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Hot Topic 10-Q 2006

Documents found in this filing:

  1. 10-Q
  2. Ex-31.1
  3. Ex-31.2
  4. Ex-32.1
  5. Ex-32.1
Form 10-Q

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended July 29, 2006

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR l5(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                      to                     

Commission file number: 0-28784

HOT TOPIC, INC.

(Exact name of registrant as specified in its charter)

 

CALIFORNIA   77-0198182
(State of incorporation)   (IRS Employer Identification No.)
18305 EAST SAN JOSE AVE., CITY OF INDUSTRY, CA   91748
(Address of principal executive offices)   (Zip Code)

(626) 839-4681

(Registrant’s telephone number, including area code)

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.   Yes  x    No  ¨

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large Accelerated Filer  x                    Accelerated Filer  ¨                    Non-Accelerated Filer  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).   Yes  ¨    No  x

APPLICABLE ONLY TO CORPORATE ISSUERS: Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: August 21, 2006 – 44,194,294 shares of common stock, no par value.

 



HOT TOPIC, INC.

INDEX TO FORM 10-Q

 

          Page No.
PART I. FINANCIAL INFORMATION   

Item 1.

  

Condensed Consolidated Financial Statements

  
  

Condensed Consolidated Balance Sheets – July 29, 2006 and January 28, 2006

   3
  

Condensed Consolidated Statements of Operations for the three months and six months ended July 29, 2006 and July 30, 2005

   4
  

Condensed Consolidated Statements of Cash Flows for the six months ended July 29, 2006 and July 30, 2005

   5
  

Notes to Condensed Consolidated Financial Statements

   6-14

Item 2.

  

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   15-24

Item 3.

  

Quantitative and Qualitative Disclosures about Market Risk

   24

Item 4.

  

Controls and Procedures

   24
PART II. OTHER INFORMATION   

Item 1.

  

Legal Proceedings

   25

Item 1A.

  

Risk Factors

   25

Item 4.

  

Submission of Matters to a Vote of Security Holders

   34

Item 6.

  

Exhibits and Reports on Form 8-K

   35

SIGNATURES

   36

 

2


PART I. FINANCIAL INFORMATION

 

Item 1. Condensed Consolidated Financial Statements

Hot Topic, Inc. and Subsidiaries

Condensed Consolidated Balance Sheets

(In thousands, except share amounts)

(Unaudited)

 

     July 29,
2006
    January 28,
2006
 

Assets

    

Current assets:

    

Cash and cash equivalents

   $ 2,263     $ 9,673  

Short-term investments

     17,620       28,001  

Inventory

     106,227       71,160  

Prepaid expenses and other

     17,277       16,781  

Deferred tax assets

     2,487       2,487  
                

Total current assets

     145,874       128,102  

Property and equipment, net

     174,070       171,089  

Deposits and other

     249       244  
                

Total assets

   $ 320,193     $ 299,435  
                

Liabilities and shareholders’ equity

    

Current liabilities:

    

Accounts payable and overdraft

   $ 47,429     $ 18,122  

Accrued liabilities

     27,595       33,569  

Income taxes payable

     —         5,788  
                

Total current liabilities

     75,024       57,479  

Deferred rent

     41,224       39,941  

Deferred tax liability

     209       954  

Commitments and contingencies

     —         —    

Shareholders’ equity:

    

Preferred shares, no par value; 10,000,000 shares authorized; no shares issued and outstanding

     —         —    

Common shares, no par value; 150,000,000 shares authorized; 44,194,294 and 43,976,536 shares issued and outstanding at July 29, 2006 and January 28, 2006, respectively

     105,312       100,328  

Retained earnings

     98,434       100,746  

Accumulated other comprehensive loss

     (10 )     (13 )
                

Total shareholders’ equity

     203,736       201,061  
                

Total liabilities and shareholders’ equity

   $ 320,193     $ 299,435  
                

See notes to condensed consolidated financial statements.

 

3


Hot Topic, Inc. and Subsidiaries

Condensed Consolidated Statements of Operations

(In thousands)

(Unaudited)

 

     Three Months Ended    Six Months Ended
     July 29,
2006
    July 30,
2005
   July 29,
2006
    July 30,
2005

Net sales

   $ 160,348     $ 152,234    $ 314,389     $ 301,996

Cost of goods sold, including buying, distribution and occupancy costs

     109,514       104,612      215,295       203,208
                             

Gross margin

     50,834       47,622      99,094       98,788

Selling, general and administrative expenses

     52,540       46,498      103,485       89,899
                             

(Loss) income from operations

     (1,706 )     1,124      (4,391 )     8,889

Interest income, net

     239       323      642       660
                             

(Loss) income before income taxes

     (1,467 )     1,447      (3,749 )     9,549

(Benefit) provision for income taxes

     (562 )     554      (1,436 )     3,657
                             

Net (loss) income

   $ (905 )   $ 893    $ (2,313 )   $ 5,892
                             

Net (loss) earnings per share:

         

Basic

   $ (0.02 )   $ 0.02    $ (0.05 )   $ 0.13
                             

Diluted

   $ (0.02 )   $ 0.02    $ (0.05 )   $ 0.13
                             

Shares used in computing net (loss) earnings per share:

         

Basic

     44,180       45,065      44,122       44,907

Diluted

     44,180       46,246      44,122       46,207

See notes to condensed consolidated financial statements.

 

4


Hot Topic, Inc. and Subsidiaries

Condensed Consolidated Statements of Cash Flows

(In thousands)

(Unaudited)

 

     Six Months Ended  
     July 29,
2006
    July 30,
2005
 

OPERATING ACTIVITIES

    

Net (loss) income

   $ (2,313 )   $ 5,892  

Adjustments to reconcile net (loss) income to net cash provided by operating activities:

    

Depreciation and amortization

     18,693       14,587  

Stock-based compensation

     2,736       77  

Tax benefit from exercise of stock options

     —         2,600  

Loss on disposal of fixed assets

     156       213  

Deferred taxes

     (745 )     —    

Gift card breakage

     (284 )     —    

Changes in operating assets and liabilities:

    

Inventory

     (35,067 )     (34,043 )

Prepaid expenses and other current assets

     (740 )     (5,940 )

Deposits and other assets

     (5 )     (4 )

Accounts payable and overdraft

     29,308       26,264  

Accrued liabilities

     (5,351 )     4,659  

Deferred rent

     1,283       5,437  

Income taxes payable

     (5,788 )     (8,811 )
                

Net cash provided by operating activities

     1,883       10,931  

INVESTING ACTIVITIES

    

Purchases of property and equipment

     (21,753 )     (49,421 )

Proceeds from sale of short-term investments

     8,541       65,525  

Purchases of short-term investments

     1,844       (37,736 )
                

Net cash used in investing activities

     (11,368 )     (21,632 )

FINANCING ACTIVITIES

    

Payments on capital lease obligations

     (263 )     —    

Excess tax benefit from stock-based compensation

     168       —    

Proceeds from employee stock purchases and exercise of stock options

     2,170       5,897  
                

Net cash provided by financing activities

     2,075       5,897  
                

Decrease in cash and cash equivalents

     (7,410 )     (4,804 )

Cash and cash equivalents at beginning of year

     9,673       5,248  
                

Cash and cash equivalents at end of period

   $ 2,263     $ 444  
                

SUPPLEMENTAL INFORMATION

    

Cash paid during the period for interest

   $ 6     $ 2  
                

Cash paid during the period for income taxes

   $ 8,904     $ 13,616  
                

See notes to condensed consolidated financial statements.

 

5


HOT TOPIC, INC. and SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 1. Organization and Basis of Presentation

We are a mall-based specialty retailer operating the Hot Topic and Torrid concepts. Hot Topic stores sell a selection of music/pop culture-licensed and music/pop culture-influenced apparel, accessories and gift items for young men and women principally between the ages of 12 and 22. Torrid stores sell apparel, lingerie, shoes and accessories designed for various lifestyles for plus-size females between the ages of 15 and 29. We were incorporated in California in 1988. We opened our first Hot Topic store in 1989 and our first Torrid store in 2001. At the end of the second quarter of fiscal 2006 (July 29, 2006 in the 53-week fiscal year ending February 3, 2007), we operated 682 Hot Topic stores throughout the United States and Puerto Rico, and 127 Torrid stores. We also sell merchandise on two websites, http://www.hottopic.com and http://www.torrid.com, which reflect the Hot Topic and Torrid store concepts and carry merchandise similar to that sold in the respective stores. Throughout this report, the terms “our”, “we” and “us” refer to Hot Topic, Inc. and its subsidiaries.

The information set forth in these financial statements is unaudited except for the January 28, 2006 Consolidated Balance Sheet. These statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information, the instructions to Form 10-Q, and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements.

In the opinion of management, all adjustments, consisting only of normal recurring entries, necessary for a fair presentation have been included. The results of operations for the six months ended July 29, 2006 are not necessarily indicative of the results that may be expected for the year ending February 3, 2007.

NOTE 2. Stock-Based Compensation

Stock Plan Activity

Under our 1996 Equity Incentive Plan, we granted stock options, stock bonuses, and other awards to our employees, directors, and consultants as deemed appropriate by the Board of Directors (the “Board”). On June 14, 2006, the 1996 Equity Incentive Plan expired and was replaced with the 2006 Equity Incentive Plan (the “2006 Plan”). The 2006 Plan was approved by the Board on March 17, 2006 and by our shareholders on June 13, 2006. Upon expiration of the 1996 Equity Incentive Plan, 1,268,265 shares out of an aggregate of 18,300,000 shares of common stock that were available for grant remained available for grant.

The new 2006 Plan provides for the grant of incentive stock options, non-statutory stock options, restricted stock awards, restricted stock unit awards, stock appreciation rights, performance stock awards and other forms of equity compensation to our employees, consultants and directors as deemed appropriate by the Board. Both incentive and non-statutory stock options granted by us under the 2006 Plan must carry an exercise price of at least 100% of the fair market value of the stock on the date of grant. Options granted may be subject to different vesting terms as determined by the Board and the

 

6


maximum term of options granted is 10 years. In addition, the maximum number of shares of common stock available for future issuance may not exceed the sum of (a) the number of unallocated shares of common stock remaining available for issuance under the 1996 Incentive plan as of June 13, 2006, (b) an additional 2,350,000 shares and (c) the number of shares subject to stock awards as of June 13, 2006 under the 1996 Incentive Plan pursuant to the terms of the 1996 Incentive Plan. As of July 29, 2006, 3,057,456 shares were available for future grants. All awards to date under the 2006 Plan have been granted to employees of the company, none have been granted to consultants.

