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KIRKLAND'S, INC - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion should be read with our consolidated financial statements and related notes included elsewhere in this annual report on Form 10-K. A number of the matters and subject areas discussed in "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Business" and elsewhere in this annual report on Form 10-K are not limited to historical or current facts and deal with potential future circumstances and developments and are accordingly "forward-looking statements." You are cautioned that such forward-looking statements, which may be identified by words such as "anticipate," "believe," "expect," "estimate," "intend," "plan" and similar expressions, are only predictions and that actual events or results may differ materially. Our fiscal year is comprised of the 52 or 53-week period ending on the Saturday closest to January 31. Accordingly, fiscal 2013 represented the 52 weeks ended on February 1, 2014. Fiscal 2012 represented the 53 weeks ended on February 2, 2013. Fiscal 2011 represented the 52 weeks ended on January 28, 2012. Introduction We are a specialty retailer of home décor and gifts in the United States, operating 324 stores in 35 states as of February 1, 2014. Our stores present a broad selection of distinctive merchandise, including framed art, mirrors, ornamental wall décor, candles and related items, lamps, decorative accessories, accent furniture, textiles, garden-related accessories and artificial floral products. Our stores also offer an extensive assortment of holiday and other seasonal merchandise, as well as items carried throughout the year suitable for gift-giving. We provide our customers with a unique combination of style and value that has led to our emergence as a leader in home décor and has enabled us to develop a strong customer franchise. As a result, we have achieved substantial growth during our 48-year history and have expanded our store base into different regions of the country. Overview of Key Financial Measures Total revenue and gross profit are the most significant drivers to our operating performance. Total revenue consists of all merchandise sales to customers, gift card breakage and shipping revenue associated with internet sales, net of returns and exclusive of sales taxes. Our total revenue for fiscal 2013 increased by 2.7% to $460.6 million from $448.4 million in fiscal 2012, which includes the extra week in the 2012 retail calendar. The net sales increase in fiscal 2013 resulted primarily from the growth in the store base and an increase in comparable store sales, partially offset by store closings. Comparable store sales, including e-commerce sales, increased 0.5% for fiscal 2013 on a 52-week basis. We use comparable store sales to measure our ability to achieve sales increases from stores that have been open for at least 13 full fiscal months. Stores closed during the year are included in the same store sales calculation only for the full fiscal months of the year the stores were open. Relocated stores are removed from the comparable store base and treated as a new store for comparable store sales purposes. Increases in comparable store sales are an important factor in maintaining or increasing the profitability of existing stores. Gross profit is the difference between total revenue and cost of sales. Cost of sales has five distinct components: product cost (including inbound freight), outbound freight cost (including e-commerce), store occupancy costs, central distribution costs, and discounts associated with our loyalty program. Product costs comprise the majority of cost of sales, while discounts associated with our loyalty program are the least significant of these five elements. Product and outbound freight costs are variable, while occupancy and central distribution costs are largely fixed. Accordingly, gross profit expressed as a percentage of total revenue can be influenced 24 -------------------------------------------------------------------------------- by many factors including overall sales performance. For fiscal 2013, gross profit increased 7.2% to $180.8 million from $168.6 million for fiscal 2012. Gross profit percentage for fiscal 2013 increased to 39.3% of total revenue from 37.6% of total revenue for fiscal 2012, due primarily to fewer markdowns as compared to the prior year period. Operating expenses, including the costs of operating our stores and corporate headquarters, are also an important component of our operating performance. Compensation and benefits comprise the majority of our operating expenses. Operating expenses contain fixed and variable costs, and managing the operating expense ratio (operating expenses expressed as a percentage of net sales) is an important focus of management as we seek to