XNAS:HOTT Quarterly Report 10-Q Filing - 7/28/2012

Effective Date 7/28/2012

 

 
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549

FORM 10-Q

(Mark One)
[X]    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended July 28, 2012

OR

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

For the transition period from _______ to _______

Commission file number:  0-28784

HOT TOPIC, INC.
(Exact name of registrant as specified in its charter)

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

(626) 839-4681
(Registrant’s telephone number, including area code)

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

Large accelerated filer  o
 Accelerated filer  x
   
Non-accelerated filer    o (Do not check if a smaller reporting company)
 Smaller reporting company  o
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange
Act).
 Yes o                      No   x
 
Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date:  August 16, 2012  – 42,282,382 shares of common stock, no par value.
 
 
1

 
 
HOT TOPIC, INC.
INDEX TO FORM 10-Q

 
.
Page
No.
PART I.  FINANCIAL INFORMATION
     
 
   
3
   
4
   
5
   
6
     
20
     
33
     
33
     
PART II.  OTHER INFORMATION
     
33
     
34
     
44
     
45
 
 
2

 
 
PART I. FINANCIAL INFORMATION
                         
Item 1. Condensed Consolidated Financial Statements
                         
Hot Topic, Inc. and Subsidiaries
Consolidated Statements of Operations and Comprehensive (Loss) Income
(In thousands, except per share amounts)
(Unaudited)
                         
   
Three Months Ended
   
Six Months Ended
 
   
July 28, 2012
   
July 30, 2011
   
July 28, 2012
   
July 30, 2011
 
                         
Net sales
  $ 157,828     $ 150,950     $ 329,372     $ 312,223  
Cost of goods sold, including buying,
                               
  distribution and occupancy costs
    103,977       102,288       213,836       213,152  
Gross margin
    53,851       48,662       115,536       99,071  
                                 
Selling, general and administrative expenses
    55,091       58,760       110,694       121,558  
(Loss) income from operations
    (1,240 )     (10,098 )     4,842       (22,487 )
                                 
Interest and other (expense) income, net
    (6 )     82       56       134  
(Loss) income before (benefit) provision for
                         
  income taxes
    (1,246 )     (10,016 )     4,898       (22,353 )
                                 
(Benefit) provision for income taxes
    (478 )     (3,796 )     1,831       (8,472 )
Net (loss) income
  $ (768 )   $ (6,220 )   $ 3,067     $ (13,881 )
                                 
(Loss) earnings per share:
                               
Basic
  $ (0.02 )   $ (0.14 )   $ 0.07     $ (0.31 )
Diluted
  $ (0.02 )   $ (0.14 )   $ 0.07     $ (0.31 )
                                 
Cash dividends declared and paid per share
  $ 0.08     $ 0.07     $ 0.16     $ 0.14  
                                 
Shares used in computing (loss) earnings per share:
                         
Basic
    42,252       44,843       42,196       44,778  
Diluted
    42,252       44,843       42,915       44,778  
                                 
Comprehensive  (loss) income:
                               
Net (loss) income
  $ (768 )   $ (6,220 )   $ 3,067     $ (13,881 )
Other comprehensive (loss) income:
                               
                                 
Foreign currency translation adjustment
    (34 )     25       (92 )     1  
Unrealized gain (loss) on short-term and
long-term  investments, net of taxes of $2
and $26 for the six-month periods
    7       (22 )     5       68  
Total other comprehensive (loss) income
    (27 )     3       (87 )     69  
Comprehensive (loss) income
  $ (795 )   $ (6,217 )   $ 2,980     $ (13,812 )
 
See accompanying Notes to Condensed Consolidated Financial Statements.
 
 
3

 
 
Hot Topic, Inc. and Subsidiaries
Consolidated Balance Sheets
(In thousands, except share amounts)
             
   
July 28, 2012
   
January 28, 2012
 
   
(Unaudited)
       
Assets
           
Current assets:
           
Cash and cash equivalents
  $ 51,575     $ 49,615  
Short-term investments
    12,068       16,503  
Inventory
    80,239       70,800  
Prepaid expenses and other
    16,006       17,474  
Deferred tax assets
    5,706       5,953  
Total current assets
    165,594       160,345  
                 
Property and equipment, net
    106,863       105,790  
Deposits and other
    7,165       7,002  
Long-term investments
    1,724       1,722  
Deferred tax assets
    3,900       3,104  
Total assets
  $ 285,246     $ 277,963  
                 
Liabilities and shareholders’ equity
               
Current liabilities:
               
Accounts payable
  $ 34,051     $ 23,828  
Accrued liabilities
    42,736       44,253  
Income taxes payable
    1,350       171  
Total current liabilities
    78,137       68,252  
                 
Deferred rent and other
    19,217       20,486  
Income taxes payable
    593       1,812  
Deferred compensation
    4,596       4,410  
                 
Commitments and contingencies
               
                 
Shareholders’ equity:
               
Preferred shares, no par value; 10,000,000 shares
               
authorized; no shares issued and outstanding
    -       -  
Common shares, no par value; 150,000,000 shares authorized;
               
42,282,382 and 42,047,991 shares issued and
               
outstanding at July 28, 2012 and January 28, 2012, respectively
    132,836       129,354  
Retained earnings
    50,171       53,866  
Accumulated other comprehensive loss
    (304 )     (217 )
Total shareholders’ equity
    182,703       183,003  
Total liabilities and shareholders’ equity
  $ 285,246     $ 277,963  
 
See accompanying Notes to Condensed Consolidated Financial Statements.
 
 
4

 
 
Hot Topic, Inc. and Subsidiaries
Consolidated Statements of Cash Flows
(In thousands)
(Unaudited)
   
Six Months Ended
 
   
July 28, 2012
   
July 30, 2011
 
OPERATING ACTIVITIES
           
Net income (loss)
  $ 3,067     $ (13,881 )
Adjustments to reconcile net income (loss) to net cash provided by
               
operating activities:
               
Depreciation and amortization
    16,941       18,217  
Stock-based compensation
    2,068       2,724  
Loss on disposal of property and equipment
    954       2,507  
Impairment of long-lived assets
    509       1,861  
Deferred taxes
    (794 )     (1,171 )
Gift card breakage
    (261 )     (249 )
Changes in operating assets and liabilities:
               
Inventory
    (9,594 )     (2,681 )
Prepaid expenses and other current assets
    1,468       (7,318 )
Deposits and other assets
    (163 )     (291 )
Accounts payable
    10,224       13,258  
Accrued liabilities
    (888 )     2,733  
Deferred rent and other
    (1,269 )     (3,690 )
Income taxes payable
    (40 )     (3 )
Foreign currency translation gain
    63       -  
Net cash provided by operating activities
    22,285       12,016  
                 
INVESTING ACTIVITIES
               
Purchases of property and equipment
    (19,491 )     (12,102 )
Proceeds from sale of short-term and long-term investments, net of purchases
    4,435       10,974  
Net cash used in investing activities
    (15,056 )     (1,128 )
                 
FINANCING ACTIVITIES
               
Excess tax benefit from stock-based compensation
    421       194  
Proceeds from employee stock purchases and exercise of stock options
    1,073       1,111  
Payment of capital lease obligation
    -       (191 )
Payment of cash dividends
    (6,762 )     (6,278 )
Net cash used in financing activities
    (5,268 )     (5,164 )
Increase in cash and cash equivalents
    1,961       5,724  
Effect of foreign currency exchange rate changes on cash
    (1 )     (35 )
Cash and cash equivalents at beginning of period
    49,615       51,316  
Cash and cash equivalents at end of period
  $ 51,575     $ 57,005  
                 
SUPPLEMENTAL INFORMATION
               
Cash paid during the period for interest
  $ 1     $ 10  
Cash paid (received) during the period for income taxes
  $ 2,219     $ (900 )
 
See accompanying Notes to Condensed Consolidated Financial Statements.
 
