Hot Topic, Inc. F2Q08 (Qtr End 08/02/08) Earnings Call Transcript

| About: Hot Topic, (HOTT)

Hot Topic, Inc. (NASDAQ:HOTT)

F2Q08 Earnings Call

August 20, 2008 4:30 pm ET

Executives

James McGinty – Chief Financial Officer

Elizabeth McLaughlin – Chief Executive Officer & Director

Gerald Cook – President

Christopher F. Daniel – President Torrid

Analysts

Adrienne Tennant – Friedman, Billings, Ramsey & Co.

Stephanie Wissink – Piper Jaffray

Kimberly Greenberger – Citigroup

[David Burman – Burman Capital]

Elizabeth Pierce – Roth Capital Partners, LLC

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

Barbara Wyckoff – Buckingham Research Group

Dana Telsey – Telsey Advisory Group

Crystal Kallik – D. A. Davidson & Co.

Operator

Welcome to the Hot Topic second quarter 2008 earnings release conference call. (Operator Instructions)

Before we begin, I would like to remind 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 things related to key personnel and operational issues. These statements as well as related information posted on the Hot Topic investor relations website involve risks and uncertainties that may cause actual results to differ materially than those projected in the forward-looking statements. These risks and uncertainties are discussed from time-to-time by the company and are more fully set forth in the periodic reports that Hot Topics files with the Securities & Exchange Commission including the most recent annual report on Form 10K and quarterly report on Form 10Q. All forward-looking statements made on this call speak only as of the time they are made and Hot Topic undertakes no obligation to update these statements to reflect subsequent events or circumstances.

To more effectively disseminate the information discussed this afternoon, this call is being webcast on the company’s investor relations website at http://investorrelations.hottopic.com and a replay will be available on that site. A replay will also be available at 888-286-8010 pass code 44743739 for approximately two weeks.

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

James McGinty

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 second quarter results and the comment on the balance sheet and cash flows. Following these details, I will turn it over to Betsy who will provide you with additional color on the quarter followed by third and fourth quarter guidance.


First, the results for the second quarter. All comparisons discussed are to the same period a year ago unless otherwise noted. Overall, total company net sales during the quarter increased by $5.1 million due to a $5.1 million sales gain from new and non-comparable Torrid stores, a $1.9 million sales gain from new and non-comparable Hot Topic stores, a $1.6 million increase in Internet sales, a $700,000 sales reduction related to the Hot Topic comparable store sales decline of 0.6%, a $600,000 sales reduction related to the Torrid comparable sales decline of 2.1% and a $2.2 million sales reduction from closed stores. For the quarter the total company comp decline was the result of a 3% decrease in the consolidated average transaction value partially offset by a 2% increase in the average number of transactions in comparable stores.

At Hot Topic, apparel was 55% of the total sales in the second quarter versus 57% last year. At Torrid, apparel was 82% of the sales in the second quarter, similar to last year. Gross margin was 33.3% of sales compared to 31.5% last year. The 180 basis point increase breaks down in to the following categories: merchandise margins improved 80 basis points due to higher realized markup primarily the result of more favorable merchandise mix; store depreciation expenses declined 60 basis points due to fewer store remodels prior to their lease expiration; distribution costs improved by 40 basis points due to productivity improvements, lower depreciation expense and lower receipts; store occupancy expenses declined 10 basis points due to negotiated reduced rents partially offset by higher common area expenses; buying costs increased by 10 basis points due to higher payroll expenses.

In the second quarter, selling, general and administrative expenses were 34.0% of net sales compared to 33.6% last year. SG&A expenses in the second quarter of fiscal 2008 include approximately $200,000 in charges associated with store impairment and asset write off. Impairment in the second quarter a year ago was approximately $300,000. Excluding these charges for both this year and last, SG&A expense were 50 basis points higher this year. This breaks down in to the following categories: other G&A expenses including stock option expense increased by 90 basis points due to increased payroll expenses, legal expenditures, performance based bonuses and expenditures related to restricted stock award; marketing expenses increased 20 basis points primarily due to online marketing efforts and increased frequency of Torrid direct mailing, partially offset by declines in store signage. Store payroll increased 10 basis points due to higher bonus and medical benefit expenses. Store payroll costs were up 2% in an average store. Administrative depreciation and amortization declined 10 basis points due to a decrease in depreciation expense for computer hardware and software. And lastly, other store expenses declined 60 basis points, the savings related to the reduced telecommunication costs, lower repairs and maintenance, partially offset by an increase in store supplies. One last note on expenses, of the 50 basis points increase that I just reviewed, 30 basis points is directly attributable to ShockHound.

For the quarter the resulting operating loss was $1.2 million versus a $3.4 million loss last year. Our effective tax rate was 39.3% for the second quarter versus 38.3% last year. During the quarter we opened two new Hot Topic stores and four new Torrid stores and closed four Hot Topic stores. We also relocated three Hot Topic stores during the quarter.

