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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the fiscal year ended January 28, 2012
For the transition period from to
Commission File 0-28784
HOT TOPIC, INC.
(Exact name of Registrant as specified in its charter)
Registrant’s telephone number, including area code: (626) 839-4681
Securities registered pursuant to Section 12(b) of the Act:
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨ No x
Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No x
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 has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.): Yes ¨ No x
The aggregate market value of Common Stock held by non-affiliates of the Registrant as of July 30, 2011, the last business day of the Registrant’s most recently completed second fiscal quarter, was approximately $335,181,036 based on the closing price on that date of the Registrant’s Common Stock on the Nasdaq Stock Market. All outstanding shares of voting stock, except for shares held by executive officers and members of the Board of Directors and their affiliates are deemed to be held by non-affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.
The number of shares outstanding of the Registrant’s Common Stock was 42,083,928 as of March 15, 2012.
Documents Incorporated By Reference
Certain portions of the Registrant’s Definitive Proxy Statement for the Annual Meeting of Shareholders to be held on June 5, 2012 to be filed with the Securities and Exchange Commission (the “SEC”) no later than 120 days after January 28, 2012, are incorporated by reference into Part III of this Form 10-K (Items 10 through 14).
HOT TOPIC, INC.
ANNUAL REPORT ON FORM 10-K
FISCAL YEAR ENDED JANUARY 28, 2012
TABLE OF CONTENTS
Cautionary Statement Regarding Forward-Looking Statements From time to time, in both written reports (such as this report) and oral statements, we make “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, or the Securities Act, and Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act. We intend that such forward-looking statements be subject to the “safe harbors” created by these sections. Generally, the words “believes,” “anticipates,” “expects,” “continue,” “intends,” “will,” “may,” “plans” and similar expressions identify such forward-looking statements, although not all forward-looking statements contain these identifying words. These statements include, for example, statements regarding our expectations, beliefs, intentions or strategies regarding the future, such as the extent and timing of future revenues and expenses, economic conditions affecting consumer demand, ability to realize anticipated benefits of cost reduction plans and business changes, ability to grow or maintain comparable store sales, response to new concepts and other expected financial results and information. All forward-looking statements included in this report are based on information available to us as of the date of this report and we assume no obligation to update or revise any forward-looking statements to reflect events or circumstances that occur after such statements are made. Readers are cautioned not to place undue reliance on these forward-looking statements as they involve risks and uncertainties which may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements. These risks, as well as other risks and uncertainties, are located in the company’s reports on Forms 10-K, 10-Q and 8-K filed with or furnished to the Securities and Exchange Commission, or SEC, including in Part I, Item 1A under the caption “Risk Factors” and in Part II, Item 7 under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this report.
Available Information Our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed with or furnished to the SEC pursuant to Section 13(a) or 15(d) of the Exchange Act, are available free of charge on our investor relations website, investorrelations.hottopic.com, as soon as reasonably practicable after such material is electronically filed with, or furnished to, the SEC. We also make available our Standards of Business Ethics at that website.
Fiscal Year Our fiscal year ends on the Saturday nearest to January 31. References to fiscal 2012 refer to the 53-week period ending February 2, 2013. References to fiscal 2011, 2010, 2009, 2008 and 2007 refer to the 52-week periods ended January 28, 2012, January 29, 2011, January 30, 2010, January 31, 2009 and February 2, 2008.
References to Hot Topic, Inc. Throughout this report, the terms “we,” “us,” “our,” “company” and similar references refer to Hot Topic, Inc. and its wholly-owned subsidiaries.
General We are a mall and web-based specialty retailer of apparel, accessories, music and gift items for young men and women whose lifestyles reflect a passion for music, fashion and pop culture. We operate under two concepts: Hot Topic and Torrid. Music and pop culture are the overriding inspirations at Hot Topic, and Torrid is focused on providing the best in fashion to young plus-size women. We generate revenues primarily through our retail stores in the United States of America, Puerto Rico and Canada, and online through our websites. We were incorporated in California in 1988.
Hot Topic At our Hot Topic stores and on our website hottopic.com, we sell a selection of licensed and non-licensed apparel, accessories and gift items that are influenced by popular music artists and pop culture trends. We also sell a limited assortment of music CDs and DVDs. Our merchandise is designed to appeal to young men and women who are passionate about and have diverse tastes in music and pop culture.
We strive to consistently be the first to expose our customers to new music, pop culture and fashion trends. We believe our ability to quickly identify, source, and oftentimes negotiate exclusivity for, unique and diverse merchandise centered around music and pop culture is one of our competitive strengths. We also believe that our deep-rooted knowledge of music and pop culture, distinctive store design and rich music experiences that we offer are competitive strengths. We opened our first Hot Topic store in California in fiscal 1989 and have since gained a national presence in the United States.
Torrid At our Torrid stores and on our website torrid.com, we sell fashion forward apparel, lingerie, shoes and accessories for plus-size young women. It is designed to appeal to women sized 12 to 26 who are young at heart and in attitude and who want their clothes to be an extension of their lifestyles. We believe that our ability to provide our plus-size customers with easy access to the latest and best in fashion without sacrificing fit or style is a core competitive strength of Torrid. We opened our first Torrid store in fiscal 2001.
ShockHound During the second quarter of fiscal 2011, the operations of ShockHound, our online digital music website launched in fiscal 2008, were discontinued. Refer to “NOTE 2 – Recent Business Events” contained in the consolidated financial statements and notes included elsewhere in this annual report on Form 10-K for more information concerning the discontinuation of ShockHound’s operations.
Hot Topic Merchandise Hot Topic’s music/pop culture-licensed merchandise includes tee shirts, hats, stickers, novelty accessories, CDs and DVDs and the music/pop culture-influenced merchandise includes women’s and men’s apparel and accessories, such as woven and knit tops, skirts, pants, shorts, jackets, shoes, costume jewelry, body jewelry, intimate apparel, sunglasses, cosmetics, leather accessories and gift items. Hot Topic’s diverse and extensive selection of merchandise is regularly tested to stay current with customer demand and new product trends. We have several lines of private label merchandise to complement and supplement our current product offerings.
The following table shows, for the periods indicated, Hot Topic’s major merchandise categories expressed as a percentage of net sales:
Torrid Merchandise Torrid sells both branded and private label merchandise that includes casual and dressy jeans and pants, fashion and novelty tops, sweaters, skirts, jackets, dresses, hosiery, shoes, intimate apparel and fashion accessories.
The following table shows, for the periods indicated, Torrid’s major merchandise categories expressed as a percentage of net sales:
Merchandising Staff Our merchandising teams typically consist of a mix of general and divisional merchandise managers; buyers and assistant buyers; product development, sourcing, fit and quality assurance teams. In determining which Hot Topic merchandise to buy, the merchants spend considerable time viewing music videos, reviewing industry music sales, viewing movie releases that appeal to our teen customers, monitoring music radio station air play, viewing YouTube videos, consulting with sales associates, reviewing customer requests, attending trade shows, nightclubs and concerts, reading music and fashion industry periodicals and monitoring music, pop culture and social media websites. Their goal is not only to identify emerging trends early, but to quickly move on from them before the popularity of the trends wane. At Torrid, in order to remain in tune with reigning trends and preferences, the merchandising team conducts fashion research from a variety of sources within and outside the United States. Such sources include fashion hot spots, customer and store associate feedback, entertainment and pop culture venues and trade shows.
Purchasing Our goal is to provide exclusive, diverse, trend-setting merchandise to our customers early and at the right price. We purchase merchandise from a broad base of domestic and international vendors and only commit to a majority of the merchandise in as little as two weeks and as much as three months in advance of delivery, depending on the category, in order to respond quickly to emerging trends. We constantly monitor sales to determine desirable product types and quantities, emerging or declining trends and the spending patterns of our customers. We solicit input from our vendors and maintain productive relationships with them to support our effort to deliver quality, fashionable merchandise that is reflective of new and emerging trends. No vendor individually accounted for more than 10% of our merchandise purchases during fiscal 2011.
Planning and Allocation Planning and allocation of our inventory is done by merchandise classification and Stock Keeping Unit, or SKU, using integrated third-party software. Most merchandise is ordered in bulk and then allocated to each store based on sales performance and inventory levels. Our buyers, merchandise planners and allocation analysts consider current inventory levels, sales history, projected sales, planned inventories, store demographics, geographic preferences, store openings and planned markdown dates to determine SKU reorder quantities.
Distribution and Fulfillment To facilitate timely and efficient merchandise distribution to our stores and internet customers, we have distribution centers located in California and Tennessee, both of which are sufficient to meet our anticipated needs over the next several years. Substantially all merchandise is delivered to our distribution centers and within one to two business days of receipt, it is inspected, allocated, picked, prepared and boxed for shipment to our stores. Merchandise is shipped from the distribution centers daily and selective SKUs are identified to maintain back stock.
