Description
Filed with the SEC from Sep 13 to Sep 19:
Hot Topic (HOTT)
Small-cap-focused investment firm Becker Drapkin increased its holdings in the mall- and Web-based retailer to 3,586,415 shares (8.5%) after it bought 51,553 on Sept. 12 at $9.12 apiece.
BUSINESS OVERVIEW
General We are a mall and web-based specialty retailer of apparel, accessories, music and gift items for young men and women whose lifestyles reflect a passion for music, fashion and pop culture. We operate under two concepts: Hot Topic and Torrid. Music and pop culture are the overriding inspirations at Hot Topic, and Torrid is focused on providing the best in fashion to young plus-size women. We generate revenues primarily through our retail stores in the United States of America, Puerto Rico and Canada, and online through our websites. We were incorporated in California in 1988.
Concepts
Hot Topic At our Hot Topic stores and on our website hottopic.com, we sell a selection of licensed and non-licensed apparel, accessories and gift items that are influenced by popular music artists and pop culture trends. We also sell a limited assortment of music CDs and DVDs. Our merchandise is designed to appeal to young men and women who are passionate about and have diverse tastes in music and pop culture.
We strive to consistently be the first to expose our customers to new music, pop culture and fashion trends. We believe our ability to quickly identify, source, and oftentimes negotiate exclusivity for, unique and diverse merchandise centered around music and pop culture is one of our competitive strengths. We also believe that our deep-rooted knowledge of music and pop culture, distinctive store design and rich music experiences that we offer are competitive strengths. We opened our first Hot Topic store in California in fiscal 1989 and have since gained a national presence in the United States.
Torrid At our Torrid stores and on our website torrid.com, we sell fashion forward apparel, lingerie, shoes and accessories for plus-size young women. It is designed to appeal to women sized 12 to 26 who are young at heart and in attitude and who want their clothes to be an extension of their lifestyles. We believe that our ability to provide our plus-size customers with easy access to the latest and best in fashion without sacrificing fit or style is a core competitive strength of Torrid. We opened our first Torrid store in fiscal 2001.
ShockHound During the second quarter of fiscal 2011, the operations of ShockHound, our online digital music website launched in fiscal 2008, were discontinued. Refer to “NOTE 2 – Recent Business Events” contained in the consolidated financial statements and notes included elsewhere in this annual report on Form 10-K for more information concerning the discontinuation of ShockHound’s operations.
Merchandising
Hot Topic Merchandise Hot Topic’s music/pop culture-licensed merchandise includes tee shirts, hats, stickers, novelty accessories, CDs and DVDs and the music/pop culture-influenced merchandise includes women’s and men’s apparel and accessories, such as woven and knit tops, skirts, pants, shorts, jackets, shoes, costume jewelry, body jewelry, intimate apparel, sunglasses, cosmetics, leather accessories and gift items. Hot Topic’s diverse and extensive selection of merchandise is regularly tested to stay current with customer demand and new product trends. We have several lines of private label merchandise to complement and supplement our current product offerings.
Merchandising Staff Our merchandising teams typically consist of a mix of general and divisional merchandise managers; buyers and assistant buyers; product development, sourcing, fit and quality assurance teams. In determining which Hot Topic merchandise to buy, the merchants spend considerable time viewing music videos, reviewing industry music sales, viewing movie releases that appeal to our teen customers, monitoring music radio station air play, viewing YouTube videos, consulting with sales associates, reviewing customer requests, attending trade shows, nightclubs and concerts, reading music and fashion industry periodicals and monitoring music, pop culture and social media websites. Their goal is not only to identify emerging trends early, but to quickly move on from them before the popularity of the trends wane. At Torrid, in order to remain in tune with reigning trends and preferences, the merchandising team conducts fashion research from a variety of sources within and outside the United States. Such sources include fashion hot spots, customer and store associate feedback, entertainment and pop culture venues and trade shows.
Purchasing Our goal is to provide exclusive, diverse, trend-setting merchandise to our customers early and at the right price. We purchase merchandise from a broad base of domestic and international vendors and only commit to a majority of the merchandise in as little as two weeks and as much as three months in advance of delivery, depending on the category, in order to respond quickly to emerging trends. We constantly monitor sales to determine desirable product types and quantities, emerging or declining trends and the spending patterns of our customers. We solicit input from our vendors and maintain productive relationships with them to support our effort to deliver quality, fashionable merchandise that is reflective of new and emerging trends. No vendor individually accounted for more than 10% of our merchandise purchases during fiscal 2011.
Planning and Allocation Planning and allocation of our inventory is done by merchandise classification and Stock Keeping Unit, or SKU, using integrated third-party software. Most merchandise is ordered in bulk and then allocated to each store based on sales performance and inventory levels. Our buyers, merchandise planners and allocation analysts consider current inventory levels, sales history, projected sales, planned inventories, store demographics, geographic preferences, store openings and planned markdown dates to determine SKU reorder quantities.
Distribution and Fulfillment To facilitate timely and efficient merchandise distribution to our stores and internet customers, we have distribution centers located in California and Tennessee, both of which are sufficient to meet our anticipated needs over the next several years. Substantially all merchandise is delivered to our distribution centers and within one to two business days of receipt, it is inspected, allocated, picked, prepared and boxed for shipment to our stores. Merchandise is shipped from the distribution centers daily and selective SKUs are identified to maintain back stock.
Stores
Location and Site Selection As of the end of fiscal 2011, we operated 628 and 148 primarily mall-based Hot Topic and Torrid stores, respectively, in the United States, Puerto Rico and Canada. Refer to “Item 2 – Properties” for a geographical breakdown of stores by state and country. In selecting a site for a new store, we target high-traffic shopping areas with favorable lease terms and suitable demographics of likely customers.
Design and Environment The look and feel of our Hot Topic and Torrid stores continue to evolve. Our newer Hot Topic stores are designed to highlight the merchandise in a unique, high-energy and eclectic shopping atmosphere. Our Torrid stores present a youthful atmosphere designed to create a comfortable and fun environment for our customers.
Sales During fiscal 2011, average sales per Hot Topic store was $0.8 million and average sales per square foot was $429. Average sales per Torrid store in fiscal 2011 was $0.9 million and average sales per square foot was $342.