increase our overall profitability. Operating expenses include cash costs as well as non-cash costs such as depreciation and amortization. Because many operating expenses are fixed costs, and because operating costs tend to rise over time, increases in comparable store sales typically are necessary to prevent meaningful increases in the operating expense ratio. Operating expenses can also include certain costs that are of a one-time or non-recurring nature. While these costs must be considered to understand fully our operating performance, we typically identify such costs separately where significant in the consolidated statements of income so that we can evaluate comparable expense data across different periods. Strategic Areas of Emphasis For fiscal 2013, we ended the year with 324 stores versus 323 stores at the end of fiscal 2012, representing a 0.3% increase in store units and a 3.1% increase in store square footage. Our approach to new store growth in fiscal 2014 will focus on opening stores in existing, underpenetrated markets as well as selected new geographic markets within the continental United States. During fiscal 2014, we expect to open a total of 35 to 40 stores, and expect to close approximately 10 to 15 stores. Fiscal 2014 new store openings will be weighted toward the back half of the year while store closings for fiscal 2014 will be weighted toward the first half of the year. The following table summarizes our stores in terms of size as of February 1, 2014 and February 2, 2013: As of As of February 1, February 2, 2014 2013 Number of stores 324 323 Square footage 2,418,254 2,345,915 Average square footage per store 7,464 7,263 An important part of our growth strategy includes investing in technology to provide the infrastructure to support our future needs. During fiscal 2013, we implemented several merchandising modules within our new merchandise management system including merchandise financial planning, allocation and replenishment tools. We also invested in our e-commerce store with several functionality enhancements designed to drive sales and conversion. During the third quarter of fiscal 2012, we completed the implementation of the foundational components of a new merchandise management system. During fiscal 2011, we completed a roll out of new point-of-sale software and hardware to our stores, and also launched a new financial and general ledger platform. Looking forward, we are focusing on process improvements as well as adding capabilities to our merchandise management technology in the areas of item, location and assortment planning. We are also implementing other key software applications in the area of order management which will help us achieve our goal of an "omni-channel" business model. We plan to further develop our e-commerce capabilities by adding numerous new features and functions, including vendor "drop-ship", allowing us to expand our product assortment on the website. These projects are in various phases and will be implemented in stages over the next two fiscal years. We view these technology projects as essential and supportive to the execution of our multi-channel growth strategy. Our cash balances increased from $67.8 million at February 2, 2013 to $89.1 million at February 1, 2014 primarily due to an increase in income taxes payable and lower capital expenditures as compared to fiscal 2012. Our objective is to finance all of our operating and investing activities for fiscal 2014 with cash provided by operations. We expect that capital expenditures for fiscal 2014 will range from $33 million to $36 million, and estimate $17 to $18 million of the total capital expenditures will relate to new store construction, $9 to $10 million will relate to omni-channel capabilities and information technology, $2 to $3 million will relate to the distribution center and supply chain, with the balance of our capital expenditures relating to office relocation and maintenance items. 25 -------------------------------------------------------------------------------- Fiscal 2013 Compared to Fiscal 2012 Results of operations. The table below sets forth selected results of our operations both in dollars (in thousands) and as a percentage of total revenue for the periods indicated: Fiscal 2013 Fiscal 2012 Change $ % $ % $ % Net sales $ 459,460 99.8 % $ 447,395 99.8 % $ 12,065 2.7 % Gift card breakage revenue 1,103 0.2 % 970 0.2 % 133 13.7 % Total revenue 460,563 100.0 % 448,365 100.0 % 12,198 2.7 % Cost of sales 279,747 60.7 % 279,749 62.4 % (2 ) (0.0 )% Gross profit 180,816 39.3 % 168,616 37.6 % 12,200 7.2 % Operating expenses: Compensation and benefits 86,620 18.8 % 83,181 18.6 % 3,439 4.1 % Other operating expenses 54,257 11.8 % 50,732 11.3 % 3,525 6.9 % Depreciation 15,947 3.5 % 13,175 2.9 % 2,772 21.0 % Operating income 23,992 5.2 % 21,528 4.8 % 2,464 11.4 % Interest expense 274 0.1 % 287 0.1 % (13 ) (4.5 )% Other income, net (241 ) (0.1 )% (253 ) (0.1 )% 12 (4.7 )% Income before income taxes 23,959 5.2 % 21,494 4.8 % 2,465 11.5 % Income tax expense 9,429 2.0 % 7,699 1.7 % 1,730 22.5 % Net income $ 14,530 3.2 % $ 13,795 3.1 % $ 735 5.3 % Total revenue. Total revenue increased by 2.7% to $460.6 million for fiscal 2013 from $448.4 million for fiscal 2012. The net sales increase in fiscal 2013 resulted primarily from the sales of new stores and an increase in e-commerce sales, partially offset by store closings. We opened 24 new stores in fiscal 2013 and 42 new stores in fiscal 2012, and we closed 23 stores in fiscal 2013 and 28 stores in fiscal 2012. The positive impact of these factors was reinforced by an increase of 0.5% in comparable store sales for fiscal 2013. During fiscal 2012, comparable store sales decreased 3.0%. The comparable store sales increase in fiscal 2013 accounted for a $2.1 million increase in overall sales, while the net growth of the store base accounted for a $17.6 million increase in sales. The impact of the 53rd week in fiscal 2012 accounted for a $7.5 million reduction in overall sales. The comparable store sales increase was comprised of a 0.6% decrease in brick-and-mortar comparable store sales, and a 31% increase in e-commerce sales. The decrease in brick-and-mortar comparable stores sales was driven by decrease in transactions resulting from lower traffic counts. Average ticket increased year-over year, and was driven by an increase in items per transaction, as well as a higher average unit retail price. Merchandise categories that performed the strongest in fiscal 2013 were ornamental wall décor, mirrors, holiday, and housewares. Categories performing below fiscal 2012 levels were art, decorative accessories, floral, furniture, and fragrance and accessories. Gross profit. Gross profit increased $12.2 million, or 7.2%, to $180.8 million for fiscal 2013 from $168.6 million for fiscal 2012. Gross profit expressed as a percentage of total revenue increased to 39.3% for fiscal 2013, from 37.6% for fiscal 2012. The increase in gross profit as a percentage of total revenue was in part driven by higher merchandise margins, which increased to 54.5% in fiscal 2013 from 52.7% in fiscal 2012. Merchandise margin is calculated as total revenue minus product cost of sales. Merchandise margin excludes outbound freight, store occupancy and central distribution costs. The increase in merchandise margin was primarily the result of a decrease in the amount of promotional activity and the rate of markdowns as compared to the prior year period. Store occupancy costs increased to $42.3 million, or 9.2% of total revenue in fiscal 2013 from $41.9 million, or 9.3% of total revenue in fiscal 2012. Outbound freight costs increased marginally as a percentage of total revenue reflecting an increase in shipping and packaging costs associated with an increase in the e-commerce business. Central distribution expenses remained flat as a percentage of total revenue. Compensation and benefits. Compensation and benefits, including both store and corporate personnel, were $86.6 million, or 18.8% of total revenue, for fiscal 2013, as compared to $83.2 million, or 18.6% for fiscal 2012. The increase in the compensation and benefits expense as a percentage of total revenue was due to an increase in headcount in the corporate offices as well as an increase in incentive bonus accruals for fiscal 2013. Other operating expenses. Other operating expenses, including both store and corporate costs, were $54.3 million, or 11.8% of total revenue, for fiscal 2013 as compared to $50.7 million, or 11.3% of total revenue, for fiscal 2012. Operating expenses as a percentage of total revenue increased primarily due to an increase in advertising and utilities, partially offset by a decrease in workers' compensation and general liability expense, as compared to the prior year period. Depreciation. Depreciation expense was $15.9 million, or 3.5% of total revenue, for fiscal 2013 as compared to $13.2 million, or 2.9% of total revenue, for fiscal 2012. The increase in depreciation reflects the impact of the increase in capital expenditures in recent fiscal years, including the implementation of major technology upgrades during 2012 and 2013. 