Hot Topic Q3 2007 Earnings Call Transcript

Nov.20.07 | About: Hot Topic, (HOTT)

Hot Topic (NASDAQ:HOTT)

Q3 2007 Earnings Call

November 20, 2007 4:30 pm ET

Executives

Elizabeth McLaughlin - Chief Executive Officer,Director

James McGinty - Chief Financial Officer

Christopher Daniel - President, Torrid

Analysts

David Berman – Berman Capital

Lauren Levitan – Cowen

Kimberly Greenberger - Citigroup

Jeff Klinefelter – Piper Jaffray

Anna for Brian Tunick – JP Morgan

Barbara Wyckoff - Buckingham Research

Jeff Van Sinderen - B. Riley & Co.

Sharon Zackfia- William Blair

Holly Guthrie -Janney Montgomery Scott

Operator

Good afternoon, ladies and gentlemen and welcome to the HotTopics third quarter 2007 earnings release conference call. At this time, all participants have beenplaced on a listen only mode and the floor will be opened for your questionsfollowing the presentation. This callwill be limited to one hour.

Before we begin, I would like to remind you that during thecourse of this conference call, the company will be making certainforward-looking statements. Suchstatements relating to financial results, guidance and future financialperformance, merchandise assortment and related matters, and statementsrelating to key personnel and operational issues. These statements, as well as relatedinformation posted on the Hot Topic investor relations website involve risk anduncertainties that may cause actual results to differ materially from currentexpectations. These risks anduncertainties are discussed from time to time by the company and are more fullyset forth in the periodic report that Hot Topics files with the Securities andExchange Commission, including its mostrecent annual report on form 10K and the quarterly report on form 10Q.

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

To more effectively disseminate the information discussedthis afternoon, this call is being webcast at www.earnings.comand a replay will be available on that site for approximately two weeks. A replay will also be available at888-286-8010, passcode 19527307, for approximately two weeks.

Now I will turn the call over to Hot Topics Chief Financial Officer, Jim McGinty.

Please proceed.

James McGinty

Hi, this is Jim and welcome to the call.

While on hold, you have been listening to “She Says” fromVHS or Beta, which released this past August. My partners on the call today are Betsy McLaughlin, Jerry Cook, andChris Daniel.

For competitive reasons we will not be discussing anyspecific forward-looking product information during this call. I will begin by discussing the third quarterresults and then comment on the balance sheet and cash flow. Following these details, I will turn it overto Betsy who will provide you with additional color on the quarter and theoutlook.

First, the results of the third quarter. Unless otherwise noted, as in the case ofcomparable store sales related to the one week calendar shift, all comparisonsdiscussed are to the fiscal third quarter last year, ending October 28,2006. Comp store sales are adjusted forthe 2006 calendar shift.

Hot Topic, Inc.’s third quarter net sales were $188.5million, a decrease of 4.2% over the third quarter of last year. Comparable store sales were down 2.6% for thequarter.

By division, Hot Topics comps were down 3.1% while Torrid’scomps were up 4/10%.

Overall the company’s net sales during the quarter decreasedby $8.2 million due to a $6.5 million sales loss related to the shift of thefiscal calendar, a $4.2 million sales loss from the total company comparablestore sales decline, a $300,000 loss from internet sales, a $200,000 sales lossfrom expanded or relocated stores, including the periods that the stores beingremodeled were closed for construction.

These losses were offset in part by a $600,000 sales gainfrom new and non-comparable Hot Topic stores and a $2.4 million sales gain fromnew and non-comparable Torrid stores.

For the quarter, total company comp decline was a result ofthe 2% increase in the average number of transactions in comparable stores anda 1% decrease in consolidated average transaction value.

At Hot Topic, apparel was 56% of total sales in the thirdquarter, versus 55% a year ago as a result of the strength of Rock T’s andrelative weakness in the accessories categories.

At Torrid, apparel 78% of total sales in the thirdquarter.

Gross margin was 36.3% of sales compared to 34.8% of saleslast year. 150 basis points improvementbreaks down into the following categories:

· Merchandise margin increased 390 basis pointsdue to significantly reduced mark downs, higher initial markup, higher damageallowances, and lowered freight and expenses

· Store occupancy and depreciation expensesincreased 200 basis points due to the accelerated depreciation related to ourstore remodel program and also due to the deleveraging of store expenses on thelower volume.

· Distribution costs increased 30 basis points dueto higher consulting fees and increased expedited freight to the storespartially offset by lower outside temp personnel expenses

· And finally, buying costs were up 10 basis points,primarily due to higher payroll expenses and deleveraging on the lower salesvolume

In the third quarter, selling, general and administrativeexpenses were 30.8% of net sales, compared with 28.9% last year. The 190 basis point increase in SG & A expensesbreaks down into the following categories:

· Storepayroll as a percentage of sales was up 150 basis points as a result of higherminimum wages, higher medical expenses and the deleveraging of payroll costs onthe lower sales volume

· Marketing expenses increased by 30 basis pointsrelated in the calendar timing of Torrid marketing expense

· Store other expenses increased by 20 basispoints primarily due to the telecommunication costs related to our conversionto DSL

· These expenses were partially offset in adecrease in store supplies

Lastly, other G & A expenses declined by 10 basis pointsdue to savings in performance based bonus and stock based compensation,partially offset by charges associated with the DSL conversion.

