Kirkland's, Inc.

Good morning and welcome to Kirkland's third quarter 2019 conference call. All participants are in a listen-only mode. Should you need assistance, please send an oil conference specialist by pressing the star key followed by zero. Please also note today's event is being recorded. At this time, I'd like to turn the conference call over to Jeff Black, SCR Partners. Please go ahead.

Thank you. Good morning and welcome to Kirkland's conference call to review results for the third 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 the accessibility of this conference call on a listen-only basis over the Internet, were announced earlier this morning in a press release that has been covered by the financial media. Except for historical information discussed during this conference call, the statements made by the company management are forward-looking and made pursuant to the 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 including the company's annual report on Form 10K filed on March 29, 2019. With that, I will turn it over to Woody.

Thanks Jeff. Good morning and thank you for joining us today. The third quarter remained challenging. We made progress on key merchandising initiatives and will continue to add new categories to Kirkland's to broaden our reach. E-commerce trends reaccelerated in the quarter and we're driving more of a total business, including the BOPUS, which supports our focus on running a true omnichannel platform. Looking at some specifics for the quarter, we had success in our seasonal products of Harvest, Halloween, and early Christmas merchandise. Our new categories are starting off well. Collections of dinnerware, flatware, drinkware, housewares, dining furniture, and tabletop textiles are emerging as the clear winners. New additions of rugs and bedding remain promising and we're excited about their potential as we increase category awareness. We experienced mixed results in core categories. Furniture and textiles performed well, though the mixed shift to furniture is impacting margin rate. We're pleased with the acceleration in our e-commerce revenue. Our BOPUS sales accounted for a growing share of e-commerce sales in the channel and we're encouraged about its potential to improve traffic and profitability. Brick and mortar traffic remained weak. Our marketing spend did not drive the returns we were looking for in Q3, which resulted in additional merchandise promotions that negatively impacted the margin rate. At the same time, new categories and growth in e-commerce were not enough to offset negative store comps, which de-leveraged operating expenses. We've adjusted our outlook to reflect these trends and Nicole and Mike will discuss those later. We are working aggressively to address infrastructure and operating costs. As we look to the fourth quarter, our focus is on helping customers find ways to bring happiness home. We have a more purposeful depth and key items to complement our seasonal merchandise and our new categories reinforce Kirkland's long heritage of offering shoppers value. We've added new colors in tabletop and a new collection in January that we're calling everyday nostalgia. In floor coverings, we're adding new larger rugs where we've seen customer demand. Our inventory balance reflects these quality investments as well as our traditional seasonal build. We've exited the Harvest inventory within the quarter and we've transitioned through Black Friday and remain on track with Christmas merchandise sell-throughs. As we look to 2020 and beyond, we will continue to evolve our merchandise to improve relevance while focusing on simplicity, function, and value. We're moving more of our mix to good, better, best merchandising approach supported by direct sourcing that will have a result of higher AURs and have potential to help offset traffic while maintaining a strong presence in value merchandise. As it relates to marketing, we've completed a customer segmentation study to better understand our target customer and we're making customer acquisition a key priority. We will continue to update you on the progress to broaden our brand appeal and to drive profitable growth. While we've had some early successes, I'm disappointed that we've not made faster progress and we're redoubling our efforts to achieve our goals. We expect to end the year in a net positive cash position and we believe our work to lower occupancy, improve product margin, and reduce other operating costs can benefit earnings in 2020 and beyond. Now I'll turn the call over to Mike.

Thanks, Woody. As we have outlined, we're moving aggressively to transform Kirkland to support a more profitable model. Woody touched on the key initiatives across merchandising and marketing. In addition, our strategy includes work to optimize our store footprint to better support a non-muchannel framework. It encompasses better supply chain efficiency and improved cost via direct sourcing model. As well, it involves reducing costs across the organization. We're working methodically and urgently against this plan. Let's start with stores which remain a critical aspect of our direct to consumer strategy. Many of our customers are choosing Pick Up in Store as their preferred delivery channel for their e-commerce purchases. Customers ordering online and picking up in store accounted for over 50% of the e-commerce business in the quarter. Buy online Pick Up in Store inside of two hours with store inventory is approaching of the e-commerce business while over 25% of the business is special order online and Pick Up after we deliver from the distribution center. The good news is that the profit model of this omnichannel transaction is significantly better than shipping directly to the consumer's residence. Clearly stores are the secret sauce in executing an effective e-commerce business. Therefore we're on the right track. As we transform our store experience to support a true omnichannel platform, we're taking aggressive actions to streamline our brick and mortar infrastructure. We made solid progress in the quarter on our program to broadly reduce occupancy costs and the initiative will include closure of unprofitable stores. We expect to have completed phase one of this process by January. Supply chain initiatives are supporting our evolution. We stood up a three PL distribution center south of Dallas that had successfully navigated its first holiday season. This distribution center is important because it saves transportation costs and mitigates risk from a single threaded distribution center. Meanwhile, we are poised to implement a new high jump one warehouse management system in Q1 of 2020. This system will add efficiency and it will enable a more robust e-commerce distribution network. Finally, we're evaluating options to expand our e-commerce delivery nodes from just one fulfillment center. More to come on this initiative though, it's clear the strategy is multiple smaller hubs to get closer to the customer. We're also making significant progress to address our IMU and lower our cost of goods to support profitability in a more promotional environment. We remain on target for 15% of our merchandise to be direct sourced in 2020. Direct importing will serve as a cost savings measure to offset the tariff impact and allow us to stabilize our margin. In addition, it opens up the merchandising team to more product and factory options. Also, we're taking an aggressive approach to cost in 2020 across the board. This includes further operating cost reductions to the cuts we implemented in 2019 in addition to the real estate opportunity. At the same time, we're streamlining our CapEx initiatives which will provide a higher level of focus, execution, and speed on the things that matter the most. Our capital allocation will be focused on the supply chain improvements just mentioned to transform the company to an omni-channel structure while continuing to invest in our e-commerce engine. We're pleased with the trajectory of our e-commerce business and continue to make site experience improvements that enhance conversion. We've made investments in the e-commerce team that will help us drive the customer experience while improving the infrastructure. In conclusion, we're taking very precise and pragmatic strategic steps to transform the model in addition to maximizing cash and profitability. I'll now turn it over to Nicole.

