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SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-Q
(Mark One)
x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the quarterly period ended November 3, 2007
OR
¨ | TRANSITION REPORT PURSUANT TO SECTION 13 OR l5(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the transition period from to
Commission file number: 0-28784
HOT TOPIC, INC.
(Exact name of registrant as specified in its charter)
CALIFORNIA | 77-0198182 | |
(State of incorporation) | (IRS Employer Identification No.) |
18305 EAST SAN JOSE AVE., CITY OF INDUSTRY, CA | 91748 | |
(Address of principal executive offices) | (Zip Code) |
(626) 839-4681
(Registrant’s telephone number, including area code)
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
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 x Accelerated Filer ¨ Non-Accelerated Filer ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
APPLICABLE ONLY TO CORPORATE ISSUERS: Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: November 26, 2007 – 43,586,679 shares of common stock, no par value.
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INDEX TO FORM 10-Q
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Item 1. | Condensed Consolidated Financial Statements |
Hot Topic, Inc. and Subsidiaries
Condensed Consolidated Balance Sheets
(In thousands, except share amounts)
(Unaudited) | ||||||||
November 3, 2007 | February 3, 2007 | |||||||
Assets | ||||||||
Current assets: | ||||||||
Cash and cash equivalents | $ | 7,019 | $ | 3,910 | ||||
Short-term investments | 28,615 | 51,580 | ||||||
Inventory | 104,881 | 73,868 | ||||||
Prepaid expenses and other | 15,355 | 14,435 | ||||||
Deferred tax assets | 4,104 | 3,258 | ||||||
Total current assets | 159,974 | 147,051 | ||||||
Property and equipment, net | 174,244 | 166,726 | ||||||
Deposits and other | 1,283 | 588 | ||||||
Deferred tax assets | 4,204 | 3,906 | ||||||
Total assets | $ | 339,705 | $ | 318,271 | ||||
Liabilities and shareholders’ equity | ||||||||
Current liabilities: | ||||||||
Accounts payable | $ | 40,494 | $ | 15,862 | ||||
Accrued liabilities | 33,327 | 34,332 | ||||||
Income taxes payable | 1,470 | 5,590 | ||||||
Total current liabilities | 75,291 | 55,784 | ||||||
Deferred rent | 40,986 | 40,674 | ||||||
Deferred compensation liability | 1,124 | 356 | ||||||
Income taxes payable | 300 | — | ||||||
Commitments and contingencies | ||||||||
Shareholders’ equity: | ||||||||
Preferred shares, no par value; 10,000,000 shares authorized; no shares issued and outstanding | — | — | ||||||
Common shares, no par value; 150,000,000 shares authorized; 43,586,679 and 44,229,848 shares issued and outstanding at November 3, 2007 and February 3, 2007, respectively | 110,599 | 107,088 | ||||||
Retained earnings | 111,408 | 114,372 | ||||||
Accumulated other comprehensive loss | (3 | ) | (3 | ) | ||||
Total shareholders’ equity | 222,004 | 221,457 | ||||||
Total liabilities and shareholders’ equity | $ | 339,705 | $ | 318,271 | ||||
See accompanying Notes to Condensed Consolidated Financial Statements.
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Hot Topic, Inc. and Subsidiaries
Condensed Consolidated Statements of Income
(In thousands, except per share amounts)
(Unaudited)
Three Months Ended | Nine Months Ended | |||||||||||
November 3, 2007 | October 28, 2006 | November 3, 2007 | October 28, 2006 | |||||||||
Net sales | $ | 188,462 | $ | 196,669 | $ | 507,427 | $ | 511,058 | ||||
Cost of goods sold, including buying, distribution and occupancy costs | 119,994 | 128,271 | 336,416 | 343,566 | ||||||||
Gross margin | 68,468 | 68,398 | 171,011 | 167,492 | ||||||||
Selling, general and administrative expenses | 57,961 | 56,904 | 165,678 | 160,388 | ||||||||
Income from operations | 10,507 | 11,494 | 5,333 | 7,104 | ||||||||
Interest income, net | 414 | 277 | 1,474 | 919 | ||||||||
Income before income taxes | 10,921 | 11,771 | 6,807 | 8,023 | ||||||||
Provision for income taxes | 4,246 | 4,701 | 2,670 | 3,265 | ||||||||
Net income | $ | 6,675 | $ | 7,070 | $ | 4,137 | $ | 4,758 | ||||
Earnings per share: | ||||||||||||
Basic | $ | 0.15 | $ | 0.16 | $ | 0.09 | $ | 0.11 | ||||
Diluted | $ | 0.15 | $ | 0.16 | $ | 0.09 | $ | 0.11 | ||||
Shares used in computing earnings per share: | ||||||||||||
Basic | 43,788 | 44,207 | 44,128 | 44,150 | ||||||||
Diluted | 44,112 | 44,735 | 44,236 | 44,744 |
See accompanying Notes to Condensed Consolidated Financial Statements.
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Hot Topic, Inc. and Subsidiaries
Condensed Consolidated Statements of Cash Flows
(In thousands)
(Unaudited)
Nine Months Ended | ||||||||
November 3, 2007 | October 28, 2006 | |||||||
OPERATING ACTIVITIES | ||||||||
Net income | $ | 4,137 | $ | 4,758 | ||||
Adjustments to reconcile net income to net cash provided by operating activities: | ||||||||
Depreciation and amortization | 31,274 | 28,398 | ||||||
Stock-based compensation | 2,767 | 3,685 | ||||||
Loss on disposal of fixed assets | 268 | 271 | ||||||
Impairment of long-lived assets | 1,035 | 562 | ||||||
Deferred taxes | (1,187 | ) | (1,017 | ) | ||||
Gift card breakage | (402 | ) | (432 | ) | ||||
Changes in operating assets and liabilities: | ||||||||
Inventory | (31,013 | ) | (30,870 | ) | ||||
Prepaid expenses and other current assets | (785 | ) | 9,530 | |||||
Deposits and other assets | (695 | ) | (4 | ) | ||||
Accounts payable | 24,632 | 14,905 | ||||||
Accrued liabilities | 204 | 2,125 | ||||||
Deferred rent | 312 | 1,470 | ||||||
Income taxes payable | (4,657 | ) | (3,918 | ) | ||||
Net cash provided by operating activities | 25,890 | 29,463 | ||||||
INVESTING ACTIVITIES | ||||||||
Purchases of property and equipment | (40,230 | ) | (31,522 | ) | ||||
Proceeds from sale of short-term investments | 81,190 | 48,165 | ||||||
Purchases of short-term investments | (58,225 | ) | (38,876 | ) | ||||
Net cash used in investing activities | (17,265 | ) | (22,233 | ) | ||||
FINANCING ACTIVITIES | ||||||||
Payments on capital lease obligations | — | (262 | ) | |||||
Excess tax benefit from stock-based compensation | 322 | 168 | ||||||
Repurchase of common stock | (7,161 | ) | — | |||||
Proceeds from employee stock purchases and exercise of stock options | 1,323 | 2,176 | ||||||
Net cash (used in) provided by financing activities | (5,516 | ) | 2,082 | |||||
Increase in cash and cash equivalents | 3,109 | 9,312 | ||||||
Cash and cash equivalents at beginning of year | 3,910 | 9,673 | ||||||
Cash and cash equivalents at end of period | $ | 7,019 | $ | 18,985 | ||||
SUPPLEMENTAL INFORMATION | ||||||||
Cash paid during the period for interest | $ | 4 | $ | 13 | ||||
Cash paid during the period for income taxes | $ | 7,660 | $ | 8,904 | ||||
See accompanying Notes to Condensed Consolidated Financial Statements.
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HOT TOPIC, INC. and SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
NOTE 1. Organization and Basis of Presentation
We are a mall-based specialty retailer operating the Hot Topic and Torrid concepts. At our Hot Topic stores, we sell a selection of music/pop culture-licensed and music/pop culture-influenced apparel, accessories and gift items for young men and women. At our Torrid stores, we sell apparel, lingerie, shoes and accessories designed for various lifestyles for plus-size females. We were incorporated in California in 1988. We opened our first Hot Topic store in 1989 and our first Torrid store in 2001. At the end of the third quarter of fiscal 2007 (November 3, 2007, in the 52-week fiscal year ending February 2, 2008), we operated 695 Hot Topic stores throughout the United States and Puerto Rico and 147 Torrid stores in 36 states. We also sell merchandise on two websites, www.hottopic.com and www.torrid.com, which reflect the Hot Topic and Torrid store concepts and sell merchandise similar to that sold in the respective stores. We have one reportable segment given the similarities of the economic characteristics among the Hot Topic and Torrid concepts. Throughout this report, the terms “our,” “we” and “us” refer to Hot Topic, Inc. and its subsidiaries.
The information set forth in these financial statements is unaudited except for the February 3, 2007 condensed consolidated balance sheet data. These statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information, the instructions to Form 10-Q, and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements.
In the opinion of management, all adjustments, consisting only of normal recurring entries, necessary for a fair presentation have been included.
NOTE 2. Stock-Based Compensation
Stock Plan Activity
Under our 1996 Equity Incentive Plan (the “1996 Plan”), we granted stock options, stock bonuses and other awards to our employees, directors and consultants as deemed appropriate by the Board of Directors (the “Board”). On June 14, 2006, the 1996 Plan expired and was replaced with the 2006 Equity Incentive Plan (the “2006 Plan”). The 2006 Plan was approved by the Board on March 17, 2006 and by our shareholders on June 13, 2006. Upon expiration of the 1996 Plan, 732,456 shares out of an aggregate of 18,300,000 shares of common stock were authorized and available for grant.
The 2006 Plan provides for the grant of incentive stock options, non-statutory stock options, restricted stock awards, restricted stock unit awards, stock appreciation rights, performance stock awards and other forms of equity compensation to our employees, consultants and directors as deemed appropriate by the Board. Both incentive and non-statutory stock options granted by us under the 2006 Plan must carry an exercise price of at least 100% of the fair market value of the stock on the date of grant. Options granted may be subject to different vesting terms as determined by the Board and the maximum term of options granted is 10 years. In addition, the maximum number of shares of common stock available for future issuance may not exceed the sum of (a) the number of unallocated shares of common stock remaining available for issuance under the 1996 Plan as of June 13, 2006, (b) an additional
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2,350,000 shares and (c) the number of shares subject to stock awards as of June 13, 2006 under the 1996 Plan pursuant to the terms of the 1996 Plan. As of November 3, 2007, 1,660,580 shares were available for future grants. All awards to date under the 2006 Plan have been granted to our employees and none have been granted to consultants.