Location and Site Selection As of the end of fiscal 2011, we operated 628 and 148 primarily mall-based Hot Topic and Torrid stores, respectively, in the United States, Puerto Rico and Canada. Refer to “Item 2 – Properties” for a geographical breakdown of stores by state and country. In selecting a site for a new store, we target high-traffic shopping areas with favorable lease terms and suitable demographics of likely customers.
Design and Environment The look and feel of our Hot Topic and Torrid stores continue to evolve. Our newer Hot Topic stores are designed to highlight the merchandise in a unique, high-energy and eclectic shopping atmosphere. Our Torrid stores present a youthful atmosphere designed to create a comfortable and fun environment for our customers.
Sales During fiscal 2011, average sales per Hot Topic store was $0.8 million and average sales per square foot was $429. Average sales per Torrid store in fiscal 2011 was $0.9 million and average sales per square foot was $342.
Expansion While we have significantly slowed our new Hot Topic store growth, we have focused on remodeling or relocating those stores where there is a reasonable expectation of satisfactory sales results after the remodel or relocation. New Torrid store growth and remodeling and relocation activity was low during fiscal 2011, however, we anticipate that in fiscal 2012, we will aggressively pursue new Torrid store growth. We continue to renegotiate or extend existing leases with more favorable terms and to close stores that do not meet our expectations of profitability.
In fiscal 2011, our capital investment to open a new Torrid store, including leasehold improvements and furniture and fixtures, was approximately $218,000. The average initial gross inventory for a new Torrid store opened in fiscal 2011 was approximately $57,000. As with our Hot Topic stores, initial inventory requirements vary at new stores depending on the season and current merchandise trends. The average pre-opening costs in fiscal 2011 for a new Torrid store were approximately $18,000. The new Torrid stores have square footage similar to current averages of 2,496 square feet.
The following table shows our historical store expansion and closure activity, as well as the number of stores included in the comparable store base, for the periods indicated. Our planned store expansion and closure activity in fiscal 2012 is also reflected in the table. All activity is evaluated by our real estate committee.
Operation Teams Hot Topic and Torrid each have a Vice President of Store Operations who leads a divisional operations team. Supporting the Vice President of Store Operations for each division are regional directors who oversee multiple district managers, and district managers who typically oversee approximately ten stores. A typical store has a store manager, two assistant managers, and five to eight part-time sales associates, depending on the season. We believe our distinct culture attracts Hot Topic sales associates that are passionate about music and pop culture and Torrid sales associates that are passionate about fashion for the plus-size customer. Each member of our store operation teams receive comprehensive training that is customized to fit their roles and responsibilities. In addition to base pay and the opportunity to participate in our Employee Stock Purchase Plan and the Hot Topic 401(k) Plan if eligible, we offer incentive programs to some members of our store operations teams based on achieving certain sales levels.
Websites Our hottopic.com and torrid.com websites provide convenient access to a broad selection of merchandise for sale, including some Internet exclusive items, information on upcoming events, promotions, store locations, job postings and community features. Customers may also access our hottopic.com website through touchscreen kiosk terminals located within each Hot Topic store. These kiosks allow customers to access, purchase and ship merchandise from hottopic.com to the store for pickup or their homes.
The following table shows, for the periods indicated, Internet sales (including sales made through kiosk terminals) for Hot Topic and Torrid (in thousands, except percent amounts):
Hot Topic We strive to increase sales and our brand recognition, enhance the customer shopping experience and reach out to new customers using a unique combination of tools including: promotional signage in stores and on our website; viral online marketing; branded gift cards; our loyalty program; social media; reliance on our customers and associates; compelling store designs; and experiential events. During the fourth quarter of 2009, we launched our loyalty program, HT+1. HT+1 is free to join and is designed to build customer loyalty and encourage repeat sales by allowing members an opportunity to earn points in a variety of ways, including store visits, store purchases and online purchases. In addition, HT+1 allows us to communicate to members about products and events that are relevant to them as well as giving members access to exclusive events that are not available to other customers. Touchscreen kiosk terminals located within most Hot Topic stores offer another way that members may access their HT+1 loyalty accounts. Since the launch, over eight million people have become HT+1 members.
Torrid We seek to build the Torrid brand with many of the same tools used by Hot Topic, as well as with print media and direct mail. Our Torrid loyalty program, divastyle®, gives us the chance to regularly communicate with our most loyal Torrid customers. They are rewarded throughout the year with special offers, promotions, information and updates on new products and current trends available at Torrid. Customers may also participate in our private label Torrid credit card program, divastatusSM.
Information Technology Our information systems provide for the integration of store, internet, merchandising, distribution, financial and human resources records and data. Many of these information systems have been customized in varying degrees to fit our business needs and we license a full range of software from different vendors. We regularly upgrade existing systems or replace all or part of an existing system with one that we believe is better suited to our business. In addition, we occasionally implement new technology to support our business. We plan to purchase and implement several major systems, replacing our merchandising system currently supporting the needs of our businesses. We expect to have the most significant systems implementations completed in early fiscal 2013.
Trademarks Our trademarks, which constitute our primary intellectual property, have been registered or are the subject of pending applications in the United States Patent and Trademark Office and with the registries of many foreign countries. In addition, we have common law rights to certain trademarks, service marks and trade names used in our business from time to time. We are unaware of the use of any of our marks raising any claims of infringement or other challenges to our right to use our marks in the United States.
Seasonality Our business, particularly at Hot Topic, is 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, respectively) 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 may not always be the case or always affect the company 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 and second fiscal quarters relative to other quarters.
Competition The apparel, music and accessory categories within the retail industry in which we operate are highly competitive and are subject to rapidly changing consumer demands and preferences. We compete with numerous retailers for vendors, teenage and young adult customers, suitable store locations and qualified associates and management personnel. We currently compete with street alternative stores located primarily in metropolitan areas; shopping mall-based teenage-focused retailers; big-box discount stores; music stores; mail order catalogs and websites; and with numerous potential competitors who may begin or increase efforts to market and sell products competitive with Hot Topic and Torrid products. Torrid has additional competitors who operate plus-size departments in department stores and discount stores. Increased competition could have a material adverse effect on our business, results of operations and financial condition.
Employees As of the end of fiscal 2011, we employed approximately 2,100 full-time and 6,700 part-time associates. Of our 8,800 associates, approximately 800 were headquarters and distribution center personnel and the remainder were field management and store associates. The number of part-time associates changes based upon seasonal needs. None of our associates are covered by collective bargaining agreements.
Executive Officers Our executive officers and their ages are as follows:
Lisa Harper has served as Chairman of our Board of Directors since November 2011 and Chief Executive Officer since March 2011. Prior to becoming Chairman, she served on our Board of Directors since June 2008. Prior to joining us, she served as Chairman of the Board of Directors of the Gymboree Corporation, a publicly-traded corporation operating a chain of specialty retail stores for children and women, from June 2002 until her retirement in July 2006. From January 2006 through July 2006, Ms. Harper served as Chief Creative Officer of the Gymboree Corporation. From February 2001 through January 2006, Ms. Harper served as Chief Executive Officer of the Gymboree Corporation and from February 2001 through June 2002, she was Vice Chairman of the Gymboree Corporation’s Board of Directors. From 1995 through 2001, Ms. Harper held various merchandising and design positions at the Gymboree Corporation and before that, held similar positions with several other clothing retailers, including Limited Too, Esprit de Corp., GapKids, Mervyn’s, and Levi Strauss. Ms. Harper also served as a director of Longs Drug Stores Corporation from February 2006 to May 2008. Since 2008, Ms. Harper has developed and operates a hotel in Mexico. Ms. Harper attended the University of North Carolina at Chapel Hill.
Gerald Cook has served as Chief Operating Officer since June 2008. From November 2005 through June 2008, he served as President, Hot Topic Inc. From September 2003 to October 2005, he was President of the Hot Topic division. From February 2001 to September 2003, he was Chief Operating Officer. From February 1999 until joining us, he was the President and Chief Operating Officer of Travel 2000, Inc. From 1995 to 1998, Mr. Cook was Senior Vice President, Operations for The Bombay Company, Inc. and from 1989 to 1995, Mr. Cook was the Vice President, Stores and the Vice President, General Merchandising Manager of Woman’s World Stores. Prior to 1989, he held management positions with Barnes & Noble/B Dalton, The Gap Stores and the Limited, Inc. Mr. Cook holds a B.S. degree in Business Administration from the University of Minnesota.
James McGinty has served as Chief Financial Officer since February 2001. Mr. McGinty joined us in August 2000 as Vice President, Finance and was promoted to Chief Financial Officer in February 2001. From July 1996 to July 2000, Mr. McGinty was Vice President-Controller at Victoria’s Secret Stores, the leading brand and largest specialty retailer division of the Limited, Inc. From 1984 to 1996, he held various financial and accounting positions within the Structure and Express divisions of The Limited, Inc. Mr. McGinty holds a B.S. degree in Accounting from Miami University in Oxford, Ohio.