Expansion While we have significantly slowed our new Hot Topic store growth, we have focused on remodeling or relocating those stores where there is a reasonable expectation of satisfactory sales results after the remodel or relocation. New Torrid store growth and remodeling and relocation activity was low during fiscal 2011, however, we anticipate that in fiscal 2012, we will aggressively pursue new Torrid store growth. We continue to renegotiate or extend existing leases with more favorable terms and to close stores that do not meet our expectations of profitability.
In fiscal 2011, our capital investment to open a new Torrid store, including leasehold improvements and furniture and fixtures, was approximately $218,000. The average initial gross inventory for a new Torrid store opened in fiscal 2011 was approximately $57,000. As with our Hot Topic stores, initial inventory requirements vary at new stores depending on the season and current merchandise trends. The average pre-opening costs in fiscal 2011 for a new Torrid store were approximately $18,000. The new Torrid stores have square footage similar to current averages of 2,496 square feet.
Operation Teams Hot Topic and Torrid each have a Vice President of Store Operations who leads a divisional operations team. Supporting the Vice President of Store Operations for each division are regional directors who oversee multiple district managers, and district managers who typically oversee approximately ten stores. A typical store has a store manager, two assistant managers, and five to eight part-time sales associates, depending on the season. We believe our distinct culture attracts Hot Topic sales associates that are passionate about music and pop culture and Torrid sales associates that are passionate about fashion for the plus-size customer. Each member of our store operation teams receive comprehensive training that is customized to fit their roles and responsibilities. In addition to base pay and the opportunity to participate in our Employee Stock Purchase Plan and the Hot Topic 401(k) Plan if eligible, we offer incentive programs to some members of our store operations teams based on achieving certain sales levels.
eCommerce Operations
Websites Our hottopic.com and torrid.com websites provide convenient access to a broad selection of merchandise for sale, including some Internet exclusive items, information on upcoming events, promotions, store locations, job postings and community features. Customers may also access our hottopic.com website through touchscreen kiosk terminals located within each Hot Topic store. These kiosks allow customers to access, purchase and ship merchandise from hottopic.com to the store for pickup or their homes.
Hot Topic We strive to increase sales and our brand recognition, enhance the customer shopping experience and reach out to new customers using a unique combination of tools including: promotional signage in stores and on our website; viral online marketing; branded gift cards; our loyalty program; social media; reliance on our customers and associates; compelling store designs; and experiential events. During the fourth quarter of 2009, we launched our loyalty program, HT+1. HT+1 is free to join and is designed to build customer loyalty and encourage repeat sales by allowing members an opportunity to earn points in a variety of ways, including store visits, store purchases and online purchases. In addition, HT+1 allows us to communicate to members about products and events that are relevant to them as well as giving members access to exclusive events that are not available to other customers. Touchscreen kiosk terminals located within most Hot Topic stores offer another way that members may access their HT+1 loyalty accounts. Since the launch, over eight million people have become HT+1 members.
Torrid We seek to build the Torrid brand with many of the same tools used by Hot Topic, as well as with print media and direct mail. Our Torrid loyalty program, divastyle®, gives us the chance to regularly communicate with our most loyal Torrid customers. They are rewarded throughout the year with special offers, promotions, information and updates on new products and current trends available at Torrid. Customers may also participate in our private label Torrid credit card program, divastatus SM .
Information Technology Our information systems provide for the integration of store, internet, merchandising, distribution, financial and human resources records and data. Many of these information systems have been customized in varying degrees to fit our business needs and we license a full range of software from different vendors. We regularly upgrade existing systems or replace all or part of an existing system with one that we believe is better suited to our business. In addition, we occasionally implement new technology to support our business. We plan to purchase and implement several major systems, replacing our merchandising system currently supporting the needs of our businesses. We expect to have the most significant systems implementations completed in early fiscal 2013.
Trademarks Our trademarks, which constitute our primary intellectual property, have been registered or are the subject of pending applications in the United States Patent and Trademark Office and with the registries of many foreign countries. In addition, we have common law rights to certain trademarks, service marks and trade names used in our business from time to time. We are unaware of the use of any of our marks raising any claims of infringement or other challenges to our right to use our marks in the United States.
Seasonality Our business, particularly at Hot Topic, is subject to seasonal influences, with heavier concentrations of sales during the back-to-school, Halloween and holiday (defined as the week of Thanksgiving through the first few days of January) seasons and other periods when schools are not in session. The holiday season has historically been our single most important selling season. We believe that the importance of the summer vacation and back-to-school seasons (which affect operating results in the second and third quarters, respectively) and to a lesser extent, the spring break season (which affects operating results in the first quarter), as well as Halloween (which affects operating results in the third quarter), all reduce our dependence on the holiday selling season, but this may not always be the case or always affect the company to the same degree. As is the case with many retailers of apparel, accessories and related merchandise, we typically experience lower net sales in the first and second fiscal quarters relative to other quarters.
Competition The apparel, music and accessory categories within the retail industry in which we operate are highly competitive and are subject to rapidly changing consumer demands and preferences. We compete with numerous retailers for vendors, teenage and young adult customers, suitable store locations and qualified associates and management personnel. We currently compete with street alternative stores located primarily in metropolitan areas; shopping mall-based teenage-focused retailers; big-box discount stores; music stores; mail order catalogs and websites; and with numerous potential competitors who may begin or increase efforts to market and sell products competitive with Hot Topic and Torrid products. Torrid has additional competitors who operate plus-size departments in department stores and discount stores. Increased competition could have a material adverse effect on our business, results of operations and financial condition.