In March 2006, we granted restricted stock unit awards under the 1996 Plan to certain members of our management. None of these awards have vested and no shares have been issued pursuant to the grants. These awards provide for the issuance of up to 454,000 shares of our common stock, net of forfeitures, with vesting and issuance contingent upon achieving performance goals for fiscal 2008 based upon our operating income for that fiscal year; and prior to vesting (or termination without vesting), the awards constitute an agreement by us to issue shares to the extent performance goals are ultimately met. The market value of our common stock as of the grant date of these restricted stock unit awards was $13.90. Compensation expense for these awards is required to be recorded over the three-year term of the award, based on the market value as of the grant date, with actual amounts expensed dependent upon the likelihood from period to period of vesting of such awards at the end of fiscal 2008. As of November 3, 2007, it is our best estimate that none of these awards will be earned at the end of the three-year term. Thus, we have not recognized any compensation expense during the three months and nine months ended November 3, 2007 for these restricted stock unit awards.
In March 2007, we granted restricted stock unit awards under the 2006 Plan to certain members of our management. These grants were substantially similar to the restricted stock unit awards granted under the 1996 Plan. None of these awards have vested and no shares have been issued pursuant to the grants. These awards provide for the issuance of up to 576,000 shares of our common stock, net of forfeitures, with vesting and issuance contingent upon achieving performance goals for fiscal 2009 based upon our operating income for that fiscal year; and prior to vesting (or termination without vesting), the awards constitute an agreement by us to issue shares to the extent performance goals are ultimately met. The market value of our common stock as of the grant date of these restricted stock unit awards was $11.31. Compensation expense for these awards is required to be recorded over the three-year term of the award, based on the market value as of the grant date, with actual amounts expensed dependent upon the likelihood from period to period of vesting of such awards at the end of fiscal 2009. As of November 3, 2007, it is our best estimate that none of these awards will be earned at the end of the three-year term. This current estimate differs from our previous best estimate as of the end of the second quarter of fiscal 2007 that 25% of these awards or 150,000 out of a then possible 600,000, will be earned and will vest at the end of the three-year term. We have accounted for the change in estimate by recording a $212,000 offset to compensation expense in the third quarter of fiscal 2007. In aggregate, we have not recognized any compensation expense during the three months and nine months ended November 3, 2007 for these restricted stock unit awards.
In June 2007, we granted 13,826 shares of restricted common stock to non-employee directors under the 2006 Plan, and we granted 11,842 and 7,496 shares of restricted common stock to non-employee directors in fiscal 2006 and fiscal 2005, respectively, under the 1996 Plan. Restricted shares generally vest in the year subsequent to the grant year. All awarded common shares remain restricted (i.e., not transferable by the holders) until such time as the recipient is no longer a member of our Board. The value of these grants is expensed over the vesting period. During the three months ended November 3, 2007, $39,000, none of which relates to the fiscal 2006 grant, was expensed. During the three months ended October 28, 2006, $39,000, none of which related to the fiscal 2005 grant, was expensed. During the nine months ended November 3, 2007, $116,000, of which $52,000 relates to the fiscal 2006 grant, was expensed. During the nine months ended October 28, 2006, $116,000, of which $52,000 related to the fiscal 2005 grant, was expensed.
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The following table summarizes stock options outstanding under all of our plans as of November 3, 2007, as well as year-to-date activity through the third quarter then ended:
Shares | Weighted- Average Exercise Price | Weighted- Average Remaining Contractual Term (in | Aggregate Intrinsic Value (in | ||||||||
Outstanding at February 3, 2007 | 5,955,355 | $ | 15.50 | ||||||||
Granted | 1,170,408 | $ | 11.27 | ||||||||
Exercised | (191,327 | ) | $ | 5.75 | |||||||
Forfeited or expired | (487,631 | ) | $ | 17.80 | |||||||
Outstanding at November 3, 2007 | 6,446,805 | $ | 14.85 | 6.31 | $ | 1,993 | |||||
Exercisable at November 3, 2007 | 4,605,120 | $ | 15.95 | 5.22 | $ | 1,993 | |||||
Cash proceeds, tax benefits and intrinsic value related to total stock options exercised during the three months and nine months ended November 3, 2007 and October 28, 2006 are provided in the following table (in thousands):
Three Months Ended | Nine Months Ended | |||||||||||
November 3, 2007 | October 28, 2006 | November 3, 2007 | October 28, 2006 | |||||||||
Proceeds from stock options exercised | $ | 278 | $ | 6 | $ | 1,100 | $ | 1,776 | ||||
Tax benefit related to stock options exercised | $ | 107 | $ | 0 | $ | 322 | $ | 168 | ||||
Intrinsic value of stock options exercised | $ | 267 | $ | 1 | $ | 806 | $ | 439 |
In June 1996, the Board adopted the Employee Stock Purchase Plan (the “Stock Purchase Plan”). The Stock Purchase Plan provides for the issuance of up to 1,350,000 shares of common stock to our employees. All eligible employees are granted identical rights to purchase common stock for each Board authorized offering under the Stock Purchase Plan. Rights granted pursuant to any offering under the Stock Purchase Plan terminate immediately upon cessation of an employee’s employment for any reason. In general, an employee may reduce contribution or withdraw from participation in an offering at any time during the purchase period for such offering. Employees receive a 15% discount on shares purchased under the Stock Purchase Plan. Rights granted under the Stock Purchase Plan are not transferable and may be exercised only by the person to whom such rights are granted. The initial offering under the Stock Purchase Plan commenced October 24, 1996 and terminated December 31, 1996. Subsequent offerings have occurred every six months commencing January 1, 1997. At November 3, 2007, 1,062,828 shares could still be sold to employees under the plan. Gross compensation expense for the three months and nine months ended November 3, 2007 was $33,000 and $67,000, respectively, related to the fair value of the rights granted to participants under the plan at the beginning of the then-current offering.
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Accounting for Stock-Based Compensation Expense
Effective January 29, 2006, we adopted Statement of Financial Accounting Standards (“SFAS”) No. 123R, “Share-Based Payments,” (“SFAS 123R”) which addresses the accounting for stock-based payment transactions whereby an entity receives employee services in exchange for equity instruments, including stock options. SFAS 123R eliminates the ability to account for stock-based compensation transactions using the intrinsic value method under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” (“APB 25”) and instead generally requires that such transactions be accounted for using a fair value based method. We have elected the modified prospective transition method as permitted under SFAS 123R, and accordingly prior periods have not been restated to reflect the impact of SFAS 123R. The modified prospective transition method requires that stock-based compensation expense be recorded for all new and unvested stock options that are ultimately expected to vest as the requisite service is rendered beginning on January 29, 2006.
The effect of recording stock-based compensation for the three months and nine months ended November 3, 2007 and October 28, 2006 was as follows:
Three Months Ended | Nine Months Ended | |||||||||||||||
November 3, 2007 | October 28, 2006 | November 3, 2007 | October 28, 2006 | |||||||||||||
Stock-based compensation by type of award: | ||||||||||||||||
Employee stock options and awards | $ | 878,091 | $ | 1,041,582 | $ | 2,699,576 | $ | 3,119,169 | ||||||||
Restricted stock units, net of adjustments | (212,062 | ) | (137,263 | ) | — | 411,787 | ||||||||||
Employee stock purchase plan | 33,406 | 44,591 | 67,321 | 153,744 | ||||||||||||
Total stock-based compensation expense | $ | 699,435 | $ | 948,910 | $ | 2,766,897 | $ | 3,684,700 | ||||||||
Tax effect on stock-based compensation expense | (158,978 | ) | (275,508 | ) | (887,990 | ) | (1,052,710 | ) | ||||||||
Net effect on net income | $ | 540,457 | $ | 673,402 | $ | 1,878,907 | $ | 2,631,990 | ||||||||
Effect on earnings per share: | ||||||||||||||||
Basic and diluted | $ | 0.01 | $ | 0.02 | $ | 0.04 | $ | 0.06 | ||||||||
For the three months ended November 3, 2007 and October 28, 2006, $187,000 and $172,000, respectively, of stock and equity awards compensation expense was recorded as a component of cost of goods sold and the remainder, $513,000 and $777,000, respectively, was charged to selling, general and administrative expense.
As of November 3, 2007, we had $8.8 million and $0.1 million of unrecognized expense related to non-vested stock option grants and restricted stock grants, respectively, which are expected to be recognized over weighted average periods of 3.02 years and 0.61 years, respectively.
Calculation of Fair Value of Options
We use a Black-Scholes option valuation model to determine the fair value of stock-based compensation under SFAS 123R, consistent with that used by us previously for pro forma disclosures under SFAS 123. The Black-Scholes model incorporates
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various assumptions including the expected term of awards, volatility of stock price, risk-free rates of return and dividend yield. The expected term of an award is generally no less than the option vesting period and is based on our historical experience. Expected volatility is based upon the historical volatility of our stock price. The risk-free interest rate is approximated using rates available on U.S. Treasury securities with a remaining term equal to the option’s expected life. We use a dividend yield of zero in the Black-Scholes option valuation model, as we do not anticipate paying cash dividends in the foreseeable future.
The following weighted average assumptions were used for stock options granted:
Three Months Ended | Nine Months Ended | |||||||||||||||
November 3, 2007 | October 28, 2006 | November 3, 2007 | October 28, 2006 | |||||||||||||
Risk free interest rate | 4 | % | 5 | % | 5 | % | 5 | % | ||||||||
Expected life | 5 years | 5 years | 5 years | 5 years | ||||||||||||
Expected volatility | 43 | % | 47 | % | 43 | % | 48 | % | ||||||||
Expected dividend yield | 0 | % | 0 | % | 0 | % | 0 | % | ||||||||
Weighted average fair value at grant date | $ | 3.48 | $ | 5.14 | $ | 5.37 | $ | 6.17 |
NOTE 3. Earnings Per Share
We compute earnings per share pursuant to SFAS No. 128 “Earnings Per Share.” Basic earnings per share is computed based on the weighted average number of common shares outstanding for the period. Diluted earnings per share is computed based on the weighted average number of common shares outstanding for the period and potentially dilutive common stock equivalents outstanding for the period.
