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Hot Topic, Inc. (NASDAQ:HOTT)

Q3 2012 Earnings Call

November 14, 2012 4:30 pm ET

Executives

James McGinty – Chief Financial Officer

George Wehlitz Jr. – Vice President - Finance

Lisa M. Harper – Chairman of the Board, Chief Executive Officer

Analysts

Janet J. Kloppenburg – JJK Research

Thomas A. Filandro – Susquehanna Financial Group, LLLP, Research Division

Jeff Van Sinderen – B. Riley & Co.

Dana Telsey – Telsey Advisory Group

Adrienne Tennant – Janney Capital Markets

Operator

Good afternoon, ladies and gentlemen. Welcome to the Hot Topic Third Quarter 2012 Earnings Conference Call. At this time all participants have been placed on a listen-only mode and the floor will be opened for your questions following the presentation. This call will be limited to one hour.

Before we begin, I would like to remind you that during the course of this conference call, the company will be making certain forward-looking statements, such as statements relating to financial results, guidance and future financial performance, merchandise assortment, new initiatives and related matters and statements relating to key personnel and operational issues.

These statements, as well as related information posted on the Hot Topic Investor Relations website, involve risks and uncertainties that may cause actual results to differ materially from those projected in the forward-looking statements. These risks and uncertainties are discussed from time-to-time by the company and are more fully set forth in the periodic reports that Hot Topic files with the Securities and Exchange Commission, including the most recent Annual Report on Form 10-K and Quarterly Report on Form 10-Q.

All forward-looking statements made on this call speak only as of the time they are made, and Hot Topic undertakes no obligation to update these statements to reflect subsequent events or circumstances.

To more effectively disseminate the information discussed this afternoon, this call is being webcast on the company’s Investor Relations website at http://investorrelations.hottopic.com, and replay will be available on that site. A replay will also be available at 888-286-8010, passcode 60862559, for approximately 2 weeks.

Now, I’ll turn the call over to Hot Topic’s Chief Financial Officer, Jim McGinty.

James McGinty

Hi, this is Jim, and welcome to the call. While on hold, you’ve been listening to I will wait by Mumford & Sons. My partners on the call today are Lisa Harper; Mark Mizicko; and George Wehlitz. George will begin by reviewing the third quarter results and making a few comments on the balance sheet.

Following Q3 details, Lisa will provide you with her thoughts on the third quarter performance and the outlook going forward. Lastly, we will discuss guidance. Now, I’ll turn it over to George.

George Wehlitz

Thanks, Jim. All comparisons discussed are to the same period from a year ago unless otherwise noted. Overall, total net sales for the third quarter increased 2% or $3.6 million. The components of this increase are as follows: $6.8 million sales increase from new and non-comparable Hot Topic and Torrid stores; $300,000 sales gain from Hot Topic and Torrid comparable store sales increases of 0.1% and 25% respectively. And lastly, a $3.5 million sales decrease from closed stores and other.

Hot Topic Division had an average transaction value increase of 12%, but the number of comparable transactions were down 11% last year. Torrid had an 8% increase in the average dollar sale with a 7% decrease in the number of transactions.

At Hot Topic, apparel was 59% of total sales for the quarter, compared to 54% last year. At Torrid, apparel was 78% of total sales for the quarter compared to 74% last year.

Gross margin was 35.8% of sales, compared to 33.9% last year. The 190 basis point increase breaks down into the following categories: 170 basis point increase in merchandise margin primarily due to higher realized mark-up as we significantly increased the number of internally designed products and the decrease of Internet sales.

30% basis point decrease in store depreciation expenses due to lower expense from comp stores and stores closures, 10% basis points decreased in distribution center expenses primarily a result of the lower depreciation, supplies and leverage on higher sales partially offset by higher freight costs. 10% basis point increase in store occupancy expense primarily due to higher rent as a result of increase in number of stores, and a 10% basis point increase in the buying payroll expenses.

In the third quarter, selling, general and administrative expenses were 32% of sales, compared to 31.5% last year. The 50 basis point increase breaks down into the following categories. Performance based bonuses increased 150 basis points, pre-opening expenses increased 20 basis points due to greater number of new relocated and remodeled stores opened in the third quarter of 2012.

Total payroll expenses increased 10 basis points as a result of an increase in number of stores and higher store performance based bonuses. These increases were partially offset by an 80 basis points decrease primarily due to lower store costs from utilities, supplies, debit/credit card processing fees and telecommunications.

A 50 basis point decrease due to lower other G&A is due from depreciation, asset impairment write-off, travel and telecommunication expenses partially offset by increase in computer maintenance cost. The third quarter operating income was $6.9 million versus $4.2 million last year, an increase of 62%.

Our effective tax rate was 37.8% versus 27.8% last year. Last year included a benefit recorded for expiring statutes of limitations. Our resulting net income for the third quarter was $4.3 million or $0.10 per share versus $3.1 million or $0.07 per share last year, an EPS increase of 43%.

This year’s third quarter EPS included a $0.01 per share loss for expenses related to the launch of Blackheart. During the quarter, we opened 18 Torrid stores and closed three Torrid stores. We also remodeled or relocated 13 Hot Topic stores and one Torrid store.

Our cash position remains strong with cash, cash equivalents and investments both short and long-term of $61 million versus last year’s $44 million. Our total inventory cost was $91 million on a per square foot basis, the inventory increase was 1% higher at the end of the third quarter compared to last year. Our year-to-date capital expenditures were $30 million, which primarily drove – were driven from store construction at IT project. Cash flows from operating activities as of the end of October increased $21 million compared to last year.

Now I’ll turn the call over to Lisa.

Lisa M. Harper

Thanks, George. Good afternoon, everyone and thanks for joining us today. We’re very pleased with our continuing earnings improvement, although the comp for Q3 was essentially flat.