 
5

 
 
HOT TOPIC, INC. and SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

NOTE 1.  Organization and Basis of Presentation

Description of 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.  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.  At our Hot Topic stores and 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, designed to appeal to young men and women.  We also sell a limited assortment of music CDs and DVDs at Hot Topic.  At our Torrid stores and on our website torrid.com, we sell on-trend fashion apparel, lingerie and accessories inspired by and designed to fit the young, voluptuous woman who wears a size 12 and up.  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 and opened our first Hot Topic store the following year in fiscal 1989.  We opened our first Torrid store in fiscal 2001.  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 – Business Events” for more information concerning the discontinuation of ShockHound’s operations.
 
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.
 
Fiscal Year  Our fiscal year ends on the Saturday nearest to January 31.  References to the second quarter of fiscal 2012 and 2011 refer to the thirteen week periods ended July 28, 2012 and July 30, 2011, respectively.  References to fiscal 2012 refer to the 53-week period ending February 2, 2013.  References to fiscal 2011, 2010 and 2009 refer to the 52-week periods ended January 28, 2012, January 29, 2011, and January 30, 2010, respectively.  Fiscal 2013 refers to the 52-week period ending February 1, 2014.
 
Segment Information We currently have one reportable segment given the similarities of the economic characteristics between the Hot Topic and Torrid concepts.
 
Interim Financial Information  The information set forth in these condensed consolidated financial statements is unaudited except for the January 28, 2012 consolidated balance sheet data.  These statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information, the instructions to Form 10-Q, and Rule 10-01 of Regulation S-X.  Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements.  These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and accompanying notes included in our Annual Report on Form 10-K filed on March 21, 2012.
 
In the opinion of management, all adjustments necessary for a fair presentation have been included in these condensed consolidated financial statements.
 
 
6

 
 
NOTE 2.  Business Events

Strategic Business Changes  In March 2011, our Board of Directors, or the Board, approved certain strategic business changes to better position the company for growth.  The business changes involved discontinuing the operations of ShockHound; writing down inventory due to a change in management’s inventory strategy; 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 recorded all charges related to the strategic business changes.

Cost Reduction Plan  In November 2010, our Board approved a cost reduction plan, designed to meet the challenges of the environment at that time, which involved closing approximately 50 underperforming stores, a majority of which closed by 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 relative to 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 the second quarter of fiscal 2012, we had closed all underperforming stores related to the cost reduction plan, totaling 41 Hot Topic stores and seven Torrid stores.

The following table details charges related to the strategic business changes and cost reduction plan recorded since their implementation in the first quarter of fiscal 2011 and the fourth quarter of fiscal 2010, respectively, (in thousands).

 
7

 
 
         
Non-Store Related
                         
         
Severance and
   
Inventory and
                   
   
Store Related
   
Outplacement
   
Asset-Related
   
Consulting
   
Stock Option
       
   
Closure Costs 1
   
Costs
   
Costs 2
   
Fees
   
Expense
   
Total
 
Balance at October 30, 2010
  $ -     $ -     $ -     $ -     $ -     $ -  
Cost Reduction Plan charges
    (7,077 )     (1,850 )     (830 )     -       -       (9,757 )
Cash payments
    93       985       -       -       -       1,078  
Non-cash adjustments
    6,497       -       830       -       -       7,327  
Balance at January 29, 2011
    (487 )     (865 )     -       -       -       (1,352 )
Cost Reduction Plan recovery
    365       -       -       -       -       365  
Strategic Business Changes charges
    -       (1,583 )     (9,605 )     (1,606 )     -       (12,794 )
Cash payments
    699       889       -       1,645       -       3,233  
Non-cash adjustments
    (659 )     -       4,891       -       -       4,232  
Balance at April 30, 2011
    (82 )     (1,559 )     (4,714 )     39       -       (6,316 )
Cost Reduction Plan recovery
    174       -       -       -       -       174  
Strategic Business Changes charges
    -       (1,330 )     (532 )     (1,383 )     (1,072 )     (4,317 )
Cash payments
    144       812       182       753       -       1,891  
Non-cash adjustments
    (455 )     -       4,866       -       1,072       5,483  
Balance at July 30, 2011
    (219 )     (2,077 )     (198 )     (591 )     -       (3,085 )
Cash payments
    197       464       -       473       -       1,134  
Non-cash adjustments
    22       (43 )     18       20       -       17  
Balance at October 29, 2011
    -       (1,656 )     (180 )     (98 )     -       (1,934 )
Cash payments
    -       682       20       -       -       702  
Non-cash adjustments
    -       -       75       -       -       75  
Balance at January 28, 2012
    -       (974 )     (85 )     (98 )     -       (1,157 )
Cash payments
    -       476       -       -       -       476  
Non-cash adjustments
    -       17       68       98       -       183  
Balance at April 28, 2012
    -       (481 )     (17 )     -       -       (498 )
Cash payments
    -       318       -       -       -       318  
Non-cash adjustments
    -       23       17       -       -       40  
Balance at July 28, 2012
  $ -     $ (140 )   $ -     $ -     $ -     $ (140 )
                                                 
 

1 Store related closure costs represent charges for 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.
 
Discontinued Operations  During the second quarter of fiscal 2011, due to its slower than expected revenue growth, ShockHound’s operations were discontinued.  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.  See “Strategic Business Changes” above for more information concerning the discontinuation of ShockHound’s operations.
 
 
8

 
 
NOTE 3.  Stock-Based Compensation

Stock Plan Activity
Under our 1996 Equity Incentive Plan, or the 1996 Plan, we granted stock options, stock bonuses and other awards to our employees, directors and consultants as deemed appropriate by the Board.  Options granted were subject to different vesting terms as determined by the Board and the maximum term of options granted was 10 years.  On June 14, 2006, the 1996 Plan expired and was replaced with the 2006 Equity Incentive Plan, or the 2006 Plan.  Upon the expiration of the 1996 Plan, no shares had been granted to consultants and 732,456 shares out of an aggregate of 18,300,000 shares of common stock were authorized and available for grant.

Under our 2006 Plan, we granted stock options, stock bonuses and other awards to our employees, directors and consultants as deemed appropriate by the Board.  Options granted were subject to different vesting terms as determined by the Board and the maximum term of options granted was 10 years.  On June 5, 2012, the 2006 Plan was terminated and replaced with the 2012 Equity Incentive Plan, or the 2012 Plan.  The 2012 Plan was approved by the Board on March 16, 2012 and by our shareholders on June 5, 2012.  Upon the termination of the 2006 Plan, no shares had been granted to consultants, except for the independent consulting services provided by Lisa Harper in February 2011 and by an independent consultant in April 2012.  There were 942,602 shares out of an aggregate of 3,082,456 shares of common stock authorized and available for grant upon the termination of the 2006 Plan.

The 2012 Plan provides for the grant of incentive stock options, non-statutory stock options, restricted stock awards, restricted stock unit awards, stock appreciation rights, performance stock awards and other forms of equity compensation to our employees, consultants and directors as deemed appropriate by the Board.  Both incentive and non-statutory stock options granted by us under the 2012 Plan must carry an exercise price of at least 100% of the fair market value of our common stock on the date of grant.  Incentive stock options must carry an exercise price of at least 110% of the fair market value of our common stock on the date of grant for persons possessing 10% or more of the total combined voting power of all classes of stock.  Options granted may be subject to different vesting terms as determined by the Board and the maximum term of options granted is 8 years.  In addition, the maximum number of shares of common stock available for future issuance may not exceed the sum of (a) 942,602 and 34,976 shares of common stock remaining available for issuance under the 2006 Plan and the 1996 Non-Employee Directors’ Stock Option Plan, or the 1996 NEDSOP, respectively, as of June 5, 2012, (b) an additional 3,100,000 shares and (c) the number of shares subject to stock awards as of June 5, 2012 under the 2006 Plan and the 1996 NEDSOP pursuant to the terms of the 2006 Plan and the 1996 NEDSOP.  As of the end of the second quarter of fiscal 2012, 3,856,736 shares were available for future grants under the 2012 Plan.  All awards to date under the 2012 Plan have been granted to our employees and directors, and none have been granted to consultants.
 