Cash, cash equivalents and short term investments were $52 million. We continue to have approximately $10 million in AAA rated auction rate securities classified as long term investments. Total inventory cost was just over $91 million. On a per square foot basis, inventory was down over 5% at the end of the second quarter. Capital expenditures were $5.6 million in the quarter primarily related to the six new stores, three Hot Topic relocations, as well as additional stores scheduled to be opened, remodeled or relocated in the third quarter of 2008. This CapEx also includes expenditures for systems development including the development of ShockHound.

Now, I’ll turn the call over to Betsy.

Elizabeth McLaughlin

We are pleased to report improvement in the Hot Topic division with our best quarterly comp sales performance in 13 quarters. Transactions per store increased 2%. Promotional activity was below last year’s level. Music and fashion accessories led the way as we continue to employ the strategies necessary to recapture market share in our Hot Topic stores.

Following is some color by major category; the music category comp’d up 6%. This was our best quarterly comp performance in music in over three years. We experienced improvement during the quarter in rock tees, rock apparel and CDs. In addition to our continued focus on emerging artist, we increased our music presence by sponsoring tours and hosting numerous store events and in store signings. We also completed the expansion of our music presence within our stores adding listening stations to all stores. Now, every Hot Topic location offers our customers and assortment of CDs and the opportunity to experience and listen to new music.

Accessories was up 5%. Fashion accessories led the way producing a mid teen comp increase. The improvement across the board in fashion accessories validates our items strategy. Licensed accessories declined by mid double digits in line with inventory. Much of the inventory in licensed accessories was shifted in to the fashion category. We will continue to control inventory and licensed accessories until a trend arises that warrants investment. The women’s business declined by 6%. Women’s novelty tees were down in the mid teens resulting from a lack of new licenses. Women’s fashion produced a mid single digit positive comp driven by denim bottoms. Unfortunately, the strength of fashion was not enough to offset novelty tees. Men’s comp’d down 11%. As with women, the primary contributor to the negative comp was novelty tees. We did see improvement however, in July as the result of the Dark Knight licensed tees. HotTopic.com comp’d up 8% for the quarter.

Looking forward to the third quarter at Hot Topic, two new music initiatives are planned. First, we’re excited to announce that Hot Topic will be featured in the game Rock Band II Battle of the Bands. Scheduled for release in mid September on all platforms. Hot Topic has been integrated in to the story line in a way that enables the Rock Band gamer, after achieving a certain degree of success to be sponsored by Hot Topic, play on the Hot Topic stage and sell their tees in a virtual Hot Topic store. Second, Shock Hound, our online music initiative is currently in its beta testing phase. We had planned to launch in late August early September but due to the number of tracks we have acquired and the resulting track ingestion, the launch has been moved to mid third quarter. We have agreements with three of the four major music labels and hope to have the fourth major label signed before we launch. We are very excited about this new opportunity, our first true venture in to a combined editorial community, product and digital music space.

On to Torrid; Torrid was down 2% in comp stores during the second quarter, consistent with the first quarter. This compares to a 3% comp increase achieved last year. We continue to generate gross margin expansion and our driving growth in the average dollar transaction. Apparel was down 3% and accessories was up 2%. Torrid.com improved on the already strong momentum experienced in the first quarter with a 31% top line increase in the second quarter. The Torrid Internet business continues to show significant traffic growth with Diva Style members leading the way in terms of average dollar purchase. To support the continued growth of Torrid.com we launched a site redesign late in July. We expect to benefit from the enhancements made to the site going forward.

In terms of Diva Style, during the second quarter, our signups have increased by 11% and our qualified member count increased by 7%. At the end of July, we launched the Torrid credit card known as Diva Status. Diva Status will enable us to connect with the customer and mine purchasing data much more effectively. The credit card program was designed to work seamlessly with our current CRM program Diva Style. We fully expect that once we build up the credit card portfolio, Diva Status will positively impact the top line.

As for the consolidated results, we continue to be focused on expense control, maximizing our inventory investment and the prudent use of capital. Inventories and open to buy are being scrutinized to ensure that we are allocating our dollars in the most deserving areas. Given that we began the quarter with inventory levels roughly flat to last year on a per square foot basis, we’re pleased to have ended the quarter with inventories down in the mid single digits.

Last, here’s an update on back to school trends; we have clearly experienced the slowing of business in our brick and mortar stores, most notably in Florid where the tax free sales event was cancelled this year. The first two and a half weeks of August have been below our internal plan for both Hot Topic and Torrid. What remains to be seen is if the consumer will hold back their spending all together or whether the business will shift in to late August and early September. Conversely, the Internet business has not seen a decline in trend. In fact, Torrid has maintained its double digit increase and HotTopic.com has accelerated with August month-to-date in dot com business at plus 32% to last year, significantly ahead of the second quarter trend of plus 8%. The increase is twofold, increased traffic and a higher conversion rate.

Our approximate August month-to-date comps are at Hot Topic down 4% and at Torrid, down 11%. At this point, our best estimates for our August consolidated comp is a mid single digit decline, consistent with our current performance.

Jim will now provide our initial guidance for the back half of fiscal 08.