Employees As of the end of fiscal 2011, we employed approximately 2,100 full-time and 6,700 part-time associates. Of our 8,800 associates, approximately 800 were headquarters and distribution center personnel and the remainder were field management and store associates. The number of part-time associates changes based upon seasonal needs. None of our associates are covered by collective bargaining agreements. Lisa Harper has served as Chairman of our Board of Directors since November 2011 and Chief Executive Officer since March 2011. Prior to becoming Chairman, she served on our Board of Directors since June 2008. Prior to joining us, she served as Chairman of the Board of Directors of the Gymboree Corporation, a publicly-traded corporation operating a chain of specialty retail stores for children and women, from June 2002 until her retirement in July 2006. From January 2006 through July 2006, Ms. Harper served as Chief Creative Officer of the Gymboree Corporation. From February 2001 through January 2006, Ms. Harper served as Chief Executive Officer of the Gymboree Corporation and from February 2001 through June 2002, she was Vice Chairman of the Gymboree Corporation’s Board of Directors. From 1995 through 2001, Ms. Harper held various merchandising and design positions at the Gymboree Corporation and before that, held similar positions with several other clothing retailers, including Limited Too, Esprit de Corp., GapKids, Mervyn’s, and Levi Strauss. Ms. Harper also served as a director of Longs Drug Stores Corporation from February 2006 to May 2008. Since 2008, Ms. Harper has developed and operates a hotel in Mexico. Ms. Harper attended the University of North Carolina at Chapel Hill.
Gerald Cook has served as Chief Operating Officer since June 2008. From November 2005 through June 2008, he served as President, Hot Topic Inc. From September 2003 to October 2005, he was President of the Hot Topic division. From February 2001 to September 2003, he was Chief Operating Officer. From February 1999 until joining us, he was the President and Chief Operating Officer of Travel 2000, Inc. From 1995 to 1998, Mr. Cook was Senior Vice President, Operations for The Bombay Company, Inc. and from 1989 to 1995, Mr. Cook was the Vice President, Stores and the Vice President, General Merchandising Manager of Woman’s World Stores. Prior to 1989, he held management positions with Barnes & Noble/B Dalton, The Gap Stores and the Limited, Inc. Mr. Cook holds a B.S. degree in Business Administration from the University of Minnesota.
James McGinty has served as Chief Financial Officer since February 2001. Mr. McGinty joined us in August 2000 as Vice President, Finance and was promoted to Chief Financial Officer in February 2001. From July 1996 to July 2000, Mr. McGinty was Vice President-Controller at Victoria’s Secret Stores, the leading brand and largest specialty retailer division of the Limited, Inc. From 1984 to 1996, he held various financial and accounting positions within the Structure and Express divisions of The Limited, Inc. Mr. McGinty holds a B.S. degree in Accounting from Miami University in Oxford, Ohio.
CEO BACKGROUND
Lisa Harper has served on our Board since June 2008, as our Chief Executive Officer since March 2011, and as our Chairman of the Board since November 2011. From February 2001 until her retirement in July 2006, she served in various capacities with The Gymboree Corporation, a publicly-traded corporation operating a chain of specialty retail stores for children and women. Her roles at Gymboree were as follows: Chairman of the Board of Directors, from June 2002 to July 2006; Chief Creative Officer, from January 2006 to July 2006; Vice Chairman of the Board of Directors, from February 2001 to June 2002; and Chief Executive Officer, from February 2001 to January 2006. Ms. Harper served as a director of Longs Drug Stores Corporation from February 2006 to May 2008. Since 2008, Ms. Harper has developed and operated a hotel in Mexico. With her retail knowledge and background, Ms. Harper provides our Board with valuable leadership, management, and merchandising expertise.
Matthew Drapkin has served on our Board since October 2010 and as our Lead Independent Director since November 2011. Since 2009, Mr. Drapkin has been a partner at Becker Drapkin Management, a Dallas-based small cap investment fund. From March 2008 to October 2009, he served as head of research, special situations and private equity at ENSO Capital, a New York-based, hedge fund, and from January 2003 to March 2008, Mr. Drapkin worked at MacAndrews & Forbes, a private investment firm, as the Senior Vice President, Corporate Development. Prior to January 2003, Mr. Drapkin was the general manager of several Condé Naste internet sites and an investment banker at Goldman Sachs. Mr. Drapkin currently serves on the board of directors of Glu Mobile, Inc., a publicly-traded publisher of mobile games, and since June 2011 Mr. Drapkin has served on the board of Ruby Tuesday, Inc., a publicly-traded restaurant chain. He previously served on the board of directors of Plato Learning until its acquisition in May 2010 and on the board of directors of Alloy, Inc., a publicly-traded media and marketing company, until its merger in November 2010. Mr. Drapkin also serves on the Columbia Law School Board of Visitors. He has an M.B.A., Finance from Columbia University School of Business, a J.D. from Columbia University School of Law and a B.A. in American History from Princeton University. With his extensive financial experience in both public and private companies, Mr. Drapkin provides our Board with valuable expertise in corporate finance, strategic planning, and corporate governance.
Steven Becker has served on our Board since October 2010. Since 2004, Mr. Becker has served as Managing Partner and founder of Becker Drapkin Management (previously known as Greenway Capital), a Dallas-based small cap investment fund. From 1997 to 2004, Mr. Becker was a partner at Special Situations Funds, a New York City-based asset manager. Prior to joining Special Situations Funds, Mr. Becker was a part of the distressed debt and leveraged equities research team at Bankers Trust Securities. He began his career at Manley Fuller Asset Management in New York as a small cap analyst. Mr. Becker currently serves on the board of directors of SDIX, Inc., a publicly-traded life sciences company. Since June 2011 Mr. Becker has served on the board of Ruby Tuesday, Inc., a publicly-traded restaurant chain and since February 2012 has been a director of Pixelworks, Inc., a publicly-traded semiconductor company. He previously served on the board of directors of Plato Learning, Inc., a publicly-traded educational software company, until it was acquired in May 2010. Mr. Becker received a B.A. from Middlebury College and a J.D. from the University of Florida. With his extensive financial experience, in both public and private companies, Mr. Becker provides our Board with valuable expertise in corporate finance, strategic planning, and corporate governance.
Evelyn D’An has served on our Board since June 2007. In November 2010, Ms. D’An joined Brightstar Corp., a privately-held company specializing in services and solutions for the wireless telecommunications industry, as their Senior Vice President of Finance and Accounting. Since 2004, she has served as President and founder of D’An Financial Services, Inc., an integrated business consulting and financial services firm. From April 2005 through February 2010, Ms. D’An served as a director and Chair of the Audit Committee of Alico, Inc., a publicly-traded land management company operating in Central and Southwest Florida. From 1998 to 2004, Ms. D’An was an audit and advisory partner at Ernst & Young LLP. Ms. D’An is a certified public accountant. With her professional certification and experience, Ms. D’An provides our Board with valuable accounting, auditing, financial, and business expertise.