Under the 1996 NEDSOP, we granted stock options to non-employee directors.  Options granted were subject to different vesting terms as determined by the Board and the maximum term of options granted was 10 years.  On June 5, 2012, the 1996 NEDSOP was terminated.  Upon the termination of the 1996 NEDSOP, no shares had been granted to anyone for their role as a consultant to the company and 34,976 shares out of an aggregate of 720,000 shares of common stock were authorized and available for grant.
 
 
9

 
 
In June 1996, the Board adopted the Employee Stock Purchase Plan, or the Stock Purchase Plan.   The Stock Purchase Plan provides for the issuance of up to 1,350,000 shares of common stock to our employees.  All eligible employees are granted identical rights to purchase common stock for each Board authorized offering under the Stock Purchase Plan.  Rights granted pursuant to any offering under the Stock Purchase Plan terminate immediately upon cessation of an employee’s employment for any reason.  In general, an employee may reduce their contribution or withdraw from participation in an offering at any time during the purchase period for such offering.  Employees receive a 15% discount on shares purchased under the Stock Purchase Plan.  Rights granted under the Stock Purchase Plan are not transferable and may be exercised only by the person to whom such rights are granted.  The initial offering under the Stock Purchase Plan commenced October 24, 1996 and terminated December 31, 1996.  Subsequent offerings have occurred every six months commencing January 1, 1997.  As of the end of the second quarter of fiscal 2012, 692,372 shares could still be sold to employees under the Stock Purchase Plan.  Compensation expense for the second quarter of fiscal 2012 and 2011 was $42,000 and $39,000, respectively, related to the fair value of the rights granted to participants under the plan.  During fiscal year-to-date 2012 and 2011, $84,000 and $78,000, respectively, was expensed.

In June 2012, we granted non-employee directors an aggregate of 21,008 shares of restricted common stock under the 2012 Plan.  In March 2012 and June 2011, we granted non-employee directors an aggregate of 515 and 25,387 shares of restricted common stock, respectively, under the 2006 Plan.  Restricted shares generally vest in one installment in the year subsequent to the grant year.  All awarded common shares remain restricted (i.e., not transferable by the holders) until such time as the recipient is no longer a member of our Board.  The value of these grants is expensed over the vesting period.  During the second quarter of fiscal 2012 and 2011, $50,000 and $47,000, respectively, was expensed.  During the fiscal year-to-date 2012 and 2011, $99,000 and $99,000, respectively, was expensed.

In April 2012, we granted an independent consultant 2,525 shares of restricted common stock under the 2006 Plan.  This grant was substantially similar to the restricted common stock granted to non-employee directors described above except that vesting shall occur in full after providing six months of continuous service to the company.  A charge of $13,000 and $17,000 was expensed for this grant during the second quarter of fiscal 2012 and fiscal year-to-date 2012, respectively.

In March 2012, we granted Lisa Harper an option to purchase 100,000 shares of our common stock under the 2006 Plan.  This 100,000 share option is subject to a service condition as well as a performance condition that the company achieves a defined earnings target in fiscal year 2012, which will be certified by the Compensation Committee of the Board during the first quarter of fiscal 2013.

In March 2011, in connection with her appointment as Chief Executive Officer, we granted Lisa Harper an option to purchase 500,000 shares of our common stock under the 2006 Plan.  This 500,000 share option vests only upon a vesting determination by the Compensation Committee of the Board.  The option will terminate on the day following the third anniversary of the date of grant if the vesting determination has not been made.   The vesting determination shall be made at any time on or before the third anniversary of the date of grant when the Compensation Committee of the Board certifies that the weighted average per share closing price of the company’s common stock for any trailing 90 trading days equals or exceeds twice the closing price per share on the date of grant.

In March 2011, we granted certain employees the option to purchase an aggregate of 440,000 shares of our common stock, net of forfeitures, under the 2006 Plan.  These share options are subject to four-year vesting, but vesting will occur in full upon the occurrence of the vesting determination described above.

In February 2011, prior to her appointment as Chief Executive Officer, we granted Lisa Harper, in her capacity as an independent consultant, 17,568 shares of restricted common stock under the 2006 Plan.  This grant was substantially similar to the restricted common stock granted to non-employee directors described above.  The total charge of $98,000 was expensed for this grant during the first quarter of fiscal 2011.
 
 
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In March 2009, we granted performance stock awards under the 2006 plan to certain members of our management.  These 2009 awards provided for the issuance of up to 100,000 shares of our common stock, net of forfeitures, with vesting and issuance contingent upon achieving a performance goal for fiscal 2011, based upon our operating income for that fiscal year; and prior to vesting (or termination without vesting), the awards constituted an agreement by us to issue shares to the extent this performance goal was ultimately met.  The market value of our common stock as of the 2009 grant date of these performance stock awards was $9.56.  Compensation expense for these awards was required to be recorded over the three-year terms of the awards, based on the market values as of the grant dates, with actual amounts expensed dependent upon the likelihood from period to period of vesting of these awards at the end of fiscal 2011.  In March 2012, the Board confirmed that the target performance goal for fiscal 2011 had not been met, and therefore all such awards terminated without vesting or issuance of the underlying shares.  We did not recognize any compensation expense for these 2009 awards.

The following table summarizes stock options outstanding under all of our plans as of the end of the second quarter of fiscal 2012, as well as activity during fiscal year-to-date 2012:
 
   
Options
   
Weighted-Average Exercise Price
   
Weighted-Average Remaining Contractual Term
(in years)
   
Aggregate Intrinsic Value
(in thousands)
 
Outstanding at January 28, 2012
    5,890,439     $ 9.29              
                             
Granted
    1,683,354     $ 9.68              
Exercised
    (152,501 )   $ 5.62              
Forfeited or expired
    (391,247 )   $ 13.73              
                             
Outstanding at July 28, 2012
    7,030,045     $ 9.21       7.23     $ 12,951  
                                 
Exercisable at July 28, 2012
    3,032,067     $ 11.03       5.15     $ 5,282  
 
The total fair value of shares vested during the second quarter of fiscal 2012 and 2011 is $0.6 million and $1.0 million, respectively.  The total fair value of shares vested during fiscal-year-to-date 2012 and 2011 was $1.5 and $2.3 million, respectively.

Cash proceeds, tax benefits and intrinsic values related to total stock options exercised during the second quarter of fiscal 2012 and 2011 and during fiscal year-to-date 2012 and 2011 are provided in the following table (in thousands):
 
 
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Three Months Ended
   
Six Months Ended
 
   
July 28, 2012
   
July 30, 2011
   
July 28, 2012
   
July 30, 2011
 
Proceeds from stock options exercised
  $ 208     $ 494     $ 857     $ 942  
Tax benefit related to stock options exercised
  $ 49     $ 44     $ 265     $ 88  
Intrinsic value of stock options exercised
  $ 123     $ 110     $ 663     $ 220  
 
Accounting for Stock-Based Compensation Expense  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 above, using the Black-Scholes option-pricing formula and a single option award approach.  The fair value is then amortized over the requisite vesting periods of the awards.  As stock-based compensation expense is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures.
 
We estimate the fair values of the share options granted in March 2011, that are subject to the vesting determination, using a Monte Carlo simulation valuation model.  The fair values of the options to purchase the aggregate of 440,000 shares, net of forfeitures, are amortized over the vesting period determined by this model.  The entire fair value of the 500,000 share option was recognized as compensation expense during fiscal 2011.

The effect of recording stock-based compensation for the second quarter of fiscal 2012 and 2011 and for fiscal year-to-date 2012 and 2011 was as follows (in thousands):
 
   
Three Months Ended
   
Six Months Ended
 
   
July 28, 2012
   
July 30, 2011
   
July 28, 2012
   
July 30, 2011
 
Stock-based compensation by type of award:
                       
    Employee and director stock options and awards
  $ 1,012     $ 1,824     $ 1,967     $ 2,646  
    Non-employee stock award
    13       -       17       -  
    Employee stock purchase plan
    42       39       84       78  
Total stock-based compensation expense
    1,067       1,863       2,068       2,724  
Tax effect on stock-based compensation expense
    (385 )     (711 )     (747 )     (1,019 )
Net effect on net income or loss
  $ 682     $ 1,152     $ 1,321     $ 1,705  
 
For the second quarter of fiscal 2012 and 2011, $172,000 and $105,000, respectively, of stock-based compensation expense was recorded as a component of cost of goods sold and the remainder, $0.9 million and $1.8 million, respectively, was charged to selling, general and administrative expense.