James McGinty

Based on our current expectations, we are issuing the following initial guidance for the third quarter 2008 ending November 1, 2008. The range of total sales for the third quarter is $187 to $192 million based on a low single digit comp decline. We expect gross margins to increase modestly versus last year as a result of a more favorable merchandise mix. We expect SG&A expenses as a percentage of sales to increase as a result of higher store payroll, marketing expenditures, cost related to ShockHound and higher incentive compensation.

As discussed in our press release, we expect to incur additional cost of approximately $0.02 for expenses related to ShockHound. This translates in to third quarter earnings in the range of $0.12 to $0.15 per diluted share. Included in the guidance is an assumed share count of approximately 44.5 million. Inventory at the end of the third quarter is expected to be down in the mid single digit percentage range on a per square foot basis. We anticipate opening one Hot Topic store and one Torrid store and closing three Hot Topic stores and one Torrid store during the third quarter.

Assuming the macro retail environment remains the same, we are guiding to a negative low single digit comp trend in the fourth quarter as well. Based upon this comp guidance, we expect fourth quarter sales to be in the range of $220 to $230 million. This translates in to fourth quarter earnings in the range of $0.25 to $0.28 per diluted share. We anticipate opening one Hot Topic store and two Torrid stores and closing six Hot Topic stores and one Torrid store during the fourth quarter.

At this time we will take questions relating to the results and outlook.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Adrienne Tennant – Friedman, Billings, Ramsey & Co.

Adrienne Tennant – Friedman, Billings, Ramsey & Co.

Can you talk a little bit more about this Rock Band II? And also, are there any other kind of derivatives from that project maybe in licensing other kind of video gaming type of licenses for the novelty tee business? Is there anything there that can be done?

Elizabeth McLaughlin

Well, yes. With Rock Band the deal that MTV and Harmonics has the actual game so the marketing arrangement we have with them is really based on the game. Included in that is also in store presence of Rock Band and if you go in to our stores now you’ll see Rock Band banners, you’ll see that we’ve taken many of the music tees that are featured from the bands within Rock Band, we also have them highlighted. One of the things that we recognized several years ago, it started with Guitar Hero and of course has progressed in to Rock Band, is that so many of the kids, which is our target customer group, and maybe even a little younger than our target group, are learning about music via these music games. They’re hearing Metallica and Guns N’ Roses and ACDC and Poison for the first time and are starting to really recognize them as viable bands. So, we’ve seen in our stores an increase in not only request but sales with some of those classic rock artists.

It caught our attention early and John came on board and felt very strongly about finding a way to integrate in to that game because it’s much more of a pop culture phenomena than a typical game. So yes, there are opportunities for us, we don’t want to be contrived about it so we’re going to be very careful in how we do that. But, yes there is definitely some product extension there. But, we think the benefit for us is really from a branding standpoint being associated by all of these people that when they’re playing when their particular band reaches a certain level of points or success that they are able to be sponsored by Hot Topic. We are the only retailer that’s featured in the game so we’re excited about that.

Adrienne Tennant – Friedman, Billings, Ramsey & Co.

Then for Halloween, what are your plans for Halloween in terms of kind of packaged versus non-packaged? I mean, it falls on a pretty decent day I guess this year, right? It’s a Friday I think so how do you look at that calendar for Halloween to capitalize on that? Then secondarily, as we go in to holiday with one less weekend and five fewer days, how are you positioning things kind of as we go between Black Friday and Christmas?

Elizabeth McLaughlin

Well, as far as Halloween is concerned, it occurs on a Friday, that’s our second favorite day for Halloween to occur, Saturday being the best. So, we’re feeling good about the calendar for this year. Packaged versus non-packaged costumes, I think that we also learned a lot from the past few years and have planned our mix accordingly. We realized last year we missed some opportunity in non-packaged outfits that customers could put together on their own so we have certainly supported that this year. But, we feel good, we’re going to incorporate music in to the theme as we always try to do so we’ll bring together both sides of the store. I think we’re feeling okay about Halloween.

As far as holiday is concerned, one of the things we learned last year is all of the shopping occurs between December the 23rd and January the 4th. Five years ago if you would have asked this question we would have had all kinds of analysis to tell you exactly what percentage of the less days and between Black Friday and Christmas, we just don’t even do that anymore because we know the peak days are happening, certainly for us, beginning on that Friday prior to Christmas.

Adrienne Tennant – Friedman, Billings, Ramsey & Co.

Will you plan to try to capture that traffic? Will you try to hold off on promotions ahead of Christmas and try to really use your markdown dollars in that post Christmas week? Is there any strategy change like that going on?

Elizabeth McLaughlin

You know, the one strategy that we did employ last year which worked which we will anniversary is making sure that we have multiple floor sets during that period. That when everybody is out shopping that week before Christmas that the floor looks fresh and the week after Christmas that the store has a move planned in as well. So, I think our strategy is more in terms of timing of receipts and merchandise presentation in the stores than it is with promotions. You know, we’re not a highly promotional concept at Hot Topic during that time period between Halloween, or actually between Thanksgiving and Christmas. We run the same store promotions so I think it’s more in terms of what the flow looks like and the newness.