In March 2006, we granted restricted stock “unit” awards under the 1996 Equity Incentive Plan to certain members of our management. None of these awards have vested and no shares have been issued pursuant to the grants. These awards provide for the issuance of up to 474,000 shares of our common stock, with vesting and issuance contingent upon achieving performance goals for fiscal year 2008 based upon operating income for the company for that fiscal year; and prior to vesting (or termination without vesting), the “units” will constitute an agreement by us to issue shares to the extent performance goals are ultimately met. The market value of our common stock as of the grant date of these restricted stock “unit” awards was $13.90. Compensation expense for these awards will be recorded over the three-year term of the award, based on the market value as of the grant date, with actual amounts expensed dependent upon the likelihood from period to period of vesting of such awards at the end of fiscal 2008. As of July 29, 2006, it is our best estimate that 50% of these awards will be earned and vest at the end of the three-year term. As a result, we recognized $275,000 and $549,000 as compensation expense during the three months and six months ended July 29, 2006 for these restricted stock unit awards.

Under our 1996 Non-Employee Directors’ Stock Option Plan, we may grant and have granted stock options and other awards to non-employee directors. The exercise price of options granted under this plan shall be determined by the Board at the date of grant and shall not be lower than (i) 100% of the fair market value of our common stock on the date of grant for incentive stock options, (ii) 85% of the fair market value of our common stock on the date of grant for non-statutory stock options, and (iii) 110% of the fair market value of our common stock on the date of grant for persons possessing 10% or more of the total combined voting power of all classes of stock. Unless the Board declares otherwise, options vest over four years and generally expire ten years from the date of grant. An aggregate of 720,000 shares of common stock may be issued pursuant to this plan. As of July 29, 2006, 23,264 shares were available for future grants. No options under this plan have been granted to consultants.

In June 2006, we granted 11,842 shares of restricted common stock to non-employee directors under the 1996 Equity Incentive Plan. Restricted shares generally vest in the year subsequent to the grant year. All awarded common shares remain restricted (i.e., not transferable by the holders) until such time as the recipient is no longer a member of our Board of Directors. The value of these grants is expensed over the vesting period and $78,000 has been expensed as of July 29, 2006. During the fiscal year ended January 28, 2006, non-employee directors were granted 7,496 shares of restricted stock and $155,000 was expensed.

In June 1996, the Board of Directors adopted the Employee Stock Purchase Plan (the “Stock Purchase Plan”). The Stock Purchase Plan provides for the issuance of up to 1,350,000 shares of common stock to our employees. All eligible employees are granted identical rights to purchase common stock for each Board authorized offering under the Stock Purchase Plan. Rights granted pursuant to any offering under the Stock Purchase Plan terminate immediately upon cessation of an employee’s employment for any reason. In general, an employee may reduce contribution or withdraw from participation in an offering at any time during the purchase period for such offering. Employees receive a 15% discount on shares purchased under the Stock Purchase Plan. Rights granted under the Stock Purchase Plan are not

 

7


transferable and may be exercised only by the person to whom such rights are granted. The initial offering under the Stock Purchase Plan commenced October 24, 1996 and terminated December 31, 1996. Subsequent offerings occur every six months commencing January 1, 1997. At July 29, 2006, 1,107,792 shares could still be sold to employees under the plan. Compensation expense for the three months and six months ended July 29, 2006 was $78,000 and $109,000, respectively, to account for the fair value of the rights granted to participants under the plan at the beginning of the then-current offering.

The following table summarizes stock options outstanding as of July 29, 2006, as well as activity through the second quarter then ended:

 

     Shares     Weighted-
Average
Exercise Price
   Weighted-
Average
Remaining
Contractual
Term (in years)
   Aggregate
Intrinsic Value

Outstanding at January 28, 2006

   5,755,313     $ 16.27      

Granted

   945,296     $ 13.80      

Exercised

   (180,660 )   $ 9.80      

Forfeited or expired

   (491,218 )   $ 19.82      
                  

Outstanding at July 29, 2006

   6,028,731     $ 15.78    6.97    $ 12,193,053
                        

Exercisable at July 29, 2006

   4,723,887     $ 16.21    6.36    $ 11,087,904
                        

The weighted average fair value of stock options estimated on the date of each grant during the three months and six months ended July 29, 2006 and July 30, 2005 are provided in the following table:

 

     Three Months Ended    Six Months Ended
     July 29,
2006
   July 30,
2005
   July 29,
2006
   July 30,
2005

Weighted average fair value at grant date

   $ 6.24    $ 8.07    $ 6.22    $ 8.21

Cash proceeds, tax benefits and intrinsic value related to total stock options exercised during the three months and six months ended July 29, 2006 and July 30, 2005 are provided in the following table (in thousands):

 

     Three Months Ended    Six Months Ended
     July 29,
2006
   July 30,
2005
   July 29,
2006
   July 30,
2005

Proceeds from stock options exercised

   $ 8    $ 2,399    $ 1,770    $ 5,533

Tax benefit related to stock options exercised

   $ 3    $ 1,317    $ 168    $ 2,600

Intrinsic value of stock options exercised

   $ 7    $ 3,518    $ 438    $ 6,944

Accounting for Stock Compensation Expense

Effective January 29, 2006, we adopted Statement of Financial Accounting Standards (“SFAS”) No. 123R, “Share-Based Payments,” (“SFAS 123R”), which addresses the accounting for stock-based payment transactions whereby an entity receives employee services in exchange for equity instruments,

 

8


including stock options. SFAS 123R eliminates the ability to account for stock-based compensation transactions using the intrinsic value method under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” (“APB 25”) and instead generally requires that such transactions be accounted for using a fair value based method. We have elected the modified prospective transition method as permitted under SFAS 123R, and accordingly prior periods have not been restated to reflect the impact of SFAS 123R. The modified prospective transition method requires that stock-based compensation expense be recorded for all new and unvested stock options that are ultimately expected to vest as the requisite service is rendered beginning on January 29, 2006. Stock-based compensation for awards granted prior to January 29, 2006 is based upon the grant-date fair value of such compensation as determined under the pro forma provisions of SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”).

Prior to fiscal 2006, the Company determined stock based compensation expense using the intrinsic value method of APB 25 and we provided the disclosures required by SFAS 123, as amended by SFAS No. 148 “Accounting for Stock-Based Compensation – Transition and Disclosure.” The following table provides the pro forma effects on our net (loss) income and net (loss) earnings per share for the three months and six months ended July 30, 2005 as if the fair value recognition provisions of SFAS 123R had been applied (in thousands, except per share amounts):

 

     Three Months Ended
July 30, 2005
    Six Months Ended
July 30, 2005
 

Net income

    

As reported

   $ 893     $ 5,892  

Add: Stock-based compensation expense included in reported net income, net of related tax effects

     24       48  

Deduct: Total stock-based compensation expense determined under fair value method for all awards, net of related tax effects

     (1,225 )     (2,300 )
                

Net (loss) income

   $ (308 )   $ 3,640  
                

Basic (loss) earnings per share:

    

As reported

   $ 0.02     $ 0.13  

Pro forma

   $ (0.01 )   $ 0.08  

Diluted (loss) earnings per share:

    

As reported

   $ 0.02     $ 0.13  

Pro forma

   $ (0.01 )   $ 0.08  

 

9


The effect of recording stock-based compensation for the three months and six months ended July 29, 2006 was as follows:

 

     Three Months Ended     Six Months Ended  
     July 29, 2006     July 29, 2006  

Stock-based compensation by type of award:

    

Employee stock options and awards

   $ 1,059,931     $ 2,077,587  

Restricted stock units

     274,525       549,050  

Employee stock purchase plan

     77,653       109,153  
                

Total stock-based compensation expense

   $ 1,412,109     $ 2,735,790  

Tax effect on stock-based compensation expense

     (401,742 )     (777,202 )
                

Net effect on net income

   $ 1,010,367     $ 1,958,588  
                

Effect on loss per share:

    

Basic and diluted

   $ (0.02 )   $ (0.04 )
                

In the second quarter of fiscal 2006 and 2005, we recognized stock and equity awards compensation costs of $1,412,000 and $77,000, respectively. Of that amount, $187,000 was recorded as a component of cost of goods sold and the remainder was charged to selling, general and administrative expense in the second quarter of fiscal 2006. The entire amount in the second quarter of fiscal 2005 was charged to selling, general and administrative expense.

The application of SFAS 123R did not impact our cash position, but resulted in a change in presentation on our consolidated statements of cash flows. Previously, the tax benefit from the exercise of stock options was recorded as a component of operating activities. Subsequent to the adoption of SFAS 123R it is recorded as a component of cash flows from financing activities in the consolidated statements of cash flows.

The incremental stock-based compensation expense resulting from the adoption of SFAS 123R includes expense related to stock options granted prior to, but not yet vested as of January 29, 2006. As of July 29, 2006, we had $7.8 million of unrecognized expense related to non-vested stock-based compensation, which is expected to be recognized over a weighted average period of 3.16 years.

Calculation of Fair Value of Options

We use a Black-Scholes option valuation model to determine the fair value of stock-based compensation under SFAS 123R, consistent with that used by us previously for pro forma disclosures under SFAS 123. The Black-Scholes model incorporates various assumptions including the expected term of awards, volatility of stock price, risk-free rates of return and dividend yield. The expected term of an award is generally no less than the option vesting period and is based on our historical experience. Expected volatility is based upon the historical volatility of our stock price. The risk-free interest rate is approximated using rates available on U.S. Treasury securities with a remaining term equal to the option’s expected life. We use a dividend yield of zero in the Black-Scholes option valuation model, as we do not anticipate paying cash dividends in the foreseeable future.

