10-K 1 hottopic_10k-013104.txt ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED JANUARY 31, 2004 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM _____________________________ TO ____________________________________ COMMISSION FILE NO. 0-28784 HOT TOPIC, INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) CALIFORNIA 77-0198182 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 18305 E. SAN JOSE AVE. 91748 CITY OF INDUSTRY, CALIFORNIA (Zip Code) (Address of principal executive offices) Registrant's telephone number, including area code: (626) 839-4681 Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: COMMON STOCK, NO PAR VALUE (Title of Class) 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (Section 229.405 of this chapter) is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K ___. Indicate by check mark whether the Registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes [X] No [ ] The aggregate market value of Common Stock held by non-affiliates of the Registrant as of August 1, 2003 was approximately $906,507,545 based on the closing price on that date of the Registrant's Common Stock on the Nasdaq National Stock Market. All outstanding shares of voting stock, except for shares held by executive officers and members of the Board of Directors and their affiliates are deemed to be held by non-affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes. The number of shares outstanding of the Registrant's Common Stock was 48,229,024 as of March 31, 2004. DOCUMENTS INCORPORATED BY REFERENCE Certain portions of the Registrant's Definitive Proxy Statement for the Annual Meeting of Shareholders to be held on June 17, 2004 to be filed with the Securities and Exchange Commission (the "SEC") no later than 120 days after January 31, 2004, are incorporated by reference into Part III of this Form 10-K (Items 10 through 13). CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING DISCLOSURE THIS ANNUAL REPORT ON FORM 10-K 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, STATEMENTS REGARDING 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 IN PART I, ITEM 1 UNDER THE CAPTION "CERTAIN RISKS RELATED TO THE COMPANY'S BUSINESS" AND IN PART II, ITEM 7 UNDER THE CAPTION "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS." PART I ITEM 1. BUSINESS GENERAL 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/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. In fiscal 2001, 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. The Company opened its first Hot Topic store in 1989 and at the end of fiscal 2003 (the fiscal year ended January 31, 2004), the Company operated 502 Hot Topic stores in 49 states throughout the United States and Puerto Rico and 52 Torrid stores. The Company also maintains two distinct websites, www.hottopic.com ("hottopic.com") and www.torrid.com ("torrid.com"), which reflect the Hot Topic and Torrid store concepts and sell merchandise similar to that sold in the respective stores. The Company opened 84 Hot Topic and 25 Torrid stores during fiscal 2003. The Company also occasionally relocates, expands, or closes existing stores. During fiscal 2003, the Company expanded or relocated four stores. The Company plans to open approximately 80 new Hot Topic stores and 25 Torrid stores in the fiscal year ending January 29, 2005 ("fiscal 2004"); and 15 of these new Hot Topic stores were open as of March 31, 2004. THE MARKET The music-licensed apparel industry began in the 1960s with bootleggers selling tee shirts at concert venues. Over the ensuing two decades, artists began to realize the commercial potential of licensing their likenesses and logos to tee shirt manufacturers and others who produced assorted merchandise. Management believes that during recent years, the music industry has been significantly impacted by the availability and accessibility of the Internet and the continuing success of MTV and other music television networks. These channels enable fans not only to listen to the latest music and artists 24 hours a day, but also to experience a full sight and sound package of appearance and attitude. The growing importance of the Internet is illustrated in a U.S. Census Bureau report, stating that 80% of America's school-age children have Internet access either at home or at school, regardless of their ethnic group or household income. MTV music television reached 79 million households in the United States in 2003, according to Viacom International, Inc., MTV's parent 2. company. As a result, both emerging and well-known artists, and the fashions they inspire are much more visible today than ever before. Management believes that this increased visibility has contributed to a rise in demand for music/pop culture-licensed and music/pop culture-influenced apparel and accessories. The Company believes teenagers throughout the United States have similar fashion preferences, largely as a result of the nationwide influence of the Internet, MTV and other music television networks, music distribution, movies and television programs. Hot Topic's target customers are young men and women between the ages of 12 and 22, who are passionate about music, music videos, pop culture trends and music-inspired fashion. The Company believes its music/pop culture-influenced merchandise appeals to teenagers from diverse socio-economic backgrounds and that its customers are broadly representative of the teenage population in the United States. Teenagers represent both a growing part of the United States population and an increasing source of purchasing power. The U.S. Census Bureau estimates that the teenage population (ages 12-19) in the United States reached approximately 33 million in 2003 and is expected to grow to approximately 34 million by 2008. By 2008, there are likely to be more teenagers in the United States than at any other time in history. Teenage spending has also increased annually. The average American teen spent approximately $103 a week in 2003 according to Teen Research Unlimited, an increase of $25 from $78 in 1998. In the past four years, teenage spending has grown from an estimated $155 billion a year in 2000 to $175 billion a year in 2003. After analyzing customer feedback and researching the market demographics, the Torrid concept was developed. Torrid was launched in the first half of fiscal 2001, with the opening of six locations across the country and a website, torrid.com. Torrid's target customers are plus-size females ages 15 to 29, who are influenced by fashion trends, pop culture and music. The Company believes the Torrid assortment allows young plus-size customers wearing sizes 12 to 26 to match the style, excitement and selection available at other non-plus-size junior retailers. HOT TOPIC BUSINESS STRATEGY The Company's goal for its Hot Topic stores is to be a leading retailer of music/pop culture-licensed and music/pop culture-influenced apparel, accessories and gift items for young men and women. The principal elements for Hot Topic's business strategy are as follows: O FOCUS ON UNIQUE MUSIC/POP CULTURE-ORIENTED MERCHANDISE Management believes that fashions and products associated with popular music artists and pop culture trends have a significant influence on teenagers. The Company has developed a unique strategy focused exclusively on offering music/pop culture-licensed and music/pop culture-influenced merchandise in the mall environment. Accordingly, the Company believes it is well positioned to capitalize on the growing teenage population and demand for music/pop culture-influenced merchandise. O OFFER "EVERYTHING ABOUT THE MUSIC" AND POP CULTURE Hot Topic stores are designed to serve as a headquarters for music/pop culture-licensed and music/pop culture-influenced apparel, accessories and gift items. Hot Topic's slogan, "Everything About The Music" and its ability to relate and understand the relevant pop culture trends are reflected in the broad assortment of products. The Company believes Hot Topic's selection of music/pop culture-licensed merchandise is the most extensive assortment available in a single mall store. Hot Topic complements its licensed merchandise with a unique and eclectic assortment of music/pop culture-influenced apparel and accessories, and frequently responds to changes in trends and demand by introducing new items and categories. The Company believes Hot Topic has a history of being the first to offer the latest music/pop culture fashions, which has made Hot Topic a destination store for teenagers. 3. O PROMOTE MUSIC-INSPIRED CULTURE Hot Topic is committed to addressing the music-inspired lifestyles of its customers by building a culture throughout the organization that reflects a passion for music. Management diligently tracks alternative and rock music trends by regularly monitoring new music, music video releases, and radio station air play, visiting nightclubs around the country and attending concerts. Hot Topic also actively solicits feedback from its associates and customers. The Company believes these activities enable it to react quickly to emerging trends, and provide it with a competitive advantage over retailers who do not devote the time and resources necessary to anticipate these trends. O LISTEN TO THE CUSTOMER Hot Topic does not dictate fashion trends, but rather seeks to identify music artists, music and pop culture trends that can directly influence the in-store product assortment. The Company has developed a disciplined approach to buying and a dynamic inventory planning and allocation process to support its merchandise strategy. The Company regularly tests new merchandise in select Hot Topic stores before chain-wide distribution, and orders a majority of its merchandise not more than 60 to 90 days before delivery, enabling it to respond quickly to emerging trends. Hot Topic is aggressive in taking prompt markdowns to maintain a fresh merchandise mix. By actively managing the mix of categories and products in Hot Topic stores, the Company believes it is able to capitalize on emerging trends and minimize its dependence on any one particular merchandise category. The Company believes this approach to managing Hot Topic's merchandise mix has contributed to its strong merchandise margins and consistent markdown rates. The Company believes Hot Topic's markdown rate is lower than industry averages. O EMPHASIZE CUSTOMER SERVICE AND THE IN-STORE EXPERIENCE Hot Topic trains its store associates to provide a value-added, non-intrusive customer experience. Sales associates are trained to greet customers, provide information about new music/fashion trends and suggest merchandise that meets the customer's lifestyle and music preferences. Hot Topic provides its teenage customers the same level of respect and attention that is afforded to adult customers at other retail stores, while also providing friendly and informed customer service for parents. The Company believes that a high level of employee product knowledge and a commitment to music/fashion create credibility and differentiate Hot Topic from other teenage-focused retailers. The Company also seeks to create an exciting and compelling shopping environment focusing on the lifestyles of the youth generation. Hot Topic stores are designed with an industrial theme that incorporates dense merchandising and utilizes a professional sound system playing alternative music releases to create a fun, high-energy store that teens will consider "their place" to shop with friends. The Company believes that this atmosphere enhances Hot Topic's image as a source for music/pop culture-inspired fashion while encouraging customers to shop in its stores for longer periods of time. TORRID BUSINESS STRATEGY The Company's goal for its Torrid stores is to become a leading specialty retailer of fashion forward plus-size young womens apparel and accessories. The principal elements of the Company's business strategy for Torrid are as follows: O FOCUS ON FASHION FORWARD PLUS-SIZE APPAREL AND ACCESSORIES THAT ARE TREND, MUSIC AND POP CULTURE-INSPIRED Torrid's merchandising team is focused on providing a fashion forward merchandise assortment that reflects the influence of current trends from fashion, pop culture and music. These influences provide the inspiration for hip, trendy apparel and accessories that the junior plus-size customer relates to. The Company believes that Torrid is the first mall concept to offer a complete store assortment of fashion forward apparel for plus-size young women. 4. O LISTEN TO THE CUSTOMER Torrid does not dictate fashion trends, but rather listens to customers and watches fashion direction, music, and pop culture influences to determine emerging trends. These trends provide merchandise that will have strong customer appeal. Torrid, like Hot Topic, receives direct feedback from Torrid store associates and customers. This feedback has a direct influence on future purchases of Torrid merchandise. O EMPHASIZE CUSTOMER SERVICE AND THE IN-STORE EXPERIENCE Torrid trains its store associates to provide one-on-one service to customers. Because the Company believes that the plus-size customer has been previously unable to find the same fashion forward merchandise available to her smaller friends, Torrid's customer service approach focuses on suggesting outfits and ensuring the correct fit. Through a focus on customer service and a fashion forward merchandise offering, Torrid seeks to create a compelling shopping environment that will be sought after by the younger plus-size female customer. The Company believes that the warm reception, up to the minute fashion offerings, and helpful customer service by associates help to create a welcoming and exciting environment that will be attractive to, and preferred by, the Torrid customer. STORE LOCATIONS As of January 31, 2004, the Company operated 499 Hot Topic stores in 49 states and 52 Torrid stores in 22 states in both metropolitan and middle markets. The Company also opened three Hot Topic stores in Puerto Rico in 2003. Between February 1, 2004 and March 31, 2004, the Company opened an additional 15 Hot Topic stores and closed one Hot Topic store (the closed store's lease expired and was not renewed). The following chart sets forth, as of March 31, 2004, the number of Hot Topic and Torrid stores the Company operates in each state in which those stores are located: 5. HOT TOPIC, INC. STORES BY STATE
------------------------------------------------------------------------------------------------- HOT TOPIC STORES TORRID STORES TOTAL COMPANY --------------------------------------------- --------------------------------- --------------- OPEN AT NEW HT CLOSED HT OPEN AT OPEN AT NEW TORRID OPEN AT OPEN AT 1/31/04 FY04 TO DATE 2/29/04 3/31/04 1/31/04 FY04 TO DATE 3/31/04 3/31/04 ------- ------------ ------- ------- ------- ------------ ------- ------- Alabama 2 1 3 3 Alaska 1 1 1 Arizona 13 13 2 2 15 Arkansas 2 2 2 California 61 (1) 60 18 18 78 Colorado 11 11 1 1 12 Connecticut 7 7 7 Delaware 2 2 2 Florida 31 31 1 1 32 Georgia 10 1 11 11 Hawaii 3 3 3 Idaho 1 1 2 2 Illinois 16 16 2 2 18 Indiana 12 12 1 1 13 Iowa 8 8 8 Kansas 5 5 5 Kentucky 5 5 5 Louisiana 7 7 7 Maine 2 2 2 Maryland 12 12 2 2 14 Massachusetts 12 12 1 1 13 Michigan 20 1 21 1 1 22 Minnesota 11 11 1 1 12 Mississippi 2 2 2 Missouri 11 1 12 2 2 14 Montana 3 3 3 Nebraska 2 2 1 1 3 Nevada 5 5 2 2 7 New Hampshire 4 4 4 New Jersey 15 15 2 2 17 New Mexico 5 5 1 1 6 New York 25 25 3 3 28 North Carolina 9 1 10 10 North Dakota 1 1 1 Ohio 21 1 22 1 1 23 Oklahoma 7 7 7 Oregon 6 6 2 2 8 Pennsylvania 22 22 1 1 23 Rhode Island 1 1 1 South Carolina 3 2 5 5 South Dakota 2 2 2 Tennessee 14 14 2 2 16 Texas 40 2 42 4 4 46 Utah 5 1 6 6 Vermont 2 2 2 Virginia 11 2 13 13 Washington 17 17 17 West Virginia 3 1 4 4 Wisconsin 9 9 1 1 10 TOTAL 499 15 (1) 513 52 52 565 -------------------------------------------------------------------------------------------------------------------- # OF STATES 49 12 49 22 22 49 -------------------------------------------------------------------------------------------------------------------- Puerto Rico 3 3 3 --------------------------------------------------------------------------------------------------------------------
