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We have recently downgraded our recommendation on Hot Topic Inc. to ‘Neutral’ based on its declining comparable-store sales transactions. Moreover, the stock is trading at a premium pertaining to our forward earnings estimates that limit its further upside.

We observe that comparable-store sales transactions at Hot Topic’s namesake stores have been falling year over year since the last four quarters. In the second quarter of fiscal 2012, number of transactions dropped by 8%, whereas in the first quarter it dipped 6%. During the fourth and third quarters of fiscal 2011, it decreased 7% and 8%, respectively.

Further, Hot Topic’s business is seasonal in nature and generates high proportion of sales during fiscal third and fourth quarters, which are characterized by the back-to-school, Halloween and holiday seasons. As a result, the company is exposed to significant risks if the seasons fail to deliver expected operating performance.

The company faces intense competition from other teenage-focused retailers in the industry such as Abercrombie & Fitch Co. (ANF - Analyst Report), Aeropostale Inc.  (ARO - Snapshot Report) and American Eagle Outfitters Inc. (AEO - Analyst Report) on the basis of brand recognition, fashion, price, service, store location, and quality. Consequently, this may hamper Hot Topic’s top and bottom-line performances.

On the reverse side of the story, Hot Topic recently posted strong second quarter of fiscal 2012, which was in line with the Zacks Consensus Estimate. The company posted a loss of 2 cents that fared better than the prior-year loss of 8 cents. Moreover, net sales grew 4.6% during the quarter.

Looking ahead, Hot Topic is quite bullish for the remaining period of fiscal 2012. The company now expects earnings in the range of 8–10 cents per share and 23–27 cents for the third and fourth quarters, respectively.

Another positive point for Hot Topic is that the company regularly monitors store sales and takes prudent steps to align merchandise mix in accordance with the rapidly changing preferences of its target customers. Furthermore, the company periodically evaluates its stores and remodels or relocates them in compliance with the latest trends. Hot Topic intends to open 18 new stores, remodel 16 and close 3 stores, during third quarter.

Based on the above analysis, we believe that the investors should seek for better visibility for Hot Topic’s prospective in the long term, before investing their money on this stock.

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