10-Q 1 hottopic_10q-050303.txt 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 May 3, 2003 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) (Telephone number of Registrant) (626) 839-4681 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 an accelerated filer (as defined in the Exchange Act Rule 12b-2). Yes [X] No [ ] APPLICABLE ONLY TO CORPORATE ISSUERS: Indicate the number of shares outstanding of the issuer's common stock as of the latest practicable date: June 2, 2003 - 31,514,578 shares, no par value. HOT TOPIC, INC. INDEX TO FORM 10-Q Page No. PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS (UNAUDITED): Consolidated Balance Sheets - May 3, 2003 and February 1, 2003 3 Consolidated Statements of Income for the three months ended May 3, 2003 and May 4, 2002 4 Consolidated Statements of Cash Flows for the three months ended May 3, 2003 and May 4, 2002 5 Notes to Consolidated Financial Statements 6-9 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 10-19 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 19 ITEM 4. CONTROLS AND PROCEDURES 19 PART II. OTHER INFORMATION ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K 20 SIGNATURE PAGE 21 CERTIFICATIONS 22-23 2 PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS Hot Topic, Inc. and Subsidiaries Consolidated Balance Sheets (in thousands except share amounts)
May 3, 2003 February 1, 2003 ------------------------------- (Unaudited) Assets Current assets: Cash and cash equivalents $ 34,389 $ 50,449 Short-term investments 37,131 32,969 Inventory 43,945 38,409 Prepaid expenses and other 8,950 7,866 Deferred tax assets 2,093 2,093 ------------------------------- Total current assets 126,508 131,786 Leaseholds, fixtures and equipment: Furniture, fixtures and equipment 63,259 58,597 Leasehold improvements 62,285 58,322 ------------------------------- 125,544 116,919 Less accumulated depreciation 48,997 44,773 ------------------------------- Net leaseholds, fixtures and equipment 76,547 72,146 Deposits and other 171 171 Deferred tax assets 683 683 ------------------------------- Total assets $ 203,909 $ 204,786 =============================== Liabilities and shareholders' equity Current liabilities: Accounts payable $ 15,922 $ 15,407 Accrued liabilities 17,272 19,524 Income taxes payable 290 6,453 Current portion of obligations under capital leases 22 23 ------------------------------- Total current liabilities 33,506 41,407 Deferred rent 2,528 2,358 Capital lease obligations, less current portion 84 92 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; 31,421,406 and 31,203,987 shares issued and outstanding at May 3, 2003 and February 1, 2003, respectively 50,289 47,837 Retained earnings 117,502 113,092 ------------------------------- Total shareholders' equity 167,791 160,929 ------------------------------- Total liabilities and shareholders' equity $ 203,909 $ 204,786 =============================== See notes to consolidated financial statements. 3
HOT TOPIC, INC. AND SUBSIDIARIES Consolidated Statements of Income (Unaudited) (in thousands except per share amounts) Three Months Ended --------------------- May 3, May 4, 2003 2002 --------------------- Net sales $100,657 $ 79,909 Cost of goods sold, including buying, distribution and occupancy costs 65,043 51,452 --------------------- Gross margin 35,614 28,457 Selling, general and administrative expenses 28,859 22,927 --------------------- Operating income 6,755 5,530 Interest income-net 358 410 --------------------- Income before income taxes 7,113 5,940 Provision for income taxes 2,703 2,257 --------------------- Net income $ 4,410 $ 3,683 ===================== Net income per share: Basic $ 0.14 $ 0.12 ===================== Diluted $ 0.14 $ 0.11 ===================== Shares used in computing net income per share: Basic 31,312 31,473 Diluted 32,378 33,315 See notes to consolidated financial statements. 4 HOT TOPIC, INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows (Unaudited) (in thousands) Three Months Ended --------------------- May 3, May 4, 2003 2002 --------------------- OPERATING ACTIVITIES Net income $ 4,410 $ 3,683 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Depreciation and amortization 4,359 3,216 Tax benefit from exercise of stock options 1,155 1,121 Deferred rent 170 127 Loss on disposal of fixed assets 13 69 Changes in operating assets and liabilities: Inventory (5,536) (6,245) Prepaid expenses and other current assets (1,083) (1,838) Deposits and other assets (1) (4) Accounts payable 514 2,051 Accrued liabilities (2,252) 8 Income taxes payable (6,163) (2,096) --------------------- Net cash provided by (used in) operating activities (4,414) 92 INVESTING ACTIVITIES Purchases of property and equipment (8,773) (11,602) Purchases of short-term investments (17,985) (9,922) Proceeds from sale of short-term investments 13,823 9,517 --------------------- Net cash used in investing activities (12,935) (12,007) FINANCING ACTIVITIES Payments on capital lease obligations (8) (9) Proceeds from employee stock purchases and exercise of stock options 1,297 1,338 --------------------- Net cash provided by financing activities 1,289 1,329 --------------------- Decrease in cash and cash equivalents (16,060) (10,586) Cash and cash equivalents at beginning of period 50,449 34,072 --------------------- Cash and cash equivalents at end of period $ 34,389 $ 23,486 ===================== SUPPLEMENTAL INFORMATION Cash paid during the period for interest $ 23 $ 4 ===================== Cash paid during the period for income taxes $ 7,743 $ 4,366 ===================== See notes to consolidated financial statements. 