What's in a name? Sometimes, very little. Other times, a lot. When supposedly hip clothier Hot Topic (NASDAQ:HOTT) reports Q4 and full-year 2005 earnings tomorrow, expect it to be one of the "little" days.

Wall Street Wisdom:

  • General consensus. For all of its troubles, Hot Topic is still the popular kid in class. Twenty analysts follow it around, and although 12 of them rate the stock a hold, eight still call it a buy.
  • Revenues. Quarterly sales are expected to climb 8% to $228.8 million.
  • Earnings. Meanwhile, profits are following the stock price downward. (Or is it the other way around?) The Street expects a 42% decline in earnings to $0.22 per share tomorrow.

Margin watch:
Here's why. Just because a company's selling more stuff doesn't necessarily mean it's making more money. In fact, if the company's margins deteriorate, selling more stuff can result in making less money. That's precisely Hot Topic's problem. Rolling gross margins have declined by 350 basis points over the past 18 months, and that amount was subtracted penny for penny from bottom-line profits. As a result, Hot Topic is barely half as profitable today as it was just a year and a half ago.

Margins %

7/04

10/04

1/05

4/05

7/05

10/05

Gross

37.6

36.7

35.6

35.5

34.8

34.1

Op.

12.1

11

9.7

9.3

8.3

6.6

Net

7.6

6.9

6

5.8

5.2

4.1

All data courtesy of Capital IQ, a division of Standard & Poor's. Data reflects trailing-12-month performance for the quarters ending in the named months.

Foolish lookout:
Mind you, Hot Topic could still "beat estimates." Analyst predictions for $0.22 in profits fall toward the low end of the $0.21-to-$0.24 range that the company posited just last month. Moreover, Hot Topic already announced Q4 sales that, at $230.6 million, exceeded the analysts' estimates.

But even if HOTT did do less horribly than analysts suspect, that's little reason to celebrate. The company is clearly in the midst of a long-term slide in profitability -- and not just accounting profitability (with profits down 47% year-to-date versus this time last year), but cash profitability as well. Inventories are rising much faster than sales -- 17% versus 12% in Q2; 22% versus 7% in Q3. As a result, the company was heading into Q4 in a much weaker position, free cash flow-wise, this year than last, with free cash outflows increasing 77% year over year.

The moral of the story: Forget the GAAP earnings tomorrow. We already know they'll be lousy -- it's only a matter of degree. Focus rather on inventories and free cash flow. That's where you'll find the first evidence of a turnaround, if one exists to be found.

Fool contributorRich Smithhas no interest, short or long, in Hot Topic.