Kirkland’s: Bullish Again For The First Time Since October 2020 (NASDAQ:KIRK)

Happy couple selecting items for the wedding registry at a furniture store

andresr

Today, I write to share that I’m really bullish, once again, on Kirkland’s, Inc. (NASDAQ:KIRK). In fact, I recently bought a decent-sized long position, in the stock, in the mid $3s. For perspective, I have been on the sidelines, on this stock, for a long time. Moreover, after a six-bagger, owning the stock from early June 2020 through early Q4 2020, I was 100% out of the stock. And by late November 2020, with the stock then trading in the mid to high teens, I was actually bearish on the company. My bearish comments are captured within the commentary thread of Cameron Smith’s November 27, 2020 article. I expressed that I hated management’s aggressive buyback program, and it was unclear to me how much of Kirkland’s success was driven by the Housing Renaissance and three rounds of stimulus programs vs. great execution and a compelling turnaround by the management team.

Incidentally, and just to be clear, I’ve continued to closely follow this company. As readers might recall, I helped put this company on the map, at least to the small-cap investing world, as I interviewed its CEO, Steve ‘Woody’ Woodward, in late June 2020. Woody is a really smart guy, and he was the Chief Merchant at Crate and Barrel, so he is very capable and a really good merchant.

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And in case anyone is unaware of Kirkland’s, from the time of publication, back in late June 2020 to late April 2021, KIRK shares ‘ripped’ from the low $2s to as high as almost $35. I was super long in the high $1s and added in the lows $2s, but was 100% out of the stock by the $11s. So, to be clear, I missed the last big leg up from the mid-$11s to the mid-$30s.

Fidelity

Fidelity

Why I’m Long (Again), Bullish (Again), and ‘Loved’ Kirkland’s Q2 FY 2022 Conference Call

Despite not really owning any KIRK shares, for quite some time, outside of a few quick and small trades, I have listened to all the conference calls and stayed current on the name. Prior to August 29, 2022, the past few conference calls were really bad and management sounded like deer in headlights. However, the Q2 FY 2022 conference call was markedly different, in a good way, and for the first time in ages, Woody sounded on point, reflective, and a step ahead as opposed to on his back foot. It was crystal clear to me that lots of adversity and some unforced errors have been and will continue to be course corrected. Moreover, the company presented tangible evidence of business re-acceleration and regained momentum.

And for perspective, it was well known and foreshadowed on its Q1 FY 2022 call that Kirkland’s had too much inventory and they more or less hinted that they needed to take the short-term hit on margins, clear through the excess inventory, and shore up the balance sheet. Despite the short-term pain, management made a smart call and got out in front of this. Therefore, to anyone actually paying attention here, everyone should have expected a kitchen sink quarter, in Q2 FY 2022.

Lo and behold, this is exactly what we got, in Q2 FY 2022, a kitchen sink quarter. And this year, unlike last year, the company has its Harvest and Holiday inventory in place and isn’t at risk, like last year, notably during Q4 FY 2021, of missing key portions of the holiday selling season.

Let me share a number of ‘Green Shoots’ and walk readers through my thought process and renewed bullishness.

Green Shoots

1) Managing the debt – The biggest threat to the business and equity is Kirkland’s elevated debt levels. As of quarter end (Q2 FY 2022), KIRK has $55 million drawn on its revolver and only $10.3 million of cash. Think about it, with only 12.754 million shares outstanding, at $3.10 per share, we are talking about only a $40 million market capitalization. The reason for such a low market capitalization is because of the $45 million of net debt and fear associated with that level of debt in a context negative Adj. EBITDA and a very difficult macro backdrop.

To understand how KIRK got here, it was driven by a confluence of negative events, almost a perfect storm. These included an aggressive buyback program at very high prices (a big misallocation of capital), misreading some of its prior strength, trying to attract a new customer and spending aggressively to acquire that customer, a sharp increase in supply chain costs and timing delays leading to missing key portions of key selling seasons and carry too much inventory.

Moreover, the company burned a bunch of Adj. EBITDA (-$5.8 million during Q1 FY 2022 and -$16.4 million during Q2 FY 2022). That said, it’s the really high inventory levels that were the major drain on working capital levels, and the biggest driver of having to tap its credit line.