5 HOT TOPIC, INC. and SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) NOTE 1. ORGANIZATION AND BASIS OF PRESENTATION Hot Topic, Inc. and its wholly owned subsidiaries (collectively, the "Company") is a mall-based specialty retailer operating the Hot Topic and Torrid store concepts. Hot Topic 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 fiscal 2001 (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. At the end of the first quarter (May 3, 2003) of fiscal 2003 (the fiscal year ending January 31, 2004), the Company operated 434 Hot Topic stores in 49 states throughout the United States, 34 Torrid stores and websites hottopic.com and torrid.com. The Company has one reportable segment given the similarities of the economic characteristics among the store formats. The information set forth in these financial statements is unaudited except for the February 1, 2003 Consolidated Balance Sheet. These statements have been prepared in accordance with accounting principles generally accepted in the United States 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 for complete financial statements. In the opinion of management, all adjustments, consisting only of normal recurring accruals, necessary for a fair presentation have been included. The results of operations for the three months ended May 3, 2003 are not necessarily indicative of the results that may be expected for the year ending January 31, 2004. Certain reclassifications have been made to prior year periods to conform to current period presentation. For further information, refer to the consolidated financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the year ended February 1, 2003. NOTE 2. NET INCOME PER SHARE The Company computes net income per share pursuant to Statement of Financial Accounting Standards ("SFAS") No. 128 "Earnings Per Share." Basic net income per share is computed based on the weighted average number of common shares outstanding for the period. Diluted net income per share is computed based on the weighted average number of common and potentially dilutive common stock equivalents outstanding for the period. A three-for-two stock split of the Company's common stock became effective February 6, 2002. All share and per share amounts have been restated to reflect the stock split and all previous stock splits effectuated by the Company. 6 A reconciliation of the numerator and denominator of basic earnings per share and diluted earnings per share is as follows (all amounts in thousands except per share amounts): Three Months Ended ------------------ May 3, 2003 May 4, 2002 ----------- ----------- Basic EPS Computation: Numerator $ 4,410 $ 3,683 Denominator: Weighted average common shares outstanding 31,312 31,473 ----------- ----------- Total shares 31,312 31,473 =========== =========== Basic EPS $ 0.14 $ 0.12 =========== =========== Diluted EPS Computation: Numerator $ 4,410 $ 3,683 Denominator: Weighted average common shares outstanding 31,312 31,473 Incremental shares from assumed conversion of options 1,066 1,842 ----------- ----------- Total shares 32,378 33,315 =========== =========== Diluted EPS $ 0.14 $ 0.11 =========== =========== NOTE 3. SHAREHOLDERS' EQUITY On May 8, 2002, the Company announced that its Board of Directors approved the repurchase of up to an aggregate of one million shares of its common stock during the period ending January 31, 2003. As of January 31, 2003, the Company had completed the repurchase of one million shares of its common stock at a cost of $19.7 million. NOTE 4. BANK CREDIT AGREEMENT The Company has an unsecured bank credit agreement for $1.0 million, which is used for issuing letters of credit. The credit agreement expires in August 2003, and the Company expects to renew the agreement under similar terms. The letters of credit are primarily used for inventory purchases. At May 3, 2003, the Company had $0.6 million of outstanding letters of credit issued under the credit agreement. NOTE 5. STOCK BASED COMPENSATION Pro forma information regarding net income and earnings per share is required by SFAS No. 123, and has been determined as if the Company had accounted for its employee stock options under the fair value method of that Statement. For purposes of pro forma disclosures, the estimated fair value of the options, based on the Black-Scholes option pricing model, is amortized to expense over the options' vesting periods. The following is the pro forma information had the fair value method under SFAS No. 123, as amended by SFAS No. 148, been adopted (in thousands, except per share amounts): 7 Three Months Ended -------------------------- May 3, 2003 May 4, 2002 Net income As reported $ 4,410 $ 3,683 Add: Stock-based compensation expense included in reported net income, net of related tax effects -- -- Deduct: Total stock-based compensation expense determined under fair value method for all awards, net of related tax effects (1,180) (933) ---------- ---------- Pro forma $ 3,230 $ 2,750 ========== ========== Basic earnings per share: As reported $ 0.14 $ 0.12 Pro forma $ 0.10 $ 0.09 Diluted earnings per share: As reported $ 0.14 $ 0.11 Pro forma $ 0.10 $ 0.08 NOTE 6. IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure - an Amendment to FASB Statement No. 123." SFAS No. 148 amends SFAS No. 123, "Accounting for Stock-Based Compensation", to provide new guidance concerning the transition when a company changes from the intrinsic value method to the fair value method of accounting for employee stock-based compensation cost. SFAS No. 123, as amended by SFAS No. 148, also requires additional disclosure regarding such cost in annual financial statements and interim financial statements. The amendment to SFAS No. 123 is effective for fiscal years ending after December 15, 2002 and effective for interim financial statements beginning after December 15, 2002. The Company has not adopted the fair value method, as permitted under SFAS No. 148, and continues to account for stock options under APB No. 25. The Company adopted the disclosure requirements of SFAS No. 148 in the year ended February 1, 2003. In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities", which addresses financial accounting and reporting for costs associated with exit or disposal activities and supersedes Emerging Issues Task Force ("EITF") Issue 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)." SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. Under Issue 94-3, a liability for an exit cost, as defined in EITF 94-3, was recognized at the date of an entity's commitment to an exit plan. SFAS No. 146 also establishes that the liability should initially be measured and recorded at fair value. The provisions of SFAS No. 146 are effective for exit or disposal activities that are initiated after December 31, 2002. The Company adopted SFAS No. 146 on February 2, 2003. The adoption of SFAS No. 146 has not had a material impact on the Company's results of operations or financial condition. 