26 -------------------------------------------------------------------------------- Income tax expense. Income tax expense was 39.4% of pre-tax income for fiscal 2013 as compared to 35.8% of pre-tax income for fiscal 2012. During fiscal 2012, the Company reversed a portion of its reserve for uncertain income tax positions for which the statute of limitations expired. This adjustment resulted in an income tax benefit of approximately $205,000. This benefit was partially offset by $87,000 in tax expense related to a prior year item. Additionally, during fiscal 2012, the Company recorded state and federal employment tax credits totaling approximately $400,000 that related to prior year periods and were in excess of previous estimates. Net income. As a result of the foregoing, we reported net income of $14.5 million, or $0.82 per diluted share for fiscal 2013 compared to net income of $13.8 million, or $0.77 per diluted share for fiscal 2012. Fiscal 2012 Compared to Fiscal 2011 Results of operations. The table below sets forth selected results of our operations both in dollars (in thousands) and as a percentage of total revenue for the periods indicated: Fiscal 2012 Fiscal 2011 Change $ % $ % $ % Net sales $ 447,395 99.8 % $429,140 99.7 % $ 18,255 4.3 % Gift card breakage revenue 970 0.2 % 1,145 0.3 % (175 ) (15.3 )% Total revenue 448,365 100.0 % 430,285 100.0 % 18,080 4.2 % Cost of sales 279,749 62.4 % 261,091 60.7 % 18,658 7.1 % Gross profit 168,616 37.6 % 169,194 39.3 % (578 ) (0.3 )% Operating expenses: Compensation and benefits 83,181 18.6 % 78,892 18.3 % 4,289 5.4 % Other operating expenses 50,732 11.3 % 47,387 11.0 % 3,345 7.1 % Depreciation 13,175 2.9 % 12,410 2.9 % 765 6.2 % Operating income 21,528 4.8 % 30,505 7.1 % (8,977 ) (29.4 )% Interest expense 287 0.1 % 101 0.0 % 186 184.2 % Other income, net (253 ) (0.1 )% (166 ) (0.0 )% (87 ) (52.4 )% Income before income taxes 21,494 4.8 % 30,570 7.1 % (9,076 ) (29.7 )% Income tax expense 7,699 1.7 % 11,455 2.7 % (3,756 ) (32.8 )% Net income $ 13,795 3.1 % $ 19,115 4.4 % $ (5,320 ) (27.8 )% Total revenue. Total revenue increased by 4.2% to $448.4 million for fiscal 2012 from $430.3 million for fiscal 2011. The net sales increase in fiscal 2012 resulted primarily from the sales of new stores and an increase in e-commerce sales, partially offset by store closings. We opened 42 new stores in fiscal 2012 and 34 new stores in fiscal 2011, and we closed 28 stores in fiscal 2012 and 25 stores in fiscal 2011. The positive impact of these factors was offset somewhat by a decline of 3.0% in comparable store sales for fiscal 2012. During fiscal 2011, comparable store sales decreased 4.0%. The comparable store sales decrease in fiscal 2012 accounted for an $11.5 million decline in overall sales, while the net growth of the store base accounted for a $22.1 million increase in sales. The impact of the 53rd week in fiscal 2012 accounted for a $7.5 million increase in overall sales. The comparable store sales decrease was primarily due to a decrease in transactions. The decrease in transactions resulted from lower traffic counts and a decline in the conversion rate. Merchandise categories that performed the strongest in fiscal 2012 were art, mirrors, furniture, fragrance and accessories, and seasonal. Categories performing below fiscal 2011 levels were decorative accessories, frames and housewares. Gross profit. Gross profit decreased $578,000, or 0.3%, to $168.6 million for fiscal 2012 from $169.2 million for fiscal 2011. Gross profit expressed as a percentage of total revenue decreased to 37.6% for fiscal 2012, from 39.3% for fiscal 2011. The decrease in gross profit as a percentage of total revenue was in part driven by lower merchandise margins, which declined from 53.5% in fiscal 2011 to 52.7% in fiscal 2012. Merchandise margin is calculated as total revenue minus product cost of sales. Merchandise margin excludes outbound freight, store occupancy and central distribution costs. The decrease in merchandise margin was primarily the result of an increase in the amount of promotional activity and the rate of markdowns as compared to the prior year period, higher ocean freight costs, as well as a fiscal 2011 gain of $1.2 million related to a change in the estimate of our accrual for customer loyalty points. Store occupancy costs increased from $38.2 million or 8.9% of total revenue in fiscal 2011 to $41.9 million, or 9.3% of total revenue in fiscal 2012. This increase, as a percentage of sales, reflects the decline in comparable store sales during fiscal 2012, as well as the reduction in the number of renegotiated leases compared with the prior year. Outbound freight costs increased as a percentage of total revenue reflecting an increase in shipping and packaging costs associated with an increase in the e-commerce business. Central distribution expenses increased slightly as a percentage of total revenue. Compensation and benefits. Compensation and benefits, including both store and corporate personnel, were $83.2 million, or 18.6% of total revenue, for fiscal 2012, as compared to $78.9 million, or 18.3% for fiscal 2011. The increase in the compensation and benefits expense as a percentage of total revenue was primarily due to an increase in the cost of health claims associated with our employee medical plan, as well as added headcount in the corporate offices and the impact of negative comparable store sales performance. 