10-Q 1 hottopic_10q-093004.txt SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549 FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended October 30, 2004 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR l5(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to COMMISSION FILE NUMBER: 0-28784 HOT TOPIC, INC. ---------------- (Exact name of registrant as specified in its charter) CALIFORNIA 77-0198182 ---------- ---------- (State of incorporation) (IRS Employer Identification No.) 18305 EAST SAN JOSE AVE., CITY OF INDUSTRY, CA 91748 ---------------------------------------------- ----- (Address of principal executive offices) (Zip Code) (626) 839-4681 -------------- (Registrant's telephone number, including area code) Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes [X] No [ ] APPLICABLE ONLY TO CORPORATE ISSUERS: Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: November 18, 2004 - 45,509,862 shares of common stock, no par value. HOT TOPIC, INC. INDEX TO FORM 10-Q
Page No. PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS (UNAUDITED): Consolidated Balance Sheets - October 30, 2004 and January 31, 2004 3 Consolidated Statements of Income for the three months and nine months ended October 30, 2004 and November 1, 2003 4 Consolidated Statements of Cash Flows for the nine months ended October 30, 2004 and November 1, 2003 5 Notes to Consolidated Financial Statements 6-10 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 11-26 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 26 ITEM 4. CONTROLS AND PROCEDURES 26 PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS 27 ITEM 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES 28 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K 28-29 SIGNATURES 30
2 PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS HOT TOPIC, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (In thousands, except share amounts) October 30, 2004 January 31, 2004 ----------------- ----------------- (Unaudited) ASSETS Current assets: Cash and cash equivalents $ 7,340 $ 11,886 Short-term investments 34,364 116,319 Inventory 78,814 51,937 Prepaid expenses and other 14,953 10,654 Deferred tax assets 2,259 2,259 ----------------- ----------------- Total current assets 137,730 193,055 Leaseholds, fixtures and equipment, net 110,120 88,348 Deposits and other 242 189 ----------------- ----------------- Total assets $ 248,092 $ 281,592 ================= ================= LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Accounts payable $ 16,498 $ 15,841 Accrued liabilities 28,185 28,133 Income taxes payable 8,322 7,242 ----------------- ----------------- Total current liabilities 53,005 51,216 Deferred rent 3,829 3,155 Deferred tax liability 3,316 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; 45,502,125 and 48,120,989 shares issued and outstanding at October 30, 2004 and January 31, 2004, respectively 4,390 62,972 Retained earnings 183,719 161,134 Accumulated other comprehensive loss (167) (201) ----------------- ----------------- Total shareholders' equity 187,942 223,905 ----------------- ----------------- Total liabilities and shareholders' equity $ 248,092 $ 281,592 ================= =================
See notes to consolidated financial statements. 3 HOT TOPIC, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (Unaudited) (In thousands, except per share amounts) Three Months Ended Nine Months Ended ---------------------------- --------------------------- October 30, November 1, October 30, November 1, 2004 2003 2004 2003 ------------- ----------- ------------ ----------- Net sales $ 180,808 $ 161,546 $ 445,214 $ 377,931 Cost of goods sold, including buying, distribution and occupancy costs 116,054 98,503 289,300 237,643 ------------- ----------- ------------ ----------- Gross margin 64,754 63,043 155,914 140,288 Selling, general and administrative expenses 44,553 38,626 120,053 99,782 ------------- ----------- ------------ ----------- Operating income 20,201 24,417 35,861 40,506 Interest income, net 188 333 744 939 ------------- ----------- ------------ ----------- Income before income taxes 20,389 24,750 36,605 41,445 Provision for income taxes 7,809 9,479 14,020 15,873 ------------- ----------- ------------ ----------- Net income $ 12,580 $ 15,271 $ 22,585 $ 25,572 ============= =========== ============ =========== Net income per share: Basic $ 0.27 $ 0.32 $ 0.48 $ 0.54 ============= =========== ============ =========== Diluted $ 0.27 $ 0.31 $ 0.47 $ 0.52 ============= =========== ============ =========== Shares used in computing net income per share: Basic 46,086 47,656 46,857 47,328 Diluted 47,202 49,917 48,468 49,263
See notes to consolidated financial statements. 4 HOT TOPIC, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (In thousands) Nine Months Ended ------------------------------------- October 30, November 1, 2004 2003 ------------------ ----------------- OPERATING ACTIVITIES Net income $ 22,585 $ 25,572 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 16,198 13,820 Tax benefit from exercise of stock options 1,458 4,318 Stock-based compensation 116 135 Loss on disposal of fixed assets 258 243 Changes in operating assets and liabilities: Inventory (26,877) (24,886) Prepaid expenses and other current assets (4,299) (3,452) Deposits and other assets (53) (18) Accounts payable 657 10,928 Accrued liabilities 174 6,400 Deferred rent 674 563 Income taxes payable 1,080 596 ------------------ ----------------- Net cash provided by operating activities 11,971 34,219 INVESTING ACTIVITIES Purchases of property and equipment (38,311) (26,952) Proceeds from sale of short-term investments 121,777 83,991 Purchases of short-term investments (39,788) (96,108) ------------------ ----------------- Net cash provided by (used in) investing activities 43,678 (39,069) FINANCING ACTIVITIES Repurchase of common stock (63,665) -- Proceeds from employee stock purchases and exercise of stock options 3,470 5,974 ------------------ ----------------- Net cash (used in) provided by financing activities (60,195) 5,974 ------------------ ----------------- (Decrease) increase in cash and cash equivalents (4,546) 1,124 Cash and cash equivalents at beginning of period 11,886 13,139 ------------------ ----------------- Cash and cash equivalents at end of period $ 7,340 $ 14,263 ================== ================= SUPPLEMENTAL INFORMATION Cash paid during the period for interest $ 4 $ 29 ================== ================= Cash paid during the period for income taxes $ 10,116 $ 10,991 ================== =================
See notes to consolidated financial statements. 5 HOT TOPIC, INC. and SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) NOTE 1. ORGANIZATION AND BASIS OF PRESENTATION Hot Topic, Inc. is a mall-based specialty retailer operating the Hot Topic and Torrid store concepts. Hot Topic sells 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 fiscal year ended February 2, 2002), we launched a second retail concept under the trade name Torrid. Torrid sells apparel, lingerie, shoes and accessories designed for various lifestyles for plus-size females between the ages of 15 and 29. At the end of the third quarter (October 30, 2004) of fiscal 2004 (the fiscal year ending January 29, 2005), we operated 580 Hot Topic stores in 50 states and Puerto Rico, and 69 Torrid stores. We also maintain 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. Throughout this report, the terms "our", "we" and "us" refer to Hot Topic, Inc. and its subsidiaries. The information set forth in these financial statements is unaudited except for the January 31, 2004 Consolidated Balance Sheet. These statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information, the instructions to Form 10-Q, and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments, consisting only of normal recurring entries, necessary for a fair presentation have been included. The results of operations for the three months and the nine months ended October 30, 2004 are not necessarily indicative of the results that may be expected for the year ending January 29, 2005. Certain reclassifications have been made to prior year periods to conform to current period presentation. For further information, refer to the consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended January 31, 2004. NOTE 2. NET INCOME PER SHARE We compute net income per share pursuant to Statement of Financial Accounting Standards ("SFAS") No. 128 "Earnings Per Share." Basic net income per share is computed based on the weighted average number of common shares outstanding for the period. Diluted net income per share is computed based on the weighted average number of common shares outstanding for the period and potentially dilutive common stock equivalents outstanding for the period. 6 A reconciliation of the numerator and denominator of basic earnings per share and diluted earnings per share is as follows (all amounts in thousands except per share amounts):
Three Months Ended Nine Months Ended ---------------------------- --------------------------- October 30, November 1, October 30, November 1, 2004 2003 2004 2003 ------------- ----------- ------------ ----------- Basic EPS Computation: Numerator $ 12,580 $ 15,271 $ 22,585 $ 25,572 Denominator: Weighted average common shares outstanding 46,086 47,656 46,857 47,328 ------------- ----------- ------------ ----------- Total shares 46,086 47,656 46,857 47,328 ------------- ----------- ------------ ----------- Basic EPS $ 0.27 $ 0.32 $ 0.48 $ 0.54 ============= =========== ============ =========== Diluted EPS Computation: Numerator $ 12,580 $ 15,271 $ 22,585 $ 25,572 Denominator: Weighted average common shares outstanding 46,086 47,656 46,857 47,328 Incremental shares from assumed conversion of options 1,116 2,261 1,611 1,935 ------------- ----------- ------------ ----------- Total shares 47,202 49,917 48,468 49,263 ============= =========== ============ =========== Diluted EPS $ 0.27 $ 0.31 $ 0.47 $ 0.52 ============= =========== ============ ===========