A reconciliation of the numerator and denominator of basic earnings per share and diluted earnings per share is as follows (in thousands, except per share amounts):
Three Months Ended | Nine Months Ended | |||||||||||
November 3, 2007 | October 28, 2006 | November 3, 2007 | October 28, 2006 | |||||||||
Basic earnings computation: | ||||||||||||
Numerator | $ | 6,675 | $ | 7,070 | $ | 4,137 | $ | 4,758 | ||||
Denominator: | ||||||||||||
Weighted average common shares outstanding | 43,788 | 44,207 | 44,128 | 44,150 | ||||||||
Incremental shares from assumed exercise of options | 324 | 529 | 108 | 594 | ||||||||
Total shares | 44,112 | 44,736 | 44,236 | 44,744 | ||||||||
Basic and diluted earnings per share | $ | 0.15 | $ | 0.16 | $ | 0.09 | $ | 0.11 | ||||
The calculation of dilutive shares excludes the effect of the following options that are considered anti-dilutive:
| ||||||||||||
Three Months Ended | Nine Months Ended | |||||||||||
November 3, 2007 | October 28, 2006 | November 3, 2007 | October 28, 2006 | |||||||||
Anti-dilutive options | 5,834,746 | 4,628,310 | 5,795,964 | 4,648,333 |
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The calculation of dilutive shares also excludes the restricted stock unit awards covering 576,000 and 454,000 shares, net of forfeitures, granted to certain members of our management in March 2007 and March 2006, respectively, as they are contingent upon achieving certain performance goals in fiscal 2009 and 2008, respectively.
NOTE 4. Comprehensive Income
Comprehensive income for the three months and nine months ended November 3, 2007 and October 28, 2006 is as follows (in thousands):
Three Months Ended | Nine Months Ended | |||||||||||||
November 3, 2007 | October 28, 2006 | November 3, 2007 | October 28, 2006 | |||||||||||
Comprehensive income | ||||||||||||||
Net income | $ | 6,675 | $ | 7,070 | $ | 4,137 | $ | 4,758 | ||||||
Unrealized loss on marketable securities, net | — | (3 | ) | — | (7 | ) | ||||||||
Total comprehensive income | $ | 6,675 | $ | 7,067 | $ | 4,137 | $ | 4,751 | ||||||
NOTE 5. Deferred Compensation Plan
In August 2006, we adopted the Hot Topic Inc. Management Deferred Compensation Plan (the “Deferred Compensation Plan”) for the purpose of providing highly compensated employees and members of our Board a program to meet their financial planning needs. The Deferred Compensation Plan provides participants with the opportunity to defer up to 80% of their base salary and up to 100% of their annual earned bonus, all of which, together with the associated investment returns, are 100% vested from the outset. The plan, which is designed to be exempt from most provisions of the Employee Retirement Security Act of 1974, is informally funded by us in order to preserve the tax-deferred savings advantages of a non-qualified plan. As such, all deferrals and associated earnings are general unsecured obligations of Hot Topic, Inc. held as an asset within a ‘rabbi trust’ on our condensed consolidated balance sheets. We do not currently contribute to the plan. As of November 3, 2007, assets and associated liabilities of the Deferred Compensation Plan were $1,045,000 and $1,124,000, respectively, and are included in other non-current assets and non-current liabilities, respectively, in our condensed consolidated balance sheets.
NOTE 6. Impairment of Long-Lived Assets
In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” we assess the impairment of long-lived assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. We group and evaluate long-lived assets for impairment at the individual store level, which is the lowest level at which individual cash
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flows can be identified. Factors we consider important that could trigger an impairment review include a significant underperformance relative to expected historical or projected future operating results, a significant change in the manner of the use of the asset or a significant negative industry or economic trend. When we determine that the carrying value of long-lived assets may not be recoverable based upon the existence of one or more of the aforementioned factors, impairment is measured based on a projected discounted cash flow method using a discount rate determined by management.
In the event future store performance is lower than forecasted results, future cash flows may be lower than expected, which could result in future impairment charges. While we believe recently opened stores will provide sufficient cash flow, material changes in results could result in future impairment charges. Based on our review, we recorded impairment charges of $629,000 and $562,000 for the three months ended November 3, 2007 and October 28, 2006, respectively, which are included in selling, general and administrative expense.
NOTE 7. Bank Credit Agreement
We maintain an unsecured bank credit agreement of $5.0 million that will expire on August 1, 2008. Letters of credit are issued under the credit agreement, which are primarily used for inventory purchases. There were letters of credit for $81,000 and $80,000 outstanding at November 3, 2007 and February 3, 2007, respectively.
NOTE 8. Impact of Recently Issued Accounting Pronouncements
In September 2006, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”), which defines fair value, establishes a framework for measuring fair value and requires enhanced disclosures about fair value measurements. SFAS 157 requires companies to disclose the fair value of their financial instruments according to a fair value hierarchy (i.e., levels 1, 2, and 3, as defined). Additionally, companies are required to provide enhanced disclosure regarding instruments in the level 3 category, including a reconciliation of the beginning and ending balances separately for each major category of assets and liabilities. SFAS 157 will be effective for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years, except for nonfinancial assets and nonfinancial liabilities recognized or disclosed on a non-recurring basis, which will be effective for fiscal years beginning after November 15, 2008 and interim periods within those fiscal years. We are currently evaluating the impact the adoption of SFAS 157 may have on our financial condition or results of operations.
NOTE 9. Income Taxes
In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement 109” (“FIN 48”). FIN 48 clarifies the accounting for the uncertainty in recognizing income taxes in an organization in accordance with FASB Statement No. 109 by providing detailed guidance for financial statement recognition, measurement and disclosure involving uncertain tax positions. On February 4, 2007, we adopted the provisions of FIN 48. Differences between the amount recognized in our condensed consolidated financial statements prior to the adoption of FIN 48 and the amounts reported as a result of adoption have been accounted for as a cumulative effect adjustment recorded to our February 4, 2007 beginning retained earnings balance. The adoption of FIN 48 decreased our February 4, 2007 balance of retained earnings and increased our liability for unrecognized tax benefits by $0.8 million, of which $0.1 million related to interest and $0.1 million related to penalties.
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As of the adoption date, the total liability for income tax associated with unrecognized tax benefits was $1.5 million, all of which, if recognized, would affect our effective tax rate. As of November 3, 2007, the liability for income tax associated with uncertain tax positions decreased by $0.6 million as a result of settlements with taxing authorities.
Our continuing practice is to recognize interest and penalties related to unrecognized tax benefits in tax expense. At November 3, 2007, we accrued $0.3 million of interest and penalties related to uncertain tax positions. The provision for interest and penalties related to uncertain tax positions during the three months ended November 3, 2007 was not material.
We operate stores throughout the United States and Puerto Rico, and as a result, we file income tax returns in the U.S. federal jurisdiction and various state and foreign jurisdictions. In the normal course of business, we are subject to examination by taxing authorities. With few exceptions, we are no longer subject to U.S. federal, state and local, or non-U.S. income tax examinations for years before fiscal 2002. While it is often difficult to predict the final outcome or the timing of resolution of any particular uncertain tax position, we believe our reserves for income taxes represent the most probable outcome. We adjust these reserves, as well as the related interest, in light of changing facts and circumstances.
We anticipate that our total amount of liability for unrecognized tax benefits may change due to the settlement of audits and the expiration of statutes of limitations in the next 12 months. As such, we have classified tax reserves of $0.6 million as a current liability.
NOTE 10. Share Repurchase
In August 2007, we announced that our Board approved the repurchase of up to $40.0 million of our outstanding common stock. As of November 3, 2007, we had repurchased 870,470 shares for approximately $7.2 million, which represents an average price of $8.23 per share. We intend to make repurchases from time to time on the open market at prevailing market prices or in negotiated transactions off the market. The timing and amount of any repurchases will be at the discretion of management and the repurchase program is expected to remain in effect through fiscal 2007 unless it is extended or shortened by the Board.
Item 2. | Management’s Discussion and Analysis of Financial Condition and Results of Operations |
STATEMENT REGARDING FORWARD LOOKING DISCLOSURE
This Quarterly Report on Form 10-Q contains various forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, which are subject to the “safe harbor” created by these sections, including statements regarding our expectations, beliefs, intentions or strategies regarding the future. Forward-looking statements include, without limitation, statements regarding the extent and timing of future revenues and expenses and customer demand, expected financial results, the profitability of future sales of our products, new store openings and new store concepts. All forward-looking statements included in this report are based on information available to us as of the date hereof and we assume no obligation to update any forward-looking statements. Forward-looking statements involve known or unknown risks, uncertainties and other factors which may cause our actual results, performance or achievements, or industry results to be materially different from any future results, performance or achievements expressed or implied by such forward-looking
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statements. Such risks, uncertainties and other factors include but are not limited to the items discussed under the captions “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this Item 2 and “Risk Factors” in Part II, Item 1A.
OVERVIEW
We are a mall-based specialty retailer operating the Hot Topic and Torrid concepts. At our Hot Topic stores, we sell a selection of music/pop culture-licensed and music/pop culture-influenced apparel, accessories and gift items for young men and women principally between the ages of 12 and 22. At our Torrid stores, we sell apparel, lingerie, shoes and accessories designed for various lifestyles for plus-size females between the ages of 15 and 29. We were incorporated in California in 1988. We opened our first Hot Topic store in 1989 and our first Torrid store in 2001. At the end of the third quarter of fiscal 2007 (November 3, 2007 in the 52-week fiscal year ending February 2, 2008), we operated 695 Hot Topic stores throughout the United States and Puerto Rico and 147 Torrid stores in 36 states. We also sell merchandise on two websites, www.hottopic.com and www.torrid.com, which reflect the Hot Topic and Torrid store concepts and sell merchandise similar to that sold in the respective stores. Throughout this report, the terms “our,” “we” and “us” refer to Hot Topic, Inc. and its subsidiaries.
Our Hot Topic division focuses on music/pop culture-licensed and music/pop culture-inspired trends and we have adopted a teen customer-focused strategy which includes immersing ourselves into the rock music and pop culture scenes, identifying products that are inspired by these scenes, and creating an in-store environment that reflects our inspiration. Our feedback loop is integral to our strategy. We gain input from customers and store associates via reading customer comment cards and associate concert reports, visiting stores, allowing direct email communication with stores and observing focus groups. We believe this direct engagement with customers, along with our music/pop culture-licensed and –inspired merchandise, provides a competitive advantage over other mall-based fashion retailers.
Our Torrid division focuses on fashion forward apparel and accessories for plus-size women. Our target customers have a youthful attitude and desire to reflect current fashion trends in their dress. We continue to make significant progress in the development of our Torrid brand. Consistent marketing, growth of our loyalty program, divastyle®, in-store operational improvements and refocusing the assortment to more correctly reflect our customers’ attitudes and preferences all contribute to the growth of the brand.
