FORM 10-Q

10-Q 1 d10q.htm FORM 10-Q FORM 10-Q

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 28, 2006

¨	TRANSITION REPORT PURSUANT TO SECTION 13 OR l5(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

Commission file number: 0-28784

HOT TOPIC, INC.

(Exact name of registrant as specified in its charter)


CALIFORNIA		77-0198182
(State of incorporation)		(IRS Employer Identification No.)

18305 EAST SAN JOSE AVE., CITY OF INDUSTRY, CA		91748
(Address of principal executive offices)		(Zip Code)

(626) 839-4681

(Registrant’s telephone number, including area code)

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non- accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large Accelerated Filer x Accelerated Filer ¨ Non-Accelerated Filer ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x

APPLICABLE ONLY TO CORPORATE ISSUERS: Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: November 20, 2006 – 44,198,357 shares of common stock, no par value.

HOT TOPIC, INC.

INDEX TO FORM 10-Q


		Page No.
PART I. FINANCIAL INFORMATION

Item 1.	Condensed Consolidated Financial Statements

Condensed Consolidated Balance Sheets – October 28, 2006 and January 28, 2006		3

Condensed Consolidated Statements of Operations for the three months and nine months ended October 28, 2006 and October 29, 2005		4

Condensed Consolidated Statements of Cash Flows for the nine months ended October 28, 2006 and October 29, 2005		5

Notes to Condensed Consolidated Financial Statements		6-15

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	16-26

Item 3.	Quantitative and Qualitative Disclosures about Market Risk	27

Item 4.	Controls and Procedures	27

PART II. OTHER INFORMATION

Item 1.	Legal Proceedings	28

Item 1A.	Risk Factors	28

Item 6.	Exhibits and Reports on Form 8-K	37

SIGNATURES		38

PART I. FINANCIAL INFORMATION

Item 1. Condensed Consolidated Financial Statements

Hot Topic, Inc. and Subsidiaries

Condensed Consolidated Balance Sheets

(In thousands, except share amounts)

(Unaudited)


	October 28, 2006			January 28, 2006
Assets
Current assets:
Cash and cash equivalents	$	18,985		$	9,673
Short-term investments		18,719			28,001
Inventory		102,030			71,160
Prepaid expenses and other		7,007			16,781
Deferred tax assets		2,725			2,487

Total current assets		149,466			128,102

Property and equipment, net		173,457			171,089
Deposits and other		387			244

Total assets	$	323,310		$	299,435

Liabilities and shareholders’ equity
Current liabilities:
Accounts payable	$	33,027		$	18,122
Accrued liabilities		34,962			33,569
Income taxes payable		1,870			5,788

Total current liabilities		69,859			57,479

Deferred rent		41,411			39,941
Deferred tax liability		175			954
Deferred compensation liability		139			—

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;
44,194,857 and 43,976,536 shares issued and outstanding at October 28, 2006 and January 28, 2006, respectively		106,228			100,328
Retained earnings		105,505			100,746
Accumulated other comprehensive loss		(7	)		(13	)

Total shareholders’ equity		211,726			201,061

Total liabilities and shareholders’ equity	$	323,310		$	299,435

See notes to condensed consolidated financial statements.

Hot Topic, Inc. and Subsidiaries

Condensed Consolidated Statements of Operations

(In thousands)

(Unaudited)


	Three Months Ended				Nine Months Ended
	October 28, 2006		October 29, 2005		October 28, 2006		October 29, 2005
Net sales	$	196,669	$	192,747	$	511,058	$	494,743
Cost of goods sold, including buying, distribution and occupancy costs		128,271		129,271		343,566		332,479

Gross margin		68,398		63,476		167,492		162,264

Selling, general and administrative expenses		56,904		54,043		160,388		143,942

Income from operations		11,494		9,433		7,104		18,322

Interest income, net		277		180		919		840

Income before income taxes		11,771		9,613		8,023		19,162

Provision for income taxes		4,701		3,682		3,265		7,339

Net income	$	7,070	$	5,931	$	4,758	$	11,823

Earnings per share:
Basic	$	0.16	$	0.13	$	0.11	$	0.26

Diluted	$	0.16	$	0.13	$	0.11	$	0.26

Shares used in computing earnings per share:
Basic		44,207		45,108		44,150		44,978
Diluted		44,735		45,738		44,744		46,064

See notes to condensed consolidated financial statements.

Hot Topic, Inc. and Subsidiaries

Condensed Consolidated Statements of Cash Flows

(In thousands)

(Unaudited)


	Nine Months Ended
	October 28, 2006			October 29, 2005
OPERATING ACTIVITIES
Net income	$	4,758		$	11,823
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		28,398			23,526
Stock-based compensation		3,685			116
Tax benefit from exercise of stock options		—			2,822
Loss on disposal of fixed assets		271			264
Impairment of long-lived assets		562			—
Deferred taxes		(1,017	)		(82	)
Gift card breakage		(432	)		—
Changes in operating assets and liabilities:
Inventory		(30,870	)		(35,923	)
Prepaid expenses and other current assets		9,530			(6,868	)
Deposits and other assets		(4	)		(5	)
Accounts payable		14,905			11,267
Accrued liabilities		2,125			7,814
Deferred rent		1,470			8,397
Income taxes payable		(3,918	)		(8,887	)

Net cash provided by operating activities		29,463			14,264

INVESTING ACTIVITIES
Purchases of property and equipment		(31,522	)		(61,101	)
Proceeds from sale of short-term investments		48,165			101,573
Purchases of short-term investments		(38,876	)		(54,400	)

Net cash used in investing activities		(22,233	)		(13,928	)

FINANCING ACTIVITIES
Payments on capital lease obligations		(262	)		—
Excess tax benefit from stock-based compensation		168			—
Proceeds from employee stock purchases and exercise of stock options		2,176			6,722
Repurchase of common stock		—			(6,392	)

Net cash provided by financing activities		2,082			330

Decrease in cash and cash equivalents		9,312			666
Cash and cash equivalents at beginning of year		9,673			5,248

Cash and cash equivalents at end of period	$	18,985		$	5,914

SUPPLEMENTAL INFORMATION
Cash paid during the period for interest	$	13		$	29

Cash paid during the period for income taxes	$	8,904		$	13,775

See notes to condensed consolidated financial statements.

HOT TOPIC, INC. and SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 1. Organization and Basis of Presentation

We are a mall-based specialty retailer operating the Hot Topic and Torrid concepts. Hot Topic stores sell a selection of music/pop culture-licensed and music/pop culture-influenced apparel, accessories and gift items for young men and women principally between the ages of 12 and 22. Torrid stores sell apparel, lingerie, shoes and accessories designed for various lifestyles for plus-size females between the ages of 15 and 29. We were incorporated in California in 1988. We opened our first Hot Topic store in 1989 and our first Torrid store in 2001. At the end of the third quarter of fiscal 2006 (October 28, 2006 in the 53-week fiscal year ending February 3, 2007), we operated 693 Hot Topic stores throughout the United States and Puerto Rico and 129 Torrid stores. We also sell merchandise on two websites, www.hottopic.com and www.torrid.com, which reflect the Hot Topic and Torrid store concepts and carry 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 28, 2006 Consolidated Balance Sheet. These statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information, the instructions to Form 10-Q, and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements.

In the opinion of management, all adjustments, consisting only of normal recurring entries, necessary for a fair presentation have been included. The results of operations for the nine months ended October 28, 2006 are not necessarily indicative of the results that may be expected for the year ending February 3, 2007.

NOTE 2. Stock-Based Compensation

Stock Plan Activity

Under our 1996 Equity Incentive Plan, we granted stock options, stock bonuses, and other awards to our employees, directors, and consultants as deemed appropriate by the Board of Directors (the “Board”). On June 14, 2006, the 1996 Equity Incentive Plan expired and was replaced with the 2006 Equity Incentive Plan (the “2006 Plan”). The 2006 Plan was approved by the Board on March 17, 2006 and by our shareholders on June 13, 2006. Upon expiration of the 1996 Equity Incentive Plan, 1,268,265 shares out of an aggregate of 18,300,000 shares of common stock that were available for grant remained unissued.

The 2006 Plan provides for the grant of incentive stock options, non-statutory stock options, restricted stock awards, restricted stock unit awards, stock appreciation rights, performance stock awards and other forms of equity compensation to our employees, consultants and directors as deemed appropriate by the Board. Both incentive and non-statutory stock options granted by us under the 2006 Plan must carry an exercise price of at least 100% of the fair market value of the stock on the date of grant. Options granted may be subject to different vesting terms as determined by the Board and the

maximum term of options granted is 10 years. In addition, the maximum number of shares of common stock available for future issuance may not exceed the sum of (a) the number of unallocated shares of common stock remaining available for issuance under the 1996 Incentive plan as of June 13, 2006, (b) an additional 2,350,000 shares and (c) the number of shares subject to stock awards as of June 13, 2006 under the 1996 Incentive Plan pursuant to the terms of the 1996 Incentive Plan. As of October 28, 2006, 3,241,863 shares were available for future grants. All awards to date under the 2006 Plan have been granted to employees of the company and none have been granted to consultants.

