Hot Topic, Inc.
(NYSE: HOTT)
Analyst Report
by
Geoff Munger
Manager, Student Managed Fund
MBA Class of 2004
University of Connecticut
Highlights
Sector: Consumer Discretionary
Industry: Apparel (also can be seen as part of the Retail Special Lines industry)
Valueline: Timeliness 1, Safety 3, Technical 3
Beta: 1.15
Small Cap: 1.331 Million
Updated: November 9, 2003
Hot Topic
Data Sources:
18305 East San Jose Avenue
Valueline Investment Survey
City of Industry, CA 91748
www.moneycentral.com
www.smartmoney.com
Ticker Symbol:
www.quicken.com
HOTT
www.investopedia.com
Listed Exchanges:
www.investorwords.com
NASDAQ
http://finance.yahoo.com/?u
Business Listings:
Bloomberg
Fortune:
One of the 100 fastest growing
RECOMMENDATION:
companies for the past 4 years
BUY 650 SHARES
Forbes.com, 10/27/03:
= $17,751.50 at $/share
4th in the top 200 up and coming
small companies
Employees:
4,500
Article about the company:
http://www.fortune.com/fortune/investing/articles/0,15114,526323,00.html
Company Overview
Hot Topic, Inc. is a mall-based specialty retailer operating the Hot Topic and Torrid store concepts.
The Company offers a selection of music-licensed and music-influenced apparel, accessories and gift
items for young men and women principally between the ages of 12 and 22. In the first half of the
fiscal year ended February 2, 2002, the Company launched a second retail concept with the opening
of six stores under the trade name Torrid. Torrid offers a selection of apparel, lingerie, shoes and
accessories centered around various lifestyles for plus-size females between the ages of 15 and 29.
As of February 1, 2003, the Company operated 418 Hot Topic stores in both metropolitan and
middle markets in 48 states across the United States, and 27 Torrid stores in 17 states. The Company
also maintains two distinct Websites, www.hottopic.com and www.torrid.com, which reflect the Hot
Topic and Torrid store concepts and sell certain items of merchandise.
Business Model
Hot Topic focuses on unique, music-oriented merchandise, offering “Everything about the music”
and promoting a music-inspired culture. The compnay targets a teenage customer base and
emphasizes listening to the customer (customer suggestions led to the Torrid store concept),
customer service, and an entertaining store environment. Hot Topic reacts quickly to trends
without attempting to predict them. All employees regularly attend concerts, the ticket price of
which is reimbursed by the company if the employee writes a fashion report afterwards, to scout the
latest trends and fashions. New products go from concept to product within two to eight weeks, as
compared to the six to nine months of many competitors. In addition, Hot Topic seeks exclusive
four- to six-month exclusive agreements with licensed distributors on items like t-shirts and
accessories, then moves on before the larger players move into the market. (Just as an example, Hot
Topic had exclusive rights to t-shirts, panties and lunchboxes of The Osbournes and SpongeBob
SquarePants before they ever became mainstream hits.
Recent News
1-Year Cumulative Returns Chart for HOTT (compared to the S&P 500)
Competition
Hot Topic is a small cap company of the consumer discretionary sector.
Timeliness, Safety, and Technical Ratings gathered from www.valueline.com.
Beta information gathered from www.valueline.com.
The Scouter Ranking information gathered from www.moneycentral.com.
It is difficult to define the actual competitors of Hot Topic. The company has carved a very specific
niche for itself and does not have any true direct competitors in its particular product lines. Hot
Topic is listed by Valueline as part of the strong Retail (Special Lines) Industry, but while there are
other mall-based, teen-oriented apparel stores in that industry such as Abercrombie and Fitch,
Aeropostale, etc…, the industry also includes entirely different companies such as Barnes & Noble
and Autozone. Thus it makes sense to compare Hot Topic to companies in the Apparel Industry.