We successfully delivered a completely new strategy for the Torrid brand, and continued to refine merchandising initiatives and operational improvement to Hot Topic. The result of these efforts is reflected in the 190 basis point improvement in gross margin for the quarter actualizing at 35.8%.

The largest improvement in margin came from the Torrid brand. We implemented a new vertical merchandising approach in a bolder fashion focused marketing strategy at Torrid in the third quarter, and we were able to validate our results very quickly with improved performance in key areas.

In the third quarter, Torrid generated a comp of 0.5% with stores delivering a comp increase of 4.2%, and torrid.com delivering a negative 10.4 comp. The comp decline at torrid.com was caused by a 50% decline in the sales for clearance merchandise through the channel.

We made a deliberate decision as an element of our markdown optimization process to eliminate the large percentage of clearance product driven to the web in previous years. This strategy helped us to maximize gross margin dollars, in fact our merchant margin rate at Torrid driven by the change in strategy as well as improved markdown optimization and allocation strategies improved by roughly 450 basis points in the quarter.

We expect aggressive improvement in merchant margin rate at Torrid over the next three quarters, and expect them to somewhat normalize – anniversary the strategy in Q3 of 2013.

I’d like to give more color on the negative performance of torrid.com. In addition to the planned lower levels of clearance inventory online, we also limited the success of the web by pushing the planned productivity by SKU too high. We’ve been focusing on higher SKU productivity for the last year, and we reached the point of diminishing returns online in Q3. We took our SKU count down too and the resulting productivity gains were not enough to offset the dramatically reduced number of styles.

We have reacted quickly to those by addressing our web only assortment more aggressively. We expect to see measured improvement in Q4 and Q1 of next year with the situation completely remediated by Q2 of 2013.

Even with the negative comp in this channel, regular price comp and margin come were both positive online in the quarter. We’re enthusiastic about the new collection of fashion apparel we introduced in the third quarter, which included new denim (inaudible) highlighted by skinny jean.

Apparel generated a five comp and represented 78% of the business as compared to 74% last year. Within apparel, we were up 10% in bottom as a result of strong Denim business and we were up 2% in tops and other categories.

Overall, we are very pleased with how our customers are reacting to our new styles, which are being and designed and sourced in-house. We are however disappointed with the overall performance of the accessories category at Torrid where comps decline 24%. We continue to focus on strategies to improve this business with a largest opportunities in footwear, size specific jewelry, and a broader assortment available on line.

Good news here is that, Internet apparel comps up 9% in the quarter. We introduced new bras as well as panties and lingerie and are encouraged by customer reaction and sales performance in this category. Accessories and Internet combined produced a negative 11 comp for the quarter, with the improvements in Internet helping to offset some of the softness in accessories.

We continue to feel confident in our real estate strategy at Torrid; we opened 14 strip center locations in Q3, two of which were relocations out of nearby mall location. This puts our quarter end number of Torrid strip centers at 31. For the balance of 2012, we’ll open three new Torrid stores and relocate three Torrid mall locations to strip centers. By the end of 2012, we expect 35 of our stores will be in strip center locations. As a group, the strip stores are still paying back within 18 months as we had indicated previously.

Moving now to Hot Topic, we delivered solid bottom line results on a very modest comp increase, just a little better than flat to a year ago. The shift of Halloween into the fourth quarter and the softer performance of Halloween this year reduced our comparable sales increase for the quarter by a couple of percentage points as the Hot Topic division was running over 2% comp, 2.4% comp increase due to the end of September.

Before I continue, I’d like to highlight a change that we’ve made in our segmentation of the Hot Topic business. In order to remain more nimble, make that our inventory investments and react more quickly to changes in customer demand, we now break the reporting segments of the business into three categories.

The first category is fashion apparel. The second category is tees and hoodies, which include music license and private label. And then the third category is accessories and other. We recently completed an internal process change that groups buying categories across fashion, music and license rather than the segmented approach that we use previously. We believe this change will help investors better understand the trends in the overall Hot Topic business from the same vantage that we use to approach the business.

Our fashion apparel assortment made the largest contribution to comp with a 22 comp in the third quarter, contributing 18% of sales versus less than 15% a year ago. We feel that we can achieve our goals to return the fashion apparel business to 20% by the end of the next year.

Tees and hoodies contributed 40% of the total business versus 38% a year ago, driven by license and private-label fees, which had a stellar quarter. The comp in this sector was 5% for Q3, with a soft release calendar.

Gains in the license and novelty apparel categories were partially offset by softness in music, tees and hoodies. Music related apparel has continued to be soft due to the lack of releases primarily in hip-hop. Q4 releases are planned at One Direction, which released yesterday Breaking Dawn, which releases November 16, and Wiz Khalifa which releases his album on December 4.

We expect the fourth quarter release calendar to be stronger than last year in music and flat to last year in license. Accessory and other made up 42% of the business versus 47% last year, result of a 10% comp sales decline and the increase in penetration of fashion and tees and hoodies.

Halloween sales were down 20% for the third quarter, and represented almost half of the accessories comp decline. We had a much lower investment in Halloween inventory this year, so we ended the season in much better inventory position.

The assortment was well received with strong early performance, and as the holiday approached, the results softened. We feel our strategy was directionally correct, and we will continue to refine it for next year. Beauty, costume, jewelry footwear and music, which includes CDs also contributed to the compness in the category, and we’re currently testing several strategies in accessories that are gaining traction and we expect comps and accessories to improve in Q4 to be only slightly negative.

In Q3 sales at hottopic.com were down 1% with a positive 8% margin comp. Sales of regular-priced merchandise were positive and sales of clearance merchandise were down double-digits. As was the with Torrid, the lower sales in the clearance category a result of lower clearance inventory levels compared to last year.