Third quarter operating income decreased $1 million to $10.5million. Operating margin for the thirdquarter was 5.6% of sales versus 5.8% last year. Interest income increased to 2/10% of sales.

Our effective tax rate was 38.9% for the third quarterversus 39.9% last year.

We reported third quarter earnings per diluted share of $.15compared to $.16 a year ago.

During the quarter, we opened a total of five new Hot Topic stores andfourteen Torrid stores and closed three Hot Topic stores. We also remodeled or expanded fourteen HotTopic stores during the quarter.

We currently have a total of 82 Hot Topic stores in our newformat.

The average Hot Topic store was 1,748 square feet at theend of Q3 compared to 1,744 at the end of last years’ third quarter.

The average Torrid store was 2,506 square feet at theend of the third quarter versus 2,514 at the end of the same period last year.

Cash, cash equivalents, and short term investments declined5% year over year to $35.6 million, primarily due to the $7.2 million spent onour share repurchase program during the third quarter.

As mentioned in our press release, we repurchased an aggregateof 870,470 shares of our common stock during Q3. We have approximately 32.8 million remainingunder our current share buy-back authorization. We will continue to review the share repurchase program authorized byour Board of Directors this past August and will proceed with a balancedperspective that considers both our forecast cash position as well as theopportunity to repurchase shares at what we consider to be a value price.

Total inventory increased 3% to $104.9 million. On a per square foot basis, inventory was down½% at the end of the third quarter.

As the quarter end is one week later this year, ourinventories were down high single digits on a per square foot basis as comparedwith the corresponding comparable week last year.

Capital expenditures were $16.3 million in the quarter,primarily related to the 19 new stores and 14 Hot Topic remodels/relocationsduring the third quarter and the additional stores scheduled to be opened orremodeled or relocated during the fourth quarter of 2007, as well asexpenditures for systems development.

Depreciation and amortization expense for the third quarterwas $10.1 million versus $9.7 million last year.

Now, I will turn the call over to Betsy.

ElizabethMcLaughlin

Although we are disappointed with our prolonged negativecomp sales trends, our initiatives to manage inventories more tightly andcontrol expenses enabled us to stabilizing earnings despite the lower top linesales in the higher store base.

On our previous earnings call, we outlined five keystrategies to improve the Hot Topic business results. I will start with a review of each of theseinitiatives.

First of the five is the evolution of the Hot Topic musicexperience. T his is a multi-year strategy which is critical to our conceptpositioning as music is the differentiating cornerstone of our brand. During the spring of ’07, we set out tobecome less dependent on major artist and support mid-tier and small bands.

We rotated the product assortment, evaluated the definitionof fair pricing, reallocated marketing dollars, and redefined the in-storemusic experience. As direct results ofthese initiatives, we have achieved a positive 18 percentage point swing in ourcomp sales in the music category since the first quarter.

We will continue to improve our in-store music presencethroughout the next years.

One of our next steps is to evolve our online offering intoa compelling experience in music discovery. We plan to launch this new online initiative in the first half of 2008and will provide more details as we get closer to the launch date.

Our second initiative was to continue to remain committed toa fundamentally regular price business in spite of the temptations to be morepromotional to drive short term comp store sales increases.

We expect to continue to experience negative comps throughthe fourth quarter until we no longer have to anniversary the heavy promotionalactivity from a year ago.

Our third initiative is inventory management. We continue to closely manage our inventoriesto levels low on a per square foot basis. These lower inventory levels are resulting in lower markdown rates. We expect to see significant P & Lbenefit from this discipline in the fourth quarter.

Next we set out to re-establish Hot Topic as an itemdestination with a primary focus on the T business. During the third quarter, total T’s includingrock T’s, novelty T’s and fashion T’s comp'd up high single digits andincreased their penetration to the total mix as planned.

Finally, we committed to remodeling or relocating 60 to 80of our existing Hot Topic stores into the new design that better represents theever-widening teen music preferences.

We are on track with our plan to remodel or relocateapproximately 70 stores this year.

The group of stores that we have remodeled thus far includestores whose leases are expiring and stores located in high volume, highexposure malls that create a significant brand presence in their respectivemarkets. The latter group clearly camein with a higher price tag as we accelerated the depreciation of assets underthe old lease and typically had to commit to new 10 year leases with higheroccupancy costs.

Though we remain convinced that this was and is the rightdecision for the brand, the pure sales lift is not adequate to offset theoccupancy costs incurred as a result of the new real estate economic.

In 2008, our conversion of stores into the new design willbe almost exclusively those stores whose leases are up for expiration and donot require an incremental write off of our accelerated assets.

We are committed to adhering to these initiatives which webelieve are correct for the long term, despite the short term comppressure.

I will now focus some comments on the third quarter.

As the third quarter was challenging on the top line, I willstart with the category that most adversely affected our total results: accessories.