In March 2006, we granted restricted stock “unit” awards under the 1996 Equity Incentive Plan to certain members of our management. None of these awards have vested and no shares have been issued pursuant to the grants. These awards provide for the issuance of up to 474,000 shares of our common stock, with vesting and issuance contingent upon achieving performance goals for fiscal 2008 based upon operating income for the company for that fiscal year; and prior to vesting (or termination without vesting), the “units” will constitute an agreement by us to issue shares to the extent performance goals are ultimately met. The market value of our common stock as of the grant date of these restricted stock “unit” awards was $13.90. Compensation expense for these awards will be recorded over the three-year term of the award, based on the market value as of the grant date, with actual amounts expensed dependent upon the likelihood from period to period of vesting of such awards at the end of fiscal 2008. As of October 28, 2006, it is our best estimate that 25% of these awards, or 118,500 out of a possible 474,000, will be earned and vest at the end of the three-year term. This new estimate is 50% of our previous best estimate in the first and second quarters of fiscal 2006. We have accounted for the change in estimate by applying the change retroactively and recognizing the cumulative effect, a $137,000 offset to compensation expense, in the third quarter. In aggregate, we have recognized $412,000 as compensation expense during the nine months ended October 28, 2006 for these restricted stock unit awards.

Under our 1996 Non-Employee Directors’ Stock Option Plan, we may grant and have granted stock options and other awards to non-employee directors. The exercise price of options granted under this plan shall be determined by the Board at the date of grant and shall not be lower than (i) 100% of the fair market value of our common stock on the date of grant for incentive stock options, (ii) 85% of the fair market value of our common stock on the date of grant for non-statutory stock options, and (iii) 110% of the fair market value of our common stock on the date of grant for persons possessing 10% or more of the total combined voting power of all classes of stock. Unless the Board declares otherwise, options vest over four years and generally expire ten years from the date of grant. An aggregate of 720,000 shares of common stock may be issued pursuant to this plan. As of October 28, 2006, 23,264 shares were available for future grants. No options under this plan have been granted to consultants.

In June 2006, we granted 11,842 shares of restricted common stock to non-employee directors under the 1996 Equity Incentive Plan, and we made additional restricted stock grants to non-employee directors in fiscal 2005 and 2004. Restricted shares generally vest in the year subsequent to the grant year. All awarded common shares remain restricted (i.e., not transferable by the holders) until such time as the recipient is no longer a member of our Board of Directors. The value of these grants is expensed over the vesting period. During the nine months ended October 28, 2006, $116,000, of which $52,000 relates to fiscal 2005 grants, has been expensed. During fiscal 2005, non-employee directors were granted 7,496 shares of restricted stock and $155,000, of which $52,000 related to fiscal 2004 grants, was expensed.

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 our employees. All eligible employees are granted identical rights to purchase common stock for each Board authorized offering under the Stock Purchase Plan. Rights granted pursuant to any offering

under the Stock Purchase Plan terminate immediately upon cessation of an employee’s employment for any reason. In general, an employee may reduce contribution or withdraw from participation in an offering at any time during the purchase period for such offering. Employees receive a 15% discount on shares purchased under the Stock Purchase Plan. Rights granted under the Stock Purchase Plan are not transferable and may be exercised only by the person to whom such rights are granted. The initial offering under the Stock Purchase Plan commenced October 24, 1996 and terminated December 31, 1996. Subsequent offerings occur every six months commencing January 1, 1997. At October 28, 2006, 1,107,792 shares could still be sold to employees under the plan. Compensation expense for the three months and nine months ended October 28, 2006 was $45,000 and $154,000, respectively, to account for the fair value of the rights granted to participants under the plan at the beginning of the then-current offering.

The following table summarizes stock options outstanding as of October 28, 2006, as well as activity through the third quarter then ended:


	Shares		Weighted- Average Exercise Price		Weighted- Average Remaining Contractual Term (in years)	Aggregate Intrinsic Value
Outstanding at January 28, 2006	5,755,313		$	16.27

Granted	990,296		$	13.67
Exercised	(181,223	)	$	9.80
Forfeited or expired	(658,816	)	$	20.11

Outstanding at October 28, 2006	5,905,570		$	15.59	6.70	$	12,366,498

Exercisable at October 28, 2006	4,643,802		$	16.03	6.06	$	11,101,110

The weighted average fair value of stock options estimated on the date of each grant during the three months and nine months ended October 28, 2006 and October 29, 2005 is provided in the following table:


	Three Months Ended				Nine Months Ended
	October 28, 2006		October 29, 2005		October 28, 2006		October 29, 2005
Weighted average fair value at grant date	$	5.14	$	6.11	$	6.17	$	8.06

Cash proceeds, tax benefits and intrinsic value related to total stock options exercised during the three months and nine months ended October 28, 2006 and October 29, 2005 are provided in the following table (in thousands):


	Three Months Ended				Nine Months Ended
	October 28, 2006		October 29, 2005		October 28, 2006		October 29, 2005
Proceeds from stock options exercised	$	6	$	254	$	1,776	$	5,788
Tax benefit related to stock options exercised	$	0	$	222	$	168	$	2,822
Intrinsic value of stock options exercised	$	1	$	593	$	439	$	7,537

Accounting for Stock-Based Compensation Expense

Effective January 29, 2006, we adopted Statement of Financial Accounting Standards (“SFAS”) No. 123R, “Share-Based Payments,” (“SFAS 123R”), which addresses the accounting for stock-based payment transactions whereby an entity receives employee services in exchange for equity instruments, including stock options. SFAS 123R eliminates the ability to account for stock-based compensation transactions using the intrinsic value method under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” (“APB 25”) and instead generally requires that such transactions be accounted for using a fair value based method. We have elected the modified prospective transition method as permitted under SFAS 123R, and accordingly prior periods have not been restated to reflect the impact of SFAS 123R. The modified prospective transition method requires that stock-based compensation expense be recorded for all new and unvested stock options that are ultimately expected to vest as the requisite service is rendered beginning on January 29, 2006. Stock-based compensation for awards granted prior to January 29, 2006 is based upon the grant-date fair value of such compensation as determined under the pro forma provisions of SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”).

Prior to fiscal 2006, we determined stock based compensation expense using the intrinsic value method of APB 25 and we provided the disclosures required by SFAS 123, as amended by SFAS No. 148 “Accounting for Stock-Based Compensation – Transition and Disclosure.” The following table provides the pro forma effects on our net income and earnings per share for the three months and nine months ended October 29, 2005 as if the fair value recognition provisions of SFAS 123R had been applied (in thousands, except per share amounts):


	Three Months Ended October 29, 2005			Nine Months Ended October 29, 2005
Net income
As reported	$	5,931		$	11,823
Add: Stock-based compensation expense included in reported net income, net of related tax effects		24			72
Deduct: Total stock-based compensation expense determined under fair value method for all awards, net of related tax effects		(1,137	)		(3,435	)

Net income	$	4,818		$	8,460

Basic earnings per share:
As reported	$	0.13		$	0.26
Pro forma	$	0.11		$	0.19
Diluted earnings per share:
As reported	$	0.13		$	0.26
Pro forma	$	0.11		$	0.18

The effect of recording stock-based compensation for the three months and nine months ended October 28, 2006 was as follows:


	Three Months Ended October 28, 2006			Nine Months Ended October 28, 2006
Stock-based compensation by type of award:
Employee stock options and awards	$	1,041,582		$	3,119,169
Restricted stock units		(137,263	)		411,787
Employee stock purchase plan		44,591			153,744

Total stock-based compensation expense	$	948,910		$	3,684,700
Tax effect on stock-based compensation expense		(275,508	)		(1,052,710	)

Net effect on net income	$	673,402		$	2,631,990

Effect on earnings per share:
Basic and diluted	$	(0.02	)	$	(0.06	)

In the three months ended October 28, 2006 and October 29, 2005, we recognized stock and equity awards compensation costs of $949,000 and $39,000, respectively. For the three month period ended October 28, 2006, $172,000 was recorded as a component of cost of goods sold and the remainder was charged to selling, general and administrative expense. In the nine months ended October 28, 2006 and October 29, 2005, we recognized stock and equity awards compensation costs of $3.7 million and $116,000, respectively. For the nine month period ended October 28, 2006, $540,000 was recorded as a component of cost of goods sold and the remainder was charged to selling, general and administrative expense. The entire amount was charged to selling, general and administrative expense in the three months and nine months ended October 29, 2005.