Now, I’d like to spend a minute on Blackheart. In addition to the improvements in our core business we also launched an important test for the company with our new Blackheart concept in November. This negatively impacted earnings by $0.01 in third quarter, but more importantly Blackheart gives us the opportunity to leverage our customer base at Hot Topic, as well as appeal to a broader customer with product offerings that do not cannibalize the core Hot Topic business.

The concept will test the viability of offering dark urge sexy lingerie, sleepwear, loungewear, rocker apparel and accessories to grow 18 to 30 in standalone stores and online. We opened our first store at Brea Mall in Southern California last week, and yesterday launched blackheartlingerie.com.

By the end of this week, we expect to have the balance of our first five stores opened in southern California and Texas. We expect to focus more of our efforts on our online business as we test this concept, and the decision to rollout stores will be made when we feel we have proof of concept.

By leveraging our 5 million Hot Topic customers, we feel that we can grow substantial online business first and grow stores as needed. Moving on to current business, as you might expect during the first couple of weeks of the fourth quarter traffic and sales were a bit slower than we expected as resulting from the impact of storms on the East Coast.

Going into the holiday week, we anticipate a very promotional environment, and believe we will be well positioned to capture our share of the business both during Black Friday weekend and in December.

Switching gears to the organization, and we’re pleased with our progress as we continue to develop and improve our internal processes and strengthen our teams across the businesses. In the second quarter, we implemented a product life cycle systems to support our new product and sourcing strategy which has already had a positive impact on our performance.

Our improved processes will be supported by improved systems, including our new core merchandising system that we’re implementing to replace our current system at the end of this year. The investment in people processing systems is paying off, and I anticipate continued improvement in the final quarter of 2012.

Now that we have covered the current business at hand, I’d like to discuss the five year outlook for our businesses, let’s start by stating that we as a management team and our Board of Directors fully support our long-term strategic initiative. Firstly, we intend to grow Torrid, which we believe can support over 600 stores.

We’re going to continue to substantially expand our gross margin rates to our direct forcing model, markdown optimization and improving store and.com productivity. We intend to grow our Hot Topic store square footage by 15% to 20% over time by opening 80 to 100 Hot Topic outlet stores and 30 to 40 new stores in Canada.

We’ll develop robust CRM programs at both brands or grow the e-commerce penetration in both businesses and Blackheart. We’ll develop merchandising and inventory management initiatives to grow sales and lower volume Hot Topic stores. Based upon these strategic initiatives, we’ve modeled and develop average annual growth expectations. These rates of grow are averages unless noted otherwise, and relate to five year period as follows.

We expect top line sales growth of 10% to 15% per year. We expect 400 plus basis points of gross margin expansion over five year. We expect 25% to 35% annual growth in operating income. We are targeting double-digit operating income rate. And we expect 10% to 15% annual growth in floor wall square footage.

We ask that you keep in mind that the numbers discussed are annual averages, and that is our objective to try to maintain a consistent and sustainable rate of growth. Also please note that the aforementioned financial goals consider only our two proven brand Hot Topic and Torrid, no assumptions is built in for the new comps up.

Now I’d like to turn the call over to Jim, who will provide further color on the guidance.

James McGinty

Thank you, Lisa. We expect to see continued improvement in our operating results compared to last year. This improvement is reflected in the previously announced Q4 earnings guidance in the range of $0.23 to $0.27 per share, compared to last year’s $0.21 per share.

The Q4 guidance includes a loss of $0.01 per share for the cost related to Blackheart.

Now few more comments on Q4 guidance and future outlook. For the fourth quarter of fiscal 2012, we expect sales to be in the range of $230 to $240 million based upon a quarterly comp sales increase in the low to mid-single digit percentage range.

Gross margin is anticipated to improve significantly over last year consistent with the third quarter. SG&A expenses are anticipated to include additional accrual of performance-based bonus, an extra week of variable expense related to the extra week in Q4, also included is investment spending related to store openings and marketing to Torrid and Blackheart brands.

Excluding these costs, SG&A is expected to improve over last year. We are expecting inventory at the end of the fourth quarter to be up in the mid single-digit percentage range on a per square foot basis. Our guidance assumes approximately 43.5 million shares outstanding for the fourth quarter.

Now an update on our expected capital expenditures for 2012 and 2013. We continue to expect that the full year of 2012 capital expenditures will be approximately $37 million. We are expecting capital expenditures for the full year of 2013 the approximately $50 million with roughly 70% expected to be spent at stores.

The stores investment include opening 40 new Torrid stores and strip centers, relocating 10 to 15 Torrid stores from mall locations to strips. Remodeling approximately 60 Hot Topic stores, opening approximately 15 Hot Topic outlet stores, and opening 5 to 10 Blackheart store.

One last note, although we continue to report sales results on a quarterly basis, we’ll issue a press release in the first week of January to provide investors with an update on sales results for the November, December combined holiday period consistent with where we reported sales last year.

With that, I will turn it over to the conference operator who will direct you on questions.

Question-and-Answer Session

Operator

(Operator Instruction) And your first question comes from the line of Janet Kloppenburg with JJK Research. Please proceed.

Janet J. Kloppenburg – JJK Research

Hi, everybody. Congratulations on a very good quarter, and on a great outlook. Lisa, you tried for little sales, what did you say we should be assuming the square footage growth rate would be for next year?

Lisa M. Harper

Well I was giving five year numbers.

Janet J. Kloppenburg – JJK Research

All right. But I thought you said at the end what we should expect for ‘13, now?

Lisa M. Harper

No, I was just talking still in five years.

Janet J. Kloppenburg – JJK Research

You could ascertain what we were expecting for next year based on the store comp that I reviewed with capital expenditures…

Janet J. Kloppenburg – JJK Research

Okay. So the 40 new Torrid and the remodels in the 15 outlets and the 5 to 10 Blackheart?

Lisa M. Harper

Right.