NOTE 3. COMPREHENSIVE INCOME Comprehensive income for the three months and nine months ended October 30, 2004 and November 1, 2003 is as follows (in thousands):
Three Months Ended Nine Months Ended ----------------------------- ---------------------------- October 30, November 1, October 30, November 1, 2004 2003 2004 2003 ------------- ------------ ------------ ------------ Comprehensive Income Net income $ 12,580 $ 15,271 $ 22,585 $ 25,572 Unrealized gain (loss) on marketable securities, net 39 (154) 34 (154) ------------- ------------ ------------ ------------ Total comprehensive income $ 12,619 $ 15,117 $ 22,619 $ 25,418 ============= ============ ============ ============
NOTE 4. SHAREHOLDERS' EQUITY On March 19, 2004, we announced that our Board of Directors approved the repurchase of up to an aggregate of 2,000,000 shares of our common stock during the period ending January 29, 2005. As of July 31, 2004 we had completed the repurchase of 2,000,000 shares of our common stock at a cost of $46.8 million at an average price of $23.41. 7 On August 18, 2004, we announced that our Board of Directors approved an additional repurchase of up to an aggregate of 2,000,000 shares of our common stock during the period ending January 29, 2005. During the quarter ended October 30, 2004, we purchased 1,000,000 shares of our common stock at an average price of $16.85. As of October 30, 2004, there are 1,000,000 shares remaining to be repurchased under the August 18, 2004 authorization. NOTE 5. BANK CREDIT AGREEMENT We maintain an unsecured bank credit agreement of $5.0 million. The credit agreement will expire in August 2005 and we expect to renew the credit agreement under similar terms. Letters of credit are issued under the credit agreement, which are primarily used for inventory purchases. At October 30, 2004, we had $1.0 million of outstanding letters of credit issued under the credit agreement. NOTE 6. COMMITMENTS AND CONTINGENCIES LITIGATION We are involved in various matters of litigation during the ordinary course of business. Management does not currently believe any such matters will have a material adverse effect on our financial condition or results of operations. INDEMNITIES, COMMITMENTS AND GUARANTEES During the ordinary course of business, we have made certain indemnities, commitments and guarantees under which we may be required to make payments in relation to certain transactions. These indemnities include those given to various lessors in connection with facility leases for certain claims arising from such facility or lease and indemnities to our directors and officers to the maximum extent permitted under the laws of the State of California. We have issued guarantees in the form of letters of credit as security for some merchandise shipments from overseas. There were $1.0 million of these letters of credit outstanding at October 30, 2004. The durations of these indemnities, commitments and guarantees vary. Some of these indemnities, commitments and guarantees do not provide for any limitation of the maximum potential future payments we could be obligated to make. We have not recorded any liability for these indemnities, commitments and guarantees in the accompanying consolidated financial statements. NOTE 7. STOCK-BASED COMPENSATION We account for stock-based awards to employees and directors using the intrinsic value method of accounting in accordance with Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees." We follow the disclosure provisions of SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure." SFAS No. 148 requires disclosures of the effects of an entity's accounting policy with respect to stock-based employee compensation on reported net income (loss) and earnings (loss) per share in annual and interim financial statements. We are required to follow the prescribed disclosure format and have provided the additional disclosures required by SFAS No. 148 for the three months and nine months ended October 30, 2004. 8 Pro forma information regarding net income and earnings per share is required by SFAS No. 123, and has been determined as if we accounted for our employee stock incentives under the fair value method of that Statement. For purposes of pro forma disclosures, the estimated fair value of the options, based on the Black-Scholes option pricing model, is amortized to expense over the options' vesting periods. The following is the pro forma information using the fair value method under SFAS No. 123, as amended by SFAS No. 148 (in thousands, except per share amounts):
Three Months Ended Nine Months Ended ----------------------------- ---------------------------- October 30, November 1, October 30, November 1, 2004 2003 2004 2003 -------------- ------------ ------------- ------------ Net income As reported $ 12,580 $ 15,271 $ 22,585 $ 25,572 Add: Stock-based compensation expense included in reported net income, net of related tax effects 24 28 72 83 Deduct: Total stock-based compensation expense determined under fair value method for all awards, net of related tax effects (1,649) (1,286) (4,966) (3,787) -------------- ------------ ------------- ------------ Pro forma $ 10,955 $ 14,013 $ 17,691 $ 21,868 ============== ============ ============= ============ Basic earnings per share: As reported $ 0.27 $ 0.32 $ 0.48 $ 0.54 Pro forma $ 0.24 $ 0.29 $ 0.38 $ 0.46 Diluted earnings per share: As reported $ 0.27 $ 0.31 $ 0.47 $ 0.52 Pro forma $ 0.23 $ 0.28 $ 0.37 $ 0.44
NOTE 8. IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS 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. FIN 46(R) clarifies the application of ARB No. 51, "Consolidated Financial Statements," to certain entities in which equity 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 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 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. FIN 46(R) applies immediately to variable interest entities created after December 31, 2003, and to variable interest entities in which an enterprise obtains an interest after that date. It applies no later than the first reporting period ending after March 15, 2004, to variable interest entities in which an enterprise holds a variable interest (other than special purpose) that it acquired before January 1, 2004. FIN 46(R) applies to public enterprises as of the beginning of the applicable interim or annual period. We do not currently have any variable interest entities and the adoption of the provisions of FIN 46 and FIN 46(R) did not have a material impact on our results of operations or financial condition. 9 In November 2003, consensus was reached on Emerging Issues Task Force ("EITF") Issue No. 03-10, "Application of EITF Issue No. 02-16, `Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor,' by Resellers to Sales Incentives Offered to Consumers by Manufacturers." Under Issue 02-16, cash consideration received by a customer from a vendor is presumed to be a price reduction of the vendor's products or services and should therefore be characterized as a reduction of cost of sales when recognized in the income statement of the customer. Issue No. 03-10 is effective for fiscal periods beginning after November 25, 2003. The adoption of Issue No. 03-10 did not have a material impact on our operating results or financial condition. In March 2004, the EITF reached a consensus on EITF Issue No. 03-1 ("EITF 03-1"), "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments," for which the measurement and recognition provisions were to be effective for reporting periods beginning after June 15, 2004. However, in September 2004, the EITF issued FASB Staff Position EITF Issue No. 03-1-1, "Effective Date of Paragraphs 10-20 of EITF Issue No. 03-1, `The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments,'" which postponed the measurement and recognition provisions of EITF 03-1, but maintained the disclosure requirements for all investments within the scope of the guidance to be effective in annual financial statements for fiscal years ending after June 15, 2004. EITF 03-1 provides a three-step process for determining whether investments, including debt securities, are other than temporarily impaired and requires additional disclosures in annual financial statements. An investment is impaired if the fair value of the investment is less than its cost. EITF 03-1 outlines that an impairment would be considered other-than-temporary unless: a) the investor has the ability and intent to hold an investment for a reasonable period of time sufficient for the recovery of the fair value up to (or beyond) the cost of the investment, and b) evidence indicating that the cost of the investment is recoverable within a reasonable period of time outweighs evidence to the contrary. Although not presumptive, a pattern of selling investments prior to the forecasted recovery of fair value may call into question the investor's intent. In addition, the severity and duration of the impairment should also be considered in determining whether the impairment is other-than-temporary. We do not expect the adoption of EITF 03-1 to have a material impact on our results of operations or financial condition because our investments are short-term in nature and consist primarily of interest bearing bonds that are highly liquid and low risk with a minimum credit quality rating of A-1 (Standard and Poor's), SP-1 (Moody's Investor Service) or equivalent. 10 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion of our results of operations, financial condition and liquidity, and other matters should be read in conjunction with our Consolidated Financial Statements and the Notes related thereto. Our 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. The discussion below includes references to "comparable stores." We consider a store comparable after it has been open for 15 full months. If a store is relocated or 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 subsequent months. RESULTS OF OPERATIONS THREE MONTHS ENDED OCTOBER 30, 2004 COMPARED TO THREE MONTHS ENDED NOVEMBER 1, 2003 The following table sets forth selected data from our income statement expressed as a percentage of net sales for the periods indicated. The discussion that follows should be read in conjunction with this table:
