Kirkland's, Inc.

Good morning and welcome to the Kirkland's first quarter 2019 conference call. All participants will be in listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press star, then one on your touch-tone phone. To withdraw your question, please press star, then two. Please note this event is being recorded. I would now like to turn the conference over to Jeff Black of SCR Partners. Jeff, please proceed.

Thank you. Good morning, and welcome to the Kirkland's Conference Call to Review Results for the first quarter of fiscal 2019. On the call this morning are Woody Woodward, Chief Executive Officer, Mike Carnes, President and Chief Operating Officer, and Nicole Strain, Interim Chief Financial Officer. The results, as well as notice of the accessibility of this call on a listen-only basis over the Internet, were announced earlier this morning in a press release that has been fully covered by the financial media. Except for historical information discussed in this call, the statements made by company management are forward-looking. They're made pursuant to the safe harbor provisions of the Private Securities Mitigation Reform Act of 1995. Forward-looking statements involve both known and unknown risks and uncertainties. which may cause Kirkland's actual results in future periods to differ materially from forecasted results. Those risks and uncertainties are more fully described in Kirkland's filings with the SEC, including the company's annual report on Form 10-K, which was filed on March 29, 2019. With that, I will turn it over to Woody.

Thanks, Jeff, and good morning to everyone on the call. We appreciate you joining us to review the first quarter and our plans for 2019 and beyond. The first quarter was challenging. Seasonal product performed well and comps positive. And we continue to make strides in Kirkland's dot com. Unfortunately, brick and mortar traffic remained a significant headwind. We're taking meaningful steps to transform the business to address ongoing changes in home decor retailing. The strategy we're executing was never going to be a first quarter story. It will take time to see the full realization of our work. Yet the measures we're taking today ensure our infrastructure is much more in line with our revenues, and I feel good about the focus as we approach the second half. As we outlined in our release this morning, we made solid progress on our strategic priorities in the quarter. Our focus for 2019 includes plans to add product categories that can significantly broaden our reach, expand BOPUS, and improve our supply chain efficiency. I'm pleased to report that all of our initiatives are on schedule. and I'm excited about prospects to improve sales and earnings and re-accelerate long-term growth. I was clear when I spoke to you that to accomplish our goals, it's imperative that we accelerate our efforts to improve the customer experience and advance our business improvement initiatives. While the environment remains challenging, we are doing what's necessary to stay on track. For example, we've added a program to reduce operating costs by $10 million in 2019. we're eliminating costs that do not impact our ability to drive scale or deliver quality. This will enable us to become more efficient while directing time and energy to our strategic priorities. This initiative is a result of comprehensive review of each element of our operations to ensure that we're pulling every lever we can to make the business stronger and more effective. In addition, we're finalizing plans to address the potential impact of additional tariffs in home decor. That includes work with our vendors, as well as a category by category assessment of pricing. While we expect tariffs to pressure our merchandise margin, our goal is to mitigate the impact while maintaining our focus on affordable home decor. The work joins initiatives that are well underway to revitalize our assortment, expand our margin, and optimize the omnichannel platform. In particular, I'm pleased with how the merchant team is coming together. We put together an exceptional seasonal assortment for fall, and we're excited about new products in bedding, tabletop, and area rugs that are on the way. The presentations are an important step in our evolution to execute a stronger design ethos across Kirkland's. We're bringing simplicity, universal appeal, and utility to our offerings while infusing more confidence in our buying decisions. We're refocusing investments in key items to make sure we're fulfilling customers' expectations. And that will be an important component of our product revitalization strategy over the coming years. As we improve our existing assortment, we're driving Kirkland's into adjacent categories that are particularly relevant to the home shopper. We've started to introduce rugs into our stores, and these are high-quality Turkish-made rugs that can fit perfectly into any home at a great value. In addition, we're preparing to launch into tabletop and bedding businesses with simple, high-quality, and attainable lines with aggressive pricing strategies designed to improve traffic, reputation, and market share. We plan on moving into some additional categories in 2020. These product categories are vital in ensuring that we are playing in non-discretionary spending spaces, particularly as millennials begin to enter key life stages, including marriage, the purchase of their first home, and the addition of children. Our seasonal offerings will remain important, but the goal is to ground the business with a better year-round balance across the central range of categories that appeal to new and existing customers. Mike and Nicole will go into some detail on our strategy and financial assumptions in a moment. I don't want to minimize the challenges that lay ahead of us, but I'm cautiously optimistic about the second half. The cost reductions we made will help stabilize performance, We're introducing three new product categories, rugs, bedding, and tabletop. We have more purposeful depth in key items, and our best-selling furniture is back in excellent in-stock position. We're applying learnings from the fourth quarter of last year, which include an earlier drop of post-Christmas floor set, and we'll benefit from a second warehouse in Dallas and a more efficient supply chain overall. The path to sustainable growth will take time, but we have a solid plan in place, and every improvement we make in the value chain from concept to customer is a chance to improve margin and deliver increasingly sustainable growth. I'll now turn it over to Mike. Thanks, Woody.