The application of SFAS 123R did not impact our cash position, but resulted in a change in presentation on our consolidated statements of cash flows. Previously, the tax benefit from the exercise of stock options was recorded as a component of operating activities. Subsequent to the adoption of SFAS 123R it is recorded as a component of cash flows from financing activities in the consolidated statements of cash flows.

The incremental stock-based compensation expense resulting from the adoption of SFAS 123R includes expense related to stock options granted prior to, but not yet vested as of January 29, 2006. As of October 28, 2006, we had $7.0 million of unrecognized expense related to non-vested stock-based compensation, which is expected to be recognized over a weighted average period of 3.06 years.

Calculation of Fair Value of Options

We use a Black-Scholes option valuation model to determine the fair value of stock-based compensation under SFAS 123R, consistent with that used by us previously for pro forma disclosures under SFAS 123. The Black-Scholes model incorporates various assumptions including the expected term of awards, volatility of stock price, risk-free rates of return and dividend yield. The expected term of an

award is generally no less than the option vesting period and is based on our historical experience. Expected volatility is based upon the historical volatility of our stock price. The risk-free interest rate is approximated using rates available on U.S. Treasury securities with a remaining term equal to the option’s expected life. We use a dividend yield of zero in the Black-Scholes option valuation model, as we do not anticipate paying cash dividends in the foreseeable future.

The following weighted average assumptions were used for stock options granted during the three months and nine months ended October 28, 2006 and October 29, 2005:


	Three Months Ended				Nine Months Ended
	October 28, 2006		October 29, 2005		October 28, 2006		October 29, 2005
Risk free interest rate	5.00	%	5.00	%	5.00	%	5.00	%
Expected life	5.0 years		5.0 years		5.0 years		5.0 years
Expected volatility	47	%	39	%	48	%	36	%
Expected dividend yield	0.00	%	0.00	%	0.00	%	0.00	%

NOTE 3. Earnings Per Share

We compute earnings per share pursuant to SFAS No. 128 “Earnings Per Share.” Basic earnings per share is computed based on the weighted average number of common shares outstanding for the period. Diluted earnings per share is computed based on the weighted average number of common shares outstanding for the period and potentially dilutive common stock equivalents outstanding for the period.

A reconciliation of the numerator and denominator of basic earnings per share and diluted earnings per share is as follows (in thousands, except per share amounts):


	Three Months Ended				Nine Months Ended
	October 28, 2006		October 29, 2005		October 28, 2006		October 29, 2005
Basic earnings computation:
Numerator	$	7,070	$	5,931	$	4,758	$	11,823

Denominator:
Weighted average common shares outstanding:		44,207		45,108		44,150		44,978
Incremental shares from assumed conversion of options		529		630		594		1,086

Total shares		44,735		45,738		44,744		46,064

Basic earnings per share	$	0.16	$	0.13	$	0.11	$	0.26
Diluted earnings per share	$	0.16	$	0.13	$	0.11	$	0.26

The calculation of dilutive shares excludes the effect of the following options that are considered anti-dilutive:


	Three Months Ended		Nine Months Ended
	October 28, 2006	October 29, 2005	October 28, 2006	October 29, 2005
Anti-dilutive options	4,628,310	4,420,806	4,648,333	2,803,595

The calculation of dilutive shares also excludes the 474,000 restricted stock unit awards granted to certain members of our management in March 2006, as they are contingent upon achieving certain fiscal 2008 performance goals.

NOTE 4. Comprehensive Income

Comprehensive income for the three months and nine months ended October 28, 2006 and October 29, 2005 is as follows (in thousands):


	Three Months Ended					Nine Months Ended
	October 28, 2006			October 29, 2005		October 28, 2006			October 29, 2005
Comprehensive Income
Net income	$	7,070		$	5,931	$	4,758		$	11,823
Unrealized (loss) gain on marketable securities, net		(3	)		70		(7	)		83

Total comprehensive income	$	7,067		$	6,001	$	4,751		$	11,906

NOTE 5. Deferred Compensation Plan

In August 2006, we adopted the Hot Topic Inc. Management Deferred Compensation Plan (the “Deferred Compensation Plan”) for the purpose of providing highly compensated employees and members of our Board of Directors a program to meet their financial planning needs. The Deferred Compensation Plan provides participants with the opportunity to defer up to 80% of their base salary and up to 100% of their annual earned bonus, all of which, together with the associated investment returns, are 100% vested from the outset. The plan, which is designed to be exempt from most provisions of the Employee Retirement Security Act of 1974, is informally funded by us in order to preserve the tax-deferred savings advantages of a non-qualified plan. As such, all deferrals and associated earnings are general unsecured obligations of Hot Topic, Inc. held as an asset within a ‘rabbi trust’ on our consolidated balance sheets. We do not currently contribute to the plan. As of October 28, 2006, assets and associated liabilities of the Deferred Compensation Plan were $139,000 and $139,000, respectively, and are included in other non-current assets and non-current liabilities, respectively, in our consolidated balance sheets.

NOTE 6. Impairment of Long-Lived Assets

In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” we assess the impairment of long-lived assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. We group and evaluate long-lived assets for impairment at the individual store level, which is the lowest level at which individual cash flows can be

identified. Factors we consider important that could trigger an impairment review include a significant underperformance relative to expected historical or projected future operating results, a significant change in the manner of the use of the asset or a significant negative industry or economic trend. 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 aforementioned factors, impairment would be measured based on a projected discounted cash flow method using a discount rate determined by management.

In the event future store performance is lower than forecasted results, future cash flows may be lower than expected, which could result in future impairment charges. While we believe recently opened stores will provide sufficient cash flow, material changes in results could result in future impairment charges. Based on our review at October 28, 2006, we recorded an impairment charge of $562,000, which is included in selling, general and administrative expenses for the quarter in our consolidated statements of operations. No impairment charges were recorded during the nine months ended October 29, 2005.

NOTE 7. Bank Credit Agreement

We maintain an unsecured bank credit agreement of $5.0 million. The credit agreement will expire in August 2007 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 28, 2006, there were letters of credit for $449,000 outstanding under the credit agreement. There were no letters of credit outstanding at January 28, 2006.

NOTE 8. Commitments and Contingencies

Litigation

In April 2006, a California resident filed a lawsuit against us in Superior Court of Los Angeles County, alleging that we violated California Civil Code Section 1747.08. That code section regulates when a retailer is permitted to obtain certain customer information in connection with credit card transactions. The case is alleged as a class action. In May 2006, we answered the complaint and denied all liability. In October 2006, the court gave preliminary approval to a settlement agreement between the plaintiff (on behalf of the purported class) and us, which agreement we entered into as opposed to incurring additional legal fees defending the claims. The settlement agreement sets forth our position that complete defenses to the claims exist. Further, there was no admission of liability and no finding of violation of law. Under the settlement agreement, if final approval is received, we would pay an estimated aggregate of approximately $250,000 to cover certain attorneys’ fees and claims administration costs; and we would provide class members who opt in to the settlement class a coupon to receive 20% off on a single purchase of up to $100 in our Hot Topic or Torrid stores. We accrued amounts to account for the settlement during our third quarter following agreement on the settlement terms. Final approval of the settlement is expected around the end of the fourth quarter of fiscal 2006, though there is some likelihood the judge will not grant final approval, in which case we would continue defense of the claims and continue to assess our position.

same law firms as Ms. Axelson, filed a substantially similar action, though two of our directors named in the Axelson complaint were not named in the Daily complaint, and the Daily complaint included an additional cause of action relating to a California insider trading statute. In October 2006, the court ordered consolidation of the two cases, and ordered plaintiffs’ attorneys to file a revised, consolidated complaint. Plaintiffs have until approximately December 11, 2006 to make such a filing, at which time we would have 45 days to respond. We will make determinations with respect to the consolidated case as it proceeds; and though we cannot predict the outcome of the case, we believe the claims are without merit and intend to defend the case vigorously.

We are involved in other matters of litigation that arise in the ordinary course of business. We do not currently believe that the cases referenced above, or any other litigation in which we are currently involved, will have a material adverse effect on our overall financial condition.

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 letters of credit for $449,000 outstanding at October 28, 2006 and none outstanding at January 28, 2006. 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 9. Impact of Recently Issued Accounting Pronouncements

In February 2006, the Financial Accounting Standards Board (“FASB”) Emerging Issues Task Force (“EITF”) issued a proposed EITF No. 06-3, “How Sales Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross Versus Net Presentation)” (“EITF No. 06-3”). The Task Force reached a tentative consensus that a company should disclose its accounting policy (i.e., gross or net presentation) regarding presentation of taxes within the scope of EITF No. 06-3. If taxes included in gross revenues are significant, a company should disclose the amount of such taxes for each period for which an income statement is presented. The consensus would be effective for the first annual or interim reporting period beginning after December 15, 2006. The disclosures are required for annual and interim financial statements for each period for which an income statement is presented. We are currently evaluating the impact of adopting EITF No. 06-3 on our results of operations.