OCTOBER 30, NOVEMBER 1, FOR THE THREE MONTHS ENDED: 2004 2003 --------------------------- ------------- -------------- Net sales 100.0% 100.0% Cost of goods sold (including buying, distribution and occupancy costs) 64.2 61.0 ------------- -------------- Gross margin 35.8 39.0 Selling, general and administrative expenses 24.6 23.9 ------------- -------------- Operating income 11.2 15.1 Interest income, net 0.1 0.2 ------------- -------------- Income before income tax expense 11.3 15.3 Income tax expense 4.3 5.8 ------------- -------------- Net income 7.0% 9.5% ============= ==============
Net sales increased $19.3 million, or 11.9%, to $180.8 million during the third quarter of fiscal 2004 from $161.5 million during the third quarter of fiscal 2003. The components of this $19.3 million increase in net sales are as follows: AMOUNT ($ MILLIONS) DESCRIPTION ------------ -------------------------------------------------------- $ 19.6 Net sales from new Hot Topic stores opened during the third quarter of fiscal 2004 and Hot Topic stores not yet qualifying as comparable stores 4.9 Net sales from new Torrid stores opened during the third quarter of fiscal 2004 and Torrid stores not yet qualifying as comparable stores 0.6 Internet sales (hottopic.com and torrid.com) 0.1 Net sales from 12 expanded or relocated Hot Topic and Torrid stores (5.9) 4.2% decrease in comparable store net sales in the third quarter of fiscal 2004 compared to the third quarter of fiscal 2003 ------------ $ 19.3 TOTAL ============ 11 At the end of the third quarter of fiscal 2004, 476 of our 649 stores (Hot Topic and Torrid) were included in the comparable store base, compared to 399 of our 540 stores (Hot Topic and Torrid) open at the end of the third quarter of fiscal 2003. Sales of Hot Topic's apparel and tee-shirts, as a percentage of total net sales, were consistent at 55% for the third quarter of fiscal 2004 and the third quarter of fiscal 2003. Within the apparel and tee-shirt category there was a change in product mix as sales of music licensed apparel increased, but offset by a decrease in men's and women's fashion apparel sales. We believe our third quarter net sales were negatively impacted by lower than expected sales from Halloween products. In addition, we also believe our net sales for the third quarter were negatively impacted as we experienced difficulty translating the current "clean and preppy" fashion trends to styles that appeal to our customer base. Gross margin increased $1.8 million to $64.8 million during the third quarter of fiscal 2004 from $63.0 million during the third quarter of fiscal 2003. As a percentage of net sales, gross margin decreased to 35.8% during the third quarter of fiscal 2004 from 39.0% in the third quarter of fiscal 2003. The significant components of this 3.2% decrease in gross margin as a percentage of net sales are as follows: % DESCRIPTION ------------ -------------------------------------------------------- (2.3)% Decrease in merchandise margin, principally due to higher markdown activity, particularly on women's fashion and Halloween-related product (0.6) Increase in store occupancy and depreciation expenses, primarily due to deleveraging these expenses over lower comparable store sales (0.2) Increase in distribution expenses, primarily due to higher freight and payroll costs (0.1) Increase in buying costs due to deleveraging of these costs over lower comparable store sales ------------ (3.2)% TOTAL ============ Selling, general and administrative expenses increased $5.9 million, or 15.3%, to $44.5 million during the third quarter of fiscal 2004 compared to $38.6 million during the third quarter of fiscal 2003. As a percentage of net sales, selling, general and administrative expenses increased to 24.6% in the third quarter of fiscal 2004 compared to 23.9% in the third quarter of fiscal 2003. The total dollar increase in selling, general and administrative expenses was primarily attributable to a 20.2% increase in the number of retail stores from 540 at the end of the third quarter of fiscal 2003 to 649 at the end of the third quarter of fiscal 2004 and the corresponding additional payroll and other expenses required to support these additional stores. The significant components of this 0.7% increase in selling, general and administrative expenses as a percentage of net sales are as follows: 12 % DESCRIPTION ------------ -------------------------------------------------------- 0.7% Increase in store payroll due to deleveraging of payroll costs over lower comparable store sales, partially offset by lower store selling bonuses 0.2 Increase in other store expenses as a result of deleveraging expenses over lower comparable store sales along with increases in supply costs and expenses related to our wide area network 0.1 Increase in depreciation and amortization as a result of new warehouse management software implemented during the second quarter of fiscal 2004 (0.3) Decrease in other general and administrative expenses due primarily to a decrease in performance based compensation, partially offset by an increase in professional fees related to implementing Section 404 of the Sarbanes-Oxley Act and an increase in marketing expenses for Torrid stores ------------ 0.7% TOTAL ============ Operating income decreased $4.2 million to $20.2 million during the third quarter of fiscal 2004 from $24.4 million during the third quarter of fiscal 2003. As a percentage of net sales, operating income was 11.2% in the third quarter of fiscal 2004 compared to 15.1% in the third quarter of fiscal 2003. Net interest income decreased $0.1 million to $0.2 million during the third quarter of fiscal 2004 from $0.3 million during the third quarter of fiscal 2003, principally due to lower average cash and short term investment balances in the third quarter of 2004 as compared to the third quarter of 2003 driven by our common stock repurchases. Income tax expense was $7.8 million for the third quarter of fiscal 2004 compared to $9.5 million for the third quarter of fiscal 2003. The effective tax rate was 38.3% for both the third quarter of fiscal 2004 and fiscal 2003. NINE MONTHS ENDED OCTOBER 30, 2004 COMPARED TO NINE MONTHS ENDED NOVEMBER 1, 2003 The following table sets forth selected data from our income statement expressed as a percentage of net sales for the periods indicated. The discussion that follows should be read in conjunction with this table:
OCTOBER 30, NOVEMBER 1, FOR THE NINE MONTHS ENDED: 2004 2003 --------------------------- -------------- --------------- Net sales 100.0% 100.0% Cost of goods sold (including buying, distribution and occupancy costs) 65.0 62.9 -------------- --------------- Gross margin 35.0 37.1 Selling, general and administrative expenses 27.0 26.4 -------------- --------------- Operating income 8.0 10.7 Interest income, net 0.2 0.3 -------------- --------------- Income before income tax expense 8.2 11.0 Income tax expense 3.1 4.2 -------------- --------------- Net income 5.1% 6.8% ============== ===============
13 Net sales increased $67.3 million, or 17.8%, to $445.2 million during the first nine months of fiscal 2004 from $377.9 million during the first nine months of fiscal 2003. The components of this $67.3 million increase in net sales are as follows: AMOUNT ($ MILLION) DESCRIPTION ------------ -------------------------------------------------------- $ 53.9 Net sales from new Hot Topic stores opened during the first nine months of fiscal 2004 and Hot Topic stores not yet qualifying as comparable stores 14.3 Net sales from new Torrid stores opened during the first nine months of fiscal 2004 and Torrid stores not yet qualifying as comparable stores 2.9 Internet sales (hottopic.com and torrid.com) 0.5 Net sales from 12 expanded or relocated Hot Topic and Torrid stores (4.3) 1.3% decrease in comparable store net sales in the first nine months of fiscal 2004 compared to the first nine months of fiscal 2003 ------------ $67.3 TOTAL ============ Sales of Hot Topic's apparel and tee-shirts, as a percentage of total net sales, were 54% in the first nine months of fiscal 2004 compared to 53% in the first nine months of fiscal 2003. The increase in apparel and tee-shirt sales as a percentage of net sales was due primarily to increased sales of men's novelty tee-shirts and men's music licensed apparel, partially offset by decreases in sales of women's apparel and men's fashion tops and bottoms. We believe our net sales for the nine month period were negatively