As we outlined in the last call, our 2019 strategy is focused on product revitalization, omnichannel growth, margin expansion, and supply chain optimization. Woody spoke about merchandising, which has been his focus the day he walked in the door. Meanwhile, we've put in place the support functions to optimize our return on the future new product assortments. Specifically, we're making advancements in supply chain to more efficiently flow the goods. We've stood up a direct sourcing team and plan forward while building an omnichannel infrastructure starting with buy online, pick up in store. As it relates to the new offerings, I want to reiterate that everything remains on schedule. We've introduced the rug assortment to several stores with positive early results. We're bringing in a value price collection of tabletop as part of our new private label brand, Simple Things by Kirkland's, that kicks off our direct sourcing initiative. And we've engineered the second half floor plan to showcase our new bedding area. All of these new products will be part of an enhanced in-store experience with more purposeful navigation, and ultimately will result in a higher average AUR to help offset the brick-and-mortar traffic patterns. As we address our core assortment and introduce new products, we're continuing to expand by online pickup and store. We doubled the number of eligible SKUs in the quarter, and BOPUS is now approaching 20% of our e-commerce revenues in Q1. We plan to reduce pickup time to two hours, and we're testing home delivery as a bolt-on service in one of our markets in the second quarter. We're excited about the potential of BOTUS for multiple reasons. It's a service that consumers desire because she gets instant gratification, it rides at full margin, and it drives traffic and add-on purchases. Strategically, it allows us to compete against pure e-commerce players. As we outlined in the release, a portion of our lower guidance for 2019 is related to a lower projection for gross margin as the 25% tariff comes into effect. That said, we were already prepared for this latest tariff announcement. The tariff impacts about 25% of our product in areas including mirrors, lamps, furniture, decorative accessories, and some floral and seasonal. Our approach is to take a more strategic, across-the-board price increase that is in the low single-digit range versus double-digit price increases on strictly affected items. That keeps the customer value proposition consistent across the entire assortment. We are partnering with our vendors to share some of the cost increases. At the same time, we continue to work with our factories to enhance quality and design so as to raise the overall value equation. On a related note, our direct sourcing program is progressing well and will result in substantial reductions to cost of goods on products. By the end of 2019, we will have as much as 10% of our on-order product for 2020 direct sourced. We're deep in the process of standing up the organization, technical capabilities, and compliance standards. Meanwhile, we've just signed on an agent for India in addition to our established agent in China. This direct sourcing arm allows us to diversify our buying strategy. As an example, we're aggressively looking at Vietnam and other countries. Our supply chain will also benefit from third-party logistics and the West Coast bypass. We are on schedule to begin shipping from a new distribution center in Texas later this year. This will serve approximately 100 stores with better efficiencies. In addition, We have expanded our West Coast bypass, which allows us to drop ship and transfer allocated product directly to our West Coast stores. Ultimately, we hope to use an e-commerce fulfillment model that further integrates our brick-and-mortar base. Now I want to shift to the big picture. We recognize and we are actively building a plan to navigate the quickly evolving retail environment. Step one in competing in a new digital world is for us to fully realize the benefit of buy online, pick up in store. Meanwhile, we're moving with speed to assess the system requirements and current store footprint as we look to enhance our digital capabilities and review potential infrastructure changes to alleviate the deleverage and enable ship from store. We'll report out on the plan architecture at a future call. In summary, We have a comprehensive strategy in place to drive profitability and revenue growth across the business. While significant changes will take time to be seen in our financial results, I remain confident that we have the right team and the right strategy to return Kirkland's to meaningful growth. I'll now turn it over to Nicole to discuss the financials in our 2019 outlook.