8 In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections." This Statement updates, clarifies and simplifies existing accounting pronouncements. SFAS No. 145 is effective for fiscal years beginning after May 15, 2002. The Company adopted SFAS No. 145 on February 2, 2003. The adoption of SFAS No. 145 has not had a material impact on the Company's results of operations or financial condition. In June 2001, the FASB issued SFAS No. 143, "Accounting for Asset Retirement Obligations." This Statement addresses financial accounting and reporting obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. SFAS No. 143 is effective for financial statements issued for fiscal years beginning after June 15, 2002. The Company adopted SFAS No. 143 on February 2, 2003. The adoption of SFAS No. 143 has not had a material impact on the Company's results of operations or financial condition. The Company adopted SFAS No. 141, "Business Combinations" and No. 142, "Goodwill and Other Intangible Assets", on February 3, 2002. SFAS No. 141 addresses the initial recognition and measurement of goodwill and other intangible assets acquired in a business combination. SFAS No. 142 addresses the initial recognition and measurement of intangible assets acquired outside of a business combination, whether acquired individually or with a group of other assets, and the accounting and reporting for goodwill and other intangibles subsequent to their acquisition. SFAS Nos. 141 and 142 require all future business combinations to be accounted for using the purchase method of accounting. Goodwill will no longer be amortized, but instead will be subject to an impairment test each reporting period. The adoption of SFAS Nos. 141 and 142 has not had a material impact on the Company's results of operations or financial condition. The Company does not have any goodwill or amortization expense related to such goodwill in its financial statements. 9 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion of the results of operations, financial condition and liquidity of the Company and other matters should be read in conjunction with the Company's Consolidated Financial Statements and the Notes related thereto. The Company considers a store comparable after it has been open for 15 full months. If a store is relocated or expanded 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 months. RESULTS OF OPERATIONS Three Months Ended May 3, 2003 Compared to Three Months Ended May 4, 2002 ------------------------------------------------------------------------- Net sales increased $20.8 million, or 26.0%, to $100.7 million during the first quarter of fiscal 2003 from $79.9 million during the first quarter of fiscal 2002. Net sales for the new Hot Topic stores opened during the first quarter of fiscal 2003 and for the other Hot Topic stores not yet qualifying as comparable stores contributed $13.1 million of the net sales increase. Net sales for the new Torrid stores and for the Torrid stores not yet qualifying as comparable stores contributed $4.1 million of the net sales increase. Comparable store sales for the Company increased 2.6% in the first quarter of fiscal 2003 and contributed $1.9 million of the increase in net sales. Hottopic.com and torrid.com sales were approximately 2.7% of total Company sales in the first quarter of fiscal 2003 and contributed $1.7 million (including shipping and handling revenue) of the net sales increase. At the end of the first quarter of fiscal 2003, 340 of the Company's 468 stores (Hot Topic and Torrid) were included in the comparable store base, compared to 261 of the Company's 379 stores (Hot Topic and Torrid) open at the end of the first quarter of fiscal 2002. Sales of apparel and tee-shirt category merchandise, as a percentage of total net sales, were 49.9% in the first quarter of fiscal 2003 compared to 53.0% in the first quarter of fiscal 2002. The decrease in apparel sales mix was due primarily to men's fashion apparel. Gross margin increased $7.2 million to $35.6 million during the first quarter of fiscal 2003 from $28.4 million during the first quarter of fiscal 2002. As a percentage of net sales, gross margin decreased to 35.4% during the first quarter of fiscal 2003 from 35.6% in the first quarter of fiscal 2002. The 0.2% decrease in gross margin as a percentage of net sales is due primarily to higher store occupancy costs, slightly lower merchandise margins, and higher store depreciation expense partially offset by lower distribution expenses. Store occupancy costs were 0.7% higher as a result of the increases in common area charges and rent expenses. Torrid's larger store size and increased store count resulted in a portion of the increase of rent expenses, as a percentage of net sales. The Company's merchandise margin decreased 0.3% of net sales in the first quarter of fiscal 2003 compared to the first quarter of fiscal 2002 principally due to higher markdowns and the increased Torrid mix relative to Hot Topic. The decrease in distribution expenses