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Kirklands (KIRK) Stores Look Set to Continue Turnaround

Kirkland's (KIRK) is a home decor, seasonal item, and gift retailer in the United States. The company operates 281 stores across 28 states as of the last quarter (May 1), a net 2 store increase over last year.

Anyone who has ever stepped foot in a Kirkland's knows what an eclectic place it is. The items are usually things you can't find at many competitors and span a wide variety of categories from framed art, candles, lamps, rugs, unique furniture items, unusual mirrors, garden decorations, and so forth. Kirkland stores also sell specialty gift and decorative items for pretty much any holiday you can imagine. Selection is huge, with 3,500 to 4,000 items in the average store. Most current stores are located in mall-based settings, although this is changing.

While the Kirkland stores are certainly interesting to shoppers, Kirkland stock has been one of the most interesting issues on the Nasdaq. Just over 2 years ago, in January of 2008, you could have purchased the stock for under $0.70 a share. At today's price around $15, you would have netted a cool 2,042% gain, making your initial capital back 20 times over, turning a $5,000 investment into $100,000! As recently as March of last year you could have purchased the stock for under $5.

These gains have come on the back of a magnificent turnaround that has turned the company from a money loser into one of the better performing home decor companies on the market. The turnaround has been due to a number of things. For one, a lot of competition has disappeared, as Linens N' Things went out of business in 2008, and Home Depot (HD) shut down its Expo home decor superstores.

Just as importantly has been Kirkland's own improved focus. Management has been shutting down underperforming stores, and focusing more on off-mall locations for new and relocated stores in order to cut down on lease costs. Better merchandising has also been key. A more compelling selection of items has allowed the firm to charge higher markups and also driven increased store traffic.

The proof is in the numbers. Same-store sales growth has come in over 10% for three straight quarters. Gross margins, critical in retail, stand today at 42.7%, vs. under 30% a couple years ago. Higher store traffic has produced better operating leverage on fixed costs like rent and salaries, leading to a solid (for retail) 13% operating margin. Kirkland's is now a strong performer, and after losing $26 million in fiscal 2008, fiscal 2010 showed a $35 million operating profit.

Going forward, what can we expect from Kirkland's? The earnings yield is quite low at 21%, and against expected 2011 results, it's 22%. We are seeing very strong business momentum, with Q1 results setting a first quarter company record for profitability. I see no reason that the company cannot continue to deliver similar results over the next year or two. With a strong balance sheet ($74 million in cash, no debut), and cash flows (over $40 million in free cash flow), management plans to return to net store growth this year, financed solely through internal cash flows.

The risks also need to be laid out before pulling the trigger. First, this is a rather remarkable turnaround because it was accomplished by the same long-term management that got the company into trouble in the first place. CEO Robert Alderson has been with the company for 25 years, and CEO for the bulk of the past 10 years. Carl Kirkland is the founder and still sits on the board, along with his son Miles.

None of this would be a major concern if it wasn't for the fact that merchandising at a retailer like this with such a crazy selection has to be extremely difficult. There is a sense here that continued success on the merchandise selection front may be fleeting, although the improvements in operations and loss of competition will prevent a relapse into unprofitability.

A more immediate risk will be higher tax rates. The tax rate for 2011 is expected to be 40%, compared to just over 26% last year. As a result, projected EPS of about 1.68 is lower than 2010's $1.71, even though operating earnings look to come in about 20% higher.

I love Kirkland's business momentum, strong balance sheet, and very cheap stock price. The risks are rather typical for retail, but are more long-term concerns than short-term ones. MagicDiligence has a solid "buy" opinion on this one - it makes a strong choice for new MFI money, just short of a Top Buy recommendation.

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