Janet J. Kloppenburg – JJK Research

Okay, then my question on that was to, there’s nothing for Hot Topic, new Hot Topic, I thought you’re going to open some in Canada, now?

Lisa M. Harper

Well, we’ll be opening outlets next year in Hot Topic, and so we’re planning to open 15 Hot Topic outlets, and then we’re intending to begin or reengage our expansion in Canada in 2014.

Janet J. Kloppenburg – JJK Research

And the outlet stores will be about the same square footage of the regular stores?

Lisa M. Harper

Probably, slightly larger.

Janet J. Kloppenburg – JJK Research

And Blackheart is about 1,800 square feet?

Lisa M. Harper

Yeah, 1,800 to 2,000, yes.

Janet J. Kloppenburg – JJK Research

Okay, great. And then Lisa, as we look into the fourth quarter here, should we be expecting that accessories will be negative for both businesses but less negative, how should we be thinking about it?

Lisa M. Harper

In Hot Topic, it will be slightly negative, In Torrid you’ll still be probably in the high single digits in terms of the negative comps, but we do think that will have more of an offset to the negative accessory trend in Torrid by the positive into men apparels brand.

Janet J. Kloppenburg – JJK Research

And have you identified for both brands, have you identified what the accessory mix should look like in order to have that be a positive category, a positive comping category?

Lisa M. Harper

Yes. I would say in Hot Topic I feel very comfortable with what we have in place in terms of the traction I’m seeing in those businesses turn that positive in Q1, in Torrid I don’t have as many – have the weapons in that area, but I do think by focusing footwear, size specific jewelry and a broader segment online, that combined with the improvement or the continued growth into men apparel should come closer to offsetting the negative in accessories.

Janet J. Kloppenburg – JJK Research

Could it just be that may be the apparel business gets bigger, and including into men apparel?

Lisa M. Harper

It is.

Janet J. Kloppenburg – JJK Research

And could it just be that overtime, may be accessory is not that important right now for that brand? I don’t know, I’m just condensing.

Lisa M. Harper

It was probably over penetrated in the past because of softness in apparel areas, and we’ve identified a lot of areas in growth in apparel. So I agree with your theory there.

Janet J. Kloppenburg – JJK Research

All right, okay. All right, great. And then I just, I’m a little bit confusion on the gross margin opportunity at Torrid, the sourcing benefits should continue to help the gross margins for the next three or four quarters or is it beyond that?

Lisa M. Harper

Well, it will be beyond that, but it won’t be substantial in the next 3.5 quarters.

Janet J. Kloppenburg – JJK Research

Okay, and you feel like that whole vertical integration process is worked out or have there been some change there Lisa?

Lisa M. Harper

I think it was amazingly successful as it was an enormous undertaking or bringing in new teams…

Janet J. Kloppenburg – JJK Research

Very quickly.

Lisa M. Harper

Very quickly, and I’m very proud of the organization, I think they did a spectacular job.

Janet J. Kloppenburg – JJK Research

Okay. Okay, and then just a couple other things, Jim, I guess (inaudible) for me, you think you’ll have SG&A leverage in the fourth quarter?

James McGinty

No, I think we will deleverage a bit, and the biggest piece of that is performance based bonus, and as we mentioned we got an extra week of variable expenses for payroll et cetera.

Janet J. Kloppenburg – JJK Research

Okay.

James McGinty

But if you exclude those things, we’ll get some nice leverage.

Janet J. Kloppenburg – JJK Research

And gross margin up significantly, does that mean more than the 190 we saw in the third quarter, or can you frame that for us?

James McGinty

Yeah, what I said was consistent with the third quarter, is there an opportunity, yes, there is, but that’s where we feel comfortable talking about it right now.

Janet J. Kloppenburg – JJK Research

Okay. And then just on the license category, I think you said that the release calendar for the third quarter was flat to last year, is that right, or it’s going to be flat for the fourth quarter?

Lisa M. Harper

It’s kind of apples-to-apples for the fourth quarter as this year the last year.

Janet J. Kloppenburg – JJK Research

You just still think that can cause Lisa, because of the assortments being chopper?

Lisa M. Harper

Yes. I mean I think the message that I’ve been delivering consistently since first quarter of this year is that, we have an opportunity and are actualizing that opportunity in all of our license properties even without new blockbuster releases. So we are eliminating that doom and bust cycle that we’ve had historically as a company related to big releases.

Janet J. Kloppenburg – JJK Research

Okay, I got it. Thank you so much, and all the best for the holiday season. I’ll talk to you guys tomorrow.

Lisa M. Harper

Okay. Thank you

James McGinty

Thank you

Operator

And your next question comes from the line of Thomas Filandro with SRG. Please proceed

Thomas A. Filandro – Susquehanna Financial Group, LLLP, Research Division

Hey thank you and congratulations as well for managing a good quarter. Lisa, can you may be expand a little bit on this Torrid comment that you made about the web. I’m not fully understanding what the initial process was going in and what the change is more specifically?

And then secondly in terms of Torrid, can you give us any thoughts around the learn as you opened up these strip center stores for maybe you’d just see a regional variance, demographic variance, where you need to be closer to other specialists or any anything that would give us an indication of your more aggressive, I should say confirm forward view of building 600 stores. And then if I can Jim, I think you said inventories, I am not exactly sure what you said inventories are, can you give us where the inventors are, what the outlook is from both the cost and unit basis, and any kind of commentary on brands, and then I have one another final question? Thank you.

Lisa M. Harper

Okay. Thanks, Tom. Okay, Torrid web just to recap that, a lot of the webness in third quarter was self inflected due to us being too aggressive on our productivity initiatives. So what we’ve really focused on, since I joined the company is making or SKUs more and more productive, because we are highly over skewed and resulting in being an aged inventory and highly over inventoried.

