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Executives

Trip Sullivan - Corporate Communications

Robert Alderson - President and Chief Executive Officer

Mike Madden - Senior Vice President and Chief Financial Officer

Analysts

Neely Tamminga - Piper Jaffray

[Christina Pilti] - Suntrust

Brad Leonard - BML Capital Management

Kirkland’s, Inc. (KIRK) Q2 2008 Earnings Call August 28, 2008 11:00 AM ET

Operator

Good day everyone and welcome to the Kirkland's, Incorporated Conference Call. Today’s call is being recorded. At this time, for opening remarks and introductions, I would like to turn the conference over to Mr. Trip Sullivan of Corporate Communications. Please go ahead Sir.

Trip Sullivan - Corporate Communications

Good morning and welcome to this Kirkland's, Incorporated conference call to review the Company's results for the second quarter of fiscal 2008. On the call this morning are Robert Alderson, President and Chief Executive Officer, and Mike Madden, Senior Vice President and Chief Financial Officer.

The results as well as notice of the accessibility of this conference call on a listen-only basis over the internet were released 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 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 risk and uncertainties were fully described in Kirkland's filings with the Securities and Exchange Commission including the Company's Annual Report on Form 10-K filed on May 1, 2008.

With that said, I will turn the call over to you, Robert.

Robert Alderson - President and Chief Executive Officer

Thanks Trip. Good morning everyone and we appreciate you joining us. We are pleased to report an improvement in our sales trends and earnings performance for the second quarter in a row. We continued our first quarter comp improvement with another positive result in the second quarter.

Like the first quarter the second quarter sales performance featured higher merchandise margins and lower operating expenses. This operating improvement also led to a further strengthened balance sheet and liquidity position.

Mike will now walk you through the second quarter financial results and I will followup with some additional remarks. Mike.

Mike Madden - Senior Vice President and Chief Financial Officer

Thank you Robert and good morning everyone. So the second quarter ended August 2, 2008, we reported a net loss of 1.7 million, or $0.09 per share as compared to a net loss of 9.2 million, or $0.47 per share in the prior year. Net sales for the quarter increased to 87.7 million from 87.4 million for the prior year despite a reduction of 23 stores. Comparable store sales increased 2.8% for the quarter.

Comp sales increased 7.2% in our mall stores and 0.7% in our off-mall stores. We faced easier comparisons in our mall group which is also been paired of many underperforming locations. The comp sales increase was driven by higher transaction counts partially offset by a slight decline in the average ticket.

Transactions were up 5% reflecting flat customer traffic and higher customer conversion rates. The average ticket decreased 2% reflecting a decrease in the average retail selling price partially offset by an increase in items for transaction.

From a merchandising standpoint, our strongest performing categories were art, furniture, and gifts each exhibiting strong sell through and improved margin. During the quarter nine of our 13 merchandise categories had a comp increase versus last year.

In the real estate we opened one store during the quarter and closed two stores. At the end of the quarter we operated 324 stores, 313 off-mall stores and 111 mall stores representing a 66% off-mall, 34% mall venue distribution. Total square footage under lease decreased to 3% versus the prior year quarter while total store units declined by 7%.

Gross profit margin for the quarter increased to 31.8% of sales from 27.3% in the prior year. The components we reported, gross profit margin were as follows: Merchandise margin increased 300 basis points as a percentage of sales, as a result of strong sell through of more compelling new merchandise resulting in fewer markdowns.

Commercial activity was live during the quarter confined primarily to the clearance activity associated with our July big sale. Coupon usage was also limited during the quarter as compare to prior year.

Stores occupancy costs decreased 180 basis points as a percentage of sales. The closing of under performing stores and favorable lease renewals and extension combined with sales leverage contributed to the improvement in Malaysia.

Central distribution costs increased 10 basis points as a percentage of sales, as a result of increased distribution center inbound and outbound activity against the relatively static total revenue base.

Freight costs increased 20 basis points as a result of the increased activity combined with pressure from higher diesel fuel prices.

Operating expenses for the quarter were 25.1 million or 28.7% of sales as compared to 27.6 million or 31.6% of sales for the prior year. Within this line item, store level operating expenses decreased 110 basis points as a percentage of sales for the quarter. Just over half the decreased in the ratio at the store level was the result of sales leverage on payroll expenses. The reminder was primarily the results of a reduction and marketing expenses.