The accessories category was down 8% for the quarter, on topof a 7% decline last year. While we havemade progress in the apparel areas with respect to an item focused on productthat Hot Topic has thought of as a destination, we have not completely evolvedthe accessories assortment.

The areas within accessories that have transitioned areseeing improved results. It is ourexpectations that when additional categories transition over the next month,the overall accessory business, while still remaining negative, will see someimprovement.

The music category comp’d up 2%. The first positive comp since the firstquarter of 2006. The positive comp is asignificant improvement from first and second quarter comps of down 16% anddown 7% respectively.

Rock T’s improved from down high single digit comps in thefirst half of the year, to up high single digits in the third quarter.

CD’s improved from being down in the high teens in the firstquarter in line with the music industry to solid positive double-digit comps inboth the second and third quarters.

Our initiatives to shift our dependence away from majorreleases and establish strong relationships with emerging and mid-tier bands asthe key driver of the sales improvement in our music classification.

As an example, the top ten bands during the third quarter ofthis year contributed 20% less volume compared to the top 10 bands of the thirdquarter of 2006.

The women’s business also comp’d up 2%. Women’s fashionsuffered from comparisons to a very high level of promotional activity lastyear. Women’s novelty T’s randouble-digit increases as a result of strong performances in the number oflicenses.

In line with our T destination strategy, we attribute theseresults to an intense focus on exclusivity, flow and fresh licenses.

Men’s comp’d down 2% - primarily a result of more difficultcomparisons associated with the high level of promotional activity last year inboth T’s and bottoms. Although the men’stops business overall was slightly positive, bottoms was down negative doubledigits.

Torrid continues on a positive trend, generating a slightlypositive comp despite a difficult fashion retail environment. Average transaction size and gross marginrate continue to grow. Inventory on acomparable week basis was down mid-single digits on a per square foot basis andwe continue to experience gains in initial markup.

Apparel continues to perform well with both tops and bottomscontributing to the positive business. Our top to bottom selling ratio also continues to rise.

Torrid.com performed at a high level, beating last year byalmost 40%. The site continues to showsignificant traffic growth with DivaStyle members leading the way in terms of average dollar purchase.

In terms of Diva Style, we have almost a million sign upsand over 130,000 full members. We have aloyal base of customers and have seen considerable success with our direct mailmarketing offers.

When we began reporting our divisional monthly comps back inAugust, we committed to providing additional Torrid store metrics on thisearnings call, so here they are:

The average new Torrid store requires an investment ofapproximately $400,000. The average newTorrid store is cash flow positive in its first year of operation and weestimate the cash investment is fully recovered by the four wall cashcontribution in a period of three years.

These numbers are based upon the actual results of storesthat we have had open for more than a full year estimating their performance throughtheir third year of operation. Goingforward, the store investment breaks out to an average build out cost for a new2,500 square footTorrid store of $360,000 less approximately $80,000 of constructionallowance. Inventory in a new store isapproximately $95,000 and store pre-opening costs average $25,000.

In terms of overall sales productivity, Torrid stores havegenerated productivity of $356 per foot. It is our goal and expectation to reach the $400 per foot level toachieve the levels of profitability that will make Torrid a true specialtyretail success story.

As for the overall Hot Topic consolidated business, allfunctional areas of the company have developed specific initiatives to improvegross margin and lower departmental operating costs.

Looking to the fourth quarter, our guidance assumes achallenging comp environment at the Hot Topic division as we continue toanniversary high promotional levels from a year ago. However, we are absolutely committed to notrepeating these promotions this year as we return to a fundamentally regularpriced business.

Our November month to date comps as of yesterday are downapproximately 7%: 8% down in the HotTopic division, up 2% at Torrid.

Now Jim will provide updated guidance for the fourth quarterof ’07.

James McGinty

Now, regarding our guidance for the fourth quarter of ’07,ending February 2, 2008. Based on our current expectations, we nowexpect fourth quarter comp store sales to be down in the low to mid singledigit percentage range versus last year.

Last year’s fourth quarter we were down 5.5% on a comparablecalendar 13 week basis.

Adjusting the months for this calendar shift are comparablestore sales in 2006 were as follows:

· Down 7.6% in November, 2006

· Down 3.9% in December, 2006

· Down 7.4% in January, 2007

We expect inventory at the end of the fourth quarter to beflat in the low single digit percentage range on a per square foot basis,primarily to support the growth of the Torrid business as well as increasingour position in music-related merchandise at Hot Topic.

We are reiterating our fourth quarter earnings per shareguidance for earnings in the range of $.29 - $.33 per diluted share as a resultof our inventory control, lower promotional activity, and strong expensecontrol. We continue to expectsignificant gross margin expansion in the fourth quarter.

For fiscal 2007, we continue to expect total capitalexpenditures to be in the range of $45 to $50 million. As of tomorrow, we expect to have completedall of our store openings for 2007 as well as all of our remodel andrelocations.

