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Hot Topic's on Fire

Niche retailer Hot Topic is smoking when it comes to same-store and total sales growth. Investors should remember, though, that owning a specialty retailer is riskier than owning an older and more established brand.

By LouAnn Lofton (TMF Lou2)
July 6, 2000

As other, more established retailers have been struggling to show positive same-store sales (or, "comps") this year, upstart teen retailer Hot Topic (Nasdaq: HOTT) has been turning in blistering results. Proving itself to be the little retailer that could, it reported June comps growth yesterday of 25.4%. That's not an anomaly, either.

Take a look at its May comps growth -- an increase of 19.7%. It's fiscal 2000 first quarter comps grew by 24.1%. Hot Topic's fiscal 1999 comps increased by 22.8%. Its stock price has reflected this growth, going from a 52-week low of $11 7/8 to a recent $30.

What's this company selling? Fueled by MTV reaching into the homes of America's kids, Hot Topic sells "music-inspired" apparel and accessories. A look at Hot Topic's website reveals that the company segments its clothes into categories named for types of music -- Lounge, Punk, Rave, and Street, for example.

Let's run some Rule Maker criteria over Hot Topic and see how the company stands up. The company's not a traditional Rule Maker because of its small size, but value can be found in looking at margins and cash and inventory management.

Hot Topic's gross margin in its most recent quarter was 37% -- not great for a Rule Maker, but not bad for a retailer. Its net profit margin was 5.4%, which is shy of Rule Makerdom by a percentage point or so. The company has no debt.

The most recent Foolish Flow Ratio for Hot Topic was 1.57, which is above the desired 1.25 level. Inventories grew by 30%, which isn't really a problem since sales grew by 58% compared to the same quarter last year. That trounces the Rule Maker's required 10% sales growth.

So, where's the catch? The catch is that owning a company like this, even though it might have some good financials, is riskier than owning a more established retailer like Gap (NYSE: GPS). Its market is strictly fickle trendy teens. Should the company make a mistake and stock the wrong thing, those great comps could dry up faster than Debbie Gibson's career. Sales growth will inevitably slow, and if the company cannot continue at that point to stay ahead of the fashion curve, look out below.

I don't begrudge this company its superb total sales and comps growth. Investors, though, should understand the risk involved with owning smaller niche-market retailers like this one. It requires much more attention than owning a more established brand. An eye should be trained on the flow ratio and inventory levels. An increasing flowie or inventories sprouting quicker than sales should be warning signs. If trouble starts to creep up on the balance sheet, watch out, 'cause your hip retailer may be becoming uncool.

Your Turn:
What do you think? Is it worth the risk to own niche retailers like Hot Topic because of their growth? Talk about it on the Retail discussion board with other Fools.

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