Recently, the private equity firm Sycamore has announced that it would take Hot Topic, Inc. (NASDAQ:HOTT) private for around $14 per share, with a total transaction value of $600 million. A price tag of $14 per share represented a 29% premium to Hot Topic, Inc. (NASDAQ:HOTT)’s closing price on Wednesday. Let’s take a closer look into Hot Topic to see whether or not this price is fair for this specialty retailer.
Business snapshot
Hot Topic, Inc. (NASDAQ:HOTT) is considered a mall and web-based specialty retailer of apparel, accessories, music and gift items, operating under two main concepts: Hot Topic, Inc. (NASDAQ:HOTT) and Torrid. The majority of Hot Topic’s revenue, 32% of its revenue, was generated from fashion accessories sales, while license and music each accounted for 27% of the total Hot Topic, Inc. (NASDAQ:HOTT)’s sales. The fashion apparel ranked fourth, accounting for only 12% of the Hot Topic’s sales. In contrast, Torrid generated the majority of its revenue from apparel sales that represented 77% of the total sales in Torrid while the accessories accounted only 23% of sales.
In the past five years, Hot Topic has experienced a sluggish operating performance. Revenue has decreased consistently from $728 million in 2007 to $698 million in 2011, while the net income dropped from $16 million to -$2 million in the same period. Hot Topic, Inc. (NASDAQ:HOTT) had small positive comparable store sales growth in only two out of the past five years. In 2011, its comp store sales growth was as small as 0.6%.
Source: Hot Topic’s 10-K filing
The operating performance seems to be much better in 2012 when it reported the comparable store sales growth of 3.4%. In addition, the 2012 sales have increased to nearly $742 million. On a positive side, Hot Topic is considered a consistent cash flow generator. Since 2007, the operating cash flow has fluctuated in the range of $35 million to $77 million while the free cash flow has been in the range of $3 million to $54 million. The good thing is that Hot Topic doesn’t employ any leverage in its operation. As of October 2012, it had $185 million in total stockholders’ equity, $59 million in cash and short-term investments, and no debt.
Body Central has the cheapest valuation
Over the past twelve months, Hot Topic, Inc. (NASDAQ:HOTT) generated about $70.85 million in EBITDA. Thus, with an offering price of $14 per share, Hot Topic is valued at nearly 5.7 times EV/EBITDA. Compared to its competitors including Abercrombie & Fitch Co. (NYSE:ANF) and Body Central Corp (NASDAQ:BODY), Hot Topic is the most expensive valued on the stock market. Abercrombie & Fitch Co. (NYSE:ANF), at the current trading price of around $47.76 per share, is worth $3.77 billion on the market. The market values the company at only 4.8 times EV/EBITDA. Body Central Corp (NASDAQ:BODY) is the smallest company among the three. It is trading at around $7.63 per share, with a total market cap of only $124 million. It has the cheapest valuation at only 3.37 times EV/EBITDA. Among the three, Body Central Corp (NASDAQ:BODY) has the most profitable with the highest return on capital at 184% while the return on capital of Hot Topic was negative at -2.6% in 2011. The return on Abercrombie & Fitch Co. (NYSE:ANF) stayed at 14.5%.
The Foolish bottom line
Hot Topic has set the bar for relative valuation between apparel specialty retailers. With much higher returns on capital, both Abercrombie & Fitch Co. (NYSE:ANF) and Body Central should be valued minimum at the same valuation of Hot Topic. At only 5.5 times EV/EBITDA, Abercrombie & Fitch Co. (NYSE:ANF) should be worth at least $54.70 per share and Body Central should be worth at least $12.45 per share.
The article Hot Topic is Getting Hot originally appeared on Fool.com and is written by Anh Hoang.
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