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Hot Topic, Inc. (NASDAQ:HOTT)

Q4 2007 Earnings

March 12, 2008 4:30 pm ET

Executives

Elizabeth McLaughlin – Chief Executive Officer

Gerald Cook – President

James McGinty – Chief Financial Officer and Principal Accounting Officer

Christopher Daniel – President of Torrid

Maria Comfort - Senior VP and Chief Merchandise Officer of Hot Topic Division

Analysts

Lauren Levitan – Cowan and Co.

Stephanie Wilson - Piper Jaffray

Kimberly Greenberger – Citigroup

Jeff Van Sinderen – B. Riley & Company, Inc.

Holly [Gauthrie – Company unknown]

Nick [Pie – Company unknown]

Liz Pierce – Roth Capital Partners

Sharon Zackfia – William Blair & Co.

Brad Stephens – Morgan, Keegan & Co.

Crystal Kallik – D.A. Davidson & Co.

Operator

Good afternoon ladies and gentlemen and welcome to the Hot Topic fourth quarter and 2007 earnings release conference call. At this time all listeners have been placed on a listen-only mode and the floor will be open for your questions following the presentation. This call will be limited to one-hour.

At this time 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’s investor relations website involves 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 in our more fully set forth in the periodic report that Hot Topic files with the Securities and Exchange Commission including its most recent annual report on form 10K and quarterly report on form 10Q and as will be updated by our upcoming annual report on form 10K for fiscal 2007. 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.thehottopic.com and a replay will be available on that site. A replay will also be available at (888) 286-8010 passcode 19194201 for approximately two weeks.

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

Jim McGinty

Hi. This is Jim and welcome to the call. While on hold you have been listening to “Heading for the Disco” from the Horror Pops new album which was released this past February. My partners on the call today are Betsy McLaughlin, Gerry Cook and Chris Daniel.

For competitive reasons, we will not be discussing any specific, forward-looking product information during this call.

I will begin by discussing the fourth quarter results and then comment on the balance sheet and cash flow. Following these details I will turn it over to Betsy, who will provide you with additional color on the quarter followed by first quarter guidance.

First the results of the fourth quarter. Our fiscal 2007 fourth quarter net sales and earnings results reflect the 13 weeks ending February 2, 2008. This compares to the fiscal 2006 fourth quarter which spanned 14 weeks and ended on February 3, 2007. All comparisons discussed reflect these time periods unless otherwise noted.

Hot Topic, Inc. fourth quarter net sales were $220.7 million a decrease of 8.2% over the fourth quarter of last year. Comparable store sales were down 6.3% for the quarter as compared to the corresponding 13-week period from the previous fiscal year.

By division, Hot Topic’s comps were down 7.2% while Torrid’s comps were down 0.4%. Overall, total company net sales during the quarter decreased by $19.8 million due to a $13.2 million sales loss related to one less week in this fiscal year’s fourth quarter as related to last year, a $12.8 million sales loss from the total company comparable store sales decline, a $600,000 loss from closed stores and non-comparable Hot Topic stores partially offset by volume from new Hot Topic stores. These losses were offset in part by a $2.8 million sales gain from the Internet sales and a $4 million sales gain from new and non-comparable Torrid stores.

For the quarter total company comp decline was the result of a 5% decrease in the average number of transactions in comparable stores and a 1% decrease in the consolidated average transaction value. At Hot Topic apparel was 59% of total sales in the fourth quarter versus 55% in the corresponding period last year as the result of the relative weakness in the accessories categories.

At Torrid apparel was 77% of the total sales in the fourth quarter versus 74% in the corresponding period last year.

Gross margin was 34.6% of sales compared to 34% last year. The 240 basis point improvement breaks down into the following categories:

Merchandise margin increased 390 basis points due to significantly reduced mark downs, lower shrinkage and higher vendor allowances.

Store occupancy and depreciation expenses increased 190 base points due to the related store remodel program and also due to the de-leveraging of store expenses on lower buying.

As to percent of sales, buying costs were flat to last year.

Distribution costs improved by 40 basis points due to lower freight out, lower outside temp personnel expenses as the result of improvement in productivity as well as lower real estate taxes.

In the fourth quarter selling general administrative expenses were 27.9% of net sales, similar to last year.

SG&A expenses in the fourth quarter of fiscal 2007 include a $600,000 nonrecurring charge primarily related to store impairment. In addition, SG&A expenses in the fourth quarter of fiscal 2006 included $3.1 million in nonrecurring charges including a $3.8 million expense related to store impairment, lease termination and asset write off charges for under performing stores, partially offset by $700,000 benefit related to other one-time items.

Excluding these nonrecurring charges both this year and last year SG&A expenses were 27.6% of net sales compared to 26.6% last year. This 10 base point increase breaks down into the following categories:

Store payroll as to percentage of sales was up 50 basis point as the result of higher minimum wages, higher medical expenses and the de-leveraging of payroll costs on the lower average store sales volume.