In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109” (“FIN 48”), which prescribes accounting for and disclosure of uncertainty in tax positions. This interpretation defines the criteria that must be met for the benefits of a tax position to be recognized in the financial statements and the measurement of tax benefits recognized. The provisions of FIN 48 will be effective as of the beginning of our 2007 fiscal year, with the cumulative effect of the change in accounting principle recorded as an adjustment to opening retained earnings. We are currently evaluating the impact of adopting FIN 48 on our financial condition, results of operations or cash flows.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”), which defines fair value, establishes a framework for measuring fair value and requires enhanced disclosures about fair value measurements. SFAS 157 requires companies to disclose the fair value of their financial instruments according to a fair value hierarchy (i.e., levels 1, 2, and 3, as defined). Additionally, companies are required to provide enhanced disclosure regarding instruments in the level 3 category, including a reconciliation of the beginning and ending balances separately for each major category of assets and liabilities. SFAS 157 will be effective for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. We are currently evaluating the impact adoption may have on our financial condition or results of operations.

In September 2006, the SEC issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”). SAB 108 provides interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. The SEC staff believes that registrants should quantify errors using both a balance sheet and income statement approach and evaluate whether either approach results in quantifying a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. SAB 108 will be effective for fiscal years ending on or after November 15, 2006, with early application encouraged. We do not expect that SAB 108 will have a material impact on our financial condition, results of operations or cash flows.

In September 2006, the EITF reached a final consensus on Issue No. 06-5, “Accounting for Purchase of Life Insurance—Determining the Amount That Could be Realized in Accordance with FASB Technical Bulletin No. 85-4” (“EITF 06-5”). EITF 06-5 requires that the cash surrender value and any amounts provided by the contractual terms of an insurance policy that are realizable at the balance sheet date be considered in determining the amount that could be realized under Technical Bulletin No. 85-4. The provisions of EITF 06-5 will be effective for fiscal years beginning after December 15, 2006 and are to be applied as a change in accounting principle through a cumulative-effect adjustment to retained earnings as of the beginning of the year of adoption. We do not expect the adoption of EITF 06-5 to have a material impact on our financial condition, results of operations or cash flows.

In October 2006, the FASB issued FASB Staff Position No. 123R-5, “Amendment of FASB Staff Position FAS 123(R)-1” (“FSP 123(R)-5”). FSP 123(R)-5 amends FSP 123(R)-1 for equity instruments that were originally issued as employee compensation and then modified, with such modification made solely to reflect an equity restructuring that occurs when the holders are no longer employees. We do not expect the adoption of FSP 123(R)-5 to have a material impact on our financial condition, results of operations or cash flows.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

STATEMENT REGARDING FORWARD LOOKING DISCLOSURE

This Quarterly Report on Form 10-Q contains various forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, which are subject to the “safe harbor” created by these sections, including statements regarding our expectations, beliefs, intentions or strategies regarding the future. Forward-looking statements include, without limitation, statements regarding the extent and timing of future revenues and expenses and customer demand, expected financial results, the profitability of future sales of our products, new store openings and new store concepts. All forward-looking statements included in this report are based on information available to us as of the date hereof and we assume no obligation to update any forward-looking statements. Forward-looking statements involve known or unknown risks, uncertainties and other factors which may cause our actual results, performance or achievements, or industry results to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Such risks, uncertainties and other factors include but are not limited to the items discussed under the captions “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this Item 2 and “Risk Factors” in Part II, Item 1A.

OVERVIEW

Our customers are at the core of our business strategies for both Hot Topic and Torrid. At the Hot Topic division we focus on current fashion trends that are music-inspired, and we listen to our customers to determine the fashion trends that they want to wear. We then merchandise our stores with these current trends. Our customer-focused strategy also includes identifying profitable customer segments, tailoring our stores to their needs, and training our associates to cater to and understand our customers’ needs. We strive to understand our customers’ needs as they relate to music and music related apparel by closely monitoring music trends, customers’ direct input via store visits, emails, and focus groups of our sales associates. By engaging with our customers in that manner, we believe we extend our competitive advantage over the other mall-based fashion retailers. Since we believe our customers continue to access music over the Internet and television, making our customers keenly fashion-focused, sophisticated, and technologically advanced, our resolve is to continue to meet their music-inspired fashion needs. At Torrid, we strive to become a leading specialty retailer of fashion forward plus-size young women’s apparel and accessories.

The current market of teen apparel is intensely competitive, especially during the holiday season (which runs roughly from the week of Thanksgiving through the beginning of January), resulting from fashion trends as well as aggressive promotional markdowns taken by many mall retailers.

The following discussion of our results of operations, financial condition and liquidity, and other matters should be read in conjunction with our Condensed Consolidated Financial Statements and the Notes related thereto.

Our fiscal year is on a 52-53 week basis and ends on the Saturday nearest to January 31. The fiscal year ending February 3, 2007 is a 53-week fiscal year, and fiscal year ended January 28, 2006, was a 52-week year.

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. If a store is closed during a period, it is included in the computation of comparable store sales for that fiscal month, quarter and year-to-date period, only for the days in which the store was operating as compared to the full month in the comparable period.

RESULTS OF OPERATIONS

Three Months Ended October 28, 2006 Compared to the Three Months Ended October 29, 2005

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:


For the three months ended:	October 28, 2006		October 29, 2005
Net sales	100.0	%	100.0	%
Cost of goods sold (including buying, distribution and occupancy costs)	65.2		67.1

Gross margin	34.8		32.9
Selling, general and administrative expenses	28.9		28.0

Operating income	5.9		4.9
Interest income, net	0.1		0.1

Income before income tax expense	6.0		5.0
Income tax expense	2.4		1.9

Net income	3.6	%	3.1	%

Net sales increased $4.0 million, or 2.1%, to $196.7 million during the third quarter of fiscal 2006 from $192.7 million during the third quarter of fiscal 2005. The components of this $4.0 million increase in net sales are as follows:


Amount ($ millions)			Description
$	9.0		Net sales from new Hot Topic stores opened since the third quarter of fiscal 2005 and Hot Topic stores not yet qualifying as comparable stores.
	3.9		Net sales from new Torrid stores opened since the third quarter of fiscal 2005 and Torrid stores not yet qualifying as comparable stores.
	3.2		Increase in Internet sales (hottopic.com and torrid.com).
	(0.1	)	Net sales from 15 expanded or relocated Hot Topic and Torrid stores.
	(12.0	)	6.8% decrease in comparable store net sales in the third quarter of fiscal 2006 compared to the prior year quarter.

$	4.0		Total

At the end of the third quarter of fiscal 2006, 689 of our 822 stores (Hot Topic and Torrid) were included in the comparable store base, compared to 580 of our 762 stores (Hot Topic and Torrid) open at the end of the third quarter of fiscal 2005. Sales of our Hot Topic division’s apparel and tee-shirts, as a percentage of total net sales, were 55% for the third quarter of fiscal 2006 compared to 56% for the third quarter of fiscal 2005. The decrease of the apparel category in the product mix was driven by decreased sales of women’s novelty tops, dresses and bottoms, as well as a decline in men’s fashion and novelty tops and music apparel.

Gross margin increased $4.9 million, or 7.7%, to $68.4 million during the third quarter of fiscal 2006 from $63.5 million during the third quarter of fiscal 2005. As a percentage of net sales, gross margin increased to 34.8% during the third quarter of fiscal 2006 from 32.9% in the third quarter of fiscal 2005. The significant components of this 1.9% increase in gross margin as a percentage of net sales are as follows:


%		Description
2.4	%	Increase in merchandise margin primarily due to higher initial markup, lower cost of goods sold and an increase in the allowance for damages, partially offset by slightly higher markdowns.
0.8		Decrease in distribution expenses primarily due to lower outside temporary personnel expenses and lower freight expenses to stores.
(0.1	)	Increase in buying costs due to higher payroll expenses.
(0.1	)	Increase in non-cash stock-based compensation expense due to adoption of SFAS No. 123R in first quarter of 2006.
(1.1	)	Increase in store occupancy and depreciation expenses, primarily due to deleveraging store expenses over lower comparable store sales.


1.9	%	Total

Selling, general and administrative expenses increased $2.9 million, or 5.4%, to $56.9 million during the third quarter of fiscal 2006 compared to $54.0 million during the third quarter of fiscal 2005. The total dollar increase in selling, general and administrative expenses was primarily attributable to a 7.9% increase in the number of retail stores from 762 at the end of the third quarter of fiscal 2005 to 822 at the end of the third quarter of fiscal 2006 and the corresponding additional payroll and other expenses required to support these additional stores. As a percentage of net sales, selling, general and administrative expenses increased to 28.9% in the third quarter of fiscal 2006 compared to 28.0% in the third quarter of fiscal 2005. The significant components of the 0.9% increase in selling, general and administrative expenses as a percentage of net sales are as follows:


%		Description
0.4	%	Increase in store payroll expense due to deleveraging of payroll costs relative to our decrease in comparable store sales.
0.4		Increase in non-cash stock-based compensation expense due to adoption of SFAS No. 123R in first quarter of 2006.
0.3		Increase in accrued expenses for performance-based bonus.
0.3		Increase in other store expenses primarily due to utilities.
(0.2	)	Decrease in marketing expenses primarily due to lower advertising expense for the Torrid marketing program, partially offset by an increase in promotional signage for Hot Topic.
(0.3	)	Decrease in pre-opening expenses due to opening fewer stores in the third quarter of 2006 as compared to the third quarter in 2005.