Thank you, Mike. Net sales for the third quarter decreased .2% or 9.6 million compared to the third quarter of the prior year. The change in sales includes a comparable store sales decrease of 6.4%, which includes a .9% increase in e-commerce revenue and a double-digit decline in brick and mortar sales. And that's on top of a .4% combined comp increase and a .9% increase in e-commerce in the prior year. In our brick and mortar stores, soft traffic continued and was the primary driver of the comparable store sales decline. The macro channel shift and the increasingly promotional environment both contributed to the traffic decline. E-commerce accounted for 23.5 million in revenue during the quarter, or approximately 16% of total revenue. We saw increases in traffic and significant increases in conversion with some of our efforts to improve our online shopping experience beginning to impact our results. These were offset by a decline in average ticket. For the quarter, approximately 53% of our e-commerce sales were fulfilled in-store at a higher level of profitability than direct to consumer sales. First profit margin in the second quarter decreased 250 basis points from the prior year to 27.7%. Merchandise margin decreased from the prior year by 360 basis points to 51.8%. That was driven by a decrease in product margin from both product mix and incremental discounting and an increase in inbound freight due to rate increases and product mix shift. Outbound freight costs, which include e-commerce shipping, decreased 80 basis points as a percentage of net sales. We saw the benefit in the quarter of standing up a second retail distribution center and reducing overall miles to deliver product to our stores. We also had a decrease in e-commerce shipping due to the increase in store fulfilled online sales and savings from a new shipping provider contract. Store occupancy costs de-leveraged 25 basis points over the prior year quarter due to the decline in brick and mortar sales. Excluding the one-time unfavorable adjustment in the prior year, store occupancy costs de-leveraged 60 basis points. We are making progress with the third party we engaged to aggressively renegotiate our store leases and reduce our store footprint as it makes sense. We continue to believe there is significant opportunity to remove costs from our brick and mortar infrastructure from both renegotiated lease terms and closing of underperforming stores. Central distribution costs decreased 55 basis points as a percent of sales compared to the prior year quarter primarily due to reduced labor costs. Operating expense, excluding depreciation and asset impairment for the third quarter was .1% of sales and that's compared to .3% of sales in the prior year quarter for an increase of 920,000. Store operating expenses increased 280 basis points as a percentage of store sales over the third quarter of 2018 primarily due to de-leveraged store labor and incremental advertising expense. E-commerce expenses increased 160 basis points as a percentage of e-commerce sales due to incremental advertising expense which was partially offset by operating leverage on fixed costs. Corporate expenses remained relatively flat to the prior year in dollars but increased 60 basis points as a percent of sales primarily due to de-leverage of payroll related costs. Depreciation and amortization decreased 10 basis points as a percent of sales or 265,000. We recorded an impairment charge of 3.4 million in the quarter related to 17 store impairments whose carrying value exceeded their fare value. We also recorded a tax valuation allowance of 11.3 million in the quarter as our estimated pre-tax loss for fiscal 2019 exceeds the cumulative pre-tax income for the prior two years. The valuation allowance covers the federal net deferred tax assets and a portion of the state net deferred tax assets. We've included adjusted EPS which excludes the asset impairment charges, tax valuation allowance and severance recorded during the quarter. For the quarter we had a net loss of $1.61 per diluted share or $0.58 on an adjusted basis and that's compared to a net loss of $0.18 per diluted share in the prior year quarter or $0.13 adjusted. And moving on to the balance sheet and the cash flow statement. At the end of the quarter we had 4.2 million of cash on hand compared to 23.8 million in the prior year period. We had 25 million of borrowings outstanding under our revolving line of credit as of the end of the quarter. The year over year decrease in cash was driven primarily by the decline in operating performance, increase in inventory, sharey purchases and capital expenditures. We currently have 50 million of availability on the credit facility and expect to end the year with no outstanding borrowings and net positive cash. Our inventory balance at the end of Q3 was $140.2 million which is an increase of approximately 23% 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 quarters. We reduced receipts in the third and fourth quarters and expect to return to lower inventory levels by the end of the fiscal year. We believe there is minimal risk of obsolete seasonal inventory as we effectively move through harvest product in the quarter and are on track to date with Christmas merchandise sell through. Year to date cash used by operations was $62.4 million and that's compared to $20.8 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 $12.8 million compared to $25 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. We are updating our earnings guidance to a range of a loss of $1.75 to $2 for our fiscal year 2019. And with that I'll hand it back to Woody for closing comments.

Thanks Nicole and thanks to everyone on the call for your interest in Kirkland's. While we're not yet where we want to be in terms of results, we are executing against a plan we laid out to transform the business to a more profitable model. We're encouraged by progress in a number of important areas and we've accelerated our work to achieve our goals. I want to thank our associates for their drive, dedication, and all the hard work they do each day to make Kirkland the best customer experience. The team will be available after the call for any questions you may have and look forward to speaking with you and updating you on our progress.

Ladies and gentlemen, with that we'll conclude today's presentation. We do thank you for joining today's conference call. You may now disconnect your lines.