Hot Topic Becomes a Queasy Topic for Investors: Stalled Turnaround?

Halloween was a pretty spooky time for Hot Topic (HOTT), a group of teenage pop-fashion stores that leans more on that holiday than most mall stores. It certainly scared the daylights out of the company’s shareholders, who blew a big hole in the stock’s 20% gains this year when they learned how slow things had been. That’s about an 11% share price drop on the day after the company’s Nov. 2 sales and earnings update.

Hot Topic Stock Chart by YCharts

The company announcement said same-stores sales were down 1.6% in the 13 weeks ended Oct. 29, and it forecast another “low-single-digit” comparable sales decrease for the fourth quarter.

So was this just a subtle miss on a pseudo holiday? Or is it more pervasive slowness that’s likely to haunt Hot Topic through the Christmas season and beyond? It’s a pertinent question for any investors interested in the Hot Topic turnaround play, which looked like it was going pretty well until these latest sales figures. Overall U.S. retail sales aren't setting the world on fire, but a chain catering to shopping-mad female teens should aim to outperform the sector.

Hot Topic’s 636 name stores aim at the under 22, often tattooed crowd that’s very much into pop music. The fashion leans towards concert-type t-shirts and hoodies and destroyed (as opposed to distressed) skinny jeans. It also operates 135 Torrid stores for the plus-sized, whose customers include slightly older women dressing for office jobs.

Hot Topic managed well enough through the worst of the recession, but things began to deteriorate in 2009. At the beginning of fiscal 2011, it began shrinking the business through a complex mixture of store closings, store relocations and remodeling projects with some new store additions. Fiscal year 2012 plans call for up to 40 more Torrid stores, with about 45 Hot Topic stores undergoing remodeling or relocation.

The second quarter results, for the period ending July 30, indicated vast improvements in the numbers. Same store sales were up 2.6% from a year earlier. The burn through cash necessitated by the restructuring seemed to be ending.

Hot Topic Free Cash Flow TTM Chart by YCharts

Profit margins got better. The company was still losing money -- $14.07 million in the previous 12 months -- but a steep decline in profit margins finally leveled off.

Hot Topic Operating Margin TTM Chart by YCharts

The company’s dividend yield, which ramped up to above 20% before good news drove the share price higher, now comes in at 3.60%. That’s on shares that go for only a fraction of Hot Topic sales, which makes sense considering the company’s store closings. YCharts Pro gives Hot Topic strong fundamentals and an average valuation on its shares.

Hot Topic Price / Sales Ratio Chart by YCharts

Hot Topic goes into explanatory mode on Nov. 17, and investors will listen closely for hints about how good or bad this particularly hard-to-forecast Christmas selling season will be. Also, profit margin and same store sales figures are at least as important here, as the company needs to drive these higher in order to make money again.

It’s easy to forget that Hot Topic is really a reorganization play, not a typical retail growth investment. The bet is not so much on the popularity of a brand that can be quickly replicated store by store, as it is on management’s ability spend the right amount of money needed to make its existing stores consistently profitable. And the test of that, with a particularly scary holiday ahead for all retailers, is yet to come.

Dee Gill is an editor for the YCharts Pro Investor Service which includes professional stock charts, stock ratings and portfolio strategies.