Terri Funk Graham is Senior Vice President and Chief Marketing Officer at Jack in the Box Inc., a publicly-traded restaurant company that operates and franchises Jack in the Box and Qdoba Mexican Grill restaurants, a position she has held since September 2007. Ms. Graham, who joined San Diego-based Jack in the Box Inc. in 1990, previously served as Vice President and Chief Marketing Officer from December 2004 to September 2007, Vice President of Marketing from May 2003 to December 2004, and Vice President of Brand Communications and Regional Marketing from July 2002 to May 2003. Ms. Graham brings to our Board extensive consumer branding, marketing, and media experience, and will provide our board with valuable expertise on developing and marketing our brands to consumers.
W. Scott Hedrick has served on our Board since January 2002. Since 1979, Mr. Hedrick has served as founder and General Partner of InterWest Partners, a venture capital fund. Since April 1991, Mr. Hedrick has served as a director of Office Depot, Inc., a publicly-traded consumer products company and as its lead independent director since February 2011. From November 1986 until April 1991, he served as a director of The Office Club, Inc., which was acquired by Office Depot, Inc. in April 1991. Since December 2006, he has served as director of the American Funds Target Date Retirement Series Inc. and American Funds Insurance Series Inc. Mr. Hedrick also serves as a director of a privately-held company. Mr. Hedrick brings to our Board an extensive background as an investor in retail and consumer product companies and, as a long-standing member of our Board, a deep knowledge of our current operations and historical development. With his knowledge and experience investing in and managing retail companies, Mr. Hedrick provides us with valuable leadership perspective, including expertise in the evaluation of assets and business opportunities.
John Kyees has served on our Board since March 2012. Mr. Kyees served as Chief Financial Officer for Urban Outfitters from 2003 to 2010. Mr. Kyees formerly held the position of Chief Financial Officer and Chief Administrative Officer for bebe stores, Inc. from 2002 to 2003. Mr. Kyees served as Chief Financial Officer for Skinmarket, a cosmetic retailer, from 2000 to 2002. Since April 2010, Mr. Kyees has served as a director, chair of the Audit Committee, and a member of the Nominating and Governance and Compensation Committees of Vera Bradley, Inc, a publicly-traded specialty retailer of accessories. Since May 2010, Mr. Kyees has served as a director and member of the audit committee of Casual Male Retail Group, Inc., a publicly-traded specialty retailer of men’s clothing. Since 2011, Mr. Kyees has served as a director and chair of the Audit Committee and member of the Compensation Committee, for Teavana, Inc. a publicly-traded specialty retailer of teas and related products. Mr. Kyees brings to our board of directors extensive specialty retail experience, particularly to a teen market. With his extensive experience as a CFO, Mr. Kyees provides our board with significant accounting, financial and operational expertise.
Andrew Schuon has served on our Board since January 1998. Since 2008, Mr. Schuon has served as a co-founder of “C” Student Entertainment, a boutique radio and mobile-focused media company. Since January 2011, Mr. Schuon has served as President of Elevated Music Services, Inc., a provider of custom music channels primarily for hotel/casinos and restaurants. Since 2008, he has served as President of Beat Advisors, Inc, a consulting firm specializing in television, radio, out of home, retail, and hotel/casino entertainment programming solutions. From January 2009 to May 2010, Mr. Schuon served as a senior executive of Live Nation Entertainment, Inc., having started with Ticketmaster Entertainment, Inc. prior to the company’s January 2010 merger with Live Nation, Inc. From July 2004 to January 2008, Mr. Schuon served as founder and President of Vivendi/Universal’s IMF: The International Music Feed, a 24-hour cable TV channel. From August 2002 to February 2004, Mr. Schuon was President of Programming of Infinity Broadcasting. From April 2001 to August 2002, he was President and Chief Executive Officer of Pressplay, a joint venture created by Sony Music Entertainment and Universal Music Group. From December 1999 to April 2001, Mr. Schuon was President and Chief Operating Officer of the Universal Music Group’s music business, Farmclub.com, Inc. From February 1998 to November 1999, Mr. Schuon was Executive Vice President/General Manager of Warner Bros. Records Inc. From 1992 to December 1997, Mr. Schuon served as Executive Vice President of MTV where he was responsible for programming, music, production and talent for the MTV and VH1 cable channels. Mr. Schuon brings to our Board an extensive background in identifying and capitalizing on current music and pop culture trends, as well as deep expertise in media and business development. With his knowledge, experience, and understanding of our historical development, Mr. Schuon provides us with valuable strategic insight and perspective.
Thomas Vellios has served on our Board since June 2008. Since 2002, he has served as co-founder, director and Chief Executive Officer of Five Below, Inc., a chain of specialty retail stores for teens and pre-teens. From 1998 to 2002, Mr. Vellios served in various capacities with Zany Brainy, a chain of specialty retail stores including roles as: Chief Executive Officer, from 2001 to 2002; President, from 1998 to 2002; and Executive Vice President of Merchandising and Marketing, from 1995 to 1998. From 1986 to 1995, Mr. Vellios served as Senior Vice President, General Merchandise Manager of Caldor Corporation, a diversified discount retailer which was acquired by May Company in 1986. Mr. Vellios brings to our Board extensive experience in the retail industry. His knowledge and experience provide us with valuable management, financial and operational expertise.
MANAGEMENT DISCUSSION FROM LATEST 10K
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 “Item 1 – Business” included elsewhere in this annual report on Form 10-K.
Strategic Business Changes We recently completed the implementation of all planned initiatives related to the strategic business changes approved by the Board in fiscal 2011 to improve our operating results and to better position us for growth. The business changes involved discontinuing the operations of ShockHound; writing down inventory; writing down property and equipment that are no longer critical to our strategic direction; and implementing other strategic business and operational initiatives. As of the end of the second quarter of fiscal 2011, we had incurred all charges related to the strategic business changes.