Don Hendricks joined us in August 2011 as Chief Information Officer. From November 1998 to August 2011, Mr. Hendricks served in various information technology and distribution and logistics positions at Gymboree Corporation, most recently as Chief Information Officer. Prior to Gymboree, Mr. Hendricks held various information technology positions with other retailers, including Bisgby & Kruthers and Reading, China & More. Mr. Hendricks holds a B.A. degree from Loyola University of Chicago.
Mark Mizicko joined us in October 2011 as Senior Vice President, Planning and Allocation. From April 2003 to March 2011, Mr. Mizicko served in various positions at Gymboree Corporation including Vice President over functions such as Planning and Allocation, E-commerce, and Marketing and Logistics. Prior to Gymboree, Mr. Mizicko served in various planning and inventory management roles with Williams-Sonoma, The Gap and Limited Brands. Mr. Mizicko holds a B.S. degree in Economics from The Ohio State University.
George Wehlitz Jr. joined us in April 2008 as Vice President, Finance. From November 2005 to January 2008, Mr. Wehlitz was Chief Financial Officer at Cycle Gear, Inc., a specialty retailer of motorcycle apparel and accessories. Mr. Wehlitz previously served Hot Topic, Inc. as Vice President, Controller in February 2002, and then served as Vice President, Finance from August 2003 to November 2005. From August 2000 to February 2002, Mr. Wehlitz was Chief Financial Officer at The Popcorn Factory, a catalog company for gourmet popcorn gifts. From 1987 to 2000, Mr. Wehlitz held various financial-related positions, at the divisional and corporate level, for The Bombay Company, Inc. Mr. Wehlitz holds a B.A. degree in Accounting from Texas Christian University and is a Certified Public Accountant.
CERTAIN RISKS 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 this annual report on Form 10-K and 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.
Our success relies on popularity of music, pop culture and fashion trends, and our ability to react to them
Our financial performance is largely dependent upon the continued popularity of apparel, accessories and other merchandise inspired by music, film, television, pop culture, and fashion trends, particularly among teenagers and college-age adults. The popularity of such products is influenced by the Internet; music videos and music television networks; the emergence of new artists; the success of music releases, movies and television shows; and music/pop culture-related products. The popularity of particular types of music, movies, television shows, artists, actors, styles, trends and brands is constantly changing. Our failure to anticipate, identify and react appropriately to changing trends and preferences of our customers could lead to, among other things, excess inventories and higher markdowns. There can be no assurance that the products we sell will be accepted by our customers.
We depend on a small number of key licensed products for a portion of our earnings and lower than expected sales of those products or the inability to obtain new licensed products could adversely affect our revenues
We license from others the rights to produce and/or sell certain products that contain a third party’s trademarks, designs and other intellectual property. If the popularity of those licensed products diminishes or if we are unable to obtain new licensed products with comparable consumer demand, our sales could decline. Furthermore, we may not be able to prevent a licensor from choosing not to renew a license with us and/or from licensing a product to one of our competitors.
Our cost reduction plan and strategic business changes may not achieve their anticipated benefits and could adversely affect our operations and revenues and our ability to respond to future growth opportunities
We recently completed the implementation of all planned initiatives related to the strategic business changes announced in fiscal 2011 to improve our overall operations and reduce costs. The strategic business changes involved closing underperforming stores, discontinuing our ShockHound operations, writing down inventory and writing down property and equipment that are no longer critical to the strategic direction of the company. A number of factors could result in our not realizing the anticipated benefits from the initiatives. Even if we are successful in implementing these initiatives, the loss of personnel and reduction in the number of stores we operate, among other things, may result in decreased operational efficiencies, unanticipated operational challenges and decreased revenues, or leave us unprepared to take advantage of growth opportunities in the future.
Our access to merchandise could be hurt by changes in vendors’ business condition
Our financial performance depends on our ability to obtain our merchandise in sufficient quantities at competitive prices. We depend on independent contractors and vendors to manufacture much of our merchandise. Substantially all of our music/pop culture-licensed products are available from vendors that have exclusive license rights. In addition, we rely on small, specialized vendors who generally have limited resources, production capacities and operating histories. Lack of access to capital, as a result of the current economic conditions or otherwise, and changes in vendors’ compliance and certification procedures may cause our vendors to delay, reduce or eliminate shipment of products we otherwise would sell in our stores. We generally do not have 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.
Remodeling, relocating, closing and opening stores may not achieve the anticipated benefits and could create challenges we may not be able to adequately meet
We depend on our ability to manage our existing store base, ensure that the performance of our remodeled and relocated stores is at acceptable levels, open new stores, and close underperforming stores. In order to open, remodel and relocate stores, among other things, we 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 or relocated stores into our existing operations and maintain adequate distribution center space and information technology systems. Moving or expanding store locations and operating stores in new markets, especially markets outside the continental United States, may present competitive, merchandising and regulatory challenges we do not have experience in or know how to face. There can be no assurance that moving or expanding store locations and operating stores in new markets will not adversely affect the individual financial performance of our existing stores or our overall results of operations. In the event that the number of our stores increases, we may face risks associated with market saturation of our products and concepts. Similarly, there can be no assurance that remodeling or relocating existing stores will not adversely affect either the individual financial performance of the store prior to the change or our overall results of operations. Furthermore, there can be no assurance that we will successfully achieve our remodel or expansion targets or, if achieved, that planned remodel or expansion will result in profitable operations.
Our business strategy requires innovating and improving our operations, and we may not be able to do this sufficiently to effectively prevent a negative impact on our business and financial results
To be successful we must innovate our products, our stores, and the shopping experience for our customers. Such innovation involves risks, including that we will not properly anticipate the need for or rate of change, that we are not able to successfully bring about such change, that we will not be able to produce anticipated results, and that our customers will not be receptive to the change. Such innovation also involves significant capital expenditures and other costs that we may not be able to recover if the innovation is not favorably received by our customers.
Failure of our vendors to use acceptable ethical business practices could negatively impact our business
We require and expect our vendors and manufacturers to operate in compliance with applicable laws, rules and regulations regarding working conditions, employment practices, the environment and intellectual property. However, we do not control their labor and other business practices. Further, we do not inspect our manufacturers’ operations and would not be immediately aware of any noncompliance by our vendors with applicable domestic or international laws and standards, including our internal standards. If one of our vendors or manufacturers violates labor or other laws or implements labor or other business practices that are regarded as unethical, the shipment of merchandise to us could be interrupted, orders could be canceled, relationships could be terminated and our reputation could be damaged.
Technology and other risks associated with our Internet sales could hinder our overall financial performance
We sell merchandise over the Internet through websites we control and affiliated websites controlled by others. Our Internet sales generate a significant portion of our total sales and are dependent on our ability to drive Internet traffic to our websites. Our Internet operations are subject to numerous risks and pose risks to our overall business, including the inability to successfully establish partnerships that are instrumental in driving traffic to our websites; diversion of sales from our stores; liability for online content; computer and consumer privacy concerns; rapid technological changes; the need to invest in additional computer hardware and software to support sales; hiring, retention and training of personnel; failure of computer hardware and software, including computer viruses, telecommunication failures, online security breaches and similar disruptions; governmental regulations; 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.
We materially rely on ecommerce, information and other technology systems, including such technology provided by third parties
We believe our dependence on ecommerce, information and other technology systems, including technology provided by third parties, will increase in the future, and it is possible we may not be able to obtain, maintain or use such systems as quickly or as effectively as needed. Implementing new systems, modifying existing systems, and restoring such systems and technology following a shut-down could present technological and operational challenges which we are unprepared for. We continue to evaluate the adequacy of the ecommerce, information and other technology systems we use to operate our business. Our failure to adapt to changing technological needs could have a material adverse effect on our results of operations and financial condition. We have agreements with third-party providers to maintain ecommerce and information technology systems, including content. We would be negatively impacted if such third parties fail to provide such services, including by way of malfunction of third-party sites, hardware, software and other equipment; service outages of third-party sites; third-party claims of data privacy violations, security breaches and intellectual property infringement; and poor integration of our technology into their software and services.
System security risk issues and system failures could disrupt our internal operations or information technology services provided to customers
Computer hacking attacks, as well as computer mal ware, denial-of-service attacks and viruses, have become increasingly prevailant in recent years. Using such methods and others, experienced computer programmers, hackers and other users 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 system failures. In addition, hardware and operating system software and applications that we procure from third parties may contain defects in design or manufacture, including “bugs” and other 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. In addition, our systems are not fully redundant and could be subject to failure. Our disaster recovery planning may not be sufficient, and we may not have adequate insurance coverage to compensate us for any significant casualty loss.
