|Shares Out. (in M):||20||P/E||5.0x||4.5x|
|Market Cap (in $M):||74||P/FCF||2.0x||2.4x|
|Net Debt (in $M):||-26||EBIT||9||11|
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By this time next year, this $3.7 stock will have $2.5 in seasonally adjusted net cash, and will trade at 1.2x trailing recurring free cash flow (market cap ex cash), 1x forward. Insiders bought 20% of the company last fall and the business model works great in a recession (+5.3% same store sales last Q vs. -10%+ for competitors). Normally a no brainer buy but here's the catch: its retail.....home décor....predominately in the south east.....for middle class women. Obviously, it doesn't initially sound appealing.
Attractive Business Model:
Kirkland's operates a cross between the Costco business model (cheap prices, high turns, small selection of the best picks in each category) and the Target business model. I've heard KIRK repeatedly and almost always mischaracterized as "mid priced" when they are the low-price leaders, usually even better than Wal-Mart. Until we get more Wall Street analysts who are middle class women living in Louisiana, this misunderstanding may continue.
Kirk runs ~10 inventory turns/year (YE numbers), vs. 3-4x for competitors. Prices are 20-60% lower than a Pier 1. Selection per category is less, for instance Kirk has 5-6 different jar candles at $6.99 each, while Pier 1 might have 15 different varieties, at $15 each. Wal-mart's similar jar candles are $7.99.
The Costco model can be risky because if you only offer a few items out of the entire category and the picked items aren't the right ones, then nothing sells. Stocking the whole category lowers risk but lowers potential return. Usually, this is not a problem for the sunbelt and middle class home décor since changes category are glacial. To prove the point, 1993-2004 were highly profitable (11% EBIT margin vs. 2.5% EBIT margin last year) and remarkable steady. It took a massive 2005-2007 experiment with "fashion forward" merchandise to change things, but when things changed the stock dropped 97%. I place zero odds on kirk repeating that experience.
Merchandising risk is low now because:
1) Old merchandisers (and COO) were fired and a new merchandise team has settled in
2) The people who made the company, such as the Chairman, CEO, and CFO, rebought into the company last fall by buying 20% of the company. The Chairman mortgaged his ski home and his plane using a 5 year note to buy shares. The Chairman has been an astute trader of the stock, selling to private equity in the late 1990s, and selling another 1/3 of his stake at the IPO in 2002 ($11/share), then buying back at $2. The CEO and CFO also took very meaningful positions compared to their income.
3) Suppliers held back choice merchandise in 2006-2008 due to the perceived financial troubles. Now, with the industry in a slump, Kirkland's can get what it wants
Recession Business Model: Low prices, low asset intensity, and the ability to negotiate rents
Low prices (cont.): The only competitor with similar prices is the TJMaxx family. However, Ross, Marshalls, etc have merchandise that has a surplus and chaotic feel to it. Using the Target business model analogy, Kirkland's aisles are wide, the lighting nice and soothing, and the shopping experience is very enjoyable. I don't think another store like Kirkland's exists that combines aspects of Costco and Target.
Asset intensity: In a deep recession, you want no assets and leases up for negotiation. Asset intensity at KIRK is quite low (10 to 1 ratio of sales to shareholders equity, vs. 4-6 some competitors), with almost no fixed assets in the stores. Each store uses its own furniture to build displays. As an example, KIRK might have a table (for sale), and on top of that table might be candle holders arranged like it would be in someone's house. This does two things: 1) saves on display costs as there are no dedicated displays. 2) Lets customers see what things would look like in their home. It looks much better than something just thrown on a shelf.
Rent: KIRK management said rental prices are back to early 1990s levels and they expect this to perhaps be the largest lever to pull this year for higher profit. Last year regional mall rents went down 21% in 2008 and vacancy rates/store shutdowns in retail I assume will drop more. Rent (rent expense + tenant allowance amortization) as a % of sales was 7% and could drop to ~4.5% as rents are renegotiated, expensive mall-based stores are closed, and tenant allowance amortization slowly wears off.
In sum, the low prices and high asset intensity make for a business model are the right business model for suddenly price conscious consumers. In boom years, consumers are less price conscious and more label conscious, and because of the boom rents are quickly increasing so land ownership is king.
Attractive Sector and Niche
Kirkland's target market is the sun belt of the US, females age 25+, and generally tilted toward those living in apartments and middle class. I believe Kirk's main markets are in better shape than the national average - a crude estimate of mine shows Kirk's markets on average 1 turn lower on the home price/family income ratio. This is because the sunbelt didn't have the huge bubble that other places did.
The sector is better than people think, or will be eventually, because it is one of the few areas of retail with large store closings happening or soon to happen. My feel is that at minimum 15%-20% of home furnishings and home décor stores will be closed by year end. Pier 1 and Cost Plus World Market are muddling through large losses due to large cash balances, and perhaps they will eventually shut their doors. Whether or not store closures are more than actual demand destruction I'm not sure because of the many different companies that offer home décor (Target, WMT, TJMaxx), BUT this is one of the few industries I know of where capacity is being actively restructured to balance out with demand.
Depreciation is higher than capex
Depreciation is around $42,000 per store vs. ~$10,000 maintenance capex. Rarely do companies truly have depreciation higher than maintenance capex. It only happens when depreciation schedules are shorter than the useful life of the asset which happens when the format doesn't need updating. I believe that Kirkland's unique business model requires little maintenance capex since the stores are essentially empty boxes with few furniture and fixtures.