For fiscal year-to-date 2012 and 2011, $333,000 and $218,000, respectively, of stock-based compensation expense was recorded as a component of cost of goods sold and the remainder, $1.7 million and $2.5 million, respectively, was charged to selling, general and administrative expense.

As of the end of the second quarter of fiscal 2012 and 2011, we had $8.0 million and $5.1 million, respectively, of unrecognized expense related to non-vested stock option grants (with the exception of Lisa Harper’s 100,000 stock options granted in March 2012 that are subject to the performance condition, and the aggregate of 440,000 stock options granted in March 2011 that are subject to the vesting determination), which are expected to be recognized over weighted average periods of 2.87 years and 2.77 years, respectively.
 
 
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As of the end of the second quarter of fiscal 2012, we had $0.3 million of unrecognized expense related to Lisa Harper’s option to purchase 100,000 shares of our common stock granted in March 2012 that are subject to the performance condition, which is expected to be recognized over a weighted average period of 3.67 years.  This option to purchase 100,000 shares has a $3.44 weighted average fair value at grant date.

As of the end of the second quarter of fiscal 2012 and 2011, we had $0.3 million and $1.0 million, respectively, of unrecognized expense related to the options to purchase an aggregate of 440,000 shares of our common stock granted in March 2011 that are subject to the vesting determination, which is expected to be recognized over weighted average periods of 2.67 years and 3.67 years, respectively.

As of the end of the second quarter of fiscal 2012 and 2011, we had $175,000 and $150,000, respectively, of unrecognized expense related to restricted stock grants, which is expected to be recognized over weighted average periods of 0.78 and 0.72 years, respectively.

Calculation of Fair Value of Options  The Black-Scholes option valuation model used to determine the fair value of stock-based compensation for all options, except for those granted in March 2011 that are subject to the vesting determination, incorporates various assumptions including the expected term of awards, volatility of stock price, risk-free rates of return and dividend yield.  The expected term of an award is generally no less than the option vesting period and is based on our historical experience.  Expected volatility is based upon the historical volatility of our stock price.  The risk-free interest rate is approximated using rates available on U.S. Treasury securities with a remaining term equal to the option’s expected life.  The dividend yield is based on the expected dividend yield as of the date of option grant.

The following weighted average assumptions were used in the Black-Scholes option valuation model for stock options granted:
 
   
Three Months Ended
 
Six Months Ended
   
July 28, 2012
 
July 30, 2011
 
July 28, 2012
 
July 30, 2011
Risk free interest rate
    1 %     2 %     1 %     2 %
Expected life
 
5 years
 
5 years
 
5 years
 
5 years
Expected volatility
    58 %     58 %     57 %     58 %
Expected dividend yield
    3 %     4 %     4 %     5 %
                                 
Weighted average fair value at grant date (with the exception of Lisa Harper’s 100,000 stock options granted in March 2012 that are subject to the performance condition)
  $ 3.77     $ 2.68     $ 3.50     $ 2.10  
 
 
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A Monte Carlo simulation was used to determine the fair value of stock-based compensation for the stock options granted in March 2011 that are subject to the vesting determination.  This risk neutral model is based on projections of stock price paths and incorporates various assumptions including the early exercise behavior, volatility of stock price, risk-free rates of return and dividend yield.  Expected volatility is based upon the historical volatility of our stock price.  The risk-free interest rate is approximated using rates available on U.S. Treasury securities with a remaining term equal to the option’s contractual life.  The dividend yield is based on the expected dividend yield as of the date of option grant.

The following weighted average assumptions were used in the Monte Carlo simulation valuation model for the stock options granted in March 2011 that are subject to the vesting determination:

Risk free interest rate
4%
Contractual life
10 years
Expected volatility
58%
Expected dividend yield
5%
   
Weighted average fair value at grant date
$2.06
 
 
NOTE 4. Cash Dividends
 
On July 5, 2012, we announced that our Board authorized a regular quarterly cash dividend of $0.08 per share.  The $0.08 per share dividend was paid in July 2012 to shareholders of record at the close of business on July 16, 2012.  We released the funds used to pay for this regular quarterly cash dividend during the second quarter of fiscal 2012.  Our Board will determine future regular quarterly cash dividends after giving consideration to our then existing levels of profit, capital requirements, current and forecasted liquidity, as well as financial and other business conditions existing at the time.  As of the end of the second quarter of fiscal 2012 and 2011, total dividends paid in fiscal 2012 and 2011 amounted to $6.8 million and $6.3 million, respectively.
 
 
NOTE 5. (Loss) Earnings Per Share

Basic earnings or loss per share is computed by dividing net income or net loss, respectively, by the weighted average number of common shares outstanding for the period.  Diluted earnings per share is applicable only in periods of net income and is computed by dividing net income by the weighted average number of common shares outstanding for the period and potentially dilutive common stock equivalents outstanding for the period.  Periods of net loss require the diluted computation to be the same as the basic computation.  As of the end of the second quarter of fiscal 2012 and 2011, options to purchase 3.2 million and 4.0 million shares, respectively, of potentially anti-dilutive common stock equivalents were outstanding.  For fiscal year-to-date 2012 and 2011, options to purchase 3.2 million and 4.2 million shares, respectively, of potentially anti-dilutive common stock equivalents were outstanding.

A reconciliation of the numerator and denominator of basic and diluted (loss) earnings per share is as follows (in thousands, except per share amounts):
 
 
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Three Months Ended
   
Six Months Ended
 
   
July 28, 2012
   
July 30, 2011
   
July 28, 2012
   
July 30, 2011
 
Basic and diluted (loss) earnings per share computation:
                       
Numerator
  $ (768 )   $ (6,220 )   $ 3,067     $ (13,881 )
Denominator:
                               
Weighted average common shares outstanding
    42,252       44,843       42,196       44,778  
Incremental shares from assumed
exercise/issuance of options and awards
    -       -       719       -  
Total shares
    42,252       44,843       42,915       44,778  
                                 
Basic (loss) earnings per share
  $ (0.02 )   $ (0.14 )   $ 0.07     $ (0.31 )
Diluted (loss) earnings per share
  $ (0.02 )   $ (0.14 )   $ 0.07     $ (0.31 )
 
 
NOTE 6.  Short-Term and Long-Term Investments

Our short-term investments consist of highly-rated interest-bearing municipal bonds that have maturities that are less than one year and are accounted for as available for sale.  As of the end of the second quarter of fiscal 2012 and as of the end of fiscal 2011, short-term investments consisted of municipal bonds of $12.1 million and $16.5 million, respectively.  Refer to “NOTE 8 – Fair Value Measurements” for further discussion on how we determined the fair value of our short-term investments.  The associated unrealized net gains and losses in fiscal year-to-date 2012 and in the full year of fiscal 2011, respectively, were immaterial and have been recorded in the consolidated statements of comprehensive income (loss).

As of the end of the second quarter of fiscal 2012 and as of the end of fiscal 2011, our long-term investment comprised of an auction rate security.  Our auction rate security is a AAA/A3-rated debt instrument with a maturity of 25 years.  It is accounted for as available for sale and backed by pools of student loans guaranteed by the U.S. Department of Education.  Its interest rate is reset through an auction process, most commonly at intervals of approximately 4 weeks.  This same auction process is designed to provide a means by which this security can be sold and prior to 2008 had provided a liquid market for it.  There continues to be uncertainty in the global credit and capital markets, which has resulted in the failure of auctions representing the auction rate security we hold as the amount of securities submitted for sale in those auctions exceed the amount of bids.  While we have continued to earn and receive interest on our auction rate security through the date of this report, we concluded that its estimated fair value no longer approximates par value.  Due to the lack of availability of observable market quotes on our auction rate security, the fair market value of this security has been based on a valuation model using current assumptions.  Refer to “NOTE 8 – Fair Value Measurements” for further discussion on how we determined the fair value of our auction rate security investment.