of 0.9% resulted from significant cost savings in freight and labor. Selling, general and administrative expenses increased $5.9 million, or 25.9%, to $28.8 million during the first quarter of fiscal 2003 compared to $22.9 million during the first quarter of fiscal 2002. Selling, general and administrative expenses were 28.7% of net sales during the first quarter of fiscal 2003, equal as a percentage of net sales to the first quarter of fiscal 2002. The total dollar increase in selling, general and administrative expenses was primarily attributable to an increase in the number of retail stores from 379 at the end of the first quarter of fiscal 2002 to 468 at the end of the first quarter of fiscal 2003 and the corresponding additional payroll and other expenses required to support these additional stores. In the first quarter of 2003, store payroll decreased 0.4%, as a percentage of net sales, as a result of more efficient usage of store payroll hours, somewhat offset by an increase in payroll related to the reclassification of store management to non-exempt status and the resulting overtime expenses. This decrease in store payroll expense was partially offset by a 0.3% increase, as a percentage of net sales, in costs related to the Company's wide area network. The remaining 0.1% increase, as a percentage of net sales, resulted from higher performance based payroll partially offset by leveraging headquarters expenses. 10 Operating income increased 22.2%, to $6.8 million, during the first quarter of fiscal 2003 from $5.5 million during the first quarter of fiscal 2002. As a percentage of net sales, the operating income was 6.7% in the first quarter of fiscal 2003 compared to 6.9% in the first quarter of fiscal 2002. Interest income, net, decreased $0.1 million to $0.3 million in the first quarter of fiscal 2003 from $0.4 million in the first quarter of fiscal 2002, due to lower interest rates offset in part by the additional interest earned from higher average cash balances. LIQUIDITY AND CAPITAL RESOURCES Historically, as well as during the first quarter of fiscal 2003, the Company's primary uses of cash have been to finance store openings and purchase merchandise inventories. The Company historically has satisfied its cash requirements principally from cash flows from operations, and, in earlier years, also from proceeds from the sale of equity securities. The Company maintains a $1.0 million unsecured credit agreement for the purpose of issuing letters of credit. At May 3, 2003, the Company had $0.6 million of outstanding letters of credit under the credit agreement. Cash flows used in operating activities were $4.4 million in the first quarter of fiscal 2003 and provided $0.1 million in the first quarter of fiscal 2002. The decrease of $4.5 million in cash flows from operating activities in the first quarter of fiscal 2003 compared to the first quarter of fiscal 2002 resulted primarily from a decrease in income taxes payable, a decrease in accrued liabilities and a decrease in accounts payable. These were partially offset by an increase in depreciation and amortization, a decrease in prepaid expenses, and an increase in net income. The decrease in income taxes payable is primarily due to timing of income tax payments. The decrease in accrued liabilities is primarily due to higher year end bonus payouts and higher gift card redemptions. Cash flows used in investing activities were $12.9 million and $12.0 million in the first quarter of fiscal 2003 and 2002, respectively. The $0.9 million increase in net cash used in investing activities is due to a net increase ($3.7 million) in the purchases of short-term investments offset by a decrease ($2.8 million) in purchases of property and equipment. Cash flows used in the purchases of property and equipment during the first quarter of fiscal 2003 relate primarily to store openings and purchase of computer hardware and software. Cash flows provided by financing activities were $1.3 million in the first quarter of fiscal 2003 and 2002. The financing activities were primarily related to the proceeds received from the exercise of stock options. The Company believes that its current cash balances and cash generated from operations will be sufficient to fund its operations and planned expansion through at least the next 12 months. 11 CRITICAL ACCOUNTING POLICIES Management's discussion and analysis of the Company's financial condition and results of operations are based upon the Company's consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information. The preparation of these financial statements requires the Company 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, the Company evaluates estimates, including those related primarily to inventories, long-lived assets and contingencies. The Company bases its estimates on historical experience and on various other assumptions that are believed 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. The Company believes the following critical accounting policies affect the more significant judgments and estimates used in the preparation of its consolidated financial statements. For a further discussion on the application of these and other accounting policies, refer to the notes included in the Company's Annual Report on Form 10-K for the year ended February 1, 2003. INVENTORIES: Inventories and related cost of sales are accounted for by the retail method. The cost of inventory is valued at the lower of average cost or market, on a first-in, first-out (FIFO) basis, utilizing the retail method. Each month, slow moving or seasonally obsolete merchandise is marked down. The first markdown is typically to 50% of the original retail. In cases where the merchandise does not sell after the first markdown, an additional markdown is made in a subsequent month. Any marked down merchandise that does not sell is