6. EXPANSION STRATEGY The following table provides a history of the Company's store expansion over the last five fiscal years: FISCAL YEAR ----------------------------------------------- 1999 2000 2001 2002 2003 2004 THROUGH 3-31-04 ----------------------------------------------- (Number of stores) Stores at beginning of year 158 212 274 352 445 554 Hot Topic stores closed* (1) (2) (1) New stores opened - Hot Topic 54 62 73 74 84 15 New stores opened - Torrid 6 21 25 0 ----------------------------------------------- Stores at end of year 212 274 352 445 554 568 ----------------------------------------------- ----------------------------------------------- Hot Topic stores expanded or relocated 0 5 7 8 4 2 ----------------------------------------------- * Victorville, CA store closed in fiscal 2001 and re-opened in first quarter of fiscal 2002. Parklane, NV and Bayfair, CA store leases expired in fourth quarter of fiscal 2002 and were not renewed. Cupertino, CA store lease expired in first quarter of fiscal 2004 and was not renewed. The Company's expansion strategy is to open stores primarily in shopping malls and selected entertainment centers in both new and existing markets throughout the United States. The Company opened 84 new Hot Topic stores and 25 Torrid stores in fiscal 2003 as well as expanded or relocated four existing Hot Topic stores. During fiscal 2004, the Company plans to open approximately 80 new Hot Topic stores and 25 new Torrid stores. Additionally, the Company plans to expand or relocate approximately ten existing stores. The Company has identified regional malls nationwide and in Puerto Rico for potential new stores. The Company evaluates potential store locations based on a variety of criteria including the sales productivity of the mall, sales of anchor stores, sales of teenage-oriented and plus-size stores, age demographics in the trade area, median family income and other economic factors relevant to the Company's merchandising strategy. The Company has a real estate committee that meets regularly to evaluate and select store locations. The Company generally seeks potential store sites between 1,500 square feet and 2,200 square feet for Hot Topic stores, and between 2,200 square feet and 2,800 square feet for Torrid stores. Hot Topic stores currently average approximately 1,700 square feet and Torrid stores currently average approximately 2,600 square feet. STORE-LEVEL ECONOMICS During fiscal 2003, the Company achieved average Hot Topic store net sales of approximately $1,132,000 and average Hot Topic store net sales per square foot of approximately $660. There can be no assurance these results will continue. In addition, the Company cannot guarantee that future average store-level sales will not vary from historical results. HOT TOPIC MERCHANDISING Hot Topic stores are designed to serve as a headquarters for music/pop culture-licensed and music/pop culture-influenced apparel, accessories and gift items. Music/pop culture-licensed merchandise includes tee shirts, hats, posters, stickers, patches, postcards, books, novelty accessories, compact discs and albums. Music/pop culture-influenced merchandise includes woven and knit tops, skirts, pants, shorts, jackets, shoes, costume jewelry, body jewelry, sunglasses, cosmetics, leather accessories and gift items. Approximately half of 7. Hot Topic's products are music/pop culture-licensed and the other half are music/pop culture-influenced products. A key strategy of Hot Topic is to offer a diverse product assortment in 22 different categories or "departments." On average, over 120 different licensed band tee shirts are carried in each store from current artists such as Good Charlotte, AFI, Dropkick Murphys, ICP and Linkin Park as well as classic rock artists such as The Ramones, Nirvana, Bob Marley, Rolling Stones, Metallica, The Doors and Led Zeppelin. New items and categories are regularly tested as customer demand and product trends evolve. During fiscal 2003, 52% of Hot Topic's net sales were generated in apparel merchandise categories and 48% of Hot Topic's net sales were produced in non-apparel merchandise categories (including accessories, gifts, intimate apparel and shoes). Hot Topic's merchandising staff consists of a General Merchandise Manager, Divisional Merchandise Managers, and a staff of buyers and assistant buyers sufficient to manage all product categories. The merchandising staff reflects the Company's culture in that its decisions and actions are influenced by music and pop culture. In determining which merchandise to buy, the staff spends considerable time viewing music videos, reviewing industry music sales, monitoring alternative radio station air play, consulting with sales associates (to draw from their different experiences and perspectives), reviewing customer requests, attending trade shows and reading music and fashion industry periodicals. In addition, the merchandising staff regularly visits nightclubs and attends concerts and other events that attract young people. Hot Topic has five lines of private label merchandise to complement and supplement current product offerings. The Company believes that Hot Topic brands play an important part in differentiating its stores from those of its competitors and provide the Company with higher margin opportunities as compared to other merchandise. The Company estimates that in fiscal 2003 Hot Topic brands accounted for approximately 25% of the Company's sales, the same percentage as in fiscal 2002. The Company's proprietary brands include Morbid Makeup (cosmetics), Morbid Metals (body jewelry), Morbid Threads (men's and women's apparel and hosiery) and MT:2 (men's and women's apparel). Some shoes are also sold under the Hot Topic label. In order to reduce fashion risk and maintain the ability to respond quickly to emerging trends, Hot Topic buys a majority of its merchandise not more than 60 to 90 days in advance of delivery, and will often begin with smaller test purchases prior to chain-wide distribution. The Company regularly monitors store sales by merchandise theme and classification, Stock Keeping Units (SKUs), color and size to determine types and amounts of products to purchase, to detect products and trends that are emerging or declining, and to manage the product mix in its stores by responding to the spending patterns of its customers. The Company believes that its relationships with its vendors are good. TORRID MERCHANDISING Torrid stores are designed to serve as the destination for fashion forward apparel and accessories for plus-size young women. The Company believes that the Torrid customer wants to wear the same types of merchandise as her smaller-sized peers. Torrid's merchandise includes novelty tee shirts, fashion tops, pants, shorts, skirts, dresses, jackets, intimate apparel, shoes, hosiery, accessories, gifts, and beauty products. Torrid apparel is sized 12 to 26. Approximately 50% of the products come from established branded vendors, including Dickies, Paris Blues, Z Cavaricchi, LEI, Necessary Objects, Kikwear, Macgirl, Fine and Hot Kiss and more fashion forward vendors, such as Serious, Lip Service, and Tripp. The Company works with these and other vendors to develop its own plus-size apparel fit specifications for young women. The Company believes its selection of fashion items from these and similar vendors gives the Torrid customer an opportunity to buy the same or similar branded items that have historically been available to other young women of the same age who are not plus-size. Working with vendors, current fashion trends and customer requests are researched, designed and manufactured for Torrid. Torrid, through its own fit specialist, works with the manufacturers' design teams to help ensure that quality standards are achieved and maintained. 8. During fiscal 2003, 71% of Torrid's net sales were generated in apparel merchandise categories and 29% of Torrid's net sales were produced in non-apparel merchandise categories (including accessories, gifts, intimate apparel and shoes). The Torrid merchandising staff consists of a Divisional Merchandise Manager and a staff of buyers and assistant buyers sufficient to manage all product categories. The Company's culture of soliciting and listening to customers and store associates is evidenced by the Torrid merchandising staff's decisions and actions. The merchandising staff spends considerable time visiting nightclubs, researching international fashion trends, attending trade shows and other events that attract young people. Furthermore, the Company believes that Torrid's merchandising direction is influenced by emerging fashion trends in the junior market, pop culture and music. The range of music and music artists that influence Torrid fashion is much broader than those influencing fashion at Hot Topic, consistent with the broader target customer base of females ages 15 to 29. Approximately 50% of Torrid merchandise is purchased from established branded vendors. The remaining 50% is Torrid private label merchandise that provides the customer with unique, fashion forward merchandise, often at more competitive price points than branded merchandise. Private label merchandise also often provides the Company with higher margin opportunities as compared to other merchandise. In order to reduce fashion risk and maintain the ability to respond quickly to emerging trends, Torrid buys a majority of its merchandise not more than 90 days, and many times less than 60 days, in advance of delivery, and will often begin with small purchases for testing. PLANNING AND ALLOCATION OF MERCHANDISE Planning and allocation of the Company's inventory is addressed at the store, merchandise classification and SKU levels using integrated third party software. Most merchandise is ordered in bulk and then allocated to each store based on store inventory plans and SKU performance using JDA's Advanced Allocation software. Buyers and inventory analysts determine SKU reorder quantities by using a proprietary automated software program which considers sales history, projected sales, planned inventories by store, store demographics, geographic preferences, store openings and planned markdown dates. The Company's headquarters and distribution facility located in the City of Industry, California is approximately 250,000 square feet. All merchandise is delivered by vendors to this facility, where it is inspected, allocated, picked, prepared and boxed for shipment to the Company's stores and its internet customers. Merchandise is shipped to stores each weekday, providing Hot Topic and Torrid stores with a steady flow of new and reordered merchandise. Minimal back stock is maintained in the Company's distribution facility and at its stores, so that most of the Company's merchandise is available for sale on the selling floors of its stores. No single vendor accounted for more than 5% of the Company's merchandise purchases during fiscal 2003. The Company is currently evaluating the distribution center space needed to support its planned growth. Among other things, the Company may determine to expand its distribution operations to an additional distribution center facility. HOT TOPIC/TORRID STORE OPERATIONS The Company's store operations organizations are both managed by a Vice President of Store Operations, regional directors and district managers. On average, each district manager supervises approximately five to eight stores. A store manager and two or three assistant managers manage individual stores. In addition to managers and assistant managers, a typical store has approximately six to ten part-time sales associates, depending on the season. The hiring and training of new associates is the responsibility of the store manager and district manager. The Company has established training and operating procedures to assist field management in the supervision and training of all associates. The Company has also designed a store manager training program, which is utilized to thoroughly train externally hired managers. 9. The Company strives to create a store environment that customers will consider "their place" to shop with friends. The Company seeks to hire sales associates who fit the profile of its target customer - energetic people who are knowledgeable and passionate about music and pop culture-inspired fashion. To consider the preferences and opinions of its target customers, selected store associates, from time to time, accompany buyers on buying trips. Further, in return for feedback on fashion and other trends, store associates are reimbursed for the cost of attending concerts and are encouraged to directly communicate customer requests and their own merchandise and product ideas to the buyers and the Company's management. Management believes that the Company's culture and its direct interaction with and respect for sales associates is a significant factor in producing associate retention rates that management believes are higher than the industry average. The primary objective of the sales associate position is to provide superior, informed customer service in order to maximize sales and minimize inventory shrinkage. Store management is provided with daily store sales and category results so that performance can be measured against set goals. Postage-paid "report cards" are provided in all stores for customers to grade performance and make recommendations to Company management. Associates are trained to greet each customer, to inform the customer about new music and fashion trends and to suggest merchandise that matches the customer's lifestyle, music and fashion preferences. The Company believes that its high level of associate product knowledge and customer service differentiates it from other specialty retailers. District managers, along with all members of the store teams, have a base compensation rate and may qualify to receive a quarterly bonus primarily based on store sales results. Additionally, district and store managers may also qualify to receive periodic stock option grants, and certain associates are eligible to participate in the Company's Employee Stock Purchase Plan. The Company believes that its continued success is dependent in part on its ability to attract, retain and motivate qualified associates. In particular, the success of the Company's expansion program will be dependent on its ability to promote and/or recruit qualified district and store managers. In order to ensure new stores have a qualified pool of candidates, the Company has assigned dedicated field recruiters to work with each region's management team. MARKETING, PROMOTION AND INTERNET The Company generally locates its stores in high traffic malls within areas of high teenage and young adult population and relies on existing customers, sales associates, store design and exciting music to attract new customers to its stores. During fiscal 2003, 2002 and 2001 the Company co-sponsored a major summer rock tour, Ozzfest (headlined by Ozzy Osbourne). As a sponsor, Hot Topic's name was associated with all promotional activities at each venue. The Company has entered into a similar sponsorship of Ozzfest in fiscal 2004. The Company continues to operate its websites, which offer merchandise, tour dates, contests, job postings, store locations and community features such as band reviews and advice columns. The Company's net sales from Internet operations rose by 80% in fiscal 2003 compared to fiscal 2002 and contributed approximately 2.6% of total sales in fiscal 2003. INFORMATION TECHNOLOGY The Company's information systems provide integration of store, merchandising, distribution, financial, and human resources. Software licensed from GERS Retail Systems is used for SKU and classification inventory tracking, purchase order management, open-to-buy, merchandise distribution, automated ticket making, and sales audit. The Company's financial systems are licensed from Lawson Software and are used for general ledger, accounts payable, and asset management as integrated financials. Sales are updated daily in the merchandising reporting systems by polling sales information from each store's point-of-sale ("POS") terminals. The Company's POS system consists of registers providing price look-up, time and attendance, e-mail and credit card/check authorization. Through automated nightly two-way electronic communication with each store, sales information and payroll hours are uploaded to the host system. The host system downloads price changes, performs system maintenance and provides software updates to the stores. The Company evaluates information obtained through nightly polling to implement merchandising decisions, including product purchasing/reorders, markdowns and allocation of merchandise on a daily basis. 