At the end of the third quarter of fiscal 2007, we operated 695 Hot Topic stores and 147 Torrid stores compared to 693 Hot Topic stores and 129 Torrid stores at the end of the third quarter of fiscal 2006. During the third quarter of fiscal 2007, we opened a total of five Hot Topic stores and 14 Torrid stores and closed three Hot Topic stores. We also remodeled or relocated 14 Hot Topic stores during the quarter; five of these remodels or relocations saw their square footage change by over 15%. We currently anticipate opening approximately 30 to 35 new stores, consisting of 5 new Hot Topic stores and between 25 to 30 new Torrid stores, during fiscal 2008. We also plan to remodel or relocate approximately 30 existing Hot Topic stores and plan to close approximately 20 Hot Topic stores and 5 Torrid stores in fiscal 2008.
The discussion below includes references to “comparable stores.” We consider a store comparable after it has been open for 15 full months. If a store is relocated, or changed by more than 15% in total square footage, it is removed from the comparable store base and, similar to new stores, becomes comparable after 15 full subsequent months. If a store is closed during a period, it is included in the computation of comparable store sales for that fiscal month, quarter and year-to-date period, only for the days in which the store was operating as compared to the full comparable period.
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Our fiscal year is on a 52-53 week basis and ends on the Saturday nearest to January 31. The fiscal year ending February 2, 2008 is a 52-week fiscal year, and the fiscal year ended February 3, 2007 was a 53-week fiscal year.
The 53rd week in fiscal 2006 caused a one-week shift in our 2007 fiscal calendar, referred to below as the “Retail Calendar Shift,” resulting in the end of the third quarter of fiscal 2007 being shifted later by one week relative to the quarter-ending date last fiscal year. Seasonal influences near quarter-end dates may cause year-over-year comparisons to be impacted by the Retail Calendar Shift. Our reported comparable store results for fiscal 2007, both in this report and in our other public disclosures, have been adjusted for the shift.
The following discussion of our results of operations, financial condition and liquidity and other matters should be read in conjunction with our Condensed Consolidated Financial Statements and the Notes related thereto.
RESULTS OF OPERATIONS
Three Months Ended November 3, 2007 Compared to the Three Months Ended October 28, 2006
The following table sets forth selected data from our statement of operations expressed as a percentage of net sales for the periods indicated. The discussion that follows should be read in conjunction with this table:
For the three months ended: | November 3, 2007 | October 28, 2006 | ||||
Net sales | 100.0 | % | 100.0 | % | ||
Cost of goods sold, including buying, distribution and occupancy costs | 63.7 | 65.2 | ||||
Gross margin | 36.3 | 34.8 | ||||
Selling, general and administrative expenses | 30.7 | 28.9 | ||||
Income from operations | 5.6 | 5.9 | ||||
Interest income, net | 0.2 | 0.1 | ||||
Income before income taxes | 5.8 | 6.0 | ||||
Provision for income taxes | 2.3 | 2.4 | ||||
Net income | 3.5 | % | 3.6 | % | ||
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Net sales decreased $8.2 million, or 4.2%, to $188.5 million during the third quarter of fiscal 2007 from $196.7 million during the third quarter of fiscal 2006. The components of this $8.2 million decrease in net sales are as follows:
Amount ($millions) | Description | |||
$ | 2.4 | Increase in net sales from new Torrid stores opened since the third quarter of the prior year and Torrid stores not yet qualifying as comparable stores. | ||
0.6 | Increase in net sales from new Hot Topic stores opened since the third quarter of the prior year and Hot Topic stores not yet qualifying as comparable stores. | |||
(0.2 | ) | Decrease in net sales from 14 expanded or relocated Hot Topic and Torrid stores, some of which were not open for the full quarter, not yet qualifying as comparable stores. | ||
(0.3 | ) | Decrease in Internet sales (hottopic.com and torrid.com). | ||
(4.2 | ) | Decrease in comparable store net sales in the third quarter of fiscal 2007 compared to the corresponding period from the previous fiscal year. | ||
(6.5 | ) | Decrease in store net sales in the third quarter of fiscal 2007 due to the weekly sales differential caused by the 2006 shift in the Retail Calendar. | ||
$ | (8.2 | ) | Total | |
At the end of the third quarter of fiscal 2007, 752 of our 842 stores (Hot Topic and Torrid) were included in the comparable store base, compared to 689 of our 822 stores (Hot Topic and Torrid) open at the end of the third quarter of fiscal 2006. Sales of our Hot Topic division’s apparel including tee-shirts, as a percentage of total net sales, increased to 56% during the third quarter of fiscal 2007 from 55% for the third quarter of fiscal 2006.
Gross margin increased $0.1 million, or 0.1%, to $68.5 million during the third quarter of fiscal 2007 from $68.4 million during the third quarter of fiscal 2006. As a percentage of net sales, gross margin increased to 36.3% during the third quarter of fiscal 2007 from 34.8% in the third quarter of fiscal 2006. The significant components of this 1.5% increase in gross margin as a percentage of net sales are as follows:
% | Description | ||
3.9 | Increase in merchandise margin primarily due to lower markdowns, higher initial markup, higher damage allowances, lower freight-in expenses and lower employee discounts. | ||
(0.1 | ) | Higher buying costs primarily as a result of higher payroll costs and deleveraging buying costs over lower comparable store sales. | |
(0.3 | ) | Increase in distribution expenses primarily due to an increase in consulting fees, increased expedited freight expense to the stores, partially offset by lower temporary personnel expenses. | |
(2.0 | ) | Increase in store occupancy and depreciation expenses, primarily due to the acceleration of depreciation and higher occupancy costs related to our store remodel and relocation program and store closures, as well as deleveraging store expenses over lower sales per square foot. | |
1.5 | % | Total | |
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Selling, general and administrative expenses increased $1.1 million, or 1.9%, to $58.0 million during the third quarter of fiscal 2007 compared to $56.9 million during the third quarter of fiscal 2006. The total dollar increase in selling, general and administrative expenses was primarily attributable to a 2.4% increase in the number of retail stores from 822 at the end of the third quarter of fiscal 2006 to 842 at the end of the third quarter of fiscal 2007 and the corresponding additional payroll and other expenses required to support these additional stores. As a percentage of net sales, selling, general and administrative expenses increased to 30.7% in the third quarter of fiscal 2007 compared to 28.9% in the third quarter of fiscal 2006. The significant components of the 1.8% increase in selling, general and administrative expenses as a percentage of net sales are as follows:
% | Description | ||
1.5 | Increase in store payroll expense due to increases in wage rates as a result of higher minimum wages, increases in medical expenses and deleveraging of payroll costs over lower average store sales. | ||
0.3 | Increase in marketing expenses primarily due to print advertising. | ||
0.2 | Increase in other store expenses primarily due to DSL conversion charges, utilities, repair and maintenance expenses and deleveraging of costs over lower average store sales, partially offset by a decrease in store supplies. | ||
(0.1 | ) | Decrease in non-cash stock-based compensation expense primarily due to reduced expense related to restricted stock unit awards and a drop off of fully amortized stock option grants in the first quarter of 2007. | |
(0.1 | ) | Decrease in depreciation and amortization primarily due to a decrease in depreciation expense from fully depreciated software assets in the third quarter of 2006. | |
1.8 | % | Total | |
Income from operations decreased $1.0 million to $10.5 million during the third quarter of fiscal 2007 from $11.5 million during the third quarter of fiscal 2006. As a percentage of net sales, income from operations was 5.6% in the third quarter of fiscal 2007 compared to 5.9% in the third quarter of fiscal 2006.
Net interest income as a percentage of sales was 0.2% in the third quarter of fiscal 2007 compared to 0.1% in the third quarter of fiscal 2006.
Provision for income taxes was $4.2 million for the third quarter of fiscal 2007 compared to $4.7 million for the third quarter of fiscal 2006. The effective tax rate was 38.9% for the third quarter of fiscal 2007 compared to 39.9% for the third quarter of fiscal 2006.
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Nine Months Ended November 3, 2007 Compared to the Nine Months Ended October 28, 2006
The following table sets forth selected data from our statement of operations expressed as a percentage of net sales for the periods indicated. The discussion that follows should be read in conjunction with this table:
For the nine months ended: | November 3, 2007 | October 28, 2006 | ||||
Net sales | 100.0 | % | 100.0 | % | ||
Cost of goods sold, including buying, distribution and occupancy costs | 66.3 | 67.2 | ||||
Gross margin | 33.7 | 32.8 | ||||
Selling, general and administrative expenses | 32.7 | 31.4 | ||||
Income from operations | 1.0 | 1.4 | ||||
Interest income, net | 0.3 | 0.2 | ||||
Income before income taxes | 1.3 | 1.6 | ||||
Provision for income taxes | 0.5 | 0.6 | ||||
Net income | 0.8 | % | 1.0 | % | ||
Net sales decreased $3.7 million, or 0.7%, to $507.4 million during the first nine months of fiscal 2007 from $511.1 million during the first nine months of fiscal 2006. The components of this $3.7 million increase in net sales are as follows:
Amount ($ millions) | Description | |||
$ | 5.8 | Increase in net sales from new Torrid stores opened since the third quarter of the prior year and Torrid stores not yet qualifying as comparable stores. | ||
5.4 | Increase in net sales from new Hot Topic stores opened since the third quarter of the prior year and Hot Topic stores not yet qualifying as comparable stores. | |||
2.8 | Increase in Internet sales (hottopic.com and torrid.com). | |||
0.3 | Increase in net sales from 59 expanded or relocated Hot Topic and Torrid stores not yet qualifying as comparable stores. | |||
(2.3 | ) | Decrease in store net sales in the first nine months of fiscal 2007 due to the weekly sales differential caused by the 2006 shift in the Retail Calendar. | ||
(15.7 | ) | Decrease in comparable store net sales in the first nine months of fiscal 2007 compared to the corresponding period from the previous fiscal year. | ||
$ | (3.7 | ) | Total | |
Sales of our Hot Topic division’s apparel, as a percentage of total net sales, increased to 56% for the first nine months of fiscal 2007 from 55% for the first nine months of fiscal 2006. The increase in women’s and men’s apparel was offset by a decline in accessories and music.