0.9	%	Total

Operating income increased $2.1 million to $11.5 during the third quarter of fiscal 2006 from $9.4 million during the third quarter of fiscal 2005. As a percentage of net sales, operating income was 5.9% in the third quarter of fiscal 2006 compared to 4.9% in the third quarter of fiscal 2005.

Net interest income remained the same at 0.1% for the third quarter of fiscal 2006 and fiscal 2005.

Income tax expense was $4.7 million for the third quarter of fiscal 2006 compared to $3.7 million for the third quarter of fiscal 2005. The effective tax rate was 39.9% and 38.3% for the third quarter of fiscal 2006 and 2005, respectively.

Nine Months Ended October 28, 2006 Compared to the Nine Months Ended October 29, 2005


For the nine months ended:	October 28, 2006		October 29, 2005
Net sales	100.0	%	100.0	%
Cost of goods sold (including buying, distribution and occupancy costs)	67.2		67.2

Gross margin	32.8		32.8
Selling, general and administrative expenses	31.4		29.1

Operating income	1.4		3.7
Interest income, net	0.2		0.2

Income before income tax expense	1.6		3.9
Income tax expense	0.6		1.5

Net income	1.0	%	2.4	%

Net sales increased $16.4 million, or 3.3%, to $511.1 million during the first nine months of fiscal 2006 from $494.7 million during the first nine months of fiscal 2005. The components of this $16.4 million increase in net sales are as follows:


Amount ($ millions)			Description
$	24.7		Net sales from new Hot Topic stores opened since the third quarter of fiscal 2005 and Hot Topic stores not yet qualifying as comparable stores.
	17.6		Net sales from new Torrid stores opened since the third quarter of fiscal 2005 and Torrid stores not yet qualifying as comparable stores.
	7.4		Increase in Internet sales (hottopic.com and torrid.com).
	(0.5	)	Net sales from 15 expanded or relocated Hot Topic and Torrid stores.
	(32.8	)	7.3% decrease in comparable store net sales in the first nine months of fiscal 2006 compared to the prior year quarter.

$	16.4		Total

Sales of our Hot Topic division’s apparel and tee-shirts, as a percentage of total net sales for the division, remained the same at 55% for the first nine months of fiscal 2006 and fiscal 2005.

Gross margin increased $5.2 million, or 3.2%, to $167.5 million during the first nine months of fiscal 2006 from $162.3 million during the first nine months of fiscal 2005. As a percentage of net sales,

gross margin remained the same at 32.8% during the first nine months of fiscal 2006 and fiscal 2005. The significant components of the unchanged gross margin as a percentage of net sales are as follows:


%		Description
1.0	%	Increase in merchandise margin primarily due to higher initial markup, lower cost of goods sold and an increase in the allowance for damages, partially offset by slightly higher markdowns.
0.3		Decrease in distribution expenses primarily due to lower outside temporary personnel expenses and lower freight expenses to stores.
(0.1	)	Increase in buying costs due to higher payroll expenses.
(0.1	)	Increase in non-cash stock-based compensation expense due to adoption of SFAS No. 123R in first quarter of 2006.
(1.1	)	Increase in store occupancy and depreciation expenses, primarily due to deleveraging store expenses over lower comparable store sales.

0.0	%	Total

Selling, general and administrative expenses increased $16.5 million, or 11.5%, to $160.4 million during the first nine months of fiscal 2006 compared to $143.9 million during the first nine months of fiscal 2005. The total dollar increase in selling, general and administrative expenses was primarily attributable to a 7.9% increase in the number of retail stores from 762 at the end of the first nine months of fiscal 2005 to 822 at the end of the first nine months of fiscal 2006 and the corresponding additional payroll and other expenses required to support these additional stores. As a percentage of net sales, selling, general and administrative expenses increased to 31.4% in the first nine months of fiscal 2006 compared to 29.1% in the first nine months of fiscal 2005. The significant components of the 2.3% increase in selling, general and administrative expenses as a percentage of net sales are as follows:


%		Description
0.7	%	Increase in store payroll expense due to deleveraging of payroll costs relative to our decrease in comparable store sales.
0.6		Increase in non-cash stock-based compensation expense due to adoption of SFAS No. 123R in first quarter of 2006.
0.4		Increase in other store expenses primarily due to utilities and business licenses/taxes.
0.3		Increase in marketing expenses primarily due to regional marketing for the Torrid marketing program, and promotional signage for Hot Topic.
0.2		Increase in other general and administrative expenses primarily due to deleveraged headquarters expenses due primarily to new support personnel and recruiting costs.
0.2		Increase in depreciation and amortization primarily due to software costs for new applications and functionality at our headquarters.
0.2		Increase in accrued expenses for performance-based bonus.
(0.3	)	Decrease in pre-opening expenses due to opening fewer stores in the first nine months of fiscal 2006 as compared to the first nine months of fiscal 2005.

2.3	%	Total

Operating income decreased to $7.1 million the first nine months of fiscal 2006 from $18.3 million during the first nine months of fiscal 2005. As a percentage of net sales, operating income was 1.4% in the first nine months of fiscal 2006 compared to 3.7% in the first nine months of fiscal 2005.

As a percentage of net sales, net interest income remained the same at 0.2% for the first nine months of fiscal 2006 and fiscal 2005.

Income tax expense was $3.3 million for the first nine months of fiscal 2006 compared to $7.3 million for the first nine months of fiscal 2005 due to the decrease in operating income. The effective tax rate was 40.7% and 38.3% for the first nine months of fiscal 2006 and 2005, respectively. The increase is due to the provision for additional contingency for tax exposure items and the implementation of SFAS 123R.

LIQUIDITY AND CAPITAL RESOURCES

Historically and during the first nine months of fiscal 2006, our primary uses of cash have been to finance store openings and purchase merchandise inventories. We have also made periodic repurchases of our common shares. 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 issuing letters of credit, primarily for inventory purchases. There were letters of credit for $449,000 outstanding at October 28, 2006 under the credit agreement. There were no letters of credit outstanding at January 28, 2006.

Cash flows provided by operating activities were $29.5 million in the first nine months of fiscal 2006 compared to $14.3 million provided by operating activities in the first nine months of fiscal 2005. The increase of $15.2 million in cash flows from operating activities in the first nine months of fiscal 2006 compared to the first nine months of fiscal 2005 resulted primarily from increases in income taxes payable and accounts payable, and decreases in prepaid expenses and other current assets and inventory, offset by reductions in net income, deferred rent, accrued liabilities and a reclassification of tax benefit from exercise of stock options.

Cash flows used in investing activities were $22.2 million in the first nine months of fiscal 2006 compared to $13.9 million used in investing activities in the first nine months of fiscal 2005. The $8.3 million increase in net cash used in investing activities resulted primarily from a $37.9 million decrease in the proceeds from the sale of short-term investments (net of purchases), offset by a $29.6 million decrease in purchases of property and equipment primarily to support store openings and for hardware and software systems.

Cash flows provided by financing activities were $2.1 million in the first nine months of fiscal 2006 compared to cash flows provided by financing activities of $0.3 million in the first nine months of fiscal 2005. The $1.8 million increase in cash flows from financing activities resulted primarily from $6.4 million used to repurchase our common stock in fiscal 2005 (with no corresponding 2006 activity) offset by a $4.5 million decrease from fiscal 2005 in proceeds from exercise of stock options.

The following table summarizes certain contractual obligations as of October 28, 2006, and the timing and effect that such commitments are expected to have on our liquidity and capital requirements in future periods:


	Payments due by period ($ in thousands)
Contractual obligations	Total		Within 1 Year		2-3 Years		4-5 Years		More than 5 Years
Operating leases	$	366,530	$	54,918	$	106,013	$	93,553	$	112,046
Purchase obligations	$	104,691		104,691		—		—		—
Letters of credit and other obligations	$	1,426		1,426		—		—		—

Total contractual obligations	$	472,647	$	161,035	$	106,013	$	93,553	$	112,046

We expect capital expenditures for fiscal 2006 to be approximately $37 million to $40 million, which will relate primarily to opening and remodeling or relocating new stores. The remainder of the expenditures will be primarily for improvements to our information technology and corporate infrastructure. We believe our current cash balances and cash generated from operations will be sufficient to fund our operations and planned expansion through at least the next 12 months.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Management’s discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities. On an ongoing basis, we evaluate estimates, including those related primarily to inventories, long-lived assets and contingencies. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

We believe the following critical accounting policies affect the more significant judgments and estimates used in the preparation of our consolidated financial statements. For a further discussion about the application of these and other accounting policies, refer to the notes included in our Annual Report on Form 10-K for the year ended January 28, 2006.