Operator

Our next question comes from Stephanie Wissink – Piper Jaffray.

Stephanie Wissink – Piper Jaffray

Betsy, I just want to look at the merchandise margin more closely. Can you provide us some insight in to how much room there remains to improve the margin back to prior peak levels? I’m just curious how far off we are currently from prior peak?

James McGinty

Actually, when you look at the merchandise margin levels that we’re currently running relative to our history, they are right at the peak levels. So, we’re at the top of the game in terms of merchandise margin rate itself. Now, obviously that doesn’t translate down in to the peak gross margin rates because we’re at a lower sales per foot and we’re not able to leverage the occupancy and depreciation and buying and DC costs in the same way we were.

Stephanie Wissink – Piper Jaffray

Then just a couple of follow ups, on the remodel plan, what’s the total for the balance of the year for Hot Topic and Torrid? Then, has there been any change in performance on both of the remodel initiatives that you have in place?

James McGinty

In terms of the remodels, what we’ve said was is that we’d be doing a few in the – I think its three in the third quarter and six in the fourth. It’s about nine we have left in the balance of the year.

Stephanie Wissink – Piper Jaffray

Any update on the performance unique to the change?

James McGinty

It really hasn’t changed significantly. What we saw initially when we did the remodels and relocations and switched out inventory was there was an initial bump in the remodels and the new downtown stores and that they gravitated back to the per-remodel trend more or less.

Stephanie Wissink – Piper Jaffray

Then how about just an update on Torrid, the economic model, what you’re learning from the new prototype and any planned payback period that you’re looking at or profitability cycle?

Gerald Cook

We have not seen a significant payback difference in the new stores design versus the old design. You know, we’re not making the progress this year we would have liked to make on [inaudible] payback but we’re going to continue to stay focused on that as a primary objective. The general sales trend has not been in our favor so far this year and that’s certainly about all I can say.

James McGinty

In terms of the payback timeframe, because our sales per foot have remained about the same and are just off a little bit this year, we’re in that $340 to $350 range, at that level, the payback time for an investment in a new store is about three years.

Stephanie Wissink – Piper Jaffray

Then just one last one, looking at the integration of the online, the ShockHound business, the HotTopic.com, Torrid.com and the in store traffic, any connection there or any patterns that you’re seeing in the basket where you may have some customers crossing over?

Elizabeth McLaughlin

Well, ShockHound hasn’t launched yet.

Stephanie Wissink – Piper Jaffray

It’s live online which is a teaser page and a sign up page?

Elizabeth McLaughlin

Right.

Stephanie Wissink – Piper Jaffray

So, how about the other dot com businesses then?

Elizabeth McLaughlin

We don’t have much crossover between Hot Topic and Torrid at all. I mean, there’s a few but certainly nothing of any kind of significance.

Stephanie Wissink – Piper Jaffray

And how about in store versus online? Any tie ins customer wise?

Elizabeth McLaughlin

You know, I absolutely think there is duplicate customers between both. You know, certainly with Torrid because we’re not located in 680 locations the way we are with Hot Topic. There are certainly new customers that are unique to Torrid.com because there may not be a brick and mortar store in their area. But, the Hot Topic, the member base, I think we share very similarly to the brick and mortar base.

Operator

Your next question comes from Kimberly Greenberger – Citigroup.

Kimberly Greenberger – Citigroup

Betsy, I’m just looking at the Torrid business and based on your comments, your month-to-date in August and the fact that I think July showed a little bit of slowing relative to the 2Q run rate, could you just comment on how you’re thinking about Torrid? Do you think it’s macroeconomic challenges that are pressuring that customer? Are there some things executionally that you think you could be doing better to improve the Torrid business?

Christopher F. Daniel

I can answer most of that. I think definitely there’s some execution in the first half of the year that added to the slowing down of the business. We think there were some assortment issues. We think there have been some physical execution issues in the stores that’s contributed to the slowdown. Beyond that, I think there’s definitely some pressure on this customer just like there are pretty much across the board in the women’s sector right now. I don’t think any that are unique to us and generally for the first half of the year I think we continue to try to outreach to the customer, attract new customers, we’re driving Diva Style, credit card has introduced us to a bunch of new customers, we’re definitely working hard back and forth between stores and the Internet and just continuing to dig in and try and figure out exactly what we can exploit in the back half of the year. Trying to keep the inventory as tight as we can, and focus inventory dollars on relearning fashion, that seems to be where she’s going right now, forward fashion is what’s working in the business and the trend is beginning to improve even in the back half of August.

Kimberly Greenberger – Citigroup

Chris, when do you think the assortment issues and the in store execution issues, when should we see those improve?

Christopher F. Daniel

I think by the end of September.

Elizabeth McLaughlin

The other thing Kimberly that I would add is that Torrid was fairly consistent for most of the second quarter and mid third week of July there was some cliff because we saw a significant drop in business to closer to where its trending now and it happened right in the middle of the third week and Torrid has not recovered. So, something else is there as well. There weren’t changes this year to last year in floor sets and certainly inventories are in line so there was something at work there that we still have not figured out.