Store payroll costs per average store were down by 3%.

Marketing expenses increased 30 basis points due to higher photographic artwork expenses and magazine print ads for Torrid.

Pre-opening expenses increased by 10 basis points due to the timing of store openings.

Store other expenses increased by 10 basis points due to the de-leveraging on the lower average store sales base.

Lastly other G&A expenses were flat including savings and performance based bonus offset by higher stock option expense, consulting and computer support costs, accounting fees and higher sales tax expense.

The fourth quarter operating income increased by $4.5 million to $19 million. Operating margin for the fourth quarter was 8.6% of sales versus 6.0% last year.

Interest income was $500,000 or 0.2% of sales.

Our effective tax rate was 38.9% for the fourth quarter versus 40.9% last year. The rate improvement was due to higher tax exempt interest income and a favorable comparison to a higher than typical tax rate a year ago, partially the result of the tax implications related to the adoption of expensive stock options.

Report fourth quarter earnings per diluted share of 27 cents compared to 20 cents a year ago, a 35% increase year-over-year.

During the quarter we opened a total of five new Torrid stores and closed five Hot Topic stores and one Torrid store. We also remodeled or relocated 12 Hot Topic stores during the quarter bringing our total number of remodeled or relocated stores during 2007 to 70. We currently have a total of 94 Hot Topic stores in our new format.

Cash and cash equivalents in short term investments declined 4% year-over-year to $53 million in part a result of the $7.2 million spent on our share repurchase program during the third quarter. Within the $53 million were $21 million in AAA rated auction rate securities at year end. Since the end of January we have liquidated approximately $8 million of these investments. All of the remaining auction rate securities are highly rated and backed primarily with federally insured student loans.

Total inventory cost was just over $80 million. On a per-square-foot basis inventory was up 5.5% at the end of the fourth quarter due to better than anticipated physical inventory results and increased January receipts for a specific product designated to establish a higher in-stock position.

Inventory at retail was up slightly on a per-square-foot basis, flat at Hot Topic and up mid single digits at Torrid.

Capital expenditures were $8.6 million in the quarter primarily related to the five new stores and twelve Hot Topic remodels and relocations during the fourth quarter and the additional stores scheduled to be opened or remodeled or relocated in the first quarter of 2008 as well as expenditures for system development.

Depreciation and amortization expense for the fourth quarter was $10 million versus $10.5 million last year.

Now I’ll turn the call over to Betsy.

Betsy McLaughlin

While our EPS improved over last year for both fourth quarter and the year, we remain dissatisfied with the extended negative comp trend in the financial performance.

We did, however, accomplish much in terms of the execution of our business strategy. I’ll start with a few comments on the fourth quarter and then review the progress we have made on this business strategy.

As the fourth quarter was challenging on the top line I’ll start with our most challenging category, accessories. The accessory category was down 16% for the quarter on top of an 8% decline last year. In fourth quarter our biggest challenge was in licensed accessories that comped down almost 30%. Lack of focus and poor execution were the causes of this dismal performance. Licensed accessories represents close to 30% of the overall accessory business.

On a positive note, fashion accessories began showing sales recovery during the last ten days of December and while this improvement was not enough to impact the quarter fashion accessories has maintained a definite trend improvement since late December. It is our expectation that the additional focus on accessories, the investment in better inventory position in items and the staff changes that have been made to the buying team will position accessories to make considerable improvement as we progress through the first half of 2008.

The music category comped up 1% against significant promotions during the holiday period of last year. We began 2007 with a negative double-digit comp trend and through the efforts of our merchandising and marketing team have seen steady improvement throughout the past year in men’s rock tees, junior rock tees, and CD’s which produced double-digit positive comps. We are pleased that our customers are validating our strategy to focus on new music and we will continue to implement initiatives that shift our dependence away from new releases and establish strong relationships with emerging and mid-tier bands. In addition, the accessories portion of the music assortment has opportunity during 2008.

The women’s business produced a flat comp for the quarter. Women’s bottoms generated a solid double-digit comp as the result of a very strong and focused item presentation. Women’s novelty tees also performed well, up a mid single-digit comp driven by several key licenses.

Offsetting the strong performances in novelty tees and bottoms were fashion tops and dresses, both of which had difficult promotional comparisons to [LY]. In addition, both of these areas were planned down in sales and inventory during the quarter to support our move away from assortments and into items.

Men’s comped down 5% primarily the result of more difficult comparisons associated with the high level of promotional activity last year. As with women’s fashion we have scaled back inventory levels and assortment width of both men’s fashion tops and bottoms in order to support items. While men’s novelty tees also suffered from the promotional comparisons we see opportunity in better receipt flow and buying execution.

On our previous earning calls I have outlined key strategies to improve the Hot Topic business results. The following is an update on each of our major initiatives.

First, our return to a fundamentally regular priced business has allowed us to re-establish pricing credibility with our customers. Beginning in mid February 2007, we scaled back on all promotional activity during non-peak traffic periods. Despite the temptation to drive short term comps with incremental promotions during this past quarter we remained committed to our strategy.