27 -------------------------------------------------------------------------------- Other operating expenses. Other operating expenses, including both store and corporate costs, were $50.7 million, or 11.3% of total revenue, for fiscal 2012 as compared to $47.4 million, or 11.0% of total revenue, for fiscal 2011. Operating expenses as a percentage of total revenue increased primarily due to increases in advertising, professional fees, and utilities as compared to the prior year period. Depreciation. Depreciation expense was $13.2 million, or 2.9% of total revenue, for fiscal 2012 as compared to $12.4 million, or 2.9% of total revenue, for fiscal 2011. The increase in depreciation reflects the impact of the increase in capital expenditures during the year. Income tax expense. Income tax expense was 35.8% of pre-tax income for fiscal 2012 as compared to 37.5% of pre-tax income for fiscal 2011. During fiscal 2012, the Company reversed a portion of its reserve for uncertain income tax positions for which the statute of limitations expired. This adjustment resulted in an income tax benefit of approximately $205,000. This benefit was partially offset by $87,000 in tax expense related to a prior year item. Additionally, during fiscal 2012, the Company recorded state and federal employment tax credits totaling approximately $400,000 that related to prior year periods and were in excess of previous estimates. Net income. As a result of the foregoing, we reported net income of $13.8 million, or $0.77 per diluted share for fiscal 2012 compared to net income of $19.1 million, or $0.95 per diluted share for fiscal 2011. Reconciliation of Non-GAAP Measures "Management's Discussion and Analysis of Financial Condition and Results of Operations" includes certain financial measures not derived in accordance with generally accepted accounting principles (Non-GAAP measures). The non-GAAP measures are "adjusted net income" and "adjusted diluted earnings per share" and are equal to net income, and earnings per share, as the case may be, excluding adjustments to the Company's valuation allowance for deferred tax assets, adjustments related to the prior year tax provision, adjustments to the state tax rate applied to the Company's deferred tax assets and certain income tax credits related to prior periods. Management uses these financial measures to focus on normalized operations, and believes that it is useful to investors because it enables them to perform more meaningful comparisons of past, present and future operating results. The Company believes that using this information, along with the corresponding GAAP measures, provides for a more complete analysis of the results of operations by fiscal year. Net income and earnings per share, respectively, are the most directly comparable GAAP measures to these non-GAAP measures. Below is a reconciliation of each of these non-GAAP measures to the corresponding most comparable GAAP measure: 52 Weeks 53 Weeks 52 Weeks 52 Weeks 52 Weeks Ended Ended Ended Ended Ended February 1, February 2, January 28, January 29, January 30, 2014 2013 2012 2011 2010 (Dollars in thousands, except per share amounts) Net income Net income in accordance with GAAP $ 14,530 $ 13,795 $ 19,115 $ 26,431 $ 34,570 Adjustments to income tax expense $ - $ - $ - $ (814 ) $ (5,881 ) Adjusted net income $ 14,530 $ 13,795 $ 19,115 $ 25,617 $ 28,689 Diluted earnings per share Diluted EPS in accordance with GAAP $ 0.82 $ 0.77 $ 0.95 $ 1.28 $ 1.71 Adjustments to income tax expense $ - $ - $ - $ (0.04 ) $ (0.29 ) Adjusted diluted earnings per share $ 0.82 $ 0.77 $ 0.95 $ 1.24 $ 1.42 Liquidity and Capital Resources Our principal capital requirements are for working capital and capital expenditures. Working capital consists mainly of merchandise inventories offset by accounts payable, which typically reach their peak in the early portion of the fourth quarter of each fiscal year. Capital expenditures primarily relate to new store openings; existing store expansions, remodels or relocations; and purchases of equipment or information technology assets for our stores, distribution facilities and corporate headquarters. Historically, we have funded our working capital and capital expenditure requirements with internally generated cash and borrowings under our credit facility. Cash flows from operating activities. Net cash provided by operating activities was $39.2 million, $32.3 million and $41.8 million for fiscal 2013, fiscal 2012 and fiscal 2011, respectively. Net cash provided by operating activities depends heavily on operating performance, changes in working capital and the timing and amount of payments for income taxes. The change in the 28 -------------------------------------------------------------------------------- amount of cash used in operations from 