Kirkland’s, Inc. (“Kirkland’s” or the “company”) is a low-cost home decor retailer operating 296 stores in 29 states with most of its stores located in the Sun Belt. The company is pretty well known in the value investing circles and a quick look into its history will reveal why. In 1996, Kirkland’s was acquired by private equity firm Advent Partners and then taken public in 2002 for $15 a share. However, between 2004 and 2007, the company began an ill-fated expansion out of its core markets while simultaneously changing their merchandising strategy to compete with more upscale competitors. (We’ll refer to this as “The Bad Times.”)
Coincidentally, as the company began to turn around its strategy to focus on its core market, two large funds owning approximately 25% of the company were having problems that caused them to sell their shares regardless of pricing. As a result, the company’s shares dropped from $5 per share to $1 per share in late 2007 and early 2008. At that point, net cash and with no debt, the company was trading for about 2x free cash flow and a little over 1x EBITDA. From that depressed share price, the company then surged to $24.45 per share in mid-April before coming to a rest last Friday at $10.79 after issuing lowered guidance for the remainder of 2010.
Investment Thesis and Valuation
The valuation here is fairly simple. As the press release issued last Friday shows, the company anticipates ending the year with $85 million in cash (still debt free) and expects 2010 earnings to come in at a range between $1.25 and $1.29. (This was a little lower than analysts expected.) At a current share price of $11.58 per share, the company has a market cap of $230 million.
Assuming that the company hits the low end of their guidance at $1.25 per share, that means the company will earn $24.85 million this year. That looks to be a large drop from last year’s $1.77 per share, but if you adjust for non-recurring tax benefits, the comp is a bit more manageable at $1.45 per share. The company has had relatively even sales of around $400 million a year since 2005 (a year into The Bad Times), so it’s unlikely that 2010’s expected revenues of $414 million represent a “peak” in revenues. Additionally, the company is expecting operating margins of 10%, which is about 50 to 60 basis points higher than before The Bad Times, and, in my opinion, not an unreasonable normalized operating margin given the move away from lower margin in-mall stores to higher margin off-mall sites.
As a result, I think it’s fairly safe to take $1.25 per share as a normalized EPS.
(1) The Low Bid
If we assume that the market completely neglects the cash on the balance sheet, we could apply a normalized 8x multiple to the $1.25 per share of EPS to get a share price of $10 per share. As a quick check, I think that from an equity capital costs perspective, an investor would want to get at least twice the ten-year average of Moody’s AAA corporate bond yield of about 6%, so, with an estimated equity capital cost of 12%, an 8x multiple seems pretty reasonable.
Note that $10 per share amount neglects the entire cash balance, and it might be a bit more realistic to include at least half the cash balance, which brings the valuation to a little more than $12 a share.
(2) The Mid Bid
Of course, EPS doesn’t tell the whole story with Kirkland’s. Kirkland’s is one of those rare companies where accounting depreciation & amortization really is much lower than the actual cash costs of maintenance expenditures. In fact, we can estimate that the cash cost of maintenance per store is roughly $8,000 per store. Over almost 300 stores, we’d get maintenance capital expenditures of about $2.4 million, and if we kick in $0.6 million for corporate/regional needs, that takes us to $3 million per year. Contrast that with the expected accounting D&A cost of $13 million, and you’ve got a $10 million differential. (The nice thing about recessions is that you can often find out a pretty good approximation of what maintenance capital expenditures should be -- in 2009, with 299 stores, the company spent $2.7 million in capital expenditures.)
That means that free cash flow normalizes at around $1.75 per share. If, again, we apply the same 8x multiple for that amount, we’ll get a $14 per share estimate for the company. One thing to note before adding in the cash is that Kirkland’s seems to require a seasonal adjustment of about $10 million to $15 million for net cash in 4Q. If we compare a seasonal adjustment of $15 million to no seasonal adjustment on the expected net cash, we’d get somewhere between a $3.50 and $4.25 for net cash. I’ll compromise and put net cash at $3.90. If we add this back to the 8x multiple, then we’d get a share price of $17.90.
