At $2.40, KIRK currently sports an enterprise value of around $43 million.  By year-end, including an estimated $20 million of cash flow generated during the second half, the enterprise value at the current stock price would be under $23 million.  And yet KIRK is on pace to generate at least $11 million in fully-taxed FCF this year, with EBITDA of over $22m and adjusted EBITDA (deducting the amortization of landlord construction allowances, explained later) of over $15 million.  With no debt currently, and anticipated net cash of over $1.25 per share at year-end, this strikes me as an outstanding risk/reward profile, particularly considering ongoing positive trends in the company’s same store sales, gross margins and operating expenses.  The gradual rationalization of the company’s store base is benefitting cash flows, with more to come through 2009 as additional unprofitable stores outside of KIRK’s core markets are closed at no cash cost to the company.  Apparently senior management and the board of directors, five of whom just agreed to buy 19.6% of the company’s common stock from private equity sponsor Advent International, agree with my assessment. 

 

KIRK is a home furnishings retailer with 324 stores in 34 states, with two thirds of its store base located in the “sun belt” extending across the southeastern and southwestern US.  The company generates almost $400 million in sales annually, selling value-priced home decorations and furnishings, mostly to women aged 25-55. Most items sell for under $50, and the company has historically carried traditional merchandise and followed widespread trends, rather than taking on increased inventory risk by catering to more fashion-forward shoppers. 

 

Founded in Jackson, TN in 1966 by Carl Kirkland, who owns about 14% of the company and recently agreed to buy more, KIRK has grown from a single store.  In 1996, KIRK was acquired by management and Advent Partners, a private equity firm, and then taken public in 2002 at $15 a share.  The stock traded as high as $22.40 in late 2003.  However, declining mall traffic, increased competition, a series of merchandising mistakes, and eventually the added pressures of the housing downturn resulted in negative same store sales and declining profits, beginning in 2004 and continuing through 2007, when adjusted EBITDA finally went negative, bottoming at -$7 million.  

 

During 2007, management reduced costs and sold assets, discontinued new store openings and eliminated certain managers, including the COO, who had been responsible for a more thematic approach to merchandising, which was not well-received by KIRK’s more traditional customers. Importantly, KIRK also evaluated its store base in detail and selected a group of unprofitable stores to close during 2008 and 2009.  Having negotiated favorable leases with frequent kick-outs, KIRK has been and will continue to be able to exit its unprofitable stores in fairly short order at zero cash cost, avoiding the unfortunate position of needing to buy out landlords or continue to burn cash through unprofitable leases’ terms.  The result is an increase in profits without any corresponding cash investment.  Finally, KIRK has been able to shift the majority of its store base out of mall locations and into off-mall locations as lease terms have allowed, with mall-based stores declining from 87% of stores in 2003 to an estimated 29% by the end of 2008.  This shift is significantly decreasing rental expense per square foot, allowing for significantly more profitable store economics, particularly given higher gross profit per square foot earned in off-mall stores. 

 

In 2008, operating performance has improved considerably.  Q1 saw the first positive same store sales result in four years, and more importantly, gross profit improved by almost $5 million while operating expenses declined by almost $5 million, contributing to over a twelve percentage point improvement in operating margin.  Q2 saw continued progress, with continued positive same store sales and an eight percentage point improvement in operating margin, against a less beneficial comparison.  The company recently reported that it continued to experience similar positive sales trends and improving margins into August, with traffic trends going positive for the first time in years.  

 

This investment reminds me of URGI in 2004-2006, which was written up on VIC by gatsby892 and proved to be an extremely profitable investment, returning over 7x in 18 months for those smart/lucky enough to sell at the top, with the company eventually being sold for 5x three years after the writeup.  Both retailers were seeing early signs of successful turnarounds following periods of weakness brought on primarily by merchandising mistakes, with strong balance sheets, significant insider ownership, and extremely depressed valuations of less than 0.1x EV/Sales. As with URGI, which saw its former parent Limited Brands (LTD) sell its 20% stake near the bottom in order to focus on larger investments, Advent recently sold its 32% stake in KIRK.  Advent recently closed on a new $10 billion “middle market” fund and is winding down the older vintage fund in which KIRK is held, explaining the timing of the sale. 