Inventories: Inventories are valued at the lower of average cost or market, on a weighted average cost basis, using the retail method. Under the retail method, inventory is stated at its current retail selling value, and then is converted to a cost basis by applying an average cost factor that represents the average cost-to-retail ratio based on beginning inventory and the purchase activity for the month. Throughout the year, we review our inventory levels in order to identify slow-moving merchandise and use permanent markdowns to sell through selected merchandise. We record a charge to cost of goods sold for permanent markdowns. Inherent in the retail method are certain significant management judgments and estimates including initial merchandise markup, future sales, markdowns and shrinkage, which significantly impact the ending inventory valuation at cost and the resulting gross margins. To the extent our estimated markdowns at period-end prove to be insufficient, additional future markdowns will need to be recorded. Physical inventories are conducted during the year to determine actual inventory on hand and shrinkage. We accrue our estimated inventory shrinkage for the period between the last physical count and current period end balance sheet date, thus, the difference between actual and estimated shrink amounts may cause fluctuations in quarterly results, but not for the fiscal year results.

Valuation of long-lived assets: In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” we assess the impairment of long-lived assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. We group and evaluate long-lived assets for impairment at the individual store level, which is the lowest level at which individual cash flows can be identified. Factors we consider important that could trigger an impairment review include a significant underperformance relative to expected historical or projected future operating results, a significant change in the manner of the use of the asset or a significant negative industry or economic trend. 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 aforementioned factors, impairment would be measured based on a projected discounted cash flow method using a discount rate determined by management. In the event future store performance is lower than forecasted results, future cash flows may be lower than expected, which could result in future impairment charges. While we believe recently opened stores will provide sufficient cash flow, material changes in results could result in future impairment charges.

Revenue Recognition: Revenue is recognized at our retail store locations at the point at which the customer receives and pays for the merchandise at the register. For online sales, revenue is recognized at the time of shipment, which we refer to as the date of purchase by the customer. We continually monitor the volume of Internet sales during the last five days of each fiscal quarter, which is the estimated time goods are received by customers. Historically, Internet sales during this five-day period have been less than a half percent of total company sales each quarter. Although title and risk and rewards of ownership pass to the buyer upon receipt of the goods by the buyer, we utilize the shipping point as the difference has not historically been material. Should the volume of sales during any period increase, we will revise our policy accordingly. Sales are recognized net of merchandise returns, which are reserved for based on historical experience. Revenue from gift cards, gift certificates and store merchandise credits is recognized at the time of redemption. Shipping and handling revenues from our websites are included as a component of net sales.

We recognize estimated gift card breakage as a component of net sales in proportion to actual gift card redemptions over the period that remaining gift card values are redeemed. Gift card breakage is income recognized due to the non-redemption of a portion of gift cards sold by us for which liability was recorded in prior periods. While customer redemption patterns result in estimated gift card breakage, which approximates 5%, changes in our customers’ behavior could impact the amount that ultimately is unused and could affect the amount recognized as a component of net sales.

Vendor Allowances: We receive certain allowances from our vendors primarily related to damaged merchandise, markdowns and, for our Torrid division, new store openings. Allowances received from vendors related to damaged merchandise and new Torrid store openings are reflected as a reduction of inventory in the period they are received and allocated to cost of sales during the period in which the items are sold. Markdown allowances received from vendors are reflected as reductions to cost of sales in the period they are received.

Stock-Based Payments: We estimate the fair value of stock options granted using the Black-Scholes option-pricing formula and a single option award approach. This fair value is then amortized over the requisite service periods of the awards. This option-pricing model requires the input of highly subjective assumptions, including the option’s expected life, price volatility of the underlying stock, risk free interest rate and expected dividend rate. As stock-based compensation expense is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. SFAS 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Forfeitures are estimated based on historical experience.

Self-Insurance: We are self-insured for certain losses related to medical and workers compensation although we maintain stop loss coverage with third party insurers to limit our total liability exposure. The estimate of our self-insurance liability involves uncertainty since we must use judgment to estimate the ultimate cost that will be incurred to settle reported claims and unreported claims for incidents incurred but not report as of the balance sheet date. When estimating our self-insurance liability, we consider a number of factors, which include historical claim experience and valuations provided by independent third party actuaries. As claims develop, the actual ultimate losses may differ from actuarial estimates. Therefore, an analysis is performed quarterly to determine if modifications to the accrual are required.

Income Taxes: Current income tax expense is the amount of income taxes expected to be payable for the current year. The combined federal, state and local income tax expense is calculated using estimated effective annual tax rates. A deferred income tax asset or liability is established for the expected future consequences of temporary differences in the financial reporting and tax bases of assets

and liabilities. We consider future taxable income and ongoing prudent and feasible tax planning in assessing the value of our deferred tax assets. Evaluating the value of these assets is necessarily based on our judgment. If we were to determine that it is more likely than not that these assets will not be realized, we would reduce the value of these assets to their expected realizable value through a valuation allowance, thereby decreasing net income. If we subsequently were to determine that the deferred tax assets, which had been written down, would be realized in the future, the value of the deferred tax assets would be increased, thereby increasing net income in the period when that determination was made. We have recorded tax contingencies based on our estimates of current tax exposures and adjust our estimates as circumstances or regulations change.

In accordance with SFAS 123R, we recognize tax benefit upon expensing certain stock-based awards associated with our stock-based compensation plans, including nonqualified stock options and restricted stock unit awards. However, under current accounting standards we cannot recognize tax benefit currently for those stock-based compensation expenses associated with incentive stock options (also known as qualified stock options) and employee stock purchase plan rights. For qualified stock options that vested after our adoption of SFAS 123R, we recognize tax benefit only in the period when disqualifying dispositions of the underlying stock occur, and for qualified stock options that vested prior to our adoption of SFAS 123R, the tax benefit is recorded directly to additional paid-in capital.

INFLATION

We do not believe that inflation has had a material adverse effect on our net sales or results of operations. We have generally been able to pass along increased costs related to inflation through increases in selling prices.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

We are not a party to any derivative financial instruments. Our exposure to market risk primarily relates to changes in interest rates on our investments with maturities of less than three months (which are considered to be cash and cash equivalents) and short-term investments with maturities in excess of three months. Changes in interest rates affect the investment income earned on those investments.

Item 4. Controls and Procedures

The management of the company maintains disclosure controls and procedures that are designed to ensure that the information required to be disclosed in our reports under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s (the “SEC”) rules and forms, and that such information is accumulated and communicated to management, including our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), as appropriate, to allow timely decisions regarding required disclosure.

We have carried out an evaluation, under the supervision and with the participation of our management, including our CEO and CFO, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end our most recent fiscal quarter. Based upon that evaluation, our CEO and CFO concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended) are effective as of the end our most recent fiscal quarter. There has been no change in our internal control over financial reporting during the most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

On August 7, 2006, Cheryl Axelson filed a purported shareholder derivative action for the benefit of Hot Topic, Inc. in the Los Angeles County Superior Court. The lawsuit names certain of our current and former executive officers and directors as individual defendants and us as a nominal defendant. The lawsuit asserts claims for breach of fiduciary duty and unjust enrichment in connection with the granting of certain stock options by us and seeks unspecified damages, disgorgement of the relevant stock options and any proceeds thereof, and other relief. On September 12, 2006, Jane Daily, who is represented by the same law firms as Ms. Axelson, filed a substantially similar action, though two of our directors named in the Axelson complaint were not named in the Daily complaint, and the Daily complaint included an additional cause of action relating to a California insider trading statute. In October 2006, the court ordered consolidation of the two cases, and ordered plaintiffs’ attorneys to file a revised, consolidated complaint. Plaintiffs have until approximately December 11, 2006 to make such a filing, at which time we would have 45 days to respond. We will make determinations with respect to the consolidated case as it proceeds; and though we cannot predict the outcome of the case, we believe the claims are without merit and intend to defend the case vigorously.

Item 1A. Risk Factors

CERTAIN RISKS RELATED TO OUR BUSINESS

Before deciding to invest in Hot Topic, Inc. or to maintain or increase an investment in Hot Topic, Inc., readers should carefully consider the risks described below, in addition to the other information contained in our Annual Report on Form 10-K and in other filings with the SEC, including our Quarterly Reports on Form 10-Q and Current Reports on Form 8-K. The risks described below are not the only

risks we face. Additional risks that are not presently known to us or that we currently deem immaterial may also affect our business. If any of these known or unknown risks actually occur, our business, financial condition and results of operations could be seriously harmed, and our stock price could decline. The risks described below include certain revisions to the risks set forth in our Annual Report on Form 10-K for the fiscal year ended January 28, 2006.