At this point, we expect to have remodeled or expanded 12Hot Topic stores during the month. Thisbrings the total number of remodels and expansions for Hot Topic in fiscal 2007to 70. As of fiscal year end, we willhave a total of 94 stores in the newdesign or approximately 14% of our store base.

In 2007, we will have opened a total of 23 new Torrid storesand 9 new Hot Topic stores. For fiscal2008, we expect to open 5 new Hot Topic stores and 25-30 new Torridstores. We also expect to close 20 HotTopic stores and 5 Torrid stores.

In addition, we plan to remodel or expand approximately 30Hot Topic stores.

We are expecting capital expenditures for the full year of2008 to be $28 to $30 million with approximately 75% of the total slated forstore projects and the other 25% for IT initiatives, internet enhancements andour new online music initiative.

For first quarter of 2008, we will be providing earningsguidance as we gain better visibility to the fourth quarter trends. We would like to disclose that we expect toincur startup costs related to the online music initiative in both the firstand second quarters of 2008 equating to approximately $.02 per quarter.

At this time we will take questions relating to the resultsand outlook. Please hold while wecontact the conference operator who will give you further instructions.

Operator

Ladies and gentlemen, if you would like to ask a question,please press *1 on your touchtone phone. If you would like to remove yourself from the queue, you may press*2. Please press *1 to begin and standby for your first question.

Question-And-AnswerSession

Our first question comes from the line of David Berman withBerman Capital. Go ahead.

David Berman – BermanCapital

It is great control of the cash and inventory control. I have two quick questions. The first is, with the music appearing to beback on track and gaining momentum, have the integral results to rethink yourresults in some of the other categories of the business?

Would you like me to ask the second question now or later?

ElizabethMcLaughlin

I will answer the first question now, David.

David Berman – BermanCapital

Oh, ok, thank you.

ElizabethMcLaughlin

You know, it is interesting because music has grown and weare very happy with how fast we have been able to turn the music business,especially since there is so much chatter out in the marketplace about musicbeing tough. We are looking at the othercategories. We certainly have looked atthe fashion categories and some of the accessory categories and there has beensome shift as we’ve planned for a leaner inventory in those areas as we supportmusic.

I think as music continues to gain momentum, we willprobably see a little bit more shifting. You know, we have a small store, averaging 1,800 square feet and mostof the buyers know they have to earn their spot on the floor, so if musiccontinues to ramp up at this pace, I think we’ll continue to see more of amixed shift toward the music areas.

David Berman – BermanCapital

Ok, good. Then thesecond question: the holiday seasonseems like it’s going to be a bit promotional as you can see what’s being doneout there. I am just curious if you feellike your margin assumptions that you have given for your guidance isconservative enough and what do you think you may have to do promotionally todrive the traffic for the business? Thank you very much.

James McGinty

Well, I think in terms of the level of conservatism of themerchandise margins, we feel good about our plan. We feel good about the inventory controlprocess that’s been put in place and our ability to control the level ofpromotional activities in the store, so we feel like based on that low tomid-single digit comp decline that we should be able to achieve those types ofmargins.

ElizabethMcLaughlin

You know, that being said, David, I think it’s going to be avery competitive holiday season and the last time we had this type of calendarwith 2001 (that was post 911) so I think it’s apples-to-oranges, even when youlook at the last time this calendar happened.

David Berman – BermanCapital

Right. Do you haveany special promotions planned or is it going to pretty much the same as lastyear?

ElizabethMcLaughlin

We are actually going to have a lot less than lastyear. Significantly less than lastyear. We will have promotions plannedduring the peak weeks, but very focused promotions. At Torrid also there are promotions that areplanned. I think we are going toattempt, despite the short term pressure, to stay on our plan. Knowing that we have control of our inventoryand we have protected ourselves the best we can on the back end, we are goingto go per our plan.

Yes, we do have promotions planned, most of which arestarting this weekend and certainly continue through the week after Januaryfirst, which is, as you know, when kids will go back to school.

David Berman – BermanCapital

Right, right. Ok, well good luck. Thank you very much.

ElizabethMcLaughlin

Thank you.

James McGinty

Thank you.

Operator

Our next question comes from the line of Lauren Levitan withCowen. Go ahead.

Lauren Levitan –Cowen

I wanted to get a little bit more color from you regardingthe thoughts on the remodels. I understand the argument for slowing down thatpace, but if you could give us a little bit more sense on how much of the chainyou expect to be in the revised format over the next few years and what kind ofdifferent reaction you are seeing in the new store? Are you seeing any category differences? Is it traffic that’s changing? Is it average dollar sale that’schanging? Are you attracting a widerrange of customers? What have youlearned so far about that new format?

Thanks very much.

Elizabeth McLaughlin

Well, a couple of things. First of all, when we look at the stores that are in the new format,it’s definitely incremental traffic that’s driving the difference between thenon-remodeled stores versus the remodeled stores. We have not seen much difference by category,which I think is very interesting, but anecdotally, we seem to be getting morecustomers while keeping our core customers and that’s what our stores tellus.

