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We have retained our Neutral stance on Hot Topic Inc. as we remain impressed by the company’s strong third-quarter performance and bullish fiscal 2013 outlook. However, the company’s declining comps transactions and rich valuations keep us on the sidelines.

Why Neutral?

Mall-based specialty retailer, Hot Topic, operates its Hot Topic and Torrid store concepts across the U.S. as well as an e-space music discovery concept, ShockHound. The company’s business strategy is based on the foundation of the pop culture and its relevance for the targeted segment of teen customers. Hot Topic operates in a unique market niche by focusing on music and music/pop culture-oriented merchandise, offering products typically unavailable at other retailers through continuous emphasis on superior customer service.

In November 2012, the company launched a new store concept, Blackheart, through which it is offering intimate apparels for women aged between 18 and 30. Blackheart branded lingerie, accessories and beauty products are now available online at www.blackheartlingerie.com, whereas 5 Blackheart stores have been opened in Southern California and Texas.

We believe Hot Topic is advantageously positioned in North America over Limited Brands Inc’s La Senza stores, which operates stores only in Canada and is spread internationally. Therefore, we anticipate that the new brand will be accretive to the company’s top line.

Moreover, it posted a 42.9% increase in earnings per share for third-quarter fiscal 2012, aided by lower cost of goods sold (COGS) and improvement in gross margin. The company’s earnings per share of 10 cents also came ahead of the Zacks Consensus Estimate by a penny. Net sales inched up 2.0% year over year to $179.4 million.

Further, Hot Topic reaffirmed its earnings expectation of 23 cents – 27 cents per share for the fourth quarter. Looking ahead, the company is quite bullish for fiscal 2013 and expects earnings per share to increase in the range of 30% – 35% from the fiscal 2012 level.

On the flip side, we observe that comps transactions have been falling year over year since the last 5 quarters. Moreover, the stock is trading at a premium compared with the industry average based on our forward earnings estimates that limits its further upside. Additionally, prevailing sluggish economic growth, intense competition and seasonal risk of business may undermine the company’s future operational performance.

Other Stocks to Consider

Besides Hot Topic, other stocks that we look up to in the apparel stores industry are Abercrombie & Fitch Co. (ANF - Analyst Report) and Citi Trends Inc. (CTRN - Analyst Report). Both these companies carry a Zacks Rank #1 (Strong Buy).

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