Kirkland's, Inc.

Good day and welcome to the Kirkland's second quarter 2019 earnings 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. Please go ahead.

Thank you. Good morning and welcome to Kirkland's conference call to review results for the second 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, Chief Financial Officer. The results, as well as a notice of accessibility of this call on a listen-only basis, were announced earlier this morning in a release that's been covered by the financial media. Except for historical information discussed in this call, the statements made by the company management are forward-looking and made pursuant to safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements involve 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 Securities and Exchange Commission, including the annual report on Form 10-K filed on March 29, 2019. I'll now turn it over to Woody.

Thanks, Jeff, and good morning to everyone on the call. We appreciate you joining us to review the second quarter and our plans for 2019 and beyond. Trends in the business remain challenging in the second quarter, driven primarily by weak store traffic. We're taking additional steps to address near-term concerns, including tariffs, and we're focused on accelerating the existing initiatives we've outlined to transform the business. We have much work ahead of us, but I want to start this call by stressing that our team is executing against a carefully thought-out plan, a plan we firmly believe will improve the vibrancy of the brand and return the company to profitable long-term growth for our shareholders and associates. We believe that we have the capital and the talent to accomplish our objectives, and we're doing everything we can to accelerate the execution of these goals. While we'd obviously like to see better top-line trends here in the short term, we've made notable progress on several important initiatives in this quarter. E-commerce sales re-accelerated in Q2, with increases in both traffic and conversion in the channel. We're also seeing solid performance from the new categories that we've added to broaden Kirkland's reach with new and exciting customers. Sales of rugs as well as the new tabletop assortments in textiles and housewares and dining products are encouraging, have made plans, and have ample room to grow. In launching new categories, considering our price value equations and our curated assortments, we've placed our emphasis on offering better quality. The Kirkland's brand must stand for great value and great quality. For example, our Turkish 5x7 rugs for $199 come in at a compelling value price point. And there's the same quality and designs available that you might see in premium home decor retailers, but at a significantly lower price. So we want to remain below the specialty luxury market at a great Kirkland's price point with quality that reinforces that value. Margins are above our plan in these categories thus far, given a high proportion of full price sales. The performance to date confirms that our strategy to showcase curated product can drive better results. Bedding, our third important launch for 2019, is being introduced to the chain this month in September. As we work to improve merchandising across the chain, the continuing shift in our customers' shopping patterns is putting pressure on our stores and related infrastructure. The new categories, while promising, are not yet offsetting the drag from the brick-and-mortar traffic. As we've discussed, we're supporting the launches with direct mail, digital marketing, and we're confident the product additions will gain momentum. Given current top line trends, we're making adjustments where needed. In addition to product launches that will add opportunity in the first half of 2020, we're also launching new excitement into existing assortments such as our art category. As many of you may have seen, yesterday we launched an exclusive art collection from Dolly Parton called From the Heart. which is a collection of nine canvas art interpretations of Dolly's most iconic songs. Check out on our Kirkland's website for new exciting news on this launch. Given current top-line trends, we're also making other adjustments where needed. For example, as we look to the second half of 2019, we're addressing promotional levers to right-size inventory with optimal margin. We're working hard to ensure that the supply chain supports plans for the heavy per-month seasonal periods. We've applied learnings from the fourth quarter last year, which included an earlier drop of the post-Christmas floor set, and we believe we'll benefit from a second warehouse in Dallas and a more efficient supply chain overall. We're continuing to focus on removing costs that do not impact the customer, and we're moving forward on the program to reduce operating costs by $10 million in 2019, and we're analyzing additional levers that we believe can make the business stronger and more effective. These are important initiatives that support our long-term transformation, and we're optimistic that they can help stabilize our financial performance. We will continue to update you on progress to broaden our brand appeal and drive profitable growth. Before I hand the call over to Mike, I want to take a moment to speak to the main pillars of the plan, which include merchandising, omnichannel growth, infrastructure improvement, and disciplined capital management. Let me start with merchandising. As I discussed, Kirkland's strategy is to improve the assortment's overall relevance while reinforcing simplicity, utility, and value. This includes a sharper focus on key items and product introductions in adjacent categories that are particularly relevant to home shoppers. We're entering the back half with more purposeful depth in key items to complement our seasonal merchandise. And our new categories reinforce Kirkland's long heritage of offering shoppers values. In addition to rugs, our tabletop launch has been received extremely well by current customers. Turning to Omnichannel, we're pleased with the sales re-acceleration in e-commerce. Both the sales accounted for a growing share of the e-commerce sales in the channel and we're encouraged about its potential to improve traffic and profitability. The teams are working to streamline checkout, increase speed, and elevate the design elements of Kirkland's.com. and we believe we can significantly reduce pickup times and add ancillary services over time. As it relates to infrastructure, Kirkland is focused on realigning its supply chain and store infrastructure to support optimizing operating costs and support a more efficient omni-channel strategy. There are a number of important levers here, which Mike will address in a moment. And lastly, we're focused on preserving our capital to execute our plans. We have a strong balance sheet, and we intend to continue to exercise discipline in our capital allocation by investing in the critical components of our business as a first priority. We're fully aware of the challenges facing our sector. Home decor has experienced dramatic shifts in consumer taste and shopping patterns, and we see that continuing. We have a loyal customer base that treasures value and expects us to remain on trend and competitively priced. and there is a large uncapped base of consumers that are not yet familiar with Kirkland's. We believe we have struck a balanced approach with our merchandising to appeal to all of our customers and fully confident that we have the right plan in place to return Kirkland's to long-term profitability. Mike?