I think that for us, as we looked at the remodels – whileyes, they are performing better than the company – when we go to renegotiateleases the developers are taking up costs on us and especially if it is done ina brand location which are those locations which we think are high visibility,and the economics are just not working when you look at the kind ofdouble-digit comps – actually fairly high double-digit comps – to be able tooffset the kind of rent increases that developers want to get with the newrenewal.

As we looked it we said, “You know, it makes sense – we arerotating the brand, we have a brand presence in most of the major markets nowthat are in the new design, we do believe that as music continues to gain steamand we become much more item focused we will continue to see incrementaltraffic at the pace of about 30 stores per year. As we get into the next few years we willhave more lease renewals because we are anniversarying between eight and tenyears of all the explosive growth per year that we had in the late ‘90’s/early2000’s. We will probably be, over thenext couple of year, about 40% of the chain will be in the new design.

Lauren Levitan –Cowen

That’s helpful. Aseparate question on Torrid, Betsy? Thetarget that you gave of driving toward that $400 per square foot in sales, canyou give us a sense of what types of stores and what percent of the chain areactually performing at that level already? Is that a goal you think you will see over the next couple of years andwhen stores are achieving that goal, is it driven by real estate or is itdriven by something you’ve experimented with in terms of merchandising oranything you can point to that makes that goal look like something that’sachievable chain wide?

Thanks.

ElizabethMcLaughlin

Well, the $400 per square foot in a 2,500 square foot locationequates to a million dollars. So, if youlook at the stores currently, yes we have a good amount that are over a milliondollar stores. In fact, performing rightnow at higher than $400 per square foot. The issue is still the differential between the west coast, the midwestand the east coast. Finally, this yearwe actually have some east coast stores that are generating over a milliondollars which is nice. We had alreadyhad some midwest stores that were doing that.

I think for us as we look at it, we still have to narrow thegap between west coast and east coast and it really is about more transactionsin the store and as we are seeing as we are adding stores into areas andgetting more of a brand presence in some of those markets that wereunderpenetrated, we are seeing all of those stores start to approach that $400a foot number. It really, I think, is acombined issue of brand recognition through better real estate presence. I also think that the loyalty program and theDiva Style program is very, very good. If we continue to drive more members, I believe we will start to seethat improve as well.

Lauren Levitan –Cowen

Great. Thank you andgood luck for holidays.

ElizabethMcLaughlin

Thank you.

Operator

Our next questioncomes from the line of Kimberly Greenberger - Citigroup. Go ahead.

Kimberly Greenberger- Citigroup

Great. Thankyou. Good afternoon. Betsy, you’ve seen some really niceimprovement in the music business, in the women’s business, and obviously men’shas started to stabilize. I was hopingyou could do just a little bit of a deeper dive in accessories? Are you making any personnel changes in theaccessories business or have you made some changes there and what are you doingin terms of changing the merchandising approach to try to reignite thatbusiness?

Thanks.

ElizabethMcLaughlin

You know, Kimberly, I think when we look at the accessorybusiness, I will approach it from a couple of different places. First, on the people side of it. Yes, we have made some changes. You know, we have said that before. We hope this is the right team. We think this is the right team. We have also gone back and looked at when wewere in our hay day with accessories doing 50% of the business, what was itthat really drove the business? Theentire strategy that has to do with item orientation and what are we thedestination for? How do we not competewith other stores in the mall that perhaps have the same accessories at a lowerprice?

We set out this year to evolve the assortment in allcategories and some of the accessory categories were better than others as faras executing the initiative. A goodexample of that is body jewelry. We areknown as a destination for that – it has had strong comp business and wecontinue to believe it will comp. Wehave also seen recently a change in our cosmetics business as we’ve gottenbehind hair dye and some of the makeup products that are known to Hot Topic wehave seen a change in that business and that business has turned comppositive.

As we’ve gone through each of the classifications, thoseclassifications which have been dedicated to providing an assortment that isunique and feels edgy are doing much, much better than those that aren’t. Shoes are a good example. If you looks at our boots within shoes, bootsare doing very well. If you look at allthe fashion shoes this year versus last year, the business is abysmal. So, we need some time to rotate out of thatproduct and away from those comparisons, but the big nuts in accessoriescontinue to be costume jewelry, shoes, hats and other miscellaneousapparel. Those three categories and thensome licensed accessories which we are working on as well.

I feel better as we move into the fourth quarter that thereare more categories that have gotten religion on protecting Hot Topicyitems. I still don’t feel good aboutshoes. I think it’s going to take awhile for us to get back in that vein and clear out of the inventory, but whenI look at the fourth quarter I am hoping that we are in negativemid-single-digit decrease. If we can getthere, then we will see the entire chain lift because, as you said, music, men’sand women’s seem to be back on track.

Kimberly Greenberger- Citigroup

Great. Then just onequestion on your November month-to-date comps, I can’t remember the cadence ofyour business last year in November, but presuming that you are hoping to get alittle bit of improvement through the back half of the month, I just wanted toknow if comparisons get easier from here or if you are planning the businesshere in November to improve from the -7% so far this month?

Thanks.