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Gross margin increased $3.5 million, or 2.1%, to $171.0 million during the first nine months of fiscal 2007 from $167.5 million during the first nine months of fiscal 2006. As a percentage of net sales, gross margin increased to 33.7% during the first nine months of fiscal 2007 from 32.8% in the first nine months of fiscal 2006. The significant components of this 0.9% increase in gross margin as a percentage of net sales are as follows:
% | Description | ||
2.4 | Increase in merchandise margin primarily due to higher initial markup, higher vendor allowances, lower freight-in expenses, lower employee discounts and lower markdowns. | ||
0.2 | Decrease in distribution expenses primarily due to lower temporary personnel expenses and lower freight expenses to stores, partially offset by increased consulting fees. | ||
(1.7 | ) | Increase in store occupancy and depreciation expenses, primarily due to the acceleration of depreciation related to our store remodel and relocation program and store closures, as well as deleveraging store expenses over lower comparable store sales. | |
0.9 | % | Total | |
Selling, general and administrative expenses increased $5.3 million, or 3.3%, to $165.7 million during the first nine months of fiscal 2007 compared to $160.4 million during the first nine months of fiscal 2006. The total dollar increase in selling, general and administrative expenses was primarily attributable to a 3.2% increase in the average number of retail stores and the corresponding additional payroll and other expenses required to support these additional stores. As a percentage of net sales, selling, general and administrative expenses increased to 32.7% in the first nine months of fiscal 2007 compared to 31.4% in the first nine months of fiscal 2006. The significant components of the 1.3% increase in selling, general and administrative expenses as a percentage of net sales are as follows:
% | Description | |
1.0 | Increase in store payroll expense due to increases in wage rates as a result of higher minimum wages, increases in medical expenses and deleveraging of payroll costs over lower comparable store sales. | |
0.5 | Increase in other general and administrative expenses due to increased payroll expense and consulting fees, partially offset by a decrease in performance based bonus. | |
0.1 | Increase in marketing expenses primarily due to print advertising. | |
(0.1) | Decrease in depreciation and amortization primarily due to a decrease in depreciation expense from fully depreciated software assets in the third quarter of 2006. | |
(0.2) | Decrease in non-cash stock-based compensation expense primarily due to reduced expense related to restricted stock unit awards and a drop off of fully amortized stock option grants in the first quarter of 2007. | |
1.3% | Total | |
Income from operations decreased $1.8 million to $5.3 million during the first nine months of fiscal 2007 from $7.1 million during the first nine months of fiscal 2006. As a percentage of net sales, income from operations was 1.0% in the first nine months of fiscal 2007 compared to 1.4% in the first nine months of fiscal 2006.
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Net interest income as a percentage of sales was 0.3% in the first nine months of fiscal 2007 compared to 0.2% in the first nine months of fiscal 2006.
Provision for income taxes decreased $0.6 million to $2.7 million for the first nine months of fiscal 2007 from $3.3 million during the first nine months of fiscal 2006. The effective tax rate was 39.2% for the first nine months of fiscal 2007 and 40.7% for the first nine months of fiscal 2006.
LIQUIDITY AND CAPITAL RESOURCES
Historically and during the first nine months of fiscal 2007, our primary uses of cash have been to finance store openings, remodels and relocations and purchase merchandise inventories. We have also made periodic repurchases of our common shares. During the third quarter of fiscal 2007 and consistent with recent years, we satisfied our cash requirements principally from cash flows from operations, and to a lesser extent, proceeds from the exercise of stock options. We also maintain a $5.0 million unsecured credit agreement for issuing letters of credit for inventory purchases. There were letters of credit for $81,000 and $80,000 outstanding at November 3, 2007 and February 3, 2007, respectively.
In August 2007, we announced that our Board approved the repurchase of up to $40.0 million of our outstanding common stock. As of November 3, 2007, we had repurchased 870,470 shares for approximately $7.2 million, which represents an average price of $8.23 per share. We intend to make repurchases from time to time on the open market at prevailing market prices or in negotiated transactions off the market. The timing and amount of any repurchases will be at the discretion of management and the repurchase program is expected to remain in effect through fiscal 2007 unless it is extended or shortened by the Board.
Net cash flows provided by operating activities were $25.9 million in the first nine months of fiscal 2007 compared to $29.5 million in the first nine months of fiscal 2006. The $3.6 million decrease in the first nine months of fiscal 2007 compared to the first nine months of fiscal 2006 was primarily attributable to an increase in prepaid expenses and other current assets along with a decrease in accrued liabilities, offset by an increase in accounts payable.
Net cash flows used in investing activities were $17.3 million in the first nine months of fiscal 2007 compared to $22.2 million in the first nine months of fiscal 2006. The $4.9 million decrease in the first nine months of fiscal 2007 compared to the first nine months of fiscal 2006 resulted principally from a $13.7 million increase in proceeds from the sale of short-term investments, net of purchases, partially offset by an $8.6 million increase in purchases of property and equipment.
Net cash flows used in financing activities were $5.5 million in the first nine months of fiscal 2007 compared to $2.1 million provided by investing activities in the first nine months of fiscal 2006. The $7.6 million decrease in the first nine months of fiscal 2007 compared to the first nine months of fiscal 2006 resulted primarily from a $7.2 million repurchase of common stock.
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The following table summarizes certain contractual obligations as of November 3, 2007, and the timing and effect that such commitments are expected to have on our liquidity and capital requirements in future periods:
Payments due by period ($ in thousands) | |||||||||||||||
Contractual obligations* | Total | Within 1 Year | 2-3 Years | 4-5 Years | More than 5 Years | ||||||||||
Operating leases | $ | 364,003 | $ | 56,213 | $ | 108,429 | $ | 93,635 | $ | 105,726 | |||||
Purchase obligations | $ | 50,711 | 50,711 | — | — | — | |||||||||
Letters of credit and other obligations | $ | 1,296 | 1,296 | — | — | — | |||||||||
Total contractual obligations | $ | 416,010 | $ | 108,220 | $ | 108,429 | $ | 93,635 | $ | 105,726 | |||||
* | Excludes obligations arising from the adoption of FIN 48. |
We expect capital expenditures for fiscal 2007 and 2008 to be in the range of $45 to $50 million and $28 to $30 million, respectively, which will relate primarily to the remodeling or relocating of Hot Topic stores and the opening of new Hot Topic and Torrid stores. The remainder of the expenditures will be primarily for improvements to our information technology, on-line music strategy and corporate infrastructure. We believe our current cash balances and cash generated from operations will be sufficient to fund our operations and planned expansion through at least the next 12 months.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Management’s discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosures of contingent assets and liabilities. On an ongoing basis, we evaluate estimates, including those related primarily to inventories, long-lived assets and contingencies. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
We believe the following critical accounting policies affect the more significant judgments and estimates used in the preparation of our consolidated financial statements. For a further discussion about the application of these and other accounting policies, refer to the notes included in our Annual Report on Form 10-K for the year ended February 3, 2007.
Inventories: Inventories are valued at the lower of average cost or market, on a weighted average cost basis, using the retail method. Under the retail method, inventory is stated at its current retail selling value, and then is converted to a cost basis by applying an average cost factor that represents the average cost-to-retail ratio based on beginning inventory and the purchase activity for the month. Throughout the year, we review our inventory levels in order to identify slow-moving merchandise and use permanent markdowns to sell through selected merchandise. We record a charge to cost of goods sold for permanent markdowns. Inherent in the retail method are certain significant management judgments and estimates including initial merchandise markup, future sales, markdowns and shrinkage, which significantly impact the ending inventory valuation at cost and the resulting gross margins. To the extent our estimated markdowns at period-end prove to be insufficient, additional future markdowns will need to be recorded. Physical inventories are conducted during the year to determine actual inventory on hand and shrinkage. We accrue our estimated inventory shrinkage for the period between the last physical count and current period end balance sheet date, thus, the difference between actual and estimated shrink amounts may cause fluctuations in quarterly results, but not for the fiscal year results.
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Valuation of long-lived assets:In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” we assess the impairment of long-lived assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. We group and evaluate long-lived assets for impairment at the individual store level, which is the lowest level at which individual cash flows can be identified. Factors we consider important that could trigger an impairment review include a significant underperformance relative to expected historical or projected future operating results, a significant change in the manner of the use of the asset or a significant negative industry or economic trend. When we determine that the carrying value of long-lived assets may not be recoverable based upon the existence of one or more of the aforementioned factors, impairment is measured based on a projected discounted cash flow method using a discount rate determined by management. In the event future store performance is lower than forecasted results, future cash flows may be lower than expected, which could result in future impairment charges. While we believe recently opened stores will provide sufficient cash flow, material changes in results could result in future impairment charges.
Revenue Recognition:Revenue is recognized at our retail store locations at the point at which the customer receives and pays for the merchandise at the register. For online sales, revenue is recognized at the time of shipment, which we refer to as the date of purchase by the customer. We continually monitor the volume of Internet sales during the last five days of each fiscal quarter, which is the estimated time goods are received by customers. Historically, Internet sales during this five-day period have been less than a half percent of total company sales each quarter. Although title and risk and rewards of ownership pass to the buyer upon receipt of the goods by the buyer, we utilize the shipping point as the difference has not historically been material. Should the volume of sales during any period increase, we will revise our policy accordingly. Sales are recognized net of merchandise returns, which are reserved for based on historical experience. Revenue from gift cards, gift certificates and store merchandise credits is recognized at the time of redemption. Shipping and handling revenues from our websites are included as a component of net sales.
We recognize estimated gift card breakage as a component of net sales in proportion to actual gift card redemptions over the period that remaining gift card values are redeemed. Gift card breakage is income recognized due to the non-redemption of a portion of gift cards sold by us for which liability was recorded in prior periods. While customer redemption patterns result in estimated gift card breakage, which approximates 5%, changes in our customers’ behavior could impact the amount that ultimately is unused and could affect the amount recognized as a component of net sales.
Vendor Allowances: We receive certain allowances from our vendors primarily related to damaged merchandise, markdowns and, for our Torrid division, new store openings. Allowances received from vendors related to damaged merchandise and new Torrid store openings are reflected as a reduction of inventory in the period they are received and allocated to cost of sales during the period in which the items are sold. Markdown allowances received from vendors are reflected as reductions to cost of sales in the period they are received.
Stock-Based Payments: We estimate the fair value of stock options granted using the Black-Scholes option-pricing formula and a single option award approach. This fair value is then amortized over the requisite service periods of the awards. This option-pricing model requires the input of highly subjective assumptions, including the option’s expected life, price volatility of the underlying stock, risk free interest rate and expected dividend rate. As stock-based compensation expense is based on awards ultimately expected to
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vest, it has been reduced for estimated forfeitures. SFAS 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Forfeitures are estimated based on historical experience.
Self-Insurance:We are self-insured for certain losses related to medical and workers compensation although we maintain stop loss coverage with third party insurers to limit our total liability exposure. The estimate of our self-insurance liability involves uncertainty since we must use judgment to estimate the ultimate cost that will be incurred to settle reported claims and unreported claims for incidents incurred but not report as of the balance sheet date. When estimating our self-insurance liability, we consider a number of factors, which include historical claim experience and valuations provided by independent third party actuaries. As claims develop, the actual ultimate losses may differ from actuarial estimates. Therefore, an analysis is performed quarterly to determine if modifications to the accrual are required.