Cost Reduction Plan We have completed the implementation of a cost reduction plan that, beginning in fiscal 2011, is expected to result in an estimated annual income improvement of approximately $13 million, pre-tax. The cost reduction plan, which was designed to meet the challenges of the environment at that time, involved closing approximately 50 underperforming stores, a majority of which closed at the end of the first quarter of fiscal 2011. These closures occurred as a result of natural lease expirations, exercising lease kick out clauses and other negotiations. The cost reduction plan also included reducing our home office and field management positions, reducing planned capital expenditures in fiscal 2011 to approximately $25 million from $31 million in fiscal 2010 and implementing other non-payroll overhead expense reduction initiatives. As of the end of the second quarter of fiscal 2011, we had recorded all charges related to the cost reduction plan, completed the announced reduction of our home office and field management positions, and completed the implementation of non-payroll overhead expense reduction initiatives as part of the cost reduction plan. As of the end of fiscal 2011, we had closed 38 Hot Topic stores and six Torrid stores as part of the plan.
Quarterly Results and Seasonality
Our quarterly results of operations may fluctuate materially depending on, among other things, the timing of store closings, store openings and related pre-opening and other startup expenses, net sales contributed by new stores, increases or decreases in comparable store sales, releases of new music, film, television and music/pop culture-related products, shifts in timing of certain holidays, changes in our merchandise mix and overall economic conditions.
Our business, particularly our Hot Topic division, is also subject to seasonal influences. Refer to “Item 1 – Business” under the caption “Seasonality” included elsewhere in this annual report on Form 10-K for further discussion about the seasonality of our business.
Liquidity and Capital Resources
During fiscal 2011, one of our primary uses of cash was to repurchase an aggregate of $25 million of our common stock (discussed in more detail in “NOTE 12 – Share Repurchase” contained in the consolidated financial statements and notes included elsewhere in this annual report on Form 10-K). We also funded cash dividend payments totaling $12.2 million during fiscal 2011 ( discussed in more detail in “NOTE 4 – Cash Dividends” contained in the consolidated financial statements and notes included elsewhere in this annual report on Form 10-K). During fiscal 2011, we made a total cash outlay of approximately $7 million related to certain strategic business changes (discussed in more detail in “NOTE 2 – Recent Business Events” contained in the consolidated financial statements and notes included elsewhere in this annual report on Form 10-K). Other uses of cash during the last three fiscal years have been to purchase merchandise inventories, improve our information technology infrastructure and fund store remodels, relocations and to a lesser extent, new store openings. We have typically satisfied our cash requirements principally from cash flows from operations and we also maintain a $5 million unsecured credit agreement (discussed in more detail in “NOTE 8 – Bank Credit Agreement” contained in the consolidated financial statements and notes included elsewhere in this annual report on Form 10-K).
Cash, cash equivalents and short-term and long-term investments, including auction rate securities, held by us were $67.8 million and $79.5 million as of the end of fiscal 2011 and 2010, respectively. We believe our current cash balances and cash generated from operations will be sufficient to fund our operations through at least the next 12 months. Auctions representing the auction rate securities we hold have continued to fail and will limit our ability to liquidate these investments for some period of time. However, we do not believe the auction failures will impact our ability to fund our working capital needs, capital expenditures or other business requirements.
Working capital was $94.2 million and $113.9 million for fiscal 2011 and 2010, respectively. The $19.7 million decrease in working capital in fiscal 2011 from 2010 is primarily attributable to the $25 million repurchase of our common stock in fiscal 2011.
Net cash flows provided by operating activities were $45.9 million and $35.0 million in fiscal 2011 and 2010, respectively. The $10.9 million increase in net cash provided by operating activities in fiscal 2011 as compared to fiscal 2010 was primarily attributable to a decrease in prepaid expenses and an increase in accrued liabilities partially offset by an increase in inventory.
Net cash flows used in investing activities were $13.8 million and $45.6 million in fiscal 2011 and 2010, respectively. The $31.8 million decrease in net cash used in investing activities in fiscal 2011 as compared to fiscal 2010 was attributable to a $24.6 million decrease in purchases of short-term and long-term investments, net of proceeds and a $7.2 million decrease in purchases of property and equipment.
Net cash flows used in financing activities were $33.7 million in fiscal 2011 compared to $56 million in fiscal 2010. The decrease in net cash used in financing activities was primarily attributable to the $44.5 million in $1.00 per share special one-time cash dividends paid in fiscal 2010 and a $1.8 million increase in proceeds from stock related purchases, partially offset by the $25 million repurchase of our common stock in fiscal 2011.
We anticipate we will spend approximately $37 million on capital expenditures in fiscal 2012. Of the $37 million, we plan to spend approximately $26 million for store construction and other improvements to existing stores, including remodeling or relocating them (refer to “Item 1 – Business” included elsewhere in this annual report on Form 10-K for detail on our store expansion activity). We plan to spend the remaining capital expenditures on various improvements in our information technology infrastructure, including technological improvements at the store level and the purchase of new computer hardware and software.
Critical Accounting Policies and Estimates
Management’s discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosures of contingent assets and liabilities. On an ongoing basis, we evaluate estimates, including those related primarily to inventories, long-lived assets and contingencies. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
We believe the following critical accounting policies affect the more significant judgments and estimates used in the preparation of our consolidated financial statements. For a further discussion about the application of these and other accounting policies, refer to “NOTE 1 – Organization and Summary of Significant Accounting Policies” contained in the consolidated financial statements and notes included elsewhere in this annual report on Form 10-K.
Inventories Inventories are valued at the lower of average cost or market, on a weighted average cost basis, using the retail method. Under the retail method, inventory is stated at its current retail selling value and then is converted to a cost basis by applying an average cost factor that represents the average cost-to-retail ratio based on beginning inventory and the purchase activity for the month. Throughout the year, we review our inventory levels in order to identify slow-moving merchandise and use permanent markdowns to sell through selected merchandise. We record a charge to cost of goods sold for permanent markdowns. Inherent in the retail method are certain significant management judgments and estimates including initial merchandise markup, future sales, markdowns and shrinkage, which significantly impact the ending inventory valuation at cost and the resulting gross margins. To the extent our estimated markdowns at period-end prove to be insufficient, additional future markdowns will need to be recorded. Physical inventories are conducted during the year to determine actual inventory on hand and shrinkage. We accrue our estimated inventory shrinkage for the period between the last physical count and current balance sheet date. Thus, the difference between actual and estimated shrink amounts may cause fluctuations in quarterly results, but not for the full fiscal year results.