At the corporate level the expense ratio decreased to 180 basis points as compared to the prior year quarter. A decreased in corporate payroll and related benefits and travel expenses as a result of personnel reductions taken in late 2007 combined with the sales leverage related to the favorable comparison.

Depreciation and amortization decreased 50 basis points as a percentage of sales reflecting the increase in sales, a reduction in capital expenditures, and the closure of underperforming stores.

Prior year results included $552,000 in expenses associated with the opening of our national office and $540,000 in store impairment charges, which together amounted to $0.04 per share.

Net interest expenses were lower than the prior year quarter, reflecting higher borrowing levels in the prior year. We have now borrowed from our line of credit thus far in 2008.

Similar to last quarter there was no income tax benefit recorded for the quarter, as a result of the valuation allowance on our deferred tax assets in our cumulative loses in recent annual periods. In the prior year quarter, we've recorded a net incoming tax benefit of 3.5 million offset largely by charge of 2.8 million to initially record the valuation allowance.

Turning to the balance sheet, inventories at the end of the quarter were 42.7 million or 132,000 per store as compared to 47.4 million or 137,000 per store in the prior year. We are comfortable with these levels of inventory in the third quarter and believe that the merchandise mix is fresh and current. We plan to end the third quarter with inventory levels in the range of 55 million or about 13% below the prior year in total.

At the end of the quarter we had 4.7 million in cash and no borrowings were outstanding under the revolving credit line. We ended the second quarter last year with borrowings outstanding of 12.9 million. As of the end of the quarter total availability under the credit line was approximately 27.2 million.

Accounts payable levels increased versus the prior year as a result of the higher receipt flow during July as compared to the prior year where receipts were reduced due to inventories inline.

For the quarter, capital expenditures were only $700,000, reflecting our one store opening and other maintenance projects. We expect capital expenditures to range between 3 and 4 million for fiscal 2008. Net of landlord allowances, our capital expenditures are expected to total 2 to $3 million for full year.

Looking forward to the second half, we continue to expect significant year-over-year earnings improvement in the third and fourth quarters. Those expectations are the result of our year-to-date performance in merchandising and our continued realization of expense savings at the store level through better execution and in the corporate office through the headcount reductions taken and cost efficiencies put in place last year.

Additionally, sales trends in August has continued to be strong and we are optimistic about our merchandise selection for the holiday season. Economic conditions are still uncertain and the consumer is currently facing many challenges, but barring any further deterioration in conditions, we believe we are on track to reach our goal profitability for fiscal 2008.

Moving on to a brief update of some of our cash flow initiatives. As it relates to new store activity, we have opened one store in the second quarter, making it three so far this year and have a commitment to one additional store for the balance of the year. We are evaluating two to four additional locations for new stores in 2008. As positive trends continue, we will likely increase our opening activity in 2009 but remain focused on relocations, off-mall replacements, and stores in proven markets. Robert is going to discuss this in more detail in just a moment.

On the closing side, we continue to aggressively pursue closures of underperforming and unproductive stores. During the second quarter, we closed two stores. The current expectation for additional closings in fiscal 2008 is around 25 stores heavily weighted toward the end of the year. This would amount to total closings for fiscal 2008 in the range of 35 to 40 stores.

We still have a former corporate headquarters building under option for sale. The option expires later in the third quarter but we remain reasonably confident about our chances to complete the sale in 2008. We have now collected before income tax refund of 2.8 million, representing the carry back of a portion of 2007's tax loss to recover prior year taxes paid. The remainder of our 2007 tax loss will be carried forward to future years.

These cash flow initiatives combined with our year-to-date operating results have improved the balance sheet and liquidity position. As of today, we are still not in the credit line and we don’t expect any borrowings under our credit facility until we reach the peak inventory periods in the late third quarter. Even during that peak time frame, we expect borrowing levels to be significantly below the peak level of $21 million, which is in the prior year.

Now I will turn it back over to Robert.

Robert Alderson - President and Chief Executive Officer

Thanks Mike. The second quarter has been challenging for us in the past several years. This year I am very pleased to announce the second quarter with positively comparable store sales and substantial improvement in earnings performance verus last year. Most of our second quarter problems in past years originated in the first quarter and were largely related to merchandise content. This year much improved content and a plan to price our inventory including promotional items and higher gross margins, we were able to deliver earnings improvement over recent years.