What we’ve done is, we’ve been very aggressive with that, and what happened in the third quarter, with all the moving pieces in Torrid and changing strategy is that, we are putting to much pressure on the per SKU productivity on line, and we dropped or SKU, our web-only SKUs dramatically in the third quarter, and the increased productivity couldn’t keep up with the decrease in SKU.

Thomas A. Filandro – Susquehanna Financial Group, LLLP, Research Division

Fine.

Lisa M. Harper

That was one side of it. The other side of it was the huge shift out of clearance inventory on line, so even with a negative 10 comp; we had a positive growth margin comp in that business, on the online business. So that comp, great gross margin, and it will balanced out as we go forward with the stronger comp, and a strong gross margin and then will moderate that as we move forward. Did that answer the Torrid web question?

Thomas A. Filandro – Susquehanna Financial Group, LLLP, Research Division

Yes. Now I fully understand. Now I get it. Thank you.

Lisa M. Harper

Okay. We’ve learned that Tom on the strip center pieces, we’ve learned demographic mixes, co-tenancies, how far we should be from the mall, who are best or every piece of that, and I think that those learnings and the deep dives that we’ve done on the analysis additionally with our traffic information or conversation information, our power hours or payroll scheduling have enabled us to make even better deals next year, and better real estate decisions on our strip. So I think that this year was great in terms of some great performances as well as a very, very valuable learning, and we have a very clear picture of what our success factor are for real estate choices that we’re making for next year.

So I would expect our choices to improve and although we’ve been very happy with our overall initial responses in these locations that though even get stronger as we move forward.

Thomas A. Filandro – Susquehanna Financial Group, LLLP, Research Division

Okay.

Lisa M. Harper

And then Jim, you can talk about inventory.

James McGinty

Sure, sure. In terms of the inventory guidance, we ended the third quarter, inventories were up about a percentage point on a per square foot basis. We expect to end the year with inventories up mid single-digits. The reason we expect them to up a bit more at end of the year is one we’ve got more of the vertical sourcing with in-transit inventory. Two, we’ve got – we closed the year out actually a week later, and that much closer to Valentine’s Day, so we’ll receive more product for that holiday. In that week that would have been the first week of February a year ago.

Thomas A. Filandro – Susquehanna Financial Group, LLLP, Research Division

And Jim, in terms of units is that a, that the cost number obviously, our unit is down, up, flat?

James McGinty

Tom, I don’t have that, my senses is that they would be flatter because we’re seeing some increases in average retail, would you?

George Wehlitz Jr.

Yeah, what I’d say on that is that in the Torrid brand we’re seeing a lot of the cost savings associated with the vertical, so while the units won’t be down as much as much as their cost inventory is. In Hot Topic where we don’t have as much of that vertical strategy in place, we have adjusted our accessory units down more than the rest of the inventory. So in the case there’ll be little bit higher average unit cost, so what we’ll see is that the, there’ll be a little miss-alignment between using cost in the opposite direction.

Thomas A. Filandro – Susquehanna Financial Group, LLLP, Research Division

Very helpful. Thank you, just one follow-up, Lisa, I think you mentioned in five-year plan a more aggressive push on CRM, can you just dig a little deeper into that, what needs to happen for that to occur, and what are you talking about it specifically by brand on CRM?

Lisa M. Harper

Well, we have honestly with a lot of the moving pieces that we’ve been dealing within the business for the last 18 months, we had it moved out quickly on e-commerce or CRM, we have our few process right now for the new CRM system that we’ll implement on mid year next year, and we’re – I’m getting more resources to that, and looking to build that business.

We have a pretty healthy group right now in both brands in terms of numbers. We’re doing a lot of more work on the analytics in terms of customer behaviors and things that we can do to encourage the type of customer behaviors that we’re big fans of. So I would say that you guys always ask me if there’s more question. And maybe the top of the second, for the process in CRM, and we have a lot of – in the CapEx number for next year, we have a lot of investment both in CRM as well as e-commerce system and processes improvement.

Thomas A. Filandro – Susquehanna Financial Group, LLLP, Research Division

Fantastic. Thank you very much. Best of luck this holiday season.

Lisa M. Harper

Thank you

Operator

And your next question comes from the line of Jeff Van Sinderen from B. Riley. Please proceed?

Jeff Van Sinderen – B. Riley & Co.

Hi, good afternoon. And let me say congratulations on the overall improvement, and it’s great to hear about your five-year plan. Maybe you can talk a little bit more about how far along the vertical sourcing initiatives is at Torrid, maybe what level of penetration is looking right to you at this juncture and with externally sourced product, and I guess how that plays into the Torrid contribution margin target, and then also maybe you can also – you can touch on what you’re seeing in your Torrid off-mall stores in terms of performance versus what you are seeing in-mall Torrid stores?

Lisa M. Harper

Okay. In terms of the vertical process, believe it or not, I think we went a little too heavily into the vertical product. And one of the initial strategies was to keep up in the buy dollars there to go out to the market and we are quickly to transact. What we did instead as we did quick turn group grew the vertical process. And so I think there is still more of a balance.

But I would say that right now in apparel, we’re probably 92% and 94% vertically source. And I think that’s around 90% and it actually became a larger percentage than I had initially intended through the process. So that’s good and so far so good on that. But it’s a matter of one or two points suggesting. It’s not a broad adjustment at this point.

Torrid off-mall, I would just say in general probably excited to be true is through lower traffic, higher conversion, higher average trend. And on that you’re seeing some of the drop in transaction numbers, average transaction numbers in Torrid related to most of the decrease in clearance as well as the shift and the trend as will become a bigger percentage of strip center stores, which will we expect to have lower transaction in that part of the model. So, so far we’re hitting, right where we expected to hit in terms of that combination.

Jeff Van Sinderen – B. Riley & Co.