(3) The High Bid
On a normalized basis, most of Kirkland’s competitors (chief among them, Pier 1) trade at an EBITDA multiple of 6x. If we back our way up the income statement starting with expected earnings of $24.85 million and a D&A of $13 million, we get about $53 million in expected 2010 EBITDA. At the normalized multiple and adding in the full amount of expected net cash, we’d get a share price of $20.27.
(4) Possible Margin Erosion - Quick Check
The big fear with the company right now is margin erosion. Freight transportation costs from China and India have gone up in recent months, and it's a question of whether a 12.8% EBITDA margin is too generous to be used on a normalized basis. So, instead, let's assume that the EBITDA margin erodes away to the tune of about 4% by the end of 2011. (That's a HUGE drop in 12 months, but we'll use it as our check anyway.)
On that basis, with an 8.8% EBITDA margin, the company would be making $36.5 million in EBITDA on flat revenues. (Keep in mind that the company is set to open 30 more stores in the next 12 months, so revenues should be higher, but we'll keep $414 for this calculation.) If we apply a 6x EBITDA multiple to that amount, we'll get $219 million. However, since it's 12 months from the end of CY2010, the cash cushion will likely have increased another $20 million above $85 million, so total valuation would come to about $324 million or $16.30 a share.
As I mentioned in "Possible Margin Erosion," there’s actually a bit of a free option in Kirkland as well. In the calculations of value above, the assumption is for little to no growth in the company; however, the company does have a growth strategy. Once burned and twice shy, the company is now infilling its core markets rather than trying to expand outside of its natural habitat. Their newly opened stores (after 12 months) average about $1.8 million in sales for a capital outlay of around $400,000 to $430,000. (They actually also receive some landlord incentives that help offset the cost, but we’ll ignore those for now.)
If we assume that the new stores contribute EBITDA at the same overall rate as the company, then EBITDA comes in at about $230,000. If we take out maintenance capital expenditures and taxes, then we’re looking at about $135,000 in profit. That’s a pretty good incremental return on capital.
As most people know, aside from BYD Company, I hate to pay up for growth. In this case, I don’t have to do so, but I’m still left with the task of figuring out a valuation for the growth prospects. I’d say that on a very conservative basis, with a net increase of about 30 stores a year, the additional profits are worth at least $4 per share. (It’s likely a lot higher, but I prefer low-balling growth in this case.)
On the latest quarterly conference call, management was asked whether they would consider a share buyback program given the current depressed price of the stock. Management declined to speak to the issue directly, but given the size of their cash hoard, it’s a definite possibility.
- Although the company isn’t likely to seek a repeat performance of its upscaling fiasco, a smaller merchandising miss could still cause stress to the company’s earnings. In fact, for this most recent quarter, management indicated that while traffic to their stores has increased, their same store sales have decreased a little as compared to 2009. My guess is that this indicates a slight merchandising miss on their part, and it should be fixable after they push out their existing inventory in their routine January sales.
- Since Kirkland’s is actually the low-cost provider in most of its markets, the recession and tightening of consumer spending could be seen as a boon for the company as individuals downscale their spending. The risk then is that when the economy comes back, and we’re back to the rah-rah consumer spending days that consumers will abandon Kirkland’s. I think this risk is slightly overblown (similar to arguments against Aeropostale) given that a recovered economy is just as likely to bring as many individuals into the stores as it takes out of them through upscaling.
China and India Risk
- Kirkland’s sources a lot of its merchandise from China and India. Increases in local currencies, labor costs, transportation costs, etc. will have an impact on the company’s margins, and it’s uncertain how well the company can pass on those costs. Kirkalnd’s is by far cheaper than Pier 1, so there’s definitely room in the price differential, but I’m uncertain how it will affect demand.
Disclosure: Long KIRK