Consistency was the most important aspect in the second quarter results. Both gross and comparable sales improved despite a difficult external environment. We actually faced prior year comparisons that were skewed from extreme efforts in 2007 to clear un-producing merchandise by extensive coupon distribution. Sales continue to be lead throughout the quarter by art, decorative accessories, lighting, furniture lamps and wall décor, our core categories which is gratifying.

As I mentioned on the previous two calls, we have had good results for our re-introductions in the impulse and gift items, which we expect provide a boost to our second half business. As we said on the first quarter call, we had a great opportunity in Q2 to improve year-over-year product gross margin and we delivered on that promise, 300 basis points.

We showed steady progress toward reaching margin levels that would help us produce consistent earnings results going forward. Part of the margin opportunity in Q2 was imparted by historically low comparisons but the real story in the second quarter was greatly improved merchandised content that resonate well with the customer as evidenced by our improved conversion rates. As a result, we ended the quarter very clean and on plan with inventory.

We expect that position to favorably impact Q3 and Q4. We expect the competition to be very promotional in Q4 again, and we have prepared accordingly with the depth of our bias and continuing to emphasize newness along the value in all of our programs. All of our seasonal merchandise was (inaudible) as an item with no intention to be part of the clean collection or story.

We continue to be consistent in improving our liquidity position. Mike gave you some details concerning our cash availability and position as of today. It’s really gratifying to be talking to you on August 28, seven months into the new fiscal year and nearing our peak inventory period for the fall season, with no debt, cash on hand and no use of our credit line. I think the ability to finance our inventory needs out of operations speaks volumes about the renewed appeal and productivity of our merchandise. The expense control remains at the forefront of management's thoughts and we expect continued focus in this area to contribute positively to our second half earnings results.

Part of our reaction during 2007's core business results was to stop the store growth for 2008 and aggressively continue our three year program of rationalizing our store base by closing unproductive stores, mostly in malls and generally located in the Northeast and Midwest. We expect to close approximately 25 stores at the end of the fiscal year in late December or late January. We also expect another 15 or so stores to close as we approach mid year of fiscal 2009.

We have opened three new stores to date this year and possibly could open two to four more as circumstances want to. While it's nice to close unproductive stores, we are also reaching leasing and announcing profitable mall stores some of which we may not be able to expand and may close since we are unwilling to invest long-term in mall properties at the required level.

We continue to expand those expiring leases for one to three year terms where possible and we are in re-negotiation of growth rentals next to deal the economically viable and provide a short-term mechanism to exit if results deteriorate.

With the measurable improvement in our store operating performance within the four walls combined with the successful merchandising strategy we expect to open somewhere between 15 and 25 new stores in 2009 representing outstanding opportunities to replace very good prudent stores in our core markets in the Sunbelt.

We will have more than adequate cash to fund the controlled and modest store opening plan focused on replace this productive store in preserving proven markets, while we will remain highly selective. Commercial real estate landscape today provides the opportunities for some great long-term deals for retailers with the ability to open stores.

We are 26 days into Q3 and the results so far are consistent with those with the prior two quarter and therefore encouraging, but it's still early in the quarter. The customer response to our Halloween and Harvest seasonal merchandise has been good today. Christmas seasonal merchandise was introduced two weeks later this year, it is also doing well, but its actually too early to form any definitive opinions on its productivity at this point.

Our seasonal merchandise as always emphasizes new items and directions and value and has been malled this year totally on item basis and the quantity is designed to minimize our margin risk and sell through. We are about so as to be in position to recently compete on seasonal promotions throughout the holiday period.

We are pleased with our results year-to-date as for further deterioration in the market place we expect to continue to deliver strong year-over-year improvement in quarterly results for the balance of the year with features on track to reach our goal of profitability for the year. Realistically, we expect continued challenges in a floppy economic situation that’s not likely to abide this year or possibly during the next.

We do believe we are uniquely positioned as a value retailer in these unsettled times with pressured middle class customers. With the strong liquidity positions, stabilized store traffic and improving store base, strong expense control and improved sales and gross margins. We remain very confident and excited about future of Kirkland's. We look forward to see you in our stores.

Operator Mike and I are available for questions from our listeners. Thank you.

Question-and-Answer Session

Operator

Ladies and gentlemen, we will now begin the question-and-answer session. (Operator Instructions). Our first question comes from the line of Neely Tamminga from Piper Jaffray. Please go ahead.