Company
Ticker Timeliness
Hot Topic
Liz Claiborne
Tommy Hilfiger
Jones Apparel Gp
Quick Silver
HOTT
LIZ
TOM
JNY
ZQK
1
3
3
4
2
Safety
3
2
3
3
3
Technical
3
3
2
4
4
Beta
1.15
.95
1.3
1.15
1.0
Scouter
Ranking
7
7
N/A
9
5
Growth Trends
Expected Growth Rates:
HOTT vs. Its Com petitors,
Next 5-year Grow th Rate
HOTT vs. Its Com petitors,
Past 5-year Grow th Rate
47.10%
50.00%
25.00% 21.80%
16.50%
15.00%
30.00%
13.40%
11.50%
10.70%
9.70% 9.80%
18.30% 19.90%
20.00%
10.00%
7.40%
5.00%
10.00%
-1.90%
P5
00
S&
In
du
st
ry
JN
Y
ZQ
K
TO
M
LI
Z
H
O
In
du
st
ry
JN
Y
ZQ
K
TO
M
LI
Z
TT
O
H
TT
0.00%
0.00%
-10.00%
19.20%
20.00%
40.00%
Hot Topic has shown tremendous growth in comparison to Apparel vendors over the past five
years. Much of this growth can be attributed to the fact that the company is small and young and
has had significant room to grow in its defined niche market. That growth will slow over the
coming years, as it cannot be sustained at such a level, but there is still plenty of room for the
company to continue to expand.
Revenue and Net Income:
HOTT, Net Incom e, 1998-2002
40.0
HOTT, Revenues 1998-2002
34.6
28.6
30.0
(in millions $)
(in millions $)
35.0
23.2
25.0
20.0
13.5
15.0
10.0
6.0
5.0
0.0
1998
1999
2000
2001
2002
500
450
400
350
300
250
200
150
100
50
0
443.3
336.1
257.2
168.9
103.4
1998
1999
2000
2001
2002
Hot Topic has been adding new stores at a rapid pace, and has thus seen dramatic increases in its
Net Income and Revenues. The new Torrid store concept, which appears to be catching on
quickly, is still too new to contribute much in overall revenues. Although the start-up costs
associated with the Torrid line have impacted some of the profit margin numbers, that
investment should continue to add to the growth of Hot Topic’s future revenues.
Net Profit Margin:
Hot Topic’s Net Profit Margin peaked in 2000
HOTT, Net Profit Margin 1998-2002
and has entered a downward trend. Part of this
10.0%
9.0%
8.0%
7.0%
6.0%
9.0%
trend might be explained by the fact that the
8.5%
8.0%
7.8%
apparel industry as a whole has had a difficult
5.8%
time over the past few years, but it is not likely
5.0%
4.0%
3.0%
2.0%
1.0%
0.0%
to have been a major factor due to Hot Topic’s
specialty nature. More probable explanations
are the company’s increased costs due to the
1998
1999
2000
2001
rapid pace of expansion and the new Torrid
2002
store line. In 2002, for example, the company
experienced a 0.4% increase in store occupancy expenses due to higher common area charges and
rent expenses. The increased rent expenses were the result of Torrid’s larger store size and
increased store count over that time.
Notable, however, are the fact that Hot Topic’s Net Profit Margin is still significantly higher
than that of the industry and the likelihood that Torrid will begin to contribute more to the Net
Profit Margin in the next few years.
Earnings per Share (EPS):
HOTT, EPS 1998-2002
0.80
0.70
0.70
0.60
0.57
0.50
0.48
0.40
0.31
0.30
0.20
0.10
0.14
0.00
1998
1999
2000
2001
2002
EPS has risen steadily over the past five years,
adjusted for a 2-for-1 stock split in December
1999, a 2-for-1 split in December 2000, a 3for-2 split in February 2002, and a 3-for-2 split
in September 2003.
Dividend per Share: HOTT does not pay any dividends, a sign that it expects further
growth and continues to reinvest in itself.
Investment Returns: Return on Equity (ROE)
Hot Topic has consistently generated an ROE
HOTT, ROE 1998-2002
over 20% for the past four years. The
23.4%
25.0%
20.1%
21.1%
21.5%
2001
2002
industry, in contrast, has an ROE of just 8.0%.