As of the end of the second quarter of fiscal 2012 and as of the end of fiscal 2011, the fair value of our auction rate security remained the same at $1.7 million.  The fair value of our auction rate security as of the end of the second quarter of fiscal 2012 reflects a cumulative decline of $0.4 million from the par value.  This cumulative $0.4 million decline ($0.2 million net of tax) is deemed temporary as we have the ability to hold this security and we do not have the intent to sell it below par value.  Furthermore, it is not likely that we will be required to sell the security before the recovery of its amortized cost basis.  If uncertainties in the credit and capital markets continue, we may incur additional losses, some of which may be other-than-temporary, which could negatively affect our financial condition or results of operations.  In addition, in the event that we decide to sell this security and it becomes likely that we will be required to sell the security before the recovery of its amortized cost basis, we may be required to recognize impairment charges against income.  We have classified our auction rate security as a non-current asset on our consolidated balance sheet, as we do not expect it to successfully auction and recover its full or par value within the next 12 months.
 
 
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For the second quarter of fiscal 2012 and 2011, we recorded immaterial unrealized losses and for fiscal year-to-date 2012, we recorded immaterial unrealized gains, for our auction rate security in the consolidated statements of comprehensive income (loss).  For fiscal year-to-date 2011, we recorded unrealized gains of $0.1 million ($0.1 million net of tax).
 
 
NOTE 7.  Impact of Recently Issued Accounting Pronouncements

In May 2011, the FASB issued new guidance that results in a consistent definition of fair value and common requirements for measurement of and disclosure about fair value between U.S. GAAP and International Financial Reporting Standards, or IFRS.  The new guidance changes some fair value measurement principles and disclosure requirements under U.S. GAAP.  Several new disclosures about Level 3 measurements are required, including quantitative information about the significant unobservable inputs used in the measurement, a qualitative discussion about the sensitivity of recurring measurements to changes in the unobservable inputs disclosed and a description of the valuation processes used by us.  The new guidance was effective for interim or fiscal years beginning on or after December 15, 2011, with early adoption prohibited.  Our adoption of this new guidance on January 29, 2012 did not have a material impact on our financial condition or results of operations.

In June 2011, the FASB issued a final standard requiring entities to present net income (loss) and other comprehensive income (loss) in either a single continuous statement or in two separate, but consecutive, statements of net income (loss) and other comprehensive income (loss).  The new standard eliminates the option to present items of other comprehensive income (loss) in the statement of changes in equity.  The new requirements do not change which components of comprehensive income (loss) are recognized in net income (loss) or other comprehensive income (loss), or when an item of other comprehensive income (loss) must be reclassified to net income (loss).  Also, earnings (loss) per share computations do not change.  The new requirements were effective for interim and fiscal years beginning after December 15, 2011, with early adoption permitted.  Full retrospective application is required.  As this standard relates only to the presentation of other comprehensive income (loss), our adoption of this new guidance on January 29, 2012 did not have a material impact on our financial condition or results of operations.
 
 
NOTE 8.  Fair Value Measurements

Our financial assets and liabilities are valued at the price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants at the measurement date.  We determine fair value based on assumptions that market participants would use in pricing an asset or liability.  As a basis for considering such assumptions, we prioritize the inputs used in measuring fair value into a three-tier fair value hierarchy, which are as follows:

Level 1: Observable inputs such as quoted prices in active markets (the fair value hierarchy gives the highest priority to Level 1 inputs);

Level 2: Inputs, other than the quoted prices in active markets, that are observable either directly or indirectly; and
 
 
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Level 3: Unobservable inputs in which there is little or no market data and require the reporting entity to develop its own assumptions (the fair value hierarchy gives the lowest priority to Level 3 inputs).

Financial assets and liabilities measured at fair value on a recurring basis as of the end of the second quarter of fiscal 2012 consisted of the following (in thousands):
 
   
Balance at
July 28, 2012
   
Quoted Prices in Active Markets for Identical Items
(Level 1)
   
Significant Other Observable Inputs
(Level 2)
   
Significant Unobservable Inputs
(Level 3)
 
Assets:
                       
Money market funds (cash equivalent)
  $ 50,120     $ 50,120     $ -     $ -  
Municipal bonds (short-term)
    12,069       -       12,069       -  
Auction rate securities (long-term)
    1,724       -       -       1,724  
Total assets
  $ 63,913     $ 50,120     $ 12,069     $ 1,724  
Liabilities:
                               
Deferred compensation plan (long-term)
  $ 4,596     $ -     $ 4,596     $ -  
 
The fair value of our short-term municipal bonds is based on market prices for similar assets from third-party pricing services using observable market information.  The money market funds fair value is determined based on quoted prices in active markets.  Due to the lack of availability of observable market quotes on our auction rate securities, the fair market value of these securities has been determined based on an internal valuation model which incorporates primarily management’s own current assumptions.  The model values the securities by estimating the present value of future principal and interest payments discounted at rates considered to reflect current market conditions.  Significant assumptions used in the valuation include those made about the liquidity horizon which we currently estimate to be approximately five years and the net trading yield rate which we currently estimate to be approximately 5%.  The fair value measurement of our auction rate securities has an inverse relationship with our liquidity horizon assumption and changes in this assumption may cause the fair value to be significantly impacted.  Other factors that impact our valuation include changes to credit ratings of our auction rate securities as well as to the underlying assets supporting these securities and the ongoing strength and quality of the credit markets.  Our valuation is subject to uncertainties that are difficult to predict and could change significantly based on future market conditions.  The deferred compensation plan liability represents the amount that would be earned by participants if the funds were invested in securities traded in active markets.  The fair value of the deferred compensation plan liability is determined based on quoted prices of similar assets that are traded in observable markets.

The activity of our auction rate securities through the second quarter of fiscal 2012, whose fair value was measured using Level 3 inputs, is summarized below (in thousands):
 
 
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Non-current
 
 
Carrying value as of  January 28, 2012
  $ 1,722  
 
Total gains
       
 
Included in earnings
    -  
 
Included in other comprehensive (loss) income1
    2  
 
Carrying value as of  July 28, 2012
  $ 1,724  
 
1
Unrealized gains of $5,000 and unrealized losses $3,000 occurred during the first and second quarters of fiscal 2012, respectively.
 
 
NOTE 9.  Deferred Compensation Plan

In August 2006, we adopted the Hot Topic Inc. Management Deferred Compensation Plan, or the Deferred Compensation Plan, for the purpose of providing highly compensated employees and members of our Board a program to meet their financial planning needs.  The Deferred Compensation Plan provides participants with the opportunity to defer up to 80% of their base salary and up to 100% of their annual earned bonus, or, in the case of members of our Board, 100% of their earned cash fees, all of which, together with the associated investment returns, are 100% vested from the outset.  The Deferred Compensation Plan, which is designed to be exempt from most provisions of the Employee Retirement Security Act of 1974, is informally funded by us in order to preserve the tax-deferred savings advantages of a non-qualified plan.  As such, all deferrals and associated earnings are general unsecured obligations of Hot Topic, Inc. held within a “rabbi trust” on our consolidated balance sheet.  We may at our discretion contribute certain amounts to eligible employees’ accounts.  In January 2009, to the extent participants were ineligible to receive such contributions from participation in our 401(k) Plan, we began to contribute 50% of the first 4% of participants’ eligible contributions into their Deferred Compensation Plan accounts.  As of the end of the second quarter of fiscal 2012, assets and associated liabilities of the Deferred Compensation Plan were $4.8 million and $4.6 million, respectively, and are included in other non-current assets and non-current liabilities, respectively, in our consolidated balance sheets.  As of the end of fiscal 2011, assets and associated liabilities of the Deferred Compensation Plan were $4.7 million and $4.4 million, respectively.
 
 
NOTE 10.  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, which we currently estimate to be approximately 13%, determined by management.  These cash flows are calculated by netting future estimated sales of each store against estimated cost of goods sold, occupancy costs and other store operating expenses such as payroll, supplies, repairs and maintenance and credit/debit card fees.  The discount rate, the estimated sales and the aforementioned costs and expenses used for this nonrecurring fair value measurement are considered significant Level 3 inputs as defined in “NOTE 8 – Fair Value Measurements.”  Changes in these assumptions may cause the fair value to be significantly impacted.  In the event future 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 store impairment charges.
 