Kimberly Greenberger – Citigroup

I just had one follow up question, I think Jim when you were giving the guidance for third quarter, you mentioned that there’s higher incentive comp and I think you talked about incentive comp being higher in the second quarter as well. I’m just trying to understand, if I look at the midpoint of your earnings guidance in third quarter and fourth quarter, it looks like 08 will show about flat earnings to 07. So, I’m just not sure how incentive compensation is going higher in a flat earnings environment?

James McGinty

Well, we’re looking at all the ranges on that too. When you consider the higher end at $0.40 versus $0.36 last year, we’re looking at this point we still have in our forecast to accrue performance based bonus and we also have included in that the stock option expense related to higher options this year than last year. That’s going to stay regardless of the outcome of the year. The other is some of the restricted shares which may or may not be variable. It just depends on the outcome for the year.

Operator

Our next question comes from [David Burman – Burman Capital].

[David Burman – Burman Capital]

I wondered if you could touch on the managerial issues of Maria Comfort leaving and you were originally looking for a president of Hot Topic and I was wondering – and Michael Cook left, I was wondering if you could comment on what you plan on doing for the search of replacing those people, if you feel that you need it at all? I was just wondering why you got a president in the first place in the sense that you seem to be quite top heavy already.

Elizabeth McLaughlin

I think that about a year and a half ago we really felt that there was a need for a president of the Hot Topic brand to coordinate all of the efforts and also from a succession planning standpoint we wanted to grow a successor.

[David Burman – Burman Capital]

Was that something the board wanted you to do?

Elizabeth McLaughlin

Actually, I was the one that presented it to the board but yes, we were all in agreement that succession planning is a good thing. So, yes we felt strongly about bringing somebody in to lead the Hot Topic brand. There are so many moving parts now with our focus on music and trying to pull together the store environment, the marketing piece, you know music and licensing and felt that there was a need for that and I still believe there is a need for someone to lead the Hot Topic brand especially if I’m not there to concentrate on it 80 hours a week as I have been doing. I think it’s better for our shareholders and better certainly for the team to have another person in the mix. So yes, that search will continue and we are looking to find somebody to put in to that position. He was not here for a long period of time so there’s not a matter of there being a vacancy and a void that we feel in the organization because he wasn’t here long enough. But certainly, I think it’s a good additive strategy.

[David Burman – Burman Capital]

But there’s not an urgency or anything like that?

Elizabeth McLaughlin

No, there’s not an urgency, we’ve got to find the right person.

[David Burman – Burman Capital]

And what about the chief merchant Maria leaving?

Elizabeth McLaughlin

The chief merchant, that’s a position that I think we’re looking at what exactly is the format of that position. I think some of it depends on when we place the Hot Topic president, if that person has a strong merchandise background we might not need a chief merchant. If that person has a strong marketing background we might want to compliment with a chief merchant. So, I actually have a lot of flexibility right now on how I marry up those two positions. That’s the way I’m looking at it and as I’m seeing candidates and trying to put the puzzle together. I’m actually in a better position now than I was six months ago because I’ve got more flexibility.

James McGinty

Hi this is Jim McGinty. Betsy and Gerry and Chris and I are back in to the call and no there has not been an earthquake in California, we were just cut off so we’ll take the next question.

Operator

Your next question comes from the line of Elizabeth Pierce – Roth Capital Partners, LLC.

Elizabeth Pierce – Roth Capital Partners, LLC

I was curious on the operating margin, as we and Jim in particular in light of the comments that you made about merchandise margins kind of being at their peak, 13% in change I think was the historical peak. I know it’s early but if you get back just to low single digit comps leveraging out occupancy, ShockHound goes – you start anniversarying that, what is the thought in terms of how high we can get back to?

James McGinty

Well, if you take the merchandise margin and translating that to operating margins, at our current level of productivity where we’re forecasting in terms of range involves something more like a 4% is where we would get to if we get back to a positive comp or low single digit. It would take a significant comp in the current model to get us significantly beyond that simply because of productivity and leveraging the fixed expenses.

Elizabeth Pierce – Roth Capital Partners, LLC

So what we really need to see is just a kick up in the volume?

James McGinty

Absolutely.

Elizabeth Pierce – Roth Capital Partners, LLC

Get the sales per square foot back up to where we were. So, it’s really a top line thing which is a comp thing?

James McGinty

That’s correct.

Elizabeth Pierce – Roth Capital Partners, LLC

And obviously you’ve anniversaried them and you’ve stuck to your guns admirably on the promotional side so it’s really going to just involve more units. Is the thought that once this ShockHound kind of comes online that it really can drive incremental traffic in to the store?

Elizabeth McLaughlin

Yes, that’s the idea.

Elizabeth Pierce – Roth Capital Partners, LLC

I have a quick question for Chris and maybe you don’t want to expand on this but I guess two things, are you comfortable talking about maybe what some of the execution issues are? And, then why you believe that they’ll be resolved by the end of September?