Thank you, Woody. I'll cover two topics. First, an update of how we are supporting the holiday season this year. Then I'll walk through our future plans to transform the infrastructure of the business. As we go into the second half of the year, we continue to make excellent progress on the initiatives we outlined in the last call. For starters, we successfully stood up a 3PL distribution center south of Dallas on schedule. This distribution center is servicing and delivering to 99 stores or over 20% of our store chain. In addition to creating a smoother flow of product, it saves approximately $1 million in transportation costs on an annual basis. Meanwhile, we are starting to dial in on the promotional levers to drive top-line sales and move inventory. We were happy with our Labor Day promotions. They were simpler and clearer, although deeper than our normal intensity it proves to drive sales, inventory, and margin dollars. In addition, the trajectory of our e-commerce sales is accelerating on the back of streamlined checkout, increased speed, and site design improvements along with improved back-end fulfillment operations. I'm very proud and excited about our store execution. They have completely reset the entire floor of merchandise presentations to accommodate the new products while continuing to up their service level to the customer as evidenced by rapid increase in focus orders and by the increase in conversion rate. I'll now pivot to the transformative work that will be going on for the balance of this year into 2020. In light of this quickly evolving and disruptive retail dynamic, We are accelerating our plans to reposition the infrastructure of the business so it better correlates with where and how the consumer buys home decor. We have the capital, the runway, the expertise, and the team that has constructed a well-thought-out plan. This will address two fundamental challenges in the architecture of the business today. First, as traffic shifts to online from brick and mortar, It's resulting in greater deleverage. Therefore, our store structure needs to be optimized. Second, our e-commerce fulfillment and supply chain network has great opportunity in profitability and competitive time to consumer. I'll walk through the plan that builds an omnichannel model of the future. Starting with the store structure, we have contracted a third party to aggressively renegotiate our store leases. We fully expect the number of store closures to be an output of this process. It is premature to release the target number of store closures and target savings from rent negotiations. We are not only taking a current look at the footprint, we have extrapolated the profitability of each store based on the current traffic trends, and we intend to take vigorous action on all EBITDA negative stores to construct a more profitable network. In early 2020, we will launch HiJump 1 to replace our current warehouse management system. This will give us greater efficiency. It will enable shared inventory with store and e-commerce products, and it will tie into a last-mile capability. We've been working on the development of HiJump 1. We are in the UAT phase now, which gives us confidence in the timing and executions. Once we launch our new warehouse management system, we will be in position to mitigate the cost structure of our supply chain operation, and it will allow us to execute our shift to store channel of e-commerce at a higher level. At the same time, we will be standing up shift from store capability by mid-2020. Our current direct-to-consumer channel of e-commerce will therefore be significantly enhanced from an earnings aspect and service standpoint. So let me summarize what our omnichannel model looks like in 2020. We'll have a more cost-effective and streamlined store structure. Buy online, pick up in store will continue to grow. In Q2, Bocas represented 28% of the total e-commerce business and we're encouraged by the trajectory of this channel going into 2020. Shift to store will be more efficient and more of a weapon in the future. As an example, when we introduced our new tabletop set, it was merchandise on a farmhouse table. We've been selling the table as a ship-to-store item so that we don't disrupt the presentation. We're planning more extended merchandise sets in the future to leverage this capability. Ship-from-store will be a new muscle. It means shorter lead times to the customer, and it will significantly cut our freight costs. In addition, it allows us to leverage our store labor. This is the next leg of our omni-channel strategy. In summary, We will offer a more profitable model that enables a portfolio of fulfillment options for the consumer that enables the ultimate in convenience and carves out a market position to compete against the pure e-commerce players. In addition to the infrastructure work, our direct import initiative is going very well. We've begun receiving product direct from factory, and we're on target for a 15% penetration in 2020. Direct importing will serve as a cost savings measure to offset the tariff impact. In addition, it opens up the merchandising team to more product and factory options. Currently, we've got active agents for China and India. We're in the process of looking to expand in other parts of Southeast Asia to mitigate our exposure to China. Then you layer on the benefits of the $10 million cost reductions. We'll continue to explore future cost reductions to coincide with our future structure. Big picture, current performance is disappointing. though we're excited about our progress to transform Kirkland's into a true omnichannel player. The foundational assets are in place to successfully reposition the model. As you overlay the new product categories along with new customer acquisition with the infrastructure just outlined, we are optimistic about the earnings potential of the business. I'll now turn it over to Nicole.