 

In early 2007, with the stock trading around $5, two large shareholders owning a combined 24% of the company (Vardon Capital and Endowment Capital, who had each paid close to $10 per share on average for their stakes) began to sell out of their positions, pressuring the stock and dropping the market cap below a level which could be owned by many institutional investors.  As a result, the stock fell below $1.00 in late 2007 and early 2008.  While the stock has begun to recover in the wake of stronger earnings and the clear demonstration of more than ample liquidity, it still trades at an enormous discount to intrinsic value.  I expect the removal of the overhang from management buying Advent’s remaining stake, as well as continued progress reported by the company in the back half of this year, will contribute to the discount closing significantly. 

 

As of the end of the second quarter, KIRK had $4.7 million in net cash.  As with many retailers, there is a seasonal element to working capital, as the company generally builds inventory into the holiday season.  For KIRK, this results in peak borrowings around the end of the third quarter, with cash flow peaking during the fourth quarter and the year-end cash balance representing the seasonal peak in the cash position.  On average over the past several years, the year-end net cash balance has been about $15m higher than the average net cash balance throughout the year.  Therefore, while I expect year-end net cash may be around $25 million, I believe a more appropriate and conservative net cash balance to use for purposes of valuation is around $10 million. 

 

Earnings and cash flows should continue to improve for several reasons.  First, and most straightforward, the company reduced corporate overhead by $3.5 million on an annual basis during the fourth quarter of 2007, primarily through reductions in staff.  Second, and probably most important, the company’s gross margin was abysmal throughout 2007, as the result of a new, fairly untested thematic merchandising strategy gone very wrong, resulting in massive markdowns.  As markdowns have returned to more acceptable levels this year, gross margins have improved dramatically.  Third, KIRK is benefitting from significant store closures.  By evaluating information the company has shared in investor presentations and comments made on earnings calls disclosing unit economics of mall-based and off-mall stores in 2006 and 2007, it is clear that KIRK’s mall-based stores, as a group, were barely above breakeven in 2007 before corporate overhead.  Mall-based stores earned a store-level operating margin of just 3.5% in 2007, approximately ten percentage points worse than KIRK’s off-mall stores.  Furthermore, management has several times identified certain underperforming clusters of mall-based stores outside its core markets which perform sharply below the mean.  A large group of about 35 underperforming mall-based stores was closed early this year, and a similar number of underperforming mall-based stores will be closed in late 2008 and early 2009.  By waiting for the kick-out clause for all its underperforming leases, KIRK has been able to walk away from these cash-flow negative stores at virtually zero cash cost.  This results in an immediate benefit to earnings and cash flows. 

 

While inexpensive on an LTM basis, the second half of 2007 marked a low point in KIRK’s history, and so it is important to look ahead a couple of quarters to appreciate just how undervalued KIRK’s stock presently is.  Starting with EBIT, I expect Q3 and Q4 each to continue to show significant year-over-year improvement, in line with management’s recent statements.  While not giving specific guidance, this much management has promised.  Q1 and Q2 showed $10 million and $7 million year-over-year improvements in EBIT, respectively, as well as substantial improvements over 2006 levels.  Management believes that 2006, which up until 2007 had been the company’s worst showing since before 1999, is a conservative baseline for where the company should currently be.  To be conservative, I am assuming that Q3 EBIT is a -$4.3m loss, which corresponds to a $3 million improvement over 2007 and zero improvement from 2006.  For Q4, I am projecting EBIT of $12.5 million, which is a $5 million improvement over 2007 but still $5 million worse than 2006.  Despite several company-specific tailwinds currently benefitting KIRK, as well as KIRK’s positioning as a value retailer, it is impossible to ignore the dim outlook for the American consumer. 

 

EBITDA looks impressive, with 2008E EBITDA of over $22 million.  However, due to KIRK’s capitalization of landlord construction allowances as deferred rent, a liability, and then subsequent amortization of this liability over the course of each lease as a reduction to rent expense on the income statement, KIRK’s accounting requires an adjustment to deduct the amortization of landlord construction allowances from reported D&A.  On a run-rate basis, reported D&A is running around $18.5 million and the amortization of landlord construction allowances is running around $7 million, resulting in adjusted D&A of about $11.5 million.  Therefore, I believe 2008E adjusted EBITDA of $15.5 million is a more accurate representation. 