Valuation of Long-Lived Assets We assess the impairment of long-lived assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. For our Hot Topic and Torrid concepts, we group and evaluate long-lived assets for impairment at the individual store level, which is the lowest level at which individual cash flows can be identified. Factors we consider important that could trigger an impairment review of our stores or online operations include a significant underperformance relative to expected historical or projected future operating results, a significant change in the manner of the use of the asset or a significant negative industry or economic trend. When we determine that the carrying value of long-lived assets may not be recoverable based upon the existence of one or more of the aforementioned factors, impairment is measured based on a projected discounted cash flow method using a discount rate determined by management. These cash flows are calculated by netting future estimated sales against associated merchandise costs and other related expenses such as payroll, occupancy and marketing. The estimated sales, net of the aforementioned costs and expenses, used for this nonrecurring fair value measurement is considered a Level 3 input as defined in “NOTE 7 – Fair Value Measurements” contained in the consolidated financial statements and notes included elsewhere in this annual report on Form 10-K . We have recorded impairment charges in fiscal 2011 and prior years. In addition, in the event future store performance is lower than forecasted results, future cash flows may be lower than expected, which could result in future impairment charges. While we believe recently opened stores will provide sufficient cash flow, material changes in results could result in future impairment charges.
Revenue Recognition Revenue is generally recognized at our retail store locations at the point at which the customer receives and pays for the merchandise at the register. For online sales, revenue is recognized upon delivery to the customer. Sales are recognized net of merchandise returns, which are reserved for based on historical experience. Revenue from gift cards, gift certificates and store merchandise credits is recognized at the time of redemption. Shipping and handling revenues from our websites are included as a component of net sales.
We recognize estimated gift card breakage as a component of net sales in proportion to actual gift card redemptions over the period that remaining gift card values are redeemed. Gift card breakage is income recognized due to the non-redemption of a portion of gift cards sold by us for which liability was recorded in prior periods. While customer redemption patterns result in estimated gift card breakage, which approximates 5 to 6%, changes in our customers’ behavior could impact the amount that ultimately is unused and could affect the amount recognized as a component of net sales.
Vendor Allowances We receive certain allowances from our vendors primarily related to damaged merchandise, markdowns and pricing. Allowances received from vendors related to damaged merchandise and pricing are reflected as a reduction of inventory in the period they are received and allocated to cost of sales during the period in which the items are sold. Markdown allowances received from vendors are reflected as reductions to cost of sales in the period they are received as these allowances are received after goods have been sold or marked down.
Stock-Based Payments We account for stock-based compensation expense by estimating the fair value of stock options granted, except for certain stock options granted in March 2011 that are subject to the vesting determination described in “NOTE 3 – Stock-Based Compensation” contained in the consolidated financial statements and notes included elsewhere in this annual report on Form 10-K, using the Black-Scholes option-pricing formula and a single option award approach. We estimated the fair value of the stock options granted in March 2011 that are subject to the vesting determination using a Monte Carlo simulation valuation model. Both of the option-pricing models used require the input of highly subjective assumptions, including the option’s expected life, price volatility of the underlying stock, risk free interest rate, early exercise behavior and expected dividend rate. As stock-based compensation expense is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Forfeitures are estimated based on historical experience.
Self-Insurance We are self-insured for certain losses related to medical and workers compensation claims although we maintain stop loss coverage with third party insurers to limit our total liability exposure. The estimate of our liability for these claims involves uncertainty since we must use judgment to estimate the ultimate cost that will be incurred to settle reported claims and unreported claims for incidents incurred but not reported as of the balance sheet date. When estimating our self-insurance liability, we consider a number of factors, which include historical claim experience and valuations provided by independent third party actuaries. As claims develop, the actual ultimate losses may differ from actuarial estimates. Therefore, an analysis is performed quarterly to determine if modifications to the accrual are required.
Rent Expense Rent expense under our operating leases typically provides for fixed non-contingent rent escalations. We recognize rent expense on a straight-line basis over the non-cancelable term of the lease, commencing when we take possession of the property. Construction allowances are recorded as a deferred rent liability, which we amortize as a reduction of rent expense over the non-cancelable term of each lease.
Income Taxes We account for income taxes using the liability method. Under this method, deferred tax assets and liabilities are determined based on differences between financial reporting bases and tax bases of assets and liabilities and are measured using the enacted tax rates expected to apply to taxable income in the periods in which the deferred tax asset or liability is expected to be realized or settled. Deferred tax assets are reduced by valuation allowances if we believe it is more likely than not that some portion or the entire asset will not be realized.
We prescribe a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more likely than not to be sustained upon examination by taxing authorities. The amount recognized is measured as the largest amount of benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. We include interest and penalties related to uncertain tax positions in income tax expense.
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.
MANAGEMENT DISCUSSION FOR LATEST QUARTER
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.
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.
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.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Management’s discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosures of contingent assets and liabilities. On an ongoing basis, we evaluate estimates, including those related primarily to inventories, long-lived assets and contingencies. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
We believe the following critical accounting policies affect the more significant judgments and estimates used in the preparation of our 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.
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.
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.
CONF CALL
James J. McGinty - Chief Financial Officer, Principal Accounting Officer and Secretary
Hi, this is Jim, and welcome to the call. While on hold, you've been listening to Smells Like Teen Spirit by Nirvana. My partners on the call today are Lisa Harper, Jerry Cook, George Wehlitz and Mark Mizicko. For competitive reasons, we will not be discussing any specific forward-looking product information during this call. George will begin by reviewing the second quarter results and making a few comments on the balance sheet. Following the Q2 details, Lisa will provide you with the thoughts on the second quarter performance and the outlook going forward. Lastly, we will discuss the guidance. Now I'll turn it over to George.
George Wehlitz - Vice President of Finance
Thanks, Jim. All comparisons discussed are to the same period from a year ago unless otherwise noted. Overall, the net sales during the quarter increased $6.9 million. The components of this increase are as follows: $4.7 million sales increase, primarily from new and noncomparable Hot Topic and Torrid stores; $3.7 million sales gain from Hot Topic comparable stores increase at 3.9%, $1.6 million sales gain from Torrid comparable sales increase of 4%; and lastly, $3.1 million sales decrease from closed stores.
