Community Perspective Is Hot Topic Hot Stuff?

	Email this page Format for printing Reuse/Reprint
	Discussion Boards Hot Topic Gap Inc. The Limited

By Dan Padavona
March 12, 2001

The following perspective was written by a member of the Fool community and regular contributor to our discussion boards. The opinions of the author are not necessarily representative of the opinions of The Motley Fool or its editorial staff.

Perhaps you are looking to diversify beyond technology stocks, but you are an aggressive investor who demands growth. Is growth available at an affordable price, and can it be found outside of tech? Of course it can. Growth is everywhere, and if the market action of 2000 taught us anything, it is that "growth at a reasonable price" provides investors with a safety net that growth at any price does not. I personally went shopping for retail companies.

Retail stocks were not kind to investors in 2000. Interest rate hikes and a slowing economy caused companies to miss earlier growth projections. Now that interest rates have been lowered, many retailers can be picked up at tremendous bargains. 

I'd like to introduce you to my favorite, Hot Topic (Nasdaq: HOTT). Hot Topic is a mall-based retailer of music-influenced apparel. The company targets a customer base between the ages of 12 and 22, a demographic with a total annual disposable income estimated at $120 billion. Hot Topic stocks T-shirts of alternative and hard rock bands, as well as related clothes and accessories, a strategy not duplicated by any other U.S. franchise, to my knowledge.

Hot Topic's unique strategy and the sustainability of this market makes it an intriguing investment. While many clothing retailers attempt to establish brand dominance by setting clothing trends, Hot Topic is a trend follower. 

I cannot overstate the importance of being a trend follower in the retail business. The inherent risk in trend setting is the trend will not be accepted by the masses or will die too soon, leaving the retailer with unsold merchandise, the generic term for which is "fashion risk." As a trend follower, Hot Topic stocks music-related paraphernalia based on bands and themes in which their shoppers are already interested. When any musical artist starts to lose popularity, its goods are relegated to less store shelf space in favor of the "hot band" that has replaced it as the new big thing. Management actively monitors MTV, M2, and the big city club scenes to catch hot musical trends early. This is also where they get many of their ideas for self-produced clothing and accessories.

As of November 2000 there were 267 established Hot Topic stores located in 45 states. Hot Topic has added 40 to 50 stores per year the last two years, and for good reason -- the store concept is as hot as the name implies. Company financials show that same-store sales have increased by an average of 9% for the last six quarters. Quarterly revenue per store exploded from $140,000 in April 1998 to $200,000 in April 2000. Top-line revenue growth quarter-over-quarter was 58% in the first quarter of this year, and is up 55% for the first nine months over last year's levels.

Is the business concept sustainable? Think about this: For the concept to fail, teens must lose interest in music, an event that I would most charitably characterize as "unlikely."  Rather, Hot Topic must stock the clothing and accessories inspired by the latest music tastes among its target market. Hot Topic has first-mover advantage as a niche music concept store, with growing brand recognition thanks to company expansion and carefully planned promotions. Hot Topic was involved with the popular hard rock festival Ozzfest in the summer of 2000, reaching out to potential customers and using the festival as a sales venue.

Hot Topic management and employees continue to add shareholder value through strong business execution. 

                    FY 1997    FY 1998    FY 2000
Revenues (millions)    70.5     103.4      169.0
Growth (annual)        62%       47%        63%
Return on Equity       10.2%     12.1%      20.3%
ROIC                   17.2%     18.0%      39.2%
Days Inv. Outstanding  63        58         54
Cash Conversion Cycle  49        46         32
Flow Ratio              1.44      1.46       0.90

Source:  Company Reports

The most striking improvement is from return on invested capital (ROIC), arguably the most important measurement of internal cash generation from existing capital. A fiscal year Flow Ratio under 1.00 is also not expected of young companies. The first 39 weeks suggest FY 2001 will show ROIC above 40%.

The second question regards future store concepts. Hot Topic announced during the July 2000 conference call a new store concept called "Torrid." Torrid, which management projects will be a 500-unit chain, will focus on plus-size women between the ages of 15 and 30. Plus-size juniors have few choices, Lane Bryant -- a subsidiary of Limited (NYSE: LTD) -- being one of only a few national chains addressing this market.  However, no existing concept chain is in the cutting-edge MTV-inspired clothing for plus-size juniors that Torrid seeks to address. Hot Topic stores claim to have tested the concept in limited quantity with strong results.

It is important for Hot Topic that this new concept works. As Tom Jacobs' recent article points out, Hot Topic is approaching an inflection point as a single-concept entity. Expansion into new store concepts is what separates the great long-term retail investments such as Gap (NYSE: GPS) and The Limited from the rest.  Hot Topic management believes that Torrid will reach a large and underserved market. It wouldn't surprise me if customer loyalty for the Torrid concept proves strong if the initial rollout is successful.

Speaking of expansion, the original Hot Topic model has a lot of room to grow, with one retail analyst projecting the potential for 800 U.S.-based Hot Topic stores, a number that, given the sheer size of the junior woman's fashion market, I believe is possible. With the global appeal of many of today's top artists, it doesn't take much imagination to envision successful expansion for Hot Topic into Europe, Asia, and Latin America.

Hot Topic trades at a price-to-earnings (P/E) multiple of 24. Hot Topic announced same-store sales growth of 8.1% for December 2000 compared to December 1999, in which time the company also added more than 50 locations. This type of performance amid a declining economic environment is evidence of the strength of Hot Topic's business model and their growing brand awareness. For investors, Hot Topic offers a strong growth story at a fair value.

Hot Topic investors should pay close attention to the ROIC trends, and also to the initial rollout of Torrid. 

The author wishes to disclose that he currently holds a long position in Hot Topic. This article is not to be taken as investment advice. As always, do your due diligence when selecting investments. The Motley Fool is investors writing for investors.