We estimate that on an annual basis the cost to our comp line in 2007 was approximately 3.5 percentage points.

Our next objective was to re-establish Hot Topic as an item destination with a primary focus on the t-shirt business. During the fourth quarter total tees, including rock tees, novelty tees and fashion tees, increased their penetration to the total mix as planned and comped up low single digits. In addition, all merchandise classifications were evaluated and planned as item businesses versus widely coordinated assortments.

Our third initiative has been the management of inventory. We continue to closely manage our inventories to levels appropriate to the demand for each category. For the fourth quarter receipts were 24% lower than last year. Although inventories ended the year up on a per-foot basis, we operated with lower inventories throughout the quarter enabling us to generate a significantly higher merchandise margin. In terms of inventory management going forward, we continue to be selective with our investments in categories and items that are trending or opportunistic.

Next, we met our commitment of remodeling or relocating 70 of our existing Hot Topic stores into the new design. We continue to believe that the new look is consistent with our re-branding efforts and that these stores better represent the ever widening teen music preferences. The group of remodeled stores includes stores whose leases were due to expire and stores that were located in high volume, high exposure malls.

As we mentioned in our third quarter earnings call, the sales left at these remodeled stores is not enough to offset the increased occupancy costs and/or any accelerated depreciation write off. As such, in 2008, stores converted to the new design will be almost exclusively those whose leases are within three years of expiration.

Our top priority has been and will continue to be the evolution of our customer’s music experience. We laid out our new music strategy in 2007 as music is the heart of Hot Topic and crucial to our positioning and differentiation. By mid 2007 we had begun the implementation of the first phase of this multi-year strategy that focused on the in-store music experience. Through assortment repositioning and dedicated marketing and touring events we have become less dependent on major artists and now focus our dollars and time to support mid-tier and small bands.

As a direct result, our music category improved from a double-digit decline in the first half of 2007 to positive comps in the second half of the year. As we move through 2008 we will continue to evolve the assortment and invest in our in-store music presence.

On previous calls we have also mentioned that to remain credible and authentic we need to nurture, evolve and innovate the music experience both in store and online. Music is the differentiating inspiration for the Hot Topic brand. We are everything about the music and more specifically we have repositioned ourselves as everything about new music.

There has never been a question that we needed to incorporate digital music into our music strategy. The challenge to present a differentiated experience along with the appropriate timing, partnership and investment have been in discussion for several years. We are now prepared to have a stronger online presence as the next phase of our music evolution.

This new experience in music discovery will be called ShockHound. ShockHound as a strategy will allow Hot Topic to enter the digital music age. New and emerging artists will be in the spotlight. A maverick point of view is desperately needed amongst the overpopulated universe of music sites. ShockHound.com will offer music merchandise including apparel and accessories, DRM free music, original content and a community experience presented to our customers in a cohesive way that embraces the passion for music that all of us at Hot Topic share with our customers. In a nutshell, we are positioning ShockHound.com as the go-to place for an experience in rock music discovery. We have targeted a launch date late in the second quarter and will keep you posted on our progress.

We are committed to adhering to these initiatives which we believe are correct for the long term despite the comp and short term earnings pressure.

Now on to Torrid. Torrid was approximately flat in comp stores during the fourth quarter on top of a double-digit comp in the fourth quarter of 2006. We continue to generate increases in the average dollar transaction size and gross margin rate. Apparel continues to perform very well led by a strong tops business. Torrid.com also generated a solid increase up almost 40% over the comparable 13-week period last year. The site continues to show significant traffic growth with Diva Style members leading the way in terms of average dollar purchase. In terms of Diva Style, as of the end of the year we have well over one million Torrid customers signed up and approximately 135,000 full-fledged members. During the quarter we experienced very favorable results from the direct mail events and we continue to view this loyal base of customers as critical to our future success and growth.

In terms of overall sales productivity, Torrid stores generated productivity of approximately $350 per foot. It continues to be our goal and expectation to reach $400 per foot to achieve the levels of profitability that will make Torrid a true specialty retail success story.

As to the overall consolidated business, all functional areas of the company continue to develop specific initiatives to improve gross margin and lower departmental operating costs.

Jim will now provide guidance for the first quarter of fiscal 2008.

Jim McGinty

Our first quarter of fiscal 2008 guidance is for a loss in the range of 3 to 6 cents per diluted share based on a comparable store sales decline in the low single-digit percentage range. As a reminder, the guidance includes approximately 2 cents in charges related to the costs for our online music initiative.

As mentioned in the last earnings call, we expect a similar charge in the second quarter of 2008.

We are expecting in-store inventory to be up in the low single-digit percentage range on a per square foot basis this year.

Our guidance assumes approximately 44 million shares outstanding for the first quarter.