marked down to a zero value and removed from the store, approximately three months after the original markdown. In determining the lower of average cost or market value of period ending inventories, consistently applied valuation criteria is used. Consideration is given to a number of quantitative factors, including anticipated subsequent permanent markdowns and aging of inventories. VALUATION OF LONG-LIVED ASSETS: The Company assesses the impairment of long-lived assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors considered 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 the Company determines that the carrying value of long-lived assets may not be recoverable based upon the existence of one or more of the above indicators of impairment, the Company will measure any impairment based on a projected discounted cash flow method using a discount rate determined by our management. The Company has not historically had an impairment of a long-lived asset. REVENUE RECOGNITION: Sales are recognized upon the purchase by customers at the Company's retail store locations and websites, less merchandise returned by customers. The Company provides a reserve for projected merchandise returns based on historical experience. Revenue from gift cards, gift certificates and store merchandise credits is recognized at the time of redemption. SELF-INSURANCE: The Company is self-insured for medical insurance coverage and workers compensation insurance coverage. Both programs have maximum exposure limits. The Company maintains a liability for estimated claims based on historical claims experience and other actuarial assumptions. 12 INFLATION The Company does not believe that inflation has had a material adverse effect on net sales or results of operations. The Company has generally been able to pass on increased costs related to inflation through increases in selling prices. 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 (the "Securities Act"), and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), including statements regarding the Company's 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 the Company's products, new store openings and new store concepts. All forward-looking statements included in this report are based on information available to the Company as of the date hereof and the Company assumes no obligation to update any forward-looking statements. Forward-looking statements involve known or unknown risks, uncertainties and other factors which may cause the Company's 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 statements. Such risks, uncertainties and other factors include but are not limited to the items discussed under the captions "Certain Risks Related to the Company's Business" and "Management's Discussion and Analysis of Financial Condition and Results of Operations" in this Item 2. CERTAIN RISKS RELATED TO THE COMPANY'S BUSINESS Before deciding to invest in the Company or to maintain or increase an investment in the Company, readers should carefully consider the risks described below, in addition to the other information contained in the Company's Annual Report on Form 10-K and in the Company's other filings with the SEC, including the Company's Quarterly Reports on Form 10-Q and Current Reports on Form 8-K. The risks described below are not the only risks facing the Company. Additional risks not presently known to the Company or that the Company currently deems immaterial may also affect the Company's business. If any of these known or unknown risks actually occur, the Company's business, financial condition and results of operations could be seriously harmed, and the Company's stock price could decline. IMPLEMENTATION AND MANAGEMENT OF AGGRESSIVE GROWTH STRATEGY The Company's net sales and net income have grown significantly 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. The Company intends to continue to pursue an aggressive growth strategy for the foreseeable future, and its future operating results will depend largely upon its ability to open and operate stores successfully and to profitably manage a larger business. The Company currently anticipates opening approximately 95 stores, consisting of 70 Hot Topic and 25 Torrid stores, during fiscal 2003, which will result in a significant increase in the number of stores operated by the Company. Operation of a greater number of new stores and expansion into new markets may present competitive and merchandising challenges that are different from those currently encountered by the Company in its existing stores and markets. In addition, 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. 13 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, train and supervise store management 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. RISKS ASSOCIATED WITH NEW TORRID CONCEPT The Company's ability to expand into new concepts, and in particular its Torrid concept, has not been fully tested. Accordingly, the operation of the Company's Torrid stores and the sale of Torrid merchandise over the Internet are subject to numerous risks, including unanticipated operating problems; lack of experience; lack of customer acceptance; new vendor relationships; competition from existing and new retailers; and diversion of management's attention from the Company's Hot Topic concept. Among other things, 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 dominantly apparel driven concept, including risks of difficulty in merchandising, uncertainty of customer acceptance, fluctuations in apparel styling and customer tastes, extreme competition with a less differentiated product offering and attendant markdown risks. The Company may not be able to generate continued customer interest in Torrid stores and products, and the Torrid concept may not be able to support the store or Internet sales formats. Risks inherent in any new