Kirkland’s, Inc. [KIRK]

Third-Quarter 2022 Earnings Call

Friday, December 2, 2022 9:00 AM ET

Company Participants:

Cody Cree; External Director of Investor Relations

Steve “Woody” Woodward; President and Chief Executive Officer

Nicole Strain; Executive Vice President, Chief Operating Officer, Chief Financial Officer

Analysts:

Anthony Lebiedzinski; Sidoti & Company

Jeremy Hamblin; Craig Hallum Capital Group

John Lawrence; Benchmark

Presentation

Operator: Good morning, everyone, and thank you for participating in today’s conference call to discuss Kirkland’s financial results for the third quarter ended October 29, 2022. Joining us today are Kirkland’s President and CEO Steve “Woody” Woodward; EVP and CFO Mike Madden; and the Company’s External Director of Investor Relations, Cody Cree. Following their remarks, we’ll open the call for your questions.

Before we go further, I would like to turn the call over to Mr. Cree as he reads the Company’s safe harbor statement within the meaning of the Private Securities Litigation Reform Act of 1995 that provides important cautions regarding forward-looking statements. Cody, please go ahead.

Cody Cree: Thanks, Jason. 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 provision 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 Securities and Exchange Commission.

I’d like to remind everyone this call will be available for replay through December 9, 2022. A webcast replay will also be available via the link provided in today’s press release, as well as on the Company’s website at kirklands.com.

Now I would like to turn the call over to Kirkland’s Home President and CEO, Woody Woodward. Woody, over to you.

Woody Woodward: Thank you, Cody, and good morning, everyone.

We continue to operate our business in one of the more dynamic and unpredictable macroenvironments I’ve ever experienced in my career, from a global pandemic to geopolitical unrest to inflationary and recessionary pressures, the challenges we’ve faced over the past two years have been tough. That being said, I’m proud of how resilient our organization has become in adapting to these challenges. As we head into 2023, I firmly believe we are on tract for a more stable year that will allow us to advance our transformation efforts.

Before I address our strategic priorities for 2023, I’d like to discuss our third quarter. While volatility within the consumer environment made it difficult to predict sales patterns heading into the quarter, our financial results were generally in line with our internal expectations. Importantly, we also remained well on track to achieve our year-end inventory number and liquidity targets we set for ourselves.

Consumer spending habits were volatile throughout the quarter. Early on we saw an improvement in our trends throughout the month of August, which resulted in sales comp decline of only [2%]. As we started the month of September, the momentum continued with our Labor Day sale, backed by a strong promotional offering, spurring customer demand. Unfortunately, business softened for the balance of September and into early October, as customers proved very price conscious and less interested in harvest decor than in years past. This resulted in total comp sales being down around 7% for Q3. However, we began seeing improvements toward the end of October, as our customer base shifted to holiday shopping. I’ll dive further into what we currently are experiencing later in the call.

During the quarter we focused on weathering a difficult consumer spending environment by leaning on our improved messaging around pricing and online promotions to capture more of our discount-oriented customer base. Our furniture and textile categories continued to perform well, while most other categories delivered performances inline with our internal projections. I’m encouraged to see that our furniture assortment is connecting with our customers and delivering fairly consistent results, as we utilize a high/low retail pricing strategy to generate more demand from our value-oriented customers and we are gaining awareness for our high-value merchandise items from customers that historically would have looked elsewhere.

Our AUR continues to grow, supported by larger ticket items and more products within the better-and- best categories compared with the prior year. The macroeconomic environment continues to hamper our trafficking conversion rates for both our stores and e-commerce due to — though the compression in conversion rates was relatively minimal by the end of the quarter. Our store conversion declined around 1%, while our e-commerce declined around 3%, both year-over-year comparisons.

While conversion rates are down, it could have been much worse, which leads me to believe that customers are still connected to our assortments even in this challenging environment. After launching our in-home delivery service last quarter, we are seeing relatively healthy adoption from our customers. While we don’t expect this to be a significant growth driver for the near term, we are pleased with our customer response so far and expect in-home delivery to gradually become a more meaningful revenue stream in the future. We will continue to develop our backroom operations to ensure that our program remains scalable and easy to use for customers across our omnichannel platform.

As we move into the fourth quarter, we are encouraged by the improvement in trends we have observed thus far in the holiday season. This momentum continued over Black Friday weekend as we experienced increased demand in response to our promotions and our results were inline with internal forecasts. The sell-through we’ve experienced thus far has allowed us to strengthen our balance sheet, which I will discuss in a minute.

While the consumer is beginning to shift away from holiday decor spending at this point of the season, we are focused on capturing remaining holiday sales through a wide assortment of merchandise that can be used for gifting and final decorating touches. With a clear promotional strategy in place, we will continue to refine our [pricing] strategy to ensure we are capturing our historically discount-oriented customer base to drive further holiday spending as we close out the season.

