Summary

Kirkland's (NASDAQ:KIRK) is a leading specialty retailer of home décor that has a fortress balance sheet and is super cheap today on every possible metric. For the patient investor that has a 5 year horizon, I believe that the risk/reward offered by Mr. Market is very compelling - very conservatively it's a ~2x upside by 2015 or an IRR of 14% and a near zero chance of permanently losing capital.

Background

KIRK sells items such as framed art, mirrors, candles, lamps, pictures frames, accent rugs, garden accessories and artificial floral products. Its customers are mostly 25-55 female from the "sun-belt" region who are looking for home décor items priced in the "value" range. KIRK appeals to its customer base by sticking to traditional styled items that are based on widespread trends, rather than by being a fashion leader. Their merchandising strategy is to house limited SKUs that are carefully selected rather than carry a full range within each category. This helps the business have a high inventory turnover, leading to a constant flow of new products thereby creating a treasure-hunt type environment, and a sticky customer that keeps coming back.

The company operated successfully for years until it went IPO in 2002. With the new money raised, management went crazy and started opening locations outside their "core" markets. What worked well in the "Middle America" didn't resonate well with the fashion conscious crowds of Los Angeles. Their problems compounded further as management experimented using a fashion forward theme-based strategy. This didn't appeal to their new customers of Los Angeles. and it alienated their loyal customers of Louisiana. Management realized that something was fundamentally broken, so they fired the responsible merchandisers, closed locations outside their core markets, and went back to their proven merchandising strategy. The numbers for 2008-2010 speaks for an honest management team that owned up to its mistakes and turned around the company. I encourage you to read previous VIC write-ups by banjo1055 (Sept 08) and edward965 (Mar 09) to get a flavor for the turnaround.

Why Cheap?

KIRK is not a turnaround today and operating within its core competencies. So, why has Mr. Market thrown this baby with the bath water?

Negative SSS

7% of the 8.4% decline in SSS last quarter was due to lower transactions, and the rest was due to slightly lower ticket. The lower transactions were mostly because of lower conversion and only slightly due to traffic. Management commented that these trends indicate that current merchandize may not be resonating well with the customers.

This is not alarming, in my opinion, and in fact quite expected on occasions given their strategy of housing only limited SKUs. Not having a full range of items, KIRK has to execute each time a customer shows up at stores (unlike a Bed Bath & Beyond where merchandize does not change that much). Current merchandize not resonating well does not trouble me much because KIRK's strategy also allows them to stay nimble and quickly get out of "unwanted" SKUs without much risk of inventory (relatively speaking). The real upside to this strategy is that KIRK has much high inventory turns than many of its peers. 

The other reason for lower conversion could be due to consumers' lower discretionary spending in light of macro concerns. Remember the last two quarters were in the backdrop of pretty high oil prices. The pendulum has now turned and oil prices are coming down, but now concerns have turned to a double dip. Not to be flippant about these issues, but I think KIRK has gone through a pretty stressed environment in 2008-2009. The last global recession was considered as one of the worst since the great depression, and in my opinion, KIRK did fine in that environment.

Margin Compression

Gross margins have compressed by 313 bps in Q1 11 compared to prior year quarter. A 175 bps reduction was due to higher promotional activity and discounting (for reasons explained above), a 69 bps reduction was due to store occupancy costs caused by deleverage and fewer rent negotiations, and the rest of the reduction was due to freight costs. Operating margin compression in Q1 11 was primarily due to deleverage caused by negative SSS. I have no ability to predict what margins will look like if US goes into a double dip, and my guess is as good as yours. But I'll take a shot anyways - I think depressed EBIT margin is closer to 6% and peak margin is closer to 11% and 2011E is pretty close to depressed margins. 

Reduction in Net New Store Growth Forecast

In Q1 11, KIRK moderated its net new store growth forecast from 40 stores to 20. Management commented that they are finding it increasingly difficult to close on deals as landlords are holding out for better rates. Management is focused on finding the right locations rather than focusing on growing for the sake of growth. Shows they learnt their lesson well from their prior life fiascos on locations. In this business, location can make or break you. The street obviously did not take the renewed guidance very well. If U.S. does indeed goes into a double dip, I think management will slow down net new growth and release much of growth capex, hopefully, for shareholder friendly uses.

Valuation

Comparing KIRK to its peers, it's clearly evident that KIRK is much cheaper than the rest. The possibility that a major revenue decline due to a double dip can cause major deleverage is always there (although these were the same consumers that showed up at KIRK's footsteps during the worst recession since the depression), but at today's price, I think even this outcome is baked in. Besides KIRK has the balance sheet to live through this scenario. 

The risk/reward profile for KIRK is very compelling. We are assuming that management uses only half of the 90M cash for buybacks over the next 5 years. This is quite drastic in my opinion, given that the cash needs of this business are quite limited and not all OCF generated from here out will be used for capex. Net of landlord allowances, fixed costs to start a store is about 125K and inventory costs are 100K. So, costs to start up 15-20 stores are 3.5M to 4.5M. Maintenance capex is another 5M and working capital needs are 8-10M at most. All in all, capital to run the business is 20M. Management is wrapping up with IT capex, so it's all set in this area for the next few years and supply chain logistics are already where they need to be for up to twice current store count. Just using my imagination here, but I wouldn't be surprised if KIRK accrues 10M per year on its balance sheet after its capex needs. 

Lastly, if the environment were to return to normalcy faster than what Mr. Market is projecting today, KIRK could accelerate its growth to net of 40 stores a year. It's store base is quite underpenetrated relative to peers, so you are essentially getting a free option on growth. (KIRK is 293 stores, PIR is ~1200) 

Risks

Dependence on US overleveraged consumer

Major recession that lasts longer than we all can imagine