impacted as we experienced difficulty translating the current "clean and preppy" fashion trends to styles that appeal to our customer base. We also believe sales were negatively impacted by some delays we experienced in product distribution to our stores in the second quarter which was attributable to our implementing a new warehouse management system during June 2004. Gross margin increased approximately $15.6 million to $155.9 million during the first nine months of fiscal 2004 from $140.3 million during the first nine months of fiscal 2003. As a percentage of net sales, gross margin decreased to 35.0% during the first nine months of fiscal 2004 from 37.1% in the first nine months of fiscal 2003. The significant components of this 2.1% decrease in gross margin as a percentage of net sales are as follows: % DESCRIPTION ------------ -------------------------------------------------------- (1.5)% Decrease in merchandise margin, principally due to higher markdown activity (0.5) Increase in store occupancy expenses, primarily due to deleveraging store expenses over lower comparable store sales (0.1) Increase in distribution expenses, primarily due to higher freight and payroll costs ------------ (2.1)% TOTAL ============ 14 Selling, general and administrative expenses increased $20.3 million, or 20.3%, to $120.1 million during the first nine months of fiscal 2004 compared to $99.8 million during the first nine months of fiscal 2003. As a percentage of net sales, selling, general and administrative expenses increased to 27.0% in the first nine months of fiscal 2004 compared to 26.4% in the first nine months of fiscal 2003. The total dollar increase in selling, general and administrative expenses is primarily attributable to a 20.2% increase in the number of retail stores from 540 at the end of the first nine months of fiscal 2003 to 649 at the end of the first nine months of fiscal 2004 and the corresponding additional payroll and other expenses required to support these additional stores. The significant components of this 0.6% increase in selling, general and administrative expenses as a percentage of net sales are as follows: % DESCRIPTION ------------ -------------------------------------------------------- 0.5% Increase in store payroll due to deleveraging of payroll costs over lower comparable store sales, partially offset by lower store selling bonuses 0.4 Increase in other store expenses as a result of deleveraging expenses over lower comparable store sales along with increases in supply costs and expenses related to our wide area network (0.2) Decrease in other general and administrative expenses due primarily to a decrease in performance based compensation, partially offset by increase in professional fees related to implementing Section 404 of the Sarbanes-Oxley Act (0.1) Decrease in store pre-opening costs due to fewer store openings as a percent of total store base ------------ 0.6% TOTAL ============ Operating income decreased $4.6 million to $35.9 million during the first nine months of fiscal 2004 from $40.5 million during the first nine months of fiscal 2003. As a percentage of net sales, operating income was 8.0% in the first nine months of fiscal 2004 compared to 10.7% in the first nine months of fiscal 2003. Net interest income decreased $0.2 million to $0.7 million during the first nine months of fiscal 2004 from $0.9 million during the first nine months of fiscal 2003, principally due to lower average cash and short term investment balances in the first nine months of 2004 as compared to the first nine months of 2003 driven by our common stock repurchases. Income tax expense was $14.0 million for the first nine months of fiscal 2004 compared to $15.9 million for the first nine months of fiscal 2003. The effective tax rate was 38.3% for both the first nine months of fiscal 2004 and fiscal 2003. 15 LIQUIDITY AND CAPITAL RESOURCES Historically and during the first nine months of fiscal 2004, our primary uses of cash have been to finance store openings and purchase merchandise inventories, as well as periodic repurchases of our common shares. In August 2004, we announced the approval by our Board of Directors of the repurchase of up to 2,000,000 shares of our common stock, of which 1,000,000 shares were purchased during the three months ended October 30, 2004 at an average price of $16.85. In addition, pursuant to authorization by our Board of Directors, we repurchased an aggregate of 2,000,000 shares of our common stock at an average price of $23.41 during the six months ended July 31, 2004. In recent years, we have satisfied our cash requirements principally from cash flows from operations and to a lesser extent proceeds from the exercise of stock options. We also maintain a $5.0 million unsecured credit agreement for the purpose of issuing letters of credit, primarily for inventory purchases. At October 30, 2004, we had $1.0 million of outstanding letters of credit under the credit agreement. Cash flows provided by operating activities were $12.0 million in the first nine months of fiscal 2004 compared to $34.2 million provided by operating activities in the first nine months of fiscal 2003. The decrease of $22.2 million in cash flows from operating activities in the first nine months of 2004 compared to the first nine months of 2003 resulted primarily from a decrease in accounts payable and accrued liabilities ($16.5 million) driven by a decrease in merchandise receipts during October 2004 compared to October 2003, a decrease in the tax benefit from the exercise of stock options ($2.9 million), a decrease in net income ($3.0 million) and changes in prepaid expenses and inventory ($2.8 million), partially offset by an increase in depreciation and amortization ($2.4 million) and an increase in income taxes payable and deferred rent ($0.6 million). Cash flows provided by investing activities were $43.7 million in the first nine months of fiscal 2004 compared to cash flows used in investing activities of $39.1 million in the first nine months of fiscal 2003. The $82.8 million increase in net cash provided by investing activities is due to an increase ($94.1 million) in the proceeds from the sale of short-term investments (net of purchases) partially offset by an increase ($11.3 million) in purchases of property and equipment primarily to support store openings, and for hardware and software systems. Cash flows used in financing activities were $60.2 million in the first nine months of fiscal 2004 compared to cash flows provided by financing activities of $6.0 million in the first nine months of fiscal 2003. The $66.2 million decrease in cash flows from financing activities is principally the result of repurchasing 3,000,000 shares of our common stock for $63.7 million in the first nine months of 2004. We believe our current cash balances and cash generated from operations will be sufficient to fund our operations, planned expansion and any shares to be repurchased as part of the approved stock repurchase described above, through at least the next 12 months. The following table summarizes our contractual obligations as of October 30, 2004, and the timing and effect that such commitments are expected to have on our liquidity and capital requirements in future periods: 16
PAYMENTS DUE BY PERIOD ($ IN THOUSANDS) ---------------------------------------------------------------------------------- CONTRACTUAL OBLIGATIONS TOTAL WITHIN 1 YEAR 2-3 YEARS 4-5 YEARS MORE THAN 5 YEARS ----------------------- ------------- ------------- ----------- ------------ ----------------- OPERATING LEASES $ 341,719 $ 44,416 $ 89,555 $ 81,976 $ 125,772 PURCHASE OBLIGATIONS 67,833 67,833 -- -- -- LETTERS OF CREDIT AND OTHER OBLIGATIONS 1,983 1,983 -- -- -- ------------- ------------- ----------- ------------ ----------------- TOTAL CONTRACTUAL OBLIGATIONS $ 411,535 $ 114,232 $ 89,555 $ 81,976 $ 125,772 ============= ============= =========== ============ =================
CRITICAL ACCOUNTING POLICIES Management's discussion and analysis of Hot Topic, Inc.'s financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities. On an ongoing basis, we evaluate estimates, including those related primarily to inventories, long-lived assets and contingencies. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies affect the more significant judgments and estimates used in the preparation of our consolidated financial statements. For a further discussion about the application of these and other accounting policies, refer to the notes included in our Annual Report on Form 10-K for the year ended January 31, 2004. INVENTORIES: Inventories and related costs 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 basis, utilizing the retail method. Each month, slow moving or seasonally obsolete merchandise is marked down. The first markdown is typically 25% to 50% of the original retail price. Typically, 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 our estimated markdowns at period-end prove to be insufficient, additional future markdowns will need to be recorded. VALUATION OF LONG-LIVED ASSETS: We assess the impairment of long-lived assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. 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. If we were to determine 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, we would measure any impairment based on a projected discounted cash flow method using a discount rate determined by management. To date, we have not recorded any significant 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 we believe recently opened stores will provide sufficient cash flow, material changes in results could result in future impairment charges. 