James McGinty

Kimberly, we expect where we are month-to-date to be prettyclose to where we end up in November. Ithink there is a little opportunity in week three, but then when you get toweek four (which was December one a year ago), you’ve got the extra day beforethe Christmas holiday that could stretch out that shopping season a bit, so weare a little bit cautious about that week.

Kimberly Greenberger- Citigroup

Ok. Thanks, Jim. And good luck here for the fourth quarter.

ElizabethMcLaughlin

Thank you.

James McGinty

Thank you.

Operator

Our next question comes from the line of Jeff Klinefelter withPiper Jaffray. Go ahead.

Jeff Klinefelter –Piper Jaffray

On the music, as you are going into more of these mid-tierand small bands, how has this changed or complicated the merchandisingprocess? The selection of thebands? The buyer’s staff side of thebusiness? Are there any implications forstore personnel as well?

Any basket analysis you have or you can share in terms ofwhere this is starting to drive? Is itthe obvious “where there are positive comps in the store”? Are you seeing any interesting market basketanalysis related to these music purchases?

ElizabethMcLaughlin

Interesting, Jeff, one of the reasons I believe that themusic initiatives worked so quickly is that both the buying staff and the storestaff got behind the strategy. I believebecause they like much more to focus on mid-tier and small bands because that’snew and that’s hip and that’s up-and-coming versus the larger bands thatperhaps in years past drove high business, but basically have kind of that“sell out” moniker attached to them. Very quickly the buyers grasped this idea of spending more time worryingabout mid-tier and small bands and the store people were just crazy becausemost of them (if you go in and speak with them and ask them what bands theylike) – the big thing is to tell you what’s the newest band in the area orsomething new that doesn’t have the widespread exposure. Like I said, both on the merchandising sideand the operations side, this is much more in the sweet spot of who we are aswell as who the employees are.

As far as – what was your second question?

Jeff Klinefelter –Piper Jaffray

Just in the market basket analysis. Anything interestingsurfacing as you see these transactions included with the music?

ElizabethMcLaughlin

No, the only thing I will say is that we have certainly seenall parts of music turn, so I have to think that our transactions haven’tchanged as far as units per transaction, but as far as what’s being purchasedwith the next product. We have seenjunior rock go positive – very, very strong. We know that men’s rock is positive. We’ve seen CD’s pick up. We knowthat when we have a new release on a CD or when there’s a buzz on a mid-tierband or when there is a tour and a small band we’re marketing – we know whenthey come in they are now able to purchase a T-shirt to go with it whereasmaybe before they weren’t able to do that because we dedicated so much of ourspace to the higher tier bands. I wouldsay they are coming in expecting that they can buy more than one music productnow.

Jeff Klinefelter –Piper Jaffray

Ok. Thank you. Lastly, your Torrid stores next year – anyspecific geographic concentration for those new locations?

Christopher Daniel

Hey, Jeff, it’s Chris. We are going to continue to expand. We have done fairly extensive analysis this year on market successcomponents – more comprehensive, perhaps, than we have done previously. We are going to continue to locate the storesprimarily in the west. The balance ofthe stores will fill out high potential markets. An example would be our expansion in Dallas. We just opened a new store there today.

That’s pretty much where we are going to go next year.

Jeff Klinefelter –Piper Jaffray

Ok. Thank you verymuch. Good luck.

Elizabeth McLaughlin

Thank you.

Operator

Our next question comes from the line of Brian Tunick withJP Morgan. Go ahead.

Anna for Brian Tunick– JP Morgan

Hi, thanks, it’s Anna for Brian. Good afternoon guys. My first question on the gross margins forthis third quarter. Could you perhapsbreak down the components of gross margin?

James McGinty

Ok. We did go throughthose (inaudible) last year?

Anna for Brian Tunick– JP Morgan

For this quarter – maybe between your markdowns and IMU?

James McGinty

Are you talking about third quarter or fourth quarter?

Anna for Brian Tunick– JP Morgan

Third quarter.

James McGinty

Third quarter. We didrun through those. I would be happy togo over those with you again after the call?

Anna for Brian Tunick– JP Morgan

I apologize. Ok. Getting back to 4Q guidance, you areembedding pretty significant gross margin improvement and if I’m not mistakenlast year you had about 200 basis points of merchandise margin improvement inthe fourth quarter, so I guess my question is kind of circling back to theprevious question: what gives you theconfidence that on the down mid-single-digit comp you can hit those kind ofnumbers?

James McGinty

Well, if you look at last year and you talk about theimprovement that we achieved in Q4, we actually in Q4 2006 had much highermarkdown rates than we had in the fourth quarter of 2005. All the improvement was from initialmarkup. We’ve made further improvementin initial markup and really, as we’ve talked about, for Q4 the opportunity isin inventory management and lower markdowns. Really, by the way we have managed inventory we expect to be able todrive a significant increase in the merchandise margin rate.

What I would tell you is that if you go back and look at ourhistory and you look at the changes that we have reported in terms ofmerchandise margin and gross margin, fourth quarter from our S days in 2003 and2002, fourth quarter clearly has declined more than any other time of theyear. We also know that that is the timeof the year we have by far the biggest opportunity to recapture some margin.