Thank you, Mike. Net sales for the second quarter decreased 10.5% or $14 million, compared to the second quarter of the prior year. The change in sales includes a comparable store sales decrease of 11.2% and an increase in store count of 1.2%, or five stores. Comparable store sales includes a 21.5% increase in e-commerce revenue and a double-digit decline in brick-and-mortar sales. And that's on top of a 3.9% combined comp decrease and a 14.5% increase in e-commerce in the prior year Q2. In our brick-and-mortar stores, we continue to see double-digit declines in traffic, and a decline in average ticket contribute to the sales decline. The macro channel shift and the increasingly promotional environment both have contributed to the traffic decline. E-commerce accounted for $20.6 million in revenue during the quarter, or approximately 17% of total revenue. We saw increases in traffic and conversion, which were offset by a decline in average ticket. For the quarter, approximately 60% of our e-commerce sales were fulfilled in-store, which supports our initiative to drive online sales and leverage our store base to increase the profitability of the e-com channel. For the first half of the year, the impact of declining brick-and-mortar sales on our fixed costs has resulted in significant expense deleverage. We are aggressively focused on right-sizing our infrastructure to maximize the profitability of our omnichannel model. Gross profit margin in Q2 decreased 530 basis points from the prior year to 22.2%, and that was primarily driven from deleverage in store occupancy and distribution costs and a decline in merchandise margin. Merchandise margin decreased from the prior year by 130 basis points to 51.9%, driven by a decrease in product margin from both product mix and incremental discounting which was partially offset by favorable shrink results from our annual store physical inventory counts. Outbound freight costs, which includes e-commerce shipping, increased 10 basis points as a percentage of net sales. Although our transportation costs of shipping products from our distribution center to our stores decreased, we saw a few leverage as a percent of sales. That increase was offset by a decline in e-commerce shipping due to the increase in store-fulfilled online sales in savings from a new shipping provider contract. Store occupancy costs deleveraged 240 basis points over the prior year quarter due to the decline in brick and mortar sales. As Mike mentioned, we have engaged a third party to aggressively renegotiate our store leases and reduce our store footprint as it makes sense. We believe there is significant opportunity to remove costs from our brick and mortar infrastructure. Central DC costs increased 150 basis points as a percent of sales compared to the prior year, which was primarily due again to sales deleverage and a change in estimate in our warehouse capitalization calculation. Operating expense for the second quarter was 36.6% of sales, which was down $167,000 but up 370 basis points to last year. Store operating expenses increased 330 basis points as a percentage of store sales over the second quarter of 2018, primarily due to the deleverage of store labor. E-commerce expenses decreased 180 basis points as a percent of e-commerce sales as we are gaining leverage on fixed costs. Corporate expenses increased by 920,000 or 180 basis points over the prior year, primarily due to payroll-related expenses which included severance restructuring charges. Depreciation and amortization increased 10 basis points as a percent of sales, but remained relatively flat in dollars to the prior year. We reported an impairment charge of $2 million in the quarter related to four stores whose carrying value exceeded their fair value. We are excluding the impairment and severance charges from