17 REVENUE RECOGNITION: Sales are recognized upon the purchase by customers at our retail store locations and websites, less merchandise returned by customers. We provide 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. Shipping and handling revenues from our websites are included as a component of net sales. SELF-INSURANCE: We are self-insured for medical insurance coverage and workers compensation insurance coverage, up to maximum exposure limits, above which we are covered by insurance policies. We maintain a liability for estimated claims based on historical claims experience and other actuarial assumptions. INCOME TAXES: Current income tax expense is the amount of income taxes expected to be payable for the current year. The combined federal, state and local income tax expense is calculated using estimated effective annual tax rates. A deferred income tax asset or liability is established for the expected future consequences of temporary differences in the financial reporting and tax bases of assets and liabilities. We consider future taxable income and ongoing prudent and feasible tax planning in assessing the value of our deferred tax assets. Evaluating the value of these assets is necessarily based on our judgment. If we were to determine that it is more likely than not that these assets will not be realized, we would reduce the value of these assets to their expected realizable value through a valuation allowance, thereby decreasing net income. If we subsequently were to determine that the deferred tax assets, which had been written down, would be realized in the future, the value of the deferred tax assets would be increased, thereby increasing net income in the period when that determination was made. INFLATION We do not believe that inflation has had a material adverse effect on our net sales or results of operations. We have generally been able to pass along increased costs related to inflation through increases in selling prices. STATEMENT REGARDING FORWARD LOOKING DISCLOSURE This Quarterly Report on Form 10-Q contains various forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, which are subject to the "safe harbor" created by these sections, including statements regarding our expectations, beliefs, intentions or strategies regarding the future. Forward-looking statements include, without limitation, statements regarding the extent and timing of future revenues and expenses and customer demand, expected financial results, the profitability of future sales of our products, new store openings and new store concepts. All forward-looking statements included in this report are based on information available to us as of the date hereof and we assume no obligation to update any forward-looking statements. Forward-looking statements involve known or unknown risks, uncertainties and other factors which may cause our actual results, performance or achievements, or industry results to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Such risks, uncertainties and other factors include but are not limited to the items discussed under the captions "Certain Risks Related to the Our Business" and "Management's Discussion and Analysis of Financial Condition and Results of Operations" in this Item 2. 18 CERTAIN RISKS RELATED TO OUR BUSINESS Before deciding to invest in Hot Topic, Inc. or to maintain or increase an investment in Hot Topic, Inc., readers should carefully consider the risks described below, in addition to the other information contained in our Annual Report on Form 10-K and in other filings with the SEC, including our Quarterly Reports on Form 10-Q and Current Reports on Form 8-K. The risks described below are not the only risks we face. Additional risks that are not presently known to us or that we currently deem immaterial may also affect our business. If any of these known or unknown risks actually occur, our business, financial condition and results of operations could be seriously harmed, and our stock price could decline. OUR AGGRESSIVE GROWTH STRATEGY ANTICIPATES A SIGNIFICANT NUMBER OF NEW STORE OPENINGS WHICH COULD CREATE CHALLENGES WE MAY NOT BE ABLE TO ADEQUATELY MEET. Our 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. We intend to continue to pursue an aggressive growth strategy for the foreseeable future, and our future operating results will depend largely upon our ability to open and operate stores successfully and to profitably manage a larger business. We currently anticipate opening approximately 110 stores, consisting of 65 Hot Topic and 45 Torrid stores, during fiscal 2005, which will result in a significant increase in the number of stores we operate. 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 us in our existing stores and markets. In addition, as the number of stores increases, we may face risks associated with market saturation of our products and concepts. There can be no assurance that our expansion will not adversely affect the individual financial performance of our existing stores or our overall results of operations, or that new stores will achieve sales and profitability levels consistent with existing stores. Further, there can be no assurance that we will successfully achieve our expansion targets or, if achieved, that planned expansion will result in profitable operations. THIS GROWTH STRATEGY REQUIRES EFFECTIVE UPSCALING OF OUR OPERATIONS, AND WE MAY NOT BE ABLE TO DO THIS SUFFICIENTLY TO EFFECTIVELY PREVENT NEGATIVE IMPACT ON OUR OPERATIONS AND FINANCIAL RESULTS. In order to manage our planned expansion, among other things, we will need to locate suitable store sites; negotiate acceptable lease terms; obtain or maintain adequate capital resources on acceptable terms; source sufficient levels of inventory; hire and train store managers and sales associates; integrate new stores into our existing operations; and maintain adequate distribution center space and information technology and other operations systems. We have entered into a lease (with a purchase option) for an additional distribution center facility, which we expect to be operational in the second quarter of fiscal 2005, and we face challenges and risks associated with establishing operations in that facility. We also need to continually evaluate the adequacy of our management information and distribution systems. Implementing new systems and changes made to existing systems could present challenges we do not anticipate and could impact our business (for example, we experienced some delay in product distribution during our second quarter of fiscal 2004 upon implementing our new warehouse management system). There can be no assurance that we will anticipate all of the changing demands that our expanding operations will impose on our business, systems and procedures, and our failure to adapt to such changing demands could have a material adverse effect on our results of operations and financial condition. Our failure to timely implement initiatives necessary to support our expanding operations could also materially impact our business. 19 EXPANDING OUR OPERATIONS TO INCLUDE AN INCREASING NUMBER OF TORRID STORES AND ANY OTHER NEW CONCEPTS PRESENTS RISKS WE HAVE FACED WITH THE HOT TOPIC CONCEPT BUT ALSO NEW RISKS DUE TO DIFFERENCES IN CONCEPT OBJECTIVES AND STRATEGIES. Our ability to expand into new concepts, and in particular our Torrid concept, has not been fully tested. Accordingly, the operation of Torrid stores and the sale of Torrid merchandise over the Internet are subject to numerous risks, including unanticipated operational problems; lack of experience; lack of customer acceptance; new vendor relationships; competition from existing and new retailers; and diversion of management's attention from the Hot Topic concept. The Torrid concept involves implementation of a retail apparel concept which is subject to most of the same risks as the Hot Topic concept, as well as additional risks inherent in a concept that concentrates on apparel and fashion, including risks of difficulty in merchandising, uncertainty of customer acceptance, fluctuations in fashion trends and customer tastes, extreme competition with a less differentiated product offering, and attendant mark-down risks. We may not be able to generate continued customer interest in Torrid stores and products, and the Torrid concept may not be able to support the store or Internet sales formats. Risks inherent in any new concept are particularly acute with respect to Torrid, because this is our first significant new venture, and the nature of the Torrid business differs in certain respects from that of the Hot Topic business. There can be no assurance that the Torrid stores or website will achieve sales and profitability levels that justify our investment. THE SUCCESS OF OUR BUSINESS DEPENDS ON ESTABLISHING AND MAINTAINING GOOD RELATIONSHIPS WITH MALL OPERATORS AND DEVELOPERS, AND PROBLEMS WITH THOSE RELATIONSHIPS COULD MAKE IT MORE DIFFICULT FOR US TO EXPAND TO CERTAIN SITES OR OFFER CERTAIN PRODUCTS. Any restrictions on our ability to expand to new store sites or to offer a broad assortment of merchandise could have a material adverse effect on our business, results of operations and financial condition. If our relations with mall operators or developers become strained, or we otherwise encounter difficulties in leasing store sites, we may not grow as planned and may not reach certain revenue levels and other operating targets. OUR COMPARABLE STORE SALES ARE SUBJECT TO FLUCTUATION RESULTING FROM FACTORS WITHIN AND OUTSIDE OUR CONTROL, AND LOWER THAN EXPECTED COMPARABLE STORE SALES COULD IMPACT OUR BUSINESS AND OUR STOCK PRICE. A variety of factors affects our comparable store sales including, among others, the timing of new music releases and music/pop culture-related products; music and fashion trends; the general retail sales environment and the effect of the overall economic environment; our ability to efficiently source and distribute products; changes in our merchandise mix; and our ability to execute our business strategy efficiently. Our comparable store sales results have fluctuated significantly in the past and we believe that such fluctuations will continue. Our comparable store sales results for fiscal 2000, 2001, 2002 and 2003 were 16.7%, 3.9%, 5.0% and 7.4%, respectively. Our comparable store sales results were 4.0%, (2.1%) and (4.2%) for the first, second and third quarters, respectively, of fiscal 2004; 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 our comparable store sales results will not decrease in the future. Changes in our comparable store sales results could cause our stock price to fluctuate substantially. 