Kirkland's Rising Margins Should Propel The Stock Higher

| About: Kirkland's, Inc. (KIRK)
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Overview and Thesis

Kirkland's (NASDAQ:KIRK) is a specialty retailer of home décor including furniture, lamps, textiles, accessories and more. The company currently operates about 320 stores that are typically located in strip malls. KIRK competes with other home décor retailers such as HomeGoods (NYSE:TJX) and Pier 1 (NYSE:PIR) but I get a different feel from KIRK's stores. They tend to be much smaller and offer a more focused array of goods than the bigger players I just mentioned. The difference is Kirkland's stores tend to feel like specialty shops despite the chain's rather large footprint. I believe it is this and other factors that have driven the stock to multi-year highs of late and up enormously since second quarter earnings were released. With shares at a seemingly stretched valuation investors are right to wonder if a pullback is warranted from current levels. I'll argue here that KIRK's fundamentals are improving drastically and while a pullback would be welcome, KIRK's ability to grow earnings over the medium term can likely justify its current valuation.

Earnings Model

Before we take a look at KIRK's business I feel it is instructive to understand what analysts think about the company's earnings prospects going forward. I'll use these and other inputs in my earnings model, which you can read about here in greater detail, in order to calculate a fair value for shares. My inputs and sources are as follows: 1) reported earnings, 2) earnings growth rates, 3) current book value and 4) current dividend rate, all from Yahoo! Finance, 5) perpetual growth rate of 3% and 6) discount rate of 8%, both of which are my numbers.

 

2012

2013

2014

2015

2016

2017

2018

Earnings Forecast

             

Reported earnings per share

$0.77

 

$0.87

$1.02

$1.12

$1.23

$1.36

x(1+Forecasted earnings growth)

 

13.00%

17.20%

10.00%

10.00%

10.00%

10.00%

=Forecasted earnings per share

 

$0.87

$1.02

$1.12

$1.23

$1.36

$1.49

               

Equity Book Value Forecasts

             

Equity book value at beginning of year

 

$7.05

$7.92

$8.94

$10.06

$11.30

$12.65

Earnings per share

 

$0.87

$1.02

$1.12

$1.23

$1.36

$1.49

-Dividends per share

 

$0.00

$0.00

$0.00

$0.00

$0.00

$0.00

=Equity book value at end of year

$7.05

$7.92

$8.94

$10.06

$11.30

$12.65

$14.15

               

Abnormal earnings

             

Equity book value at begin of year

 

$7.05

$7.92

$8.94

$10.06

$11.30

$12.65

x Equity cost of capital

8.00%

8.00%

8.00%

8.00%

8.00%

8.00%

8.00%

=Normal earnings

 

$0.56

$0.63

$0.72

$0.80

$0.90

$1.01

               

Forecasted EPS

 

$0.87

$1.02

$1.12

$1.23

$1.36

$1.49

-Normal earnings

 

$0.56

$0.63

$0.72

$0.80

$0.90

$1.01

=Abnormal earnings

 

$0.31

$0.39

$0.41

$0.43

$0.45

$0.48

               

Valuation

             

Future abnormal earnings

 

$0.31

$0.39

$0.41

$0.43

$0.45

$0.48

x discount factor(0.08)

 

0.926

0.857

0.794

0.735

0.681

0.630

=Abnormal earnings disc to present

 

$0.28

$0.33

$0.32

$0.32

$0.31

$0.30

               

Abnormal earnings in year +6

           

$0.48

Assumed long-term growth rate

           

3.00%

Value of terminal year

           

$9.62

               

Estimated share price

             

Sum of discounted AE over horizon

 

$1.56

         

+PV of terminal year AE

 

$6.06

         

=PV of all AE

 

$7.62

         

+Current equity book value

 

$7.05

         

=Estimated current share price

 

$14.67

         

With the inputs described above the model produces a current fair value of a bit less than $15 per share. With shares pushing $20 currently a significant downside risk is implied. However, I'm going to deviate from my model in this case because I believe strongly that analyst expectations are too bearish. As a point of reference before we begin our discussion of KIRK's business, in order to match the current price of KIRK shares an earnings growth rate of 17% is required instead of the 10% analysts are expecting. While this is a large discrepancy I will explain why I think that is a reasonable, and possibly too conservative, earnings growth rate. Thus, KIRK's current valuation is likely justified in my view.

The Quarter

First, KIRK reported second quarter earnings just a few days ago. We learned some things about the company's business and the stock is up almost 20% as a result. Thus, I feel like working through the release is warranted. And as a housekeeping note, all performance metrics provided in relation to the quarter are year over year numbers in relation to last year's second quarter.

Total comparable sales decreased 0.2% which included a 1.3% decline in comparable sales for the company's brick and mortar operations. Declines in comparables are never good and while the overwhelming majority of sales are from brick and mortar, there was a bright spot: e-commerce. The company's web sales, which are being pursued aggressively via various marketing efforts, rose 27% in the quarter. I believe the company's web sales are a source of material potential growth in the future and we'll discuss that along with other catalysts later on.

Knowing that comparables declined is one thing but understanding why is even better. KIRK's total transactions decreased 6% but the average ticket price was up 5%. Further, the company stated its measure of traffic in the stores was down 7% but conversion rates were up 1%.

Here's what I take away from those numbers. The company's stores saw less traffic but higher conversion rates. The same amount of units were sold but prices were up by 5% and transactions decreased less than the decrease in traffic. So while the headline drop in comparables was undesirable I believe that once you dig into why comparables dropped, the picture is rosier.