Rent Expense: Rent expense under our operating leases typically provides for fixed non-contingent rent escalations. We recognize rent expense on a straight-line basis over the non-cancelable term of each lease, commencing when we take possession of the property. Construction allowances are recorded as a deferred rent liability, which we amortize as a reduction of rent expense over the non-cancelable term of each lease.
Income Taxes:Current income tax expense is the amount of income taxes expected to be payable for the current year. The combined federal, state and local 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 were to determine that it is more likely than not that these assets will not be realized, we would reduce the value of these assets to their expected realizable value through a valuation allowance, thereby decreasing net income. If we subsequently were to determine that the deferred tax assets, which had been written down, would be realized in the future, the value of the deferred tax assets would be increased, thereby increasing net income in the period when that determination was made. We have recorded tax contingencies based on our estimates of current tax exposures and adjust our estimates as circumstances or regulations change.
Additionally, we recognize uncertain tax positions in our financial statements if they meet more-likely-than-not recognition and measurement thresholds in accordance with FASB Interpretation No. 48. Interest and penalties related to unrecognized tax benefits are recorded in tax expense.
In accordance with SFAS 123R, we recognize tax benefit upon expensing certain stock-based awards associated with our stock-based compensation plans, including nonqualified stock options and restricted stock unit awards. However, under current accounting standards we cannot recognize tax benefit currently for those stock-based compensation expenses associated with incentive stock options (also known as qualified stock options) and employee stock purchase plan rights. For qualified stock options that vested after our adoption of SFAS 123R, we recognize tax benefit only in the period when disqualifying dispositions of the underlying stock occur, and for qualified stock options that vested prior to our adoption of SFAS 123R, the tax benefit is recorded directly to additional paid-in capital.
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INFLATION
We do not believe that inflation has had a material adverse effect on our net sales or results of operations. We have generally been able to pass along increased costs related to inflation through increases in selling prices.
Item 3. | Quantitative and Qualitative Disclosures about Market Risk |
We are not a party to any derivative financial instruments. Our exposure to market risk primarily relates to changes in interest rates on our investments with maturities of less than three months (which are considered to be cash and cash equivalents) and short-term investments with maturities in excess of three months. Changes in interest rates affect the investment income earned on those investments.
Item 4. | Controls and Procedures |
Our management maintains disclosure controls and procedures that are designed to ensure that the information required to be disclosed in our reports under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s (the “SEC”) rules and forms, and that such information is accumulated and communicated to management, including our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), as appropriate, to allow timely decisions regarding required disclosure.
We have carried out an evaluation, under the supervision and with the participation of our management, including our CEO and CFO, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of our most recent fiscal quarter. Based upon that evaluation, our CEO and CFO concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended) are effective as of the end of our most recent fiscal quarter. There has been no change in our internal control over financial reporting during the most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
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Item 1. | Legal Proceedings |
We are involved in matters of litigation that arise in the ordinary course of business. We do not currently believe that litigation in which we are currently involved will have a material adverse effect on our overall financial condition.
Item 1A. | Risk Factors |
CERTAIN RISKS RELATED TO OUR BUSINESS
Before deciding to invest in Hot Topic, Inc. or to maintain or increase an investment in Hot Topic, Inc., readers should carefully consider the risks described below, in addition to the other information contained in our Annual Report on Form 10-K and in our other filings with the SEC, including our Quarterly Reports on Form 10-Q and Current Reports on Form 8-K. The risks described below are not the only risks we face. Additional risks that are not presently known to us or that we currently deem immaterial may also affect our business. If any of these known or unknown risks actually occur, our business, financial condition and results of operations could be seriously harmed, and our stock price could decline. The risks described below include certain revisions to the risks set forth in our Annual Report on Form 10-K for the fiscal year ended February 3, 2007.
Our strategy of opening a significant number of new stores could create challenges we may not be able to adequately meet, and our remodeling, relocating or closing of existing stores may not achieve their anticipated benefits.
Our net sales have grown during the past several years, primarily as a result of the opening of new stores and, to a lesser extent, the introduction of new products. We intend to continue to open and operate a significant number of new stores for the foreseeable future, as well as to evolve our existing business by remodeling, relocating or closing certain existing stores. We currently anticipate opening approximately 30 to 35 new stores, consisting of approximately 5 new Hot Topic and approximately 25 to 30 new Torrid stores, during fiscal 2008. We also plan to remodel or relocate approximately 30 existing Hot Topic stores and plan to close approximately 20 Hot Topic stores and 5 Torrid stores in fiscal 2008.
Our future operating results will depend substantially upon our ability to successfully open and operate new stores and to improve the performance of our remodeled and relocated stores. Operation of a greater number of new stores, moving or expanding store locations and expansion into new markets may present competitive and merchandising challenges that are different from those currently encountered by us in our existing stores and markets. There can be no assurance that our expansion will not adversely affect the individual financial performance of our existing stores or our overall results of operations. As the number of our stores increases, we may face risks associated with market saturation of our products and concepts.
Similarly, there can be no assurance that remodeling or relocating existing stores will not adversely affect either the individual financial performance of the store prior to the change, or our overall results of operations. Further, there can be no assurance that we will successfully achieve our remodel or expansion targets or, if achieved, that planned remodel or expansion will result in profitable operations. Finally, our closing of existing stores may not result in the desired improvements to our overall results of operations.
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Our business strategy requires improving our operations, and we may not be able to do this sufficiently to effectively prevent negative impact on our business and financial results.
In order to open and operate new stores as we have planned, among other things, we will need to locate suitable store sites, negotiate acceptable lease terms, obtain or maintain adequate capital resources on acceptable terms, source sufficient levels of inventory, hire and train store managers and sales associates, integrate new stores into our existing operations and maintain adequate distribution center space and information technology and other operations systems. Our opening of a second distribution center in Tennessee during fiscal 2005 was designed to address some of our growth challenges, but achieving and maintaining operating efficiencies in multiple distribution centers is subject to numerous risks and uncertainties.
We also need to continually evaluate the adequacy of our management information and distribution systems. Implementing new systems and changes made to existing systems could present challenges we do not anticipate and could negatively impact our business. We cannot anticipate all of the changing demands that our expanding and changing operations will impose on our business, systems and procedures, and our failure to adapt to such changing demands could have a material adverse effect on our results of operations and financial condition. Our failure to timely implement initiatives necessary to support our expanding and changing operations could also materially impact our business.
Expanding our operations to include new concepts presents risks we have faced with our existing concepts but also new risks due to differences in concept objectives and strategies.
Since our inception, we have expanded our business to include our Torrid concept in addition to our historical Hot Topic concept. We may implement other new concepts, such as a digital music concept, in the future. Starting and operating new concepts presents new and challenging risks and uncertainties, including unanticipated operational problems; lack of experience; lack of customer acceptance; new vendor relationships; competition from existing and new retailers; and diversion of management’s attention from our existing concepts. For example, the Torrid concept involves implementation of a retail apparel concept which is subject to most of the same risks as the Hot Topic concept, as well as additional risks inherent in a concept that concentrates on apparel and fashion, including risks of difficulty in merchandising, uncertainty of customer acceptance, fluctuations in fashion trends and customer tastes, extreme competition with a less differentiated product offering and attendant markdown risks. Any digital music concept we implement will be subject to the general risks for new concepts described above as well as its own particular risks and uncertainties, such as risks related to obtaining access to third party digital content and maintaining adequate information technology and data security systems. We may not be able to generate continued customer interest in any of our new concepts, nor can there be any assurance that any new concepts will achieve sales and profitability levels that justify our investment.
The success of our business depends on establishing and maintaining good relationships with mall operators and developers, and problems with those relationships could make it more difficult for us to expand to certain sites or offer certain products.
Any restrictions on our ability to expand to new store sites, remodel or relocate stores where we feel it necessary or to offer a broad assortment of merchandise could have a material adverse effect on our business, results of operations and financial condition. If our relations with mall operators or developers become strained, or we otherwise encounter difficulties in leasing store sites, we may not grow as planned and may not reach certain revenue levels and other operating targets. Risks associated with these relationships are more acute given recent consolidation in that industry, and we have seen certain increases in expenses as a result of such consolidation that could continue.
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Our comparable store sales are subject to fluctuation resulting from factors within and outside our control, and lower than expected comparable store sales could impact our business and our stock price.
A variety of factors affects our comparable store sales including, among others, the timing of new music releases and music/pop culture-related products; music and fashion trends; the general retail sales environment and the effect of the overall economic environment; our ability to efficiently source and distribute products; changes in our merchandise mix; ability to attain exclusivity and certain pop-culture related licenses; competition from other retailers; opening of new stores in existing markets and our ability to execute our business strategy efficiently. Our comparable store sales results have fluctuated significantly in the past and we believe that they will continue to fluctuate. Our comparable store sales results were (2.3)%, (5.8%) and (2.6)% for the first, second and third quarter, respectively, of fiscal 2007. For the first nine months of fiscal 2007, our comparable store sales results were (3.5)%. The following table shows our comparable store sales results for other recent periods:
Fiscal Year | 2006 | 2005 | 2004 | 2003 | ||||||||
Total Year | (6.6 | )% | (3.4 | )% | (2.9 | )% | 7.4 | % | ||||
1st Quarter | (9.6 | )% | 0.9 | % | 4.0 | % | 2.6 | % | ||||
2nd Quarter | (5.5 | )% | (3.5 | )% | (2.1 | )% | 5.2 | % | ||||
3rd Quarter | (6.8 | )% | (6.2 | )% | (4.2 | )% | 10.8 | % | ||||
4th Quarter | (5.3 | )% | (3.8 | )% | (6.0 | )% | 8.5 | % |
Past comparable store sales results are not an indicator of future results, and there can be no assurance that our comparable store sales results will not continue to decrease in the future. Changes in our comparable store sales results could cause our stock price to fluctuate substantially.
Our success relies on popularity with young people of music, pop culture, and fashion trends, and we may not be able to react to trends in a way to prevent declining popularity and sales of our products.
Our financial performance is largely dependent upon the continued popularity of alternative and rock music, the Internet and digital music, music videos and MTV and other music television networks among teenagers and college-age adults; the emergence of new artists and the success of music releases and music/pop culture-related products; the continuance of a significant level of teenage spending on music/pop culture-licensed and music/pop culture-influenced products; and our ability to anticipate and keep pace with the music, fashion and merchandise preferences of our customers. The popularity of particular types of music, artists, styles, trends and brands is subject to change. Our failure to anticipate, identify and react appropriately to changing trends could lead to, among other things, excess inventories and higher markdowns, which could have a material adverse effect on our results of operations and financial condition and on our image with customers. There can be no assurance that our new products will be met with the same level of acceptance as in the past or that the failure of any new products will not have an adverse material effect on our business, results of operations and financial condition.