Christopher F. Daniel

One of the things that we saw very clearly is that this year, Betsy referred to it in terms of a certain point in July she had just had enough. She had had enough wear now, she had had enough summer product and generally that sort of wear now shoulder season has been really good for us and has been a really important part of back to school. She has clearly decided to move forward, the customer, she wants fall, she wants fashion. I have the advantage of knowing what we have on order in September. So, that’s part of it. I think we also are lucky enough to offset the penetration of owned brand and internally designed products which has given us the marginal flexibility to move through some of that June/July early August product faster which we have done. So, that’s kind of why I feel like by the end of September you should see a pretty substantial difference.

Elizabeth McLaughlin

I would add too, as Chris talked about execution, the question that he asked is, “How could we have anticipated this better?” So, is it not having receipts in or not having planograms, or not having new product in or not managing the inventory? We’re just hard on ourselves and saying, “Okay, how could we have foreseen this [inaudible] shift when it was going to occur?” So obviously it was time for September as it has been in the past and what we’re seeing is her preference has changed sometime around the third week of July.

Elizabeth Pierce – Roth Capital Partners, LLC

And that’s really A Typical if we think about what we’re seeing with consumers in general buying closer to need?

Elizabeth McLaughlin

Right.

Elizabeth Pierce – Roth Capital Partners, LLC

Do you think it’s just this customer has a pent up demand for fashion because there just haven’t been that many resources for her? Is this something that will translate in to the next kind of shoulder season like in the spring trans season?

Christopher F. Daniel

Well, we continue to manage the inventory very tightly. We’re definitely looking at the percentage of basic versus fashion. I think it was we transitioned very early in the spring so she sees summer from us for a really long time and she was done. X amount of dollars to spend, I’m going to spend it on something new and fresh that I can wear and have go forward. I don’t think that pattern is going to change so we’re going to play very closely to the vest, manage inventory very tightly, continue to flow new fashion every week and reorder the things that really work.

Elizabeth McLaughlin

I think part of the issue too Liz is that we know that these customers are cutting back just like every consumer seems to be cutting back and she’s probably recycling some of her basics. She doesn’t need a new white, black or ecru cami anymore. She doesn’t need some of those things that maybe she buys every single year. She wants the outer piece of the fashion piece that really does look different.

Elizabeth Pierce – Roth Capital Partners, LLC

How’s the denim performing?

Christopher F. Daniel

Denim actually was a little scary for the beginning of August but looks like it’s going to be good. We have an extensive program of inseam styles this year, we brought it forward the last couple of weeks in the store, the reaction is really good and the reaction of fashion denim, there’s some good trends. We continue to maximize skinny, high waisted is really good for us, some of the new trouser styles are good for us so we’re, I think, going to be in good shape in denim.

Operator

Your next question comes from the line of Jeff Van Sinderen – B. Riley & Company, Inc.

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

Since we’re on the subject of Torrid I wonder if maybe you could give us a sense of the promotional cadence there, how you see that developing versus last year and I guess versus how it has been and what we should expect for Q3 there?

Christopher F. Daniel

Our promotional cadence is the same or less than it was a year ago. We will focus more effort on the Torrid credit card. We launched Torrid credit card at the end of July so third and fourth quarter will be focused on that, attracting new customers through the card, application online to the card. But, the overall promo plan is the same or less than a year ago.

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

So basically you’re moving through the merchandise, it’s not an issue of something where you have a lot of merchandise where you have to take big markdowns or promote it? It sounds like you’re just kind of moving through it.

Christopher F. Daniel

No, we kept the inventory pretty tightly controlled all the way through so, so far so good. And, I anticipate that to be true through the rest of the year.

James McGinty

Jeff, I would just add to that, we reported Hot Topic for consolidated inventories to be down over 5%. Torrid was down several percentage points more than that, they were down high single digits in inventory per foot.

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

Then I guess since you were talking a little bit about the hiring process, I was just wondering as you’re working through that for the new president, how you’re feeling about that search in terms of the candidates you’re finding? Is there anything I guess, more that you can say about the timing of that hire?

Elizabeth McLaughlin

No. I mean, we reignited it again about a month ago and I’m back to my going through and screening candidates. I have no idea how long it will take.

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

Then one other thing I wanted to follow up on, in terms of your landlords and store closures, are you starting to see in some cases yet landlords come back to you when you want to close a store and say, “Maybe you shouldn’t close this sore we’ll give you better terms, we’ll do this, we’ll do that.” Are you seeing any of that yet?

James McGinty

Yes Jeff, we’ve seen that in many of the cases where we’ve been in a position to get out of a store either because of a kick out clause prior to its lease expiration or at lease expiration where the landlords really wanted to keep us in and has offered us some favorable incentives to do so.

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

So in some cases that might actually keep you in the stores because the stores can actually be cash flow positive?

James McGinty

Absolutely.