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

Question-And-Answer Session

Operator

Ladies and gentlemen if you wish to ask a question please press * followed by a 1 on your touchtone telephone. If your question has been answered or you wish to withdraw your question please press * followed by 2. Questions must be submitted at this time in order for them to be registered. Please press *1 to begin.

Your first question comes from the line of Lauren Levitan. Please proceed.

Lauren Levitan – Cowan and Co.

Thanks. Good afternoon. Betsy two questions for you. First I’m wondering if with respect to the online music initiatives I know you said that ShockHound is intended to be a destination for rock music. I’m curious if there is opportunities or thoughts to take what you are doing there beyond that genre? Second, on the February sales release you were very helpful in giving us regular price comp trends to help us understand the impact that the promotional cadence is having on the business and you’re now anniversarying the beginning of eliminating those promotions. Can you give us some reconciliation between the comp guidance you just gave us for Q1 and the regular price trends that you have been seeing and how we should think about whether there might be really no difference between the two comp numbers as reported? Thanks.

Betsy McLaughlin

Okay. First let’s talk about the regular price comp trends for Q1. As we recorded our message in January on the call and also in February we started to see regular price business versus clearance business…regular price business turned positive as we moved through January and into February, which was very encouraging for us. Last year we had an extraordinary amount of clearance inventory due to the mark downs that we took in January so we felt it important to separate the two just so we could get an understanding of whether we were continuing to make progress with regular price. Also as we move through the back half of February the promotional comparisons stopped as mid-February last year was when we decided that everything would be regular price during non-peak periods.

So, our intention and what we hope is that the regular price portion of our assortment will be positive for the first quarter. We certainly have seen encouraging results to that end. The clearance business though continues to be substantially negative just because we do not have the inventory that we had last year. As we move through March and through April we will see less of an impact and by the time that we get to the end of the first quarter clearance should not be an issue. So our guidance which is down in a low single-digit comp does include an assumption that regular price would be positive and that clearance would continue in its low to mid double-digit negative.

Lauren Levitan – Cowan and Co.

That’s helpful. But by Q2 you wouldn’t expect a differential between those two trends?

Betsy McLaughlin

That is correct.

Lauren Levitan – Cowan and Co.

Okay. Thank you.

Betsy McLaughlin

Actually I would say the middle of April because we have the Easter shift this year and so the calendar is compounding our ability to forecast. I don’t think any retailer is sure what this very early Easter is going to do to March and April. We said to ourselves we will truly get an apples-to-apples comparison in the back half of April.

Lauren Levitan – Cowan and Co.

Great. Thank you. And then on the music side?

Betsy McLaughlin

As far as ShockHound is concerned we are going to start with where we have the most expertise, which is certainly rock music. The reason we are calling it ShockHound versus must making it a part of HotTopic.com was because we felt there was a wider universe of rock music out there available. The Hot Topic brand has been very much about alternative rock music and with the 1,800 sf and how we have positioned the brand it is a narrower experience in our stores. What we want to do online with ShockHound is broaden the entire rock experience to include quite a bit of classic rock, indie rock, crossover rock. So our initial foray into this will certainly be rock related. As to whether over the years this could expand to have alternative genres of music, you know alternative teams that are experts at those genres of music that is absolutely a possibility but for now our investment and our focus is purely on rock.

Lauren Levitan – Cowan and Co.

Great thank you and good luck.

Operator

The next question comes from the line of Stephanie Wilson with Piper Jaffray. Please proceed.

Stephanie Wilson - Piper Jaffray

Thank you. We appreciate all the extra details you gave us on your remarks. Thanks for that. Just a couple of questions. The first is on the music category I’m not sure if you’ve broken this out in the past, but what percentage is the rock tees of that category?

Betsy McLaughlin

We have not broken that out but rock tees is a majority of the category. When you add men’s rock tees and junior rock tees it is a significant percentage of the total.

Stephanie Wilson - Piper Jaffray

Okay and secondly can you characterize what you are seeing out there in terms of the licensing type line whether it is coming from entertainment or from music. How would you categorize it? Is it getting better? Similar? Some sense…

Betsy McLaughlin

We’ll split music and entertainment because it is two different animals. I think on the music side of the business we are seeing…I don’t know if it is because of the nature of the business focus or because of the nature of the world, but we are certainly seeing increased attention being paid to new bands and this artistic explosion. You Tube has fueled that. If you are in a band and you’ve got a camera you can go into your garage and upload it on You Tube and get a few million hits and create the demand for yourself. So technology certainly has helped with the buzz with new music. I also think the state of the world helps as most historians will tell you the greatest music and art comes out of tough periods. Whether that is globally or whether that is nationally, we certainly have seen a great menu and landscape out there for new music. I think we feel very good about that and as we have rotated our focus to pay attention more so to those bands and our actually as you look at our rock tee assortment and our music assortment we have close to 80% now dedicated to the mid-tier and the small tier bands versus where we were last year which was half of that. So it has been very, very encouraging.