Neely Tamminga

Hey, good morning to you guys and congratulations on much better performance.

Robert Alderson

Thank you, Neely.

Neely Tamminga

Just a couple of housekeeping questions and just I have a strategic question for you too, Robert. First on terms of Q3, are you still guiding us so to think that you are going to have losses in Q3 or is it actually possibly you could hit profitability yet in Q3?

Michael Madden

Well, yeah, we are not providing detailed guidance Neely, but I think profitability in Q3 will be kind of stretched yet in what we have had in the first couple of quarter. So I would…

Michael Madden

Just looking for Q4 to be that inflection point?

Michael Madden

Right.

Neely Tamminga

And then how should we -- you have been making some comments about the tax rate, just in terms of the benefit et cetera. And Mike to think then that we are still looking for as your provision for tax in Q3/Q4 or you didn’t start when you get taxed in Q3/Q4, and doesn't that not kick until next year?

Michael Madden

I think more of a next year issue. I think what you are going to see from the last few years kind of what we have seen the first couple of quarters where you don’t have much going either way because we have taken the valuation allowances that we took last year. And we really need to show profitability before those accounting rules start to kick in the way you can start reversing some of that. So long story short, I think the Q3/Q4 is still going to be kind of a no impact from a tax endpoint.

Neely Tamminga

Well, thanks. And then just one more housekeeping for you and then I have got a question for Robert. Mike, in terms of regional performance, can you call up some of the best performing regions?

Michael Madden

Yeah, I mean it's been pretty consistent and I would call out one on the high end alone on the downside where we are seeing the best results right now is in Texas, which is a big state for us, probably it's our biggest state in terms of store count and then we continue to struggle a little bit in Florida and I think we are impacted particularly in the southern part of the state with a little bit more difficult economic conditions down there related to housing and that’s really what we saw in Q1 as well.

Neely Tamminga

Great. And Robert, in terms of -- I think it's fantastic that you guys have been able to really help effective turnaround in your business in just an awful environment. Just wondering what point do you think strategically you start really investing into some of the business in terms of people, process, systems, things like that? I mean, is this -- you kind of right up a storm here and continue to do well next and it's a mid '09 discussion or do you think even as early as beginning of this next year?

Robert Alderson

Neely, I think we are reasonably happy where the employee base is right now relative to the size of the company and I think we did that work last year and I think as I said expense control is at the forefront of our -- to remain there, we watch that very very closely and headcount is part of it and I don’t expect any significant headcount adds. And as you know from looking at the number of closings, the store count is likely to shrink a bit before it begins to go the other way. So we have a little bit of store base reduction that we are going to have to go through as we go through the balance of this year and into 2009. So we will stay pretty tight on that. I don’t think we have any other systems that are up on the IS side that are occurring out to be changed. I mean I would like to begin a project to replace our retail management systems or to significantly upgrade that but that’s a two or three year project when you get into it and we may start thinking about it in 2009 and maybe working on it some, but I don’t see any impact next year.

Neely Tamminga

Okay. And just one last housekeeping for Mike. Thanks Robert. I would imagine with better performing top line and at least from our perspective ahead of expectations results down to the bottom line, just wondering how does it work when you guys, are you accruing for bonus accruals as you go with each quarter because your comps have been positive or do you wait till the earnings show up to the P&L in Q4 and not when you accrue for it?

Michael Madden

We accrue throughout the year and it's really based on the structure of the bonus, which is large part company performance but also individual but we do it throughout the year. So there is portion of that that's already accrued, but as you know fourth quarter it tends to tell the story for the year and so we are guarded about how we do accrue bonus because of that fact. So there is a slightly more amount that’s already accrued, so we progress through the year with that but a lot depends on Q4.

Neely Tamminga

Excellent. Thanks guys. Good luck and I hope you guys get every last (inaudible) okay.

Michael Madden

Thank you, Neely.

Operator

Thank you. The next question comes from the line of [Christina Pilti] from Suntrust. Please go ahead.

Christina Pilti

Hi. Of course on the call for David today. Congratulations on the good trends.

Robert Alderson

Thank you

Christina Pilti

I guess just with that it sounds different than we are hearing from some others in the space. Do you feel like you are seeing more of a return of your traditional customer or do you feel like you actually maybe gaining some folks that have been in the stores before appealing to different group than in the past?