Okay, good. And then maybe you can just touch a little bit on the Hot Topic outlet strategy, and you’re opening some stores there. You announce that maybe you can just give us a better sense of what kind of merchandise will be in the outlets and kind of what the strategies there?

Lisa M. Harper

For Hot Topic, we currently operate four outlets and we’ve been operating them for a while, and primarily it’s similar equipment we do special buys, they might get a higher percentage of clearance, we might have the different promotional strategy for them. But it’s not a separate assortment, wholly separate assortment in Hot Topic outlet.

So, primarily a real estate strategy and then we’ll use more pricing power, information modelling in those location. They again picked our full quarters just before that we’ve had and we’ll green the best practices from what we’ve learned in those areas that we feel strongly that especially because we’re wide open in terms of our real estate opportunity there, but replacing them in a very strong location to the first around of 15 that we will have in next year. So it’s not a wholly separate merchandising or inventory strategy there.

Jeff Van Sinderen – B. Riley & Co.

Okay. So I mean even though you’re going to have more of them now. You’re not going to gravity towards using it as a clearance vehicle for the whole chain or just like that?

Lisa M. Harper

Well, we do in a little bit now with those stores. I’ll point out what stores carry a little bit higher penetration of clearance. But they still have a large percentage of regular price product in the mix and we think that we can augment it with some private label business that we are developing in Hot Topic as well. So it won’t be exactly as it stands today, but we will certainly take what we know from our current operations and trend it as we open more and more units here.

Jeff Van Sinderen – B. Riley & Co.

Okay, good. And then just one final one, any color you can give us on plan promotional levels, or new promotional programs at Hot Topic for holiday this year versus last year, just trying to get a sense of, is there anything, any major change we should think about there?

Lisa M. Harper

I feel comfortable with the plans that we have in place.

Jeff Van Sinderen – B. Riley & Co.

Okay, fair enough. Thank you very much and good luck for the quarter.

Lisa M. Harper

Thanks, Joe.

James McGinty

Thanks, Joe.

Operator

And your next question comes from the line of Dana Telsey with Telsey Advisory. Please proceed.

Dana Telsey – Telsey Advisory Group

Good afternoon, everyone, and congratulations on the improvement. As you think about the product categories apparel and accessories in each of the businesses, how you are thinking of the AUR in each of them and tops versus bottoms in each of them and what the margin opportunities are? Thank you.

Lisa M. Harper

Well, I think that the conversation earlier about the shift, accessories are soft, I think as a macro softness in accessories. I think that as our apparel and assortments improve in both brands that we are seeing a push towards slightly lower penetration of accessories in both businesses.

I think the good news with that is that, because we are adding the vertical piece of that, we are not really getting hit with the margin, negative margin impact as we shift out of accessories into apparel. And that also is driving our average unit retails office they were up, our average transaction rate sizes were up in both brands have continued to be both, up in both brands related to lower clearance levels as well to shift out of accessories into apparel.

So we are seeing that happening. We expect it to continue to happen hopefully our plan or at this point that great will moderate at some point and that we won’t see the same year-over-year changes in those levels that we’ve seen this year. Tops versus bottoms in the businesses, we are very comfortable in Hot Topic, because we’ve done a great job I think of building that Denim in bottoms business, as well as skirt business in the girl side. And that penetration is much healthier than it was even a year ago.

And in Torrid I think we have an opportunity to drive more tops business and I think a lot of that is getting back into the license tees business in the world, as well as being able to chase product a little bit more efficient way faster either out of the market, or still down vertically by a quick turn partner. So I think that we have, I feel comfortable with it in Hot Topic and I think we have more of an opportunity in Torrid.

Dana Telsey – Telsey Advisory Group

Thank you. And on Blackheart, how much CapEx do you think will be diverged to that next year?

Lisa M. Harper

A minimal amount.

James McGinty

Yeah. Somewhere between in terms of the stores $1 million and $2 million.

Dana Telsey – Telsey Advisory Group

Thank you. Good luck for the holiday season.

Lisa M. Harper

Thank you.

James McGinty

Thank you.

Operator

And your next question comes from the line of Adrienne Tennant with Janney Capital Markets. Please proceed.

Lisa M. Harper

Adrienne?

James McGinty

Adrienne? It looks like Adrienne is not in the queue.

Adrienne Tennant – Janney Capital Markets

Hello.

Lisa M. Harper

There you are.

Adrienne Tennant – Janney Capital Markets

Can you here me? Sorry, just saying I’m having phone problems and they can’t get into the queue, but here I am, anyway congratulations on the progress. Lisa, my question for you with Blackheart sort of what was the slot behind that in term I know the stores are very small Hot Topic in terms of testing it and then deciding to launch at a separate entity. What would then be this notion you said sort of proof-of-concept online first and then for more aggressive rollout. So what do we looking for in terms of maybe revenue targets in the first year or something like that, maybe if you can talk a little bit about that?

And then Jim for you, I think Lisa, are you made some commented of Hurricane Sandy the early impact of that, we too assume that causes at the lower end of the range and what we accelerate as we get into the heart of the selling season? And a final question is on Torrid, the strip versus mall. It is still about the 700 basis points spread or is that starting to actually widen out now that you have the new strategy in place? Thank you.

Lisa M. Harper

Okay, I’ll start with the boycott question. Boycott really came from couple of different directions. One was that we were investing heavily in talent in order to grow our Internet business at Torrid, adding sourcing basis and production basis and internal talent, both design and technical and product development to do the businesses.

And we thought that doing the analysis that there was an opportunity for an alternative look and instrument apparel mix on graduate, our current end graduate is Hot Topic customers. So we saw like the combination of building the team to work on Torrid, leveraging that teams to expand a new concept and being able to use that we graduate a lot of customers every year in Hot Topic and we also feel like the upper range of our growth and guys quite honestly, this concepts appeals to them.