On the call, management was laser focused and specifically said they have a realistic pathway to getting year-end inventory back down to $85 million (mid-point) and have goal of only having $10 million drawn on the revolver, at the end of fiscal year-end 2022. If this happens, and management sounded pretty upbeat, the debt is no longer an issue and the short thesis gets defused.

(Enclosed below are specific excerpts from its Q2 FY 2022 conference call.)

We quickly removed approximately $50 million in receipt from the back half of 2022 and began to ramp up promotions in Q2 to turn this excess inventory into cash. As we mentioned on the last call, we expected early Q3 to be our peak in those inventory and borrowing on our line of credit. And I’m pleased to share that we are where we expect it to be with inventory peaking up in August and a current balance on our revolver of $60 million, which we don’t expect to go any higher. As we start to sell through harvest, we are already seeing our working capital improve and expect to start gradually paying down our revolver and outstanding payables in the third quarter with most of the progress beginning in November.

We expect to end the year with inventory in the $80 million to $90 million range and to have less than $10 million borrowed. We intend to manage our inventory tightly and keep it lean throughout fiscal 2023 to further improve our working capital position.

2) Nicely Improving Comps

Per the call:

Breaking down sales within the quarter we had a total comp decline of 12.7% in May, a comp decline of 7.4% in June, and a 5.8% decrease in July. E-commerce sales declined by 9.1% compared to the prior year quarter, and improved from down 15.5% in May to down to 1% in July, e-commerce was 28% of total sales in the quarter, which is similar to the prior year.

Moreover, although there were still a few days left in August 2022, at the time of the call, August comps were only trending down 3% and landed margins were 500 Bps better than Q2 FY 2022!

While it’s difficult to predict we want to keep our expectations realistic. We are beginning to see encouraging results. Same-store sales during August continue to improve with only being down 3% on a year-over-year basis. And we’ve seen an approximately 500 basis point improvement on landed margin from our Q2 rate.

If you synthesize the call, the biggest driver of this improvement, despite a ridiculously difficult macro with interest rate/mortgage rates materially higher, record inflation, and super low consumer sentiment is Kirkland’s furniture business is inflection and this enhanced by offering home delivery.

See exhibit A:

We still believe that inflationary pressures and a slowing housing market have continued to impact consumer demand for home furnishings as a majority of our categories were down on a year-over-year basis. However, our furniture category was a bright spot this quarter, with a 13% increase in sales compared to the prior year.

We successfully launched our in-home delivery service earlier this quarter through our partnership with Ryder, which we believe will play an integral role, expanding our customer base and delivering a positive customer experience when ordering larger items like furniture and outdoor.

Exhibit B:

During the analyst Q&A, Woody provides some illuminating context on why furniture is working and how the home delivery enables customers, for the first time ever, to be able to shop for a house vs. piecemeal items.

This is huge and should be a big tailwind during the second half of 2022 and well into 2023!

And then we’ve gone back on our assortment for 2023 and really looked at supporting opening price points. And some of the things that have traditionally motivated that customer, whether it’d be pick up items or items that she can come in and purchase. And then she’s been very supportive. Our customer has been of our upgraded quality and furniture and furniture is one of our best categories right now, which was mostly the poster child of our new strategy, improve the quality, improve the packaging, improve the design, and still maintain great pricing. So we didn’t want to say that we are walking away from that strategy, but we did go back and alter it with adding some items and opening price points. And then I think that we said in the call Kirkland’s has traditionally done pretty well during an economic downturn, because people that might have purchased the higher end home furnishings retailer would look at our assortment as a value opportunity. And we had to do that, in terms of really being able to compare our products with other retailers. And then we also needed to get in-home delivery. And that’s taken off and done a better job than we had anticipated. And so we’re looking forward towards that in the next several years, putting it in the set of somebody coming in and wanting to do a whole room and spending several thousand dollars and getting a fair delivery charge.

3) FY 2023 Margins Should Look Better – The outlook for margins, in FY 2023, is improving as ocean freight is coming down and with the global supply chain, finally, moving better. Now, they won’t have to over-order inventory and there is lower risk of missing key seasonal selling periods.

See here:

We’re also seeing input costs within the supply chain coming down as gas prices and shipping rates start to normalize. However, due to the timing of when we bring in inventory, our margins will likely not see a benefit from this until early 2023.

See here:

Going back to how we got here, we had accumulated a significant amount of already produced products in 2021 that had not shipped due to supply chain constraints.