 

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The following weighted average assumptions were used for stock options granted during the three months and six months ended July 29, 2006 and July 30, 2005:

 

     Three Months Ended     Six Months Ended  
     July 29,
2006
    July 30,
2005
    July 29,
2006
    July 30,
2005
 

Risk free interest rate

   5.00 %   5.00 %   5.00 %   5.00 %

Expected life

   5.0  years   5.0  years   5.0  years   5.0  years

Expected volatility

   48 %   35 %   48 %   34 %

Expected dividend yield

   0.00 %   0.00 %   0.00 %   0.00 %

NOTE 3. Net (Loss) Earnings Per Share

We compute net (loss) earnings per share pursuant to SFAS No. 128 “Earnings Per Share.” Basic net (loss) earnings per share is computed based on the weighted average number of common shares outstanding for the period. Diluted net (loss) earnings per share is computed based on the weighted average number of common shares outstanding for the period and potentially dilutive common stock equivalents outstanding for the period.

A reconciliation of the numerator and denominator of basic (loss) earnings per share and diluted (loss) earnings per share is as follows (in thousands, except per share amounts):

 

     Three Months Ended    Six Months Ended
     July 29,
2006
    July 30,
2005
   July 29,
2006
    July 30,
2005

Basic (loss) earnings computation:

         

Numerator

   $ (905 )   $ 893    $ (2,313 )   $ 5,892

Denominator:

         

Weighted average common shares outstanding:

     44,180       45,065      44,122       44,907

Incremental shares from assumed conversion of options

     —         1,181      —         1,300
                             

Total shares

     44,180       46,246      44,122       46,207
                             

Basic (loss) earnings per share

   $ (0.02 )   $ 0.02    $ (0.05 )   $ 0.13

Diluted (loss) earnings per share

   $ (0.02 )   $ 0.02    $ (0.05 )   $ 0.13

The calculation of dilutive shares excludes the effect of the following options and restricted stock units that are considered anti-dilutive:

 

     Three Months Ended    Six Months Ended
     July 29,
2006
   July 30,
2005
   July 29,
2006
   July 30,
2005

Anti-dilutive options

   4,740,913    2,575,031    4,652,426    2,239,539

Anti-dilutive restricted stock units

   474,000    —      474,000    —  

 

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NOTE 4. Comprehensive (Loss) Income

Comprehensive (loss) income for the three months and six months ended July 29, 2006 and July 30, 2005 is as follows (in thousands):

 

     Three Months Ended    Six Months Ended
     July 29,
2006
    July 30,
2005
   July 29,
2006
    July 30,
2005

Comprehensive (loss) Income

         

Net (loss) income

   $ (905 )   $ 893    $ (2,313 )   $ 5,892

Unrealized income on marketable securities, net

     3       29      4       13
                             

Total comprehensive (loss) income

   $ (902 )   $ 922    $ (2,309 )   $ 5,905
                             

NOTE 5. Bank Credit Agreement

We maintain an unsecured bank credit agreement of $5.0 million. The credit agreement will expire in August 2007 and we expect to renew the credit agreement under similar terms. Letters of credit are issued under the credit agreement, which are primarily used for inventory purchases. At July 29, 2006, there were letters of credit for $302,000 outstanding under the credit agreement. There were no letters of credit outstanding at January 28, 2006.

NOTE 6. Commitments and Contingencies

Litigation

On September 17, 2004, a former Torrid employee filed a lawsuit against us in the Superior Court of Los Angeles County, on behalf of a purported class. The lawsuit asserted claims for failure to provide adequate meal or rest breaks, improper payment of overtime wages, failure to timely pay wages at end of employment and unfair business practices. The lawsuit sought compensatory damages, statutory penalties, punitive damages, attorneys’ fees and injunctive relief. On October 21, 2004, we filed an answer denying the material allegations of the complaint. In June 2006, the court gave final approval to a settlement agreement between the plaintiff (on behalf of the purported class) and us. We accrued amounts to account for the settlement in fiscal 2005 following agreement on the settlement terms. No further activity is expected with respect to the case, and we do not expect any further costs or expenses associated with it.

In April 2006, a California resident filed a lawsuit against us in Superior Court of Los Angeles County, alleging that we violated California Civil Code Section 1747.08. That code section regulates when a retailer is permitted to take down certain customer information in connection with credit card transactions. The case is alleged as a class action. In May 2006, we answered the complaint and denied all liability.

We are involved in other matters of litigation that arise in the ordinary course of business. We do not currently believe that the cases referenced above, or any other litigation in which we are currently involved, will have a material adverse effect on our overall financial condition.

 

12


Indemnities, Commitments and Guarantees

During the ordinary course of business, we have made certain indemnities, commitments and guarantees under which we may be required to make payments in relation to certain transactions. These indemnities include those given to various lessors in connection with facility leases for certain claims arising from such facility or lease and indemnities to our directors and officers to the maximum extent permitted under the laws of the State of California. We have issued guarantees in the form of letters of credit as security for some merchandise shipments from overseas. There were letters of credit for $302,000 outstanding at July 29, 2006 and none outstanding at January 28, 2006. The durations of these indemnities, commitments and guarantees vary. Some of these indemnities, commitments and guarantees do not provide for any limitation of the maximum potential future payments we could be obligated to make. We have not recorded any liability for these indemnities, commitments and guarantees in the accompanying consolidated financial statements.

NOTE 7. Impact of Recently Issued Accounting Pronouncements

In February 2006, the Financial Accounting Standards Board (“FASB”) Emerging Issues Task Force (“EITF”) issued a proposed EITF No. 06-3, “How Sales Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross Versus Net Presentation),” (“EITF No. 06-3”) The Task Force reached a tentative consensus that a company should disclose its accounting policy (i.e., gross or net presentation) regarding presentation of taxes within the scope of EITF No. 06-3. If taxes included in gross revenues are significant, a company should disclose the amount of such taxes for each period for which an income statement is presented. The consensus would be effective for the first annual or interim reporting period beginning after December 15, 2006. The disclosures are required for annual and interim financial statements for each period for which an income statement is presented. We are currently evaluating the impact of adopting EITF No. 06-3 on our results of operations.

In March 2006, the FASB issued SFAS No. 156, “Accounting for Servicing of Financial Assets – an amendment of FASB Statement No. 140” (“SFAS 156”), which is effective for fiscal years beginning after September 15, 2006. SFAS 156 was issued to simplify the accounting for servicing rights and to reduce the volatility that results from using different measurement attributes. We do not expect the adoption of SFAS 156 to have a material impact on our financial condition, results of operations or cash flows.

In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109” (“FIN 48”), which prescribes accounting for and disclosure of uncertainty in tax positions. This interpretation defines the criteria that must be met for the benefits of a tax position to be recognized in the financial statements and the measurement of tax benefits recognized. The provisions of FIN 48 are effective as of the beginning of the company’s 2007 fiscal year, with the cumulative effect of the change in accounting principle recorded as an adjustment to opening retained earnings. We are currently evaluating the impact of adopting FIN 48 on our financial condition, results of operations or cash flows.

Additionally, during 2005 and 2006 the FASB Staff issued four FASB Staff Positions (“FSP”s) related to SFAS 123R, FSP FAS 123R-1, “Classification and Measurement of Freestanding Financial Instruments Originally Issued in Exchange for Employee Services under FASB Statement No. 123R”, FSP FAS 123R-2, “Practical Accommodation to the Application of Grant Date as Defined in FASB Statement No. 123R”, FSP FAS 123R-3, “Transition Election Related to Accounting for the Tax Effects of Share-Based

 

13


Payment Awards” and FSP FAS 123R-4 “Classification of Options and Similar Instruments Issued as Employee Compensation That Allow for Cash Settlement upon the Occurrence of a Contingent Event.” Each of these FSPs have been considered and have been incorporated, to the extent necessary, into the adoption of SFAS 123R.

NOTE 8. Subsequent Event

Litigation

On August 7, 2006, Cheryl Axelson filed a purported shareholder derivative action for the benefit of Hot Topic, Inc. in the Los Angeles County Superior Court. The lawsuit names certain of our current and former executive officers and directors as individual defendants and us as a nominal defendant. The lawsuit asserts claims for breach of fiduciary duty and unjust enrichment in connection with the granting of certain stock options by us and seeks unspecified damages, disgorgement of the relevant stock options and any proceeds thereof, and other relief. We are reviewing the complaint and the claims raised and will make determinations with respect to the case as it proceeds; and though we cannot predict the outcome of the case, we believe the claims are without merit and intend to defend the case vigorously.

Deferred Compensation Plan

We have adopted the Hot Topic Inc. Management Deferred Compensation Plan (the “Deferred Compensation Plan”), effective and commencing as of August 2006, for the purpose of providing highly compensated employees and the members of the Board of Directors with a program to meet their financial planning needs. The Deferred Compensation Plan provides the participants with the opportunity to defer up to 80% of their base salary and up to 100% of their annual earned bonus, all of which, together with the associated investment returns, are 100% vested. The plan, which is designed to be exempt from most provisions of the Employee Retirement Security Act of 1974, will be informally funded by us in order to preserve the tax-deferred savings advantages of a non-qualified plan. As such, all deferrals and associated earnings will be general unsecured obligations held as an asset within a “Rabbi Trust” on the company’s balance sheet.

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

STATEMENT REGARDING FORWARD LOOKING DISCLOSURE

This Quarterly Report on Form 10-Q contains various forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, which are subject to the “safe harbor” created by these sections, including statements regarding our expectations, beliefs, intentions or strategies regarding the future. Forward-looking statements include, without limitation, statements regarding the extent and timing of future revenues and expenses and customer demand, expected financial results, the profitability of future sales of our products, new store openings and new store concepts. All forward-looking statements included in this report are based on information available to us as of the date hereof and we assume no obligation to update any forward-looking statements. Forward-looking statements involve known or unknown risks, uncertainties and other factors which may cause our actual results, performance or achievements, or industry results to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Such risks, uncertainties and other factors include but are not limited to the items discussed under the captions “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this Item 2 and “Risk Factors” in Part II, Item 1A.