10. The Company's Wide Area Network ("WAN") is used to connect all Company locations with real-time e-mail and several Intranet applications to improve operating efficiency. In addition, this technology has improved operating efficiency in such areas as credit card authorization, store-to-store transfer, product lookup, product location and several other applications to eliminate paper distribution and paperwork. The Company has invested approximately $5 million to enhance the functionality of its current GERS Retail Systems software and to implement new financial system software from Lawson. As a result of these enhancements, the Company expects to see improvements in functionality and reporting capability, which the Company believes will adequately support its planned growth. In addition, the Company is investing approximately $6 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. These investments will help support the Company's planned growth. TRADEMARKS The Company has registered on the Principal Register of the United States Patent and Trademark Office its retail store service mark Hot Topic(R) and various trademarks for merchandise including Hot Topic(R), Morbid Make-Up(R), Morbid Scents(R), Morbid Metals(R), Tragedy(R), Misery(R), MT:2(R), Morbid Threads(R), Everything About the Music(R), Torrid(R), and Torrid Flaming Heart Design(R). Each federal registration is renewable indefinitely if the mark is in use at the time of the renewal. Applications have been made to register Flaming Heart Design(TM) and Torrid & Design(TM) in the United States. The Company is not aware of any claims of infringement or other challenges to the Company's right to use its marks in the United States. The Company also has additional registrations and pending applications in foreign jurisdictions. All other trademarks, tradenames and servicemarks referenced herein are the property of their respective owners. HOT TOPIC COMPETITION The Company competes with other retailers for vendors, customers, suitable retail locations and qualified associates. Hot Topic currently competes with street alternative and vintage clothing stores located primarily in metropolitan areas and 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., Forever 21, 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. Some of the Company's competitors are larger and have substantially greater financial, marketing and other resources than the Company. The principal factors of competition in the Company's business are merchandise selection, connection to the music industry, customer service, store location and price. TORRID COMPETITION Based on direct customer research conducted by the Company, it believes that plus-size female teens and young women have historically shopped for apparel at department stores, discount stores such as Target and specialty stores such as Lane Bryant. The Company believes such stores generally target more mature customers, which is also reflected in their store environments. The Company is not aware of other exclusively mall-based chains that are specifically targeting younger plus-size fashion forward customers. Torrid competes with traditional department stores, local specialty stores and junior teen retailers that offer a combination of junior and plus-sizes, such as Deb Shops. Torrid also competes with traditional plus-size catalogs and web sites, as well as Delia's Corp. and Alloy, Inc. which carry both junior and junior plus-sizing. Many companies compete for the junior customers and additional competitors may enter into the plus-size female market. 11. EMPLOYEES The Company employed approximately 1,740 full-time and 5,020 part-time employees, which the Company refers to as associates, as of March 31, 2004. Of the Company's 6,760 associates, approximately 515 were headquarters and distribution center personnel and the remainder are field management and store associates. The number of part-time associates fluctuates with seasonal needs. None of the Company's associates are covered by collective bargaining agreements. The Company believes that its relationships with its associates are good. EXECUTIVE OFFICERS AND KEY EMPLOYEES The executive officers and key employees of the Company and their ages at March 31, 2004 are as follows: NAME AGE POSITION -------------------- ----- ----------------------------------------------------- Elizabeth McLaughlin 43 Chief Executive Officer and Director Gerald Cook 51 President, Hot Topic Patricia Van Cleave 56 President, Torrid James McGinty 41 Chief Financial Officer and Secretary Jane Cruz 44 Senior Vice President, Human Resources Cindy Boden 49 Vice President, Torrid Store Operations Tricia Higgins 36 Vice President, Internet John Horwath 44 Vice President, Information Technology Darrell Kinsley 41 Vice President, Hot Topic Store Operations Alain Krakirian 38 Vice President, Planning and Allocation Cindy Levitt 43 Vice President, Hot Topic General Merchandise Manager Sue McPherson-Spissu 36 Vice President, Distribution Center and E-Commerce John Neppl 47 Vice President, Real Estate and Construction George Wehlitz, Jr. 43 Vice President, Finance ELIZABETH MCLAUGHLIN has served as Chief Executive Officer of the Company since August 2000, and has served on the Board of Directors since May 2000. She also served as President of the Company from August 2000 through September 2003. From June 1996 through February 2000, Ms. McLaughlin served as Senior Vice President and General Merchandise Manager of the Company. From May 1993 through May 1996, Ms. McLaughlin was the Company's Vice President, Operations. Prior to joining the Company, Ms. McLaughlin held various positions with Millers Outpost and The Broadway. Ms. McLaughlin holds a B.A. degree in Economics from the University of California at Irvine. Ms. McLaughlin is a member of the Board of Visitors for the Anderson School at UCLA. 12. GERALD COOK has been President, Hot Topic since September 2003. Prior to September 2003, he had been Chief Operating Officer of the Company since February 2001. From February 1999 until joining the Company, he was the President and Chief Operating Officer of Travel 2000, Inc. Subsequent to his departing Travel 2000, Inc., that company filed for chapter 11 bankruptcy in March 2001. From 1995 to April 1998, Mr. Cook was Senior Vice President, Operations for The Bombay Company, Inc. and from 1989 to 1995, Mr. Cook was the Vice President, Stores and the Vice President, General Merchandising Manager of Woman's World Stores. Prior to 1989, he held management positions with Barnes & Noble/B Dalton, The Gap Stores and the Limited, Inc. Mr. Cook holds a B.S. degree in Business Administration from the University of Minnesota. PATRICIA VAN CLEAVE has been President, Torrid since September 2003. Prior to September 2003, she had been Chief Merchandising Officer of the Company since September 2002. From July 1998 to June 2001, she was the President and CEO of Sundance Catalog Company. From May 1995 until joining Sundance, she was the President of Cherokee. Prior to joining Cherokee, she was Executive Vice President of Merchandising for apparel, fashion accessories and intimate apparel for The Broadway. She came to The Broadway from The Bon Marche, a Seattle-based division of Federated Department Stores where she was Senior Vice President, General Merchandise Manager of Apparel. Prior to that she held management positions for The Broadway Southwest, John Wanamaker, The May Company and Daytons. Ms. Van Cleave holds a B.S. degree in Business and Textiles from the University of Minnesota. JAMES MCGINTY has served as Chief Financial Officer of the Company since February 2001. Mr. McGinty has also served as Secretary of the Company since November 2002. Mr. McGinty joined Hot Topic in August 2000 as its Vice President, Finance and was promoted to Chief Financial Officer in February 2001. From July 1996 to July 2000, Mr. McGinty was Vice President-Controller at Victoria's Secret Stores, the leading brand and largest specialty retailer division of the Limited, Inc. From 1984 to 1996, he held various financial and accounting positions within the Structure and Express divisions of the Limited, Inc. Mr. McGinty holds a B.S. degree in Accounting from Miami University in Oxford, Ohio. JANE CRUZ joined the Company in August 2001 as Senior Vice President, Human Resources. From July 1996 to July 2001, Ms. Cruz held human resource management positions with Universal Studios' Television and Networks Group, including most recently, Senior Vice President, Human Resources. At Universal Studios her responsibilities included both domestic and international operations. From November 1994 to July 1996, Ms. Cruz was Director, Human Resources of EQE International, an engineering consulting firm. She spent March 1983 through November 1994 in various Human Resources positions with Viacom - Cable Division, including Regional Director, Human Resources. Ms. Cruz has a B.S. degree in Economics from the University of San Francisco and an M.B.A. from the University of California, Berkeley. CINDY BODEN has been Vice President, Torrid Store Operations since October 2003. Prior to October 2003, Ms. Boden held Regional Director positions with Hot Topic both in the Northeast and the Midwest regions. From 1993 to 1997, Ms. Boden was a Regional Manager for County Seat stores. From 1990 to 1992, she held the position of Regional Manager for Millers Outpost stores. Prior to Millers Outpost, she was a District Manager for Brookstone for five years. Ms. Boden holds a B.S. degree in Textiles and Clothing with a minor in Business Administration from the University of Minnesota at Mankato. TRICIA HIGGINS has been Vice President, Internet since February 2004. Prior to February 2004, she was the Company's Director, Internet since June 2002. Prior to joining the Company, she was Director, Contact Center Operations for Cooking.com. From 1997 to August 2000, Ms. Higgins was Director, Retail Operations for the Williams-Sonoma, Pottery Barn and Hold Everything divisions of Williams-Sonoma, Inc. From 1994 to July 1997, she held various positions with The Disney Stores, Inc. in Retail Operations and New Business Development. Ms. Higgins holds a B.A. degree in Psychology from Indiana University. JOHN HORWATH has been the Company's Vice President, Information Technology since June 2001. From May 2000 until joining the Company, he was Director of Information Technology at World Wide Restaurants, Inc. From August 1998 until May 2000, Mr. Horwath was the Vice President and Chief Information 13. Officer for Wherehouse Entertainment, Inc. From February 1992 to July 1998, he was Regional Vice President of Information Technology for PolyGram Holding, Inc. Prior to 1992, he held management positions with LA Gear, Inc., Pic`N'Save, Inc., Tutor/Saliba, Inc., and Kasler Corporation. DARRELL KINSLEY has been Vice President, Hot Topic Store Operations since February 2000. From June 1998 through February 2000, Mr. Kinsley was the Company's Regional Director for the western United States. From February 1997 through June 1998, he was the Company's Regional Director for the eastern United States. Mr. Kinsley joined the Company in February 1995 as the District Manager for the eastern United States and was responsible for the expansion into the East Coast. Mr. Kinsley holds a business management leadership certificate from the Anderson School of Business at the University of California, Los Angeles. ALAIN KRAKIRIAN has been the Company's Vice President, Planning and Allocation since February 2000. From July 1997 through February 2000, Mr. Krakirian was the Company's Director of Planning and Allocation. Mr. Krakirian was the Planning Manager at Disney Stores from December 1996 to July 1997 and the Director of Merchandise Planning and Allocation at Kids Mart from February 1996 to December 1996. From September 1991 to January 1996, Mr. Krakirian held various merchandise control and planning positions at Clothestime Stores, including Director of Merchandise Control and Information Office from October 1994 to January 1996. Mr. Krakirian holds a B.S. degree in Finance from the University of LaVerne and an M.B.A. degree from Pepperdine University. CINDY LEVITT has been Vice President, Hot Topic General Merchandise Manager since February 2000. From June 1996 to February 2000, she served as the Company's Divisional Merchandise Manager, Apparel and Music. Since 1989, Ms. Levitt has held senior buying positions at the Company. Prior to her career at Hot Topic, Ms. Levitt held buying positions at The May Company. Ms. Levitt holds a degree in Fashion Merchandising from Orange Coast College. SUE MCPHERSON-SPISSU was promoted to the Company's Vice President, Distribution Center and E-Commerce in October 2001. Ms. McPherson-Spissu was the Company's Vice-President, Distribution Center from February 2001 to October 2001 and was the Company's Divisional Vice President of Distribution Center from February 2000 to February 2001. From March 1995 to February 2000, she was the Company's Director of the Distribution Center. Ms. McPherson-Spissu joined the Company in 1989 as a store associate in its first store while attending the University of Southern California. Ms. McPherson-Spissu holds a B.S. degree in Business from the University of Southern California. JOHN NEPPL joined the Company in October 2001 as Vice President, Real Estate and Construction. From January 1995 to September 2001, Mr. Neppl served as Vice-President of Real Estate and Construction for Eastern Mountain Sports, Inc., a specialty retailer based in New Hampshire. Mr. Neppl served as Director of Real Estate at Miller's Outpost/Anchor Blue from October 1987 to December 1994. Mr. Neppl held various financial positions with Mervyn's department stores, a division of Target Corporation, from October 1978 to September 1987. Mr. Neppl received a B.S. degree in Accounting from Villanova University. GEORGE WEHLITZ, JR. has been the Company's Vice President, Finance since August 2003. He joined the Company in February 2002 as its Vice President, Controller. From August 2000 to February 2002, Mr. Wehlitz was Chief Financial Officer at The Popcorn Factory, Inc., a catalog company for gourmet popcorn gifts. From 1987 to 2000 Mr. Wehlitz held various financial related positions, at the divisional and corporate level, for The Bombay Company, Inc. Mr. Wehlitz holds a B.A. degree in Accounting from Texas Christian University and is a Certified Public Accountant. COMPLIANCE WITH ENVIRONMENTAL REGULATIONS To the Company's present knowledge, compliance with federal, state and local provisions enacted or adopted for protection of the environment has had no material effect upon its operations. 