For the second quarter, Hot Topic Division had an average transaction value increase of 13%, but the number of comparable transactions were down 8% from last year. Torrid had a 3% increase in the average dollar sale with a 1% increase in the average number of transactions.
At Hot Topic, apparel was 56% of total sales for the quarter, compared to 51% last year. At Torrid, apparel was 83% of total sales for the quarter compared to 81% last year.
Gross margin was 34.1% of sales, compared to 32.2% last year. The 190 basis point increase breaks down into the following categories: 120 basis points increase in merchandise margin as a result of higher realized markup and lower markdowns; 40% basis point decrease in the store depreciation expense due to leverage on higher sales and store closures; 40 basis points decrease in distribution expenses, primarily a result of lower freight, depreciation, supply and leverage on higher sales, partially offset by higher payroll and consulting costs; 20 basis points decrease in store occupancy percentage due to leverage on higher sales, partially offset by deferred rent credits recognized in the prior year as part of our cost-reduction plan; and lastly, 30% -- 30 basis points increase in our buying payroll expenses.
In the second quarter, selling, general and administration expenses were 34.9% of sales compared to 38.9% last year. Last year's SG&A expenses included approximately $4.1 million related to the strategic business changes and cost-reduction plan.
Excluding these costs, SG&A expenses for last year were 36.2% of sales. The 130 basis point improvement breaks down into the following categories: Store and Internet payroll expenses decreased 130 basis points, as a result of leverage on higher comp sales, improved productivity and lower store performance-based bonuses; the other store expenses decreased 80 basis points, primarily due to lower debit and credit card processing costs, utility costs, supplies and freight costs. These are partially offset by higher inventory service fees.
Other general and administrative expenses decreased 50 basis points as a result of lower relocation and asset impairment charges, partially offset by an increase in computer maintenance costs, a 20 basis point decrease due to lower depreciation expense and leverage on higher sales.
Marketing expenses increased 20 basis points as a result of increases in payroll, marketing events and media placement costs. These were partially offset by a decrease in store signage expenses.
Our pre-opening expenses increased 20 basis points, due to a greater number of new, relocated and remodeled stores open in the second quarter of 2012. Our performance-based bonuses increased 110 basis points for the quarter.
Our results ended in a net loss of $800,000, or $0.02 per share, versus a net loss of $3.6 million or $0.08 per share last year, excluding the $4.1 million of expenses related to the strategic business changes and cost-reduction plan.
During the quarter, we opened 1 Hot Topic store and 10 Torrid stores, closed 5 Hot Topic stores and 3 Torrid stores. We also remodeled or relocated 20 Hot Topic stores and 4 Torrid stores. Our cash position remains strong. Our cash, cash equivalents and investments, both short and long-term, were $65 million compared to $74 million last year. Our total inventory cost was $80 million. On a per-square-foot basis, our inventory was 7% higher at the end of the second quarter compared to last year. And on a 2-year basis, our inventory decreased 6% on a per-square-foot basis.
Year-to-date, our capital expenditures were $19 million, primarily related to store construction projects and IT projects. Our cash flows from operating activities, year-to-date, as of July, increased $10 million compared to last year. Now I'll turn the call over to Lisa.
Lisa M. Harper - Chairman and Chief Executive Officer
Thanks, George, good afternoon, everyone, and thanks for joining us today. We are pleased with the continued improvement in our overall business. On a consolidated basis, we delivered a 3.9% comp and generated solid bottom line results to improve gross margins and SG&A expense leverage.
At Hot Topic, we again delivered solid results with a 3.9% comp. This was true in the first quarter, our fashion apparel assortment made the largest contribution to the positive comps, contributing 16% of sales versus less than 10% a year ago.
Consistent with the strong trend established in the first quarter, the fashion apparel category comped up 67%. Denim, both fashion and core, performed well. Women's comped up 192% in the second quarter, and men's comped up 41%. Both numbers are consistent with the strong trend established in Q1.
These results are promising indicators that we can achieve our goal to return the fashion apparel to 20% of the business. We continue to expect that we will achieve that level next year.
Fashion accessories made up 32% of the business versus 34% last year, the result of a 2% comp decline and the increase in penetration in the fashion apparel and licensing to the total. We have had a few challenges in fashion accessories, most notably, shoes comped down 70%. You'll remember that we made a decision last year to exit the athletic shoe business. At this time last year, we were selling Converse and Vans at prices below $20. As the year goes on, this negative impact diminishes.
Hats and costume jewelry also negatively impacted the comp this quarter as they did in first quarter. We've adjusted inventory to more appropriate levels until we've identified the right balance and the assortment.
In beauty, over the course of the quarter, our focus was on working through the balance of the old and unproductive product that was committed to in early 2011. Sales of the new Blackheart Beauty product were challenged because of the competition with the Warpaint product that was deeply discounted and on clearance. We expect this to change in Q3 now that we worked through most of the unproductive inventory.
Overall, we're very focused on turning our fashion accessory category to positive comps in the back half of 2012 and expect it to help drive comps in 2013. License product contributed 29% to the business versus 28% last year. You'll recall that during the second quarter last year, we had very strong license sales, primarily driven by Harry Potter. We're pleased that this year, we were able to deliver a 7% comp in this category. Thanks to a strong overall assortment led by the superhero releases.
Our performance in the license product category is a testament to the success of our strategy to better manage movie-related license properties, to maximize gross margin dollars and chase the business instead of our traditional method of building inventory levels early.
This strategy applies to all areas of the company. But this year, it has made a significant impact in the license area, where we have historically suffered from a feast or famine approach particularly in the movie properties.
Music contributed 22% of the business versus 27% last year, and comps were down 14%. We've reduced our assortment of CD's in the stores, as this is the area of the company with the lowest GMROI. And as we discussed during the call last quarter, we knew music would be somewhat soft in the second quarter as a result of a slow release schedule.
For the back half of 2012, we're facing a much better release schedule and therefore, expect an uptick in the music category. We anticipate releases from Deadmau5, Machine Gun Kelly, Wiz Khalifa, Lil Wayne and Green Day, which has 3 releases scheduled. We've played Nirvana for the whole music today as a nod to our strong and growing classic business in the music area.