Economic conditions could change in ways that reduce our sales or increase our expenses.
Certain economic conditions affect the level of consumer spending on merchandise we offer, including, among others, employment levels, salary and wage levels, interest rates, taxation and consumer confidence in future economic conditions. We are also dependent upon the continued popularity of malls as a shopping destination, the ability of mall anchor tenants and other attractions to generate customer traffic and the development of new malls. A slowdown in the United States economy or an uncertain economic outlook could lower consumer spending levels and cause a decrease in mall traffic or new mall development, each of which would adversely affect our growth, sales results and financial performance.
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Recording impairment charges for certain underperforming Hot Topic and Torrid stores may negatively impact our future financial condition or results of operations, and closing stores might not have a positive impact on our operating results.
Based on our review of certain underperforming stores, we recorded $1.0 million, $3.4 million and $1.7 million in impairment charges during the first nine months of fiscal 2007, the full year fiscal 2006 and the full year fiscal 2005, respectively. There can be no assurance that we will not incur future impairment charges for underperforming stores which could have a significant negative impact on our operating results. In addition, we closed four stores during fiscal 2006, consisting of three Hot Topic stores and one Torrid store. Although the stores closed in 2006 had been underperforming as compared with our other Hot Topic and Torrid stores, there is no assurance these store closures will have a significant positive impact on our operating results. We expect to close approximately 12 Hot Topic stores and 3 Torrid stores in fiscal 2007. We also expect to close additional stores in the future, which also could adversely affect our operating results.
Changes in laws, including employment laws and laws related to our merchandise, could make conducting our business more expensive or change the way we do business.
In addition to increased regulatory compliance requirements, changes in laws could make ordinary conduct of our business more expensive or require us to change the way we do business. For example, changes in federal and state minimum wage laws could raise the wage requirements for certain of our associates, which would likely cause us to reexamine our entire wage structure for stores. Other laws related to treatment of employees, including laws related to employee benefits and privacy, could also negatively impact us such as by increasing benefits costs like medical expenses. Moreover, changes in product safety or other consumer protection laws could lead to increased costs to us for certain merchandise, or additional labor costs associated with readying merchandise for sale. It is often difficult for us to plan and prepare for potential changes to applicable laws.
Timing and seasonal issues could negatively impact our financial performance for given periods.
Our quarterly results of operations may fluctuate materially depending on, among other things, the timing of store openings and related pre-opening and other startup expenses, net sales contributed by new stores, increases or decreases in comparable store sales, releases of new music and music/pop culture-related products, shifts in timing of certain holidays, changes in our merchandise mix and overall economic and political conditions.
In addition, seasonal influences near quarter-end dates may cause financial results for given periods to be impacted by shifts in our fiscal year, which is on a 52-53 week basis. For example, the fiscal year ending February 2, 2008 is a 52-week fiscal year, and the fiscal year ended February 3, 2007 was a 53-week fiscal year. The 53rd week in fiscal 2006 caused a one-week shift in our 2007 fiscal calendar, resulting in the end of the third quarter of fiscal 2007 being shifted later by one week relative to the quarter-ending date last fiscal year.
Our business is also subject to seasonal influences, with heavier concentrations of sales during the back-to-school, Halloween and holiday (defined as the week of Thanksgiving through the first few days of January) seasons and other periods when schools are not in session. The holiday season has historically been our single most important selling season. We believe that the importance of the summer vacation and back-to-school seasons (which affect operating results in the second and third quarters) and to a lesser
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extent, the spring break season (which affects operating results in the first quarter) as well as Halloween (which affects operating results in the third quarter), all reduce our dependence on the holiday selling season, but this will not always be the case to the same degree. As is the case with many retailers of apparel, accessories and related merchandise, we typically experience lower net sales in the first fiscal quarter relative to other quarters.
We have many important vendor relationships, and our ability to get merchandise could be hurt by changes in those relationships and events harmful to our vendors could impact our results of operations.
Our financial performance depends on our ability to purchase desired merchandise in sufficient quantities at competitive prices. Although we have many sources of merchandise, substantially all of our music/pop culture-licensed products are available only from vendors that have exclusive license rights. In addition, small, specialized vendors, some of which create unique products primarily for us, supply certain of our products. Our smaller vendors generally have limited resources, production capacities and operating histories and some of our vendors have restricted the distribution of their merchandise in the past. We generally have no long-term purchase contracts or other contractual assurances of continued supply, pricing or access to new products. There can be no assurance that we will be able to acquire desired merchandise in sufficient quantities on acceptable terms in the future. Any inability to acquire suitable merchandise, or the loss of one or more key vendors, may have a material adverse effect on our business, results of operations and financial condition.
Technology and other risks associated with our Internet sales could hinder our overall financial performance.
We sell merchandise over the Internet through the websites www.hottopic.com and www.torrid.com. Our Internet operations are subject to numerous risks and pose risks to our overall business, including, among other things: hiring; retention and training of personnel to conduct the Internet operations; diversion of sales from our stores; rapid technological change and the need to invest in additional computer hardware and software to support sales; liability for online content; failure of computer hardware and software, including computer viruses, telecommunication failures, online security breaches and similar disruptions; governmental regulation; and credit card fraud. There can be no assurance that our Internet operations will achieve sales and profitability levels that justify our investment in them.
System security risk issues could disrupt our internal operations or information technology services provided to customers, and any such disruption could harm our revenue, increase our expenses, and harm our reputation and stock price.
Experienced computer programmers and hackers may be able to penetrate our network security and misappropriate our confidential information or that of third parties, create system disruptions or cause shutdowns. As a result, we could incur significant expenses addressing problems created by security breaches of our network. Moreover, we could incur significant expenses in connection with system failures. In addition, sophisticated hardware and operating system software and applications that we procure from third parties may contain defects in design or manufacture, including “bugs” and other problems that could unexpectedly interfere with the operation of the system. The costs to us to eliminate or alleviate security problems, viruses and bugs could be significant, and the efforts to address these problems could result in interruptions, delays or cessation of service that may impede our sales, distribution or other critical functions.
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We have made and plan to continue to make significant changes to information systems and software used in operation of our business, and we may not be able to effectively adopt changes in a way to prevent failures in our operations or negative impact on our financial performance and reporting.
Over the past several years, we have made improvements to existing hardware and software systems, as well as implemented new systems. For example, we have invested approximately $6 million dollars to enhance the functionality of our current Escalate software and to implement new financial and human resources systems software from Lawson Software. In addition, we invested approximately $10 million in the implementation of a new warehouse management software system, a new Internet order management software system and a new customer loyalty software system. We expect to significantly increase our reliance on these systems throughout fiscal 2007. If these information systems and software do not work effectively, we may experience delays or failures in our operations. These delays or failures could adversely impact the promptness and accuracy of our merchandise distribution, transaction processing, financial accounting and reporting and ability to properly forecast earnings and cash requirements. To manage growth of our operations and personnel, we will need to continue to improve our operational and financial systems, transaction processing and procedures and controls, and in doing so, we could incur substantial additional expenses.
Loss of key people or an inability to hire necessary and significant personnel could hurt our business.
Our financial performance depends largely on the efforts and abilities of senior management, especially Elizabeth McLaughlin, our Chief Executive Officer, who has been with us since 1993. The sudden loss of Ms. McLaughlin’s services or the services of other members of our management team could have a material adverse effect on our business, results of operations and financial condition. Furthermore, there can be no assurance that Ms. McLaughlin and our existing management team will be able to manage our growth or that we will be able to attract and retain additional qualified personnel as needed in the future.
Decreased effectiveness of stock-based compensation could adversely affect our ability to attract and retain employees.
We have historically used stock options as a component of our total employee compensation program in order to align employees’ interests with the interests of our shareholders, encourage employee retention and provide competitive compensation and benefit packages. As a result of the decline in our stock price in recent periods, many of our employee stock options have exercise prices in excess of our stock price, which reduces their value and could affect our ability to retain present, or attract prospective, employees. There are other forms of stock-based compensation available to us, but these are similarly less attractive when a company’s stock price is declining. In addition, in accordance with SFAS 123R, we began recording expenses for stock-based payments, including stock options, in the first quarter of fiscal 2006. As a result, we now incur increased compensation costs associated with our stock-based compensation programs. Moreover, difficulties relating to obtaining shareholder approval of equity compensation plans could make it harder or more expensive for us to grant stock-based payments to employees in the future. Like other companies, we review our equity compensation strategy in light of regulatory and competitive environments, and we may decide to reduce the total number of options granted, or the form of stock awards, to employees, or reduce the number of employees who receive stock-based payments. Due this change in our stock-based compensation strategy, we may find it difficult to attract, retain and motivate employees, and any such difficulty could materially adversely affect our business.
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Our reliance on Federal Express, temporary employees and other mechanics of shipping of our merchandise creates distribution risks and uncertainties that could hurt our sales and business.
We recently changed our primary service provider for shipping merchandise and other materials to our stores from United Parcel Service to Federal Express. Our reliance on Federal Express for shipments is subject to risks associated with its ability to provide delivery services that adequately meet our shipping needs, as well as factors such as weather and transportation prices. It is also a new relationship for us, and there may be challenges and risks in integrating Federal Express’s services into our distribution program. There is also no assurance we will see benefits in terms of service or price from switching from United Parcel Service to Federal Express and the switch could end up more costly for us, or disruptive to our distribution efforts.
We are also dependent upon temporary associates to adequately staff our distribution centers, particularly during busy periods such as the holiday season and while multiple stores are opening. There can be no assurance that we will continue to receive adequate assistance from our temporary associates, or that there will continue to be sufficient sources of temporary associates.
We began operation of our second distribution center in Tennessee during the second quarter of 2005, and as a result we also now face risks and uncertainties associated with achieving and maintaining operating efficiencies in two distribution centers that are located approximately 2,000 miles apart. Additionally, certain products we offer in our stores are imported and subject to delivery delays based on availability and port capacity.
We could acquire merchandise without full rights to sell it, which could lead to disputes or litigation and hurt our financial performance and stock price.