adjusted EPS. The tax benefit for the quarter was $3.7 million, or 18% of the pre-tax loss, compared to 23% in the prior year period. For the quarter, we had a net loss of $1.21 per diluted share, or $1.05 adjusting for the store impairment and severance charges. And that's compared to a net loss of $0.43 per diluted share in the prior year, or $0.41 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 14.7 million of cash compared to 35.4 million in the prior year period, and no long-term debt or borrowings were outstanding under our revolving line of credit. The year-over-year decrease was primarily driven by share repurchases, the decline in operating performance, and an increase in inventory. Subsequent to the end of the quarter, we drew 10 million on our $75 million revolver. We currently have approximately $62.5 million of availability in the credit facility. We do expect additional borrowings in the third quarter, but to end the year with no outstanding borrowings. Our inventory balance at the end of Q2 was $108.2 million, which is an increase of approximately 13% over the prior year period. The inventory increase includes funding the new product categories released early in the third quarter as well as inventory from the soft sales in both the first and second quarter. There is minimal risk of obsolete seasonal inventory, and with a combination of reduced receipts in the third and fourth quarters and increased promotions, we expect to return to normal inventory levels by the end of the fiscal year. Year-to-date cash used by operations was $31.5 million compared to $22.5 million in the prior year. The decrease is due to the decline in operating performance and changes in working capital, primarily driven by the increase in inventory. Capital expenditures were 8.5 million compared to 18.3 million in the prior year. For fiscal 2019, we have reduced our expected capital expenditures and will continue to focus capital dollars on e-commerce and supply chain initiatives to improve top-line e-commerce sales and the efficiency and profitability of our model. During the second quarter, we repurchased approximately 346,000 shares. Our existing share repurchase authorization will be exhausted during the third quarter. We believe our stock is significantly undervalued, but feel strongly that funding our initiatives and conserving cash are in the best interest of our long-term value, and so we do not intend to initiate any additional share repurchase authorizations in this fiscal year. We are updating our earnings guidance to a range of a loss of $1.25 to $1.50 for our fiscal year 2019. This guidance is reflective of our results for the first half of the year and current sales and margin trends. Specifically, traffic remains challenging. New products are outperforming their plan but have not impacted store traffic to the degree we expected at this point in the year. The guidance now contemplates a longer runway for customers to become aware of our new categories and the improvements in style and quality and our ability to attract new customers while obtaining existing key customers. As it relates to tariffs, we moderately increased prices where we thought we had elasticity throughout the store to offset the prior tariff increase on List 3 in June. We expect our vendor partners to absorb the most recent round of tariff increases and are working through those details. However, the full impact of existing or future tariffs is expected to have some impact on our results for this fiscal year. This guidance range includes the cost reductions we announced last quarter, which were primarily spread across the third and fourth quarters. We continue to fully expect to realize those benefits and a greater carry-forward benefit to fiscal 2020. And now we would be happy to answer any questions.

