Hot Topic: Turning Short Sellers Into Angsty Goth Kids
[For original version of this article, complete with charts, visit Seeking Alpha]
Over the past few weeks, I have encountered an innumerable amount of articles, pitches, and recommendations in favor of shorting Hot Topic (HOTT). Some have been argued poorly and some, such as Shaun Loh’s recent write-up on Seeking Alpha, have been argued fairly well. Regardless, I’m not sold. I’m leaning in the completely opposite direction and would warn that Hot Topic is a very dangerous short. Business Model
It is interesting to hear many shorters describe Hot Topic’s business model. Some typical responses:
(1) They’re a counter-cultural retailer
(2) They sell goth stuff
(3) They make money off of that Twilight movie
(4) They sell stuff to whiny teenagers
(5) They’re a trend
I’m not going to break into a discussion of gothic subculture and its relation to Hot Topic except to suggest that Hot Topic isn’t necessarily “goth”. For those who believe otherwise, the only advice I can give you is to watch South Park more often. They do have some relation to the gothic community, however, but they sell items relating to a variety of other musical genres, as well. (By the way, Hot Topic sells South Park merchandise, too.)
It’s also not really a “counter-cultural” retailer so much as a pop culture retailer that borrows from the counter-culture. Saying Hot Topic can’t be commercially viable is like saying that Nirvana was doomed for failure after they released “Smells Like Teen Spirit.” Similarly, walk by a Hot Topic store in a busy suburban mall on any given weekend and you’ll probably find at least a dozen or more people in there. Teenagers, kids, their parents --- it’s a real stretch to say it’s not a “mainstream retailer” at this point.
Just to state the obvious, Hot Topic is a corporation listed on the NASDAQ stock exchange that sells mass-manufactured clothing and goods relating to popular culture in the U.S. Roughly 30% of their merchandise revenues come from sells of licensed band items, such as t-shirts. They operate in commercial malls across the nation and their target audience is teenagers and young adults that mostly associate with various alt-pop cultures. They also sell goods online and operate a handful of Torrid stores, which cater to plus-sized women. Is Hot Topic a “Trend”?
The next question to ponder is whether or not Hot Topic represents a “trend.” Hot Topic was founded in 1988, so they have been around for over two decades already. That would represent a rather lengthy trend.
I have personally visited Hot Topic a few times over the past few years. I bought a The Clash t-shirt there once. Think I bought some knickknacks there before, as well. From this, I can tell you that Hot Topic has evolved significantly in the time from 2003 to 2009. The merchandise is somewhat different, the layout is somewhat different, and their style is somewhat different, but they still appeal to the same target audience: teenagers and very young adults interested in alt-pop culture.
This leads us to an important distinction: Hot Topic is not a “trend.” They are a seller of trends. Walk around a mall and you’ll notice that nearly every franchise located inside these beacons of American consumer-mania is similar. You can say, “Hot Topic is a goth store!” or “Hot Topic sells Twilight stuff and their toast once that goes away”, but that makes a big assumption --- that they wouldn’t change their offerings as the market changes.
If you’re still not convinced, consider this: Spencer’s Gifts is another mall retailer that caters to a somewhat similar target audience as Hot Topic. Take a guess as to when Spencer’s Gifts was founded. 1993? 1982? 1974? 1966?
I’m not suggesting that Hot Topic will necessarily be around till 2050. It could go out of business in 2018. Or 2027. Or 2035. Or 2043. Or 2089. Who knows? My bigger point is that those who think the company will cease to exist once the “Goth/Twilight/[Insert Teenage Fad]” trend is over are doing themselves a disservice. They are assuming that a corporation that operates several hundred stores across the nation would not have an incentive to move with the times. Hot Topic is not an aging hippie selling his wares in a run-down part of town next to a huge college campus. It’s a corporation with a profit motive. Why Hot Topic Won’t Be Hurt Much By the Recession
If I’ve managed to convince you that Hot Topic is not some bizarre fringe retailer that operates out of the back of a van, they are still a retailer in one of the worst downturns in American history, right? For that reason, you might believe the company is doomed. However, consider what Hot Topic sells and who they sell it to.
Hot Topic is not a “luxury retailer” and contrary to the beliefs of many, they sell many necessities. From their most recent earnings call, CFO James McGinty states that 56% of Hot Topic’s sales were apparel-related. That’s an important stat. People are not going to stop wearing t-shirts, jeans, skirts, hose, or many of the other items that Hot Topic sells in mass quantities. For many teenagers, stores like Hot Topic supply the vast majority of their wardrobe. The $20 Green Day shirt isn’t any more expensive than a t-shirt anywhere else at the mall. In fact, that’s a relatively inexpensive price. That’s why I dare state that Hot Topic is much more secure than most retailers.
There’s more to like about Hot Topic, as well. Just a few weeks ago, a friend informed me that he was going on a national tour with his new band. Since I want to see them a few times while they are in the Baltimore/Washington area, I decided to check their tour line-up. I was rather surprised to learn that they will play at a few Hot Topic stores while on their tour.
This is a very intriguing development since it benefits local bands by allowing them to gain exposure and sell their merchandise to a new audience. At the same time, it brings new people into Hot Topic stores, which increases their sales over the long-term. It seems brilliant to me --- it benefits Hot Topic heavily without requiring them to incur any significant costs.
