Some people think scratch-and-sniff underwear could end up chafing

Hot Topic

(HOTT)

.

The teen fashion retailer has jumped 60% since September on strong sales of hip duds like banana-scented boxers. But some observers say a patent-infringement suit filed by a small California clothing company could spell trouble for the music-themed apparel and accessories chain. They say Hot Topic has repeatedly run afoul of trademark holders in the past, and warn that the company could be vulnerable to a costly court setback.

The company, based in City of Industry, Calif., rejects the notion that it has engaged in copycatting, and calls the Caution Underwear suit "totally without merit." Hot Topic says it has always acted responsibly in licensing and trademarking matters.

"I think from time to time we have sold items where someone has come forward with a license and we have stopped," says Jay Johnson, senior vice president for strategic alliances and investor relations at Hot Topic. "We've stopped immediately."

Still, with same-store sales growth slowing and short interest in the stock growing, some observers expect to see Hot Topic's fortunes decline in coming months. Short-sellers say that even if an infringement case doesn't bring a big judgment against the company, it could turn sentiment against the stock. Hot Topic rose 34 cents Tuesday, to $24.25.

Minor, Major

The case itself is minor. Jim Vitello, owner of Caution Underwear, seeks to recoup about $50,000 in attorney fees and damages of $20,000 to $30,000; he says he expects a hearing on the matter May 2. Hot Topic doesn't appear to consider the case material to its results, as it hasn't disclosed the suit in regulatory filings.

But the issues raised in the case highlight a broader problem at Hot Topic, say people in the industry who complain that the retailer has sold copycat goods that violate trademarks. The risk isn't just to the company's name: A lawyer with no connection to the case says that if a court were to rule against the company, it could cost Hot Topic a pretty penny.

"They will buy bootleg goods as long as no one complains," says one source, who annually sells several million dollars' worth of rock music T-shirts to Hot Topic and also owns shares in the company. "They are very aggressive."

Cindy Levitt, Hot Topic's vice president and general merchandise manager, estimates the company has received about 10 cease-and-desist letters from license holders within the last couple years, according to a transcript of a deposition she gave for Vitello's lawsuit. The companies included toymaker

Mattel

and

Dairy Queen

, the Girl Scouts and the punk band Misfits. In each case, she said in the deposition, Hot Topic immediately stopped selling the merchandise in question.

Talking to some of the complainants seems to back up her comments. In the case of Dairy Queen, Hot Topic was selling T-shirts with a logo similar to Dairy Queen's red swirl with the words "Drama Queen," says Mike Rinke, assistant general counsel at Dairy Queen, who sent a cease-and-desist letter to the retailer. "We actually heard back in only eight days," Rinke says. "It went better than often happens in these cases." Hot Topic halted sales of the shirts almost immediately, he says. (Representatives of Mattel and Girl Scouts said they wouldn't be able to comment in time for publication.)

Whether or not a company knows it is violating trademark rights matters little, say experts in trademark law. "Ignorance isn't a defense," says William Goldman, a trademark and copyright attorney at Litman Law, a Virginia law firm. "I'd say it's like Russian roulette. Eventually it's going to catch up with you, and you're going to run into a company that is aggressive in protecting their rights." He says there is little excuse for companies to claim ignorance, given that in most cases trademark and licensing information can be found on the Internet.

"Sometimes that's true, but it's not always the case," Johnson, the Hot Topic spokesman, says.

Vitello, a mortgage-broker-turned-underwear-designer who has pitched his wares on the Howard Stern show, began selling his products to Hot Topic in 1999. In 2000 the company stopped buying his products and began selling knock-offs under the same name, he alleges in the suit, which was filed last August. "They've destroyed my career," he says.

Fickle Teens

Meanwhile, short-sellers have increasingly put the company under a microscope. About 10.6 million shares are short, according to the most recent figures provided by

Nasdaq

, about double the level of a year ago.

While shorts say the company's merchandise is faddish and that consistently delivering what fickle teens want is difficult, sell-side bulls say the company's Torrid chain, which caters to plus-size women, will ensure growth for years to come. The company rolled out the new chain last year and currently has six stores open, with plans for 15 more this year.

"We believe the validation of Torrid as another high-return growth expansion vehicle for the company could result in earnings upside for FY03 (and beyond) and lead to multiple expansion for HOTT," writes Eric Beder, an analyst at Ladenburg Thalmann, in a recent report. (He has a buy rating on the stock and his firm does not have an investment banking relationship with the company.)

But latching on to such bullish growth projections for Torrid, which is untested and faces steep competition from a host of retailers, such as

Charming Shoppes'

(CHRS) - Get Report

Lane Bryant chain, is risky, say shorts, and hardly justifies a premium valuation.

At recent levels, the stock trades at 23 times forward earnings, making it more expensive than a host of other chains, such as

Abercrombie & Fitch

(ANF) - Get Report

and

American Eagle Outfitters

(AEOS)

.

Indeed, some shorts wonder if Hot Topic is starting to head in the direction of

Gap

(GPS) - Get Report

, once a darling of the apparel sector that is now in a two-year run of falling same-store sales. In 2000, for example, Hot Topic consistently posted monthly comp gains over 20%, before growth began slowing last year. In October, comps turned negative, before rebounding slightly amid heavy promotions over the holidays. Same-store sales fell again in January and February, before edging up 1.2% in March.

"People are extrapolating out two years and saying that Torrid's going to be worth more than the core business, and that's ridiculous," says one hedge fund manager who has been short Hot Topic for about six months.