Turning to our liquidity, I firmly believe we are on track to restoring and maintaining a healthier balance

sheet. I’ll let Mike go into further details shortly, but I’d like to highlight that we’ve already paid down $30 million of our borrowing so far in the fourth quarter and expect to achieve our year-end target of net borrowings in the $10-million-or-less-range. We also continue to successfully work through our peak inventory position from August. In fact, we believe that we will be below our initial inventory, [year-end] inventory, target and now we expect to end the year with inventory in the $70 million to $80 million range.

As we continue to convert existing inventory into cash, our margins will remain relatively suppressed due to the high costs in which we procured that inventory. However, supply chain tensions are starting to ease and we expect to begin meaningfully recapturing margin in the new year. Coupled with the disciplined cost structure we’ve implemented, our profitability has room to grow in 2023.

We have identified several initiatives in the coming quarters that we believe will get us back on track with our transformation strategy. After executing towards our critical objectives to manage inventories to appropriate levels and decrease our borrowing needs, we can begin to focus more on other objectives, such as stabilizing store costs, growing e-commerce sales and targeting high-ROI projects that enable sales growth and improved [profitability]. Our projects include using our customer data platform, or CDP, to carefully manage price points and create targeted promotions; increasing the effectiveness of our marketing program and improving ROI on existing advertising expense; the reorganizing of our distribution channels to ensure optimum inventory distribution to stores and our e-commerce channel.

Throughout this past year we targeted our historically price-sensitive customer base through tailored promotions, and we look to continue to capture their demand by rebalancing our furniture growth with diverse opening price points across multiple categories. While we are committed to adding more high- value items, we’re going to be thoughtful in curating items at price points that appeal to a broad base. The CDP will be an integral part to finding the right price points for the right customers, as well as providing the data necessary for developing targeted promotions.

We will also evaluate our marketing strategy to ensure that we maintain the highest ROI per marketing dollar spent. As we acquire new traffic we plan to invest in our stores to increase coverage during peak selling hours and, in turn, drive increased conversion rates. Our stores have undergone dramatic changes throughout the past [year,] including refreshed arrangements and a shift towards an engaged selling culture by our team members. We will continue our transformation and support our stores with additional investments in the coming quarters.

As a result of our omnichannel platform, it is important that we optimize our inventory distribution capabilities to provide added flexibility to our customers. We have identified technology investments to our existing point-of-sale and order-management systems that will enhance inventory availability across the system. We believe these investments will make our [DC] and delivery channels better optimized, including margins, inventory turns and leading to more efficient working capital use.

Our e-commerce platform will also undergo operational enhancements to drive growth and support a better user experience. We look forward to sharing more with you on these upcoming events.

As we begin ordering new inventory for 2023, we will be maintaining a leaner inventory flow and delivering margin improvements through our inbound freight cost reductions and targeted initial markup increases. While we are uncertain of the sales landscape for next year, we’re diversifying our opening price points to ensure that we can operate successfully in this shifting market environment.

Overall, I would like to reiterate that we are sticking with our plan to manage inventory to appropriate levels, improve our liquidity position and set the table for stabilization in ’23. We’re firmly committed to

our shareholders and creating a best-in-class company that can unlock the immense potential and value we believe it has.

Before I turn the call over to our new CFO, Mike Madden, I would like to officially welcome him back to Kirkland’s Home. Mike’s substantial executive experience and previous long tenure with this organization has helped him transition quickly into our operations and make an instant impact as we navigate through the current macroeconomic landscape. Mike’s deep understanding of our business model makes him a superb fit to lead our financial operations and support the execution of our long-term growth strategy. And I’m grateful to have him back on our team.

With that, I’ll now turn the call over to Mike, who will provide detailed commentary on our performance in the third quarter and our outlook. I’ll be back for the Q&A to answer any questions you might have. Mike, the floor is yours.

Mike Madden: Thanks, Woody. Good morning, everybody. I’m pleased to be back at Kirkland’s, where I spent a large part of my career and I’m looking forward to contributing to the successful recovery of the business. While we do have a lot of work to do, I believe in the long-term opportunity that’s before us to make Kirkland’s Home a dominant specialty home furnishings retailer.

As Woody outlined, our third-quarter performance was focused on working within a difficult sales environment, combined with margin pressures from elevated inventory levels and higher freight and supply chain costs. I’ll go over the details of the P&L in a minute, but I want to start with a summary of our current financial position.

Since our last update, our primary focus has been on improving our liquidity position by converting excess inventory into cash, reducing the borrowings under our revolving credit facility and returning our accounts payable to normal levels. Despite the challenges we faced in the third quarter, we made considerable progress in each of these areas.