Thank you, Mike. Net sales for the first quarter decreased 9%. or $12.8 million compared to the first quarter of the prior year. Comparable store sales decreased 10.7%, which included an approximately 11% increase in e-commerce revenue. And that's on top of a 1.4% combined comp increase and a 39% increase in e-commerce in the prior year. In our brick-and-mortar stores, we continued to see the same softness throughout the quarter, as we referenced in our last call, with double-digit declines in traffic and comp store sales. Overall, the traffic decline and a decline in average ticket were partially offset by an increase in conversion. We opened three new stores and had no closures during the quarter, ending the quarter with 431 stores, which is a net year-over-year gain of six stores, or 1.4%. E-commerce accounted for $20.1 million in revenue during the quarter, or approximately 15% of total revenue. Traffic increased during the quarter by 29%, but was offset by a decrease in both conversion and average order value. For the quarter, approximately 50% of our e-commerce sales were fulfilled in-store, with buy online, pick up in-store continuing to grow throughout the quarter. We intend to focus on increasing sales fulfilled in-store and leverage our store base to improve profitability of our e-commerce business. Moving on to margin. Gross profit margin in Q1 decreased 390 basis points, from the prior year to 27.9%, and that was driven primarily by a decline in merchandise margin and deleverage of store occupancy costs. Merchandise margin decreased from the prior year by 130 basis points to 54.7%, primarily driven by an increase in inbound freight and a decrease in product margin, partially offset by an initiative to improve vendor compliance. We continue to see an increase in inbound rates, specifically ocean rates, as demand outpaces supply due to the tariff pull forward. Outbound freight costs, which include e-commerce shipping, increase 50 basis points as a percentage of net sales. Although we continue to see rate and fuel pressures on the transportation of product from our DCs to our stores, we are seeing the beginning of some softness in the market, which we think will start to benefit the second half of the year. Store occupancy costs increased 180 basis points over the prior year quarter due to the decline in brick-and-mortar sales. Central D.C. costs increased 30 basis points as a percent of sales compared to the prior year quarter, primarily due to increased labor costs. Operating expense for the first quarter was 34.9 percent of sales, which was up approximately 320 basis points to last year, however flat to prior year in dollars. Store operating expenses increased 260 basis points as a percentage of store sales over the first quarter of 2018 due to deleverage of store labor and incremental advertising expense. E-commerce expenses increased 240 basis points as a percent of e-commerce sales primarily due to incremental advertising expense. Corporate expenses increased by 180,000 or 100 basis points over the prior year primarily due to payroll-related expenses. Depreciation and amortization increased 20 basis points as a percent of sales, but remained relatively flat in dollars to the prior year. We recorded an impairment charge of $1.9 million in the quarter related to eight stores whose carrying value exceeded their fair value. With the adoption of the lease accounting guidance, we revisited our method of assessing fair value of underperforming stores which resulted in the impairment charge. The impairment charge is excluded from adjusted EPS. The tax benefit for the quarter was 3.5 million, or 28% of the pre-tax loss, compared to 35% in the prior year period. For the quarter, we had a net loss of 62 cents per diluted share, or 53 cents after adjusting for the store impairment charges. And that's compared to a net loss of 6 cents per diluted share in the prior year quarter, or flat after adjusting for the CEO transition costs. And moving on to the balance sheet and the cash flow statement, at the end of the quarter, we had $32.5 million of cash compared to $58.2 million in the prior year period, and no long-term debt or borrowings were outstanding under our evolving line of credit. The year-over-year decrease was driven primarily by share repurchases of $15.1 million during the year, the decline in operating performance, and an increase in inventory. Our inventory balance at the end of Q1 was $90.4 million, which was an increase of approximately 9% over the prior year period. The increase in inventory was primarily due to the sales miss. We have been able to cut receipts to mitigate and will continue to do so as needed. Year-to-date cash used by operations was $19.2 million compared to $8 million in the prior year. Capital expenditures were 3.9 million compared to 11.1 million in the prior year. During the first quarter, we repurchased approximately 287,000 shares. As of the end of the quarter, approximately 1.3 million remained under our existing share repurchase authorization. We are updating our earnings guidance to arrange a flat to up 15 cents for the fiscal year 2019. The guidance is reflective of our results for the first quarter, and sales and margin trends for the second quarter, which continue to be softer than anticipated. For the full year, we expect an improvement in sales trends with comparable store sales down in the low to mid single-digit range. The full year guidance also includes $10 million of operating cost savings, which will be realized primarily during the third and fourth quarters. The first half of the year has proven more challenging than we expected. but our key initiatives remain on track and we are confident in their impact on the back half of 2019 and their incremental long-term financial benefit. And now, operator, we are ready for questions.