Robert Alderson

It's a bit hard for us to tell -- to be definitive about that an answer to that. Our traffic trends are as we said are basically flat to last year but they have been improving actually in recent weeks. So the trend is encouraging and it's also encouraging to stabilize the traffic after having three years of fairly dramatic decline. I think you always have to go back to traffic because there are many things that you can do to try to drive traffic, but at the end of the day it's really about content, what you have to offer and the greatest aid to that you can possibly have or satisfy customers, you tell others and who bring others including their families and friends to the store and anecdotally we have a lot of comment from customers who feel like that sort of the old Kirkland is back in terms of presentation and the content and value and I think that's probably the most gratifying part of it is when you see the numbers back up the anecdotal comments that you get and they are passed along to you. So a little difficult to tell because we can't compare individual customers except in our credit card base and that’s very small.

Christina Pilti

And then secondly, you still don’t focused on the off-mall strategy, is there current ultimate 50/50 , 60/40 sort of breakdown that you have in mind for that mix?

Robert Alderson

Well, I think in prior years we have been very much committed to largely making a total exit from malls. I think that was very -- maybe where we started with this three years ago and it was because (inaudible) at the end of the day when you look at any numbers or however you cut it, there are two or three things remain true. One of them is that in the off-mall venues, it simply cost less to operate there. And we also have been able to have more productive stores in terms of sales and profitability and we find ourselves as co-tenants with more of the kind of tenants that sell the kinds of things that we do, that we sell and therefore what we believe contributes to everyone's business. So those are sort of the underlying principles was that we believe continue to drive us to an off-mall strategy. However, there are a number of mall stores that are productive and we continue to extend those leases where it's possible with the landlords willing and we are able to renegotiate that lease for the extension period in such a way as to make it productive and fruitful for us to be there. And we will continue to do that where possible and we will stay in some of those markets until we no longer can make those deals or it make sense to replace the store with an off-mall store. I don’t think that given the cost to build in-mall stores and the structure of leases in mall stores in terms of time that you must commit, I don’t think that we are interested at this moment in doing a lot of mall stores but we would certainly look at anything on a case by case basis that we think improves our business.

Christina Pilti

Hey thanks very much.

Robert Alderson

Thank you.

Operator

Thank you. (Operator Instructions) We will now go to the line of Brad Leonard from BML Capital Management. Please go ahead.

Brad Leonard

Hey guys, nice job on the quarter.

Robert Alderson

Thank you.

Brad Leonard

Question on the SG&A, when do we start to annualize some of these reductions that we made last year?

Michael Madden

That will start to add in the fourth quarter, Brad. Most of that was accomplished at the tail-end of the third, so the fourth quarter will be the first time we go up against it.

Brad Leonard

Okay. So if we are looking at the -- to me it looks like about 2.5 million reduction in Q1 and Q2. I know Q1 was more of a -- there was a big advertising job I believe.

Michael Madden

That’s right.

Brad Leonard

I mean is that the reasonable level that you are looking year-over-year to think 2.5 million less in SG&A in Q3 and then somewhere in Q4 it's going to be lower than that because you have already -- you hit some of those or is that not a good way to look at it?

Michael Madden

That’s pretty reasonable.

Brad Leonard

Okay, okay. And then on the -- the way we are thinking for CapEx and for 2009 if we are going to -- Robert, did you say 15 to 25 stores?

Robert Alderson

Yeah, I think that could be -- it's not the net, but that would be the number of openings that we are currently watching on.

Michael Madden

We did withhold our CapEx number for that. We are still kind of working on these deals and identifying things. Robert, do you have more to say on that maybe (multiple speakers)?

Robert Alderson

I think, Brad, we only get in front of our sales on this. It's only as we become a bit more be confident in directions and in our – the way that our merchandising is taking hold and unfolding that we have been willing to think about this and I don’t think you rush out and build a lot of new stores and so you feel like you have your box back under control and you are going in the right direction.

Brad Leonard

Agree. Okay, that's all I have. Thanks guys.

Robert Alderson

Thanks Brad.

Operator

Thank you. And at this time, there are no further questions in the queue. I would like to turn the call back to Mr. Alderson for closing remarks.

Robert Alderson

Thanks everyone. We appreciate you being on the call. We look forward to talking with you next time.

Operator

Thank you. This concludes the Kirkland Incorporated conference call. You may now disconnect.

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