Thank you. We will now begin the question and answer session. To ask a question, you may press star then 1 on your touch-tone phone. If you're using a speaker phone, please pick up your handset before pressing the keys. To withdraw your question, please press star then 2. At this time, we will pause for a moment to assemble our roster. Our first question today will come from Anthony Lebedzinski of Sudodian Company. Please go ahead.

Yes, good morning, and thank you for taking the questions. So first, I just wanted to start with perhaps the Q3 to date trends. Are you guys seeing kind of similar results as the second quarter, or can you comment on that as to how you're trending so far through the first week of September?

Well, our August was relatively consistent with previous trends. As we introduced new products and the floors were somewhat disrupted with getting new categories on the floor. We have seen an uptick in trend starting in September for the first four days, which we're optimistic about. And we're hopeful, but we're not out of the woods yet in terms of the trends and the traffic.

Got it. Right. So as far as your marketing spending plans, can you elaborate on that as to how you're looking to try to gain – both your existing customers to come more to your stores and also perhaps reach out to some new customers?

Because of budgets being relatively conservative in our marketing spend, depending on because of the trends, we're putting most of our marketing dollars into driving digital increases. But where we do have some of our traditional marketing campaigns We're taking an approach where we're engaging and educating our current customers as to new categories. We feel like they're our best bet for communicating out to the world that they've seen a change in Kirkland, a better floor set, a better quality improvement. And then we did take a slight portion of our money and drive towards prospecting to get new customers into the store. But I firmly believe that new customers in the store have to be earned over a period of time. where customers come in that are our current customers and tell people that we have more relevance. Remember that in the past, customers was kind of a location that you came to at the end of your decorating process. You bought your seasonal products, your wreaths, your Christmas products, and maybe some candles. And we're trying to make the transition to become relevant throughout the entire decorating process. So to buy a rug and a dining table and tabletop products and bedding, it just takes a little while to get that customer engaged and let them know that we're now qualified for the entire decorating process.

Got it. Okay. And then, you know, as far as the number of potential store closures, I know you're not prepared to give a specific number for that, but would you say that would most of those be done at lease maturity or do you think you'll need to exit out of store leases early or And also while we're on that subject, can you give us maybe a sense as to how many of your stores are unprofitable on a perhaps EBITDA negative basis? If you could share some of those metrics, that would be very helpful.

Good morning, Anthony. So what I will say is the following. We've been looking at this for a while. Currently, less than 10% of our store base is EBITDA negative. And perhaps the majority of those stores tend to be in the west or in the northeast. And we just initiated this process with a third party. And we are looking at all opportunities to dramatically increase our store profitability. So that also includes rent reductions, Yes, there will be some closure of unprofitable stores, but we're also, as outlined with our infrastructure changes, we're going to be leveraging our store asset base for e-commerce shipping and, therefore, get better flow through from the stores. So we'll be taking a portfolio approach as we get into this, and I'm very confident that in the next three to four months we'll be in a position to update you more specifically where all that stands.

Yeah, I think, Anthony, very specifically, not just looking at them as they come up for term renewal, but looking at holistically, as Mike said, our entire portfolio and addressing them regardless of term.

Got it. Okay, that's helpful. And so obviously you have a number of initiatives that are in the pipeline. You mentioned that at some point you would expect to return to profitable growth. Can you give us a sense as to when – that could happen?

Yeah, I think as we look at 2020, we definitely, and we'll release more specifics, you know, when we get to that point, but do you think there's the opportunity to improve profitability? But again, it's a year with a lot of changes and resets to our infrastructure, so we'll give more details on that in the future, but there's a lot of things that we have on the initiative list that will impact future profitability that will still be in play in the first part of 2020. Got it.

All right. Well, thank you, and best of luck.

Thank you.

Thank you.

Our next question today will come from Jeff Van Sinneren of B. Reilly FBR. Please go ahead.

Good morning, everyone. Good morning. What does the excess inventory consist of? Is it just run of the mill, or are there any concentrations to be aware of? And also, can you add more color on how you're handling that? And then it's kind of a multi-part question here, but can you speak more about the cost reductions in place for second half that we should expect? Do you think that those are Just kind of looking at the other operating expense line, are you still thinking it's evenly split between Q3 and Q4? And then are there other areas you've identified where you could further reduce that line going forward?