On the license side. The license pipeline is not as healthy as we would like it to be. Within the women’s world there seems to be some good things happening. On the men’s side of it we are working hard. There is a mix between gaming properties, movie properties, cartoon properties, so it is much smaller. We don’t see any big key license as one that will create a substantial percent of the business. It is probably healthier for us to go at it that way. As we move to the back half of the second quarter we are up against Harry Potter, which was a large license for us last year, so we’re trying to offset that business that really started in the beginning of the second quarter with some smaller licenses.

I think we are lukewarm on the licensing pipeline and we are very encouraged by what is in the music pipeline.

Stephanie Wilson - Piper Jaffray

Great and my last question. Based on the first quarter guidance you gave us last year you had a very similar low single-digit negative comp and a relatively similar sales rate so is the variance in the guidance just that 2 cents of increase spend on the e-commerce business?

James McGinty

Well its that on top of the fact that we’d be running a negative comp on top of what we ran last year and slower productivity levels.

Stephanie Wilson - Piper Jaffray

Okay thank you.

Operator

The next question comes from the line of Kimberly Greenberger with Citigroup.

Kimberly Greenberger - Citigroup

Great thanks. Good afternoon. Betsy other than the big Harry Potter license in the second quarter and the anniversary, are there any other big licenses in 2007? I’m not looking for guidance beyond comp in the first quarter but just as you feel the movement of the business and you get to a more regular full-price business do you think that we could move into positive comps as we progress through the year?

Betsy McLaughlin

I’ll answer your first piece of that Kimberly on the licenses. You know we had a couple of strong licenses last year in Transformers and that was really second quarter or third quarter on the men’s side. Hello Kitty was also strong on the women’s side. But I think we have enough…we have [animals] right now and have some other things in the works. Something also is that Nightmare Before Christmas, which has always been a strong property for us in the back half of the third quarter and fourth quarter, we actually could have done more business this past year. We tapered it down thinking we weren’t going to have the same kind of demand I think we left quite a bit on the table with customers. Certainly the demand was there – we sold out of a lot of product. So I think there is the opposite effect where even though NBC was strong last year we can beat it this year by finding a happy medium on the assortment levels.

And as far as the guidance is concerned, I think the most encouraging piece of this is that we all believe in the music part of the business obviously and we are seeing those results. We have all been waiting for fashion accessories to finally turn the corner and we have some great leadership in fashion accessories and a strong buying team and in addition to the margin benefit that we get when our mix shifts to fashion accessories…I think if we can continue on the path of fashion accessories now I think it looks good for us. That said, licensing is still a big part of our business. We’ve got to get licensed accessories turned around and we said we were targeting that for the back half of the year and a stabilization of the novelty tee business from a consistency standpoint but I think that anchored by the fashion group which has done a very, very good job concentrating on items and seems to have hit their cadence and the builded fashion accessories I think we are encouraged as we get out of these big clearance comparisons.

Kimberly Greenberger - Citigroup

I just have one follow-up for you. Gross margin last year was really up nicely every quarter I think since the second quarter. What sort of opportunities do you have to continue to take that gross margin up here in 2008 in the absence of the comps?

Jim McGinty

I think in 2008 we will have anniversaried a lot of that…the changes that we made, the higher IMU, some of the vendor policy changes that allowed us to generate some allowances so I would expect that we’ll continue to make more incremental gains through control of mark downs, control of inventories and maybe slightly better mark ups but they certainly won’t be to the extent of what you saw a year ago. In addition I would say that any quarter that we have a negative comp that is where you get into the de-leveraging of your fixed occupancy and depreciation expenses and that has a tendency to mitigate any gains you make on the merch margin side.

Kimberly Greenberger - Citigroup

Thanks Jim. That was helpful.

Operator

The next question comes from the line of Jeff Van Sinderen with B. Riley. Please proceed.

Jeff Van Sinderen – B. Riley & Company, Inc.

Hi Betsy and Jim. So fashion accessories is starting to improve, but on the licensed accessories front I’m just wondering if you can share anything in terms of thoughts directionally what changes may be to licensed accessories. Nothing too specific obviously but just any more color you can give us there in terms of changes you are considering.

Betsy McLaughlin

Sure. We’re looking at a new buying group that is looking at licensed accessories with some fresh new eyes to give it some attention so I certainly think that is going to be helpful. As we have noticed, all of us who have been in this business for a long time we know that an expert looking at the business tends to help, so I think we are happy so far certainly with the changes that we’ve made to the team. Marina is directly involved with the licensing group now and is working with them on the strategy and execution. The licensed gift piece of the business is a longer lead time because so much of it is imported so that’s why we can’t really impact the business. I mean we might see some of it in late second quarter but we’ve really target Q3 and Q4 as to where we start to see improvement. That’s about all I can tell you without giving you specifics.

Jeff Van Sinderen – B. Riley & Company, Inc.

Fair enough. Let me ask you…in terms of the remodeled stores, what difference are you seeing in performance there versus the older Hot Topic stores and would it make any sense at this point to expand or accelerate the remodel program for the Hot Topic stores?