concept are particularly acute with respect to Torrid, because this is the first significant new venture by the Company. There can be no assurance that the Company's Torrid stores or website will achieve sales and profitability levels that justify the Company's investment. DEPENDENCE ON RELATIONSHIPS WITH MALL OPERATORS AND DEVELOPERS Any restrictions on the Company's ability to expand to new store sites or to offer a broad assortment of merchandise could have a material adverse effect on the Company's business, results of operations and financial condition. If the Company's relations with mall operators or developers become strained, or the Company otherwise encounters difficulties in leasing store sites, the Company may not grow as planned, may not reach certain revenue levels and other operating targets. FLUCTUATIONS IN COMPARABLE STORE SALES RESULTS A variety of factors affect the Company's comparable store sales including, among others, the timing of new music releases and music-related products; music and fashion trends; the general retail sales environment and the effect of the difficult overall economic environment; the Company's ability to efficiently source and distribute products; changes in the Company's merchandise mix; and the Company's ability to execute its business strategy efficiently. The Company's comparable store sales results have fluctuated significantly in the past and the Company believes that such fluctuations may continue. The Company's comparable store sales results for fiscal 1999, 2000, 2001 and 2002 were 22.8%, 16.7%, 3.9% and 5.0%, respectively. The Company's comparable store sales results were (0.5%), 0.6%, 6.3% and 9.7% for the first, second, third and fourth quarters, respectively, of fiscal 2002 and 8.0%, 2.4%, 2.2% and 3.8% for the first, second, third and fourth quarters, respectively, of fiscal 2001. Past comparable store sales results are not an indicator of future results, and there can be no assurance as to whether Company's comparable store sales results will increase or decrease in the future. The Company's comparable store sales results could cause the Company's stock price to fluctuate substantially. 14 DEPENDENCE ON AND CHANGES IN MUSIC AND FASHION TRENDS The Company's financial performance is largely dependent upon the continued popularity of alternative and rock music, Internet, music videos, 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-related products; the continuance of a significant level of teenage spending on music-licensed and music-influenced products; and the Company's ability to anticipate and keep pace with the music, fashion and merchandise preferences of its customers. The popularity of particular types of music, artists, styles and brands is subject to change. The Company's 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 the Company's results of operations and financial condition, and on its image with customers. There can be no assurance that the Company's 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 the Company's business, results of operations and financial condition. IMPACT OF ECONOMIC CONDITIONS; WAGE RATE STRUCTURE AND BENEFITS Certain economic conditions affect the level of consumer spending on merchandise offered by the Company, including, among others, employment levels; salary and wage levels; interest rates; taxation; and consumer confidence in future economic conditions. The Company is 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 continued slowdown in the United States economy as well as a continued 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 the Company's growth, sales results and financial performance. Changes in federal and state minimum wage laws or statutory employment regulations could raise wages above current wage rates or change the wage structure of certain of the Company's associates, and competitive factors could require corresponding increases in higher associate wage rates. These factors, as well as continued significant increased benefits cost primarily driven by medical expenses, would increase the Company's expenses and adversely affect results of operations. QUARTERLY RESULTS AND SEASONALITY The Company's 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-related products, shifts in timing of certain holidays, changes in the Company's merchandise mix and overall economic and political conditions. The Company's 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 the Company's single most important selling season. The Company believes, however, that the importance of the summer vacation and back-to-school seasons (which affect operating results in the second and third quarters, respectively) and to a lesser 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 the Company's dependence on the Holiday selling season. As is the case with many retailers of apparel, accessories and related merchandise, the Company typically experiences lower net sales in the first fiscal quarter relative to other quarters. 15 DEPENDENCE ON KEY VENDORS The Company's financial performance depends on its ability to purchase current music-related merchandise in sufficient quantities at competitive prices. 