Anna for Brian Tunick– JP Morgan

And had you said last year what the markdowns were in 4Q?

James McGinty

We had discussed how much those impacted the fourth quarterrelative to how much IMU it impacted it, yes.

Anna for Brian Tunick– JP Morgan

And just how should we think about SG&A for 4Q?

James McGinty

SG&A? We shouldthink about it if we achieve our down-low to down-mid-single-digit guidance weshould think of at the better end of that we should be about flat on our SG& A rating.

Anna for Brian Tunick– JP Morgan

And then, just as we look at next year in terms of the HotTopic store closings, I am assuming some of those were the underperforminglocations for Hot Topic. Could you justspecify – give us some color on that – maybe some of the markets that you willbe closing those stores in? I amassuming that going forward – just as you look ahead at the business – do youthink there is further opportunity to rationalize the real estate just down theroad?

James McGinty

Anna, I would tell you that we are always looking at thefleet and the cash contribution of each location. The twenty stores that we have identified arenot in any specific geographic market. Theyare dispersed throughout the country and what we are targeting first are thosethat are cash flow negative or those that are close to being cash flow negativewhere there may be a belief that the mall is on the decline or that we mayshift some of the sales by closing that store into another store that is in anearby market.

Anna for Brian Tunick– JP Morgan

Ok. Great. Well, that’s really helpful. I appreciate it. Good luck, guys.

Operator

Our next question comes from the line of Barbara Wyckoff - BuckinghamResearch. Go ahead.

Barbara Wyckoff -Buckingham Research

The move toward design, the old white store, how many storesdo you have in that design? Is it tooearly to know if there is an improved performance versus the older stores and alsowith regard to Torrid – how are you choosing new locations and what do you doto get the word out when you enter a new market? Are you just having soft openings? This is a market where you don’t already haveexisting stores.

Thanks

Elizabeth McLaughlin

Barbara, I would say in the new store design we have about20 stores. Secondly, have we seen anydifference? No. Torrid stores sales were very robust lastyear and continuing into this year so we have not seen much of a differencealthough we like it better and the cost per square foot are at or below the olddesign. It makes for a more profitableequation. We do think it is updated andit definitely speaks to the evolving Torrid brand.

As far as the real estate strategy – your question was it sitecollection or entry?

Barbara Wyckoff -Buckingham Research

How do you pick the new locations?

ElizabethMcLaughlin

Ok. We have the greatfortune of having all the mall data and all of the demographic data along withit, so we have a very careful site selection process that is based on all thesales (inaudible) malls and what the women’s apparel retailers are doing. We have comparative metrics from otherspecialty stores. Our overall strategyis really to pick markets that we want to be in that have the characteristicsthat we feel make Torrid successful. Second to that within the market, our real estate team is very specificin how they go after stores and the order they go after stores.

As far as market entry is concerned – not really a soft opening. We actually, because we have got almost amillion sign ups on our Diva Style base as well as the kind of business we havebeen producing on our Torrid.com site. We have a lot of data. So, as weenter new markets and especially in 2008, we will enter with a marketing planthat gets the buzz going prior to the store opening that tries to get all ofthe plus sized customers in the area aware of Torrid and the marketing campaignwill be viral as well as media oriented.

Barbara Wyckoff -Buckingham Research

Thank you.

Operator

Our next question comes from the line of Jeff Van Sinderen -B. Riley & Co.

Go ahead.

Jeff Van Sinderen -B. Riley & Co.

Good afternoon. Justas a follow-up on Torrid – are you finding that there is a difference in profitabilitybetween A or B or maybe even C malls?

James McGinty

Yes, I think what we’ve seen when we stratified the resultsis – and it’s pretty typical across other chains to – that you do see a higherlevel of profitability in your A stores relative to your B’s and B’s to C’s andboth in pure dollars, obviously because they are higher volumes in the A andthe B, but in the rate as well.

ElizabethMcLaughlin

I will say, though, that in a B mall in a removed marketthat has some sort of access to a metropolitan market, we can see some verygood levels of profitability. Maybe not topline but certainly on the profitability side because in a B mall you may get alesser rent.

Jeff Van Sinderen -B. Riley & Co.

Ok, it’s not that it has to be an A mall concept – itcertainly can expand to B and maybe even some C malls?

ElizabethMcLaughlin

Absolutely.

James McGinty

Yes. And, Jeff what Iwould tell you is that the difference between A, B and C is much less distinctthan there might be in other stratifications like the east-to-west that Betsywas talking about.

Christopher Daniel

I think it also depends on a level of saturation where whatcan you achieve by market? Some marketsit makes total sense to have a more balanced portfolio of A, B and C malls.

Jeff Van Sinderen -B. Riley & Co.

Ok. I know you guysare planning to be less promotional. You’ve been less promotional for a while. Anything else you can give us in terms ofcolor on maybe which areas you are going to be less promotional for holidaythis year? I know this is a sensitivearea, but versus last year? Anythingthere you can give us that – versus where the big promotions were last year? I know there were quite a few.