Okay, we will now begin the question and answer session. To ask a question, you may press star then one on your touch-tone phone. If you are using a speakerphone, please pick up your handset before pressing the keys. If at any time your question has been addressed and you would like to withdraw your questions, please press star, then two. At this time, we will pause momentarily to assemble our roster. Our first question comes from Jeff Van Zanderen of B Raleigh FBR. Jeff, please proceed.

Good morning. Can you guys speak a little bit more about the monthly sales progression? Just wondering kind of if there was a little bit of improvement, maybe in April when traffic improved, and maybe you can just talk to how that's trending in Q2, how we should think about your promotional and discounting plans for second quarter. And then if you could just speak more about your thinking around What's driving the broader slowdown in traffic and overall business in the broader home goods space?

Yeah, I think the broader home goods space is under attack, it seems like. There's a huge disruption for people choosing to go online versus shopping, and I think that we're feeling part of that, and we're trying to adjust our models going forward so that we can benefit from the fact that we have a a strong store base, and an e-commerce business that is healthy and growing. The first quarter was a surprise because the continued down traffic, which resulted in our down comps, was in the 10% to 11% range. We are seeing slight improvements, not necessarily in the traffic, but improvements in our performance as we are starting to change assortments and make some improvements strategic moves within the store and how we're promoting. But I would say that we're still in the storm and we're weathering that and we're very optimistic that the goods that we have coming in that we believe will really change the trajectory of the company are on schedule and should start landing at the end of the second quarter and make us a fresh new look with our new floor plans and our new store assortments for the third and fourth quarter. So kind of... It is slightly improved, but not back to where we assumed it would be when we did the plan.

Yeah.

Hey, Jeff, this is Mike. I'll just punctuate and bolt on to what Woody just said. So what we're seeing is a dynamic where more of that traffic is shifting online. We have greater confidence in second half for several reasons. Number one, Our seasonal product is when we tend to shine, and we have got a great seasonal assortment for second half, which we think will help pick up traffic both in-store and online. We are very bullish about our new product assortments that we've got coming in, such that we'll be identifiable to both our core customer as well as new customers. And at the same time – we will be letting out more of our marketing spend second half as well to put topspin on these product assortments.

Okay. And then just since we're talking about merchandise content, can you just give us maybe a little bit more? I know you touched on kind of the broader categories, some new categories in bedding, tabletop, and rugs. And then maybe just help us understand a little bit better how the direct sourcing picture is changing. I think you mentioned India. That should help you mitigate some of the pressure in China. And then also just if you could touch on the new concept store test plans for second half.

