Hot Topic Investors Are Playing With Fire

Apparently, the goth look is back in style. Last night, teen retailer Hot Topic (NAS: HOTT) reported its fourth-quarter results and issued first-quarter guidance -- both of which slightly surpassed Wall Street's expectations.

For the quarter, Hot Topic reported a profit of $0.21 per share on a 1.2% decline in sales to $209.9 million. Same-store sales for the quarter rose 1.3%. To the chagrin of pessimists, Hot Topic also forecast a profit of $0.02 to $0.05 per share in the first quarter and boosted its quarterly dividend by $0.01 to $0.08.

Not bad, right? Well, these results, which investors seem to be cheering in after-hours trading, are the perfect example of why Hot Topic might be the perfect sell candidate.

The delusion of value
For one, let's look at how Hot Topic returned to profitability. Hot Topic closed 29 of its namesake stores and five of its Torrid locations over the past year. In an attempt to rein in costs, the company has been closing underperforming stores, yet surprisingly, its inventory level has actually risen by about 1%. This either means Hot Topic feels optimistic about its business prospects and has been purchasing more merchandise, or it's slowly becoming swamped with merchandise that's not selling.

Looking at other retailers, Gap (NYS: GPS) reported a 4% increase in same-store sales over the year-ago period, Nordstrom (NYS: JWN) yielded a 10.2% rise in comp sales, and TJX (NYS: TJX) clawed 9% higher versus last year. I'm going to have to guess that, at just 1.3% same-store sales growth, Hot Topic is having problems ridding itself of unwanted merchandise.

Now this would be counterintuitive thinking when you consider that Hot Topic actually grew its gross margin from 32.2% to 35.4%. This would at least imply that Hot Topic has slimmed down on its discounting and is selling more at full price. But what if Hot Topic is simply refusing to mark down its merchandise and the inventory is continuing to build? That's pure speculation on my part, but a possible problem.

Is this sustainable?
One aspect I can't deny about Hot Topic is its stubbornness to keep to its path. Sales have been in a steady decline since 2007, and the company hasn't been profitable on an annual basis since 2009.

While investors might be cheering the newly raised dividend, I'm cringing in horror. Frankly, with Hot Topic only expected to earn about $0.20 per share in 2012, its payout ratio of 160% looks unsustainable. Management feels confident the company's cash flow and cash balance are enough to cover the dividend (and for the time being I agree), but what happens if the tide turns even slightly downward in the retail sector? India just cut off cotton exports to the rest of the world -- what happens if cotton prices rise 20%? Can Hot Topic pass along those input cost increases to consumers and still afford to pay its dividend? I don't think so.

Hot Topic's valuation is also a concern. Despite management touting the company's strong cash flow, from a price-to-cash-flow perspective Hot Topic is more expensive than it has been in six years. Excluding the wild ride the market took in 2009, Hot Topic's forward P/E of 31 is also the highest the company will have seen since 2006.

Foolish roundup
Hot Topic has disappointed investors before, and there's really no reason to believe that this turnaround plan will effect real growth in the company's bottom line. Expenses are now under control, but there's little in the way of growth for the company to build upon. I'm convinced this rally will fizzle just like Hot Topic's growth and, as such, I'm making a CAPScall of underperform on the company. The question now is: Would you do the same?

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At the time thisarticle was published Fool contributor Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy that never has cotton mouth.

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