 
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For the second quarter of fiscal 2012 and 2011, we recorded store impairment charges of $0.1 million and $0.4 million, respectively, which are included in selling, general and administrative expenses in our consolidated statements of operations.  For fiscal year-to-date fiscal 2012 and 2011, we recorded store impairment charges of $0.4 million and $1.6 million, respectively.
 
 
NOTE 11.  Bank Credit Agreement

We maintain an unsecured bank credit agreement of $5.0 million that will expire on September 1, 2013.  Letters of credit, which are primarily used for inventory purchases, are issued under the credit agreement.  There were no letters of credit as of the end of the second quarter of fiscal 2012 and as of the end of fiscal 2011.
 
 
NOTE 12.  Income Taxes

As of the end of the second quarter of fiscal 2012, the total liability for income tax associated with unrecognized tax benefits consisted of tax of $1.5 million ($0.7 million net of federal benefit), interest of $0.2 million ($0.1 million net of federal benefit) and $0.1 million related to penalties.  Our effective tax rate will be affected by any portion of this liability we may recognize.  As of the end of fiscal 2011, the total liability for income tax associated with unrecognized tax benefits consisted of tax of $1.6 million ($0.7 million net of federal benefit), interest of $0.3 million ($0.2 million net of federal benefit) and $0.1 million related to penalties.
 
We believe that it is reasonably possible that our liability for unrecognized tax benefits consisting of tax of $1 million ($0.7 million net of federal benefit), interest of $0.2 million ($0.1 million net of federal benefit) and penalties of $0.1 million, may be recognized in the next 12 months due to the settlement of audits and the expiration of statutes of limitations.  As such, we have classified these amounts as current liabilities.

Our continuing practice is to recognize interest and penalties related to unrecognized tax benefits as a tax expense.  Tax expense during the second quarter of fiscal 2012 and 2011 related to interest and penalties was not material.  As of the end of the second quarter of fiscal 2012 and as of the end of fiscal 2011, we had accrued $0.3 million and $0.4 million, respectively, of interest and penalties related to uncertain tax positions.

We operate stores throughout the United States as well as in Canada and Puerto Rico, and as a result, we file income tax returns in the United States federal jurisdiction and various states, local and foreign jurisdictions.  In the normal course of business, we are subject to examination by taxing authorities.  With few exceptions, we are no longer subject to United States federal, state, local or foreign income tax examinations for years before fiscal 2007.  While it is often difficult to predict the final outcome or the timing or resolution of any particular uncertain tax position, we believe our reserves for income taxes represent the most probable outcome.  We adjust these reserves, as well as the related interest and penalties, in light of changing facts and circumstances.
 
 
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NOTE 13.  Commitments and Contingencies

From time to time, we are involved in matters of litigation that arise in the ordinary course of business.  Though significant litigation or awards against us could seriously harm our business and financial results, we do not at this time expect any of our litigation to have a material adverse effect on our overall financial condition.


NOTE 14.  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 the end of fiscal 2011, we had completed the repurchase of 3,212,628 shares of our common stock under this program for approximately $25 million (excluding expenses), which represents an average price of $7.78 per share.

On June 6, 2012, we announced that our Board approved the repurchase of up to $15 million of our outstanding common stock during the period ending February 2, 2013.  As of the end of the second quarter of fiscal 2012, we had not repurchased any shares of our common stock under this program.
 
 

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

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 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, among other places, in this Part I, Item 2 and in Part II, Item 1A under the caption “Risk Factors.”
 
 
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OVERVIEW

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 “NOTE 1 – Organization and Basis of Presentation” contained in the accompanying financial statements.

Strategic Business Changes  We have 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  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 implementation of the cost reduction plan was expected to improve annual income of approximately $13 million.  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 the second quarter of fiscal 2012, we had closed all underperforming stores related to the cost reduction plan, totaling 41 Hot Topic stores and seven Torrid stores.

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).
 
 
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Non-Store Related
                         
         
Severance and
   
Inventory and
                   
   
Store Related
   
Outplacement
   
Asset-Related
   
Consulting
   
Stock Option
       
   
Closure Costs 1
   
Costs
   
Costs 2
   
Fees
   
Expense
   
Total
 
Balance at October 30, 2010
  $ -     $ -     $ -     $ -     $ -     $ -  
Cost Reduction Plan charges
    (7,077 )     (1,850 )     (830 )     -       -       (9,757 )
Cash payments
    93       985       -       -       -       1,078  
Non-cash adjustments
    6,497       -       830       -       -       7,327  
Balance at January 29, 2011
    (487 )     (865 )     -       -       -       (1,352 )
Cost Reduction Plan recovery
    365       -       -       -       -       365  
Strategic Business Changes charges
    -       (1,583 )     (9,605 )     (1,606 )     -       (12,794 )
Cash payments
    699       889       -       1,645       -       3,233  
Non-cash adjustments
    (659 )     -       4,891       -       -       4,232  
Balance at April 30, 2011
    (82 )     (1,559 )     (4,714 )     39       -       (6,316 )
Cost Reduction Plan recovery
    174       -       -       -       -       174  
Strategic Business Changes charges
    -       (1,330 )     (532 )     (1,383 )     (1,072 )     (4,317 )
Cash payments
    144       812       182       753       -       1,891  
Non-cash adjustments
    (455 )     -       4,866       -       1,072       5,483  
Balance at July 30, 2011
    (219 )     (2,077 )     (198 )     (591 )     -       (3,085 )
Cash payments
    197       464       -       473       -       1,134  
Non-cash adjustments
    22       (43 )     18       20       -       17  
Balance at October 29, 2011
    -       (1,656 )     (180 )     (98 )     -       (1,934 )
Cash payments
    -       682       20       -       -       702  
Non-cash adjustments
    -       -       75       -       -       75  
Balance at January 28, 2012
    -       (974 )     (85 )     (98 )     -       (1,157 )
Cash payments
    -       476       -       -       -       476  
Non-cash adjustments
    -       17       68       98       -       183  
Balance at April 28, 2012
    -       (481 )     (17 )     -       -       (498 )
Cash payments
    -       318       -       -       -       318  
Non-cash adjustments
    -       23       17       -       -       40  
Balance at July 28, 2012
  $ -     $ (140 )   $ -     $ -     $ -     $ (140 )
                                                 
 
1 Store related closure costs represent charges for 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.
 
Discontinued Operations  During the second quarter of fiscal 2011, due to its slower than expected revenue growth, ShockHound’s operations were discontinued.  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.  See “Strategic Business Changes” above for more information concerning the discontinuation of ShockHound’s operations.
 
 
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Comparable 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 sales for full fiscal months in which it was open.  Partial fiscal months are excluded from the computation of comparable sales.  During the first quarter of fiscal 2012, we began including our internet sales in the computation of comparable sales.  All prior year comparable sales results have been adjusted. The following table shows our comparable sales results, including Internet, by division for the second quarter of fiscal 2012 and 2011 and fiscal year-to-date 2012 and 2011.
 
 
Comparable Sales
   
Comparable Sales
 
 % Change
   
 % Change
Second Quarter
2012
2011
 
Year-to-date
2012
2011
Hot Topic
3.9%
1.7%
 
Hot Topic
6.8%
0.4%
Torrid
4.0%
7.4%
 
Torrid
3.2%
6.9%
Total Company
3.9%
3.2%
 
Total Company
5.8%
2.1%
 
 
During the second quarter of fiscal 2012, the comparable sales increase in the Hot Topic division resulted primarily from increases in the fashion apparel and license categories, partially offset by decreases in the music and fashion accessories categories.  During the same period, the comparable sales increase in the Torrid division was due to an increase in apparel, partially offset by a decrease in accessories.

We continue to evaluate the need to close, remodel, relocate or open new stores.  The following table shows our store expansion and closure activity during the fiscal year-to-date 2012 and 2011.   Our planned store expansion and closure activity in fiscal 2012 is also reflected in the table.
 