OVERVIEW

We are a mall-based specialty retailer operating the Hot Topic and Torrid concepts. Hot Topic stores sell a selection of music/pop culture-licensed and music/pop culture-influenced apparel, accessories and gift items for young men and women principally between the ages of 12 and 22. Torrid stores sell apparel, lingerie, shoes and accessories designed for various lifestyles for plus-size females between the ages of 15 and 29. We were incorporated in California in 1988. We opened our first Hot Topic store in 1989 and our first Torrid store in 2001. At the end of the second quarter of fiscal 2006 (July 29, 2006 in the 53-week fiscal year ending February 3, 2007), we operated 682 Hot Topic stores throughout the United States and Puerto Rico, and 127 Torrid stores. We also sell merchandise on two websites, http://www.hottopic.com and http://www.torrid.com, which reflect the Hot Topic and Torrid store concepts and carry merchandise similar to that sold in the respective stores. Throughout this report, the terms “our”, “we” and “us” refer to Hot Topic, Inc. and its subsidiaries.

Our customers are at the core of our business strategies for both Hot Topic and Torrid. At the Hot Topic division we focus on current fashion trends that are music-inspired, and we listen to our customers to determine the fashion trends that they want to wear. We then merchandise our stores with these current trends. Our customer-focused strategy also includes identifying profitable customer segments, tailoring our stores to their needs, and training our associates to cater to and understand our customers’ needs. We strive to understand our customers’ needs as they relate to music and music related apparel by closely monitoring music trends, customers’ direct input via store visits, emails, and focus groups of our sales associates. By engaging with our customers in that manner, we believe we extend our competitive advantage over the other mall-based fashion retailers. Since we believe our customers continue to access music over the Internet and television, making our customers keenly fashion-focused, sophisticated, and technologically advanced, our resolve is to continue to meet their music-inspired fashion needs. At Torrid, we strive to become a leading specialty retailer of fashion forward plus-size young women’s apparel and accessories.

 

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The current market of teen apparel is intensely competitive, especially during the holiday season (which runs roughly from the week of Thanksgiving to the beginning of January), resulting from fashion trends as well as aggressive promotional markdowns taken by many mall retailers.

The following discussion of our results of operations, financial condition and liquidity, and other matters should be read in conjunction with our Condensed Consolidated Financial Statements and the Notes related thereto.

Our fiscal year is on a 52-53 week basis and ends on the Saturday nearest to January 31. The fiscal year ending February 3, 2007 is a 53-week fiscal year, and fiscal year ended January 28, 2006, was a 52-week year.

The discussion below includes references to “comparable stores.” We consider a store comparable after it has been open for 15 full months. If a store is relocated, or expanded by more than 15% in total square footage, it is removed from the comparable store base and, similar to new stores, becomes comparable after 15 full subsequent months.

RESULTS OF OPERATIONS

Three Months Ended July 29, 2006 Compared to the Three Months Ended July 30, 2005

The following table sets forth selected data from our income statement expressed as a percentage of net sales for the periods indicated. The discussion that follows should be read in conjunction with this table:

 

For the three months ended:

   July 29,
2006
    July 30,
2005
 

Net sales

   100.0 %   100.0 %

Cost of goods sold (including buying, distribution and occupancy costs)

   68.3     68.7  
            

Gross margin

   31.7     31.3  

Selling, general and administrative expenses

   32.8     30.5  
            

Operating (loss) income

   (1.1 )   0.8  

Interest income, net

   0.2     0.2  
            

(Loss) income before income tax (benefit) expense

   (0.9 )   1.0  

Income tax (benefit) expense

   (0.3 )   0.4  
            

Net (loss) income

   (0.6 )%   0.6 %
            

 

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Net sales increased $8.1 million, or 5.3%, to $160.3 million during the second quarter of fiscal 2006 from $152.2 million during the second quarter of fiscal 2005. The components of this $8.1 million increase in net sales are as follows:

 

Amount
($ millions)
   

Description

$ 7.0     Net sales from new Hot Topic stores opened since the second quarter of fiscal 2005 and Hot Topic stores not yet qualifying as comparable stores.
  6.0     Net sales from new Torrid stores opened since the second quarter of fiscal 2005 and Torrid stores not yet qualifying as comparable stores.
  2.3     Increase in Internet sales (hottopic.com and torrid.com).
  (7.2 )   5.5% decrease in comparable store net sales in the second quarter of fiscal 2006 compared to the prior year quarter.
       
$ 8.1     Total
       

At the end of the second quarter of fiscal 2006, 648 of our 809 stores (Hot Topic and Torrid) were included in the comparable store base, compared to 548 of our 728 stores (Hot Topic and Torrid) open at the end of the second quarter of fiscal 2005. Sales of Hot Topic division’s apparel and tee-shirts, as a percentage of total net sales, were 56% for the second quarter of fiscal 2006 compared to 55% for the second quarter of fiscal 2005. The increase of the apparel category in the product mix was driven by increased sales of women’s tops, partially offset by a decline in men’s fashion and novelty tops and men’s bottoms.

Gross margin increased $3.2 million, or 6.7%, to $50.8 million during the second quarter of fiscal 2006 from $47.6 million during the second quarter of fiscal 2005. As a percentage of net sales, gross margin increased to 31.7% during the second quarter of fiscal 2006 from 31.3% in the second quarter of fiscal 2005. The significant components of this 0.4% increase in gross margin as a percentage of net sales are as follows:

 

%    

Description

1.0 %   Increase in merchandise margin primarily due to higher initial markup, partially offset by slightly higher markdowns.
0.4     Decrease in distribution expenses primarily due to lower freight expenses to stores.
(0.1 )   Increase in buying costs due to higher payroll expenses.
(0.1 )   Increase in stock-based compensation.
(0.8 )   Increase in store occupancy and depreciation expenses, primarily due to deleveraging store expenses over lower comparable store sales.
     
0.4 %   Total
     

 

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Selling, general and administrative expenses increased $6.0 million, or 12.9%, to $52.5 million during the second quarter of fiscal 2006 compared to $46.5 million during the second quarter of fiscal 2005. As a percentage of net sales, selling, general and administrative expenses increased to 32.8% in the second quarter of fiscal 2006 compared to 30.5% in the second quarter of fiscal 2005. The total dollar increase in selling, general and administrative expenses was primarily attributable to a 11.1% increase in the number of retail stores from 728 at the end of the second quarter of fiscal 2005 to 809 at the end of the second quarter of fiscal 2006 and the corresponding additional payroll and other expenses required to support these additional stores. The significant components of this 2.3% increase in selling, general and administrative expenses as a percentage of net sales are as follows:

 

%    

Description

0.6 %   Increase in store payroll expense due to deleveraging of wage rate increases relative to our decrease in comparable store sales.
0.4     Increase in other store expenses, primarily due to utilities and business licenses/taxes.
0.7     Increase in stock-based compensation expense.
0.4     Increase in marketing expenses primarily due to magazine and regional marketing for the Torrid marketing program, and promotional signage for Hot Topic.
0.3     Increase in other general and administrative expenses primarily due to deleveraging headquarters expenses for new support personnel, recruiting costs, and consulting fees for enhancements to computer systems.
0.3     Increase in depreciation and amortization primarily due to software costs for the IT data center expansion and merchandising financial systems.
(0.4 )   Decrease in pre-opening expenses due to opening fewer stores in the second quarter of 2006 as compared to the second quarter in 2005.
     
2.3 %   Total
     

Operating loss was $1.7 million in the second quarter of fiscal 2006, compared to operating income of $1.1 million during the second quarter of fiscal 2005. As a percentage of net sales, operating loss was 1.1% in the second quarter of fiscal 2006 compared to 0.8% operating income in the second quarter of fiscal 2005.

Net interest income remained the same at 0.2% for the second quarter of fiscal 2006 and fiscal 2005.

Income tax benefit was $0.6 million for the second quarter of fiscal 2006 compared to a $0.6 million expense for the second quarter of fiscal 2005. The effective tax rate was 38.3% for the second quarter of fiscal 2006 and 2005.

 

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Six Months Ended July 29, 2006 Compared to the Six Months Ended July 30, 2005

The following table sets forth selected data from our income statement expressed as a percentage of net sales for the periods indicated. The discussion that follows should be read in conjunction with this table:

 

For the six months ended:

   July 29,
2006
    July 30,
2005
 

Net sales

   100.0 %   100.0 %

Cost of goods sold (including buying, distribution and occupancy costs)

   68.5     67.3  
            

Gross margin

   31.5     32.7  

Selling, general and administrative expenses

   32.9     29.8  
            

Operating (loss) income

   (1.4 )   2.9  

Interest income, net

   0.2     0.2  
            

(Loss) income before income tax (benefit) expense

   (1.2 )   3.1  

Income tax (benefit) expense

   (0.5 )   1.2  
            

Net (loss) income

   (0.7 )%   1.9 %
            

Net sales increased $12.4 million, or 4.1%, to $314.4 million during the first six months of fiscal 2006 from $302.0 million during the first six months of fiscal 2005. The components of this $12.4 million increase in net sales are as follows:

 

Amount
($ millions)
   

Description

$ 15.5     Net sales from new Hot Topic stores opened since the second quarter of fiscal 2005 and Hot Topic stores not yet qualifying as comparable stores.
  13.4     Net sales from new Torrid stores opened since the second quarter of fiscal 2005 and Torrid stores not yet qualifying as comparable stores.
  4.1     Increase in Internet sales (hottopic.com and torrid.com).
  (0.5 )   Net sales from 19 expanded or relocated Hot Topic and Torrid stores.
  (20.1 )   7.6% decrease in comparable store net sales in the first six months of fiscal 2006 compared to the prior year quarter.
       
$ 12.4     Total
       

Sales of Hot Topic division’s apparel and tee-shirts, as a percentage of total net sales for the division, were 56% for the first six months of

 

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fiscal 2006 compared to 55% for the first six months of fiscal 2005. The increase of the apparel category in the product mix was driven by increased sales of women’s tops, partially offset by a decline in men’s fashion and novelty tops and men’s bottoms.