We are responsible for maintaining the privacy of personally identifiable information of our customers
Through our sale transactions, loyalty programs and other methods, we obtain personally identifiable information about our customers which is subject to federal, state and international privacy laws. These laws are constantly changing. If we fail to comply with these laws, we may be subject to fines, penalties or other adverse actions. For example, we are highly dependent on the use of credit cards to complete sale transactions in our stores and through our websites, and if we fail to comply with Payment Card Industry (PCI) Data Security Standards, we may become subject to limitations on our ability to accept credit cards. Moreover, third parties may seek to access this information through improper means such as computer hacking, malware and viruses. Any incidents involving unauthorized access or improper use of our customers’ personally identifiable information could damage our reputation and brand and result in legal or regulatory action against us.
Loss of key people or an inability to hire necessary and significant personnel could hurt our business
Our ability to achieve and maintain operating efficiency and to anticipate and effectively respond to changing trends and consumer preferences depends in part on our ability to retain and attract senior management and other key personnel in our operations, merchandising, music and other departments. Competition for these personnel is intense, and we cannot be sure that we will be able to retain or attract qualified personnel as needed. The sudden loss of the services of key people could have a material adverse effect on our business, results of operations and financial condition.
Our supply chain has risks and uncertainties that could affect our sales and business
The merchandise we sell is obtained from vendors and manufacturers in the United States and outside of the country. Generally, this product is shipped to our distribution centers in California and Tennessee, and from our distribution centers to our stores or directly to our customers using Federal Express and the United States Postal Service. Certain products we sell are imported and subject to delivery delays based on availability and port capacity. Our reliance on Federal Express and the United States Postal Service for shipments is subject to risks associated with their ability to provide delivery services that meet our shipping needs and our ability to obtain such services at an affordable cost. We are also dependent upon the ability to hire temporary associates to adequately staff our distribution centers, particularly during busy periods such as the holiday season. We may not be able to achieve or maintain operating efficiencies using two distribution centers that are located approximately 2,000 miles apart.
Risks associated with contracting directly with manufacturers for merchandise could hinder our financial performance
Over time we expect to source a greater percentage of our merchandise directly from manufacturers. We have limited experience in sourcing and importing merchandise directly from manufacturers. We may encounter administrative challenges and operational difficulties with the manufacturers from which we may source our merchandise. Operational difficulties could include reductions in the availability of production capacity, errors in complying with merchandise specifications, insufficient quality control and failures to meet production deadlines. A manufacturer’s failure to ship merchandise to us on a timely basis or to meet the required quality standards could cause supply shortages that could result in lost sales. If a manufacturer conducts its operations in a manner that is illegal or regarded as unethical, it could affect our business and our reputation could be damaged.
We could acquire merchandise without full rights to sell it, which could inhibit sales and lead to disputes or litigation
We purchase licensed merchandise from vendors who represent that they hold manufacturing and distribution rights to such merchandise. We also contract directly with licensors to obtain the manufacturing and distribution rights. We do not independently verify whether these vendors legally hold adequate rights to the licensed properties they are manufacturing, distributing or licensing. If we license merchandise that we have not legally obtained the rights to sell, we could be obligated to remove such merchandise from our stores, incur costs associated with destruction of merchandise and be subject to liability under various civil and criminal causes of action, including actions to recover unpaid royalties and other damages. As we expand our efforts to contract directly with manufacturers and licensors for licensed merchandise, we may incur difficulties securing the necessary manufacturing and distribution rights. Even when we have secured the rights needed to sell such products in the United States, we may not be able to secure the rights to sell the products outside of the United States.
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
We are involved from time to time with litigation and other claims against us. Often these cases can 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 matter of litigation or claim 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, judgments or resolutions may 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. We may in the future be the target of material litigation, including class-action and securities litigation, which could result in substantial costs and divert our management’s attention and resources.
Uncertainty in the global capital and credit markets may materially impair the liquidity of a portion our cash and investment portfolio
We hold cash, cash equivalents and short-term and long-term investments, including auction rate securities (discussed in more detail in “NOTE 1 – Organization and Summary of Significant Accounting Policies” contained in the financial statements and notes included elsewhere in this annual report on Form 10-K). Continued failures of auctions for the auction rate securities we hold limit our ability to liquidate these investments and are expected to continue failing for some period of time. Although the money market funds and municipal bonds we hold are highly rated and are comprised of high-quality, liquid instruments, if the financial markets trading the underlying assets experience a disruption, we may need to temporarily rely on other forms of liquidity. In addition, a risk exists that our cash and investments may not always be optimally managed and this may affect our profitability and results of operations.
Our charter documents and other circumstances could prevent a takeover or cause dilution of our existing shareholders, which could be detrimental to existing shareholders
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, or Board, 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. The issuance of these shares could have a dilutive effect on shareholders and potentially prohibit a takeover of Hot Topic, Inc. by requiring the preferred shareholders to approve such a transaction. 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. The issuance of these shares could result in dilution to our shareholders.
We are dependent upon malls remaining popular as shopping destinations, the ability of shopping mall anchor tenants and other attractions to generate customer traffic and maintaining good relationships with shopping mall operators
The global economic downturn and other factors have diminished the ability of shopping mall operators to operate profitably and, in some cases, forced them to declare bankruptcy or cease operations entirely. The ongoing slowdown in the United States economy, uncertain economic outlook, and other factors could continue to curtail shopping mall development, decrease shopping mall traffic, reduce the number of hours shopping mall operators keep their shopping malls open, cause shopping mall operators to lower their operational standards and negatively impact our lease contracts. Consolidation of ownership of shopping malls may give landlords more leverage in negotiations and adversely affect our ability to negotiate favorable lease terms. Such consolidation may result in increased lease costs. We believe we have favorable relationships with shopping mall operators and developers, however if this changes it could inhibit our ability to negotiate with them and may make it more difficult for us to manage our leases, including for us to expand, remodel or relocate to certain sites. If our relations with shopping mall operators or developers become strained, or we otherwise encounter difficulties in leasing store sites, we may not be able to open stores in malls we would otherwise be interested in maintaining stores; we may not be able to negotiate lease terms favorable to the company; and we may be inhibited in our ability to close underperforming stores.
We face intense competition
The apparel, music and accessory categories within the retail industry in which we operate are highly competitive. Increased competition could have a material adverse effect on our business, results of operations and financial condition. Our competitors, particularly big-box retailers, may have the ability to sell merchandise at substantially lower prices than we are able to sell such merchandise. This may cause us to incur greater than anticipated price reductions and unanticipated increases in our inventories for such products. It may also cause us to elect not to sell such products, despite the fact the products would otherwise attract customers and sell well in our stores.
Timing, seasonal issues and other fluctuations outside of our control could negatively impact our financial performance for given periods
Our business, particularly our Hot Topic division, is subject to seasonal influences that affect our comparable store sales. There are 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. Our 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; timing, popularity of and our ability to obtain, certain pop culture-related licenses, including on an exclusive basis; releases of new music, film and television; releases of new music/pop culture-related products; our ability to efficiently source and distribute products; changes in our merchandise mix and the challenges involved in getting the right mix into stores at the right time; shifts in timing of certain holidays; weather conditions; and overall economic conditions.
Our profitability could be adversely affected by volatile commodity prices, including petroleum and cotton
The profitability of our business depends to a certain degree upon the price of certain commodities, including petroleum and cotton products. We are affected by changes in such prices to the extent that such commodities are part of the costs of delivery of merchandise to our stores and to the extent that the commodities are used in the production of our merchandise. Higher gasoline prices may also affect the willingness of consumers to drive to our stores.
Significant fluctuation in the value of the U.S. dollar or foreign exchange rates may affect our profitability
Substantially all of our foreign purchases of merchandise have been negotiated and paid for in U.S. dollars. As a result, our sourcing operations may be adversely affected by significant fluctuation in the value of the U.S. dollar against foreign currencies, restrictions on the transfer of funds and other trade disruptions. A portion of our revenues come from foreign markets. Changes in foreign exchange rates applicable to these markets may adversely affect our revenues, even if the volume of sales remains the same. We may not be able to repatriate revenues earned in foreign markets.
Recording impairment charges for certain underperforming stores may negatively impact our future financial condition or results of operations, and closing stores might not have a positive impact on our operating results
We are required to assess, and where appropriate, record a charge for, the impairment of underperforming assets. This may negatively impact our reported and future financial condition and results of operations. In addition, we continue to close stores that do not meet our expectations of profitability which may cause us to impair or accelerate the depreciation of certain store assets and incur additional amounts for lease termination, severance and other closing costs. There can be no assurance that we will not incur future impairment charges and store closure expenses for underperforming assets or that store closures will have a significant positive impact on our operating results.