 
 
Number of Stores
 
Actual
 
Estimate
 
Six Months Ended
 
Six Months Ended
   
 
July 28, 2012
 
July 30, 2011
 
Fiscal 2012
Hot Topic
         
Beginning of Period
628
 
657
 
628
     Open
2
 
1
 
2
     Close*
(10)
 
(22)
 
(13)
End of Period
620
 
636
 
617
Remodel/relocate
33
 
19
 
50
           
Torrid
         
Beginning of Period
148
 
153
 
148
     Open
27
 
1
 
55
     Close*
(4)
 
(9)
 
(12)
End of Period
171
 
145
 
191
Remodel/relocate
4
 
-
 
6
 
 
*Includes stores impacted by our cost reduction plan.
 
 
Share Repurchase Our recent share repurchase activity is discussed in more detail in “NOTE 14 – Share Repurchase” contained in the accompanying financial statements.
 
 
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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 accompanying financial statements.
 
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 in our annual report on Form 10-K filed on March 21, 2012, 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 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 condensed consolidated financial statements and the notes related thereto.

Three Months Ended July 28, 2012 Compared to the Three Months Ended July 30, 2011

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:

 
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For the three months ended:
 
July 28, 2012
     
July 30, 2011
   
                 
Net sales
    100.0   %     100.0   %
Cost of goods sold, including buying, distribution and occupancy costs
    65.9         67.8    
                     
Gross margin
    34.1         32.2    
Selling, general and administrative expenses
    34.9         38.9    
                     
Loss before benefit for income taxes
    (0.8 )       (6.7 )  
Benefit for income taxes
    (0.3 )       (2.6 )  
                     
Net loss
    (0.5 ) %     (4.1 ) %
 
Net sales increased $6.9 million, or 4.6%, to $157.8 million during the second quarter of fiscal 2012 from $150.9 million during the second quarter of fiscal 2011.  The components of this $6.9 million increase in net sales are as follows:
 
Amount
     
(in millions)
   
Description
$ 4.7    
Increase in sales from Hot Topic and Torrid stores not yet qualifying as comparable stores.
  3.7    
Hot Topic comparable sales increase of 3.9%.
  1.6    
Torrid comparable sales increase of 4.0%.
  (3.1 )  
Decrease in sales due to store closures.
$ 6.9    
Total
 
 
Gross margin increased $5.2 million, or 10.7%, to $53.9 million during the second quarter of fiscal 2012 from $48.7 million during the second quarter of fiscal 2011.  As a percentage of net sales, gross margin increased to 34.1% during the second quarter of fiscal 2012 from 32.2% in the second quarter of fiscal 2011.  The significant components of this 1.9 percentage point increase in gross margin as a percentage of net sales are as follows:
 
 
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%
   
Description
  1.2    
Increase in merchandise margin primarily as a result of higher realized markup.
  0.4    
Decrease in store depreciation expenses related to leverage on higher sales and store closures.
  0.4    
Decrease in distribution expenses, primarily due to lower freight, depreciation, supplies, and leverage on higher sales, partially offset by higher payroll and consulting costs.
  0.2    
Store occupancy percentage decrease primarily due to leverage on higher sales, partially offset by deferred rent credits recognized in the prior fiscal year as part of our cost reduction plan.
  (0.3 )  
Increase in buying payroll expenses.
  1.9 %  
Total
 
Selling, general and administrative expenses decreased $3.7 million, or 6.3%, to $55.1 million during the second quarter of fiscal 2012 from $58.8 million during the second quarter of fiscal 2011.  As a percentage of net sales, selling, general and administrative expenses decreased to 34.9% in the second quarter of fiscal 2012 from 38.9% in the second quarter of fiscal 2011.  The significant components of the 4.0 percentage point decrease in selling, general and administrative expenses as a percentage of net sales are as follows:
 
%
   
Description
  (2.7 )  
Costs associated with the write-down of non-critical property and equipment, severance payments, consulting fees and other costs related to the strategic business changes incurred in the second quarter of the prior fiscal year.
  (1.3 )  
Decrease in store and internet payroll expenses and related benefits as a result of leverage on higher sales, improved productivity, and lower store performance based bonuses.
  (0.8 )  
Decrease in other store expenses, primarily due to lower debit/credit card processing costs, utility expenses, supplies, and freight costs, partially offset by higher inventory service fees.
  (0.7 )  
Decrease in depreciation, relocation costs, and asset impairment charges, partially offset by an increase in computer maintenance costs.
  0.2    
Increase in marketing expenses, primarily due to increases in payroll, marketing events, and media placement costs, partially offset by decreases in store signage expenses.
  0.2    
Increase in preopening expenses as a result of a greater number of new, relocated and remodeled stores in the second quarter of fiscal 2012.
  1.1    
Increase in performance based bonuses.
  (4.0 )%  
Total
 
 
Loss from operations decreased $8.9 million to $1.2 million during the second quarter of fiscal 2012 from $10.1 million during the second quarter of fiscal 2011.  As a percentage of net sales, loss from operations was 0.8% in the second quarter of fiscal 2012 compared to 6.7% in the second quarter of fiscal 2011.
 
 
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Benefit for income taxes was $0.5 million in the second quarter of fiscal 2012 compared to $3.8 million in the second quarter of fiscal 2011.  The effective tax rate was 38.3% for the second quarter of fiscal 2012 compared to 37.9% for the second quarter of 2011.

Six Months Ended July 28, 2012 Compared to the Six Months Ended July 30, 2011

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:
 
For the six months ended:
 
July 28, 2012
 
July 30, 2011
               
Net sales
    100.0  %     100.0   %
Cost of goods sold, including buying, distribution and occupancy costs
    64.9       68.3    
                   
Gross margin
    35.1       31.7    
Selling, general and administrative expenses
    33.6       38.9    
                   
Income (loss) before provision (benefit) for income taxes
    1.5       (7.2 )  
Provision (benefit) for income taxes
    0.6       (2.8 )  
                   
Net income (loss)
    0.9  %     (4.4 ) %
 
Net sales increased $17.2 million, or 5.5%, to $329.4 million during fiscal year-to-date 2012 from $312.2 million during fiscal year-to-date 2011.  The components of this $17.2 million increase in net sales are as follows:
 
Amount
(in millions)
   
Description
$ 13.1    
Hot Topic comparable sales increase of 6.8%.
  7.9    
Increase in sales from Torrid stores not yet qualifying as comparable stores.
  2.7    
Torrid comparable sales increase of 3.2%.
  0.8    
Increase in sales from Hot Topic stores not yet qualifying as comparable stores (includes two new stores and 43 expanded or relocated stores opened since the second quarter of the prior year).
  (7.3 )  
Decrease in sales due to store closures.
$ 17.2    
Total
 
 
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Gross margin increased $16.4 million, or 16.5%, to $115.5 million during fiscal year-to-date 2012 from $99.1 million during fiscal year-to-date 2011.  As a percentage of net sales, gross margin increased to 35.1% during the fiscal year-to-date 2012 from 31.7% in the fiscal year-to-date 2011.  The significant components of this 3.4 percentage point increase in gross margin as a percentage of net sales are as follows:

%
   
Description
  2.6    
Increase in merchandise margin as a result of higher realized markup and lower markdowns, which included markdowns from strategic business changes in the prior fiscal year.
  0.5    
Decrease in distribution expenses, primarily due to  lower freight, depreciation, supplies, payroll costs, and leverage on higher sales, partially offset by higher consulting fees.
  0.5    
Decrease in store depreciation expenses related to store closures and leverage on higher sales.
  0.1    
Store occupancy percentage decrease primarily due to leverage on higher sales, partially offset by deferred rent credits recognized in the prior fiscal year as part of our cost reduction plan.
  (0.3 )  
Increase in buying payroll expenses.
  3.4 %  
Total
 
Selling, general and administrative expenses decreased $10.9 million, or 9.0%, to $110.7 million during fiscal year-to-date 2012 from $121.6 million during fiscal year-to-date 2011.  As a percentage of net sales, selling, general and administrative expenses decreased to 33.6% in fiscal year-to-date 2012 from 38.9% in fiscal year-to-date 2011.  The significant components of the 5.3 percentage point decrease in selling, general and administrative expenses as a percentage of net sales are as follows:
 