2012 to 2013 was the result of improved operating performance combined with an increase in income taxes payable, accounts payable, and accrued expenses as compared to the prior year. This was partly offset by an increase in inventory of 2% on a per-store basis. The remainder of the inventory increase relates to growth in the ecommerce business. Cash income taxes paid also declined $1.4 million as compared to fiscal 2012. The decline in the amount of cash from operations from fiscal 2011 to fiscal 2012 was primarily due to the year-over-year decline in operating performance, combined with an increase in inventory due to store growth, and timing differences in the collection of landlord construction allowances. Cash flows from investing activities. Net cash used in investing activities was $18.0 million, $31.4 million and $26.7 million for fiscal 2013, fiscal 2012, and fiscal 2011, respectively. For each period presented, the amounts of cash used in investing activities consisted principally of capital expenditures related to new store construction and information technology projects. The decrease in capital expenditures from fiscal 2012 to 2013 was primarily due to the reduction in technology projects and fewer store openings. During fiscal 2013, we opened 24 stores compared to 42 stores in fiscal 2012 and 34 stores in fiscal 2011. The increase in capital expenditures from fiscal 2011 to fiscal 2012 was primarily the result of additional new stores and several information technology projects. During 2012, we completed the initiative to replace our current merchandise management system with new software and completed improvements to store merchandise display fixtures, and the reset and refreshing of many of our older, small locations. Cash flows from financing activities. Net cash used in financing activities was $6,000, $16.3 million, and $23.2 million for fiscal 2013, 2012, and 2011, respectively. During fiscal 2011, we authorized a share repurchase plan allowing for the use of up to $40 million in cash for repurchases of our common stock. No shares were repurchased during fiscal 2013. Net cash used in 2013 related to the exercise of employee stock options, the vesting of restricted stock units, employee stock purchases, and the related tax benefits. During fiscal 2012, we repurchased 1.4 million shares of our common stock for a total purchase price of $16.6 million. During fiscal 2011, we repurchased 2.0 million shares for a total purchase price of $23.4 million. The small offset to repurchase activity during fiscal 2012 and 2011 related to cash received from employees for stock purchases and option exercises. During fiscal 2013, fiscal 2012, and fiscal 2011, we did not make any draws on our revolving credit facility. Revolving credit facility. On August 19, 2011, we entered into an Amended and Restated Credit Agreement (the "Credit Agreement") with Bank of America, N.A. as administrative agent and collateral agent, and the lenders named therein (the "Lenders"), replacing our credit agreement entered into in 2004. The Credit Agreement increased our senior secured revolving credit facility from $45 million to $50 million and extended the maturity date to August 2016. Borrowings under the facility bear interest at an annual rate equal to LIBOR plus a margin ranging from 175 to 225 basis points with no LIBOR floor. We also pay the banks a fee of 0.375% per annum on the unused portion of the facility. Pursuant to the Credit Agreement, borrowings are subject to certain customary conditions and contain customary events of default, including, without limitation, failure to make payments, a cross-default to certain other debt, breaches of covenants, breaches of representations and warranties, a change in control, certain monetary judgments and bankruptcy and ERISA events. Upon any such event of default, the principal amount of any unpaid loans and all other obligations under the Credit Agreement may be declared immediately due and payable. The maximum availability under the facility is limited by a borrowing base formula which consists of a percentage of eligible inventory and eligible credit card receivables, less reserves. Also on August 19, 2011, we entered into an Amended and Restated Security Agreement with our Lenders. Pursuant to the Security Agreement, we pledged and granted to the administrative agent, for the benefit of itself and the secured parties specified therein, a lien on and security interest in all of the rights, title and interest in substantially all of our assets to secure the payment and performance of the obligations under the Credit Agreement. As of February 1, 2014, we were in compliance with the covenants in the facility and there were no outstanding borrowings under the credit facility, with approximately $32.5 million available for borrowing. At February 1, 2014, our