Operator

Our next question comes from [David Burman – Burman Capital]

[David Burman – Burman Capital]

I was starting to ask about inventories and I think you must have been discussing the strategies when the phone was off. But, the question is it’s been about – in the last four quarters your inventories have grown faster than your sales and I think it was intentional. And, this is the first quarter where your inventories are growing slower than your sales and I was just wondering if there was a change in strategy there because it was intentional before. I was just wondering if that was timing or if there was a change in strategy?

Elizabeth McLaughlin

Well, and I think better sales and having more than have of the categories perform well certainly helped that. I think 18 months in to having open to buy discipline and being just emphatic about not investing until we see some sign of real sales, I think that has helped too. I think also when you’ve got fashion accessories that has zoomed ahead with the kind of comps it has been producing that also helps. And of course, you’ve got fashion accessories is a high mark up so conversion to cost, that’s also beneficial to us. I would love to tell you it was manufactured to happen right as the second quarter happened but I think it was something that has been coming for a while. I think it’s the culmination of better trend, higher accessory mix and anniversarying disciplines and having it become part of the normal process.

[David Burman – Burman Capital]

The other question Jim is on the payables which are down 13%. Sometimes that could be a red flag for aging inventory and I was just wondering if you could comment on the aging of your inventory?

James McGinty

Well, really when you look at the payables and their terms, they’re fairly tight and any time you look at the current liability balance at a point in time like you are in the second quarter, what you’re really looking at is the receipts in the month of July.

[David Burman – Burman Capital]

So it’s a timing issue?

James McGinty

It’s really about the timing of it.

[David Burman – Burman Capital]

It’s gone from 34 to 30 days so it’s not a big deal.

James McGinty

And David also our aging inventory is actually down this year.

[David Burman – Burman Capital]

One final thing, you mentioned that this month, the first few weeks have been a little bit slower so I’m sure they’ve been slower everywhere. Then, you gave guidance of comps a little bit better in the back half of the year. Are you expecting some sort of improvement towards the back half of August and September to make the numbers? Or, are you using the current run rate? I wasn’t quite clear on that.

Elizabeth McLaughlin

I think we’re expecting a slight improvement at Hot Topic. The last week of August we’ve got a very strong release and we feel like we’ll pick up – our music release, we’ll be able to pick up some business there and we’re also still of the mindset that there’s chance that the shopping pattern is delayed and September will be stronger than we think. But, I mean clearly it’s that incremental shopping that happens during back to school that we’re feeling the pull back so as we get back to more normalized period of September and certainly the first two weeks of October, I think we feel better to normalize to what our trend has been for the past few months.

Operator

Your next question comes from Barbara Wyckoff – Buckingham Research Group.

Barbara Wyckoff – Buckingham Research Group

Betsy, what do you see happening in the apparel business? I mean men’s has been negative for a long time, women’s hasn’t hit a solid trend in a while, how are you rethinking this business say second half of this year in to 09? I guess penetration classifications, are there new buyers? What’s the strategy? The other classifications have improved nicely but apparel still seems to struggle. Then, I have a question I guess for Jim.

Elizabeth McLaughlin

Barbara, I think it’s important to separate out apparel and license because both the men’s and women’s totals include fashion apparel and license tees. If you carve out fashion apparel, fashion apparel is doing exactly what we wanted it to do and actually making its numbers. I will say that we probably scaled back men’s fashion apparel, the tops specifically a bit too much and there’s some opportunity there. But, when I look at the fashion apparel numbers, they’re making their numbers and they’re comping the way they’re suppose to be comping and I feel very, very good about fashion apparel. Licensing, specifically, I mean all three areas of licensing, men’s novelty tees, women’s novelty tees and license accessories have been what the drag is. How do we rethink that business? Well, I think that’s really predicated on the strength of licenses. We’re not ready to talk about go forward licenses but we do think we have a strong license in the bag here for the back half of the this year which we’re feeling good about. As far as supervision, the licensing group has a new boss and it happens to be the VMM who was running fashion accessories and she is now supervising the licensing group so I think that team as a whole will benefit from that as well as the emergence of a new license here in the back half of the year.

Barbara Wyckoff – Buckingham Research Group

Then my question for Jim is how are you thinking about maintain margins on ShockHound say end of year one?

James McGinty

Maintain margins on ShockHound, that’s a really difficult question to answer at this point because we haven’t launched and we haven’t seen what the mix is between the downloads and the merchandise we will sell. It all really depends on that mix. Obviously the downloads, the margins are very thin and the merchandise there more consistent with what we currently experience in our music, more specifically rock tees and rock apparel. I would be guessing to quote a number at this point and we’ll have to wait and see, at least get out there for a month and see how the customer responds to the site and what their purchasing pattern is.

Barbara Wyckoff – Buckingham Research Group

Outside of just say the promotion in the stores, how are you promoting the launch of ShockHound? How are you going to get the word out?

Elizabeth McLaughlin

We have a marketing firm out of New York that has the project and there’s a multilayered marketing plan for ShockHound that includes online, offline, within the Hot Topic stores, some special shows, all kinds of steal teams that are helping to get the word out. So, it’s a layered strategy and as soon as we are close to launch we’ll start to see that. Some of it has already happened but the big portion of it will happen two, three months after the launch and then certainly as we move in to next year we’ll reinforce that with increased marketing.