Gross margin increased $0.3 million, or 0.3%, to $99.1 million during the first six months of fiscal 2006 from $98.8 million during the first six months of fiscal 2005. As a percentage of net sales, gross margin decreased to 31.5% during the first six months of fiscal 2006 from 32.7% in the first six months of fiscal 2005. The significant components of this 1.2% decrease in gross margin as a percentage of net sales are as follows:

 

%    

Description

0.2 %   Increase in merchandise margin primarily due to higher initial markup, partially offset by slightly higher markdowns.
0.1     Decrease in distribution expenses primarily due to lower freight expenses to stores.
(0.2 )   Increase in buying costs due to higher payroll expenses.
(0.1 )   Increase in stock-based compensation.
(1.2 )   Increase in store occupancy and depreciation expenses, primarily due to deleveraging store expenses over lower comparable store sales.
     
(1.2 )%  

Total

     

Selling, general and administrative expenses increased $13.6 million, or 15.1%, to $103.5 million during the first six months of fiscal 2006 compared to $89.9 million during the first six months of fiscal 2005. As a percentage of net sales, selling, general and administrative expenses increased to 32.9% in the first six months of fiscal 2006 compared to 29.8% in the first six months of fiscal 2005. The total dollar increase in selling, general and administrative expenses was primarily attributable to a 11.1% increase in the number of retail stores from 728 at the end of the first six months of fiscal 2005 to 809 at the end of the first six months of fiscal 2006 and the corresponding additional payroll and other expenses required to support these additional stores. The significant components of this 3.1% increase in selling, general and administrative expenses as a percentage of net sales are as follows:

 

%    

Description

1.0 %   Increase in store payroll expense due to deleveraging of wage rate increases relative to our decrease in comparable store sales.
0.7     Increase in stock-based compensation.
0.6     Increase in other store expenses, primarily due to utilities and business licenses/taxes.
0.5     Increase in marketing expenses primarily due to magazine and regional marketing for the Torrid marketing program, and promotional signage for Hot Topic.
0.3     Increase in other general and administrative expenses primarily due to deleveraging headquarters expenses for new support personnel, recruiting costs, and consulting fees for enhancements to computer systems.
0.3     Increase in depreciation and amortization primarily due to software costs for the IT Data Center expansion.
(0.3 )   Decrease in pre-opening expenses due to opening fewer stores in the first six months of fiscal 2006 as compared to the first six months of fiscal 2005.
     
3.1 %   Total
     

 

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Operating loss was $4.4 million the first six months of fiscal 2006, compared to operating income of $8.9 million during the first six months of fiscal 2005. As a percentage of net sales, operating loss was 1.4% in the first six months of fiscal 2006 compared to 2.9% operating income in the first six months of fiscal 2005.

Net interest income remained the same at 0.2% for the first six months of fiscal 2006 and fiscal 2005.

Income tax benefit was $1.4 million for the first six months of fiscal 2006 compared to a $3.7 million expense for the first six months of fiscal 2005. The effective tax rate was 38.3% for the first six months of fiscal 2006 and 2005.

LIQUIDITY AND CAPITAL RESOURCES

Historically and during the first six months of fiscal 2006, our primary uses of cash have been to finance store openings and purchase merchandise inventories. We have also made periodic repurchases of our common shares. In recent years, we have satisfied our cash requirements principally from cash flows from operations, and to a lesser extent, proceeds from the exercise of stock options. We also maintain a $5.0 million unsecured credit agreement for issuing letters of credit, primarily for inventory purchases. There were letters of credit for $302,000 outstanding at July 29, 2006 under the credit agreement. There were no letters of credit outstanding at January 28, 2006.

Cash flows provided by operating activities were $1.9 million in the first six months of fiscal 2006 compared to $10.9 million provided by operating activities in the first six months of fiscal 2005. The decrease of $9.0 million in cash flows from operating activities in the first six months of fiscal 2006 compared to the first six months of fiscal 2005 resulted primarily from net a loss of $2.3 million versus net income of $5.9 million during these six month periods, a reduction in accrued liabilities and deferred rent, an increase in inventory and deferred taxes and a reclassification of tax benefit from stock options exercised out of operating into financing activities, offset by an increase in prepaid expenses and other current assets, depreciation expense, stock-based compensation expense, accounts payable and income taxes payable.

Cash flows used in investing activities were $11.4 million in the first six months of fiscal 2006 compared to $21.6 million used in investing activities in the first six months of fiscal 2005. The $10.3 million decrease in net cash used in investing activities is due to a $17.4 million decrease in the proceeds from the sale of short-term investments (net of purchases), offset by a $27.7 million decrease in purchases of property and equipment primarily to support store openings and for hardware and software systems.

Cash flows provided by financing activities were $2.1 million in the first six months of fiscal 2006 compared to cash flows provided by financing activities of $5.9 million in the first six months of fiscal 2005. The $3.8 million decrease in cash flows from financing activities is principally the result of a $3.7 million decrease in the proceeds from exercise of stock options offset by the $0.2 million reclassification of tax benefit from stock options exercised out of operating into financing activities.

 

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The following table summarizes our contractual obligations as of July 29, 2006, and the timing and effect that such commitments are expected to have on our liquidity and capital requirements in future periods:

 

     Payments due by period ($ in thousands)

Contractual obligations

   Total    Within 1
Year
   2-3 Years    4-5
Years
   More than
5 Years

Operating leases

   $ 361,028    $ 53,830    $ 103,610    $ 91,585    $ 112,003

Purchase obligations

   $ 69,939      69,939      —        —        —  

Letters of credit and other obligations

   $ 1,280      1,280      —        —        —  
                                  

Total contractual obligations

   $ 432,247    $ 125,049    $ 103,610    $ 91,585    $ 112,003
                                  

We expect capital expenditures for fiscal 2006 to be approximately $37 to $40 million, which will relate primarily to opening approximately 45 new stores. The remainder of the expenditures will primarily be for improvements to our information technology and corporate infrastructure. We believe our current cash balances and cash generated from operations will be sufficient to fund our operations and planned expansion through at least the next 12 months.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Management’s discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities. On an ongoing basis, we evaluate estimates, including those related primarily to inventories, long-lived assets and contingencies. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

We believe the following critical accounting policies affect the more significant judgments and estimates used in the preparation of our consolidated financial statements. For a further discussion about the application of these and other accounting policies, refer to the notes included in our Annual Report on Form 10-K for the year ended January 28, 2006.

Inventories: Inventories and related costs of sales are accounted for by the retail method. The cost of inventory is valued at the lower of average cost or market, on a first-in, first-out (FIFO) basis, utilizing the retail method. Each month, slow moving or seasonally obsolete merchandise is marked down. The first markdown is typically 25% to 50% of the original retail price. Typically, in cases where the merchandise does not sell after the first markdown, an additional markdown is made in a subsequent month. Any marked down merchandise that does not sell is typically marked down to a zero value and removed from the store approximately three months after the original markdown. In determining the lower of average cost or market value of period-ending inventories, consistently applied valuation criteria are used. Consideration is given to a number of quantitative factors, including anticipated subsequent permanent markdowns and aging of inventories. To the extent our estimated markdowns at period-end prove to be insufficient, additional future markdowns will need to be recorded.

Valuation of long-lived assets: We assess the impairment of long-lived assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors considered important that could trigger an impairment review include a significant underperformance relative to expected historical or projected future operating results, a significant change in the manner of the use of

 

22


the asset or a significant negative industry or economic trend. If we were to determine that the carrying value of long-lived assets may not be recoverable based upon the existence of one or more of the above indicators of impairment, we would measure any impairment based on a projected discounted cash flow method using a discount rate determined by management. During the second quarter, we had no impairment charge for long-lived assets. In the event future store performance is lower than forecasted results, future cash flows may be lower than expected, which could result in future impairment charges. While we believe recently opened stores will provide sufficient cash flow, material changes in results could result in future impairment charges.

Revenue Recognition: Sales are recognized upon the purchase by customers at our retail store locations and websites, less merchandise returned by customers. We provide a reserve for projected merchandise returns based on historical experience. As the reserve for merchandise returns is based on estimates the actual returns could differ from the reserve, which could impact sales. We recognize estimated gift card breakage as a component of net sales in proportion to actual gift card redemptions over the period that remaining gift card values are redeemed. Gift card breakage is income recognized due to the non-redemption of a portion of gift cards sold by us for which liability was recorded in prior periods.

While customer redemption patterns result in estimated gift card breakage, which approximates 5%, changes in our customers’ behavior could impact the amount that ultimately is unused and could affect the amount recognized as a component of net sales.

Vendor Allowances: We receive certain allowances from our vendors primarily related to damaged merchandise or markdown allowances. Allowances received from vendors related to damaged merchandise are reflected as a reduction of inventory in the period they are received and allocated to cost of sales during the period in which the items are sold. Markdown allowances received from vendors are reflected as reductions to cost of sales in the period they are received.

Stock-Based Payments: We estimate the fair value of stock options granted using the Black-Scholes option-pricing formula and a single option award approach. This fair value is then amortized over the requisite service periods of the awards. This option-pricing model requires the input of highly subjective assumptions, including the option’s expected life, price volatility of the underlying stock, risk free interest rate and expected dividend rate. As stock-based compensation expense is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. SFAS 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Forfeitures were estimated based on historical experience.

Self-Insurance: We are self-insured for medical insurance coverage and workers compensation insurance coverage, up to maximum exposure limits, above which we are covered by insurance policies. We maintain a liability for estimated claims based on historical claims experience and other actuarial assumptions.

Income Taxes: Current income tax expense is the amount of income taxes expected to be payable for the current year. The combined federal, state and local income tax expense is calculated using estimated effective annual tax rates. A deferred income tax asset or liability is established for the expected future consequences of temporary differences in the financial reporting and tax bases of assets and liabilities. We consider future taxable income and ongoing prudent and feasible tax planning in assessing the value of our deferred tax assets. Evaluating the value of these assets is necessarily based on our judgment. If we were to determine that it is more likely than not that these assets will not be realized, we would reduce the value of these assets to their expected realizable value through a valuation

 

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allowance, thereby decreasing net income. If we subsequently were to determine that the deferred tax assets, which had been written down, would be realized in the future, the value of the deferred tax assets would be increased, thereby increasing net income in the period when that determination was made. We have recorded tax contingencies based on our estimates of current tax exposures and adjust our estimates as circumstances or regulations change.