balance of cash and cash equivalents was approximately $89.1 million. We did not borrow from our credit facility during fiscal 2013, nor do we expect any borrowings during fiscal 2014. We believe that the combination of our cash balances and cash flow from operations will be sufficient to fund our planned capital expenditures and working capital requirements for at least the next twelve months. Share repurchase authorization. On August 19, 2011, the Company's Board of Directors authorized a stock repurchase plan providing for the purchase in the aggregate of up to $40 million of the Company's outstanding common stock from time to time until February 2013. As of July 3, 2012, the Company had completed this $40 million share repurchase program and repurchased and retired a total of 3,394,693 shares of common stock at a weighted average cost of $11.78 per share. The Company's Board of Directors has not authorized any additional repurchase program as of the date of this filing. 29-------------------------------------------------------------------------------- Contractual Obligations The following table identifies payment obligations for the periods indicated under our current contractual arrangements. The amounts set forth below reflect contractual obligations as of February 1, 2014. The timing and/or the amount of the payments may be changed in accordance with the terms of the contracts or new contractual obligations may be added. A summary of the Company's contractual obligations and other commercial commitments as of February 1, 2014 is listed below (in thousands): Amount of Commitment per Period Total Contractual Less Than 1 More Than 5 Obligations Year 1 to 3 Years 3 to 5 Years Years Operating leases(1) $ 281,845 $ 49,774 $ 83,688 $ 62,929 $ 85,454 Purchase obligations(2) $ 59,278 $ 59,278 $ - $ - $ - Construction commitments(3) $ 400 $ 400 $ - $ - $ - Total $ 341,523 $ 109,452 $ 83,688 $ 62,929 $ 85,454 (1) These amounts represent future minimum lease payments under non-cancelable operating leases. (2) Purchase obligations consist entirely of open purchase orders of merchandise inventory as of February 1, 2014; such orders are generally cancelable at the discretion of the Company until the order has been shipped. (3) These amounts represent commitments for new store construction projects. Related Party Transactions In July 2009, we entered into a Vendor Agreement with a related party vendor to purchase merchandise inventory. The vendor is considered a related party because its principal owner is the spouse of our Vice President of Merchandising. During fiscal 2013, purchases from this vendor totaled approximately $29.7 million, or 13.7% of total merchandise purchases. During fiscal 2012, purchases from this vendor totaled approximately $28.1 million, or 12.7% of total merchandise purchases. During fiscal 2011, purchases from this vendor totaled approximately $25.1 million, or 12.0% of total merchandise purchases. Included in cost of sales for fiscal years 2013, 2012, and 2011 were $29.1 million, $26.7 million, and $22.5 million, respectively, related to this vendor. Payable amounts outstanding to this vendor were approximately $1.8 million as of February 1, 2014, $2.2 million as of February 2, 2013, and $1.9 million as of January 28, 2012. Our payable terms with this vendor are consistent with the terms offered by other vendors in the ordinary course of business. Off-Balance Sheet Arrangements None Seasonality and Quarterly Results We have historically experienced and expect to continue to experience substantial seasonal fluctuations in our net sales and operating income. We believe this is the general pattern typical of our segment of the retail industry and, as a result, expect that this pattern will continue in the future. Our quarterly results of operations may also fluctuate significantly as a result of a variety of other factors, including the timing of new store openings, net sales contributed by new stores, shifts in the timing of certain holidays and competition. Consequently, comparisons between quarters are not necessarily meaningful and the results for any quarter are not necessarily indicative of future results. Our strongest sales period is the fourth quarter of our fiscal year when we generally realize a disproportionate amount of our net sales and a substantial majority of our operating and net income. In anticipation of the increased sales activity during the fourth quarter of our fiscal year, we purchase large amounts of inventory and hire temporary staffing help for our stores. Our operating performance could suffer if net sales were below seasonal norms during the fourth quarter of our fiscal year. The following table sets forth certain unaudited financial and operating data for Kirkland's in each fiscal quarter during fiscal 2013 and fiscal 2012 (dollars in