A Teen Dream for Investors?

S&P likes rapidly growing retailer Hot Topic, with its cutting-edge merchandise -- and conservative finances

By Karen Sack

Solid growth in the teenage and the young-adult population should keep sales of Hot Topic (HOTT ), a merchandiser of music-related products, outpacing most other retailers. The relative immunity of its customers to political and economic issues -- accounting scandals and market slumps don't typically cause a teen to put off a purchase -- helps make this niche attractive. Hot Topic's shares carry Standard & Poor's highest investment recommendation of 5 STARS (buy).

This specialty retailer believes fashions and popular music artists exert a powerful influence over teenagers. One indication: According to a Neilsen Media Research Report, in 2001, MTV music network programming could be seen by more than 83 million households in the U.S. and 384 million households worldwide. This massive exposure makes popular artists and fashions highly visible. Hot Topic believes that this translates into high demand for music-licensed and music-influenced apparel and accessories, and it sells this merchandise to its target audience, 12- to 22-year-olds.

Hot Topic stores are located in malls throughout the country, where teenagers spend a fair amount of their time. The stores have an industrial theme that incorporates densely placed merchandise and feature a professional sound system playing alternative music releases -- the better to create a fun, high-energy place for teens to shop with their friends. The chain comprises 328 Hot Topic stores and 11 Torrid units in 48 states. Torrid is the company's newest retailing concept, offering apparel for plus-size women between the ages of 15 and 30.


  The idea for Torrid stores originated with customers. Hot Topic solicits their feedback at its stores and on its Web site. Management, from its CEO down, prides itself on reading these customer responses. As a result, the company began offering large sizes in the stores and online. The response was so overwhelming that it opened six locations and a special Web site (www.torrid.com) in the first half of 2001. The strong performance of these stores resulted in a rapid rollout of Torrid stores.

With the number of teenagers projected to grow at twice the rate of the overall population, according to Teenage Research Unlimited, a Northbrook (Ill.) market researcher, teens should number 34 million by 2005, up from 32 million in 2000. The group's spending is also on the rise. The average American teen spent more than $104 a week in 2001, according to Teenage Research, an increase of $26 from $78 in 1998. In the past five years, teen spending has grown to $172 billion a year, from $122 billion.

Given the strong growth in this demographic group, Hot Topic plans to increase retail square footage by 25% annually. In its fiscal year ending January, 2003, it plans to add 70 new Hot Topic stores and 15 Torrid units -- and to expand 10 existing stores. Torrid stores are slightly larger than Hot Topic stores, containing around 2,400 square feet, vs. 1,800 square feet. Also, the merchandise mix is geared more toward apparel at Torrid units, 75% apparel and the balance accessories. At Hot Topic stores, the mix is approximately 50-50.


  Margins are high, and inventory turns quickly. To reduce the risk of heavy markdowns, which erode profitability, and to maintain its ability to respond quickly to fashion trends, the majority of merchandise is purchased only 60 days in advance of delivery. Its stores maintain a lean inventory of four to six weeks' supply of merchandise.

Often, Hot Topic begins with small purchases to test the response to a product before distributing it throughout the chain. It also regularly monitors sales by merchandise classification, stock-keeping unit (SKU), color, and size to determine the product's popularity. All of these efforts are important, because the teenage market is fickle.

In fiscal 2002, the average Hot Topic store had net sales of just over $1 million, with sales per square foot of $642. Store-level operating cash flow (store operating income before depreciation and excluding changes in working capital) was $310,000, or 30% of average net sales. The stores don't require a large investment. The average capital expense to open a new store was less than $338,000 in fiscal 2002 and should remain about the same this year.


  As a result, the stores are profitable by the end of their first year of operation and have a high return on investment. All of the company's Hot Topic stores are generating positive store-level operating income.

Hot Topic is conservatively financed. It has no long-term debt. In addition, at May 4, 2002, its cash and short-term investments totaled $61 million. Ample cash-flow generation should fund its $32 million capital spending program in fiscal 2003. S&P is projecting earnings per share to rise 22% in fiscal 2003, to $1.05, and with more stores in operation, a slightly larger increase in fiscal 2004.

Based on our discounted assumptions of free cash-flow growth of 22% in the next five years, gradually trailing down to a 14% growth rate, S&P estimates Hot Topic's intrinsic value is $38 to $40 per share. That's a significant premium to its July 10, 2002 closing price of $26.22. Our target price is $36, based on p-e analysis and free cash-flow projections, or 27% above the July 10 closing price.

Analyst Sack covers retail stocks for Standard & Poor's

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