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
Changes in laws and any future changes could make our operations more expensive or require us to change the way we do business. Changes in federal and state minimum wage laws could require us to change our entire wage structure for stores. Other laws related to treatment of employees, including laws related to employee benefits and privacy, could also negatively impact us, such as by increasing medical insurance costs and related expenses. Changes in product safety or other consumer protection laws, and private-party enforcement of existing laws, could lead to increased costs to us for certain merchandise, additional labor costs associated with readying merchandise for sale, or serve as the basis for litigation.
A disruption of imports may increase our costs and reduce our supply of merchandise
We receive apparel and other merchandise from foreign sources, both purchased directly in foreign markets and indirectly through domestic vendors with foreign sources. As a result of our reliance on international vendors and manufacturers, we are subject to the risks generally associated with global trade and doing business abroad, which include foreign and domestic laws and regulations, political unrest, disruptions or delays in cross-border shipments and changes in economic conditions in countries in which our merchandise is manufactured. In addition, disease outbreaks, terrorist acts or military conflicts could increase the risks of doing business with suppliers who rely on foreign markets. Trade restrictions in the form of tariffs or quotas, or both, that are applicable to the merchandise we sell also could affect the importation of the merchandise and increase the cost and reduce the supply of products available to us. Further, changes in tariffs or quotas for merchandise imported from individual foreign countries could lead us to shift our sources of supply among various countries. Any shift we might undertake in the future could result in a disruption of our sources of supply and lead to a reduction in our revenues and earnings. Supply chain security initiatives undertaken by the United States or foreign governments that impede the normal flow of product could also negatively impact our business.
We incur costs associated with regulatory compliance, and this cost could be significant
There are numerous regulatory requirements for public companies that we comply with or may be required to comply with in the future and compliance with these rules could result in the diversion of management’s time and attention, which could be disruptive to normal business operations. These regulations may include more stringent accounting standards, taxation requirements (including changes in applicable income tax rate, new tax laws and revised tax law interpretations), trade restrictions, regulations regarding financial matters, privacy and data security, environmental regulations, advertising, safety and product liability. We may in the future be required to adopt International Financial Reporting Standards, and doing so could be time-consuming and causes us to incur significant expense. If we do not satisfactorily or timely comply with these requirements, possible consequences could include sanction or investigation by regulatory authorities such as the SEC or the Nasdaq Stock Market; fines and penalties; incomplete or late filing of our periodic reports, including our annual report on Form 10-K or quarterly reports on Form 10-Q or civil or criminal liability.
Government or consumer concerns about product safety could result in regulatory actions, recalls or changes to laws, which could harm our reputation, increase costs or reduce sales
We are subject to regulation by the Consumer Product Safety Commission and similar state and international regulatory authorities, and our products could be subject to involuntary recalls and other actions by these authorities. We purchase merchandise from suppliers domestically as well as outside the United States. One or more of our suppliers might not adhere to product safety requirements or our quality control standards, and we might not identify the deficiency before such merchandise is received by our customers. Issues of product safety could result in a recall of products we sell. Additionally, regulatory authorities, including the Consumer Product Safety Commission, have undertaken reviews of product safety and are in the process of enacting or are considering various proposals for more stringent laws and regulations. In particular, the Consumer Product Safety Improvement Act of 2008, which imposes significant requirements on the sale of consumer products and enhanced penalties for noncompliance. Such regulations contain provisions which have uncertain applicability to products we sell, and such lack of certainty may inhibit our willingness carry products or cause us to carry product we otherwise would not. These regulations could result in delays in getting products to our stores, lost sales, the rejection of our products by consumers, damage to our reputation or material increases in our costs, and may have a material adverse effect on our business. Moreover, individuals and organization may assert legal claims for our non-compliance with consumer product rules and regulations, and we may be subject to lawsuits relating to these claims. There is a risk that these claims or liabilities may exceed or fall outside the scope of indemnities provided by third parties or outside the coverages of our insurance policies.
Economic conditions could decrease consumer spending and reduce our sales
Certain economic conditions could affect the level of consumer spending on merchandise we offer, including, among others, employment levels; salary and wage levels, particularly of teens and college-age adults; interest rates; availability of consumer credit; taxation; and consumer confidence in future economic conditions. For example, the global economic downturn has significantly reduced consumer spending levels and mall customer traffic in general. The ongoing slowdown in the United States economy and uncertain economic outlook could continue to cause lower consumer spending levels and mall customer traffic which could adversely affect our sales results and financial performance. In addition, we are highly dependent on a significant level of teenage and college-age spending on music/pop culture-licensed and music/pop culture-influenced products, and we likely would be adversely affected if economic conditions limited such spending.
War, terrorism and other catastrophes could negatively impact our customers, places where we do business and our expenses
The continued threat of terrorism, heightened security and military action in response to this threat, any future acts of terrorism, and significant natural disasters or other catastrophic events may cause disruptions and create uncertainties that affect our business. To the extent that such disruptions or uncertainties negatively impact shopping patterns and/or shopping 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. A significant natural disaster or other catastrophic event affecting our facilities could materially affect our supply chain, our information system and other aspects of our operations.
Our stock price could fluctuate substantially for reasons outside of our control
Our common stock is quoted on the Nasdaq Stock 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, music 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, including the global economic downturn; the condition of the financial markets, including the credit crisis; and other events or factors outside of our control could cause our stock price to fluctuate substantially.
Environmental risks associated with the retail industry may result in significant costs and decreased sales
We are exposed to risks arising out of environmental matters and existing and potential laws relating to the protection of the environment. Adverse and unexpected weather conditions, including such conditions caused by the global climate change phenomena, could affect our supply chain, mall traffic and customer interest in our products. We receive apparel and other merchandise from foreign sources, both purchased directly in foreign markets and indirectly through domestic vendors with foreign sources. Stricter global and domestic greenhouse gas emission requirements may cause our vendors to incur higher costs, including increased transportation costs. There is a risk that we may occupy retail space that may require remediation to comply with environmental laws. In addition to potential liability for remediation costs, the cleanup process may cause our stores to be closed for an extended period of time, resulting in loss of sales.
We lease all of our existing store locations, with lease terms expiring between 2012 and 2022. As of the end of fiscal 2011, we had a total of approximately 1,112,000 leased store square feet for Hot Topic and approximately 369,000 leased store square feet for Torrid. The leases for most of the existing stores are for approximately ten-year terms and provide for minimum rent payments as well as contingent rent based upon a percent of sales in excess of the specified minimums.
We lease our headquarters and distribution center facility, located in City of Industry, California, which is approximately 250,000 square feet. Our lease expires in April 2014, with an option to renew for two more five-year terms, and the annual base rent is approximately $1.1 million. We own our distribution center in LaVergne, Tennessee, which is approximately 300,000 square feet.
The following chart shows, as of the end of fiscal 2011, the number of Hot Topic and Torrid stores operated within each state in the United States, Puerto Rico and Canada, as well as the aggregate number of Hot Topic and Torrid stores we operated as of the end of fiscal 2010:
Our legal proceedings are discussed in more detail in “NOTE 9 – Commitments and Contingencies” contained in the consolidated financial statements and notes included elsewhere in this annual report on Form 10-K.
Our common stock is traded on the Nasdaq Stock Market under the symbol “HOTT.” The following table shows, for the periods indicated, the high and low sales prices of our shares of common stock, as reported on the Nasdaq Stock Market. Such quotations represent inter-dealer prices without retail markup, markdown or commission and may not necessarily represent actual transactions.
On March 15, 2012, the last sales price of our common stock as reported on the Nasdaq Stock Market was $9.89 per share. As of March 15, 2012, there were approximately 173 holders of record of our common stock. This number does not reflect the actual number of beneficial holders of our common stock, which we believe is significantly higher.
Share Repurchase On August 17, 2011, we announced that our Board approved the repurchase of up to $25 million of our outstanding common stock during the period ended January 28, 2012. As of January 28, 2012, we had completed the repurchase of 3,212,628 shares of our common stock for approximately $25 million (excluding expenses), which represents an average price of $7.78 per share.
The following table contains information regarding repurchases of our common stock during the fourth quarter of fiscal 2011:
We began to pay cash dividends during the first quarter of fiscal 2010. Cash dividends are discussed in more detail in “NOTE 4 – Cash Dividends” contained in the consolidated financial statements and notes included elsewhere in this annual report on Form 10-K.
Please see “Item 12 – Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters” included elsewhere in this annual report on Form 10-K for information about our equity compensation plans.
Performance Measurement Comparison
The material in this section is not “soliciting material,” is not deemed “filed” with the SEC, and is not to be incorporated by reference into any filing of Hot Topic under the Securities Act or the Exchange Act.
The following graph shows a comparison of five-year cumulative total returns to shareholders for Hot Topic, the NASDAQ Composite Index and the NASDAQ Retail Trade Index for the period that commenced February 3, 2007 and ended on January 28, 2012. The graph assumes an initial investment of $100 and that all dividends have been reinvested.