Operator

Our next question comes from Dana Telsey – Telsey Advisory Group.

Dana Telsey – Telsey Advisory Group

Can you talk a little bit about product inflation? How you’re thinking of pricing for both for either the back half of this year or next year? And, how that relates to both Torrid and Hot Topic and just the opportunities on the gross margin side?

Elizabeth McLaughlin

Well, I think certainly the consumer is more sensitive to pricing. I’ll start with Hot Topic and I’ll let Chris talk about Torrid. Our average sale has been around $21 and our average unit on hand, I think what is it $8? $10? Jim?

James McGinty

It’s about $10 or $11.

Elizabeth McLaughlin

So the pricing is not high at Hot Topic. We did begin a strategy last year where we repriced CDs and repriced tees within music and I think we looked at all of the areas and said, “Okay how do we have an entry level price point?” I think we’re trying to be sensitive in pricing. I don’t think – I think given, I don’t know if you heard Jim’s answer on merchandise margin, there’s not much more merch margin we can push and so we’re trying to price each item as we need to price the item but I definitely think that the higher priced garment certainly, it’s tough because we’re not going to squeeze out an extra couple of points in margin either by getting the cost down or by increasing the retail.

Operator

Our next question comes from Crystal Kallik – D. A. Davidson & Co.

Crystal Kallik – D. A. Davidson & Co.

Jim, I think you started to address this a couple of questions ago. When we’re talking about ShockHound and just thinking about the margins and I guess that makes sense until you really see what the mix of the downloads versus merchandise it’s a little bit trickier. But, as you guys were developing the business model, what did you use for revenue and earnings? What are you thinking as far as time frame to breakeven on the ShockHound project?

James McGinty


Well, we ran a number of models. Is it going to be 60/40, 40/60, 50/50? You just have to run it several ways to make sure that within a period of a few years you can at least get to a breakeven make money at a certain level of volume. Now, the real trick is what’s the level of volume relative to what’s happening down there in digital music. I think anything you put together is a guess but if anything we’ve been very conservative in what we might be able to generate in terms of the volume going these next couple of years. I think the other thing, with an online business like ShockHound, you don’t have the same level of fixed costs you do when you open stores. So, the depreciation base, etc., is not as substantial and there’s a lot more flex in the model.

Elizabeth McLaughlin

One thing you have to remember too about ShockHound is we really looked at the incremental sales. The music position of ShockHound is much wider than Hot Topic so it includes genres of music that we would not carry in a Hot Topic store so there’s incremental revenue that we also looked at. You want to add to the top line and have it flow down or do you not want to do that? So I think that the model is very different because it’s an online model that has a high percentage of digital music but we also believe that it represents a growth vehicle in the sense that it will provide incremental volume that would not have otherwise been there.

Crystal Kallik – D. A. Davidson & Co.

So I guess it’s safe to say that towards the end of the year you’ll have a better idea of whether or not its breakeven, dilutive or accretive looking towards 09?

Elizabeth McLaughlin

Yes. I would say we thought in three years let’s get to that breakeven point and let’s see how much volume we can drive.

Crystal Kallik – D. A. Davidson & Co.

Just looking at you know the music business has certainly turned around for you. It’s nice to see that and I know you’ve completed the listening stations in all the stores. Is there any way to measure because you have so many initiatives going on, have you been able to directly measure the impact of having the listening stations in the stores, how that’s impacted your music business in Q2?

Elizabeth McLaughlin

We did towards the middle of Q2. But yes, it did impact the music business, certainly the CD business as we went from 450 to 680 stores, I think those are about the right numbers. Obviously, we saw some increase there. But remember, music and CDs is a very small percentage of our business and so it doesn’t really impact the top line much. We did see I think less than a point difference when we added it in so it didn’t transfer any business but we got a tiny bit of a bump but the reason – part of the music strategy supports is having that experience of new music when you walk in to a store so it’s as much a part of the store environment as it is about selling CDs.

Crystal Kallik – D. A. Davidson & Co.

Then Jim just a couple of quick questions, I think you walked through this, does it still make sense with the way that the model is running that on a flatter or slightly positive comp that you will indeed leverage your fixed costs at this point? Or, has that changed in your mind?

James McGinty

That has not changed. That’s about the level, as we you know, turn the corner and get that flat comp or up a little bit, that’s where we’ll see leverage on the fixed costs particularly the occupancy, depreciation and even in to the SG&A.

Crystal Kallik – D. A. Davidson & Co.

Then just finally, how do you think about the tax rate? It’s been up a little bit in the first half, what would you suggest we look at as far as looking at the second half tax rate?

James McGinty

I think you can take what we booked in the first half and look at the second half in the same manner. Really, when you look at tax rates, it’s all about what you end the year with and last year we ended the year over 39% and it’s just a matter of the way the quarterlies booked. I think this year we have it a little bit more evenly spread.

Operator

There are no further questions at this time.

Elizabeth McLaughlin

Thanks for joining us on the call. We look forward to talking to you next quarter.

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