20 OUR SUCCESS RELIES ON POPULARITY WITH YOUNG PEOPLE OF MUSIC, POP CULTURE, AND FASHION TRENDS, AND WE MAY NOT BE ABLE TO REACT TO TRENDS IN A WAY TO PREVENT DECLINING POPULARITY AND SALES OF OUR PRODUCTS. Our financial performance is largely dependent upon the continued popularity of alternative and rock music, the Internet, music videos, and MTV and other music television networks among teenagers and college age adults; the emergence of new artists and the success of music releases and music/pop culture-related products; the continuance of a significant level of teenage spending on music/pop culture-licensed and music/pop culture-influenced products; and our ability to anticipate and keep pace with the music, fashion and merchandise preferences of our customers. The popularity of particular types of music, artists, styles, trends and brands is subject to change. Our failure to anticipate, identify and react appropriately to changing trends could lead to, among other things, excess inventories and higher markdowns, which could have a material adverse effect on our results of operations and financial condition, and on our image with customers. There can be no assurance that our new products will be met with the same level of acceptance as in the past or that the failure of any new products will not have an adverse material effect on our business, results of operations and financial condition. ECONOMIC CONDITIONS COULD CHANGE IN WAYS THAT REDUCE OUR SALES OR INCREASE OUR EXPENSES. Certain economic conditions affect the level of consumer spending on merchandise we offer, including, among others, employment levels; salary and wage levels; interest rates; taxation; and consumer confidence in future economic conditions. We are also dependent upon the continued popularity of malls as a shopping destination, the ability of mall anchor tenants and other attractions to generate customer traffic, and the development of new malls. A slowdown in the United States economy 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 our growth, sales results and financial performance. CHANGES IN LAWS, INCLUDING EMPLOYMENT LAWS AND LAWS RELATED TO OUR MERCHANDISE, COULD MAKE CONDUCTING OUR BUSINESS MORE EXPENSIVE OR CHANGE THE WAY WE DO BUSINESS. Aside from increased regulatory compliance requirements, changes in laws could make ordinary conduct of our business more expensive or require us to change the way we do business. For example, changes in federal and state minimum wage laws could raise the wage requirements for certain of our associates, which would likely cause us to reexamine our entire wage structure for stores. Other laws related to employee benefits and treatment of employees could also negatively impact us such as by increasing benefits costs such as medical expenses. Moreover, changes in product safety or other consumer protection laws could lead to increased costs to us for certain merchandise, or additional labor costs associated with readying merchandise for sale. It is often difficult for us to plan and prepare for potential changes to applicable laws. TIMING AND SEASONAL ISSUES COULD NEGATIVELY IMPACT OUR FINANCIAL PERFORMANCE FOR GIVEN PERIODS. Our quarterly results of operations may fluctuate materially depending on, among other things, the timing of store openings and related pre-opening and other startup expenses, net sales contributed by new stores, increases or decreases in comparable store sales, releases of new music and music/pop culture-related products, shifts in timing of certain holidays, changes in our merchandise mix and overall economic and political conditions. 21 Our business is also subject to seasonal influences, with heavier concentrations of sales during the back-to-school, Halloween and Holiday (defined as the week of Thanksgiving through the first few days of January) seasons, and other periods when schools are not in session. The Holiday season has historically been our single most important selling season. We believe that the importance of the summer vacation and back-to-school seasons (which affect operating results in the second and third quarters, 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 our dependence on the Holiday selling season, but this may not always be the case to the same degree. As is the case with many retailers of apparel, accessories and related merchandise, we typically experience lower net sales in the first fiscal quarter relative to other quarters. WE HAVE MANY IMPORTANT VENDOR RELATIONSHIPS, AND OUR ABILITY TO GET MERCHANDISE COULD BE HURT BY CHANGES IN THOSE RELATIONSHIPS AND EVENTS HARMFUL TO OUR VENDORS COULD IMPACT OUR RESULTS OF OPERATION. Our financial performance depends on our ability to purchase desired merchandise in sufficient quantities at competitive prices. Although we have many sources of merchandise, substantially all of our music/pop culture-licensed products are available only from vendors that have exclusive license rights. In addition, certain of our products are supplied by small, specialized vendors, some of which create unique products primarily for us. Our smaller vendors generally have limited resources, production capacities and operating histories, and some of our vendors have restricted the distribution of their merchandise in the past. We generally have no long-term purchase contracts or other contractual assurances of continued supply, pricing or access to new products. There can be no assurance that we will be able to acquire desired merchandise in sufficient quantities on acceptable terms in the future. Any inability to acquire suitable merchandise, or the loss of one or more key vendors, may have a material adverse effect on our business, results of operations and financial condition. TECHNOLOGY AND OTHER RISKS ASSOCIATED WITH OUR INTERNET SALES COULD HINDER OUR OVERALL FINANCIAL PERFORMANCE. We sell merchandise over the Internet through the websites hottopic.com and torrid.com. Our Internet operations are subject to numerous risks and pose risks to our overall business, including, among other things, hiring, retention and training of personnel to conduct the Internet operations; diversion of sales from our stores; rapid technological change and the need to invest in additional computer hardware and software; liability for online content; failure of computer hardware and software, including computer viruses, telecommunication failures, online security breaches and similar disruptions; governmental regulation; and credit card fraud. There can be no assurance that our Internet operations will achieve sales and profitability levels that justify our investment in them. WE HAVE MADE AND PLAN TO CONTINUE TO MAKE SIGNIFICANT CHANGES TO INFORMATION SYSTEMS AND SOFTWARE USED IN OPERATION OF OUR BUSINESS, AND WE MAY NOT BE ABLE TO EFFECTIVELY ADOPT CHANGES IN A WAY TO PREVENT FAILURES IN OUR OPERATIONS OR NEGATIVE IMPACT ON OUR FINANCIAL PERFORMANCE AND REPORTING. Over the past several years, we have made improvements to existing hardware and software systems, as well as implemented new systems. For example, we have invested approximately $6 million to enhance the functionality of our current GERS Retail Systems software and to implement new financial system software from Lawson. In addition, we are investing approximately $9 million in the implementation of a new warehouse management software system, a new Internet order management software system, and a new customer loyalty software system. We expect to begin relying heavily on these systems in fiscal 2004 and 2005. If these information systems and software do not work effectively, we may experience delays or failures in our operations. These delays or failures could adversely impact the promptness and accuracy of our merchandise distribution, transaction processing, financial accounting and reporting and ability to properly forecast earnings and cash requirements. For example, in the second quarter of 2004, we experienced some delay in product distribution upon implementation of our new warehouse management system. To manage growth of our operations and personnel, we may need to continue to improve our operational and financial systems, transaction processing, and procedures and controls, and in doing so, we could incur substantial additional expenses. 