Betsy McLaughlin

We see a bump when the store first opens and part of that I think is because there is pent up demand from the store being closed or if the store has been in a temp space….temp spaces are certainly not as attractive as the permanent spaces so we see a bit of a honeymoon as the store opens but within about 90 days it migrates back to the company comp trend and we have not really seen a difference in the sales mix in the store as far as music versus apparel and accessories so that pretty much flows back as well. The customers all think it is a new assortment, I’ll tell you that. So there seems to be this perception that it is bigger. And we are getting incremental customers in. Whether they are buying or not we are not seeing that in the numbers but we certainly anecdotally have had responses and certainly all of us feel that it is a better representation of our brand.

I think at this point as we go in and remodel and relocate a store it causes us to have to renegotiate the leases with the developer. Intuitively you would believe that with so many people cutting back on their new stores or exiting the malls that there would be a bit more of a competitive environment out there and perhaps better power in the hands of the retailers to negotiate…that is not true at least yet. So as we have gone through and done the analysis and said okay if we do expedite it because we do think it is a better representation of a brand and it is not genre specific and not as exclusionary if we do that what kind of comps do we have to achieve to offset the accelerated depreciation write off as well as the renegotiated terms? We can’t make the numbers work. It is high double digits to be able to offset what these increased expenses are.

So we feel that especially given the uncertainty of the environment and you know conservation of our cash on our balance sheet and remaining healthy that the prudent thing to do is to remodel these stores as they come close to the end of their lease. After seven years most of the leasehold improvements have been written off and it makes financial sense for us as we renegotiate naturally to remodel the stores.

Jeff Van Sinderen – B. Riley & Company, Inc.

It sounds like you’ve thought that through pretty extensively. Thanks very much and good luck this quarter.

Operator

The next question comes from the line of Holly [Gauthrie]. Please proceed.

Holly [Gauthrie – Company unknown]

Yes good afternoon. I have two questions on the remodeled stores and the one on ShockHound. First, the remodeled stores…I was wondering if there are any categories, items or price points that are comping differently and is there anything you can learn from any of those differences? And then on to ShockHound can you give us some additional color on how revenues will be generated and the costs to start up the business? Is it the website costs? Are you buying any library music or buying any rights?

Betsy McLaughlin

Okay Holly. As I just answered on Jeff’s question, there is no difference by category in our remodeled stores. It is very similar to the non-remodeled stores. So it does allow us a little bit more room to do some things and from a testing standpoint we can experiment a bit more but nothing that is of any kind of significance that would cause us to think anything is different.

As far as ShockHound is concerned obviously we are not giving any specifics on purpose certainly prior to the launch. The model is based on sales revenue and those sales are generated from products on the site whether it is apparel, accessories, gifts, whatever the products are as well as sales of digital music. You could say the top line revenue is driven by growth and the bottom line profit is driven by sales of product not sales of music as we all know the margins are very low on that but it is a driver to the site.

In launching the site yes there is web development that has to happen. There is the acquisition or the ingestion of music from both major and independent labels and there is a fee attached to that so those fees have been included in our calculation of start-up costs and then of course there is the marketing piece of it pre-launch and then the six month after launch that are also included that are reflected in the 2 cent costs for the first and second quarter.

Holly [Gauthrie – Company unknown]

Thank you.

Operator

Again ladies and gentlemen if you wish to ask a question please press * followed by 1 on your touchtone telephone. Again please press *1 to ask any more questions.

The next question comes from the line of Brad Stephens with Morgan Keegan. Please proceed. Please proceed Mr. Stephens.

The next question comes from the line of Nick [Pie]. Please proceed.

Nick [Pie – Company unknown]

Hi. Considering that when you adjust for the cash that you spent in buying shares, the company actually has more cash in 2007 than it did in 2006 and the stock setting up at 1.5 times EBITDA, why not buy in some shares? What stopped you during the fourth quarter?

Jim McGinty

Well actually in terms of cash and cash equivalents in short term investments we actually have a little bit less cash than we had at the end of the year last year. We also are looking at the long term future of our business and we want to be very prudent with our capital resources and how we use them. We’re always discussing with the Board the opportunities, strategic alternatives and whether share repurchase is appropriate or not appropriate. At this point in time in the current environment we feel like the preservation of our cash should be our key concern.

Nick [Pie – Company unknown]

Got it. Could you give us more detail on Torrid? Whether the stores are getting closer to getting operationally profitable? What timeline do you think they will get there?

Jim McGinty

We talked about in the third quarter call we talked about the economics of store profitability and the level of contribution and the fact that an average Torrid store takes about three years to repay back on a cash basis. So from a store contribution basis they are currently profitable. But we haven’t broken that out down to the net income line as of yet.

Nick [Pie – Company unknown]

Any sense of when you might do that? How big do you need to go before you break it out?