 

For normalized free cash flow, I take the $15.5 million of adjusted EBITDA, subtract $1.6 million of normalized taxes, and subtract maintenance capital expenditures of $3 million.  KIRK expects to spend $2m or less in net capital expenditures this year, including the opening of three off-mall stores.  This results in unlevered FCF of about $11 million, excluding working capital swings and other items such as tax refunds and asset sale proceeds.  On a per share basis, I am estimating 2008E FCF of $0.55.  Not bad for a company with a $2.40 share price which should have over $1.25 a share in net cash on the balance sheet at year-end. 

 

In terms of the balance sheet, I arrive at my estimate of around $25 million in year-end cash based on the following:

 

Adjusted 2008E EBITDA 15.5

CapEx                                       (3.0)

Interest Expense                        (0.0)

Taxes                                        (1.6)

Change in Inventory                    5.0

Change in A/P                           (0.6)

Tax Refund Proceeds                  2.9

Asset Sales Proceeds                  0.8

  Total 2008E FCF                    19.1

 

2007 Year-end Net Cash            5.8

2008E FCF                               19.1

  2008E Year-end Net Cash      24.9

 

As for my working capital projections, I am assuming that management is successful in achieving the low end of their target to reduce inventory by $5 to $8 million during 2008.  At the end of Q1, inventory was down over $7 million year-over-year, although it was down less than $5 million at the end of Q2.  A/P should return to the low 40’s as a percentage of inventory at year-end, vs. just 38% last year but 46% and 49% in the prior two years, as it has been running somewhere between 2007 and 2005/2006 levels this year.   

 

The tax refund relates to a refund received from the IRS in the first half of 2008.  Asset sale proceeds are from a small propeller plane sold this year and do not include $2.9 million in anticipated proceeds from the sale of KIRK’s former headquarters, currently on the balance sheet as an asset held for sale, which may not close until Q1 2009. 

 

KIRK is clearly inexpensive.  Based on my projections for the rest of the year and the year-end balance sheet, the stock currently trades for about 2x 2008 unlevered FCF and 1.5x 2008 adjusted EBITDA.  On a “headline” basis, KIRK trades at just 1x 2008 EBITDA, but this ignores the meaningful non-cash reduction in rent expense related to landlord allowances previously discussed, so I am not considering headline EBITDA a meaningful metric.  If I adopt a more conservative stance and use an average net cash balance of $10 million, rather than the year-end balance, then valuation looks more like 3.4x FCF and 2.4x adjusted EBITDA.  Yet these numbers reflect KIRK achieving just a 1% EBIT margin in 2008, whereas the company historically enjoyed EBIT margins between 5% and 10% through 2003.  As additional poorly performing stores are closed, and sales per square foot and merchandise margins continue to recover from depressed levels, KIRK has the opportunity to return margins to historical levels… although I am certainly not paying for this prospect. 

 

On a relative basis, KIRK also appears attractive.  Comparable companies I have considered include PIR, CPWM, TUES, ACMR and JAS.  I have used recent balance sheets, as all face similar seasonal swings in working capital.  These companies currently trade for EV/2008E Sales multiples between 0.19x and 0.35x, vs. KIRK at 0.11x.  PIR and CPWM won’t earn enough in 2008 to make even an EBITDA multiple meaningful, however TUES, JAS and ACMR all trade for around 6x 2008E EBITDA, vs. KIRK at 2.8x.  The reason I consider relative valuation is to dispel the notion that KIRK only trades at a discount due to its seemingly unfavorable positioning as a retailer of home-related products.  The company is materially outperforming struggling competitors PIR and CPWM, and yet if KIRK were to trade at only a similar EV/Sales valuation to either, KIRK’s stock price would more than double. 

 

A firm target price does not make sense for KIRK.  If KIRK continues along its current path, it seems the stock should trade for a more normal multiple of FCF, before incorporating some additional value for the potential for KIRK to earn high returns on incremental invested capital (discussed later) and the potential to continue to increase profitability to historical levels.  A $5 stock price, representing a high single-digit multiple of current FCF, seems an easy hurdle, absent evidence of further progress in profitability.  Eventually, it is not hard to envision KIRK trading for 0.5x Sales (implying 10x EBIT and a 5% EBIT margin), which would result in at least a $10 stock price.  It bears remembering that KIRK came public in a tough market over six years ago at $15 a share, with effectively the same capital structure and a substantially smaller store base (even pro forma for current closings). 