14. INTERNET WEBSITE The Company makes available, free of charge through its investor relations website at www.corporatewindow.com/fl/hott/frame.html, its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after such material is electronically filed with, or furnished to, the SEC. The Company also makes available its Standards of Business Ethics at www.corporatewindow.com/fl/hott/frame.html. 15. 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 this 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. Of the Company's 554 stores opened as of January 31, 2004, 109 had been open for less than one full year. 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 105 stores, consisting of 80 Hot Topic and 25 Torrid stores, during fiscal 2004, which will result in a significant increase in the number of stores operated by the Company; 15 of these Hot Topic stores have opened as of March 31, 2004. 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. 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; integrate new stores into its existing operations; and obtain adequate distribution center space. The Company is currently evaluating the distribution center space needed to support its planned growth. Among other things, the Company may determine to expand its distribution operations to an additional distribution center facility. 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 and fashion driven concept, 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 mark-down 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. 16. Risks inherent in any new concept are particularly acute with respect to Torrid, because this is the first significant new venture by the Company, and the nature of the Torrid business differs in certain respects from that of the Company's Hot Topic business. 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 and 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/pop culture-related products; music and fashion trends; the general retail sales environment and the effect of the 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 2000, 2001, 2002 and 2003 were 16.7%, 3.9%, 5.0% and 7.4%, respectively. The Company's comparable store sales results were 2.6%, 5.2%, 10.8%, and 8.5% for the first, second, third and fourth quarters, respectively, of fiscal 2003 and (0.5%), 0.6%, 6.3% and 9.7% for the first, second, third and fourth quarters, respectively, of fiscal 2002. Past comparable store sales results are not an indicator of future results, and there can be no assurance that the Company's comparable store sales results will not decrease in the future. Changes in the Company's comparable store sales results could cause the Company's stock price to fluctuate substantially. 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, the Internet, 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 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, trends 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 slowdown in the United States economy as well as 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 the Company's growth, sales results and financial performance. 17. 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 its 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/pop culture-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. DEPENDENCE ON KEY VENDORS The Company's financial performance depends on its ability to purchase current music/pop culture-related merchandise in sufficient quantities at competitive prices. Although the Company has many sources of merchandise, substantially all of the Company's music/pop culture-licensed products are available only from vendors that have exclusive license rights. In addition, many of the Company's music/pop culture-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, 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. 18. UNCERTAINTIES REGARDING IMPLEMENTATION OF NEW INFORMATION SYSTEMS AND SOFTWARE Over the past several years, the Company has made improvements to existing hardware and software systems, as well as implemented new systems. For example, the Company has invested approximately $5 million to enhance the functionality of its current GERS Retail Systems software and to implement new financial system software from Lawson. In addition, the Company is investing approximately $6 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. 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 promptness and accuracy of the Company's transaction processing, financial accounting and reporting and 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. 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, 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 young adult 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 19. (Millers Outpost), Charlotte Russe Inc., Claire's Stores, Inc., Forever 21, 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, Delia's Corp., 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. Some 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. 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, a few years ago, California 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. 20. 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 2. PROPERTIES The Company leases all of its existing store locations, with lease terms expiring between 2004 and 2014. At January 31, 2004, the Company had a total of 998,628 leased store square feet (Hot Topic and Torrid stores) with an average store size of 1,788 square feet (Hot Topic and Torrid stores). The leases for most of the existing stores are for ten-year terms and provide for contingent rent based upon a percent of sales in excess of specified minimums. Leases for future stores will likely include similar contingent rent provisions. The Company leases its headquarters and distribution center facility, located in City of Industry, California. Construction to expand the Company's headquarters and distribution center facility was completed during the second quarter of fiscal 2002. The Company's lease expires April 2004 and the Company is negotiating a long-term lease extension, effective May 2004. The annual base rent for the lease extension is approximately $1,110,000. The Company believes the property covered by the lease extension will allow for growth of up to 700 stores. The Company is currently evaluating the distribution center space needed to support its planned growth. Among other things, the Company may determine to expand its distribution operations to an additional distribution center facility. ITEM 3. LEGAL PROCEEDINGS The Company is not a party to any material pending legal proceedings. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. 21. PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES The Common Stock of the Company is traded on the Nasdaq National Market under the symbol "HOTT." The following table sets forth, for the periods indicated, the high and low end of day closing sales prices of the shares of Common Stock of the Company, as reported on the Nasdaq National Market. Such quotations represent inter-dealer prices without retail markup, markdown or commission and may not necessarily represent actual transactions. 2003 FISCAL YEAR QUARTERS HIGH LOW ------------------------------------------------------------- First Quarter $16.35 $14.01 Second Quarter $19.67 $15.69 Third Quarter $29.25 $18.33 Fourth Quarter $31.85 $26.60 2002 FISCAL YEAR QUARTERS HIGH LOW ------------------------------------------------------------- First Quarter $16.09 $13.22 Second Quarter $18.63 $10.18 Third Quarter $15.17 $9.91 Fourth Quarter $16.67 $13.93 On August 12, 2003, the Company announced that its Board of Directors approved a three-for-two stock split (in the form of a dividend) of its common stock. On the effective date of September 2, 2003, shareholders received a dividend of one additional share for every two shares they owned at the close of business on the record date of August 21, 2003. The prices listed in the above table have been adjusted for the split. On March 31, 2004, the last sales price of the Common Stock as reported on the Nasdaq National Market was $26.45 per share. As of March 31, 2004, there were approximately 200 holders of record of the Company's Common Stock. This number does not reflect the actual number of beneficial holders of the Company's Common Stock, which the Company believes to be in excess of 24,000 holders. On March 19, 2004, the Company announced that its Board of Directors approved the repurchase of up to an aggregate of 2,000,000 shares of its Common Stock during the period ending January 28, 2005. The Company has not paid any cash dividends since inception and does not anticipate paying any cash dividends in the foreseeable future. Please see Item 12 for information about the Company's equity compensation plans. 22. ITEM 6. SELECTED FINANCIAL DATA The following table summarizes selected financial data for each of the five fiscal years in the period ended January 31, 2004. This data should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Consolidated Financial Statements and Notes thereto included elsewhere in this Annual Report on Form 10-K.
Fiscal Year --------------------------------------------------------- 2003 2002 2001 2000 1999 --------- --------- --------- --------- --------- (In thousands, except per share data, number of stores, comparable store sales and sales per square foot) Statement of Operations Data: Net sales $572,039 $443,250 $336,094 $257,187 $168,949 Cost of goods sold, including buying, distribution and occupancy costs 351,542 273,132 204,993 154,298 103,998 --------- --------- --------- --------- --------- Gross margin 220,497 170,118 131,101 102,889 64,951 Selling, general and administrative expenses 143,952 115,634 86,950 67,917 44,749 --------- --------- --------- --------- --------- Operating income 76,545 54,484 44,151 34,972 20,202 Interest income, net 1,318 1,371 1,884 1,925 933 --------- --------- --------- --------- --------- Income before income taxes 77,863 55,855 46,035 36,897 21,135 Provision for income taxes 29,821 21,225 17,435 13,652 7,634 --------- --------- --------- --------- --------- Net income $ 48,042 $ 34,630 $ 28,600 $ 23,245 $ 13,501 ========= ========= ========= ========= ========= Net income per share: Basic $ 1.01 $ 0.74 $ 0.62 $ 0.52 $ 0.32 Diluted $ 0.97 $ 0.70 $ 0.57 $ 0.48 $ 0.31 Weighted average shares outstanding: Basic 47,479 47,027 46,467 44,502 41,701 Diluted 49,588 49,276 49,829 48,104 44,088 Selected Operating Data: Number of stores at year end 554 445 352 274 212 Comparable stores sales 7.4% 5.0% 3.9% 16.7% 22.8% Average sales per square foot $ 619 $ 619 $ 636 $ 669 $ 623 Average sales per store $ 1,106 $ 1,064 $ 1,036 $ 1,020 $ 909 Balance Sheet Data: Cash and short-term investments $128,205 $ 83,418 $ 71,310 $ 51,288 $ 39,550 Working capital 141,839 90,287 82,370 61,253 37,564 Total assets 281,592 204,786 162,662 118,646 89,022 Long-term obligations including current portion -- 115 218 123 231 Shareholders' equity $223,905 $160,929 $135,368 $ 99,291 $ 67,278
23. ITEM 7. 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 should be read in conjunction with the information contained in the Consolidated Financial Statements and Notes thereto included in Item 8. "Financial Statements and Supplementary Data" in this Form 10-K. These statements have been prepared in conformity with accounting principles generally accepted in the United States and require Management to make estimates and assumptions that affect amounts reported and disclosed in the financial statements and related notes. Actual results could differ from these estimates. GENERAL Hot Topic, Inc. and its wholly owned subsidiaries (collectively, the "Company") is a mall-based specialty retailer operating the Hot Topic (includes Hot Topic stores and hottopic.com) and Torrid (includes Torrid stores and torrid.com) concepts. Hot Topic offers 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. In fiscal 2001, 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 young women between the ages of 15 and 29. At the end of fiscal 2003, the Company operated 502 Hot Topic stores and 52 Torrid stores in 49 states throughout the United States and Puerto Rico and websites hottopic.com and torrid.com. 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. At the end of fiscal 2003, 401 of the 502 Hot Topic stores were included in the comparable store base, compared to 321 of the 418 stores open at the end of fiscal 2002. At the end of fiscal 2003, 22 of the 52 Torrid stores were included in the comparable store base, compared to 6 of the 27 stores open at the end of fiscal 2002. The Company operates on a 52 or 53-week fiscal year, which ends on the Saturday nearest to January 31. Fiscal 2003, 2002 and 2001 were 52-week fiscal years. 24. RESULTS OF OPERATIONS The following table sets forth, for the periods indicated, certain selected statement of operations data expressed as a percentage of net sales and certain store data: FISCAL YEAR --------------------------- 2003 2002 2001 ------ ------ ------ Net sales 100.0% 100.0% 100.0% Cost of goods sold, including buying, distribution & occupancy costs 61.5% 61.6% 61.0% ------ ------ ------ Gross margin 38.5% 38.4% 39.0% Selling, general and administrative expenses 25.1% 26.1% 25.9% ------ ------ ------ Operating income 13.4% 12.3% 13.1% Interest income, net 0.2% 0.3% 0.6% ------ ------ ------ Income before income tax 13.6% 12.6% 13.7% Provision for income taxes 5.2% 4.8% 5.2% ------ ------ ------ Net income 8.4% 7.8% 8.5% ====== ====== ====== Number of stores at year end 554 445 352 Comparable store sales 7.4% 5.0% 3.9% FISCAL 2003 COMPARED TO FISCAL 2002 Net sales increased approximately $128.7 million, or 29.1%, to $572.0 million in fiscal 2003 from $443.3 million in fiscal 2002. Net sales for the 84 Hot Topic stores opened during fiscal 2003 and for the other Hot Topic stores not yet qualifying as comparable stores contributed $71.5 million of the net sales increase. Comparable store sales for the Company increased 7.4% in fiscal 2003 and contributed $29.1 million of the increase in net sales. Net sales for the 25 new Torrid stores and for the other Torrid stores not yet qualifying as comparable stores operating during fiscal 2003 contributed $20.3 million of the net sales increase. Hottopic.com and torrid.com sales were approximately 2.6% of total Company sales in fiscal 2003 and contributed $7.9 million (including shipping and handling income) of the net sales increase. The annual average Hot Topic store volume increased to $1.13 million in fiscal 2003 from $1.07 million in fiscal 2002. Hot Topic sales of apparel category merchandise, as a percentage of total net sales, were 52% in fiscal 2003 compared to 51% in fiscal 2002. The increase in apparel was primarily due to increases in men's novelty tee shirts and men's music-related tee shirts partially offset by decreases in women's apparel (women's bottoms and novelty tees), men's fashion tops and men's bottoms. The sales mix for Hot Topic in fiscal 2003 saw a decrease in sales of non-apparel merchandise (including accessories, gifts, intimate apparel and shoes) to 48% from 49% in fiscal 2002. Gross margin increased approximately $50.4 million to $220.5 million in fiscal 2003 from $170.1 million in fiscal 2002. As a percentage of net sales, gross margin increased to 38.5% in fiscal 2003 from 38.4% in fiscal 2002. The 0.1% improvement in gross margin, as a percentage of net sales, was primarily due to a 0.4% decrease in distribution expenses and a 0.1% decrease in depreciation and store occupancy, offset by a 0.4% reduction in merchandise margin. The decrease in distribution expenses of 0.4% in fiscal 2003 resulted from significant savings in freight costs, due to change in shipping method to stores, and labor costs, due to productivity improvements. Store depreciation decreased 0.2% in fiscal 2003 as compared to fiscal 2002 as a result of leverage gained from higher comparable store sales. This decrease in depreciation was partially offset by a 0.1% increase in store occupancy resulting from higher rent expenses and common area charges. Torrid's larger store size and increased store count resulted in the increase of rent expenses, as a percentage of net sales. The Company's merchandise margin, as a percentage of net sales, was lower in fiscal 2003 compared to fiscal 2002 principally from lower initial markup and higher shrinkage partially offset by lower markdowns. 