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. In addition, many of the Company's music-influenced products are supplied by small, specialized vendors that create unique products primarily for the Company. The Company's smaller vendors generally have limited resources, production capacities and operating histories, and some of the Company's vendors have restricted the distribution of their merchandise in the past. The Company has no long-term purchase contracts or other contractual assurances of continued supply, pricing or access to new products. There can be no assurance that the Company will be able to acquire desired merchandise in sufficient quantities on terms acceptable to the Company 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 the Company's business, results of operations and financial condition. RISKS ASSOCIATED WITH INTERNET SALES The Company sells merchandise over the Internet through the websites hottopic.com and torrid.com. The Company's Internet operations are subject to numerous risks, including, among other things, lack of experience; hiring, retention and training of personnel to conduct the Company's Internet operations; diversion of sales from the Company's stores; rapid technological change, and the need to invest in additional computer hardware and software; 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 the Company's Internet operations will achieve sales and profitability levels that justify the Company's investment. UNCERTAINTIES REGARDING INFORMATION SYSTEMS AND SOFTWARE During fiscal 1999, after completing an evaluation of its long-term management information system needs, the Company selected new hardware and software for its stores, office and distribution center. The Company implemented the host hardware and software systems at its office and distribution center during the second half of fiscal 2000 and installed certain point-of-sale upgrades at its stores in fiscal 2001. In addition, in fiscal 2002 the Company installed a new Wide Area Network at its locations. If these information systems and software do not work effectively, the Company may experience delays or failures in its operations. These delays or failures could adversely impact the timeliness and accuracy of the Company's ability to purchase and distribute merchandise, and sales transaction processing. Additionally, such delays or failures could impact the Company's ability to provide accurate and timely financial accounting and reporting requirements, and the Company's ability to properly forecast earnings and cash requirements. To manage growth of its operations and personnel, the Company may need to continue to improve its operational and financial systems, transaction processing, procedures and controls, and in doing so, could incur substantial additional expenses. 16 DEPENDENCE ON KEY PERSONNEL The Company's financial performance depends largely on the efforts and abilities of senior management, especially Elizabeth McLaughlin, the Company's Chief Executive Officer and President, who has been with the Company since 1993. The Company has a $2,000,000 key-person life insurance policy on Ms. McLaughlin. However, the sudden loss of Ms. McLaughlin's services or the services of other members of the Company's management team could have a material adverse effect on the Company's business, results of operations and financial condition. Furthermore, there can be no assurance that Ms. McLaughlin and the Company's existing management team will be able to manage the Company or its growth or that the Company will be able to attract and retain additional qualified personnel as needed in the future. UNCERTAINTIES REGARDING DISTRIBUTION OF MERCHANDISE The Company relies upon United Parcel Service for its product shipments, including shipments to and from a significant number of its stores, and, accordingly, is subject to risks, including employee strikes and inclement weather, associated with United Parcel Service's ability to provide delivery services to meet the Company's shipping needs. The Company is also dependent upon temporary associates to adequately staff its distribution facility, particularly during busy periods such as the Holiday season and while multiple stores are opening. There can be no assurance that the Company will continue to receive adequate assistance from its temporary associates, or that there will continue to be sufficient sources of temporary associates. FAILURE TO AUTHENTICATE LICENSING RIGHTS The Company purchases licensed merchandise from a number of suppliers who hold manufacturing and distribution rights under the terms of certain licenses. The Company generally relies upon vendors' representations concerning manufacturing and distribution rights and does not independently verify whether these vendors legally hold adequate rights to licensed properties they are manufacturing or distributing. If the Company acquires unlicensed merchandise, it could be obligated to remove such merchandise from its stores, incur costs associated with destruction of merchandise if the distributor is unwilling or unable to reimburse the Company, 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 the Company's business, results of operations and financial condition. COMPETITION The retail apparel and accessory industry is highly competitive. The Company competes with other retailers for vendors, teenage and college age customers, suitable store locations and qualified associates and management personnel. Hot Topic currently competes with street alternative stores located primarily in metropolitan areas; with other mall-based teenage-focused retailers such as Abercrombie & Fitch, Aeropostale, American Eagle Outfitters, Anchor Blue (Millers Outpost), Charlotte Russe Inc., Claire's Stores, Inc., Delias Inc., Gadzooks, Inc., Old Navy (a division of Gap Inc.), Pacific Sunwear of California, Inc., Spencer Gifts, Inc., The Buckle, The Wet Seal, Inc., Urban Outfitters, Inc.; and, to a lesser extent, with music stores and mail order catalogs and websites. Torrid has additional competitors, such as Alloy, Inc., Deb Shops, Lane Bryant, 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's products. Many of the Company's competitors are larger and have substantially greater financial, marketing and other resources than the Company. Direct competition with these and other retailers may increase significantly in the future, which could require the Company, among other things, to lower its prices. Increased competition could have a material adverse effect on the Company's business, results of operations and financial condition. 