In accordance with SFAS 123R, we recognize tax benefit upon expensing certain stock-based awards associated with our stock-based compensation plans, including nonqualified stock options and restricted stock unit awards. However, under current accounting standards we cannot recognize tax benefit currently for those stock-based compensation expenses associated with incentive stock options (also known as qualified stock options) and employee stock purchase plan rights. For qualified stock options that vested after our adoption of SFAS 123R, we recognize tax benefit only in the period when disqualifying dispositions of the underlying stock occur, and for qualified stock options that vested prior to our adoption of SFAS 123R, the tax benefit is recorded directly to additional paid-in capital.

INFLATION

We do not believe that inflation has had a material adverse effect on our net sales or results of operations. We have generally been able to pass along increased costs related to inflation through increases in selling prices.

 

Item 3. Quantitative and Qualitative Disclosures about Market Risk

We are not a party to any derivative financial instruments. Our exposure to market risk primarily relates to changes in interest rates on our investments with maturities of less than three months (which are considered to be cash and cash equivalents) and short-term investments with maturities in excess of three months. Changes in interest rates affect the investment income earned on those investments.

 

Item 4. Controls and Procedures

The management of the company maintains disclosure controls and procedures that are designed to ensure that the information required to be disclosed in our reports under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s (the “SEC”) rules and forms, and that such information is accumulated and communicated to management, including our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), as appropriate, to allow timely decisions regarding required disclosure.

A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Because of inherent limitations, our disclosure controls and procedures may not prevent or detect misstatements. In addition, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected.

We have carried out an evaluation, under the supervision and with the participation of our management, including our CEO and CFO, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the most recent fiscal year. Based upon that evaluation, our CEO and CFO concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended) are effective. There has been no change in our internal control over financial reporting during the most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

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PART II. OTHER INFORMATION

 

Item 1. Legal Proceedings

On September 17, 2004, a former Torrid employee filed a lawsuit against us in the Superior Court of Los Angeles County, on behalf of a purported class. The lawsuit asserted claims for failure to provide adequate meal or rest breaks, improper payment of overtime wages, failure to timely pay wages at end of employment and unfair business practices. The lawsuit sought compensatory damages, statutory penalties, punitive damages, attorneys’ fees and injunctive relief. On October 21, 2004, we filed an answer denying the material allegations of the complaint. In June 2006, the court gave final approval to a settlement agreement between the plaintiff (on behalf of the purported class) and us. We accrued amounts to account for the settlement in fiscal 2005 following agreement on the settlement terms. No further activity is expected with respect to the case, and we do not expect any further costs or expenses associated with it.

In April 2006, a California resident filed a lawsuit against us in Superior Court of Los Angeles County, alleging that we violated California Civil Code Section 1747.08. That code section regulates when a retailer is permitted to take down certain customer information in connection with credit card transactions. The case is alleged as a class action. In May 2006, we answered the complaint and denied all liability.

On August 7, 2006, Cheryl Axelson filed a purported shareholder derivative action for the benefit of Hot Topic, Inc. in the Los Angeles County Superior Court. The lawsuit names certain of our current and former executive officers and directors as individual defendants and us as a nominal defendant. The lawsuit asserts claims for breach of fiduciary duty and unjust enrichment in connection with the granting of certain stock options by us and seeks unspecified damages, disgorgement of the relevant stock options and any proceeds thereof, and other relief. We are reviewing the complaint and the claims raised and will make determinations with respect to the case as it proceeds; and though we cannot predict the outcome of the case, we believe the claims are without merit and intend to defend the case vigorously.

We are involved in other matters of litigation that arise in the ordinary course of business. We do not currently believe that the cases referenced above, or any other litigation in which we are currently involved, will have a material adverse effect on our overall financial condition.

 

Item 1A. Risk Factors

CERTAIN RISKS RELATED TO OUR BUSINESS

Before deciding to invest in Hot Topic, Inc. or to maintain or increase an investment in Hot Topic, Inc., readers should carefully consider the risks described below, in addition to the other information contained in our Annual Report on Form 10-K and in other filings with the SEC, including our Quarterly Reports on Form 10-Q and Current Reports on Form 8-K. The risks described below are not the only risks we face. Additional risks that are not presently known to us or that we currently deem immaterial may also affect our business. If any of these known or unknown risks actually occur, our business, financial condition and results of operations could be seriously harmed, and our stock price could decline.

 

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The risks described below include certain revisions to the risks set forth in our Annual Report on Form 10-K for the fiscal year ended January 28, 2006.

Our aggressive growth strategy of new store openings could create challenges we may not be able to adequately meet.

Our net sales have grown appreciably during the past several years, primarily as a result of the opening of new stores and, to a lesser extent, the introduction of new products. Of our 809 stores opened as of July 29, 2006, 84 had been open for less than one full year. We intend to continue to pursue a growth strategy for the foreseeable future, and our future operating results will depend largely upon our ability to open and operate stores successfully and to profitably manage a larger business. We currently anticipate opening approximately 45 stores, consisting of 35 Hot Topic and 10 Torrid stores, during fiscal 2006, further increasing the number of stores we operate. As of July 29, 2006, 21 of those new Hot Topic stores were open and seven Torrid stores were open. Operation of a greater number of new stores and expansion into new markets may present competitive and merchandising challenges that are different from those currently encountered by us in our existing stores and markets. In addition, as the number of stores increases, we may face risks associated with market saturation of our products and concepts. There can be no assurance that our expansion will not adversely affect the individual financial performance of our existing stores or our overall results of operations, or that new stores will achieve sales and profitability levels consistent with existing stores. Further, there can be no assurance that we will successfully achieve our expansion targets or, if achieved, that planned expansion will result in profitable operations.

This growth strategy requires improving our operations, and we may not be able to do this sufficiently to effectively prevent negative impact on our business and financial results.

In order to manage our planned expansion, among other things, we will need to locate suitable store sites, negotiate acceptable lease terms, obtain or maintain adequate capital resources on acceptable terms, source sufficient levels of inventory, hire and train store managers and sales associates, integrate new stores into our existing operations, and maintain adequate distribution center space and information technology and other operations systems. Our opening of a second distribution center in Tennessee in 2005 was designed to address some of our growth challenges, but achieving and maintaining operating efficiencies in multiple distribution centers is subject to numerous risks and uncertainties.

We also need to continually evaluate the adequacy of our management information and distribution systems. Implementing new systems and changes made to existing systems could present challenges we do not anticipate and could impact our business. We cannot anticipate all of the changing demands that our expanding operations will impose on our business, systems and procedures, and our failure to adapt to such changing demands could have a material adverse effect on our results of operations and financial condition. Our failure to timely implement initiatives necessary to support our expanding operations could also materially impact our business.

Expanding our operations to include an increasing number of Torrid stores and any other new concepts presents risks we have faced with the Hot Topic concept but also new risks due to differences in concept objectives and strategies.

The operation of Torrid stores and the sale of Torrid merchandise over the Internet are subject to numerous risks, including unanticipated operational problems; lack of experience; lack of customer acceptance; new vendor relationships; competition from existing and new retailers; and diversion of management’s attention from the Hot Topic concept. The Torrid concept involves implementation of a

 

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retail apparel concept which is subject to most of the same risks as the Hot Topic concept, as well as additional risks inherent in a concept that concentrates on apparel and fashion, including risks of difficulty in merchandising, uncertainty of customer acceptance, fluctuations in fashion trends and customer tastes, extreme competition with a less differentiated product offering, and attendant markdown risks. We may not be able to generate continued customer interest in Torrid stores and products, and the Torrid concept may not be able to support the store or Internet sales format. Risks inherent in any new concept are particularly acute with respect to Torrid, because this is our first significant new venture, and the nature of the Torrid business differs in certain respects from that of the Hot Topic business. There can be no assurance that the Torrid stores or website, or any future concept, will achieve sales and profitability levels that justify our investment.

The success of our business depends on establishing and maintaining good relationships with mall operators and developers, and problems with those relationships could make it more difficult for us to expand to certain sites or offer certain products.

Any restrictions on our ability to expand to new store sites or to offer a broad assortment of merchandise could have a material adverse effect on our business, results of operations and financial condition. If our relations with mall operators or developers become strained, or we otherwise encounter difficulties in leasing store sites, we may not grow as planned and may not reach certain revenue levels and other operating targets. Risks associated with these relationships are more acute given recent consolidation in that industry, and we have seen certain increases in expenses as a result of such consolidation that could continue.

Our comparable store sales are subject to fluctuation resulting from factors within and outside our control, and lower than expected comparable store sales could impact our business and our stock price.

A variety of factors affects our comparable store sales including, among others, the timing of new music releases and music/pop culture-related products; music and fashion trends; the general retail sales environment and the effect of the overall economic environment; our ability to efficiently source and distribute products; changes in our merchandise mix; ability to attain exclusivity and certain pop-culture related licenses; competition from other retailers; opening of new stores in existing markets and our ability to execute our business strategy efficiently. Our comparable store sales results have fluctuated significantly in the past and we believe that such fluctuations will continue. Our comparable store sales results were (9.6)% and (5.5)% for the first and second quarters of fiscal 2006, respectively, and the following table shows our comparable store sales results for other recent periods:

 

Fiscal Year

   2005     2004     2003     2002  

Total Year

   (3.4 )%   (2.9 )%   7.4 %   5.0 %

1st Quarter

   0.9 %   4.0 %   2.6 %   (0.5 )%

2nd Quarter

   (3.5 )%   (2.1 )%   5.2 %   0.6 %

3rd Quarter

   (6.2 )%   (4.2 )%   10.8 %   6.3 %

4th Quarter

   (3.8 )%   (6.0 )%   8.5 %   9.7 %

Past comparable store sales results are not an indicator of future results, and there can be no assurance that our comparable store sales results will not decrease in the future. Changes in our comparable store sales results could cause our stock price to fluctuate substantially.

 

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Our success relies on popularity with young people of music, pop culture, and fashion trends, and we may not be able to react to trends in a way to prevent declining popularity and sales of our products.