Yeah, I'll start with the last part. The new store concept test, which we set up last year, is still continuing to do well. But the rollout of the remodels and the new stores are just beginning. I think we have a couple stores that are a couple weeks old. So we're very optimistic about those, but the test is still too early to call in the broader picture. But results look positive. The other thing is on new merchandise, we've only landed the Rugged Assortment into two stores, and it's doing well. But that gives us a lot of optimism that when you take that interpreted into 430 stores, that it's very positive. We have approached all of our new categories, rugs, tabletop embedding, with a very deliberate, deeply purchased key item approach versus trying to go broad in the marketplace. So what we believe we're putting together is the ultimate farmhouse look in all three of those categories at a super value. So rather than going broad and offering a lot of choices, we're being very deliberate So, for example, in our new tabletop assortment, we are doing all of our dinner plates, bowls, mugs, and salad plates all at a very low everyday price that I think will be stimulating to the customer to say, we've done the curation for them. We've made the decision. It's ultra durable. It's for everyday use. And I think our customers will see that as a huge value. So that's kind of where we are on the product assortments. Mike, did you want to chime in on the – I'll speak on the direct sourcing.

I will tell you that we are making terrific progress on direct sourcing. So just to set the table, we have an organization in place. We have a clear plan forward on direct sourcing. We've signed on an agent for China, and we're in the process right now of signing on an agent for India. We have already begun taking orders direct from factory and are receiving them in the United States. So that pipeline is being built, and now we're opening up that pipeline. We believe that the direct sourcing is going to do multiple things for us. The obvious is that it's going to help us at the gross margin level as that We are going to be realizing a better cost of goods, but also strategically it will allow us to diversify our buying opportunities across multiple countries. And In a world right now where we're dealing with tariffs, you've got where other retailers may be optimized in the direct sourcing. We're really coming off of ground zero on that. And so we're really excited about what that could bring us. And just going back on the new concept store, we had stood up a concept, a single concept store, and it continues to do well. Particularly, what we're seeing by enhancing the experiential piece of the brick and mortar experience, we're seeing an increase in the overall basket in that store. Our goal this year is to stand up 12 remodels of this store and analyze the sales lift that we get to make sure that we hurdle the investment in these stores. We're just now starting that remodel process. A couple of stores are now stood up very early on the results, but we continue to be very excited about what that's going to bring us in the future.

Just one quick thing, too, on direct sourcing, Jeff. I think we mentioned before, but not expecting any material impact to 2019. We have, by the end of the year, penetration goals for 2020, and those escalate from 2020 for the next three years. But No, nothing built into our model for significant impact in 2019.

Okay, thanks for taking my questions and best of luck for the remainder of Q2.

Thank you, Jeff.

Once again, if you have a question, please press star then one. Our next question will come from Anthony Leberzinski. of Sidoti and Company. Anthony, please proceed.

Good morning and thank you for taking the question. Just to follow up on the direct sourcing piece, you mentioned China and India. Are there any other potential countries that you can go into? Obviously, there is a lot of noise with the tariffs for China. Ideally, I would think that you probably want to stay away from China longer term, but I just want to get your thoughts on that.

Okay. Thanks, Anthony. Yes, there's a very healthy business coming out of Vietnam as people started migrating 10 years ago when the bedding business migrated from China to Vietnam. So that furniture business is strong and healthy. We've been dealing somewhat direct with them. We are anticipating that we will expand our agent base across the world as we take on opportunities. We're going to primarily start with Asia, but within Asia, there's multiple countries. Of course, we believe Malaysia has opportunity, Indonesia, Vietnam, Philippines. These are all places where we feel like would round out our assortment and make us look more interesting and balanced. While we're starting with the two big ones, which would be, of course, China and India, our goal is to round out our infrastructure with having capabilities to look all over Asia and then potentially some places in Europe.

Got it. Okay. That's great to hear that you're looking to diversify elsewhere. So, Woody, you also talked about some additional new product categories that you may go into. In fiscal 20, can you share with us any examples so far?

Yeah. I was kind of hoping that nobody would ask this, but now that you do, it's my favorite thing to talk about. One of the categories that has been extremely strong in other retailers and is as much as 50% of their furniture business is upholstery. We have stayed away from that because we needed infrastructure improvements and changes to be able to handle that through our pipeline, but we're anticipating that we would have an introduction of upholstery into our stores in early 2020. And as a point of reference, the upholstery business in some cases is half of the furniture business in many other retailers, so that we have a disadvantage by not playing in that. Plus, where we do have upholstery with wood, In our stores, it's some of our best-selling products. So we would take it from being like a McKenna chair, which is one of our very best-selling wood and upholstered pieces, and take it to a fully upholstered piece. But we're evaluating partners right now, plus looking at our infrastructure. Mike is looking into all sorts of ways to either have it come directly from the vendor to the source, or if it's an in-stock piece, have it come directly from the D.C. to our – to our customers or to our stores. And we are once again putting that value equation. So we want it to be at an exceptional value for a chain that could be simple, could fit into any farmhouse environment. And so we've been doing a lot of work, but this one took a little longer than we could get placed for 2019. And so there are other categories for 2020, but they're minor. This will be the big game changer for us in 2020.