As expected, our revolver borrowings peaked at $60 million during the third quarter and we’ve reduced our borrowings by $30 million thus far in the fourth quarter, leaving $30 million currently outstanding. Our inventory position at the end of Q3, which is traditionally our peak period, was $126.3 million and that’s down from $141.7 million at the end of Q2, as we emphasized clearing excess inventory and reducing our receipts planned for the balance of the year.

This is likewise influencing our accounts payable, which dropped from $61.6 million at the end of Q2 to $47.2 million at the end of Q3. For the balance of fiscal 2022, we will continue to prioritize improving our liquidity position heading into 2023 by converting inventory into cash, creating top-line momentum through targeted promotional activity.

As Woody mentioned, we expect our net borrowings outstanding at the end of the year to be $10 million or less and our inventory balance to be in the range of $70 million to $80 million.

Moving to our third-quarter results, net sales were $131 million compared to $143.6 million in the year- ago quarter, which includes a 3.5% decline in store count and a comparable sales decline of 7%. The comparable sales result was driven by year-over-year decline in store and online traffic and conversion, partially offset by an increase in average ticket. E-commerce was 27% of the total sales in the quarter, which was similar to the prior year. Breaking down sales within the quarter, we had a total comp decrease of 3% in August, a decrease of 10% in September and a 6% decrease in October. Comp trends improved in the latter part of October and into the early part of Q4.

Gross profit margin declined 970 basis points to 25% of sales compared to 34.7% in the prior-year quarter. I’ll break out this decline into 5 components. First, merchandise margin declined 480 basis points to 52.9% versus 57.7% in the prior-year quarter. Heavier discounting associated with our efforts to reduce inventory levels and higher inbound freight rates led to this decrease. Inbound freight rates spiked in late 2021 and early 2022 and much of the product that sold through in Q3 carried the impact of higher freight rates and cost of goods.

Second, central distribution costs increased 290 basis points to 7.2% of sales from 4.3% in the prior-year quarter. This increase was largely due to operational inefficiencies in our distribution centers resulting from elevated inventory levels and uneven product flows. These costs spiked during the first and second quarters of this year and were capitalized as the underlying inventory was held prior to sale and are now being recognized in the P&L as the inventory sells through. This is an important call-out, because this timing is atypical. The third quarter is usually a period of rising inventory levels and supply chain costs, with cost buildup being recognized in the P&L during the fourth quarter. This year, with inventories peaking much earlier and heavier than normal and order flows curtailed for the back half of the year, inventory levels declined sequentially from Q2 to Q3. However, the inventory that sold through in Q3 had the higher distribution costs from earlier in the year attached, which negatively impacted our operating results.

Third, store occupancy costs increased 130 basis points to 10.8% of sales from 9.5% in the prior-year quarter due to deleverage from a lower sales base.

Fourth, our outbound freight costs, including both store and e-commerce shipping expenses, increased 110 basis points to 8% of sales from 6.9% in the prior-year quarter. The increase was primarily at the store level and due to additional routes deployed to move more product from our elevated inventory level. Additionally, shipping rates and fuel costs were higher than in the prior year. E-commerce shipping costs were up slightly versus the prior year, reflecting the loss of our in-home delivery service.

And, lastly, depreciation included in cost of sales decreased 40 basis points to 1.9% of sales from 2.3% in the prior-year quarter.

Total operating expenses were $39.4 million, or 30.1% of sales, compared to $40.8 million, or 28.4% of sales in the prior-year quarter. A reduction of advertising expense of over $3 million drove the overall decline. This is offset somewhat by increases in insurance and corporate salaries due to the collection of a property insurance claim and favorable accrual adjustments in the prior year. The increase as a percentage of sales was primarily due to the lower sales base.

Adjusted EBITDA, excluding impairment and other minor nonoperating expenses, was negative $1.7 million compared to $14.8 million in the prior-year quarter. Our normalized tax rate in the third quarter was 24% compared to 25% in the prior-year quarter. Adjusted loss per share, which excludes noncash impairment, normalizes the tax rate and excludes other minor nonoperating adjustments, was $0.38 compared to an adjusted earnings per share of $0.51 in the prior year. GAAP loss per share, including these items, was $0.58 compared to earnings per share of $0.51 in the prior-year quarter.

While we are not providing specific guidance for the fourth quarter, we do want to provide some color around our expectations for sales and margin performance, as well as our outlook for liquidity and other key balance sheet components.

Sales thus far in Q4 have improved from Q3 trends. For the fiscal month of November, which ended this past Saturday, comparable sales were approximately flat. This is something we anticipated, as we were in a better in-stock position on our holiday seasonal category this year and, as Woody mentioned, the

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