Our financial performance is largely dependent upon the continued popularity of alternative and rock music, the Internet and digital music, music videos, and MTV and other music television networks among teenagers and college-age adults; the emergence of new artists and the success of music releases and music/pop culture-related products; the continuance of a significant level of teenage spending on music/pop culture-licensed and music/pop culture-influenced products; and our ability to anticipate and keep pace with the music, fashion and merchandise preferences of our customers. The popularity of particular types of music, artists, styles, trends and brands is subject to change. Our failure to anticipate, identify and react appropriately to changing trends could lead to, among other things, excess inventories and higher markdowns, which could have a material adverse effect on our results of operations and financial condition, and on our image with customers. There can be no assurance that our new products will be met with the same level of acceptance as in the past or that the failure of any new products will not have an adverse material effect on our business, results of operations and financial condition.

Economic conditions could change in ways that reduce our sales or increase our expenses.

Certain economic conditions affect the level of consumer spending on merchandise we offer, including, among others, employment levels, salary and wage levels, interest rates, taxation, and consumer confidence in future economic conditions. We are also dependent upon the continued popularity of malls as a shopping destination, the ability of mall anchor tenants and other attractions to generate customer traffic, and the development of new malls. A slowdown in the United States economy or an uncertain economic outlook could lower consumer spending levels and cause a decrease in mall traffic or new mall development, each of which would adversely affect our growth, sales results and financial performance.

Changes in laws, including employment laws and laws related to our merchandise, could make conducting our business more expensive or change the way we do business.

In addition to increased regulatory compliance requirements, changes in laws could make ordinary conduct of our business more expensive or require us to change the way we do business. For example, changes in federal and state minimum wage laws could raise the wage requirements for certain of our associates, which would likely cause us to reexamine our entire wage structure for stores. Other laws related to employee benefits and treatment of employees, and privacy, could also negatively impact us such as by increasing benefits costs like medical expenses and record retention costs. Moreover, changes in product safety or other consumer protection laws could lead to increased costs to us for certain merchandise, or additional labor costs associated with readying merchandise for sale. It is often difficult for us to plan and prepare for potential changes to applicable laws.

Timing and seasonal issues could negatively impact our financial performance for given periods.

Our quarterly results of operations may fluctuate materially depending on, among other things, the timing of store openings and related pre-opening and other startup expenses, net sales contributed by new stores, increases or decreases in comparable store sales, releases of new music and music/pop culture-related products, shifts in timing of certain holidays, changes in our merchandise mix and overall economic and political conditions.

 

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Our business is also subject to seasonal influences, with heavier concentrations of sales during the back-to-school, Halloween and holiday (defined as the week of Thanksgiving through the first few days of January) seasons, and other periods when schools are not in session. The holiday season has historically been our single most important selling season. We believe that the importance of the summer vacation and back-to-school seasons (which affect operating results in the second and third quarters) and to a lesser extent, the spring break season (which affects operating results in the first quarter) as well as Halloween (which affects operating results in the third quarter), all reduce our dependence on the holiday selling season, but this will not always be the case to the same degree. As is the case with many retailers of apparel, accessories and related merchandise, we typically experience lower net sales in the first fiscal quarter relative to other quarters.

We have many important vendor relationships, and our ability to get merchandise could be hurt by changes in those relationships and events harmful to our vendors could impact our results of operations.

Our financial performance depends on our ability to purchase desired merchandise in sufficient quantities at competitive prices. Although we have many sources of merchandise, substantially all of our music/pop culture-licensed products are available only from vendors that have exclusive license rights. In addition, small, specialized vendors, some of which create unique products primarily for us, supply certain of our products. Our smaller vendors generally have limited resources, production capacities and operating histories, and some of our vendors have restricted the distribution of their merchandise in the past. We generally have no long-term purchase contracts or other contractual assurances of continued supply, pricing or access to new products. There can be no assurance that we will be able to acquire desired merchandise in sufficient quantities on acceptable terms in the future. Any inability to acquire suitable merchandise, or the loss of one or more key vendors, may have a material adverse effect on our business, results of operations and financial condition.

Technology and other risks associated with our Internet sales could hinder our overall financial performance.

We sell merchandise over the Internet through the websites http://www.hottopic.com and http://www.torrid.com. Our Internet operations are subject to numerous risks and pose risks to our overall business, including, among other things: hiring; retention and training of personnel to conduct the Internet operations; diversion of sales from our stores; rapid technological change and the need to invest in additional computer hardware and software to support sales; liability for online content; failure of computer hardware and software, including computer viruses, telecommunication failures, online security breaches and similar disruptions; governmental regulation; and credit card fraud. There can be no assurance that our Internet operations will achieve sales and profitability levels that justify our investment in them.

System security risk issues could disrupt our internal operations or information technology services provided to customers, and any such disruption could harm our revenue, increase our expenses, and harm our reputation and stock price.

Experienced computer programmers and hackers may be able to penetrate our network security and misappropriate our confidential information or that of third parties, create system disruptions or cause shutdowns. As a result, we could incur significant expenses addressing problems created by security breaches of our network. Moreover, we could incur significant expenses in connection with our system failures. In addition, sophisticated hardware and operating system software and applications that we procure from third parties may contain defects in design or manufacture, including “bugs” and other

 

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problems that could unexpectedly interfere with the operation of the system. The costs to us to eliminate or alleviate security problems, viruses, and bugs could be significant, and the efforts to address these problems could result in interruptions, delays or cessation of service that may impede our sales, distribution or other critical functions.

We have made and plan to continue to make significant changes to information systems and software used in operation of our business, and we may not be able to effectively adopt changes in a way to prevent failures in our operations or negative impact on our financial performance and reporting.

Over the past several years, we have made improvements to existing hardware and software systems, as well as implemented new systems. For example, we have invested millions of dollars to enhance the functionality of our current GERS software and to implement new financial and human resources systems software from Lawson Software. In addition, we invested significant amounts in the implementation of a new warehouse management software system, a new Internet order management software system, and a new customer loyalty software system. We expect to significantly increase our reliance on these systems throughout fiscal 2006. If these information systems and software do not work effectively, we may experience delays or failures in our operations. These delays or failures could adversely impact the promptness and accuracy of our merchandise distribution, transaction processing, financial accounting and reporting and ability to properly forecast earnings and cash requirements. To manage growth of our operations and personnel, we will need to continue to improve our operational and financial systems, transaction processing, and procedures and controls, and in doing so, we could incur substantial additional expenses.

Loss of key people or an inability to hire necessary and significant personnel could hurt our business.

Our financial performance depends largely on the efforts and abilities of senior management, especially Elizabeth McLaughlin, our Chief Executive Officer, who has been with us since 1993. We have a $2,000,000 key-person life insurance policy on Ms. McLaughlin. However, the sudden loss of Ms. McLaughlin’s services or the services of other members of our management team could have a material adverse effect on our business, results of operations and financial condition. Furthermore, there can be no assurance that Ms. McLaughlin and our existing management team will be able to manage our growth or that we will be able to attract and retain additional qualified personnel as needed in the future.

Decreased effectiveness of stock-based compensation could adversely affect our ability to attract and retain employees.

We have historically used stock options as a component of our total employee compensation program in order to align employees’ interests with the interests of our shareholders, encourage employee retention, and provide competitive compensation and benefit packages. In recent periods, our outstanding employee stock options have had exercise prices in excess of Hot Topic’s stock price, which reduces their value to employees and could affect our ability to retain present, or attract prospective employees. There are other forms of stock-based compensation available to us, but these are similarly less attractive when a company’s stock price is declining. In addition, in accordance with SFAS 123R, we began recording expenses for stock-based payments, including stock options, in the first quarter of fiscal 2006. As a result, we now incur increased compensation costs associated with our stock-based compensation programs. Moreover, difficulties relating to obtaining shareholder approval of equity compensation plans and additional shares authorized for issuance thereunder could make it harder or more expensive for us to grant stock-based payments to employees in the future. Like other companies, we review our equity

 

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compensation strategy in light of regulatory and competitive environments, and we may decide to reduce the total number of options granted, or the form of stock awards, to employees, or reduce the number of employees who receive stock-based payments. Due to any change in our stock-based compensation strategy, we may find it more difficult to attract, retain and motivate employees, and any such difficulty could materially adversely affect our business.

Our reliance on United Parcel Service, temporary employees and other mechanics of shipping of our merchandise creates distribution risks and uncertainties that could hurt our sales and business.

We rely upon United Parcel Service for our product shipments, including shipments to and from a significant number of our stores. Our reliance on this source for shipments is subject to risks, including employee strikes and inclement weather, associated with United Parcel Service’s ability to provide delivery services that adequately meet our shipping needs. We are also dependent upon temporary associates to adequately staff our distribution centers; particularly during busy periods such as the holiday season and while multiple stores are opening. There can be no assurance that we will continue to receive adequate assistance from our temporary associates, or that there will continue to be sufficient sources of temporary associates. We began operation of our second distribution center in Tennessee during the second quarter of 2005, and as a result we also now face risks and uncertainties associated with achieving and maintaining operating efficiencies in two distribution centers that are located approximately 2,000 miles apart. Additionally, certain products are imported and subject to delivery delays based on availability and port capacity.

There is a risk we could acquire merchandise without full rights to sell it, which could lead to disputes or litigation and hurt our financial performance and stock price.

We purchase licensed merchandise from a number of suppliers who hold manufacturing and distribution rights under the terms of certain licenses. We generally rely upon vendors’ representations concerning manufacturing and distribution rights and do not independently verify whether these vendors legally hold adequate rights to licensed properties they are manufacturing or distributing. If we acquire unlicensed merchandise, we could be obligated to remove such merchandise from our stores, incur costs associated with destruction of merchandise if the distributor is unwilling or unable to reimburse us, and be subject to liability under various civil and criminal causes of action, including actions to recover unpaid royalties and other damages. Any of these results could have a material adverse effect on our business, results of operations and financial condition.

We face intense competition, and an inability to adequately address it, or the success of our competitors, could limit or prevent our business growth and success.