The idea is that it has some custom stores, would be very active with the online presence and we couldn’t really set whereas we are space constrained in our current Hot Topic stores. We thought like to do the brand justice that needed space that needed to have a slightly more mature point of view and not be surrounded with Adventure Time and Brony, although we love Adventure Time and Brony’s daily.

And so that was the revenue target, I don’t know if I want to get that specific, but I really expect that they would be in a couple of years similar to the same type of sales productivity that we have in the Hot Topic and the same type of location. So what we’re looking with that contents we basically baked everything that happened so far in the quarter and to the type of guidance that we’re giving today. So we feel comfortable still with the guidance that we have out there both from a comp basis as well as on an earnings basis. So we don’t need to adjust that based on current result.

Adrienne Tennant – Janney Capital Markets

Okay, great.

Lisa M. Harper

And then the Torrid [dress] versus the mall, I would just say that a little kind of maybe that kind of answer I gave a little earlier, if we’re willing so much about the right size, or right location or right tenancy, the right demographics and the right way to open them the green opening strategies the promotional strategies, that are necessary with the store openings. And we’re still seeing the improvements that we talked about in terms of lower occupancy so the flow through on [four wall] contribution is higher.

We’re not at the mature number yet. We think that the 700 basis point is not in the first month started open. But we certainly are well in track achieve the goals that we’ve set with that. We haven’t seen that expansion change with the additional gross margin improvements right now. It’s kind of happened in all locations. So it prioritize taking all the shifts up and so we’re very comfortable still with the essentials that we given before, which is that 700 basis point improvement in contribution and an 18 month are the last pay back on these new stores.

Adrienne Tennant – Janney Capital Markets

Okay, great.

James McGinty

And I would just add that our goals also improved contribution at the mall stores. So we’ve done a lot thing in the last year outside of the whole real estate strategy.

Adrienne Tennant – Janney Capital Markets

Right.

James McGinty

Such as we closed the least profitable store locations we’ve negotiated other reduced rents in certain location all which are benefited some of the more mature mall based stores.

Adrienne Tennant – Janney Capital Markets

Right. And then the clearance, the online clearance activity at Torrid, was that isolated to the third quarter or does that have sort of still over effect from last year into the fourth quarter? Do we still have that for a net offset to the strong comp performance at the store level in Q4?

Lisa M. Harper

I would say for about one month of the fourth quarter, it has an impact for the other two months in a week improves.

Adrienne Tennant – Janney Capital Markets

Okay, wonderful. Best of luck for holiday.

Lisa M. Harper

Thank you.

Adrienne Tennant – Janney Capital Markets

Thanks.

Operator

And your next question comes from the line of Stephanie Wissink with Piper Jaffray. Please proceed.

Stephanie S. Wissink – Piper Jaffray Companies, Research Division

Thank you. Most of my questions have been asked, but I have just a couple, Lisa one for you on the merchandise margin go as you look over the next five years. I think you are indicating something in that 400 basis point range, which would take you into the high 30s on the percentage basis on the gross margin at level, do you think it prioritize for us kind of the major building blocks if you can of where you are today and getting to that level what the major pieces are of that?

And then just the second question on the incentive compensation that’s built into the store level payroll, has been any change in the incentive structures to really compile this pursuit drive traffic and transaction value at both the Hot Topic and Torrid store? Thank you.

Lisa M. Harper

Okay. So gross margin gets broken into purely on the top line, I knew and then we have so much opportunity and markdown optimization and allocation strategies. We just recently started the Blackheart strategy where we don’t 100% commit, 75% or 70% to 80% commit, and then flow into sales, so that’s getting our inventory in the right places. We have some opportunity rolling it down to a gross margin basis and distribution where we have never been able to do a pre-pack at Hot Topic and next year we will be able to start doing pre-pack. So that would substantially lower our distribution and logistics costs in our business. We have, I would guess every line item there were as you roll down to get to your gross margin, we are addressing every line. We are having a lot of improvement in store, other expenses were having occupancy (inaudible) in our strategy. So I would say obviously a big chunk of it comes through the gross margin, but gross margin is more than just markup.

And then every other layer is a incremental annual improvement on each of those areas as we become more and more productive and more like the current investor breed in terms of retail operations. What was the second question?

James McGinty

The incentive compensation as it pertains to store payroll, when we were talking about the deleveraging of the expense in both the third and fourth quarter really that was the HQ performance-based compensation, it’s not…

Stephanie S. Wissink – Piper Jaffray Companies, Research Division

If there is some stores now.

James McGinty

There is a little bit of stores.

Lisa M. Harper

Yeah, so the method hasn’t changed yet, I would say what changing is especially in Torrid, the KPI process that’s happening, there is a much more awareness on traffic conversion dollars per customer, power hours and resource scheduling and so we’re seeing improvement there and that all kind of rolls down to the store productivity and profitability and that’s right there on bonus line.

Stephanie S. Wissink – Piper Jaffray Companies, Research Division

Okay, that’s very, very helpful. And then just on the transaction declines, Jim if you could give us some insight into how that flows kind of quarter-to-quarter? Where should we start to see that transaction level normalize?

James J. McGivney

Well, certainly it’s been our observation in the last year that we’ve seen our customers shopping maybe a little less frequently buying more. We’ve also seen a decline in the transactions which are really just clearance, because the clearance penetration as well, that in and of itself drives the average transaction down. In addition to that there is the accessory penetration, which obviously commands in a much lower average unit retail and therefore the incremental transaction that were accessories.

Lisa M. Harper

Largely, loss in transaction specifically at Hot Topic are very small transactions, the transactions under $10. And so that peak sale clearance as well as accessories loss in those business and so, we then see, we’re annualizing those trends right now and we’ll start seeing and we would expect the transaction trends to start improving.

Stephanie S. Wissink – Piper Jaffray Companies, Research Division

All right, best of luck. Thank you.