Jim McGinty

It is something we are constantly reviewing. We certainly over the past year have disclosed more information about Torrid than we ever have in the past so I would expect that in the future that trend will continue.

Nick [Pie – Company unknown]

Got it. Thank you.

Operator

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

Liz Pierce – Roth Capital Partners

I presume that’s me. Jim in your remarks about guidance and closings and openings, did you mention closings for 2008?

Jim McGinty

We didn’t today but we covered some of that in the third quarter call and we talked about 20 closings over the course of 2008 for Hot Topic and a handful for Torrid, more opportunistic in that regard.

Liz Pierce – Roth Capital Partners

So no update on that?

Jim McGinty

No update on that.

Liz Pierce – Roth Capital Partners

And then Betsy your goal on Torrid to get to $400 sales per square foot what kind of initiatives…is it going to be to drive the bottom portion of the business? Is this a one or two year process or is this just kind of the evolution of the brand or all of the above?

Betsy McLaughlin

Well I think we want to be at $400 per foot over the next couple of years. That is the goal. More than just the merchandise assortment. I think that as we continue the evolution of the brand has seen gains and positive gains as far as the assortment is concerned. There is the marketing and branding piece of it. How do you reach out to more customers? We think there is more great opportunity in getting more percent share of those target customers. Many of them don’t even know we’re there even though we’ve been there now for several years in their local mall. So there is the branding piece of it. There is the Diva Style piece of it…we’ve acquired names over the past several years being able to really mine that information and individually target those customers with promotions and events that they feel are targeted to them specifically. I think that is a huge opportunity. Every time we invest in Diva Style we get the return. As I said in my commentary during the fourth quarter we continued to see that. So there is that piece of it on the top line that drives the sales per square foot. Within the Torrid PNL model there certainly is opportunity on the design standpoint and product development and Chris is investing time and money this year into ramping up the direct sourcing. So there is components across the board but as far as driving that top line it is really about getting more feet into each location.

Liz Pierce – Roth Capital Partners

Okay so it really does sound more like the evolution versus the product specific like we need to change the mix or change the balance, which is just kind of the maturation phase?

Betsy McLaughlin

Absolutely. That’s correct.

Liz Pierce – Roth Capital Partners

I was just trying to clarify. Then kind of a bigger picture question…you somewhat eluded to the general environment…one would think that the ball would be back in the retailers court in terms of having a little bit of leverage but as you look at the landscape and how many people are closing stores and the number of stores that you guys have are you comfortable that this is still a good number for you? Putting aside that every year there will be a handful that you will close. If you had to think about five years from now is this 700 or something…for Hot Topic…is that a number that you can live with and prune every year a little bit?

Betsy McLaughlin

We are so lucky with the expansion between 1996 and 2003 because we were so productive and the growth in productivity during the period really put us in a position with our high sales per square foot that our fleet is very profitable. I think that as we went through because it is a very good question to ask especially as you have success at the years of comps, have you cannibalized stores, are you over-penetrated, what is the right number…we saw for so many years specialty stores of 800, 900, 1000, 1200 and then the retrenching back to 800…I think as we have looked at our store base we believe 650 is about the right number. When we look at all of our stores and stores that are cash flow positive we have about a dozen that are not cash flow positive and we are very lucky to be in that position. Most of those stores either have lease expirations over the next few years or kick outs. So we have a healthy fleet. We’d like the entire fleet to rise because we’d like our productivity or our sales productivity to be higher, but at the end of the day we’ve done some very careful analysis over the past two or three months at extrapolating out what if it is another tough year and what does that mean to our store base? We keep coming back to the same number which is about 650 for Hot Topic.

Liz Pierce – Roth Capital Partners

That’s good news. That’s all I have. Best of luck. Thanks.

Operator

The next question comes from the line of Sharon Zackfia with William Blair. Please proceed.

Sharon Zackfia – William Blair & Co.

Hi. I have two questions. First on merchandise margins we’ve seen some nice improvement for the past few years and I’m wondering if you expect to see similar results in 2008? Secondarily, on ShockHound it seems intuitively it seems a little late to get into online music. There are a lot of sites out there. Can you give us a better feel for how this might be different than other sites we might be familiar with?

Jim McGinty

Well in terms of your first question on merchandise margin expansion, I think somebody talked to that earlier. The answer was about 2007 we had a lot of nice increases in IMU. We were able to manage inventories better and see a much improved merchandise margin. I think the opportunity in 2008 will be one of incremental improvement as we continue to manage inventories, continue to improve mark up but they will be much narrower than they were this past year when we had a big opportunity.