The retail apparel and accessory industry is highly competitive. We compete with other retailers for vendors, teenage and young adult customers, suitable store locations and qualified associates and management personnel. Our Hot Topic stores currently compete with street alternative stores located primarily in metropolitan areas; with other mall-based teenage-focused retailers and their subsidiaries such as Abercrombie & Fitch, Aeropostale, American Eagle Outfitters, Anchor Blue, Charlotte Russe Inc., Claire’s Stores, Inc., Forever 21, Pacific Sunwear of California, Inc., Spencer Gifts, Inc., H&M, The Buckle, Wet Seal, Inc., Urban Outfitters, Inc., and Zumiez, Inc.; and, to a lesser extent, with music stores and mail order catalogs and websites. Torrid has additional competitors, such as Alloy, Inc., Charming Shoppes, Inc., Deb Shops, Delia’s Corp., Old Navy (a division of Gap Inc.), and plus-size departments in department stores and discount stores as well as numerous potential competitors who may begin or increase efforts to market and sell products competitive with Torrid products. Some of our competitors are

 

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larger and may have greater financial, marketing and other resources. Direct competition with these and other retailers may increase significantly in the future, which could require us, among other things, to lower our prices. Increased competition could have a material adverse effect on our business, results of operations and financial condition.

War, terrorism and other catastrophes could negatively impact our customers, places where we do business, and our expenses, all of which could hurt our business.

The effects of war or acts of terrorism could have a material adverse effect on our business, operating results and financial condition. The continued threat of terrorism and heightened security and military action in response to this threat, or any future acts of terrorism, may cause further disruptions and create further uncertainties. To the extent that such disruptions or uncertainties negatively impact shopping patterns and/or mall traffic, or adversely affect consumer confidence or the economy in general, our business, operating results and financial condition could be materially and adversely affected. Similar risks would exist in the event of other types of national and regional catastrophes or circumstances, such as a flu pandemic or other public health or welfare scare.

Our principal executive offices, a distribution center and a significant number of our stores are located in California. If we experience a sustained disruption in energy supplies, or if electricity and gas costs in California fluctuate dramatically, our results of operations could be materially and adversely affected. California is also subject to natural disasters such as earthquakes and floods. A significant natural disaster or other catastrophic event affecting our facilities could have a material adverse impact on our business, financial condition and operating results.

There are numerous risks that could cause our stock price to fluctuate substantially.

Our common stock is quoted on the Nasdaq National Market, which has experienced and is likely to experience in the future significant price and volume fluctuations, which could adversely affect our stock price without regard to our financial performance. In addition, we believe that factors such as quarterly fluctuations in our financial results and comparable store sales; announcements by other apparel, accessory and gift item retailers; the trading volume of our stock; changes in estimates of our performance by securities analysts; litigation; overall economic and political conditions; the condition of the financial markets; and other events or factors outside of our control could cause our stock price to fluctuate substantially.

Our charter documents and other circumstances could prevent a takeover or cause dilution of our existing shareholders, which could be detrimental to existing shareholders and hinder business success.

Our Articles of Incorporation and Bylaws contain provisions that may have the effect of delaying, deterring or preventing a takeover of Hot Topic, Inc. For instance, our Articles of Incorporation include certain “fair price provisions” generally prohibiting business combinations with controlling or significant shareholders unless certain minimum price or procedural requirements are satisfied, and our Bylaws prohibit shareholder action by written consent. Additionally, our Board of Directors has the authority to issue, without shareholder approval, up to 10,000,000 shares of “blank check” preferred stock having such rights, preferences and privileges as designated by the Board of Directors. The issuance of these shares could have a dilutive effect on certain shareholders, and potentially prohibit a takeover of Hot Topic, Inc. by requiring the preferred shareholders to approve such a transaction.

 

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We also have a significant number of authorized and unissued shares of our common stock available under our Articles of Incorporation. These shares provide us with the flexibility to issue our common stock for future business and financial purposes including stock splits, raising capital and providing equity incentives to employees, officers and directors. However, the issuance of these shares could result in dilution to our shareholders.

We incur costs associated with regulatory compliance, and this cost could be significant.

There are numerous regulatory requirements for public companies, including the provisions of the Sarbanes-Oxley Act of 2002. With regard to the Sarbanes-Oxley Act, we have and will continue to incur significant expense as we continue to address the implications of applicable rules and our operations relative thereto, and as we work to respond to and comply with applicable requirements. Among other things, we have incurred and will incur additional expenses as we implement Section 404 of the Sarbanes Oxley Act. Section 404 requires management to report on, and our independent auditors to attest to, our internal controls. Compliance with these rules could also result in continued diversion of management’s time and attention, which could be disruptive to normal business operations.

If we do not satisfactorily or timely comply with these requirements, possible consequences could include sanction or investigation by regulatory authorities such as the Securities and Exchange Commission or the Nasdaq National Market, incomplete or late filing of our periodic reports, including our Annual Report on Form 10-K, or civil or criminal liability. Our stock price and business could also be adversely affected.

There are litigation and other claims against us from time to time, which could distract management from our business activities, and could lead to adverse consequences to our business and financial condition.

As a growing company with expanding operations, we are increasingly involved from time to time with litigation and other claims against us. These arise primarily in the ordinary course of our business, and include employee claims, commercial disputes, intellectual property issues and product-oriented allegations. Often these cases raise complex factual and legal issues, which are subject to risks and uncertainties and which could require significant management time. Although we do not currently believe that the outcome of any current litigation and claims against us will have a material adverse effect on our overall financial condition, we have, in the past, incurred unexpected expense in connection with litigation matters. In the future, adverse settlements or resolutions may occur and negatively impact earnings, injunctions against us could have an adverse effect on our business by requiring us to do or prohibiting us from doing certain things, and other unexpected events could have a negative impact on us.

Recent accounting regulation changes require the expensing of stock options.

Recently effective accounting regulation changes require that all publicly traded companies record compensation expense related to stock options (and other equity awards). Accordingly, we now include compensation expense related to stock options and certain other equity awards in our reported earnings in our financial statements. Our reported earnings have been negatively impacted by this new requirement of recording stock-based compensation expense, and our stock price could go down or fluctuate in the future as the amount and extent of these expenses may fluctuate from quarter to quarter, as they are recognized.

 

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Item 4. Submission of Matters to a Vote of Security Holders

The annual meeting of shareholders of the Company (the “Annual Meeting”) was held on June 13, 2006 in the City of Industry, California. The Company had 44,153,594 shares of common stock outstanding as of the close of business on April 20, 2006, the record date for the Annual Meeting.

Proposal 1 – Each of the candidates listed below was duly elected to the Board of Directors at the Annual Meeting by the tally indicated.

 

Candidate

   Votes in Favor    Votes Withheld

Cynthia Cohen

   38,354,311    4,243,577

Corrado Federico

   37,532,530    5,065,358

W. Scott Hedrick

   37,415,269    5,182,619

Kathleen Mason

   28,423,156    14,174,732

Elizabeth McLaughlin

   42,129,844    468,044

Bruce Quinnell

   42,147,281    450,607

Andrew Schuon

   42,147,218    450,670

Proposal 2 – Approval of 2006 Equity Incentive Plan was ratified by the tally indicated.

 

Votes in Favor    Votes Against    Votes Abstained
28,542,661    9,123,542    322,253

Proposal 3 – The selection of Ernst & Young LLP as Independent Registered Public Accounting Firm of the Company for its fiscal year ending February 3, 2007 was ratified by the tally indicated.

 

Votes in Favor    Votes Against    Votes Abstained
47,476,159    1,113,124    8,605

 

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Item 6. Exhibits and Reports

 

Exhibit
Number
  

Description of Document

  3.1    Amended and Restated Articles of Incorporation. (1)
  3.2    Certificate of Amendment of Amended and Restated Articles of Incorporation. (2)
  3.3    Amended and Restated Bylaws, as amended. (2)
  4.1    Reference is made to Exhibits 3.1 and 3.2.
  4.2    Specimen stock certificate. (1)
10.1    Hot Topic, Inc. 2006 Equity Incentive Plan. (3)
10.2    Form of Incentive Stock Option Agreement under the Hot Topic, Inc. 2006 Equity Incentive Plan. (3)
10.3    Form of Non-statutory Stock Option Agreement under the Hot Topic, Inc. 2006 Equity Incentive Plan. (3)
10.4    Hot Topic, Inc. Deferred Compensation Plan. (4)
10.5    Union Bank of California Trust Agreement. (4)
31.1    Certification, dated August 22, 2006, of Registrant’s Chief Executive Officer required by Section 302 of the Sarbanes-Oxley Act of 2002.
31.2    Certification, dated August 22, 2006, of Registrant’s Chief Financial Officer required by Section 302 of the Sarbanes-Oxley Act of 2002.
32.1    Certifications, dated August 22, 2006, of Registrant’s Chief Executive Officer and Chief Financial Officer required by Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C § 1350, as adopted).

(1) Filed as an exhibit to Registrant’s Registration Statement on Form SB-2 (No. 333-5054-LA) and incorporated herein by reference.

 

(2) Filed as an exhibit to Registrant’s Annual Report on Form 10-K for the year ended January 29, 2005 and incorporated herein by reference.

 

(3) Filed as an exhibit to Registrant’s Current Report of From 8-K filed with the Commission on June 13, 2006 and incorporated herein by reference.

 

(4) Filed as an exhibit to Registrant’s Current Report of From 8-K filed with the Commission on July 6, 2006 and incorporated herein by reference.

 

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

   

Hot Topic, Inc.

(Registrant)

Date: August 22, 2006

   

/s/ Elizabeth McLaughlin

   

Elizabeth McLaughlin

   

Chief Executive Officer

(Principal Executive Officer)

Date: August 22, 2006

   

/s/ James McGinty

   

James McGinty

   

Chief Financial Officer

(Principal Financial And Accounting Officer)

 

36


Exhibit Index

 

Exhibit No.   

Document

31.1    Certification, dated August 22, 2006, of Registrant’s Chief Executive Officer required by Section 302 of the Sarbanes-Oxley Act of 2002.
31.2    Certification, dated August 22, 2006, of Registrant’s Chief Financial Officer required by Section 302 of the Sarbanes-Oxley Act of 2002.
32.1    Certifications, dated August 22, 2006, of Registrant’s Chief Executive Officer and Chief Financial Officer required by Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C § 1350, as adopted).
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