Great. Jeff, this is Woody here. I'm talking on the inventory, and then Michael probably handles the second half of that question. On the inventory, I would say half of the overage is quite intentional with the purchasing of new categories and being in stock on those new categories. And they're mostly core categories, so they don't have the same short life that a lot of our seasonal product carries. The other half is just simply missing the sales plans in the first and second quarters. Although we've done a good job at liquidating any product that would be considered more seasonal. So anything that's left in our overage, we feel good about as a relevant product. high quality, good merchandise. So we're really not in a position yet where we have lumps of poor products. So we're going into our number one selling season in the third and fourth quarter so that we can probably hit a number that we feel really great about. So inventory, not a huge concern. We did specifically buy that up, but Anyway, so I'm going to turn it over to Michael.

I got a dirty look when I said that.

So just a bolt on on the inventory part. Our strength historically at Kirkland has been our seasonal product. And the initial selling of our harvest set is an indicator. We have very little concerns about any – overhang of seasonal products, both in our fall and Christmas assortments, which we feel very strong about. Regarding the cost reductions, we are still well on track to take the $10 million of cost reductions second half of this year, which will also carry into 2020. And yes, it's relatively split 50-50 in Q3 and Q4. Meanwhile, we'll continue to look at additional cost reductions as needed without disrupting the business and specifically anything that would interfere with top-line sales and any forward movement on our infrastructure changes.

Okay. And then I know you mentioned some early success in your prepared comments, but of the changes that you've made so far to the website and the in-store merchandise content, obviously some new categories there. Can you give us any more color on what you're learning, where you're seeing the traction, how the customer's responding, even if only on a relative basis? And then I guess what other changes to merchandising should we anticipate heading into 2020 to the extent that you can talk about that?

Okay. So several good points there. First of all, fully engaged right now in tabletop and in rugs on the floor. So those are hitting their plans. The tabletop, I would say, was a full home run, both in the dinnerware and in the home textiles. Rugs made its plan. We are going to be looking at some adjustments there, but feel really good about both those introductions. The third introduction happens next week, in fact. In the next two weeks, we land the bed and the bedding on the floor. So that will be our third and final introduction of new products, brand new products into the store. Our products that are more ongoing, we're having some uptick in art. You know, we just announced the Dolly Parton partnership with her original artwork. We've got some musical artwork that seems to be taking fold. Our seasonal product seems to be working. But the overall problem is still when you're having a double-digit traffic decline, it's really hard to offset just the overall sales trend with those traffic declines, and we haven't been able to absolutely ensure that our traffic is improving quite yet. Now, for the first part of next year, we did say on the last call that we would be introducing a line of upholstered furniture, starting mostly with a chair, a recliner or a chair, and then going forward with some other upholstery in the first half of next year. So we're really excited about that. Like I said before, we want to be considered as one of the players for the entire journey of somebody redecorating their home, not just at the very end of the home cycle purchase. And so it's all very intentional. Our stores are saying and our customers are saying they love the new floor set. it's more open, it's easier to shop, and we're getting a lot of credit from both store associates and store employees that the whole assortment and store looks fresh and new. So, you know, we just need to let that take place.

And then, Jeff, to address your question on the e-commerce and the website, we feel great about our ability to accelerate our e-commerce sales. We're continuing a slate of improvements, both on the front end and the back end of our e-commerce experience. We're getting smarter on the promotional levers that drives it. We are very excited about our acceleration on buy online, pick up in store, which is now approaching 30% of our e-commerce sales. And We're now building out the ability, the muscles on ship to store, as I mentioned in the previous opening comment. And then we will be bolting on in 2020 ship from store, which I think will take us to a whole other level. So this is an area where we're continuing to invest in and leveraging the store as an asset base in combining with our e-commerce capabilities for a true omni-channel model.

Okay. And then just one more, if I could. Given some moving parts, how should we think about gross margin for second half?

Yeah, built into our guidance is that sales and margin trends relative to last year will remain pretty consistent through the back half of the year.

Okay. Thanks for taking my questions, and best of luck. Thank you, Jeff.

Ladies and gentlemen, this will conclude our question and answer session. At this time, I'd like to turn the conference back over to Woody Woodard for any closing remarks.

Just thank you for being on the call today, and we'll look forward to our next several calls of hopefully improved results. Thank you.

The conference has now concluded, and we thank you for attending today's presentation. You may now disconnect your lines.