Betsy McLaughlin

As far as ShockHound is concerned, intuitively you would think it would be late although nobody is doing it. I think what has happened with the labels and the state of the music business it has created an opening. If you look at what has happened out there, yes there is online music. Is it DRM free? Some of it is. Most of it is not. It is just now starting to have labels that are partnering and allowing music to be able to be DRM free and MP3 format rather than being proprietary. So that is part of the reason for our timing in this launch as we know from our customers and this research that our customers do not want proprietary downloads. They want to be able to buy those downloads and use them on any device that they choose to do so. So that is part of it. In addition to that as you look at ShockHound and how we positioned ourselves the big guys out there whether it is iTunes, eMusic or Yahoo or Amazon, they are kind of warehouses of music. They are all the Wal-Mart’s of music. There is not a lot of original content. There isn’t a point of view. It is more in the terms that if you know the music that you want come to the site, search for it and you can get it. One of the ways that we are going to differentiate ourselves and the same way that we have differentiated our in-store experience is that we want to be able to have a point of view and we want to be able to direct those customers of ours who truly are into the rock genres of music to learn about new music and to have some direction.

We’ve heard from many customers that there is so much music out there they just don’t even know where to find new music and who is the credible voice for that. And with our position in Hot Topic and the fact that we still believe our brand represents authenticity and credibility within the rock music world we think this is the perfect time to be able to launch and to be able to give our customers not only that unique experience of discovery via content and community and the connection to each other but also given where the labels are right now and their willingness to start offering DRM free downloads that our timing is right where it needs to be. I do not think we could have done it earlier.

Operator

The next question comes from the line of Brad Stephens with Morgan, Keegan. Please proceed.

Brad Stephens – Morgan, Keegan & Co.

Hi. Can you hear me this time?

Betsy McLaughlin

We can hear you now.

Brad Stephens – Morgan, Keegan & Co.

Sorry about that. Jim, if I take out ShockHound how do I think about SG&A at leverage points throughout the year?

Jim McGinty

I think in terms of overall SG&A we would have to have at least a very low single-digit comp to get any kind of leverage at this point.

Brad Stephens – Morgan, Keegan & Co.

Okay. Thanks and good luck.

Operator

The next question comes from the line of Crystal Kallik with D.A. Davidson. Please proceed.

Crystal Kallik – D.A. Davidson & Co.

Good afternoon. Betsy I’m looking at another viewpoint question. Certainly the past few years have been different than prior years and overall how has it changed your viewpoint on the positioning of Hot Topic?

Betsy McLaughlin

Over the past several years?

Crystal Kallik – D.A. Davidson & Co.

Well really the last two to three years specifically. How have you changed your viewpoint on really where Hot Topic sits in the grand scheme of things and how you are evolving the brand?

Betsy McLaughlin

Well I think for the first several years…and we’ve gone through four years of tough business. I think for the first year we weren’t really sure what it was. By the second year we started to have a feeling that the availability of music had changed what our customer preferences were. That no longer were our customers in line with only one genre of music. We felt that certainly through all of 2005. As we moved into 2006 and saw more of that we knew we had to alter our strategy. That it wasn’t just about having whatever the hottest band was out there and providing product for that band in the stores and, oh by the way, those customers like all different genres of bands so no longer could we just assort to just appeal to music genres. So the gothic kids were buying goth, and the punk kids were buying punk, and the rockabillies were buying rockabilly (guys and girls). So I think we’ve shifted quite a bit on how Hot Topic plays not only in how we offer the assortment but also how do we make it about the music experience and specifically new music. I think prior to this we were always about new music from big artists. Now we’re really about new music from new artists and that is very different in not only the branding piece of it and where we spend our share of mind but also in how we support marketing and what types of tours we support and how we align ourselves with the bands.

We had not had a music strategy prior to a year and a half ago that really addressed where do we want to position ourselves to our customers, to our internal team. As employees we’ve got 8 or 9,000 very passionate music fans out there who have incredible intelligence about what is happening in their area. How do we mine that information and get that information and use that to our advantage? How do we put ourselves at the forefront of bands and become their launch partner? Not just their merch partner but how do we become their launch partner and gain them exposure? And then for the labels who are in a state of disarray as they are trying to figure out what their model is how do we work with the labels to be a part of that platform of distribution and exposure?

So we’ve really looked at all pieces of music and said okay this is where we want to position ourselves. We’re not just out there selling stuff. We’re out there to create this music experience and as we have implemented more of those pieces of the puzzle we certainly are seeing some traction.

Crystal Kallik – D.A. Davidson & Co.

This is a tough question to answer, but looking at the music business how far along are you in terms of getting to where you’d like to be now?

Betsy McLaughlin

It will probably take us 3-4 years and where are we now? We certainly have addressed those areas we feel will get us the quickest short-term comps which are rock tees and CD’s and positioning that in-store music experience. As far as the overall music strategy? It is a multi-year strategy so I’d say we are probably 25-30% of the way there.

Crystal Kallik – D.A. Davidson & Co.

Thank you so much and good luck.

Operator

At this time we do not have any more questions in the queue and I’d like to return the presentation back to Ms. McLaughlin for closing remarks.

Betsy McLaughlin

Thanks for joining our call. Have a good day.

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Source: Hot Topic, Inc. (HOTT) Q4 2007 Earnings Call Transcript
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