.  Let's cut their revenue down to $600 million.  We then get earnings of $48 million and a value of around $700 million.  Let's watch out for stock option dilution so we'll add the full 7 million outstanding options onto the 45 million share count to get 52 million shares.  So if they were to turn this around, the end value might be $13 a share.  The shares are currently selling for $7.28, which seems like a fair price given the uncertainty of a turnaround.  

I think the basic business of Hot Topic has a lot of value (maybe $700 million) that could be saved.  If I knew that were going to happen, I'd be likely to double my money on this.  I need to think about this a bit more and watch them to see whether they seem like they'll save it or kill the goose that lays golden eggs.

This could be great in the event of a major stock market meltdown because it would look like crap during the meltdown, but the balance sheet and basic cash flows are essentially solid.

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