Our aggressive growth strategy of new store openings could create challenges we may not be able to adequately meet.

Our net sales have grown appreciably 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 our 822 stores opened as of October 28, 2006, 65 had been open for less than one full year. We intend to continue to pursue a growth strategy for the foreseeable future, and our future operating results will depend in part upon our ability to open and operate stores successfully and to profitably manage a larger business. We currently anticipate opening a total of approximately 46 stores, consisting of 34 Hot Topic and 12 Torrid stores, during fiscal 2006, further increasing the number of stores we operate. As of October 28, 2006, 32 of those new Hot Topic stores were open and 10 Torrid stores were open. 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 improving our operations, and we may not be able to do this sufficiently to effectively prevent negative impact on our business and financial results.

In order to 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. Our opening of a second distribution center in Tennessee in 2005 was designed to address some of our growth challenges, but achieving and maintaining operating efficiencies in multiple distribution centers is subject to numerous risks and uncertainties.

We also need to continually evaluate the adequacy of our management information and distribution systems. Implementing new systems and changes made to existing systems could present challenges we do not anticipate and could negatively impact our business. We cannot anticipate all of the changing demands that our expanding and changing operations will impose on our business, systems and procedures, and our failure to adapt to such changing demands could have a material adverse effect on our results of operations and financial condition. Our failure to timely implement initiatives necessary to support our expanding and changing operations could also materially impact our business.

Expanding our operations to include 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.

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 markdown 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 format. 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, or any future concept, 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. Risks associated with these relationships are more acute given recent consolidation in that industry, and we have seen certain increases in expenses as a result of such consolidation that could continue.

Our comparable store sales are subject to fluctuation resulting from factors within and outside our control, and lower than expected comparable store sales could impact our business and our stock price.

A variety of factors affects our comparable store sales including, among others, the timing of new music releases and music/pop culture-related products; music and fashion trends; the general retail sales environment and the effect of the overall economic environment; our ability to efficiently source and distribute products; changes in our merchandise mix; ability to attain exclusivity and certain pop-culture related licenses; competition from other retailers; opening of new stores in existing markets and our ability to execute our business strategy efficiently. Our comparable store sales results have fluctuated significantly in the past and we believe that such fluctuations will continue. Our comparable store sales results were (9.6)%, (5.5)% and (6.8)% for the first, second and third quarters of fiscal 2006, respectively, and the following table shows our comparable store sales results for other recent periods:


Fiscal Year	2005		2004		2003		2002
Total Year	(3.4	)%	(2.9	)%	7.4	%	5.0	%

1st Quarter	0.9	%	4.0	%	2.6	%	(0.5	)%
2nd Quarter	(3.5	)%	(2.1	)%	5.2	%	0.6	%
3rd Quarter	(6.2	)%	(4.2	)%	10.8	%	6.3	%
4th Quarter	(3.8	)%	(6.0	)%	8.5	%	9.7	%

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.

Our success relies on popularity with young people of music, pop culture, and fashion trends, and we may not be able to react to trends in a way to prevent declining popularity and sales of our products.

Our financial performance is largely dependent upon the continued popularity of alternative and rock music, the Internet and digital music, music videos, and MTV and other music television networks among teenagers and college-age adults; the emergence of new artists and the success of music releases and music/pop culture-related products; the continuance of a significant level of teenage spending on music/pop culture-licensed and music/pop culture-influenced products; and our ability to anticipate and keep pace with the music, fashion and merchandise preferences of our customers. The popularity of particular types of music, artists, styles, trends and brands is subject to change. Our failure to anticipate, identify and react appropriately to changing trends could lead to, among other things, excess inventories and higher markdowns, which could have a material adverse effect on our results of operations and financial condition, and on our image with customers. There can be no assurance that our new products will be met with the same level of acceptance as in the past or that the failure of any new products will not have an adverse material effect on our business, results of operations and financial condition.

Economic conditions could change in ways that reduce our sales or increase our expenses.

Certain economic conditions affect the level of consumer spending on merchandise we offer, including, among others, employment levels, salary and wage levels, interest rates, taxation, and consumer confidence in future economic conditions. We are also dependent upon the continued popularity of malls as a shopping destination, the ability of mall anchor tenants and other attractions to generate customer traffic, and the development of new malls. A slowdown in the United States economy or an uncertain economic outlook could lower consumer spending levels and cause a decrease in mall traffic or new mall development, each of which would adversely affect our growth, sales results and financial performance.

Changes in laws, including employment laws and laws related to our merchandise, could make conducting our business more expensive or change the way we do business.

In addition to increased regulatory compliance requirements, changes in laws could make ordinary conduct of our business more expensive or require us to change the way we do business. For example, changes in federal and state minimum wage laws could raise the wage requirements for certain of our associates, which would likely cause us to reexamine our entire wage structure for stores. Other laws related to employee benefits and treatment of employees, and privacy, could also negatively impact us such as by increasing benefits costs like medical expenses and record retention costs. 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.

Our business is also subject to seasonal influences, with heavier concentrations of sales during the back-to-school, Halloween and holiday (defined as the week of Thanksgiving through the first few days of January) seasons, and other periods when schools are not in session. The holiday season has historically been our single most important selling season. We believe that the importance of the summer vacation and back-to-school seasons (which affect operating results in the second and third quarters) and to a lesser extent, the spring break season (which affects operating results in the first quarter) as well as Halloween (which affects operating results in the third quarter), all reduce our dependence on the holiday selling season, but this will not always be the case to the same degree. As is the case with many retailers of apparel, accessories and related merchandise, we typically experience lower net sales in the first fiscal quarter relative to other quarters.

We have many important vendor relationships, and our ability to get merchandise could be hurt by changes in those relationships and events harmful to our vendors could impact our results of operations.

Our financial performance depends on our ability to purchase desired merchandise in sufficient quantities at competitive prices. Although we have many sources of merchandise, substantially all of our music/pop culture-licensed products are available only from vendors that have exclusive license rights. In addition, small, specialized vendors, some of which create unique products primarily for us, supply certain of our products. Our smaller vendors generally have limited resources, production capacities and operating histories, and some of our vendors have restricted the distribution of their merchandise in the past. We generally have no long-term purchase contracts or other contractual assurances of continued supply, pricing or access to new products. There can be no assurance that we will be able to acquire desired merchandise in sufficient quantities on acceptable terms in the future. Any inability to acquire suitable merchandise, or the loss of one or more key vendors, may have a material adverse effect on our business, results of operations and financial condition.

Technology and other risks associated with our Internet sales could hinder our overall financial performance.

We sell merchandise over the Internet through the websites www.hottopic.com and www.torrid.com. Our Internet operations are subject to numerous risks and pose risks to our overall business, including, among other things: hiring; retention and training of personnel to conduct the Internet operations; diversion of sales from our stores; rapid technological change and the need to invest in additional computer hardware and software to support sales; liability for online content; failure of computer hardware and software, including computer viruses, telecommunication failures, online security breaches and similar disruptions; governmental regulation; and credit card fraud. There can be no assurance that our Internet operations will achieve sales and profitability levels that justify our investment in them.

System security risk issues could disrupt our internal operations or information technology services provided to customers, and any such disruption could harm our revenue, increase our expenses, and harm our reputation and stock price.

Experienced computer programmers and hackers may be able to penetrate our network security and misappropriate our confidential information or that of third parties, create system disruptions or cause shutdowns. As a result, we could incur significant expenses addressing problems created by security

breaches of our network. Moreover, we could incur significant expenses in connection with system failures. In addition, sophisticated hardware and operating system software and applications that we procure from third parties may contain defects in design or manufacture, including “bugs” and other problems that could unexpectedly interfere with the operation of the system. The costs to us to eliminate or alleviate security problems, viruses, and bugs could be significant, and the efforts to address these problems could result in interruptions, delays or cessation of service that may impede our sales, distribution or other critical functions.

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 millions of dollars to enhance the functionality of our current GERS software and to implement new financial and human resources systems software from Lawson Software. In addition, we invested significant amounts in the implementation of a new warehouse management software system, a new Internet order management software system, and a new customer loyalty software system. We expect to significantly increase our reliance on these systems throughout fiscal 2006. If these information systems and software do not work effectively, we may experience delays or failures in our operations. These delays or failures could adversely impact the promptness and accuracy of our merchandise distribution, transaction processing, financial accounting and reporting and ability to properly forecast earnings and cash requirements. To manage growth of our operations and personnel, we will need to continue to improve our operational and financial systems, transaction processing, and procedures and controls, and in doing so, we could incur substantial additional expenses.

Loss of key people or an inability to hire necessary and significant personnel could hurt our business.