For a bottoms up maint capex calculation, if we look at the balance sheet, total net furniture and fixtures is likely around $25 million, which I'll assume $5M of that is for corporate/divisional, and so $20M divided by 330 stores = $60,000. Replacing fixtures every 10 years = $6,000 per store. Add paint + other = $8,000 per store, or $2.4M for the stores. Add $0.6M corporate/regional, and its $3M total, vs. ~$13M in depreciation (forward looking).
As a gut check, per store maintenance capex estimates are similar to Pier One and Tuesday Morning's reported numbers. TUES does $5 - $10K/store, vs. Pier One of $5-$6 per store. Banjo1055 already discussed this point in his Sept. 08 report. I would highly recommend reading his excellent report in conjunction with this one since I didn't repeat some points he made abundantly clear.
Hence, I believe P/E is not the right metric for Kirklands but free cash flow is.
Current EBIT margins are 2.5%. I expect 4.5% this year to $16.7M EBIT. Lower rent can add 1% to margins this year, and another 1% in CY 2010. Store closures (12-13% expected in CY 2009, 5% last Q) help immensely because they are all four wall negative. If those stores had $70M in revenue and lost 6% on average, that's a $4M in pickup (1% of sales) pickup. 2.5% previous + 1% rent + 1% closures = 4.5% in CY 2009. A continuation of those trends leads to ~6% in CY 2010.
Add in excess depreciation over maintenance capex, and EBIT margins are 5% trailing, 7% CY 2009, 8%+ CY 2010. For comparison, from 1993-2003 EBIT margins averaged 11%.
By 2010, Kirkland's will start growing again. Since stores are small (5,600 sq. feet) and often spread out, I believe there is ample room to add in each market based on my checking out a couple of markets.
Banjo succinctly went through why previous store expansion failed, namely going to non-core markets in the pursuit of growth and not profits. Trust me, this stuff is great for Louisiana, but not as good for LA. Management has learned well that size does not equal profits, and by closing stores that lose money at the store level, overall profitability has increased even as total sales decrease. I believe it is very rare to find a manager who is willing to downsize unless times are bleak because every CEO wants to be the head of a bigger empire, and Kirkland's willingness to get in front of the ball by steady store closings in CY 2007 and CY 2008 says a lot about their realism. Closing stores was a huge about face from store count growth of 50% from 2002-2006 outside their core markets, which together with the poor merchandise sunk the stock. Since management has learned from both, I think we are setup for a return to prior profit trends.
With minimal upfront expense and store marginal contribution of $200K+/year, adding 20 stores a year = $40+ million per year in value, or $2/share in value per year. $5 - $10/share could be a reasonable valuation to pay for growth options.
One Year Price Target:
I can see a very wide range. At the bottom, perhaps the market incorrectly focuses on reported EPS and not recurring FCF, and assigns this an 8x multiple of CY 2009 EPS of 54 cents. With $2.5 in cash, that would be $6.8/share. For "fair value", I could see 12x forward recurring FCF ($14.5) + $2.5 seasonally adjusted cash + $7 for growth options = $24/share. In its peak form, say in 2012, upwards of $2/share in FCF could be possible with 360 stores, 39% gross margin, and 12% adjusted EBIT margins (1993-1998's lowest gross margin was 37%, and EBIT margin averaged 14%). That said, I'm not predicting 2012, but just illustrating what would happen if things worked very well. In fact, just mentioning such a big upside may take away from the idea because of the huge uncertainty in predicting years out, but I'm pretty sure directionally this stock is going to be a winner from here.
The recession is not the risk, but this company lives or dies by its merchandising. Or as Banjo said, "either it resonates or it doesn't." I'm confident the company could do fine in a deeper recession if merchandise was good, just as a stronger economy could be vastly overshadowed by poor merchandise. Luckily, as I went through previously, sunbelt home décor is hard to screw up, and frankly I'm glad they screwed it up in 2006-2007 did because now management is better for it, and the stock price is down 85% from the 2003 high. Frankly, the recession is helpful for Kirklands, net net, as I previously opined.
People are going to keep buying home accents because having sthe same 'ol things around the house get old and spending $30 - $50 to do a small makeover is money well spent for some. People just may put less dollars into the home category, which suits KIRK's low price model well but hurts the full-priced retailers, and especially hurts the super-full-price "Scandinavia hand carved furniture market", whose stores I see closing left and right. Also, people in apartments will continue to move annually (or regularly) and will continue to decorate. Finally, I do think that some % of KIRK sales are recurring (e.g. candles), perhaps 20% total. 20% isn't much but it is something.
Why is this cheap?
1) Small cap home décor retail market - good luck pitching that
2) Not in the northeast where most professional investors are
3) Poor sell-side coverage - only one analyst covers it
Two years ago, a friend told me he only shopped at this store that would put Pier One out of business. Not until this fall did I revisit that thought, and after researching the market (prices, offering) I ended up decorating my new apartment mostly from Kirkland's. Regardless of stock ownership, I would have done the same because of the good stuff and great prices. Trust me, I can tell you how much a wall clock costs at Target, Kirkland's, Pier One, Wal-Mart, Ross, etc. I wouldn't have such a high % of my portfolio in this idea if I didn't know it so well as a customer. I've been to Kirkland's stores dozens of times and have a good feel for the merchandise. Every time I walk in the stores look very nice, employees are happy, and there are usually many customers.
1) More sell side coverage (just one active today)
2) Increase in market cap = more funds can buy (now at $73M, was $45M a few months ago)
3) Buy screens - before Friday March 20 2009, the company had no net cash for the two prior years. Last year at this time, people thought that cash would run out. Now half the market cap is in cash ($36M cash, although $26M is a seasonally adjusted number)
4) Momentum - better profitability means better vendor deals and better landlord deals as malls want winners to help drive overall traffic
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