17 EFFECTS OF WAR, TERRORISM OR OTHER CATASTROPHES The effects of war or acts of terrorism could have a material adverse effect on the Company's business, operating results and financial condition. The terrorist attacks in New York and Washington, D.C. on September 11, 2001 disrupted commerce and intensified the uncertainty of the U.S. economy, a condition which has persisted due to recent military actions in Afghanistan and Iraq. 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, the Company's business, operating results and financial condition could be materially and adversely affected. In addition, California has recently experienced substantially increased costs of electricity and gas caused by, among other things, disruption in energy supplies. The Company's principal executive offices and a significant number of its stores are located in California. If the Company experiences a sustained disruption in energy supplies, or if electricity and gas costs in California continue to increase, the Company's 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 the Company's facilities could have a material adverse impact on its business, financial condition and operating results. PRICE VOLATILITY The Company's common stock is quoted on the Nasdaq National Market, which has experienced and is likely to experience in the future significant price and volume fluctuations, which could adversely affect the Company's stock price without regard to the Company's financial performance. In addition, the Company believes that factors such as quarterly fluctuations in the Company's financial results and comparable store sales; announcements by other apparel, accessory and gift item retailers; the trading volume of the Company's stock; changes in estimates of the Company's performance by securities analysts; overall economic and political conditions; the condition of the financial markets; and other events or factors could cause the Company's stock price to fluctuate substantially. ANTI-TAKEOVER MATTERS; SHAREHOLDER DILUTION The Company's Articles of Incorporation and Bylaws contain provisions that may have the effect of delaying, deterring or preventing a takeover of the Company. For instance, the Company's 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 the Company's Bylaws prohibit shareholder action by written consent. Additionally, the Company's Board of Directors 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 of Directors. The issuance of these shares could have a dilutive effect on the Company's shareholders, and potentially prohibit a takeover of the Company by requiring the preferred shareholders to approve such a transaction. 18 The Company also has a significant number of authorized and unissued shares of its common stock available under its Articles of Incorporation. These shares provide the Company with the flexibility to issue its 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 by the Company could result in dilution to the Company's shareholders. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company is not a party to any derivative financial instruments. The Company's exposure to market risk relates to changes in interest rates on its investments with maturities of less than three months (which are considered to be cash and cash equivalents) and its 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 (a) Evaluation of Disclosure Controls and Procedures Based on their evaluation of the Company's disclosure controls and procedures conducted within 90 days of the date of filing this report on Form 10-Q, the Company's Chief Executive Officer and Chief Financial Officer have concluded that the Company's disclosure controls and procedures (as defined in Rules 13a-14(c) and 15d-14(c) promulgated under the Securities Exchange Act of 1934) are effective. (b) Changes in Internal Controls There were no significant changes in the Company's internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation. 19 PART II. OTHER INFORMATION ITEMS 1 - 5 ARE NOT APPLICABLE. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K. (a) Exhibits: Exhibit Number Description of Document ------ ----------------------- 3.1 Amended and Restated Articles of Incorporation. (1) 3.2 Amended and Restated Bylaws. (2) 4.1 Reference is made to Exhibits 3.1 and 3.2. 4.2 Specimen stock certificate. (1) 99.1 Certifications, dated June 6, 2003, required by Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.Css.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 February 3, 2001 and incorporated herein by reference. (b) Reports on Form 8-K Not applicable. 20 SIGNATURES 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: June 6, 2003 /s/ Elizabeth McLaughlin ------------------------------------- Elizabeth McLaughlin Chief Executive Officer and President (Principal Executive Officer) Date: June 6, 2003 /s/ James McGinty ------------------------------------- James McGinty Chief Financial Officer and Secretary (Principal Financial Officer) 21 CERTIFICATION I, Elizabeth McLaughlin, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Hot Topic, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "EVALUATION DATE"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officer and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: June 6, 2003 /s/ Elizabeth McLaughlin -------------------------------------- Elizabeth McLaughlin Chief Executive Officer and President 22 CERTIFICATION I, James McGinty, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Hot Topic, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "EVALUATION DATE"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officer and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: June 6, 2003 /s/ James McGinty -------------------------------------- James McGinty Chief Financial Officer and Secretary 23