My interpretation of the results says that KIRK probably lost its most price-sensitive customers, which caused the drop in traffic. However, the customers that did return spent more money on the same amount of items and at a higher conversion rate than last year. This is actually a positive as KIRK is trying to get away from a promotion-heavy model, which would attract those most price-sensitive customers, and into a more stable, higher-priced model that we saw some progress towards during the quarter. Thus, over the long term, the company's drop in comparables isn't nearly as bad as it looks; I believe the most price-sensitive, and ostensibly least profitable, customers are the ones who fled and that isn't necessarily a bad thing.

In terms of margins, merchandise produced margins that were up a staggering 370 basis points due to less markdowns and promotions, as we just discussed. This led to gross margins that increased a similar 374 basis points in the quarter, driving higher operating profit than otherwise would have been possible. When you consider also that operating expenses were roughly flat, were it not for the traffic decline, the second quarter could have been immensely profitable. But as I said, I believe KIRK probably lost is least profitable customers and as a result, it's just not that big of a deal to me.

Some final notes on the quarter included a very strong $64 million cash position versus no long term debt, which is roughly 19% of the company's market cap, and a very lean $54 million inventory position, which constitutes only about six weeks' worth of sales. That means the company's inventory is very lean and the risk of obsolescence is much lower with such a lean inventory position. I always love to see this in a retailer because it shows the company's procurement practices are well-disciplined.

Catalysts

Now we'll move onto the exciting part of the analysis of KIRK and that is the catalysts for future earnings growth. I briefly mentioned some catalysts above but we'll take look at each one now. First, I mentioned above that margins were favorably impacted in the second quarter by less promotional activity. When companies begin to promote less it means that demand for their products is strong and pricing discipline can reenter the equation. KIRK is at this point now and it means that average revenue per unit should be increasing in the future, as it did in the fiscal second quarter that was just reported. I mentioned that this was likely the cause of decreased traffic in stores but I also posited that the customers that KIRK lost were probably the deal-hungry, more price-sensitive customers that are looking for promotions. These customers are much more difficult to sell to profitably, all else equal, so if I'm right that those are the customers that fled, it is probably a positive over the long term.

The company's e-commerce business is also showing signs of terrific promise. While it still makes up only a fraction of the company's total revenue, it comped at 27% over last year's number and management stated conversion rates are ever-improving. It will likely be some time before this segment is making up a material portion of revenue and earnings but whatever management is doing is working. In addition, the earnings call showed renewed focus on growing that platform through marketing efforts. I'm encouraged by the amount of effort management has poured into growing the fledgling online business and I think we'll see it potentially reach 10%+ of total sales.

Along the marketing lines, management stated that it is piloting a new marketing strategy in select markets where messages are tailored to specific regions. In addition, the new ads are roughly split between cable television and newspaper inserts. The new strategy is currently only covering roughly 20% of stores but the results are encouraging so far. Management reported higher conversion rates in the markets with the new ads so I'm quite certain we'll see these roll out to the whole chain later this year or next year.

On the CRM front, KIRK's new system allows for tremendous amounts of data collection on its customers. While the system isn't particularly useful right now due to lack of history, next year and beyond will likely see material benefits from its repositories of customer data. This customer data will allow KIRK to understand who its customers are, what they like to buy, what prices they are willing to pay, when they like to buy, etc. This will enable KIRK to tailor its products to specific regional mixes, know when to use promotions more effectively and help better plan its procurement needs for specific stores. Other retailers have implemented this type of system before with tremendous results and I don't expect anything different from KIRK. It can be easy to overlook something as uninteresting as new software but having access to enormous amounts of customer data can prove invaluable if properly utilized.

Finally, on the margin front, KIRK is experiencing some tremendous tailwinds that will drive profitability in the years to come. I touched on the tremendous expansion in merchandise and gross margins in the second quarter and the drivers behind them. Those drivers are going to continue, however, and we'll continue to see margins elevated in the future, according to management. Apart from what I already mentioned above management is calling for a freight expense margin tailwind of 50 to 75 basis points in the second half of this year. While this is not an enormous amount in relation to the company's size these multi-million dollar savings add up over time to increased profitability and KIRK is doing an excellent job of this.

Management also stated that KIRK will be doing fewer promotions this holiday season than last year as was the case with the first half of this year. Strong demand means strong pricing and less need to use promotions to drive traffic into the stores and move inventory. This is always a great sign that a retailer is firing on all cylinders and KIRK has shown us this is the new normal.

All of these factors that we've discussed will eventually drive merchandise margins into the 55% to 60% range from the low 50's now. This is perhaps the biggest reason that I think analysts' earnings estimates are too low; KIRK is poised to drive more revenue to the bottom line in the coming years and I don't believe current estimates capture this fact. Consider that KIRK is going to do something like $500 million in sales next fiscal year; an additional 300 basis points of margin is $15 million of additional potential profit. For a company that netted $14 million last fiscal year you can see how quickly millions of dollars in additional margin can add up. I'm not suggesting 300 basis points of margin improvement will happen by next year but just as an example, it is easy to see how I think 10% earnings growth is likely far too low.

Conclusion

The bottom line on KIRK is that you have a company in a niche of retail that management has found ways to exploit and make profitable. While I concede there have been some growing pains, and a volatile stock, it appears that the worst is behind the company. When you factor in all the margin tailwinds, 10% annual square footage growth, the e-commerce business and strong pricing you've got a recipe for success. I think we'll see KIRK's operating leverage shine through in 2014 and beyond and the 10% earnings growth over the medium term analysts are calling for will likely prove to be far too low. In fact, I feel the 17% I quoted above may prove to be conservative but time will tell. When you find a company that is firing on all cylinders it deserves a look for your portfolio. I wouldn't necessarily chase KIRK after it has moved up almost 20% in two days but once things settle down, it could be a solid addition to your portfolio.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in KIRK over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.