Our financial performance depends largely on the efforts and abilities of senior management, especially Elizabeth McLaughlin, our Chief Executive Officer, who has been with us since 1993. 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 our growth or that we will be able to attract and retain additional qualified personnel as needed in the future.

Decreased effectiveness of stock-based compensation could adversely affect our ability to attract and retain employees.

We have historically used stock options as a component of our total employee compensation program in order to align employees’ interests with the interests of our shareholders, encourage employee retention, and provide competitive compensation and benefit packages. In recent periods, our outstanding employee stock options have had exercise prices in excess of Hot Topic’s stock price, which reduces their value to employees and could affect our ability to retain present, or attract prospective employees. There are other forms of stock-based compensation available to us, but these are similarly less attractive when a company’s stock price is declining. In addition, in accordance with SFAS 123R, we began recording expenses for stock-based payments, including stock options, in the first quarter of fiscal 2006. As a result, we now incur increased compensation costs associated with our stock-based compensation programs.

Moreover, difficulties relating to obtaining shareholder approval of equity compensation plans and additional shares authorized for issuance thereunder could make it harder or more expensive for us to grant stock-based payments to employees in the future. Like other companies, we review our equity compensation strategy in light of regulatory and competitive environments, and we may decide to reduce the total number of options granted, or the form of stock awards, to employees, or reduce the number of employees who receive stock-based payments. Due to any change in our stock-based compensation strategy, we may find it more difficult to attract, retain and motivate employees, and any such difficulty could materially adversely affect our business.

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 centers; particularly during busy periods such as the holiday season and while multiple stores are scheduled to open. There can be no assurance that we will continue to receive adequate assistance from our temporary associates, or that there will continue to be sufficient sources of temporary associates. We began operation of our second distribution center in Tennessee during the second quarter of 2005, and as a result we also now face risks and uncertainties associated with achieving and maintaining operating efficiencies in two distribution centers that are located approximately 2,000 miles apart. Additionally, certain products are imported and subject to delivery delays based on 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.

We face intense competition, and an inability to adequately address it, or the success of our competitors, could limit or prevent our business growth and success.

The retail apparel and accessory industry is highly competitive. We compete with other retailers for vendors, teenage and young adult customers, suitable store locations and qualified associates and management personnel. Our Hot Topic stores currently compete with street alternative stores located primarily in metropolitan areas; with other mall-based teenage-focused retailers and their subsidiaries such as Abercrombie & Fitch, Aeropostale, American Eagle Outfitters, Anchor Blue, Charlotte Russe Inc., Claire’s Stores, Inc., Forever 21, Pacific Sunwear of California, Inc., Spencer Gifts, Inc., H&M, The Buckle, Wet Seal, Inc., Urban Outfitters, Inc., and Zumiez, Inc.; and, to a lesser extent, with music stores and mail order catalogs and websites. Torrid has additional competitors, such as Alloy, Inc., Charming

Shoppes, Inc., Deb Shops, Delia’s Corp., Old Navy (a division of Gap Inc.), and plus-size departments in department stores and discount stores as well as numerous potential competitors who may begin or increase efforts to market and sell products competitive with Torrid products. Some of our competitors are larger and may have greater financial, marketing and other resources. Direct competition with these and other retailers may increase significantly in the future, which could require us, among other things, to lower our prices. Increased competition could have a material adverse effect on our business, results of operations and financial condition.

War, terrorism and other catastrophes could negatively impact our customers, places where we do business, and our expenses, all of which could hurt our business.

The effects of war or acts of terrorism could have a material adverse effect on our business, operating results and financial condition. The continued threat of terrorism and heightened security and military action in response to this threat, or any future acts of terrorism, may cause further disruptions and create further uncertainties. To the extent that such disruptions or uncertainties negatively impact shopping patterns and/or mall traffic, or adversely affect consumer confidence or the economy in general, our business, operating results and financial condition could be materially and adversely affected. Similar risks would exist in the event of other types of national and regional catastrophes or circumstances, such as a flu pandemic or other public health or welfare scare.

Our principal executive offices, a distribution center and a significant number of our stores are located in California. If we experience a sustained disruption in energy supplies, or if electricity and gas costs in California fluctuate dramatically, our results of operations could be materially and adversely affected. California is also subject to natural disasters such as earthquakes and floods. A significant natural disaster or other catastrophic event affecting our facilities could have a material adverse impact on our business, financial condition and operating results.

There are numerous risks that could cause our stock price to fluctuate substantially.

Our common stock is quoted on the Nasdaq 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; litigation; overall economic and political conditions; the condition of the financial markets; and other events or factors outside of our control could cause our stock price to fluctuate substantially.

Our charter documents and other circumstances could prevent a takeover or cause dilution of our existing shareholders, which could be detrimental to existing shareholders and hinder business success.

Our Articles of Incorporation and Bylaws contain provisions that may have the effect of delaying, deterring or preventing a takeover of Hot Topic, Inc. For instance, our Articles of Incorporation include certain “fair price provisions” generally prohibiting business combinations with controlling or significant shareholders unless certain minimum price or procedural requirements are satisfied, and our Bylaws prohibit shareholder action by written consent. Additionally, our Board 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.

There are numerous regulatory requirements for public companies, including the provisions of the Sarbanes-Oxley Act of 2002. With regard to the Sarbanes-Oxley Act, we have and will continue to incur significant expense as we continue to address the implications of applicable rules and our operations relative thereto, and as we work to respond to and comply with applicable requirements. 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 rules could also result in continued diversion of management’s time and attention, which could be disruptive to normal business operations.

If we do not satisfactorily or timely comply with these requirements, possible consequences could include sanction or investigation by regulatory authorities such as the Securities and Exchange Commission or the Nasdaq National Market, incomplete or late filing of our periodic reports, including our Annual Report on Form 10-K, or civil or criminal liability. Our stock price and business could also be adversely affected.

There are litigation and other claims against us from time to time, which could distract management from our business activities, and could lead to adverse consequences to our business and financial condition.

As an evolving company with expanding and changing operations, we are increasingly involved from time to time with litigation and other claims against us. These arise primarily in the ordinary course of our business, and include employee claims, commercial disputes, intellectual property issues and product-oriented allegations. Often these cases raise complex factual and legal issues, which are subject to risks and uncertainties and which could require significant management time. Although we do not currently believe that the outcome of any current litigation and claims against us will have a material adverse effect on our overall financial condition, we have, in the past, incurred unexpected expense in connection with litigation matters. In the future, adverse settlements or resolutions may occur and negatively impact earnings, injunctions against us could have an adverse effect on our business by requiring us to do or prohibiting us from doing certain things, and other unexpected events could have a negative impact on us.

Recent accounting regulation changes require the expensing of stock options.

Recently effective accounting regulation changes require that all publicly traded companies record compensation expense related to stock options (and other equity awards). Accordingly, we now include compensation expense related to stock options and certain other equity awards in our reported earnings in our financial statements. Our reported earnings have been negatively impacted by this new requirement of recording stock-based compensation expense, and our stock price could go down or fluctuate in the future as the amount and extent of these expenses may fluctuate from quarter to quarter, as they are recognized.

Item 6. Exhibits and Reports


Exhibit Number		Description of Document
3.1		Amended and Restated Articles of Incorporation. (1)

3.2		Certificate of Amendment of Amended and Restated Articles of Incorporation. (2)

3.3		Amended and Restated Bylaws, as amended. (2)

4.1		Reference is made to Exhibits 3.1 and 3.2.

4.2		Specimen stock certificate. (1)

31.1		Certification, dated November 21, 2006, of Registrant’s Chief Executive Officer required by Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification, dated November 21, 2006, of Registrant’s Chief Financial Officer required by Section 302 of the Sarbanes-Oxley Act of 2002.

32.1		Certifications, dated November 21, 2006, of Registrant’s Chief Executive Officer and Chief Financial Officer required by Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C § 1350, as adopted).

(1)	Filed as an exhibit to Registrant’s Registration Statement on Form SB-2 (No. 333-5054-LA) and incorporated herein by reference.

(2)	Filed as an exhibit to Registrant’s Annual Report on Form 10-K for the year ended January 29, 2005 and incorporated herein by reference.

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 21, 2006		/s/ Elizabeth McLaughlin
		Elizabeth McLaughlin
		Chief Executive Officer
		(Principal Executive Officer)

Date: November 21, 2006		/s/ James McGinty
		James McGinty
		Chief Financial Officer
		(Principal Financial
		And Accounting Officer)

Exhibit Index


Exhibit No.		Document
31.1		Certification, dated November 21, 2006, of Registrant’s Chief Executive Officer required by Section 302 of the Sarbanes-Oxley Act of 2002.
31.2		Certification, dated November 21, 2006, of Registrant’s Chief Financial Officer required by Section 302 of the Sarbanes-Oxley Act of 2002.
32.1		Certifications, dated November 21, 2006, of Registrant’s Chief Executive Officer and Chief Financial Officer required by Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C § 1350, as adopted).

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