Kirkland’s, Inc. (KIRK) is a retailer of home decor, with 293 stores throughout the southeastern United States. I came across KIRK via Saj Karsan’s blog back in November, and I agreed with his analysis and confirmed via my own valuation and research the opportunity that was presented at the time. Along with Saj, I rode KIRK up until mid-February when I sold at a handsome profit.
I now believe that Mr. Market is offering KIRK for an even better deal today. The company has a good strategy and it is executing well. About six years ago, the company made the decision to transition to off-mall locations (regional power centers and plazas), in order to take advantage of lower rents per square foot and expand into larger locations. The follow chart depicts the company’s implementation of this strategy so far:
[Click all to enlarge]
Kirkland's, Inc. store characteristics, 2002-1Q 2011
As you can see, the company has made great progress in transitioning away from enclosed malls. Let’s look at how average square footage has changed and sales per square foot:
Kirkland's, Inc. sales per square foot, 2001-1Q 2011
From this, we see the drastic increase in the average store size. The interesting point here is that since 2007 the company has been able to expand sales per square foot – despite the increase in square feet.
We can also see the importance of sales around the holiday season (as expected for a retailer like this). Note how the Christmas bump in 4Q 2010 was somewhat smaller than the same period in 2009 and 2008? To quantify that difference, the company’s sales per square foot were 11% below 4Q 2009, and 1.2% below 4Q 2008 (using average square footage for the period). Not a very good showing, but as value investors, it is important to take a long-term view of the company and consider whether this recent poor holiday season is indicative of deeper issues, or more of an anomaly.Here’s what the company said in November when it lowered its holiday season forecast:
However, the tough comparison to last year’s record earnings and robust comparable store sales, as well as the higher in-bound freight costs that we have previously discussed, presented difficult challenges. Traffic counts remained strong, but in a few of our key categories, our assortments did not convert customers at sufficient rates to achieve a comparable store sales increase for the quarter. We understand where the challenges and opportunities lie in our merchandise, and we are taking steps to achieve more consistent performance across all product categories for fiscal 2011.
Then, after the holiday season ended, here’s what it said:
Despite the effect of severe winter weather in our markets in January and a tough comparison from a year ago, we produced sales and margin that keeps us generally in line with our expectations.
Our fourth quarter results were in line with the sales we previously reported and certainly affected by the tough comparisons we faced this year. We managed the promotional environment well during the quarter, had a strong performance from our Christmas merchandise, and finished the year with inventory levels on plan.
This is the same message we’ve heard from many retailers. Sales weren’t materializing as normal and this led to a more competitive pricing environment. It is important to not dismiss this out of hand; I’ll be sure to consider this when forming assumptions for my valuation scenarios.
Absolute sales are one thing, but it is important to look at the company’s margins (especially given the company’s note about the promotional environment):
Kirkland's margins, 2001-1Q 2011
This shows how much the company’s margins have been improving for several years. The company could have discounted more heavily in 4Q 2010 to push sales up but instead chose to hold gross margins relatively steady, which I think is important for the brand long-term.
Let’s check the company’s free cash flows:
Kirkland's free cash flows, 2001-1Q 2011
The company’s FCFs have grown dramatically in the last three years. Additionally, free cash flow tracks very close to net income over time, which readers of Financial Shenanigans will recognize as a good sign. Let’s confirm that free cash flow isn’t the result simply of one-time shenanigans (punishing suppliers by slowing payments, harassing customers to pay more quickly or liquidating inventory)
Kirkland's cash conversion cycle, 2001-1Q 2011
The company’s days’ inventory have trended upward over the last five years (the consequence of its transition to larger locations), but otherwise there is nothing here that raises any concerns.
We’ve seen how the company has earned steady and strong returns, is executing well on its strategy, and doesn’t appear to be engaging in financial shenanigans. But is the company cheap?
In valuing KIRK, I took into account the company’s recent decline in sales per square foot as noted above. In my base case, I use the current stores open and square footage and the company’s trough sales per square foot from 2007. Despite this, I find the company to have a sizable margin of safety. In my bear case, which assumes a sales p.s.f. decline even beyond the 2007 trough, the company is only slightly overvalued. I like these odds.
Further, the company has significant room for expansion, both in terms of further improving its margins by moving away from high cost enclosed malls and also in terms of expanding the number of locations it has, which would improve revenues and likely also margins as administration and distribution center costs are spread over more locations.
Also, I should note that the company has only scratched the surface of deploying technology to help improve sales and margins. The company is transitioning to a new POS system in 2H 2011 and early 2012 which it expects will help improve labor costs by enabling store managers to make better staffing decisions and help with inventory control. The company has also only recently joined the e-commerce game with its attractive new website. The success of this site should help improve inventory turns and allow for a wider variety of products as the company incorporates drop-shipping direct from suppliers. I may not be willing to pay for potential growth, but I sure do enjoy when it's thrown in for free.
One more quick comparison to when I first invested in KIRK. Back in November, the company had about $65 million in cash on hand versus a market cap of about $230 million. Today, the company comes with $90 million in cash with the same market cap; only about $12 million of this increase is due to the holiday season inventory build-up and then liquidation. What a great company.
Disclosure: Long KIRK.