The following table summarizes selected financial data for each of the five most recent fiscal years. This data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and notes included elsewhere in this annual report on Form 10-K.
The following discussion of our results of operations, financial condition and liquidity and other matters should be read in conjunction with the consolidated financial statements and notes included in “Item 8 – Financial Statements and Supplementary Data” elsewhere in this annual report on Form 10-K. These statements have been prepared in conformity with accounting principles generally accepted in the United States of America and require our management to make estimates and assumptions that affect amounts reported and disclosed in the financial statements and related notes. Actual results could differ from these estimates. Our ability to achieve business objectives in fiscal 2012 and beyond will be dependent on many factors, known and unknown, including those outlined in the sections entitled “Cautionary Statement Regarding Forward Looking Disclosure” before Part I and “Item 1A – Risk Factors” included elsewhere in this annual report on Form 10-K.
Business We are a mall and web-based specialty retailer of apparel, accessories, music and gift items for young men and women whose lifestyles reflect a passion for music, fashion and pop culture. We operate under two concepts: Hot Topic and Torrid. Our business is discussed in more detail in “Item 1 – Business” included elsewhere in this annual report on Form 10-K.
Strategic Business Changes We recently completed the implementation of all planned initiatives related to the strategic business changes approved by the Board in fiscal 2011 to improve our operating results and to better position us for growth. The business changes involved discontinuing the operations of ShockHound; writing down inventory; writing down property and equipment that are no longer critical to our strategic direction; and implementing other strategic business and operational initiatives. As of the end of the second quarter of fiscal 2011, we had incurred all charges related to the strategic business changes.
Cost Reduction Plan We have completed the implementation of a cost reduction plan that, beginning in fiscal 2011, is expected to result in an estimated annual income improvement of approximately $13 million, pre-tax. The cost reduction plan, which was designed to meet the challenges of the environment at that time, involved closing approximately 50 underperforming stores, a majority of which closed at the end of the first quarter of fiscal 2011. These closures occurred as a result of natural lease expirations, exercising lease kick out clauses and other negotiations. The cost reduction plan also included reducing our home office and field management positions, reducing planned capital expenditures in fiscal 2011 to approximately $25 million from $31 million in fiscal 2010 and implementing other non-payroll overhead expense reduction initiatives. As of the end of the second quarter of fiscal 2011, we had recorded all charges related to the cost reduction plan, completed the announced reduction of our home office and field management positions, and completed the implementation of non-payroll overhead expense reduction initiatives as part of the cost reduction plan. As of the end of fiscal 2011, we had closed 38 Hot Topic stores and six Torrid stores as part of the plan.
The following table details charges related to the strategic business changes and the cost reduction plan recorded since their implementation in the first quarter of fiscal 2011 and the fourth quarter of fiscal 2010, respectively (in thousands).
1 Store related closure costs represent charges related to the closure of approximately 50 underperforming stores. Such charges include the write down and accelerated depreciation of store assets, the write down of inventory, early lease terminations and store severance, partially offset by certain credits and allowances.
2 Inventory and asset-related costs represent charges related to the write down and impairment of inventory and non-critical property and equipment.
We recorded charges related to store closures; write down of assets; store severance; non-store related severance and outplacement; consulting fees and stock option expense in selling, general and administrative expenses in our consolidated statements of operations. Charges related to the write down of store inventory; accelerated depreciation of store assets; and early lease terminations were recorded in cost of goods sold in our consolidated statements of operations.
Non-Cash Impairment Charge and Discontinued Operations During the third quarter of fiscal 2010, we concluded that ShockHound’s assets had become impaired due to its slower than expected revenue growth. Revenues from partnerships entered into in the earlier part of fiscal 2010, as well as other revenues, did not build as much as we had anticipated. In the third quarter of fiscal 2010, we recorded an impairment charge of approximately $3 million to selling, general and administrative expenses in our consolidated statements of operations. The assessment of our long-lived assets for impairment is discussed in more detail in “NOTE 1 – Organization and Summary of Significant Accounting Policies” contained in the financial statements and notes included elsewhere in this annual report on Form 10-K. In addition, during the second quarter of fiscal 2011, ShockHound’s operations were discontinued. See “Strategic Business Changes” above for more information concerning the discontinuation of ShockHound’s operations.
Comparable Store Sales and Store Count We consider a store comparable after it has been open for 15 full fiscal months. If a store is closed during a fiscal year, it is only included in the computation of comparable store sales for full fiscal months in which it was open. Partial fiscal months are excluded from the computation of comparable store sales. The following table shows our comparable store sales results by division for fiscal 2011 and other recent periods:
In fiscal 2011, the comparable store sales increase in the Hot Topic division resulted from an increase in fashion apparel, music and license categories, partially offset by a decrease in the fashion accessories category. The comparable store sales increase at our Torrid division was due to an increase in apparel, primarily dresses, partially offset by a decrease in the accessories category.
Our historical and planned store count, as well as the number of stores included in the comparable store base, is discussed in more detail in “Item 1 – Business” included elsewhere in this annual report on Form 10-K.
Share Repurchase Our recent share repurchase activity is discussed in more detail in “NOTE 12 – Share Repurchase” contained in the consolidated financial statements and notes included elsewhere in this annual report on Form 10-K.
Cash Dividends We began to pay cash dividends during the first quarter of fiscal 2010. Cash dividends are discussed in more detail in “NOTE 4 – Cash Dividends” contained in the consolidated financial statements and notes included elsewhere in this annual report on Form 10-K.
Segment Information We currently have one reportable segment given the similarities of the economic characteristics among the Hot Topic and Torrid concepts.
Seasonality Our business, particularly at Hot Topic, is subject to seasonal influences. Refer to “Item 1 – Business” included elsewhere in this annual report on Form 10-K for further discussion about the seasonality of our business.
Key Performance Indicators There are several key indicators that we use to help us evaluate the financial condition and operating performance of our business, including:
Store Sales Productivity is used to assess the operational performance of each of our stores. Store productivity metrics include year over year store sales comparisons (or comparable store sales results), net store sales per average square foot, number of transactions per store, dollars per transaction, number of units sold per store and number of units per transaction.
Merchandise Margin is used to allocate a variety of resources to each of our concepts, determine initial mark-ups, mark-downs, inventory reserves, freight costs, etc. for both concepts and to measure the general performance of each of our stores. We consider merchandise margin to be the difference between net sales and certain costs associated with our merchandise, such as product costs, markdowns, freight, vendor allowances and inventory reserves.
Gross Margin is the difference between merchandise margin and buying, distribution and store occupancy costs.
Income from Operations is primarily driven by net sales, gross margin, our ability to control selling, general and administrative expenses, and our level of capital expenditures that affect depreciation expense.
Results of Operations
The following discussion of our results of operations, financial condition and liquidity and other matters should be read in conjunction with our consolidated financial statements and notes included elsewhere in this annual report on Form 10-K.
The following table shows, for the periods indicated, certain selected statement of operations data expressed as a percentage of net sales. The discussion that follows should be read in conjunction with this table:
Fiscal 2011 Compared to Fiscal 2010
Net sales decreased approximately $10.3 million, or 1.5%, to $697.9 million in fiscal 2011 from $708.2 million in fiscal 2010. The components of this $10.3 million decrease in net sales are as follows:
Gross margin decreased approximately $0.4 million, or 0.2%, to $232.9 million in fiscal 2011 from $233.3 million in fiscal 2010. As a percentage of net sales, gross margin increased to 33.4% in fiscal 2011 from 32.9% in fiscal 2010. The components of this 0.5 percentage point increase in gross margin as a percentage of net sales are as follows:
Selling, general and administrative expenses decreased approximately $10.8 million, or 4.4%, to $236.3 million in fiscal 2011 from $247.1 million in fiscal 2010. As a percentage of net sales, selling, general and administrative expenses were 33.9% in fiscal 2011 compared to 34.9% in fiscal 2010. The components of this 1.0 percentage point decrease in selling, general and administrative expenses as a percentage of net sales are as follows:
Loss from operations decreased approximately $10.3 million to $3.5 million in fiscal 2011 from $13.8 million in fiscal 2010. As a percentage of net sales, loss from operations was 0.5% in fiscal 2011 compared to 2.0% in fiscal 2010. Operating loss on an average store basis was approximately $4,000 in fiscal 2011 compared to $17,000 in fiscal 2010. Net loss included net losses from our ShockHound concept of $0.3 million, or $0.01 per share, in fiscal 2011 compared to $4.1 million, or $0.09 per share, in fiscal 2010.
As a percentage of net sales, other interest and income, net, was immaterial in fiscal 2011 and 0.1% in 2010.
Our effective tax rate was 42.2% and 38.7% in fiscal 2011 and 2010, respectively. The increase was primarily due to a change in the liability associated with unrecognized tax benefits and higher state income tax.