ElizabethMcLaughlin

You know, fashion apparel will be much lesspromotional. Accessories will be muchless promotional. Last year in fourthquarter we were attempting to not only sell more, but to liquidate inventory –both of which we didn’t’ do a great job with. Because we are not in the kind of over-inventory position that we wereentering fourth quarter last year, the promotions that are planned this yeartruly are to drive sales and to have a good focused offering for the customerwhen he or she walks in the door. It’s adifferent approach than trying to liquidate those areas where you think you’llbe stuck with product after Christmas.

Jeff Van Sinderen -B. Riley & Co.

Thanks very much and good luck.

Operator

Our next question comes from the line of Sharon Zackfia - William Blair.

Sharon Zackfia - William Blair

Hi. Good afternoon. I was wondering if you could break out a fewthings – out of the 25 stores that were scheduled for closure last year, arethose stores that were actually losing money and how many others are out therethat might be in that basket?

Secondarily,what kind of a good time frame to get Torrid up to the $400 per square foot?

James McGinty

I will take thefirst question in terms of are those stores losing money? The answer is yes, most of them are – or as Idiscussed earlier they are close to it and trending in the wrongdirection. What I would tell you is thatbeyond that 25 there aren’t a significant number of stores that fall into thatbucket where it makes sense to close them at this point. That was how we arrived at those numbers forboth Torrid and Hot Topic.

Christopher Daniel

As far as thesecond part of the question, as soon as we can get there. Our strategy is focusing on the top businessand the jean business and the cost of the new stores seems to be the formula.

ElizabethMcLaughlin

I think thatwhen you look at $400 per foot, there are some that are already over $400 persquare foot, so their goal is to get to $500 per square foot. When you look at the average of $400 persquare foot, we have got to have some more market penetration and we’ve got tosee some of those under-a-million-dollar stores pick up to be closer to a milliondollars or over a million dollars.

I think we willstart to see it change by market, so my answer would be different from marketto market. I think over the next two tothree years, certainly, it is where we can go.

Sharon Zackfia - William Blair

Ok, thank you.

Operator

Our nextquestion comes from the line of Holly Guthrie - Janney Montgomery Scott.

Holly Guthrie - Janney Montgomery Scott

Thank you. Question going back to gross margin. If youlook at the breakdown of the improvement that you gave us which contributed tothe 150 basis point increase over the prior year and you look at going back to’05, again last year was up and this year was up again and you look at thecontribution from merchandise margin offset by store occupancy, distributionand buying costs. If we look at thatcomparison over a one and two and three year time frame – in the fourth quarterare there any of those components like store occupancy such as there will beless remodels – will that be less of a negative distribution cost? Can you give me some sort of feedback on thecontributions that will go into that gross margin in the fourth quarter versusthe third over a multi-year basis?

James McGinty

Yes, Holly, Ican help you with that. In terms of howthat looks multi-year – any type of expenditure in the fourth quarter becauseof the greater volume is less impactful from a percentage of sales. To your point, yes occupancy will be lessimpactful. Yes, depreciation will beless impactful. Now, depreciation willbe less impactful from a second standpoint – that is that all the stores thatwe accelerated – the remodels and then relocations on we had to accelerate the depreciation over a very shortlife in those stores that weren’t up for natural lease expiration. We won’t be hitting as much of that in thefirst quarter as we did in the first second or third.

Holly Guthrie - Janney Montgomery Scott

Ok. Great. Then, a question on your comp assumption – let’s see negative low to midsingle digit for the fourth quarter. Could you give me some feeling for traditionally the drivers forparticularly black Friday and the week post-Christmas tend to be promotions andwhat is your strategy? Last year I thinkyou ran buy-one-get-one-half-off of all t’s during some periods and it seemedto drive some traffic. What is yourstrategy for traffic drivers going into those occasions and into those days.

ElizabethMcLaughlin

Hi, Holly. Yes, you will see the weekend of black Fridayweekend promotions strong in our stores and yes, we agree with you thatpromotions are one of the primary traffic drivers for us, especially theweekend after Thanksgiving since most of our customers are not shopping forgifts at that point in time. It reallyis a purchase for self – period. Youwill definitely see that when you are out in stores this weekend.

As for the weekafter Christmas, our primary driver is gift cards because they are such a highpercentage of our business and our customers are still out of school. We get tremendous traffic – I don’t believepredicated on what the promotions are. In fact, 50-off-clearance which was one of those promotions we ran lastyear. Most of them are buying regularprice with their gift cards because they want current product.

In addition,last year we tried to liquidate a lot of the products we couldn’t sell atregular price so there were various categories that were on sale that we werenot able to sell through even at a discounted rate. This year we are hoping not to have thatproblem. That said, during all of thepeak traffic periods there will be some offerings for the customers.

Holly Guthrie - Janney Montgomery Scott

Great. Thank you.

Operator

Ladies andgentlemen, there are no further questions at this time. I would like to turn the call back over toBetsy McLaughlin for any closing remarks? Please proceed.

ElizabethMcLaughlin

Thanks forjoining us. Happy Thanksgiving to all ofyou. Bye-bye.

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