20.0%
15.0%
12.3%
10.0%
5.0%
0.0%
1998
1999
2000
Investment Returns: Return on Assets (ROA)
Return on Invested Capital (ROIC)
HOTT, ROIC 1999-2002
HOTT, ROA 1998-2002
35.0%
25.0%
30.0%
19.6%
20.0%
17.6%
16.9%
15.2%
15.0%
31.2%
27.0%
25.4%
24.6%
25.0%
20.0%
10.2%
15.0%
10.0%
10.0%
5.0%
5.0%
0.0%
0.0%
1998
1999
2000
2001
2002
1999
2000
2001
2002
Investment Returns: Return on Assets (ROA) & Return on Equity (ROE) comparison
Again, the trends in management efficiency are
HOTT vs. Industry vs. S&P500
ROE and ROA 2002
tending downwards, but the question is whether
that is a factor of management or of the slowdown
25
20.7
in growth. The raw numbers for ROE and ROIC
in percent (%)
20
16.2
Company
15
10
7.6
Industry
8.8
S&P500
4
5
are still well above that of both the industry and
the S&P 500, and they are expected to remain at a
very high level over the next 5 years.
1.4
0
Return On Equity
Return On Assets
Free Cash Flow:
The free cash flow of Hot Topic has
HOTT, FCF before Goodw ill 1999-2002
been increasing significantly over the
74.9
80
(in millions $)
70
growth and the addition of new stores.
60
50
Because
42.3
25.5
many
young,
growing
companies put a large percentage of
40
30
past three years, despite continued
22.3
their cash into investments, this might
20
be another indication that Hot Topic is
10
0
1999
2000
2001
2002
moving out of its phase of rapid growth
and into a more mature phase.
Financial Health: Updated 2/1/04
Capital Structure:
HOTT has no short or long term debt.
Equity Capital Structure
Debt Capital Structure
Market Capitalization = $3.111 Bn
Short-term debt = 0
Preferred equity = 0
Long-term debt = 0
Common Weight = 100%
Short Debt Weight = 0%
Preferred Weight = 0%
Long Debt Weight = 0%
Cost of Equity (CAPM Model)
CAPM = Rf + beta(Rm-Rf)
Rf = risk free rate (5 year treasury bond rate) = 3.27 (www.forecasts.org 2/1/04)
Rm = 7.90%
Rm - Rf = historical long term equity risk premium (market risk) = 4.63
Beta = 1.15
CAPM = 3.27 + 1.25(4.63) = 8.59%
Cost of Equity for HOTT = 8.59%
Cost of Debt for HOTT = 0%
Cost of Preferred Stock for HOTT = 0.0%
WACC = 8.59%
ROIC = 24.6%
SPREAD = 24.6% - 8.59% = 16.01%
P/E Ratio:
HOTT: 35.40 (source: smartmoney.com)
Industry: 25.90 (source: smartmoney.com)
Forward P/E:
HOTT: 32.30
Industry: 19.90
PEG Ratio:
HOTT: 1.39
Industry: 1.35
Stock Valuation: Updated 2/1/04____________________________________
Average Annual Compound Growth Rates
7-year EPS growth
66.18%
3-year EPS growth
31.2%
The EPS growth is not a particularly accurate picture, as HOTT has been in existence for less
than 10 years, and its initial earnings were just $.02/share. EPS growth over the past three years,
however, has still been over 30%.
Average Plowback, Payout, and ROE (10-year)
Average Payout
0.0%
Average Plowback
100.0%
Average ROE
20.64%
Growth Rate
3-year EPS
10-year DPS
31.2%
N/A
ROE*b
20.64%
Average of 2 growth rates
25.92%
P/E Valuation Model
Avg. P/E
Projected Earnings 2004
Projected Price
17.59
SELL
.96
16.88
HOTT is currently trading at just above $30. Thus, the P/E Model implies that the stock is
significantly overvalued.
ValuePro.net
Intrinsic Value
For the time being, intrinsic value was taken off of ValuePro.com, using the following
assumptions:
Growth Rate:
18.2%
10-year Treasury Yield:
5.0%
Beta
1.15
Current Price
30.47
Intrinsic Value
34.92
BUY
According to this calculation, despite the stock’s rapid growth in the past year, there is still room
to continue to see increases in price. ValuePro’s default settings value HOTT at $34.19.
Stock Rankings
Timeliness
Valueline
Safety
1
3
Technical
Beta
3
1.15
MoneyCentral StockScouter Rating:
5
MoneyCentral Average Analyst Recommendation:
Hold
Yahoo!Finance Average Analyst Recommendation:
Hold
The Company Board
Board of Directors
1 linked, 7 independent
Edgar Berner:
Vice President of Real Age, Inc.