Also, they are straight up telling the street, margin will improve in Q3 and Q4 FY 2022.

From a margin perspective, we will continue to be promotional for the remainder of the year, as our first priority is improving our liquidity and inventory position to set us up for a successful 2023. However, our level of discounts will normalize from what we saw in Q2. We expect margins to sequentially improve from the second quarter that continue to be down compared to the prior year by 400 to 500 basis points in Q3 and 200 to 300 basis points in Q4. While we are seeing inbound freight rates decline, we won’t see a significant benefit in our financials until the first part of fiscal 2023.

4) Lastly, for perspective, Q3 and Q4 are Kirkland’s big quarters, from a seasonality perspective. So, as Kirkland’s has regained some momentum, Adj. EBITDA and cash flow should look a whole lot better in Q3 and Q4 FY 2022 compared to the first half of 2022. Yes, given the lower gross margins profile and still negative, but improving trajectory of comps, I don’t expect Kirkland’s Q3 and Q4 FY 2022 to be anywhere close to the monster numbers the company posted during 2nd half of FY 2020 and FY 2021. To be clear here, I’m highlighting that I think 2nd half of FY 2022 will be better than 1st half of FY 2022.

Here is historical Adj. EBITDA, so you can see Q3 and Q4 are important quarters.

Q1 and Q1 FY 2022: Adj. EBITDA:

(Q1: -$5.8 million, Q2: -$16.4 million)

FY 2021: EBITDA $45.7 million

(Q1: $7.3 million, Q2: $5.4 million, Q3: $14.1 million, Q4: $18.9 million)

FY 2020: Adj. EBITDA $41.5 million

(Q1: -$17.5 million, Q2: $6.8 million, Q3: $18.9 million, Q4: $33.3 million)

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Seeking Alpha

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Seeking Alpha

Putting It All Together

As I’m sure readers have worked out, my process is 75% Art and 25% Science. Stock prices are about the future. Management provided a clear and realistic pathway towards greatly reducing its net debt, and the second half FY 2022 should look much better than the abysmal first half of FY 2022. Given this business momentum, despite an exceptionally tough macro backdrop, Kirkland shares look compelling.

My short-term price target is $5, but I think we might have a decent shot at $6, over the next six to twelve months. Let me briefly explain. Despite Kirkland’s posting monster FY 2020 and FY 2021 Adj. EBITDA, its current market capitalization is only $40 million. This is largely due to its currently leveraged balance sheet and the formidable macro headwinds. This has compressed its valuation as the market is only willing to pay very low valuation for this business. Moreover, sentiment is currently super negative, and the market isn’t currently optimistic on its normalized Adj. EBITDA power. In a nutshell, I think Kirkland’s has a smart plan to get its balance sheet back on track, and Woody and team are good operators that can generate better FY 2023 Adj. EBITDA. If this happens, the stock re-rates and gets de-risked.

Nasdaq.com

Nasdaq.com

Lastly, there are still way too many shares sold short here. Another tailwind.

And one other point, Detective Columbo style, note management’s commentary on resuming its buybacks. The subtext of this comment is management feels like the business is back on track and once its balance sheet gets back in order, they understand the equity is ridiculously undervalued.

As most of the inventory we will sell-through this year shift to higher rate. Lastly, as we discussed on our last call, we paused our share buyback program given the restrictions our credit facility has in place while in a borrowing position, and to maintain an appropriate level of liquidity needed to support the business. We still believe that share repurchases will be a valuable component of our capital allocation strategy over the long term. And we will provide any updates on resuming buybacks as we move into a better liquidity position in the coming quarters.

(Source: Kirkland’s Q2 FY 2022 Conference Call)

Risks

The primary risk is the balance sheet. Kirkland’s needs to convert its excess inventory and working capital dollars into operating cash flow that will be earmarked to materially pay down its revolver. Secondly, the macro headwinds with housing slowing dramatically combined with a consumers that is under pressure due to record inflation and extraordinary weak consumer sentiment are also real risks.

In closing, despite the risks, and they are real, I think Woody Woodward is a great merchant and smart. He and his team have experienced some major successes and made a number of unforced errors. On balance, though, given the valuation combined with management presenting a smart plan, I think the equity, in the $3s, offers exceptional upside and compelling risk/reward.

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