%
   
Description
  (3.6 )  
Costs associated with the write-down of non-critical property and equipment, severance payments, consulting fees and other costs related to the strategic business changes incurred in the  prior fiscal year.
  (1.5 )  
Decrease in store and internet payroll expenses and related benefits as a result of leverage on higher sales and improved productivity.
  (0.8 )  
Decrease in other store expenses, primarily due to lower debit/credit card processing costs, utility expenses, supplies, and freight costs.
  (0.6 )  
Decrease in general and administrative payroll, depreciation and relocation costs, partially offset by an increase in consulting fees and computer maintenance costs and software assets writeoff.
  0.2    
Increase in preopening expenses as a result of a greater number of new, relocated and remodeled stores in fiscal 2012.
  1.0    
Increase in performance based bonuses.
  (5.3 )%  
Total
 
Income from operations increased $27.3 million to $4.8 million during fiscal year-to-date 2012 from loss from operations of $22.5 million during fiscal year-to-date 2011.  As a percentage of net sales, income from operations was 1.5% in fiscal year-to-date 2012 compared to loss from operations of 7.2% in the fiscal year-to-date 2011.
 
 
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Provision for income taxes was $1.8 million in fiscal year-to-date 2012 compared to a benefit for income taxes of $8.5 million in fiscal year-to-date 2011.  The effective tax rate was 37.4% for fiscal year-to-date 2012 compared to 37.9% for fiscal year-to-date 2011.

 
LIQUIDITY AND CAPITAL RESOURCES

Historically and during the second quarter of fiscal 2012, uses of cash have been to purchase merchandise inventories, improve our information technology infrastructure and fund new store openings, store remodels and relocations.  We also funded cash dividend payments totaling $6.8 million during fiscal year-to-date 2012 and $12.2 million in the full fiscal year of 2011.  Our cash dividends are discussed in more detail in “NOTE 4 – Cash Dividends” contained in the accompanying financial statements.  While we have not repurchased any of our common stock during fiscal 2012, one of our primary uses of cash during fiscal 2011 was to repurchase an aggregate of $25 million of our common stock (discussed in more detail in “NOTE 14 – Share Repurchase” contained in the accompanying financial statements).  During fiscal 2012 and the full fiscal year of 2011, we made cash outlays of approximately $0.8 million and $7 million, respectively, related to the strategic business changes and cost reduction plan discussed in more detail in “NOTE 2 – Business Events” contained in the accompanying financial statements.  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 11 – Bank Credit Agreement” contained in the accompanying financial statements).

Cash, cash equivalents and short-term and long-term investments, including auction rate securities, held by us were $65.4 million and $67.8 million as of the end of the second quarter of fiscal 2012 and as of the end of fiscal 2011, respectively, and are discussed in more detail in “NOTE 6 – Short-Term and Long-Term Investments” contained in the accompanying financial statements.  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.

Net cash flows provided by operating activities were $22.3 million and $12.0 million during fiscal year-to-date 2012 and 2011, respectively.  The $10.3 million increase in net cash provided by operating activities in fiscal year-to-date 2012 as compared to fiscal year-to-date 2011 was primarily attributable to an increase in net income and a decrease in prepaid expenses and other current assets, partially offset by decreases in accounts payable and accrued liabilities, and an increase in inventory.

Net cash flows used in investing activities were $15.1 million and $1.1 million during fiscal year-to-date 2012 and 2011, respectively.  The $14 million increase in net cash used in investing activities in fiscal year-to-date 2012 as compared to fiscal year-to-date 2011 was primarily attributable to a $7.4 million increase in purchases of property and equipment and a $6.6 million decrease in proceeds from sale of short-term and long-term investments, net of purchases.
 
 
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Net cash flows used in financing activities were $5.3 million and $5.2 million during fiscal year-to-date 2012 and 2011, respectively.  The $0.1 million increase in cash flows used in financing activities was primarily attributable to an increase in the cash dividends paid.

The following table summarizes our contractual obligations as of fiscal year-to-date 2012 and the timing and effect that such commitments are expected to have on our liquidity and capital requirements in future periods:
 
   
Payments due by period (in thousands)
 
Contractual obligations
 
Total
   
Less Than
1 Year
   
1-3 Years
   
3-5 Years
   
More than 5
Years
 
                               
Operating leases
  $ 223,376     $ 50,597     $ 80,083     $ 49,546     $ 43,150  
Purchase obligations
    87,077       87,077       -        -        -  
Letters of credit and other obligations
    6,755       4,647       2,108       -       -  
Income tax audit settlements¹
    506       506       -       -       -  
Total contractual obligations
  $ 317,714     $ 142,827     $ 82,191     $ 49,546     $ 43,150  
 

1.  
The $0.5 million of income tax audit settlements relate to certain open audits we expect to be fully settled in fiscal 2012 and to gross unrecognized tax benefits for which the statutes of limitations are expected to expire in fiscal 2012.  Due to the uncertainty regarding the timing of future cash outflows associated with other noncurrent unrecognized tax benefits of $0.4 million, we are unable to make a reliable estimate of the periods of cash settlement with the respective tax authorities and have not included such amount in the contractual obligations table above.

In fiscal 2012, we anticipate we will spend approximately $25 million on capital expenditures for store construction and other improvements to existing stores, including remodels and relocations.  In fiscal 2012, we also plan to spend approximately $12 million on capital expenditures for various improvements in our information technology infrastructure, including technological improvements at the store level and the purchase of new computer hardware and software. We may make additional capital expenditures in fiscal 2012 for other strategic and operational purposes.

 

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.
 
 
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We believe the following critical accounting policies affect the more significant judgments and estimates used in the preparation of our condensed consolidated financial statements.  For a further discussion about the application of these and other accounting policies, refer to the notes included in our Annual Report on Form 10-K filed on March 21, 2012.
 
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 of each store against estimated cost of goods sold, occupancy costs and other store operating expenses such as payroll, supplies, repairs and maintenance and credit/debit card fees.  The discount rate, the estimated sales and the aforementioned costs and expenses used for this nonrecurring fair value measurement are considered significant Level 3 inputs as defined in “NOTE 8 – Fair Value Measurements.”  Changes in these assumptions may cause the fair value to be significantly impacted.  In the event future 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 store 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.

 
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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 accompanying financial statements, 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.
 
 
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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.


INFLATION

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.

Item 3.  Quantitative and Qualitative Disclosures about Market Risk
 
We are not a party to any derivative financial instruments.  Our exposure to market risk primarily relates to changes in interest rates on our investments with maturities of less than three months (which are considered to be cash and cash equivalents) and short-term 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 the second quarter of fiscal 2012.  Cash, cash equivalents and short-term and long-term investments, including auction rate securities, are discussed in more detail in “NOTE 6 – Short-Term and Long-Term Investments” contained in the accompanying financial statements.
 
Item 4.  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 our 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.  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.


PART II.  OTHER INFORMATION

Item 1.  Legal Proceedings

Our legal proceedings are discussed in more detail in “NOTE 13 – Commitments and Contingencies” contained in the accompanying financial statements.

 
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Item 1A.  Risk Factors

CERTAIN RISKS RELATED TO OUR BUSINESS

Before deciding to invest in Hot Topic, Inc. or to maintain or increase an investment in Hot Topic, Inc., readers should carefully consider the risks described below, in addition to the other information contained in this Quarterly Report on Form 10-Q and in our other filings with the SEC, including our Annual Report on Form 10-K, 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.  The risks described below include certain changes to the “Risk Factors” set forth in our Annual Report on Form 10-K filed on March 21, 2012.

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.
 
 
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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.
 
 
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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.
 
 
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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 malware, denial-of-service attacks and viruses, have become increasingly prevalent 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 loss of revenue and increased 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.  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.
 
 
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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 6 – Short-Term and Long-Term Investments” contained in the accompanying financial statements).  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.
 
 
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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.
 
 
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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 sales.  There are heavier concentrations of sales during th