My general thesis here is that there are a lot of reasons to believe Hot Topic is in a better position than most retailers and unless you believe that American teenagers will disappear with the recession, Hot Topic is going to be alright. The Financials
If I haven’t discredited the criticisms of Hot Topic’s business model, an appeal to the financials should add some ammo against the short case. Hot Topic’s balance sheet is pristine. It is absolutely beautiful. There is no junk on it. They have $371 million in total assets compared to $112 million in total liabilities. They have a cash position of $90 million, $80 million in inventories, and their current ratio is 2.75. The rest of their assets mostly consist of PP&E. Total net tangible assets are equal to $5.86 per share.
So if their balance sheet looks fantastic, then surely their earnings must be sour, right? Well, apparently not. You see, during the worst economic crisis of the past 70 years, they actually managed to increase their year-over-year revenues by 4.5%, slightly improve their margins, and increase year-over-year profit by 25% for the most recent year. Not too shabby, eh?
A quick anecdote here --- when I attended graduate school, my semi-famous accounting professor, C.J. Skender, had a frequent saying: “Depreciation is Not Cash.”
I bring this quote up because it’s an important thing to consider when looking at HOTT’s Statement of Cash Flows. I hear numerous people cite HOTT’s P/E ratio as evidence that it is a poor buy, but they neglect to consider the high amount of Depreciation and Amortization expenses they incur on their Income Statements. Operating cash flows have been roughly 300% - 400% higher than earnings over the past three fiscal years. This is especially important as the company matures and slows down its Capital Expenditures.
Another important measure to examine: the increase in stockholders’ equity. This a metric that I occasionally like to use for certain firms to try to ascertain the “added value” they have created over the years. This figure has increased roughly $1.30 in per share terms over the past three years; or an average increase of $0.43 per share for each year. Once again, that might seem moderate, but consider the company’s net assets and high CapEx over much of the decade and that doesn’t seem to bad at all to me.
Here’s a chart laying out all relevant figures:
Just in case you don't recognize any of the abbreviations I use, here's a quick guide:
DEPS = Diluted Earnings Per Share
NI +DA = Net Income + Depreciation & Amortization
CFOs = Cash Flows from Operations
FCFs = Free Cash Flows
INCR in SE = Increase in Stockholders' Equity
As a note, the 70 cent decrease in SE for FY '05 was due to stock buybacks.
Here are the averages based on the above chart:
[see Seeking Alpha version for chart]
A Tricky Valuation
As Hot Topic appears to be moving into a more mature stage of its development, it becomes trickier to value. This is perhaps one reason why Mr. Market has turned extremely sour on the company, since it has a relatively high P/E. However, I’d argue P/E is a very poor valuation metric for this company.
I have run a few valuation scenarios using a quick Discounted Cash Flow analysis. Since Hot Topic’s CapEx was higher in its growth state than it will probably be in the future, I will project future average cash flows based on all the metrics above. For the five scenarios below, I will begin the DCF with a Year 1 “average added value”/free cash flows figure and assume a 3% growth rate. As with all my scenarios, the purpose is not to create an absolute valuation and dogmatically proclaim it to be correct --- my goal is always to find a tradable range complete with upside and downside.
The five scenarios are below: Scenario #1 – Conservative: Y1 FCFs = $0.35
This scenario is based around average “earnings” over the past few years, which I feel is a very conservative metric to base a forecast around for HOTT due to their much stronger cash flows. Scenario #2 – Moderately Conservative: Y1 FCFs = $0.50
This scenario is based around the average increase in stockholders’ equity over the past few years. This metric also looks moderately conservative to me. Scenario #3 – More Aggressive: Y1 FCFs = $1.00
This scenario is based around the high Cash Flows from Operations (CFOs), high Net Income plus Depreciation & Amortization (NI +DA), plus the incredibly high FCFs for the last fiscal year. However, I have assumed that these figures are a bit of an aberration for this analysis and lowered them a bit. Scenario #4 – Aggressive: Y1 FCFs = $1.35, Y2 FCFs = $1.40, Y3 FCFs = $1.50
This scenario is similar to the last one, except I assume that CFOs and NI+DA are the best metrics. Plus, I have assumed they can create a bit more growth in the next few years. Scenario #5 – The Middle Ground: Y1 FCFs = $0.75
This is more or less a middle ground between all the metrics.
Here are the results:
Scenario #1 = $10.76
Scenario #2 = $12.86
Scenario #3 = $19.87
Scenario #4 = $26.87
Scenario #5 = $16.37
Based on my assessment of the business prospects for Hot Topic, plus the valuation scenarios, I would assign Hot Topic a valuation of $18 per share. This is based on my belief that the company’s free cash flows should increase in the upcoming years as it enters into a more mature stage, coupled with a discount for market risk in the current environment. Downside probable valuation is $10 and upside probable valuation is $26.
Downside risk for the stock should be around $4. My reasoning for this figure is that HOTT’s net tangible assets are equal to $5.86 and if the company was to become unprofitable or if the market were to panic and believe the company to be unprofitable, this should be a reasonable floor for the next few years.
Upside potential is $30 - $35. I base this on Scenario #4’s valuation coupled with the prospect for potential growth and the stock entering into a boom phase where it becomes too aggressively valued by the market. Conclusion
After the Hot Topic short-squeeze spiked the price of the stock up to $13, I believe it was bound to experience a technical retreat, but all the same, I see this as a terrible shorting target. Believe it or not, this is necessity-retailer that caters to a demographic that is not going away and offers apparel to this target audience at relatively inexpensive prices. Management appears solid to me given the financial shape of the company and their success at growing the company, even during a difficult consumer environment.
Short sellers should beware --- this stock has the potential to turn you into angsty goth kids. It has burned many shorters over the past month and it will continue to burn short sellers in the future. While I tend to keep away from retailers; based on my reading of this stock, it would actually appear to be a relatively good buy under $10.
Disclosure: Author holds no position in HOTT.