25. Selling, general and administrative expenses increased approximately $28.4 million to $144.0 million during fiscal 2003 from $115.6 million during fiscal 2002. As a percentage of net sales, selling, general and administrative expenses were 25.1% for fiscal 2003 compared to 26.1% in 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 445 at the end of fiscal 2002 to 554 at the end of fiscal 2003 and the corresponding additional payroll and other expenses required to support these additional stores. The decrease, as a percentage of net sales, was primarily attributable to the decreases in total store payroll and administrative salary expense of 1.2% resulting from leverage gained from higher comparable store sales and controlling payroll costs, and a decrease in pre-opening expenses of 0.1%, offset by an increase in administrative performance based payroll expenses of 0.4%. Operating income increased approximately $22.0 million to $76.5 million during fiscal 2003 from $54.5 million during fiscal 2002. As a percentage of net sales, operating income was 13.4% in fiscal 2003 compared to 12.3% in fiscal 2002. Operating income on an average store basis was approximately $152,000 in fiscal 2003 as compared to $133,000 in fiscal 2002. Net interest income decreased to $1.3 million in fiscal 2003 from $1.4 million in fiscal 2002, principally due to lower interest rates offset in part by the additional interest earned from higher average cash balances. The Company's effective tax rate was 38.3% in fiscal 2003 and 38.0% in fiscal 2002. The higher rate for fiscal 2003 is principally attributable to lower tax-exempt interest income as a percentage of pre-tax income in fiscal 2003 as compared to fiscal 2002. FISCAL 2002 COMPARED TO FISCAL 2001 Net sales increased approximately $107.2 million, or 31.9%, to $443.3 million in fiscal 2002 from $336.1 million in fiscal 2001. Net sales for the 74 Hot Topic stores opened during fiscal 2002 and for the other Hot Topic stores not yet qualifying as comparable stores contributed $78.8 million of the net sales increase. Comparable store sales for the Company increased 5.0% in fiscal 2002 and contributed $14.3 million of the increase in net sales. Net sales for the 21 new Torrid stores and for the Torrid stores not yet qualifying as comparable stores operating during fiscal 2002 contributed $9.4 million of the net sales increase. Hottopic.com and torrid.com sales were approximately 1.8% of total Company sales in fiscal 2002 and contributed $4.7 million (including shipping and handling income) of the net sales increase. The annual average Hot Topic store volume increased to $1.07 million in fiscal 2002 from $1.04 million in fiscal 2001. Hot Topic sales of apparel category merchandise, as a percentage of total net sales, were 51% in fiscal 2002 compared to 53% in fiscal 2001. The decrease in apparel was primarily due to decreases in men's tops and bottoms partially offset by increases in sales of music-related tee shirts and women's apparel (women's tops and bottoms). The sales mix for Hot Topic in fiscal 2002 saw an increase in sales of non-apparel merchandise (including accessories, gifts, intimate apparel and shoes) to 49% from 47% in fiscal 2001 which resulted from the strong sales performance of accessories merchandise in the third and fourth quarter of fiscal 2002. Gross margin increased approximately $39.0 million to $170.1 million in fiscal 2002 from $131.1 million in fiscal 2001. As a percentage of net sales, gross margin decreased to 38.4% in fiscal 2002 from 39.0% in fiscal 2001. The 0.6% reduction in gross margin, as a percentage of net sales, was primarily due to a 0.4% increase in store occupancy expenses and a 0.2% reduction in merchandise margin. The increase in store occupancy costs primarily resulted from higher common area charges and rent expenses. Torrid's larger store size and increased store count resulted in the increase of rent expenses, as a percentage of net sales. The Company's merchandise margin, as a percentage of net sales, was lower in fiscal 2002 compared to fiscal 2001 principally from higher markdowns partially offset by a higher initial markup and lower 26. shrinkage. The higher markdowns were primarily due to markdowns in men's tops and bottoms for Hot Topic and higher Torrid markdowns related to minimum purchases of merchandise required in excess of what was needed for the small store base. Selling, general and administrative expenses increased approximately $28.7 million to $115.6 million during fiscal 2002 from $86.9 million during fiscal 2001. As a percentage of net sales, selling, general and administrative expenses were 26.1% for fiscal 2002 compared to 25.9% in fiscal 2001. The total dollar increase in selling, general and administrative expenses was primarily attributable to an increase in the number of retail stores from 352 at the end of fiscal 2001 to 445 at the end of fiscal 2002 and the corresponding additional payroll and other expenses required to support these additional stores. The increase, as a percentage of net sales, was primarily attributable to higher benefits cost of 0.3%, costs associated with implementing a wide area network of 0.2%, and an increase in store performance based payroll of 0.1%, partially offset by the leveraging of headquarters expenses of 0.4% Operating income increased approximately $10.3 million to $54.5 million during fiscal 2002 from $44.2 million during fiscal 2001. As a percentage of net sales, operating income was 12.3% in fiscal 2002 compared to 13.1% in fiscal 2001. Operating income on an average store basis was approximately $133,000 in fiscal 2002 as compared to $137,000 in fiscal 2001. Net interest income decreased to $1.4 million in fiscal 2002 from $1.9 million in fiscal 2001, principally due to lower interest rates offset in part by the additional interest earned from higher average cash balances. The Company's effective tax rate was 38.0% in fiscal 2002 and 37.9% in fiscal 2001. The higher rate for fiscal 2002 is principally attributable to lower tax-exempt interest income as a percentage of pre-tax income, in fiscal 2002 as compared to fiscal 2001 and higher effective state income tax rates in fiscal 2002. 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/pop culture-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 seasons (defined as the week of Thanksgiving through the first few days of January), and other periods when schools are not in session. The Holiday season remains 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. Furthermore, summer vacation, back-to-school season and spring break season take place at somewhat different times in different parts of the country, spreading the impact of these events on the Company's sales over a longer period. As is the case with many retailers of apparel, accessories and related merchandise, the Company typically experiences lower first fiscal quarter net sales relative to other quarters. 27. The following table sets forth certain statement of operations and selected operating data for each of the Company's last eight fiscal quarters (13 week periods). The quarterly statement of operations data and selected operating data set forth below were derived from unaudited financial statements of the Company, which in the opinion of management of the Company contain all adjustments (consisting only of normal recurring adjustments) necessary for fair presentation thereof. Results in any quarter are not necessarily indicative of results that may be achieved for a full year.
(In thousands, except selected operating and per share data) FISCAL YEAR 2003 FISCAL YEAR 2002 --------------------------------------------- ---------------------------------------------- FIRST SECOND THIRD FOURTH FIRST SECOND THIRD FOURTH --------- --------- --------- --------- --------- --------- --------- --------- STATEMENT OF OPERATIONS DATA: Net sales $100,657 $115,728 $161,546 $194,108 $ 79,909 $ 92,473 $122,590 $148,278 Gross margin 35,614 41,641 63,033 80,209 28,457 32,792 46,760 62,109 Operating income 6,755 9,334 24,417 36,039 5,530 6,658 15,908 26,388 Net income $ 4,410 $ 5,890 $ 15,271 $ 22,471 $ 3,683 $ 4,344 $ 10,048 $ 16,555 Net income per share: Basic $ 0.09 $ 0.12 $ 0.32 $ 0.47 $ 0.08 $ 0.09 $ 0.22 $ 0.35 Diluted $ 0.09 $ 0.12 $ 0.31 $ 0.45 $ 0.07 $ 0.09 $ 0.21 $ 0.34 Weighted average shares outstanding: Basic 46,968 47,360 47,656 47,932 47,210 47,568 46,691 46,639 Diluted 48,567 49,127 49,917 50,342 49,973 50,240 48,390 48,501 SELECTED OPERATING DATA: Comparable stores sales 2.6% 5.2% 10.8% 8.5% (0.5)% 0.6% 6.3% 9.7% Stores open at end of period 468 497 540 554 379 415 437 445
LIQUIDITY AND CAPITAL RESOURCES During the last three fiscal years, the Company's primary uses of cash have been to finance store openings, purchase merchandise inventories, upgrade information systems, and expand its headquarters and distribution center. In addition, during fiscal 2002, the Company used cash to repurchase common shares. The Company has satisfied its cash requirements exclusively from cash flows from operations, and, in earlier years, also from proceeds from the sale of equity securities. The Company maintains a $5.0 million unsecured credit agreement for the purpose of issuing letters of credit. At January 31, 2004, the Company had $0.1 million of outstanding letters of credit under the credit agreement. The letters of credit are primarily used for inventory purchases. At the end of fiscal 2003, the Company had $128.2 million in cash, cash equivalents and short-term investments, an increase of $44.8 million, or 54%, compared to the $83.4 million at the end of fiscal 2002. Working capital was $141.8 million, $90.3 million and $82.4 million for fiscal 2003, 2002 and 2001, respectively. The increase in working capital for each of these fiscal years was primarily attributable to cash provided by net income. 28. Net cash flows provided by operating activities were $72.3 million, $60.3 million, and $42.4 million in fiscal 2003, 2002 and 2001, respectively. The $12.0 million increase in cash flows from operating activities in fiscal 2003 as compared to fiscal 2002 was primarily attributable to the increases in net income, deferred taxes and depreciation and amortization, offset in part by an increase in inventory and a decrease in accounts payable and income taxes payable. The significant changes in net cash provided by operating activities were due primarily to the Company's increase in store growth to 554 stores at the end of fiscal 2003 compared to 445 stores at the end of fiscal 2002. Net cash flows used in investing activities were $81.9 million, $37.1 million and $43.0 million in fiscal 2003, 2002 and 2001, respectively. In fiscal 2003, approximately $23.4 million was used for the construction of 84 Hot Topic stores, 25 Torrid stores, expansion and refurbishment of four Hot Topic stores and progress payments for construction of stores opening in early fiscal 2004. The Company used approximately $11.2 million on computer hardware and software and $1.1 million on its headquarters and distribution center infrastructure. The Company opened 109, 95, and 79 stores in fiscal 2003, 2002 and 2001, respectively. The increase in net cash used in investing activities was also due to a net increase ($43.0 million) in purchases of short-term investments. Net cash flows provided by financing activities were $8.3 million in fiscal 2003 compared to net cash flows used in financing activities of $14.3 million and net cash flows provided by financing activities of $3.7 million in fiscal 2002 and 2001, respectively. The $22.7 million increase in fiscal 2003 compared to fiscal 2002 was principally a result of a $3.0 million increase from proceeds received from the exercise of stock options and employee stock purchases, and $19.7 million of cash was used to repurchase Company common stock in fiscal 2002. The Company anticipates that it will spend approximately $42 million on capital expenditures in fiscal 2004, including approximately $27 million for stores, $11 million for computer hardware and software and $4 million on its headquarters and distribution center infrastructure. The $27 million for stores is to be primarily used for the construction of 80 Hot Topic stores and 25 Torrid stores, expansion of approximately 10 existing stores and progress payments for early fiscal 2005 new store openings. During fiscal 2003, the Company's average capital expenditures for a new Hot Topic store, including leasehold improvements and furniture and fixtures, totaled approximately $169,000, net of landlord allowances. The average initial gross inventory for the new Hot Topic stores opened in 2003 was approximately $120,000 (which was partially financed by trade credit) and the average pre-opening costs for a new Hot Topic store was approximately $18,000. Initial inventory requirements vary at new stores depending on the season and current merchandise trends. The Company expects the average total cost per square foot associated with opening a Hot Topic store to be approximately the same in fiscal 2004 as those in fiscal 2003. Hot Topic stores are planned to be approximately 1,700 square feet compared to Torrid stores which are planned to be approximately 2,400 square feet. The costs associated with opening a new Torrid store will be higher than a Hot Topic store due to the larger size of the Torrid stores. The actual costs that the Company will incur in connection with opening future stores cannot be predicted with precision because such costs will vary based upon, among other things, geographic location, store size, and the extent of the build-out required at the selected sites. The following table summarizes the Company's contractual obligations as of January 31, 2004, and the timing and effect that such commitments are expected to have on the Company's liquidity and capital requirements in future periods: 29.