James J. McGivney

Thanks.

Operator

And your next question comes from the line of Liz Pierce with Roth Capital Partners. Please proceed.

Liz O. Pierce – ROTH Capital Partners LLC

Thanks. I was afraid I wasn’t going to get in. Couple of housekeeping questions, Jim, are you going to restate comps for this new where you guys are reporting?

Lisa M. Harper

With the segment of business in Hot Topic?

Liz O. Pierce – ROTH Capital Partners LLC

Right.

James McGinty

As we go through these calls, we’ll give you some kind of breakdown in terms of the penetration what it was last year and this year.

Lisa M. Harper

We’ll give any penetration or giving just their comp.

Liz O. Pierce – ROTH Capital Partners LLC

Okay, so what’s the rate for each apparel?

Lisa M. Harper

Right, fashion apparel was about 22, and tees and hoodies were 45 and accessories was down 10.

Liz O. Pierce – ROTH Capital Partners LLC

That was last year?

Lisa M. Harper

That was this year.

Liz O. Pierce – ROTH Capital Partners LLC

That was this year, okay. All right, maybe I can get to some of this off line. And then on Blackheart, I’m curious if we seen other retailers attempt to into apparel and then haven’t really have the infrastructure to do so. Do you guys feel confident based on what you’ve already done with Torrid and Hot Topic that you do have the infrastructure just because it is size intensive.

Lisa M. Harper

Yes, is that the end of your question? All right, I thought there was so much, sorry about that Liz. Yeah, I think we casually see it as a huge growth opportunity in Torrid and we are investing in that infrastructure anyway, the sourcing partners, the manufacturing product assortment that we felt more able to address that at this category. I will also say that the point of view of Blackheart if you go online or you have an opportunity to visit a store and for you, Irvine Spectrum will open this weekend that it’s more of a lifestyle point of view than it is kind of your traditional pure play internet apparel.

And we are very serious about the product, it fit well, it’s well produced, high quality, and so we are serious about it, but the reality is it’s very much a lifestyle environment. And we feel we have opportunity to capture customers that would necessarily go into a Hot Topic. We are seeing customer trends in the store, one store that really indicates that we are getting a much broader base of customer checking it out and purchasing.

So there is a couple of, there are many layers of strategy kind of worked into those process, and the levers that we have internally is there and really driven by the fact that we already have a proven business that we know the intimate apparel should be as, have a substantial growth, so we are already investing in that.

Liz Pierce – ROTH Capital Partners

Is it the same key inventory that’s funding us, or is it a separate team?

Lisa M. Harper

From a product development piece, it’s the same team…

Liz Pierce – ROTH Capital Partners

Okay.

Lisa M. Harper

But from design, it’s different.

Liz Pierce – ROTH Capital Partners

Okay. All right, that’s all I have. Thanks and best of luck.

Lisa M. Harper

Thank you, Liz.

James McGinty

Thanks.

Operator

The next question comes from the line of Joe Yurman with 1221 Partners. Please proceed.

Joseph J. Yurman – 1221 Partners, LLC

Hey, guys, congratulations on running the business in for the validation of the strategy.

Lisa M. Harper

Thanks, Joe.

Joseph J. Yurman – 1221 Partners, LLC

And thanks for the five-year plan. Lisa, I didn’t catch all of the different bullet points on the five-year plan, if you could just kind of take them off again, I would appreciate that?

Lisa M. Harper

Okay, I will speak. Once again these are averages that are not per year.

Joseph J. Yurman – 1221 Partners, LLC

Sure.

Lisa M. Harper

Okay, we expect top line sales growth of 10% to 15% per year. We expect a 400 plus basis point of gross margin expansion. We expect 25% to 35% annual growth in operating income, and we are targeting double-digit operating income rate. And then we expect that 10% to 15% annual growth in square footage.

Joseph J. Yurman – 1221 Partners, LLC

Gotcha, okay. And I can extrapolate some of that and are you willing to give a sense of kind of and again it could be a range of ballpark whatever you want and do, what is the revenue breakdown of the company look like given some of these metrics between Torrid and Hot Topic?

James McGinty

Yeah, I don’t prepared to do that test today in terms of giving that kind of detailed break out. But I think we provided enough information in terms of units store growth by divisions and changes there and that we have also outlined – the productivity of the levels of those stores by division that you would be able to model that forward.

Joseph J. Yurman – 1221 Partners, LLC

Gotcha.

Lisa M. Harper

Just one more please note those number relates to Hot Topic and Torrid, Hot Topic outlet and Torrid outlet and Hot Topic Canada and none no other new business.

Joseph J. Yurman – 1221 Partners, LLC

Sure, no I was just including those two. Anyway I’ll do the work on my end, great job once again.

Lisa M. Harper

Thank you.

James McGinty

Thank you.

Operator

And your last question comes from the line of Adrienne Tennant with Janney Capital Markets. Please proceed.

Adrienne Tennant – Janney Capital Markets

Hi, I just had a follow up on Jim this is actually a clarification question on the gross margin yielded for the fourth quarter up significantly, consistent with the third quarter did you mean consistent with the up 190 in the third quarter or consistent with the rate of the third quarter?

James McGinty

Consistent with the differential to the prior year.

Adrienne Tennant – Janney Capital Markets

Okay just say (inaudible) how is it consistent with the 35.8. So, I just want make sure that that clear was the up 190.

James McGinty

That is great. Thank you.

Adrienne Tennant – Janney Capital Markets

Okay. Great thanks. Bye

James McGinty

Bye.

Operator

Now I will like to hand the call back over to management for closing remarks.

James McGinty

Thank you for continued interest in Hot Topic and if you have any questions fell free to drop us an e-mail or give us a call. Thanks.

Operator

Ladies and gentlemen that concludes today’s conference. Thank you for your participation. You may now disconnect. Have a wonderful day.

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