Independent
Director of Real Age, Inc.
Director of Garden Fresh Inc.
Director on Barbeques Galore Ltd.
CEO of Sweet Factory Inc 1991-1996
Cynthia Cohen:
President of Strategic Mindshare
Independent
Partner of Mgmt Consulting for Deloitte & Touche,
Prior to 1990
Director of Office Depot, Inc.
Director of The Sports Authority
Corrado Federico
Director of Bebe Stores
Independent
President of Corado, Inc.
Former President and CEO of Esprit
Former President of Solaris Properties
W. Scott Hedrick
Founder and Partner of Interwest Partners
Independent
Director of Office Depot, Inc.
Past Director of the Office Club Inc.
Director of Golden State Vintners, Inc.
Elizabeth McLaughlin CEO of Hot Topic since Aug 2000
Linked**
President of Hot Topic since Feb 2000
Past Senior Vice President of Hot Topic
Past General Merchandise Manager of Hot Topic
Has held various positions with Miller’s Outpost
Has held various positions with The Broadway
Bruce Quinnell
Past Vice Chairman of Borders Group, Inc.
Independent
Past President and COO of Borders Group, Inc.
Past President and COO of Waldenbooks, Inc.
Andrew Schuon
President of Programming of Infinity Broadcasting
Independent
Past President of Pressplay
Past President and COO of FarmClub.com
Past Exec Vice President of Warner Brothers Inc, Records.
Past Exec Vice President of MTV
Risk Analysis
Insider Trading:
Date
10/14/2003
10/10/2003
10/10/2003
10/1/2003
9/29/2003
No. of
Shares
Name
Edgar
Berner
Position
Transaction
Market Value
Director
Sale
4500
$
127,929
Cindy Levitt
Edgar
Berner
Edgar
Berner
James
McGinty
Officer
Sale
12,000
$
331,560
Director
Sale
11,000
$
302,610
Director
Sale
1,000
$
23,800
CFO
Sale
16,000
$
369,760
Comments
Sale of indirect
holdings
Sale of exercised
options
Sale of indirect
holdings
Sale of indirect
holdings
Sale of exercised
options
There have been a number of insider trades over the preceding months, though the vast majority of
them have been either the exercise of stock options or the sale of relatively small levels of indirect
holdings. There have not been any recent large sell-offs that would indicate any major negative
events.
External Risk Factors

Dependence on and changes in music fashion trends
o There is always the chance, with a specialty store such as Hot Topic that focuses so much on
the latest trends, that its customer base will simply move on to the next best thing. Because
of the company’s business model and continued popularity, however, it seems unlikely that
such a severe change will occur within the next few years.

Dependence on relationships with mall operators and developers

Competition:
o
The possibility that a large, powerful company may decide to move into Hot Topic’s niche is
of significant concern to Hot Topic management.
Internal Risk Factors

Risks inherent in expansion (see below):
o As the number of Company stores increases, the Company may face risks associated with
market saturation of its products and concepts. There can be no assurance that the
Company's expansion will not adversely affect the individual financial performance of the
Company's existing stores or its overall results of operations, or that new stores will achieve
sales and profitability levels consistent with existing stores.
o In order to manage its planned expansion, among other things, the Company will need to
locate suitable store sites; negotiate acceptable lease terms; obtain adequate capital resources
on acceptable terms; source sufficient levels of inventory; hire and train store managers and
sales associates; and integrate new stores into its existing operations. The Company will also
need to continually evaluate the adequacy of its management information and distribution
systems. There can be no assurance that the Company will anticipate all of the changing
demands that its expanding operations will impose on its business, systems and procedures,
and the Company's failure to adapt to such changing demands could have a material adverse
effect on the Company's results of operations and financial condition. Further, there can be
no assurance that the Company will successfully achieve its expansion targets or, if achieved,
that planned expansion will result in profitable operations.

Dependence on key vendors (though the risk here is minimized by the fact that no
more than 5% of Hot Topic’s merchandise comes from any one vendor)
o

Although the Company has many sources of merchandise, substantially all
of the Company's music-licensed products are available only from vendors that have
exclusive license rights. The Company has no long-term purchase contracts or other
contractual assurances of continued supply, pricing or access to new products.
Dependence on key personnel