PAYMENTS DUE BY PERIOD ($ IN THOUSANDS) ---------------------------------------------------------------------- CONTRACTUAL OBLIGATIONS TOTAL WITHIN 1 YEAR 2-3 YEARS 4-5 YEARS MORE THAN 5 YEARS ------------ ------------ ------------ ------------ -------------- OPERATING LEASES $ 276,249 $ 36,548 $ 72,040 $ 67,045 $ 100,616 PURCHASE OBLIGATIONS 50,310 50,310 -- -- -- LETTERS OF CREDIT AND OTHER OBLIGATIONS 688 688 -- -- -- ------------ ------------ ------------ ------------ -------------- TOTAL CONTRACTUAL OBLIGATIONS $ 327,247 $ 87,546 $ 72,040 $ 67,045 $ 100,616 ============ ============ ============ ============ ==============
See Note 5 to the Company's consolidated financial statements for additional disclosure related to operating lease obligations. On May 8, 2002, the Company announced that its Board of Directors approved the repurchase of up to an aggregate of 1,500,000 shares of its Common Stock during the period ending January 31, 2003. As of January 31, 2003, the Company had completed the repurchase of 1,500,000 shares of its Common Stock at a cost of $19.7 million, at an average price of $13.13 per common share. On March 19, 2004, the Company announced that its Board of Directors approved the repurchase of up to an aggregate of 2,000,000 shares of its Common Stock during the period ending January 28, 2005. The Company believes that its existing cash balances and cash generated from operations will be sufficient to fund its operations, planned expansion and repurchase of Company Common Stock through at least the next 12 months. 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. 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, see Note 1 to the Company's audited consolidated financial statements included elsewhere in this report. 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 typically 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 are used. Consideration is given to a number of quantitative factors, including anticipated subsequent permanent markdowns and aging of inventories. To the extent the Company's estimated markdowns at year-end prove to be insufficient, additional future markdowns will need to be recorded. 30. 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 management. The Company has not historically had an impairment of a long-lived asset. 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 the Company believes recently opened stores will provide sufficient cash flow, material changes in results could result in future impairment charges. 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. As the reserve for merchandise returns is based on estimates the actual returns could differ from the reserve, which could impact sales. 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. INFLATION The Company does not believe that inflation has had a material adverse effect on its 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. ITEM 7A. 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 the Company considers 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 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The consolidated financial statements and notes of the Company listed in Item 15(a) are incorporated herein by reference. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. ITEM 9A. CONTROLS AND PROCEDURES (a) Evaluation of Disclosure Controls and Procedures Based on their evaluation of the Company's disclosure controls and procedures conducted prior to the date of filing this report on Form 10-K, 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 as of the end of the period covered by this report. 31. (b) Changes in Internal Control Over Financial Reporting There were no changes in the Company's internal control over financial reporting that occurred during the Company's fourth fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT See the section entitled "Executive Officers and Key Employees" in Part I, Item 1 hereof for information regarding the Company's executive officers. The information required by this item with respect to directors is incorporated by reference to the information appearing under the caption "Election of Directors", contained in the Company's Definitive Proxy Statement which will be filed with the SEC within 120 days of January 31, 2004 pursuant to Regulation 14A in connection with the solicitation of proxies for the Company's Annual Meeting of Shareholders to be held on June 17, 2004 (the "2004 Proxy Statement"). Certain other information required by this item is incorporated by reference to the information appearing under the captions "Section 16(a) Beneficial Ownership Reporting Compliance" and "Standards of Business Ethics" in the 2004 Proxy Statement. ITEM 11. EXECUTIVE COMPENSATION The information required by this item is incorporated by reference to the information appearing under the caption "Executive Compensation" in the 2004 Proxy Statement. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS The information required by this item is incorporated by reference to the information appearing under the captions "Security Ownership of Certain Beneficial Owners and Management" and "Equity Compensation Plan Information" in the 2004 Proxy Statement. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this item is incorporated by reference to the information appearing under the caption "Certain Transactions" in the 2004 Proxy Statement. ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES The information required by this item is incorporated by reference to the information appearing under the caption "Ratification of Selection of Independent Auditors" in the 2004 Proxy Statement. PART IV ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a)(1) CONSOLIDATED FINANCIAL STATEMENTS The following consolidated financial statements required by this item are submitted in a separate section beginning on page F-1 of this Annual Report on Form 10-K: 32. PAGE Report of Ernst & Young LLP, Independent Auditors.................... F-1 Consolidated Balance Sheets as of January 31, 2004 and February 1, 2003............................................... F-2 Consolidated Statements of Income for the years ended January 31, 2004, February 1, 2003 and February 2, 2002................ F-3 Consolidated Statements of Shareholders' Equity for the years ended January 31, 2004, February 1, 2003 and February 2, 2002........ F-4 Consolidated Statements of Cash Flows for the years ended January 31, 2004, February 1, 2003 and February 2, 2002................ F-5 Notes to Consolidated Financial Statements........................... F-6 (a)(2) FINANCIAL STATEMENT SCHEDULES All financial statement schedules are omitted because they are not required, are not applicable, or the information is included in the consolidated financial statements or notes thereto. (a)(3) EXHIBITS The exhibits listed under Item 15(c) hereof are filed with, and incorporated by reference into, this Annual Report on Form 10-K. Management contracts or compensatory plans or arrangements required to be filed pursuant to Item 15(c) are so identified therein. (b) REPORTS ON FORM 8-K On November 5, 2003, the Company filed a report on Form 8-K furnishing, under Item 12, information related to its sales for the third quarter of fiscal 2003 (quarter ended November 1, 2003). On November 19, 2003, the Company filed a report on Form 8-K furnishing, under Item 12, information related to its results for the third quarter of fiscal 2003. (c) EXHIBITS EXHIBIT NUMBER DESCRIPTION OF DOCUMENT ------ ----------------------- 3.1 Amended and Restated Articles of Incorporation. (1) 3.2 Amended and Restated Bylaws. (3) 4.1 Reference is made to Exhibits 3.1 and 3.2. 4.2 Specimen stock certificate. (1) 10.1a Form of Indemnity Agreement to be entered into between Registrant and its directors and officers. (1) 10.2a 1996 Equity Incentive Plan (the "1996 Plan"). (1) 10.3a Form of Nonstatutory Stock Option Agreement of Registrant pursuant to the 1996 Plan. (1) 10.4a Form of Incentive Stock Option Agreement of Registrant pursuant to the 1996 Plan. (1) 10.5a Non-Employee Directors' Stock Option Plan. (1) 10.6a Employee Stock Purchase Plan. (1) 10.7a 401(k) Defined Contribution Plan of Registrant, effective as of August 1, 1995. (1) 33. EXHIBIT NUMBER DESCRIPTION OF DOCUMENT ------ ----------------------- 10.8 Industrial Real Estate Lease (Multi-Tenant Facility), dated December 10, 1998, entered into between Registrant's wholly owned subsidiary, Hot Topic Administration, Inc. and Majestic Realty Co. and Patrician Associates, Inc. (2) 10.9 Guaranty of Lease, dated December 10, 1998, entered into between the Registrant and Majestic Realty Co. and Patrician Associates, Inc. (2) 10.10 First Amendment to Industrial Real Estate Lease, dated March 19, 2001, by and between Majestic - Fullerton Road, LLC, PFG Fullerton Limited Partnership, and Hot Topic Administration, Inc. (3) 10.11a Employment Offer Letter dated January 12, 2001, between the Registrant and Gerald Cook. (3) 10.12a Form of Restricted Stock Bonus Agreement between the Registrant and each of its non-employee directors as of March 7, 2001 (with Robert Jaffe for 1,905 shares, and with each of Bruce Quinnell, Edgar Berner, Andrew Schuon and Corrado Federico for 1,587 shares) and as of September 24, 2001 (with Cynthia Cohen for 1,178 shares and vesting from September 24, 2001) and as of January 28, 2002 (with W. Scott Hedrick for 618 shares and vesting from January 28, 2002). (4) 10.13a Employment Offer Letter dated June 11, 2001, between the Registrant and Jane Cruz. (5) 10.14a Employment Offer Letter dated August 14, 2002, between the Registrant and Patricia Van Cleave. (6) 10.15a Employment Letter dated January 23, 2003, between the Registrant and James McGinty. (6) 23.1 Consent of Ernst & Young LLP, Independent Auditors. 24.1 Power of Attorney is contained on the signature page. 31.1 Certification, dated April 5, 2004, of Registrant's Chief Executive Officer required by Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certification, dated April 5, 2004, of Registrant's Chief Financial Officer required by Section 302 of the Sarbanes-Oxley Act of 2002. 32.1 Certifications, dated April 5, 2004, of Registrant's Chief Executive Officer and Chief Financial Officer required by Section 906 of the Sarbanes-Oxley Act of 2002. ____________ (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 30, 1999 and incorporated herein by reference. (3) 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. (4) Filed as an exhibit to Registrant's Quarterly Report on Form 10-Q for the quarter ended May 5, 2001 and incorporated herein by reference. (5) Filed as an exhibit to Registrant's Annual Report on Form 10-K for the year ended February 2, 2002 and incorporated herein by reference. 34. (6) Filed as an exhibit to Registrant's Annual Report on Form 10-K for the year ended February 1, 2003 and incorporated herein by reference. a Denotes management contract or compensatory plan or arrangement. (d) FINANCIAL STATEMENT SCHEDULES Reference is made to Item 15(a)(2). 35. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. HOT TOPIC, INC. By: /s/ Elizabeth McLaughlin ------------------------------------ Elizabeth McLaughlin Chief Executive Officer and Director April 5, 2004 POWER OF ATTORNEY KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Elizabeth McLaughlin and James McGinty, or either of them, his attorney-in-fact, each with the power of substitution, for him or her in any and all capacities, to sign any amendments to this Report, and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his substitute or substitutes, may do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
NAME POSITION DATE --------------------------- ------------------------------------- ------------- /s/ ELIZABETH MCLAUGHLIN Chief Executive Officer and Director April 5, 2004 ------------------------ (PRINCIPAL EXECUTIVE OFFICER) Elizabeth McLaughlin /s/ JAMES MCGINTY Chief Financial Officer (PRINCIPAL April 5, 2004 ------------------------ FINANCIAL OFFICER) James McGinty /s/ GEORGE WEHLITZ, JR. Vice President, Finance (PRINCIPAL April 5, 2004 ------------------------ ACCOUNTING OFFICER) George Wehlitz, Jr. /s/ BRUCE QUINNELL Chairman of the Board April 5, 2004 ------------------------ Bruce Quinnell /s/ EDGAR BERNER Director April 5, 2004 ------------------------ Edgar Berner /s/ CORRADO FEDERICO Director April 5, 2004 ------------------------ Corrado Federico /s/ ANDREW SCHUON Director April 5, 2004 ------------------------ Andrew Schuon /s/ CYNTHIA COHEN Director April 5, 2004 ------------------------ Cynthia Cohen /s/ W. SCOTT HEDRICK Director April 5, 2004 ------------------------ W. Scott Hedrick
36. REPORT OF INDEPENDENT AUDITORS The Board of Directors and Shareholders of Hot Topic, Inc. We have audited the accompanying consolidated balance sheets of Hot Topic, Inc. and its subsidiaries as of January 31, 2004 and February 1, 2003, and the related consolidated statements of income, shareholders' equity, and cash flows for each of the three years in the period ended January 31, 2004. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Hot Topic, Inc. and its subsidiaries at January 31, 2004 and February 1, 2003, and the consolidated results of their operations and their cash flows for each of the three years in the period ended January 31, 2004 in conformity with accounting principles generally accepted in the United States. /s/ Ernst & Young LLP Los Angeles, California February 27, 2004 F-1 Hot Topic, Inc. and Subsidiaries Consolidated Balance Sheets (In thousands, except share amounts) JANUARY 31, FEBRUARY 1, 2004 2003 ---------- ---------- Assets Current assets: Cash and cash equivalents $ 11,886 $ 13,139 Short-term investments 116,319 70,279 Inventory 51,937 38,409 Prepaid expenses and other 10,654 7,866 Deferred tax assets 2,259 2,093 ---------- ---------- Total current assets 193,055 131,786 Leaseholds, fixtures and equipment, net 88,348 72,146 Deposits and other 189 171 Deferred tax assets -- 683 ---------- ---------- Total assets $ 281,592 $ 204,786 ========== ========== Liabilities and shareholders' equity Current liabilities: Accounts payable $ 15,841 $ 15,407 Accrued liabilities 28,133 19,639 Income taxes payable 7,242 6,453 ---------- ---------- Total current liabilities 51,216 41,499 Deferred rent 3,155 2,358 Deferred tax liability 3,316 -- 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; 48,120,989 and 46,805,980 shares issued and outstanding at January 31, 2004 and February 1, 2003, respectively 62,972 47,837 Retained earnings 161,134 113,092 Accumulated other comprehensive loss (201) -- ---------- ---------- Total shareholders' equity 223,905 160,929 ---------- ---------- Total liabilities and shareholders' equity $ 281,592 $ 204,786 ========== ========== See notes to consolidated financial statements. F-2 Hot Topic, Inc. and Subsidiaries Consolidated Statements of Income (In thousands, except per share amounts)