We purchase licensed merchandise from a number of suppliers who hold manufacturing and distribution rights under the terms of certain licenses. We generally rely upon vendors’ representations concerning manufacturing and distribution rights and do not independently verify whether these vendors legally hold adequate rights to licensed properties they are manufacturing or distributing. If we acquire unlicensed merchandise, we could be obligated to remove such merchandise from our stores, incur costs associated with destruction of merchandise if the distributor is unwilling or unable to reimburse us, and be subject to liability under various civil and criminal causes of action, including actions to recover unpaid royalties and other damages. Any of these results could have a material adverse effect on our business, results of operations and financial condition.
We face intense competition, and an inability to adequately address it, or the success of our competitors, could limit or prevent our business growth and success.
The retail apparel and accessory industry is highly competitive. We compete with other retailers for vendors, teenage and young adult customers, suitable store locations and qualified associates and management personnel. Our Hot Topic stores currently compete with street alternative stores located primarily in metropolitan areas; with other mall-based teenage-focused retailers and their subsidiaries such as Abercrombie & Fitch, Aeropostale, American Eagle Outfitters, Anchor Blue, Charlotte Russe, Claire’s Stores, Inc., Forever 21, Pacific Sunwear of California, Inc., Spencer Gifts, Inc., H&M, The Buckle, Wet Seal, Inc., Urban Outfitters, Inc. and Zumiez, Inc.; and, to a lesser extent, with music stores and mail order catalogs and websites. Torrid has additional competitors, such as Alloy, Inc., Charming Shoppes, Inc., Deb Shops, Delia’s Corp., Old Navy (a division of Gap Inc.) and plus-size departments in department stores and discount stores as well as numerous potential competitors who may begin or increase efforts to market and sell products competitive with Torrid products. Some of our competitors are larger and may have greater financial, marketing and other resources. Direct competition with these and other retailers may increase significantly in the future, which could require us, among other things, to lower our prices. Increased competition could have a material adverse effect on our business, results of operations and financial condition.
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War, terrorism and other catastrophes could negatively impact our customers, places where we do business and our expenses, all of which could hurt our business.
The effects of war or acts of terrorism could have a material adverse effect on our business, operating results and financial condition. The continued threat of terrorism and heightened security and military action in response to this threat, or any future acts of terrorism, may cause further disruptions and create further uncertainties. To the extent that such disruptions or uncertainties negatively impact shopping patterns and/or mall traffic, or adversely affect consumer confidence or the economy in general, our business, operating results and financial condition could be materially and adversely affected.
Our principal executive offices, a distribution center and a significant number of our stores are located in California. If we experience a sustained disruption in energy supplies, or if electricity and gas costs in California fluctuate dramatically, our results of operations could be materially and adversely affected. California is also subject to natural disasters such as earthquakes and floods. A significant natural disaster or other catastrophic event affecting our facilities could have a material adverse impact on our business, financial condition and operating results.
There are numerous risks that could cause our stock price to fluctuate substantially.
Our common stock is quoted on the Nasdaq Stock Market, which has experienced and is likely to experience in the future significant price and volume fluctuations, which could adversely affect our stock price without regard to our financial performance. In addition, we believe that factors such as quarterly fluctuations in our financial results and comparable store sales; announcements by other apparel, accessory and gift item retailers; the trading volume of our stock; changes in estimates of our performance by securities analysts; litigation; overall economic and political conditions; the condition of the financial markets; and other events or factors outside of our control could cause our stock price to fluctuate substantially.
Our charter documents and other circumstances could prevent a takeover or cause dilution of our existing shareholders, which could be detrimental to existing shareholders and hinder business success.
Our Articles of Incorporation and Bylaws contain provisions that may have the effect of delaying, deterring or preventing a takeover of Hot Topic, Inc. For instance, our Articles of Incorporation include certain “fair price provisions” generally prohibiting business combinations with controlling or significant shareholders unless certain minimum price or procedural requirements are satisfied, and our Bylaws prohibit shareholder action by written consent. Additionally, our Board has the authority to issue, without shareholder approval, up to 10,000,000 shares of “blank check” preferred stock having such rights, preferences and privileges as designated by the Board. The issuance of these shares could have a dilutive effect on shareholders, and potentially prohibit a takeover of Hot Topic, Inc. by requiring the preferred shareholders to approve such a transaction.
We also have a significant number of authorized and unissued shares of our common stock available under our Articles of Incorporation. These shares provide us with the flexibility to issue our common stock for future business and financial purposes including stock splits, raising capital and providing equity incentives to employees, officers and directors. However, the issuance of these shares could result in dilution to our shareholders.
We incur costs associated with regulatory compliance, and this cost could be significant.
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There are numerous regulatory requirements for public companies, including the provisions of the Sarbanes-Oxley Act of 2002. With regard to the Sarbanes-Oxley Act, we have and will continue to incur significant expense as we continue to address the implications of applicable rules and our operations relative thereto, and as we work to respond to and comply with applicable requirements. Section 404 requires management to report on, and our independent auditors to attest to, our internal controls. Compliance with these rules could also result in continued diversion of management’s time and attention, which could be disruptive to normal business operations.
There are other regulations and standards associated with our business operations. For example, an independent standards-setting organization working with credit card companies has developed regulations concerning payment card account security throughout the transaction process, called the Payment Card Industry (PCI) Data Security Standard. All merchants and service providers that store, process and transmit payment card data are required to comply with the regulations as a condition to accepting credit cards. The organization is expected to start levying fines on companies that are non-compliant, and though we believe we are proceeding toward full compliance, there is no guarantee we will not incur fines or delays in our ability to comply.
If we do not satisfactorily or timely comply with these requirements, possible consequences could include sanction or investigation by regulatory authorities such as the Securities and Exchange Commission or the Nasdaq Stock Market; fines and penalties; incomplete or late filing of our periodic reports, including our annual report on Form 10-K or quarterly reports on Form 10-Q; or civil or criminal liability. Our stock price and business could also be adversely affected.
There are litigation and other claims against us from time to time, which could distract management from our business activities, and could lead to adverse consequences to our business and financial condition.
As a growing company with expanding operations, we are increasingly involved from time to time with litigation and other claims against us. These arise primarily in the ordinary course of our business, and include employee claims, commercial disputes, intellectual property issues and product-oriented allegations. Often these cases raise complex factual and legal issues, which are subject to risks and uncertainties and which could require significant management time. Although we do not currently believe that the outcome of any current litigation and claims against us will have a material adverse effect on our overall financial condition, we have, in the past, incurred unexpected expense in connection with litigation matters. In the future, adverse settlements or resolutions may occur and negatively impact earnings, injunctions against us could have an adverse effect on our business by requiring us to do or prohibiting us from doing certain things, and other unexpected events could have a negative impact on us.
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Item 2. | Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities |
Issuer Purchases of Equity Securities
Fiscal Period | Total Number of Shares Purchased | Average Price Paid per Share | Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs (1) | Approximate Dollar Value of Shares that May Yet Be Purchased Under the Plans or Programs | ||||||
August 5, 2007 – September 1, 2007 | 782,470 | $ | 8.21 | 782,470 | $ | 33,573,000 | ||||
September 2, 2007 – October 6, 2007 | 88,000 | $ | 8.34 | 88,000 | $ | 32,838,000 | ||||
October 7, 2007 – November 3, 2007 | — | — | — | $ | 32,838,000 | |||||
Total | 870,470 | $ | 8.23 | 870,470 | $ | 32,838,000 | ||||
(1) | In August 2007, we announced that our Board approved a stock repurchase program, authorizing the repurchase of up to $40.0 million of our outstanding common stock. We intend to make repurchases from time to time on the open market at prevailing market prices or in negotiated transactions off the market. The timing and amount of any repurchases will be at the discretion of management and the repurchase program is expected to remain in effect through fiscal 2007 unless it is extended or shortened by the Board. The purchases disclosed in the table above were completed in the quarter ended November 3, 2007. We intend to remain active with our share repurchase program should the right market conditions exist. |
Item 6. | Exhibits |
Exhibit Number | Description of Document | |
3.1 | Amended and Restated Articles of Incorporation. (1) | |
3.2 | Certificate of Amendment of Amended and Restated Articles of Incorporation. (2) | |
3.3 | Amended and Restated Bylaws, as amended. (2) | |
4.1 | Reference is made to Exhibits 3.1, 3.2 and 3.3. | |
4.2 | Specimen stock certificate. (1) | |
31.1 | Certification, dated November 28, 2007, of Registrant’s Chief Executive Officer required by Section 302 of the Sarbanes-Oxley Act of 2002. | |
31.2 | Certification, dated November 28, 2007, of Registrant’s Chief Financial Officer required by Section 302 of the Sarbanes-Oxley Act of 2002. | |
32.1 | Certifications, dated November 28, 2007, of Registrant’s Chief Executive Officer and Chief Financial Officer required by Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C § 1350, as adopted). | |
(1) Filed as an exhibit to Registrant’s Registration Statement on Form SB-2 (No. 333-5054-LA) and incorporated herein by reference. | ||
(2) Filed as an exhibit to Registrant’s Annual Report on Form 10-K for the year ended January 29, 2005 and incorporated herein by reference. |
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Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
Hot Topic, Inc. | ||||
(Registrant) | ||||
Date: | November 28, 2007 | /s/ Elizabeth McLaughlin | ||
Elizabeth McLaughlin | ||||
Chief Executive Officer | ||||
(Principal Executive Officer) | ||||
Date: | November 28, 2007 | /s/ James McGinty | ||
James McGinty | ||||
Chief Financial Officer | ||||
(Principal Financial And Accounting Officer) |
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Exhibit Index
Exhibit Number | Description of Document | |
3.1 | Amended and Restated Articles of Incorporation. (1) | |
3.2 | Certificate of Amendment of Amended and Restated Articles of Incorporation. (2) | |
3.3 | Amended and Restated Bylaws, as amended. (2) | |
4.1 | Reference is made to Exhibits 3.1, 3.2 and 3.3. | |
4.2 | Specimen stock certificate. (1) | |
31.1 | Certification, dated November 28, 2007, of Registrant’s Chief Executive Officer required by Section 302 of the Sarbanes-Oxley Act of 2002. | |
31.2 | Certification, dated November 28, 2007, of Registrant’s Chief Financial Officer required by Section 302 of the Sarbanes-Oxley Act of 2002. | |
32.1 | Certifications, dated November 28, 2007, of Registrant’s Chief Executive Officer and Chief Financial Officer required by Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C § 1350, as adopted). | |
(1) Filed as an exhibit to Registrant’s Registration Statement on Form SB-2 (No. 333- 5054-LA) and incorporated herein by reference. | ||
(2) Filed as an exhibit to Registrant’s Annual Report on Form 10-K for the year ended January 29, 2005 and incorporated herein by reference. |