Description

Kirkland’s, Inc. (KIRK) is a specialty retailer of mid priced home décor merchandise. At its current price of roughly $12/shr you are buying the earnings stream of the existing store base at a modest discount to intrinsic value, with a free option on the company’s substantial growth opportunities. On a conservative estimate of potential growth opportunities for the company’s concept, there is an incremental $7/shr in value. This yields a target price of roughly $20/shr – 70% above today’s trading level. This is not a complex story with numerous moving parts. It is a well-managed specialty retailer with outstanding returns on invested capital that has been unduly depressed by below-consensus near-term comp guidance. The management team has risen to the merchandising challenge of near-term depressed comps in the past, and we believe that they will do so again.

KIRK operated 280 stores at its most recent fiscal year-end. 80% of the company’s store base is mall-based, with the balance located in “power” and “lifestyle” strip centers. The company’s merchandise assortment is predominantly discretionary home décor items, with the three largest categories being wall décor (framed art, mirrors – 28% of revs), decorative accessories (11% revs), and lamps (10% revs). The merchandise can be described as trendy, think Pier 1 Imports, so inventory management and merchandising are key to the company’s success. The target audience is middle aged, middle-income women.

KIRK stock has taken a beating lately as a result of below-consensus guidance for Q2 on both earnings and comps. The company has struggled with lackluster comps over the last 12 mos as a result of both merchandising missteps and general consumer malaise. The company’s average quarterly comp over the last 12 mos has been –0.4%, and the company is guiding towards comps down 2-4% for Q2. Prior to the most recent twelve months, KIRK has posted an average trailing four-quarter comp range of 2%-18%. To buttress its buying and merchandising capabilities, KIRK recently hired both a new senior VP of merchandising and senior buyer. The company is also looking for a VP of marketing, and indicates that it is making good progress on the search. As a point of reference on the macro side, Pier 1 has also now warned two quarters in a row so there are clearly weaknesses in this retail subsegment that are affecting all the players.

Same store comp weakness (and the associated operational deleveraging), in conjunction with incremental expenses from the opening of a new distribution center, have driven margin compression over the last 18 mos. Peak LTM EBIT margins of 10.6% during fiscal 2003 (the year ended Feb 2003) have declined to a current level of 8.2%. Of note, the recent incremental expenses associated with the new distribution center will abate as capacity ramps and over time the portion of gross margin associated with distribution will decrease, driving margin expansion. Mgmt is confident that with a rebound in comp store sales it can ultimately exceed former peak margins – given the expansion opportunities (detailed below), and associated benefit of operational leverage, I believe this is a reasonable assumption. On the Feb 2004 revenue base, a 10.6% EBIT margin would generate roughly $1.35/shr in earnings as compared to current guidance of $0.90-$1.00/shr.

From my standpoint, the most exciting part of the KIRK story is the potential expansion of the concept. KIRK has a long and successful history, but didn’t begin aggressively rolling out stores until it gained access to the necessary capital through its 2002 IPO. Mgmt has spent the last several years building out its real estate team, and in 2003 began rolling out stores on a more aggressive basis than it had historically. The company proved its ability to successfully accelerate the rollout of the concept during 2003. This year, mgmt expects to roll out 40 net new stores (55 gross), and plans to grow square footage by 15% annually for several years thereafter. Ultimately, mgmt believes that the concept can support 1000 stores. Returns on a new box are absolutely phenomenal, with after-tax returns north of 40%. A new store requires <$300k in capital, or approximately $165k in fixed assets and $125k in inventory. Boxes are cash flow positive in year 1, and ramp to $1.5mm in revenues within 3-4 yrs at a store-level EBITDA margin of 16-17% (corresponding to a 14-15% EBIT margin). Going forward, it is likely that expansion will be focused on non-mall venues. The shift away from malls as a shopping destination is well-documented, however, it is important to recognize that KIRK is not saddled with numerous underperforming mall locations. Last fiscal year, only one store in KIRK’s entire store base was not cash flow positive on a 4-wall basis. Moreover, given KIRK’s relatively small store base its mall locations tend to be in the more active, better performing malls. In addition, savvy lease negotiations have allowed the company to remain free of onerous lease terms that lock it into specific locations for long-term commitments.

Other items to note:
1) The company’s founder and Chairman, Carl Kirkland, currently owns or controls (thru trusts) > 10% of the company’s stock.
2) Advent, a Boston-based PE firm, owns 1/3 of the company. Advent purchased the company in 1996 and IPOed it in 2002. The fund in which it holds the shares it winding down and Advent is looking to get liquid. There is currently a shelf registration filed on its shares. It is highly unlikely Advent would exit at current levels, however, liquidity needs will need to be addressed over the coming 18-24 mos. Mgmt considers it unlikely that Advent would distribute shares directly to its LPs, preferring instead to manage the liquidity process through a secondary offering.
3) KIRK is currently beta-testing a private label credit card. The company is partnering with GE capital and will not retain residual risk on the receivables. Based on preliminary results to date, mgmt expects the card to be a valuable marketing and data-gathering tool upon full rollout.

Valuation:
I value KIRK on the basis of its current business + the present value of its growth opportunities.

Current business – with a rebound in operating margins to 9.5% – well below both the historical high and management expectations – the current fiscal year revenue base would deliver $1.20/shr in EPS. With 3.5% comp store growth, and assuming a 12% discount rate, this implies fair value of 11.8x, or $14.15/shr.

Growth opportunities – based on the per-store economics detailed above, the NPV of a new box is roughly $750k; I assume store rollout of 40-50 stores/annum over the next five years (representing square footage growth of 9-14% – well below mgmt guidance) which yields a store base of 505 stores by 2009, keep in mind that mgmt believes the concept can support 1000 stores total; at $750k NPV/box and assuming this rollout the growth plans have a current NPV of $143mm, or $7.35/shr

Risks:
Advent share overhang; trendy nature of merchandise can lead to SSS volatility – buying, merchandising, and inventory control are key; exposure to mall venues – believe this risk is minimal given the details above but need to acknowledge nonetheless; general consumer spending weakness; misexecution as new store rollout accelerates

Catalyst

Rebound in comp store performance, continued successful rollout of new boxes, incremental sell-side coverage launched in conjunction with secondary offering of Advent shares