22 LOSS OF KEY PEOPLE OR AN INABILITY TO HIRE NECESSARY AND SIGNIFICANT PERSONNEL COULD HURT OUR BUSINESS. Our financial performance depends largely on the efforts and abilities of senior management, especially Elizabeth McLaughlin, our Chief Executive Officer, who has been with us since 1993. We have 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 our management team could have a material adverse effect on our business, results of operations and financial condition. Furthermore, there can be no assurance that Ms. McLaughlin and our existing management team will be able to manage Hot Topic, Inc. or our growth or that we will be able to attract and retain additional qualified personnel as needed in the future. OUR RELIANCE ON UNITED PARCEL SERVICE, TEMPORARY EMPLOYEES AND OTHER MECHANICS OF SHIPPING OF OUR MERCHANDISE CREATES DISTRIBUTION RISKS AND UNCERTAINTIES THAT COULD HURT OUR SALES AND BUSINESS. We rely upon United Parcel Service for our product shipments, including shipments to and from a significant number of our stores. Our reliance on this source for shipments is subject to risks, including employee strikes and inclement weather, associated with United Parcel Service's ability to provide delivery services that adequately meet our shipping needs. We are also dependent upon temporary associates to adequately staff our distribution facility, particularly during busy periods such as the Holiday season and while multiple stores are opening. There can be no assurance that we will continue to receive adequate assistance from our temporary associates, or that there will continue to be sufficient sources of temporary associates. Additionally, certain products are imported and subject to delivery delays based on ship availability and port capacity. THERE IS A RISK WE COULD ACQUIRE MERCHANDISE WITHOUT FULL RIGHTS TO SELL IT, WHICH COULD LEAD TO DISPUTES OR LITIGATION AND HURT OUR FINANCIAL PERFORMANCE AND STOCK PRICE. We purchase licensed merchandise from a number of suppliers who hold manufacturing and distribution rights under the terms of certain licenses. We generally rely upon vendors' representations concerning manufacturing and distribution rights and do not independently verify whether these vendors legally hold adequate rights to licensed properties they are manufacturing or distributing. If we acquire unlicensed merchandise, we could be obligated to remove such merchandise from our stores, incur costs associated with destruction of merchandise if the distributor is unwilling or unable to reimburse us, and be subject to liability under various civil and criminal causes of action, including actions to recover unpaid royalties and other damages. Any of these results could have a material adverse effect on our business, results of operations and financial condition. 23 WE FACE INTENSE COMPETITION, AND AN INABILITY TO ADEQUATELY ADDRESS IT, OR THE SUCCESS OF OUR COMPETITORS, COULD LIMIT OR PREVENT OUR BUSINESS GROWTH AND SUCCESS. The retail apparel and accessory industry is highly competitive. We compete with other retailers for vendors, teenage and young adult customers, suitable store locations and qualified associates and management personnel. 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, Charlotte Russe Inc., Claire's Stores, Inc., Forever 21, Pacific Sunwear of California, Inc., Spencer Gifts, Inc., H&M, The Buckle, The Wet Seal, Inc., and 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., Old Navy (a division of Gap Inc.), 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 our competitors are larger and may have greater financial, marketing and other resources. Direct competition with these and other retailers may increase significantly in the future, which could require us, among other things, to lower our prices. Increased competition could have a material adverse effect on our business, results of operations and financial condition. WAR, TERRORISM AND OTHER CATASTROPHES COULD NEGATIVELY IMPACT OUR CUSTOMERS, PLACES WHERE WE DO BUSINESS, AND OUR EXPENSES, ALL OF WHICH COULD HURT OUR BUSINESS. The effects of war or acts of terrorism could have a material adverse effect on our business, operating results and financial condition. The 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, our 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. Our principal executive offices, distribution center and a significant number of our stores are located in California. If we experience a sustained disruption in energy supplies, or if electricity and gas costs in California fluctuate dramatically, our results of operations could be materially and adversely affected. California is also subject to natural disasters such as earthquakes and floods. A significant natural disaster or other catastrophic event affecting our facilities could have a material adverse impact on our business, financial condition and operating results. THERE ARE NUMEROUS RISKS THAT COULD CAUSE OUR STOCK PRICE TO FLUCTUATE SUBSTANTIALLY. Our common stock is quoted on the Nasdaq National Market, which has experienced and is likely to experience in the future significant price and volume fluctuations, which could adversely affect our stock price without regard to our financial performance. In addition, we believe that factors such as quarterly fluctuations in our financial results and comparable store sales; announcements by other apparel, accessory and gift item retailers; the trading volume of our stock; changes in estimates of our performance by securities analysts; overall economic and political conditions; the condition of the financial markets; and other events or factors outside of our control could cause our stock price to fluctuate substantially. 24 OUR CHARTER DOCUMENTS AND OTHER CIRCUMSTANCES COULD PREVENT A TAKEOVER OR CAUSE DILUTION OF OUR EXISTING SHAREHOLDERS, WHICH COULD BE DETRIMENTAL TO EXISTING SHAREHOLDERS AND HINDER BUSINESS SUCCESS. Our Articles of Incorporation and Bylaws contain provisions that may have the effect of delaying, deterring or preventing a takeover of Hot Topic, Inc. For instance, our Articles of Incorporation include certain "fair price provisions" generally prohibiting business combinations with controlling or significant shareholders unless certain minimum price or procedural requirements are satisfied, and our Bylaws prohibit shareholder action by written consent. Additionally, our Board 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 certain shareholders, and potentially prohibit a takeover of Hot Topic, Inc. by requiring the preferred shareholders to approve such a transaction. We also have a significant number of authorized and unissued shares of our common stock available under our Articles of Incorporation. These shares provide us with the flexibility to issue our common stock for future business and financial purposes including stock splits, raising capital and providing equity incentives to employees, officers and directors. However, the issuance of these shares could result in dilution to our shareholders. WE INCUR COSTS ASSOCIATED WITH REGULATORY COMPLIANCE, AND THIS COST COULD BE SIGNIFICANT. All companies are subject to laws and regulations, some of which require certain actions to be taken (or not taken) and costs to be incurred relating to business processes and risk management. There are additional requirements for public companies, including the provisions of the Sarbanes-Oxley Act of 2002. With regard to the Sarbanes-Oxley Act, we have and will continue to incur significant expense as we evaluate the implications of new rules and our operations relative thereto, and as we work to respond to and comply with new requirements. Among other things, we have incurred and will incur additional expenses as we implement Section 404 of the Sarbanes Oxley Act. Section 404 requires management to report on, and our independent auditors to attest to, our internal controls. Compliance with these new rules could also result in continued diversion of management's time and attention, which could be disruptive to normal business operations. We are currently performing testing and taking other actions required to ensure compliance with the management certification and auditor attestation requirements under Section 404. We have retained expert consultants to help us in this process, and are working with our auditors as appropriate. We cannot be certain as to the timing of completion of our evaluation and related actions, or the impact of any of them on our operations. If we do not satisfactorily or timely complete these steps, possible consequences could include sanction or investigation by regulatory authorities such as the Securities and Exchange Commission or The Nasdaq National Market, incomplete or late filing of our annual report on Form 10-K, civil or criminal liability; and our stock price and business could also be adversely affected. THERE ARE LITIGATION AND OTHER CLAIMS AGAINST US FROM TIME TO TIME, WHICH COULD DISTRACT MANAGEMENT FROM OUR BUSINESS ACTIVITIES, AND COULD LEAD TO ADVERSE CONSEQUENCES TO OUR BUSINESS AND FINANCIAL CONDITION. As a growing company with expanding operations, we are increasingly involved from time to time with litigation and other claims against us. These arise primarily in the ordinary course of our business, and include employee claims, commercial disputes, intellectual property issues and product-oriented allegations. Often these cases raise complex factual and legal issues, which are subject to risks and uncertainties and which could require significant management time. Although we do not currently believe that the outcome of any current litigation and claims against us will have a material adverse effect on us, adverse settlements or resolutions may occur and negatively impact earnings, injunctions against us could have an adverse effect on our business by requiring us to do or prohibiting us from doing certain things, and other unexpected events could have a negative impact on us. 25 THERE ARE PENDING ACCOUNTING REGULATION CHANGES THAT MAY REQUIRE THE EXPENSING OF STOCK OPTIONS. The FASB currently expects to issue a final standard regarding equity-based compensation in the fourth quarter of 2004. The FASB's existing exposure draft proposes that all publicly traded companies begin recording compensation expense related to all unvested and newly granted stock options prospectively for interim or annual periods beginning after June 15, 2005. Currently, we include such expenses on a pro forma basis in the notes to our quarterly and annual financial statements in accordance with accounting principles generally accepted in the United States of America and do not include compensation expense related to stock options in our reported earnings in the financial statements. If accounting standards are changed to require us to expense stock options, our reported earnings would be lower under the new standard in the fiscal year beginning January 30, 2005 and our stock price could decline. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We are not a party to any derivative financial instruments. Our exposure to market risk primarily relates to changes in interest rates on our investments with maturities of less than three months (which are considered to be cash and cash equivalents) and short-term investments with maturities in excess of three months. Changes in interest rates affect the investment income earned on those investments. ITEM 4. CONTROLS AND PROCEDURES (a) Evaluation of Disclosure Controls and Procedures Based on our evaluation of our disclosure controls and procedures conducted prior to the date of filing this report on Form 10-Q, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934) are effective as of the end of the period covered by this report. (b) Changes in Internal Controls There were no changes in our internal controls over financial reporting that occurred during the period covered by this report, that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting. 26 PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS On June 23, 2004, a non-profit corporation named Center for Environmental Health filed a lawsuit in Federal district court in Alameda, California against over two dozen retailers, large and small, including Hot Topic, Inc. Other defendants include teen retailers like Claire's and Wet Seal, department stores like Sears, Nordstrom, Macy's and J.C. Penney, and large retailers like Wal-Mart and Target. Certain of the defendants, but not Hot Topic, were also named defendants in a substantially similar lawsuit filed by the State of California. The complaint in each case alleges, in general, that the defendant retailers have violated certain California statutes by not providing sufficient warning about an alleged potential for lead exposure relating to costume jewelry sold in stores. The complaints do not contain allegations of personal injury. In August 2004, we were served another complaint, filed in the Circuit Court of Shelby County, Tennessee, claiming we are liable due to alleged lead content in our costume jewelry. This complaint is an alleged class action, with counts of negligence and breach of implied warranty. Similar claims had been made, prior to service upon us, against other retailers in the same jurisdiction by plaintiffs represented by the same law firm. Currently, proceedings in this Tennessee case against us are on hold, pending events and potential resolution relating to the previously existing similar lawsuits against other retailers. The plaintiffs in the above California cases seek unspecified fines and penalties, attorneys' fees and costs, and injunctive and other equitable relief; and the plaintiff in the Tennessee case seeks unspecified money damages on behalf of the alleged class. We continue investigating appropriate action in each of these cases with our counsel. In each case, we believe we have meritorious defenses to the plaintiff's claims and intend to defend against such claims; though it is impossible to predict the outcome of the proceeding, and it is possible the plaintiff will be awarded requested remedies or that we may determine it appropriate to settle the lawsuit which could require us to take or not take certain actions. On September 17, 2004, a former Torrid employee filed a lawsuit against us in Superior Court of Los Angeles County, on behalf of a purported class. The lawsuit asserts claims for failure to provide adequate meal or rest breaks, improper payment of overtime wages, failure to timely pay wages at end of employment and unfair business practices. The lawsuit seeks compensatory damages, statutory penalties, punitive damages, attorneys' fees and injunctive relief. On October 21, 2004, we filed an answer denying the material allegations of the complaint. Discovery has not yet been conducted, and at the present time, we are unable to predict the outcome of this matter. Though significant litigation or awards against us could seriously harm our business and financial results, we do not at this time expect any of the above-described litigation to have a material adverse effect on us. 27 ITEM 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES
Issuer Purchases of Equity Securities ------------------------------------------------------------------------------------------------------------------- TOTAL NUMBER OF MAXIMUM NUMBER OF SHARES PURCHASED AS SHARES THAT MAY YET PART OF PUBLICLY BE PURCHASED UNDER TOTAL NUMBER OF AVERAGE PRICE PAID ANNOUNCED PLANS OR THE PLANS OR FISCAL PERIOD SHARES PURCHASED PER SHARE PROGRAMS (1) PROGRAMS ---------------- ---------------- ------------------ ------------------- ------------------- August 29, 2004 - October 2, 2004 1,000,000 $16.85 1,000,000 1,000,000 ---------------- ------------------ ------------------- ------------------- Total 1,000,000 $16.85 1,000,000 1,000,000 ================ ================== =================== ===================
(1) On August 18, 2004, we announced that our Board of Directors approved a stock repurchase program, authorizing repurchase of up to 2,000,000 shares of our common stock. We are authorized to make repurchases from time to time in the open market pursuant to existing rules and regulations and other parameters set by the Board. The purchases disclosed in the table above were completed in the quarter ended October 30, 2004. We intend to remain active with our share repurchase program should the right market conditions exist. ITEMS 3, 4 & 5 ARE NOT APPLICABLE. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K. (a) Exhibits: Exhibit Number Description of Document ------- ----------------------- 3.1 Amended and Restated Articles of Incorporation. (1) 3.2 Amended and Restated Bylaws. (2) 4.1 Reference is made to Exhibits 3.1 and 3.2. 4.2 Specimen stock certificate. (1) 10.1 Centre Pointe Distribution Park Lease, dated June 1, 2004, by and among Crescent Resources, LLC and Hot Topic, Inc. (3) 10.2a Employment Offer Letter dated May 13, 2004, between the Registrant and Thomas Beauchamp. (3) 31.1 Certification, dated November 24, 2004, of Registrant's Chief Executive Officer required by Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certification, dated November 24, 2004, of Registrant's Chief Financial Officer required by Section 302 of the Sarbanes-Oxley Act of 2002. 32.1 Certifications, dated November 24, 2004, of Registrant's Chief Executive Officer and Chief Financial Officer required by Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C section 1350, as adopted). 28 (1) Filed as an exhibit to Registrant's Registration Statement on Form SB - 2 (No. 333-5054-LA) and incorporated herein by reference. (2) Filed as an exhibit to Registrant's Annual Report on Form 10-K for the year ended February 3, 2001 and incorporated herein by reference. (3) Filed as an exhibit to Registrant's Quarterly Report on Form 10Q for the quarterly period ended July 31, 2004 and incorporated herein by reference. a. Denotes management contract or compensatory plan or arrangement. (b) Reports on Form 8-K On August 4, 2004, we filed a report on Form 8-K furnishing, under Item 12, information related to our sales for the second quarter of fiscal 2004 (quarter ended July 31, 2004). On August 18, 2004, we filed a report on Form 8-K furnishing, under Item 12, information related to our overall financial results for the second quarter of fiscal 2004. 29 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. HOT TOPIC, INC. (Registrant) Date: November 24, 2004 /s/ Elizabeth McLaughlin ------------------------ Elizabeth McLaughlin Chief Executive Officer (Principal Executive Officer) Date: November 24, 2004 /s/ James McGinty ----------------- James McGinty Chief Financial Officer (Principal Financial Officer) 30 EXHIBIT INDEX Exhibit No. Document ----------- -------------------------------------------------------------- 31.1 Certification, dated November 24, 2004, of Registrant's Chief Executive Officer required by Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certification, dated November 24, 2004, of Registrant's Chief Financial Officer required by Section 302 of the Sarbanes-Oxley Act of 2002. 32.1 Certifications, dated November 24, 2004, of Registrant's Chief Executive Officer and Chief Financial Officer required by Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C Section 1350, as adopted). 31