Fiscal 2010 Compared to Fiscal 2009
Net sales decreased approximately $28.5 million, or 3.9%, to $708.2 million in fiscal 2010 from $736.7 million in fiscal 2009. The components of this $28.5 million decrease in net sales are as follows:
Gross margin decreased approximately $23.0 million, or 9.0%, to $233.3 million in fiscal 2010 from $256.3 million in fiscal 2009. As a percentage of net sales, gross margin decreased to 32.9% in fiscal 2010 from 34.8% in fiscal 2009. The components of this 1.9 percentage point decrease in gross margin as a percentage of net sales are as follows:
Selling, general and administrative expenses increased approximately $10.1 million, or 4.3%, to $247.1 million in fiscal 2010 from $237.0 million in fiscal 2009. As a percentage of net sales, selling, general and administrative expenses were 34.9% in fiscal 2010 compared to 32.2% in fiscal 2009. The components of this 2.7 percentage point increase in selling, general and administrative expenses as a percentage of net sales are as follows:
Loss from operations was $13.8 million in fiscal 2010 compared to income of $19.2 million in fiscal 2009. As a percentage of net sales, loss from operations was 2.0% in fiscal 2010 compared to income of 2.6% in fiscal 2009. Operating loss on an average store basis was approximately $17,000 in fiscal 2010 compared to operating income of $23,000 in fiscal 2009. Net loss included net losses from our ShockHound concept of $4.1 million, or $0.09 per share, in fiscal 2010 compared to $3.1 million, or $0.07 per share, in fiscal 2009.
As a percentage of net sales, other interest and income, net, remained the same at 0.1% in fiscal 2010 and 2009.
Our effective tax rate was 38.7% and 39.9% in fiscal 2010 and 2009, respectively. The decrease was primarily due to lower effective state income tax rates and a decrease in the liability associated with unrecognized tax benefits.
Quarterly Results and Seasonality
Our quarterly results of operations may fluctuate materially depending on, among other things, the timing of store closings, 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, film, television and music/pop culture-related products, shifts in timing of certain holidays, changes in our merchandise mix and overall economic conditions.
Our business, particularly our Hot Topic division, is also subject to seasonal influences. Refer to “Item 1 – Business” under the caption “Seasonality” included elsewhere in this annual report on Form 10-K for further discussion about the seasonality of our business.
The following table shows certain statements of operations and selected operating data for each of our last eight fiscal quarters (13-week periods). The quarterly statements of operations data and selected operating data shown below were derived from our unaudited financial statements, which in the opinion of management contain all adjustments (consisting only of normal recurring adjustments) necessary for fair presentation. Results in any quarter are not necessarily indicative of results that may be achieved for a full year.
Liquidity and Capital Resources
During fiscal 2011, one of our primary uses of cash was to repurchase an aggregate of $25 million of our common stock (discussed in more detail in “NOTE 12 – Share Repurchase” contained in the consolidated financial statements and notes included elsewhere in this annual report on Form 10-K). We also funded cash dividend payments totaling $12.2 million during fiscal 2011 (discussed in more detail in “NOTE 4 – Cash Dividends” contained in the consolidated financial statements and notes included elsewhere in this annual report on Form 10-K). During fiscal 2011, we made a total cash outlay of approximately $7 million related to certain strategic business changes (discussed in more detail in “NOTE 2 – Recent Business Events” contained in the consolidated financial statements and notes included elsewhere in this annual report on Form 10-K). Other uses of cash during the last three fiscal years have been to purchase merchandise inventories, improve our information technology infrastructure and fund store remodels, relocations and to a lesser extent, new store openings. We have typically satisfied our cash requirements principally from cash flows from operations and we also maintain a $5 million unsecured credit agreement (discussed in more detail in “NOTE 8 – Bank Credit Agreement” contained in the consolidated financial statements and notes included elsewhere in this annual report on Form 10-K).
Cash, cash equivalents and short-term and long-term investments, including auction rate securities, held by us were $67.8 million and $79.5 million as of the end of fiscal 2011 and 2010, respectively. We believe our current cash balances and cash generated from operations will be sufficient to fund our operations through at least the next 12 months. Auctions representing the auction rate securities we hold have continued to fail and will limit our ability to liquidate these investments for some period of time. However, we do not believe the auction failures will impact our ability to fund our working capital needs, capital expenditures or other business requirements.
Working capital was $94.2 million and $113.9 million for fiscal 2011 and 2010, respectively. The $19.7 million decrease in working capital in fiscal 2011 from 2010 is primarily attributable to the $25 million repurchase of our common stock in fiscal 2011.
Net cash flows provided by operating activities were $45.9 million and $35.0 million in fiscal 2011 and 2010, respectively. The $10.9 million increase in net cash provided by operating activities in fiscal 2011 as compared to fiscal 2010 was primarily attributable to a decrease in prepaid expenses and an increase in accrued liabilities partially offset by an increase in inventory.
Net cash flows used in investing activities were $13.8 million and $45.6 million in fiscal 2011 and 2010, respectively. The $31.8 million decrease in net cash used in investing activities in fiscal 2011 as compared to fiscal 2010 was attributable to a $24.6 million decrease in purchases of short-term and long-term investments, net of proceeds and a $7.2 million decrease in purchases of property and equipment.
Net cash flows used in financing activities were $33.7 million in fiscal 2011 compared to $56 million in fiscal 2010. The decrease in net cash used in financing activities was primarily attributable to the $44.5 million in $1.00 per share special one-time cash dividends paid in fiscal 2010 and a $1.8 million increase in proceeds from stock related purchases, partially offset by the $25 million repurchase of our common stock in fiscal 2011.
We anticipate we will spend approximately $37 million on capital expenditures in fiscal 2012. Of the $37 million, we plan to spend approximately $26 million for store construction and other improvements to existing stores, including remodeling or relocating them (refer to “Item 1 – Business” included elsewhere in this annual report on Form 10-K for detail on our store expansion activity). We plan to spend the remaining capital expenditures on various improvements in our information technology infrastructure, including technological improvements at the store level and the purchase of new computer hardware and software.
The following table summarizes our contractual obligations as of the end of fiscal 2011, and the timing and effect that such commitments are expected to have on our liquidity and capital requirements in future periods:
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 “NOTE 1 – Organization and Summary of Significant Accounting Policies” contained in the consolidated financial statements and notes included elsewhere in this annual report on Form 10-K.
Inventories Inventories are valued at the lower of average cost or market, on a weighted average cost basis, using the retail method. Under the retail method, inventory is stated at its current retail selling value and then is converted to a cost basis by applying an average cost factor that represents the average cost-to-retail ratio based on beginning inventory and the purchase activity for the month. Throughout the year, we review our inventory levels in order to identify slow-moving merchandise and use permanent markdowns to sell through selected merchandise. We record a charge to cost of goods sold for permanent markdowns. Inherent in the retail method are certain significant management judgments and estimates including initial merchandise markup, future sales, markdowns and shrinkage, which significantly impact the ending inventory valuation at cost and the resulting gross margins. To the extent our estimated markdowns at period-end prove to be insufficient, additional future markdowns will need to be recorded. Physical inventories are conducted during the year to determine actual inventory on hand and shrinkage. We accrue our estimated inventory shrinkage for the period between the last physical count and current balance sheet date. Thus, the difference between actual and estimated shrink amounts may cause fluctuations in quarterly results, but not for the full fiscal year results.
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. For our Hot Topic and Torrid concepts, we group and evaluate long-lived assets for impairment at the individual store level, which is the lowest level at which individual cash flows can be identified. Factors we consider important that could trigger an impairment review of our stores or online operations include a significant underperformance relative to expected historical or projected future operating results, a significant change in the manner of the use of the asset or a significant negative industry or economic trend. When we determine that the carrying value of long-lived assets may not be recoverable based upon the existence of one or more of the aforementioned factors, impairment is measured based on a projected discounted cash flow method using a discount rate determined by management. These cash flows are calculated by netting future estimated sales against associated merchandise costs and other related expenses such as payroll, occupancy and marketing. The estimated sales, net of the aforementioned costs and expenses, used for this nonrecurring fair value measurement is considered a Level 3 input as defined in “NOTE 7 – Fair Value Measurements” contained in the consolidated financial statements and notes included elsewhere in this annual report on Form 10-K. We have recorded impairment charges in fiscal 2011 and prior years. In addition, 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 Revenue is generally recognized at our retail store locations at the point at which the customer receives and pays for the merchandise at the register. For online sales, revenue is recognized upon delivery to the customer. Sales are recognized net of merchandise returns, which are reserved for based on historical experience. Revenue from gift cards, gift certificates and store merchandise credits is recognized at the time of redemption. Shipping and handling revenues from our websites are included as a component of net 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 to 6%, 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, markdowns and pricing. Allowances received from vendors related to damaged merchandise and pricing 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 as these allowances are received after goods have been sold or marked down.