Years Ended ------------------------------------ January 31, February 1, February 2, 2004 2003 2002 ---------- ---------- ---------- Net sales $ 572,039 $ 443,250 $ 336,094 Cost of goods sold, including buying, distribution and occupancy costs 351,542 273,132 204,993 ---------- ---------- ---------- Gross margin 220,497 170,118 131,101 Selling, general and administrative expenses 143,952 115,634 86,950 ---------- ---------- ---------- Operating income 76,545 54,484 44,151 Interest income (1,358) (1,390) (1,912) Interest expense 40 19 28 ---------- ---------- ---------- Income before income taxes 77,863 55,855 46,035 Provision for income taxes 29,821 21,225 17,435 ---------- ---------- ---------- Net income $ 48,042 $ 34,630 $ 28,600 ========== ========== ========== Net income per share: Basic $ 1.01 $ 0.74 $ 0.62 ========== ========== ========== Diluted $ 0.97 $ 0.70 $ 0.57 ========== ========== ========== Shares used in computing net income per share: Basic 47,479 47,027 46,467 Diluted 49,588 49,276 49,829
See notes to consolidated financial statements. F-3 Hot Topic, Inc. and Subsidiaries Consolidated Statements of Shareholders' Equity (In thousands)
Accumulated Common Shares Other Total ----------------------- Retained Comprehensive Shareholders' Shares Amount Earnings Income (Loss) Equity ---------- ---------- ---------- ---------- ---------- BALANCE AT FEBRUARY 3, 2001 45,662 $ 49,429 $ 49,862 $ -- $ 99,291 Exercise of stock options 1,376 3,680 -- -- 3,680 Employee stock purchase plan 25 205 -- -- 205 Fractional shares purchased in 3-for-2 stock split -- (6) -- -- (6) Tax benefit from exercise of stock options -- 3,598 -- -- 3,598 Net income -- -- 28,600 -- 28,600 ---------- ---------- ---------- ---------- ---------- BALANCE AT FEBRUARY 2, 2002 47,063 56,906 78,462 -- 135,368 Exercise of stock options 1,195 4,942 -- -- 4,942 Employee stock purchase plan 33 418 -- -- 418 Restricted stock awards 15 153 -- -- 153 Repurchase of common stock (1,500) (19,700) -- -- (19,700) Tax benefit from exercise of stock options -- 5,118 -- -- 5,118 Net income -- -- 34,630 -- 34,630 ---------- ---------- ---------- ---------- ---------- BALANCE AT FEBRUARY 1, 2003 46,806 47,837 113,092 -- 160,929 Exercise of stock options 1,261 7,696 -- -- 7,696 Employee stock purchase plan 46 666 -- -- 666 Restricted stock awards 8 180 -- -- 180 Fractional shares purchased in 3-for-2 stock split -- (23) -- -- (23) Tax benefit from exercise of stock options -- 6,616 -- -- 6,616 Comprehensive income: Net income -- -- 48,042 -- 48,042 Unrealized loss on marketable securities, net -- -- -- (201) (201) ---------- Total comprehensive income 47,841 ---------- ---------- ---------- ---------- ---------- BALANCE AT JANUARY 31, 2004 48,121 $ 62,972 $ 161,134 $ (201) $ 223,905 ========== ========== ========== ========== ==========
See notes to consolidated financial statements. F-4 Hot Topic, Inc. and Subsidiaries Consolidated Statements of Cash Flows (In thousands)
Years Ended ------------------------------------- January 31, February 1, February 2, 2004 2003 2002 --------- --------- --------- OPERATING ACTIVITIES Net income $ 48,042 $ 34,630 $ 28,600 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 18,793 15,309 11,082 Tax benefit from exercise of stock options 6,616 5,118 3,598 Stock-based compensation 155 142 130 Deferred rent 797 597 358 Deferred taxes 4,075 (322) (1,061) Loss on disposal of fixed assets 656 278 401 Changes in operating assets and liabilities: Inventory (13,528) (8,856) (8,217) Prepaid expenses and other current assets (2,787) (2,431) 118 Deposits and other assets (18) 3 (73) Accounts payable 434 4,155 4,620 Accrued liabilities 8,519 7,528 741 Income taxes payable 548 4,166 2,096 --------- --------- --------- Net cash provided by operating activities 72,302 60,317 42,393 INVESTING ACTIVITIES Purchases of property and equipment (35,654) (33,879) (26,119) Proceeds from sale of short-term investments 52,906 46,105 16,476 Net purchase of short-term investments (99,146) (49,296) (33,398) --------- --------- --------- Net cash used in investing activities (81,894) (37,070) (43,041) FINANCING ACTIVITIES Repurchase of common stock (23) (19,700) (6) Proceeds from employee stock purchases and exercise of stock options 8,362 5,370 3,755 --------- --------- --------- Net cash provided (used) by financing activities 8,339 (14,330) 3,749 --------- --------- --------- Increase (decrease) in cash and cash equivalents (1,253) 8,917 3,101 Cash and cash equivalents at beginning of year 13,139 4,222 1,121 --------- --------- --------- Cash and cash equivalents at end of year $ 11,886 $ 13,139 $ 4,222 ========= ========= ========= SUPPLEMENTAL INFORMATION Cash paid during the year for interest $ 40 $ 19 $ 28 ========= ========= ========= Cash paid during the year for income taxes $ 18,614 $ 12,317 $ 10,799 ========= ========= ========= Capital lease obligations entered into for equipment $ -- $ -- $ 147 ========= ========= =========
See notes to consolidated financial statements. F-5 Hot Topic, Inc. and Subsidiaries Notes to Consolidated Financial Statements January 31, 2004 1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES ORGANIZATION AND BUSINESS ACTIVITY 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 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. The Company opened its first Hot Topic store in 1989 and at the end of fiscal 2003(the fiscal year ended January 31, 2004), the Company operated 502 Hot Topic stores and 52 Torrid stores in 49 states throughout the United States and Puerto Rico. The Company also maintains two distinct websites, www.hottopic.com ("hottopic.com") and www.torrid.com ("torrid.com") which reflect the Hot Topic and Torrid store concepts and sell certain items of merchandise. The Company has one reportable segment given the similarities of the economic characteristics among the store formats. PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All significant intercompany transactions and balances have been eliminated in consolidation. RECLASSIFICATIONS Certain reclassifications have been made to prior year amounts to conform to current year presentation. FISCAL YEAR The Company's fiscal year is on a 52-53 week basis and ends on the Saturday nearest to January 31. The fiscal years ended January 31, 2004, February 1, 2003 and February 2, 2002 were 52-week years. CASH AND CASH EQUIVALENTS The Company considers all highly liquid investments with maturities of less than three months when purchased to be cash equivalents. The Company is potentially exposed to a concentration of credit risk when cash deposits in banks are in excess of federally insured limits. FAIR VALUE OF FINANCIAL INSTRUMENTS The Company considers carrying amounts of cash and cash equivalents, receivables, and accounts payable to approximate fair value because of the short maturity of these financial instruments. Amounts outstanding under the unsecured bank credit agreement are held at their estimated fair values because they accrue interest at rates which generally fluctuate with interest rate trends. F-6 SHORT-TERM INVESTMENTS Short-term investments with maturities in excess of three months consist primarily of interest bearing bonds that are highly liquid, low risk with a minimum credit quality rating of A-1 (Standard and Poor's), SP-1 (Moody's Investor Service) or equivalent, and are available for sale. Other Comprehensive Loss items consist of fluctuations in the fair market value of certain short-term investments. Other Comprehensive Income was lower than net income for fiscal year ended January 31, 2004 as a result of Other Comprehensive Loss items aggregating $201,000. Other Comprehensive Loss items are reported in the Shareholders' Equity section of the Consolidated Balance Sheet. INVENTORY 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. PROPERTY AND EQUIPMENT Property and equipment are recorded at cost or in the case of capitalized leases, at the present value of future minimum lease payments. Depreciation is calculated using the straight-line method over the estimated useful lives of the assets (3-10 years). Leasehold improvements are amortized using the straight-line method over the shorter of the lease term or ten years. Expenditures for repairs that do not significantly extend the life of the asset are expensed as incurred. 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. Shipping and handling revenues from our websites are included as a component of net sales. STORE PRE-OPENING COSTS Costs incurred in connection with the opening of a new store are expensed as incurred. SHIPPING AND HANDLING COSTS The Company classifies shipping and handling costs in costs of goods sold, including buying, distribution and occupancy costs in the accompanying statements of income. ADVERTISING COSTS Advertising costs are expensed the first time the event occurs or as incurred. Advertising expenses were $1,065,000, $521,000, and $334,000 for the years ended January 31, 2004, February 1, 2003 and February 2, 2002, respectively. INCOME TAXES The Company utilizes Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes", which prescribes the use of the liability method to compute the difference between the tax basis of assets and liabilities and the related financial reporting amounts using currently enacted tax laws and rates. F-7 NET INCOME PER SHARE Net income per share has been computed in accordance with Financial Accounting Standards Board ("FASB") Statement No. 128, "Earnings per Share" (see Note 7). A three-for-two stock split became effective September 2, 2003. All share and per share amounts have been restated to reflect the stock split and all previous stock splits. USE OF ESTIMATES The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. LONG-LIVED ASSETS Long-lived assets are reviewed for events or changes in circumstances that indicate that their carrying value may not be recoverable. The review is based on comparing the expected undiscounted cash flows to the carrying amount of such assets. If it is determined that the carrying amount of the long-lived assets is not recoverable, the Company will recognize an impairment loss, measured by the future discounted cash flow method. At January 31, 2004, the Company believes there has been no impairment of the value of such assets to date. In August 2001, the Financial Accounting Standards Board issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets", which establishes accounting and reporting standards for impairment and disposition of long-lived assets, including discontinued operations. SFAS No. 144 became effective for all financial statements issued for fiscal years beginning after December 15, 2001 and, generally, its provisions are to be applied prospectively. The adoption of SFAS No. 144 did not have a significant impact on the Company's results of operations or financial condition. STOCK-BASED COMPENSATION Statement of Financial Accounting Standards No. 148 ("SFAS 148"), "Accounting for Stock-Based Compensation--Transition and Disclosure an Amendment of FASB Statement No. 123", amends the disclosure requirements of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123"), to require more prominent disclosures in both annual and interim financial statements regarding the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company accounts for stock-based awards to employees and directors using the intrinsic value method of accounting in accordance with Accounting Principles Board Opinion No. 25 ("APB 25"), "Accounting for Stock Issued to Employees." As such, compensation expense for stock options issued to employees is recorded on the date of the grant only if the current market price of the underlying stock exceeded the exercise price. 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. The fair value for these options was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted average assumptions for fiscal 2003, 2002, and 2001: weighted average risk-free interest rates of 5%; dividend yields of 0%; weighted average volatility factors of the expected market price of the Company's common stock of .40 for fiscal 2003, and 0.61 for fiscal 2002 and 2001; and a weighted average expected life of the options of 5 years. The weighted average fair value of options granted during the year are $6.70, $8.53, and $6.14 per share for fiscal 2003, 2002 and 2001, respectively. F-8 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): Years Ended ----------------------------------------- January 31, February 1, February 2, 2004 2003 2002 ----------- ----------- ----------- Net income As reported $ 48,042 $ 34,630 $ 28,600 Add: Stock-based compensation expense included in reported net income, net of related tax effects 96 88 81 Deduct: Total stock- based compensation expense determined under fair value method for all awards, net of related tax effects (5,166) (4,189) (3,120) ----------- ----------- ----------- Pro forma $ 42,972 $ 30,529 $ 25,561 =========== =========== =========== Basic earnings per share: As reported $ 1.01 $ 0.74 $ 0.62 Pro forma $ 0.91 $ 0.65 $ 0.55 Diluted earnings per share: As reported $ 0.97 $ 0.70 $ 0.57 Pro forma $ 0.88 $ 0.62 $ 0.51 NEW ACCOUNTING PRONOUNCEMENTS During April 2003, the FASB issued Statement of Financial Accounting Standards No. 149 ("SFAS 149"), "Amendment of Statement 133 on Derivative Instruments and Hedging Activities." SFAS 149 amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under Statement 133. SFAS 149 is effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. The guidance should be applied prospectively. The adoption of SFAS 149 did not have any material impact on the Company's operating results or financial condition as the Company does not have any derivative instruments that are affected by FAS 149. In January 2003, the FASB issued FASB Interpretation No. 46 ("FIN 46"), "Consolidation of Variable Interest Entities." In general, a variable interest entity is a corporation, partnership, trust, or any other legal structure used for business purposes that either (a) does not have equity investors with voting rights or (b) has equity investors that do not provide sufficient financial resources for the entity to support its activities. FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. The consolidation requirements of FIN 46 apply immediately to variable interest entities created after January 31, 2003. The consolidation requirements apply to older entities in the first fiscal year or interim period F-9 beginning after June 15, 2003. Certain of the disclosure requirements apply in all financial statements issued after January 31, 2003, regardless of when the variable interest entity was established. The Company does not currently have any variable interest entities and the adoption of the provisions of FIN 46 did not have a material impact on the Company's results of operations or financial condition. Beginning in 2003, the Company adopted the provisions of Emerging Issues Task Force("EITF") Issue No. 02-16, "Accounting by a Customer (Including a Reseller) for Cash Consideration Received from a Vendor." Issue No. 02-16 provides guidance on how a reseller should characterize the cash consideration received from a vendor and when and how the cash consideration should be recorded on its income statements. Issue No. 02-16 requires that the cash consideration received from the vendor be considered as a reduction of cost of sales when recognized in the reseller's income statement. If the cash consideration received from a vendor is the direct, specific and incremental reimbursement of costs incurred by the reseller to sell the vendor's products, the cash consideration should be treated as a reduction of such selling costs. Historically, the Company has only received money from vendors when product sell-through was below expectations and markdowns were required to be taken. Amounts received are treated as a reduction of cost of sales when received as the goods are typically sold prior to the receipt of vendor money. 