From a promotional standpoint, we ran our Hot Cash promotion in July, which helped drive customers back into the stores during a historically lower traffic period. This was the first time we ran Hot Cash in the second quarter, and we are happy with the results.
In Q2, sales at hottopic.com were up 1%. This is -- sales of regular-priced merchandise were up substantially and sales of clearance were down double-digits. We're pleased with our progress in balancing the mix here.
Moving on to Torrid. In the second quarter, the comp increased by 4%, an improvement over the 2.5% increase generated in the first quarter. Apparel generated a 6% comp increase and represented 83% of the business, as compared to 81% last year. Within Apparel, the bottoms category, was up in the high-teens, primarily as a result of our strong denim business. We were up 2% in Tops and other apparel categories.
We continue to be disappointed with Torrid accessories, where comps declined 5% due to declines in leather, jewelry and shoes. However, we are pleased that we delivered strong double-digit positive comps in intimate apparel, which is substantial go-forward opportunity at Torrid. You'll see an increase in intimate apparel inventory and assortment throughout the fall, which will continue to offset some of the declines in the traditional accessory business.
As you know, we've been testing styles and fits over the last year and gathering feedback from our customers. As a result, we've developed a new merchandising approached and introduced updated apparel collections to which our customers are responding very positively.
For example, our new stiletto skinny denim is performing well and has gotten a great deal of buzz in the marketplace, particularly for its fit. Overall, we are pleased with the improvement in the Torrid business and believe it's a very strong growth opportunity for the company. Our new apparel offering that dropped July 30, coupled with our revamped vertical merchandising approach, are already helping to drive improved sales and margin.
A few weeks ago, we unveiled a completely new brand, look and message that's reflected in-store and online, as well as a new integrated marketing campaign that includes national print, digital and social media marketing with local marketing -- local marketing programs. The campaign was shot by fashion photographer, Ellen von Unwerth, and we believe the photos are a great reflection of the image we want to portray, that Torrid is about fashion and sex appeal, not just about size. We anticipate expanding our marketing campaigns in 2013, as we continue to grow the Torrid business. In the second quarter, we opened 10 new stores for Torrid, 8 of which were in strip centers, our predominant go-forward real estate strategy. This brings the total number of Torrid stores and strip center locations to 17. We continue to expect our stores and strips to payback in less than 18 months on a cash basis. We also expect strip center stores to generate a higher store contribution in the long run, as we leverage lower occupancy costs.
Our experience so far indicates that while traffic is lower in strip center stores, conversion and average transactions are higher than the mall counterparts. We believe that the high ROI and relatively fast payback makes Torrid a very compelling growth opportunity.
For the balance of 2012, we anticipate opening 18 new Torrid stores in Q3 and 3 in Q4. In addition, we expect to relocate approximately 8 Torrid mall locations to strip centers in the back half of 2012.
By the end of 2012, we expect that approximately 20% of our stores will be in strip centers. Torrid.com was up 9% in the quarter and comprised over 20% of the total division sales. Regular price selling improved dramatically in this channel, well ahead of the 9% gain. We continue to actively pursue various customer acquisition strategies to further improve our traffic and broaden our customer base.
As we discussed on the last call, we continue to anticipate strong gross margin improvement in Torrid at the back half of 2012, specifically related to our product sourcing model, as we move from a primarily market-driven purchases to a vertically integrated model where we design and contract manufacture our own product. I continue to feel strongly that the new processes and product focus will dramatically improve Torrid's performance over the next several years. We will continue to evaluate the ultimate potential of the business, as we benchmark our progress on these fronts.
Looking ahead to Q3, for the first couple of weeks of the third quarter, traffic and sales were slower than we had anticipated. We think this was due to a shift in the start of schools in major markets like Texas; the oppressive heat; and the Olympics, which drew the largest viewing audiences ever. However, this week, we've seen substantial improvement in both businesses and are very encouraged by the rebound.
We are happy with our inventory levels that we're up 7% on a square foot basis to a year ago, well under our original plan. Overall, we're pleased with our progress as we continue to develop and improve our internal processes and our teams across all aspects of the business.
Our improved processes are being supported by revamp systems, including a new core merchandising system that we're adding at the beginning of fiscal 2013. Recently, we've implemented a product life cycle system to support our new product sourcing, product and sourcing strategies. The investment in people, processes and systems are showing traction. And I anticipate continued improvement in the back half of 2012.
Now I'd like to turn the call over to Jim, who will provide color on guidance.
James J. McGinty - Chief Financial Officer, Principal Accounting Officer and Secretary
Thanks, Lisa. We expect to see continuing improvement in our operating results compared to last year. This improvement is reflected in our previously announced Q3 earnings guidance in the range of $0.08 to $0.10 per share, compared to last year's $0.07 per share. Now a few more details on the third quarter.
For the third quarter of fiscal 2012, we expect sales to be in the range of $181 million to $185 million based on quarterly comp sales increase in the low single-digit percentage range.
Gross margin is anticipated to improve substantially over last year. SG&A expenses are anticipated to deleverage as they include investments in store preopening costs, Torrid brand marketing, as well as an increase in performance based bonus accrual. We are expecting inventory at the end of the third quarter to be up in the low single-digit percentage range on a per-square-foot basis, which compares to last year's flat per square foot.
We expect depreciation and amortization to be approximately $9 million for the quarter. For the third quarter, we expect to open approximately 18 new Torrid stores. We also expect to remodel approximately 16 Hot Topic stores and 1 Torrid store, as well as relocate 2 Torrid stores to strip center locations from malls. We also expect to close approximately 3 Torrid stores in the quarter.
Our guidance assumes approximately 43 million shares outstanding for the third quarter. We expect our fiscal 2012 capital expenditures for store projects to be approximately $25 million, and approximately $12 million for new IT systems. We may make additional capital expenditures in fiscal 2012 for other strategic and operational purposes. Depreciation and amortization is expected to be approximately $35 million for the full year of 2012.
At this time, we will take questions related to the results and outlook. Please hold while we contact the conference operator, who will give you further instructions.
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