 

Management is very solid.  They are very accessible to shareholders, and I recommend speaking to them.  Their largest mistake to date has been expanding the store base beyond its proven markets too rapidly, encouraged by extraordinary unit economics on new stores in existing markets.  At the time of the IPO, KIRK was earning a high double-digit ROIC, and management made a mistake common in retail in that they aggressively extrapolated impressive returns generated in core markets.  They are now adamant that re-trenching around their proven markets will be the best way forward, and I would not expect a return to the northeast or Midwest markets, which have fared poorly as a whole. 

 

Most importantly, management and the board will own well over 30% of the company following the closing of the Advent purchase, which is expected any day now. 

 

In addition to management, Integrity Brands filed a 13G as a 5% holder in June 2008.  Integrity Brands is an investment vehicle managed by John Pound, who also invested in URGI and was instrumental in pushing for progress, eventually settling a proxy contest with management.  KIRK management is much more talented and more shareholder-friendly than was URGI’s prior management, who were below average, so I don’t anticipate Pound will feel the need to become involved with KIRK in the same way, but it is interesting that an investor with an extensively proven knack for identifying successful turnarounds in small-cap consumer and retail companies has recently taken an interest in KIRK. 

 

One thing to consider with KIRK is that they will likely resume store growth eventually, as long as the turnaround holds.  They currently anticipate opening 15 to 25 new stores in 2009, which will at least offset mall store closures and which should prevent de-leveraging of fixed distribution and corporate overhead expenses.  They point to strong unit economics in off-mall locations.  They have recently seen new off-mall stores open with an average of $1.4 million in sales and $225 thousand in store-level profit, which compares very favorably to modest cash investments of $160 thousand in net fixed assets and $125 thousand in inventory.  Further, they will likely pledge that they have learned not to expand beyond core markets, and instead will look to continue to re-locate mall stores to nearby off-mall locations, as well as open new stores in successful existing markets in order to leverage local brand awareness, marketing expense and distribution.  This commitment to historically profitable southern markets should result in lower-risk store openings, however as free cash flow will likely be reinvested in the business rather than returned to shareholders, this will ultimately increase both the potential risk and reward of the investment.  However, from where the shares sit today, the risk seems minimal. 

 

It is important to note that management has considered, and will continue to consider, corporate share repurchases, and views this potential use of cash favorably.  I would expect management to do so beginning next year if they feel the stock remains undervalued, irrespective of store opening plans, and believe that the primary reason part of the Advent stake isn’t being repurchased by the company is that management and the board wanted the whole stake for themselves.  To the extent this further aligns management with shareholders without any dilution, I am content to forego the accretion from buying back stock below fair value.  Additionally, the extra liquidity may prove beneficial at this still relatively early stage of the company’s recovery. 

 

KIRK is still a home furnishings retailer during a terrible US housing market, serving a consumer who has overspent for years and is stretched by any metric.  All stores are leased, as is the company’s distribution facility and new headquarters, and there are few hard assets outside of cash and inventory.  Should trends reverse entirely and stay negative, current TBV of approximately $1.95 a share may not be a meaningful proxy of liquidation value or downside protection.  Liquidity could eventually become a concern given the seasonal working capital requirements.  However, I believe this risk has diminished significantly in the wake of greatly improved fundamentals and several moves to preserve cash over the past two years, resulting in significant cash generation and a dramatically improved liquidity profile. 

 

Recently, Hurricanes Ike and Gustav have impacted KIRK’s store base.  Houston is likely KIRK’s single best market, and while the company is not overly exposed with about a dozen stores in the region, these are highly profitable stores and so the impact on profits may be exacerbated.  According to the company, no damage was suffered by the store base, however shopping patterns have clearly been affected, and some stores were temporarily closed.  Gustav’s impact on Louisiana stores will also be felt, as Louisiana is another of KIRK’s strongest markets (although it represents fewer than a dozen stores).  Management plans to quantify the impact of the hurricanes when they report Q3, and while I expect a noticeable impact to same store sales and profits, I do not expect it will be a meaningful event in the context of my investment thesis.