2. LEASEHOLDS, FIXTURES AND EQUIPMENT Leaseholds, fixtures and equipment are summarized as follows (in thousands): January 31, February 1, 2004 2003 ----------- ----------- Furniture, fixtures and equipment $ 78,476 $ 58,597 Leasehold improvements 72,507 58,322 ----------- ----------- 150,983 116,919 Less accumulated depreciation and amortization (62,635) (44,773) ----------- ----------- $ 88,348 $ 72,146 =========== =========== 3. ACCRUED LIABILITIES Accrued liabilities consist of the following (in thousands): January 31, February 1, 2004 2003 ----------- ----------- Accrued payroll and related expenses $ 9,833 $ 7,185 Gift cards, gift certificates and store merchandise credits 5,713 3,739 Accrued percentage rents 4,012 1,642 Other 8,575 7,073 ----------- ----------- $ 28,133 $ 19,639 =========== =========== 4. BANK CREDIT AGREEMENT The Company has an unsecured bank credit agreement for $5,000,000, which is used for issuing letters of credit. The credit agreement expires in August 1, 2004 and the Company expects to renew the agreement under similar terms and conditions. The letters of credit are primarily used for inventory purchases. At January 31, 2004, the Company had $56,000 of outstanding letters of credit under the credit agreement. F-10 5. COMMITMENTS AND CONTINGENCIES LEASES The Company has entered into lease agreements for retail and office space, vehicles, and equipment under primarily noncancelable leases with terms ranging from approximately three to ten years. The retail space leases provide for rents based upon the greater of the minimum annual rental amounts or 5% to 8% of annual sales volume. Certain of the leases provide for increasing minimum annual rental amounts. Rent expense is recorded on a straight-line basis over the term of the lease. Accordingly, deferred rent, as reflected in the accompanying balance sheets, represents the difference between rent expense accrued and amounts paid under the terms of the lease agreements. Total rent expense for the years ended January 31, 2004, February 1, 2003 and February 2, 2002 was $39,403,000, $30,966,000, and $21,784,000, respectively, including contingent rentals of $4,866,000, $3,670,000, and $3,164,000, respectively. Annual future minimum lease payments under operating leases as of January 31, 2004 are as follows (in thousands): Operating Fiscal Year Leases ------------ --------- 2004 $ 36,548 2005 36,288 2006 35,752 2007 34,596 2008 32,449 Thereafter 100,616 --------- Total minimum lease payments $276,249 ========= LITIGATION The Company is involved in various matters of litigation during the ordinary course of business. Management does not believe any such matters will have a material impact on the financial condition or results of operations of the Company. 6. SHAREHOLDERS' EQUITY Stock Split On August 12, 2003, the Company announced that its Board of Directors approved a three-for-two stock split (in the form of a dividend) of its common stock. On the effective date of September 2, 2003, shareholders received a dividend of one additional share for every two shares they owned at the close of business on the record date of August 21, 2003. All share and per share amounts have been restated to reflect this stock split and all previous stock splits effectuated by the Company. Stock Repurchase On May 8, 2002, the Company announced that its Board of Directors approved the repurchase of up to an aggregate of 1,500,000 shares of its common stock during the period ending January 31, 2003. As of January 31, 2003, the Company had completed the repurchase of 1,500,000 shares of its common stock at a cost of $19.7 million, at an average price of $13.13 per common share. F-11 Employee Stock Purchase Plan In June 1996, the Board of Directors 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 employees of the Company. 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 withdraw from participation in an offering at any time during the purchase period for such offering. 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 occur every six months commencing January 1, 1997. Equity Incentive and Stock Option Plans Under the Company's 1996 Equity Incentive Plan, the Company may grant stock options, stock bonuses, restricted stock purchase rights and stock appreciation rights to employees, directors or consultants of the Company, as deemed appropriate by the Board of Directors. Under the Company's 1996 Non-Employee Directors' Stock Option Plan and together with the 1996 Equity Incentive Plan (the "Plans"), the Company may grant stock options to non-employee directors of the Company. The exercise price of options granted under the Plans shall be determined by the Board of Directors at the date of grant and shall not be lower than (i) 100% of the fair market value of the Company's common stock on the date of grant for incentive stock options, (ii) 85% of the fair market value of the Company's common stock on the date of grant for non-statutory stock options, and (iii) 110% of the fair market value of the Company's common stock on the date of grant for persons possessing 10% or more of the total combined voting power of all classes of stock of the Company. Unless the Board of Directors declares otherwise, options vest over four years and generally expire ten years from the date of grant. An aggregate of 19,020,000 shares of common stock may be issued pursuant to the Plans. During fiscal 2003, the Plans were amended to increase the aggregate number of shares of common stock authorized for issuance by 2,775,000 shares. As of January 31, 2004, 3,684,904 shares were available for future grants. No options, under the Plans, have been granted to consultants. The Company granted 8,855, 8,424, and 14,766 shares of restricted common stock in the year ended January 31, 2004, February 1, 2003, and February 2, 2002, respectively, to non-employee directors under the 1996 Equity Incentive Plan. The 8,855 restricted shares issued in fiscal 2003 will vest in the year ending January 29, 2005, the 8,424 restricted shares issued in fiscal 2002 vested in the year ended January 31, 2004, and the 14,766 restricted shares issued in fiscal 2001 vested in the year ended February 1, 2003. All awarded common shares will remain restricted until such time the recipient is no longer a member of the Company's Board of Directors. The value of these grants is expensed over the vesting period and $155,000, $142,000, and $130,000 was expensed in the years ended January 31, 2004, February 1, 2003, and February 2, 2002 respectively. F-12 A summary of the Company's stock option activity and related information follows:
January 31, 2004 February 1, 2003 February 2, 2002 --------------------- ---------------------- ---------------------- Weighted Weighted Weighted Average Average Average Exercise Exercise Exercise Options Price Options Price Options Price ----------- ------- ----------- -------- ----------- -------- Outstanding at beginning of year 4,876,941 $ 8.70 4,891,268 $ 5.85 5,624,420 $ 3.35 Granted 1,396,931 $15.78 1,394,475 $ 15.14 1,522,013 $ 10.90 Exercised (1,260,630) $ 6.11 (1,195,529) $ 4.13 (1,375,739) $ 2.67 Forfeited (199,447) $12.37 (213,273) $ 10.88 (879,426) $ 3.57 ----------- ------- ----------- -------- ----------- -------- Outstanding at end of year 4,813,795 $11.28 4,876,941 $ 8.70 4,891,268 $ 5.85 =========== ======= =========== ======== =========== ======== Exercisable at end of year 2,146,586 $ 7.80 2,000,054 $ 5.06 1,709,822 $ 3.31 =========== ======= =========== ======== =========== ========
Exercise prices for the 4,813,795 options outstanding as of January 31, 2004 ranged from $1.51 to $23.02. The weighted average contractual life of those options is 7.5 years. The following table summarizes information about stock options outstanding as of January 31, 2004:
Outstanding Options ------------------------------------------------------------ Weighted Weighted Weighted Average Average Average Number Exercise Contractual Number Exercise Range of Exercise Prices Outstanding Price Life Exercisable Price ------------------------ ----------------------------------- ------------------------ $1.51 - $5.83 859,579 $ 2.93 5.4 798,688 $ 2.85 $5.97 - $10.64 1,299,677 $ 8.67 6.8 859,340 $ 8.44 $11.00 - $15.33 1,271,783 $ 14.65 8.1 473,100 $ 14.67 $15.61 - $23.02 1,382,756 $ 15.83 9.1 15,458 $ 17.66 ----------------------------------- ------------------------ $1.51 - $23.02 4,813,795 $ 11.28 7.5 2,146,586 $ 7.80 =================================== ========================
The Company recorded tax benefits associated with the exercise of non-qualified stock options. The tax benefits increased shareholders' equity and decreased income taxes payable in the amounts of $6,616,000, $5,118,000, and $3,598,000 for the years ended January 31, 2004, February 1, 2003 and February 2, 2002, respectively. 7. NET INCOME PER SHARE The Company computes net income per share pursuant to 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 shares and potentially dilutive common stock equivalents outstanding for the period. A three-for-two stock split of the Company's common stock became effective September 2, 2003. All share and per share amounts have been restated to reflect this stock split and all previous stock splits effectuated by the Company. F-13 Reconciliation of the numerator and denominator of basic earnings per share and diluted earnings per share for the years ended (in thousands, except per share amounts): January 31, February 1, February 2, 2004 2003 2002 ---------- ---------- ---------- Basic Earnings Per Share Computation: Numerator $ 48,042 $ 34,630 $ 28,600 Denominator: Weighted average common shares outstanding 47,479 47,027 46,467 ---------- ---------- ---------- Total shares 47,479 47,027 46,467 ========== ========== ========== Basic earnings per share $ 1.01 $ 0.74 $ 0.62 ========== ========== ========== Diluted Earnings Per Share Computation: Numerator $ 48,042 $ 34,630 $ 28,600 Denominator: Weighted average common shares outstanding 47,479 47,027 46,467 Incremental shares from assumed conversion of options 2,109 2,249 3,362 ---------- ---------- ---------- Total shares 49,588 49,276 49,829 ========== ========== ========== Diluted earnings per share $ 0.97 $ 0.70 $ 0.57 ========== ========== ========== 8. INCOME TAXES Composition of the provision for income taxes for the years ended (in thousands): January 31, February 1, February 2, 2004 2003 2002 ----------- ----------- ----------- Current: Federal $ 21,169 $ 18,584 $ 15,727 State 4,577 2,963 2,769 ----------- ----------- ----------- 25,746 21,547 18,496 ----------- ----------- ----------- Deferred: Federal 4,397 (125) (859) State (322) (197) (202) ----------- ----------- ----------- 4,075 (322) (1,061) ----------- ----------- ----------- Total income tax expense $ 29,821 $ 21,225 $ 17,435 =========== =========== =========== F-14 Significant components of the Company's deferred tax assets and liabilities as of (in thousands): January 31, February 1, 2004 2003 ----------- ----------- Current deferred tax assets (liabilities): Accrued vacation and other $ 727 $ 835 Inventory 701 496 State taxes 597 1,004 Other assets (liabilities) 234 (242) ----------- ----------- Net current deferred tax assets 2,259 2,093 ----------- ----------- Noncurrent deferred tax assets (liabilities): Depreciation (4,048) 419 Deferred rent 732 264 ----------- ----------- Total noncurrent deferred tax assets (liabilities) (3,316) 683 ----------- ----------- Net deferred tax assets (liabilities) $ (1,057) $ 2,776 =========== =========== Reconciliation of the provision for income taxes to the statutory tax rate for the years ended: January 31, February 1, February 2, 2004 2003 2002 ----------- ----------- ----------- Statutory federal rate 35.0% 35.0% 35.0% Permanent differences (0.4) (0.5) (1.0) State and local taxes, net of federal benefit 3.6 3.7 3.4 Other items 0.1 (0.2) 0.5 ----------- ----------- ----------- Effective income tax rate 38.3% 38.0% 37.9% =========== =========== =========== 9. EMPLOYEE BENEFIT PLAN Effective January 1, 1995, the Company adopted the Hot Topic 401(k) Retirement Savings Plan (the "401(k) Plan"). All employees who have been employed by the Company for at least one year of service, maintained a minimum of 1,000 hours worked during the year and are at least 21 years of age are eligible to participate. Employees may contribute to the 401(k) Plan up to 25% of their current compensation, subject to a statutorily prescribed annual limit. The Company may at its discretion contribute certain amounts to eligible employees' accounts. The Company has not made any contributions to the 401(k) Plan. F-15