Got it, got it. Okay, thanks for that explanation. And as far as the cost reduction program, can you give us a sense into broad buckets as to where that $10 million will come from? If you can share any details, that would be great.

Yes, so it's all from operating expenses, and really what we looked at as we approached this was two things. One, it doesn't include people, so it really was just going line by line and looking at contracts and just, in some cases, renegotiating, in some cases, deciding that we didn't need certain things. But what we made sure to protect was the initiatives that we have moving forward in the back half of the year. So it was a company-wide effort to just go through and line by line, dig into everything and evaluate and then renegotiate contracts with vendors.

Got it. All right. And Anthony, I would just Yeah, I appreciate that. I'll just add on to that. This was really, as we looked at the cost reductions, what we really took out were all the costs that were really low or no value to our overall operating infrastructure. And so in no way, shape, or form Does it impair us to do the things that we want to do to manage and stabilize the business and also to invest in the strategic initiatives as we go forward?

All right. Thank you, and best of luck.

Thank you, Anthony.

Our next question comes from Brad Thomas of KeyBank. Brad, please proceed.

Yeah, hi, good morning. I apologize I got on late as I was on another earnings call that was overlapping with yours, but had a few questions if I could. First of all, I was hoping to talk about same-store sales and see if you could give us a little bit of color about how you're thinking about the outlook for 2Q and the balance of the year, particularly given what a challenging backdrop the whole industry has really gone through And 1Q, thank you.

Yes, I can take that one. So as we look at 2Q comp sales, I think we mentioned this earlier in the call, trends still not where we want them to be, but have improved from Q1. So expecting a comp sales in Q2 in the range of mid to upper single-digit negatives. And then I think as we look at the back half, I mean, we have a lot of things in the pipeline that will affect Q3 and Q4, so expecting a pretty significant change in trend in the back half of the year based on all the new products and all the initiatives that we have that start to impact in the first part of Q3.

Gotcha. And so just as we think about your EPS guidance of the flat to 15 cents, obviously fourth quarter is the big important quarter for you for earnings. How are you thinking about comps? I mean, can you get to that earnings range with a negative comp of some sort, or do you need to be flat to positive in 4Q to hit that earnings range?

We need to be positive in 4Q. Great.

Okay. And then with respect to the cost program, you may have addressed this in your prepared remarks, but just what's the timing of the of the $10 million opportunity as we think about the quarters?

Yeah, there'll be a little bit in Q2, but for the most part, it's Q3 and Q4. And I think you could look at it as evenly spread across the two quarters.

Okay, great. And then just lastly for me here, you all still have a very strong balance sheet. Just with the stock coming down, how do you think about perhaps utilizing some of that cash to support the stock to do a buyback program? How are you all thinking about that at this point?

So we do have, we are continuing to repurchase shares, not at the volume that we did in the prior year. And I think for us, the first priority right now, even though our stock price is definitely undervalued, is making sure that we are in a financial position condition to execute all the initiatives that we have lined up. So I think my answer would be we'll continue to repurchase shares, probably not at the volume that we've done in the past, but also make sure that we are in a good place to execute the things that are in front of us.

Yeah. Brad, in addition to that, as you know, we have significantly slowed down the opening of new stores. which allows us to repurpose some of that capital to the strategic initiatives that we have in front of us.

Great. Well, thank you all so much, and good luck going forward here.

Thank you. Thank you, Brad.

This concludes our question and answer session. I would like to turn the conference back over to Woody Woodward for any closing remarks. Thank you very much, everybody. Have a great day. The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.