Stock-Based Payments We account for stock-based compensation expense by estimating the fair value of stock options granted, except for certain stock options granted in March 2011 that are subject to the vesting determination described in “NOTE 3 – Stock-Based Compensation” contained in the consolidated financial statements and notes included elsewhere in this annual report on Form 10-K, using the Black-Scholes option-pricing formula and a single option award approach. We estimated the fair value of the stock options granted in March 2011 that are subject to the vesting determination using a Monte Carlo simulation valuation model. Both of the option-pricing models used require the input of highly subjective assumptions, including the option’s expected life, price volatility of the underlying stock, risk free interest rate, early exercise behavior and expected dividend rate. As stock-based compensation expense is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Forfeitures are estimated based on historical experience.
Self-Insurance We are self-insured for certain losses related to medical and workers compensation claims although we maintain stop loss coverage with third party insurers to limit our total liability exposure. The estimate of our liability for these claims involves uncertainty since we must use judgment to estimate the ultimate cost that will be incurred to settle reported claims and unreported claims for incidents incurred but not reported as of the balance sheet date. When estimating our self-insurance liability, we consider a number of factors, which include historical claim experience and valuations provided by independent third party actuaries. As claims develop, the actual ultimate losses may differ from actuarial estimates. Therefore, an analysis is performed quarterly to determine if modifications to the accrual are required.
Rent Expense Rent expense under our operating leases typically provides for fixed non-contingent rent escalations. We recognize rent expense on a straight-line basis over the non-cancelable term of the lease, commencing when we take possession of the property. Construction allowances are recorded as a deferred rent liability, which we amortize as a reduction of rent expense over the non-cancelable term of each lease.
Income Taxes We account for income taxes using the liability method. Under this method, deferred tax assets and liabilities are determined based on differences between financial reporting bases and tax bases of assets and liabilities and are measured using the enacted tax rates expected to apply to taxable income in the periods in which the deferred tax asset or liability is expected to be realized or settled. Deferred tax assets are reduced by valuation allowances if we believe it is more likely than not that some portion or the entire asset will not be realized.
We prescribe a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more likely than not to be sustained upon examination by taxing authorities. The amount recognized is measured as the largest amount of benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. We include interest and penalties related to uncertain tax positions in income tax expense.
We do not believe that inflation has had a material adverse effect on our net sales or results of operations in the past. However, we cannot assure that our business will not be affected by inflation in the future.
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 and long-term investments with maturities in excess of three months. A 100 basis point change in interest rates over a three month period would not have a material impact on the fair value of our investment portfolio as of the end of fiscal 2011. Cash, cash equivalents and short-term and long-term investments, including auction rate securities, are discussed in more detail in “NOTE 1 – Organization and Summary of Significant Accounting Policies” contained in the consolidated financial statements and notes included elsewhere in this annual report on Form 10-K.
Our consolidated financial statements and notes listed in Part IV, Item 15(a)(1) are incorporated herein by reference.
Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures Our management maintains disclosure controls and procedures that are designed to ensure that the information required to be disclosed in our reports under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to management, including the Chief Executive Officer, or CEO, and Chief Financial Officer, or CFO, as appropriate, to allow timely decisions regarding required disclosure.
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 our most recent fiscal quarter. 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 Exchange Act) are effective as of the end of our most recent fiscal quarter.
Report of Management on Internal Control Over Financial Reporting Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f). Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of our assets; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of our management and directors; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of our assets that could have a material effect on the financial statements.
Our management assessed the effectiveness of our internal control over financial reporting as of the end of fiscal 2011. In making this assessment, we used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework. Our management concluded that, as of the end of fiscal 2011, our internal control over financial reporting was effective based on the criteria set forth by COSO in Internal Control-Integrated Framework.
Changes in Internal Control Over Financial Reporting 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. Ernst & Young LLP, the independent registered public accounting firm that audited the financial statements included in this Annual Report on Form 10-K, has issued an attestation report on our internal control over financial reporting.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Shareholders of Hot Topic, Inc. and subsidiaries
We have audited Hot Topic, Inc. and subsidiaries’ internal control over financial reporting as of January 28, 2012, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Hot Topic, Inc. and subsidiaries’ management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Report of Management on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, Hot Topic, Inc. and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of January 28, 2012 based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Hot Topic, Inc. and subsidiaries as of January 28, 2012 and January, 29, 2011, and the related consolidated statements of operations, shareholders' equity and comprehensive (loss) income, and cash flows for each of the three years in the period ended January 28, 2012, and our report dated March 21, 2012 expressed an unqualified opinion thereon.
On March 16, 2012, the Board, upon the recommendation of our Compensation Committee, awarded bonuses to certain of our executive officers and established the fiscal 2012 base salaries, equity grants and annual bonus plan for our executive officers.
The following table sets forth the bonus amounts awarded to certain of our named executive officers:
Ms. Harper’s bonus was a discretionary bonus awarded in recognition of her contribution to the company. Mr. Cook and Mr. McGinty’s bonuses were awarded pursuant to retention bonus agreements entered into in March 2011.
The following table sets forth the fiscal 2012 base salaries established for, and equity compensation granted to, certain of our named executive officers (as more fully described below):
Except as described in the last sentence of this paragraph, all stock options described above (i) were granted pursuant to our 2006 Equity Incentive Plan, or the 2006 Plan, as amended, (ii) terminate ten years after the date of grant, or earlier in the event the optionholder’s service to the company is terminated and (iii) have an exercise price per share of $9.69, or the closing price of our common stock as reported on the Nasdaq Stock Market for Friday, March 16, 2012. Subject to the optionholder’s continuous service to the company, 25% of the shares of common stock subject to such stock options vest on the first anniversary of the date of grant, and the remaining shares vest quarterly over the following three years. In addition to the time-based vesting condition discussed in the preceding two sentences, the vesting of Ms. Harper’s option to purchase 100,000 shares of the 350,000 shares described above is subject to an additional condition that the company achieve a defined earnings target in fiscal year 2012.
With respect to potential annual bonuses, the Compensation Committee annually establishes target profitability levels for the ensuing fiscal year in conjunction with our annual financial plan, in order to reflect the Compensation Committee’s belief that a significant portion of the annual compensation of each executive officer should be contingent upon our performance and officer contribution to that performance. Accordingly, our fiscal 2012 bonus plan provides for cash bonus targets based upon the achievement of certain specified financial goals for the fiscal year. The performance targets range from a minimum (or threshold) level to a maximum level, with a target level in between. Upon the achievement of various increasing levels of financial performance above the minimum level, varying amounts are awardable; however, the Compensation Committee may choose to recommend increasing bonuses above the original bonus targets, or to recommend awarding less than the target bonuses, or no bonuses. The financial performance targets attributable to particular executive officers are varied to align the officers’ duties with the appropriate metrics that best reflect the officers’ impact on the company and our performance.
The following table details the fiscal 2012 annual bonus performance targets attributable to certain of our named executive officers:
In addition, the Board confirmed that the target goals for fiscal 2011 set for performance share awards granted in fiscal 2009 had not been met, and therefore all such awards terminated and are of no further force or effect. The Board also confirmed that the target goals for fiscal 2010 and 2011 set for its Long-Term Cash Incentive Awards were not met and therefore all such awards terminated and are of no further force or effect.
The Board also agreed to make certain other changes to the employment agreement of Ms. Harper, eliminating her living allowance and providing for severance benefits. In the event Ms. Harper’s employment is terminated in a manner which would result in the payment of severance benefits, she would be entitled to receive one year base salary plus an amount that has a value equal to her target bonus for the year of termination, continuation of health benefits for three years, and accelerated vesting of outstanding stock options. Mr. Cook’s and Mr. Mc.Ginty’s agreements were also amended to reduce their severance and health benefit continuation from twelve months to six months.
See the section entitled “Executive Officers” in Part I, Item 1 hereof for information regarding our executive officers.
The information required by this item with respect to directors is incorporated by reference to the information appearing under the caption “Election of Directors,” contained in our Definitive Proxy Statement which will be filed with the SEC within 120 days of January 28, 2012 pursuant to Regulation 14A in connection with the solicitation of proxies for our Annual Meeting of Shareholders to be held on June 5, 2012, or the Proxy Statement.
Certain other information required by this item is incorporated by reference to the information appearing under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” in the Proxy Statement.
We have adopted Standards of Business Ethics that apply to all of our officers, directors and employees. The Standards of Business Ethics is available on our investor relations website at investorrelations.hottopic.com. If we make any substantive amendments to the Standards of Business Ethics or grant any waiver from a provision of the Standards of Business Ethics to any executive officer or director, we will promptly disclose the nature of the amendment or waiver on our website, as well as via any other means then required by Nasdaq listing standards or applicable law.
The information required by this item is incorporated by reference to the information appearing under the captions “Executive Compensation,” “Compensation Committee Report