Hot Topic HOTT S
November 25, 2008 - 12:13pm EST by
2008 2009
Price: 7.60 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 310 P/FCF
Net Debt (in $M): 0 EBIT 0 0
Borrow Cost: NA

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HOTT is a short after a recent run-up based on what will likely be short-term trends.

Hot Topic is a mall based specialty retailer with two main concepts:  Hot Topic and Torrid.  With 683 stores, Hot Topic "offers music/pop culture-licensed and music/pop culture-influenced apparel, accessories, music and gift items for young men and women principally between the ages of 12 and 22."  With 158 stores, Torrid "offers apparel, lingerie, shoes and accessories designed for various lifestyles for plus-size females principally between the ages of 15 and 29."  

Hot Topic's core business has been struggling for some time with negative comps.  The last time comps were solidly positive was back in the early 2000's, when the concept was a lot less penetrated (274 stores in 2001 vs. 841 now).  Since then, management feels like their core rock/metal music customer has become interested in a much broader range of music categories (and may not always want to dress like a rock musician).  I think this is a huge problem for their business and a longer term trend that has been hard for them to break out of.
More recently, the stock has been on a tear the past couple months, rising from $5.00 in early October to a recent price of $7.60 on better than expected comps and earnings.  After posting flat to negative comps throughout the year, the company surprised the market in October with a 8.3% comp and raised guidance for Q3.  Moreover, trends appear to be going well in November as well.  These trends, however, have benefited from one-time type items (successful Halloween merchandise, the upcoming release of the Twilight movie) and do not represent fundamental improvement in the core business.  With the stock at 18.7x '08 consensus eps and 16.2x '09 consensus eps, and comps like ANF, AEO, and URBN trading at 7.7x '09 eps, 6.8x '09 eps, and 10.8x '09 eps respectively, Hot Topic appears overvalued.  Expectations about a turn-around are unrealistic and in time the stock should come back down, trading more in line with its peers.  At 10x '08 eps plus $1.40/share in cash, the stock would trade at $5.40. 
Comp Trends

After a string of not so impressive comps for the year, HOTT shocked the market by posting a 8.3% comp in October.  More than halfway through the month, however, comp trends were flat.  Though the company cited strength of both Halloween and non-Halloween items, it seems like the holiday certainly had a strong positive impact and that some of this business will not continue into the future.  "Going into the last ten days of October our trend was running flat. The increased traffic and the resulting sales of both Halloween-specific items and non Halloween items allowed us to produce a high single-digit comp for the full month ." 

On their Q3 earnings call on Nov. 19, the company commented on November trends, which were also strong:  "November month to date, Hot Topic is running a mid single-digit comp increase and Torrid is running a high single-digit comp decrease."  Again, it seems like the company has benefited from the strength of temporary trends - in this case, from the sale of licensed items from the movie Twilight, a recently released movie that is having a lot of success.  As management explained:
"At Hot Topic the entire comp month to date has been driven by the strength of the Twilight license. In addition to the cast member signing events that occurred in malls across the country last week, the remainder of the chain has seen significant increases in Twilight products as we approach the movie release scheduled for this Friday, November 21st. Torrid shifted their promotional cadence in line with the later holiday, so comparisons were difficult during week two. However, the most difficult comparisons in November are still ahead of us due to the Thanksgiving calendar shift. We continue to view November cautiously and expect that our monthly comp will be down a low single digit."
Right now, Twilight is the clear driver of the business.  While it is unclear how exactly the rest of the business is doing (management did not want to specifically disclose this on the call), saying that "the entire comp month to date has been driven by the strength of the Twilight license" suggests that the rest of the business is much weaker.  The obvious question then is whether the Twilight business is sustainable and if so, for how long?  I don't have great insight into the first question, but it seems like this boost should fade at some point.  More importantly, management already expects Twilight to be less significant to the business going forward as it will make up less of a percentage of December's sales than November's. 

"I think that having a catalyst to drive traffic is really important and right now in November the catalyst driving traffic into store -- into our stores is Twilight, therefore it represents a greater percentage of business, just like in October Halloween was the catalyst to drive customers into our stores. As you get to December I think the holiday is the catalyst and so there are many different customers who come into the stores for a reason, and while Twilight will certainly be a strong item Rock tees is always strong, many of our fashion apparel items post holiday are very strong and then certainly the accessory items that we saw do so well during back to school will carry through for holiday, as well. So I think it's more that the pie is a lot lighter in December from a consumer preference standpoint than it is currently in November."


To summarize, if we strip out the impact from the sale of Halloween and Twilight items, it seems like the core business is at best trending flat.  This is reflected in the company's comp guidance for Q4 (down low single digits) and management's remarks, "So I think for us to say that we're feeling better about business is a little premature at this point."  With the business experiencing little to no bump from these one-timers going forward, the market will have a more accurate read into the company's performance in December/January/February, which should look weaker (and more like the rest of the retail space) than the strong trends of October and November. 



With the run-up in the stock, it seems like investors' expectations have outpaced reality.  The market seems to think HOTT is on the verge of a turnaround whereas core business trends suggest something different.  The long case is summarized, by a recentPali Research report, which comes up with a " $8.50 TP is based on 17x our 2009 EPS estimate of $0.50. This represents a significant premium to the group but is on depressed EPS with upside potential, a standout in retail today."  


The reality is that HOTT's turnaround and margin goals are no more than hopeful expectations at this point.  As the boost from Twilight eventually fades, this should become clear and the stock should trade closer to the $5 level of early October. 


1) Core business trends not improving;
2)Comps fail to meet expectations and turn negative in December, January, or February;
3)Twilight boost is temporary
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