thousands). The unaudited quarterly information includes all normal recurring adjustments that we consider necessary for a fair statement of the information shown. Fiscal 2013 Quarter Ended May 4, August 3, November 2, February 1, 2013 2013 2013 2014 Total revenue $ 101,233 $ 97,123 $ 106,134 $ 156,073 Gross profit 39,406 35,643 41,135 64,632 Operating income (loss) 2,836 (1,074 ) 1,694 20,536 Net income (loss) 1,773 (577 ) 1,008 12,326 Earnings (loss) per share: Basic 0.10 (0.03 ) 0.06 0.71 Diluted 0.10 (0.03 ) 0.06 0.69 Stores open at end of period 317 317 323 324 Comparable store net sales increase (decrease) (2.3 )% (0.2 )% 4.9 % 0.0 % 30 -------------------------------------------------------------------------------- Fiscal 2012 Quarter Ended April 28, July 28, October 27, February 2, 2012 2012 2012 2013 (1) Total revenue $ 97,788 $ 91,004 $ 96,688 $ 162,885 Gross profit 38,469 29,994 34,019 66,134 Operating income (loss) 3,170 (3,952 ) (746 ) 23,056 Net income (loss) 1,955 (1,997 ) (416 ) 14,253 Earnings (loss) per share: Basic 0.11 (0.11 ) (0.02 ) 0.83 Diluted 0.10 (0.11 ) (0.02 ) 0.82 Stores open at end of period 297 302 308 323 Comparable store net sales decrease (1.2 )% (3.6 )% (4.7 )% (2.6 )% (1) The quarter ended February 2, 2013, includes 14 weeks. Inflation We do not believe that our operating results have been materially affected by inflation during the preceding three fiscal years. There can be no assurance, however, that our operating results will not be adversely affected by inflation in the future. Critical Accounting Policies and Estimates The discussion and analysis of our financial condition and the results of our operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates that affect the reported amounts contained in the financial statements and related disclosures. We base our estimates on historical experience and on various other assumptions which are believed to be reasonable under the circumstances. Actual results may differ from these estimates. Our critical accounting policies are discussed in the notes to our consolidated financial statements. Certain judgments and estimates utilized in implementing these accounting policies are likewise discussed in the notes to our consolidated financial statements. The following discussion aggregates the various critical accounting policies addressed throughout the financial statements, the judgments and uncertainties affecting the application of these policies and the likelihood that materially different amounts would be reported under varying conditions and assumptions. Inventory valuation - Our inventory is stated at the lower of cost or market, net of reserves and allowances, with cost determined using the average cost method with average cost approximating current cost. The carrying value of our inventory is affected by reserves for shrinkage and obsolescence. We estimate as a percentage of sales the amount of shrinkage that has occurred between the most recently completed store physical count and the end of the financial reporting period based upon historical physical inventory count results. Management adjusts these estimates based on changes, if any, in the trends yielded by our physical inventory counts, which occur throughout the fiscal year. Historically the variation between our recorded estimates and observed results has been insignificant, and although possible, significant future variation is not expected. If our estimated shrinkage percentage varied by 10% from the amount recorded, the carrying value of inventory would have changed approximately $150,000 as of February 1, 2014. We also evaluate the cost of our inventory by category and class of merchandise in relation to the estimated sales price. This evaluation is performed to ensure that we do not carry inventory at a value in excess of the amount we expect to realize upon the sale of the merchandise. Our reserves for excess inventory and inventory obsolescence (in connection with which we reduce merchandise inventory to the lower of cost or market) are also estimated based upon our historical experience of selling goods below cost. Historically, the variation between our estimates to account for excess and obsolete inventory and actual results has been insignificant. As of February 1, 2014, our reserve for obsolescence was $348,000. 31 -------------------------------------------------------------------------------- Impairments - In accordance with the provisions of FASB ASC 360, "Property, Plant, and Equipment", we evaluate the recoverability of the carrying amounts of long-lived assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. This review includes the evaluation of individual underperforming retail stores and assessing the recoverability of the carrying value of the assets related to such stores. Future cash flows are projected for the remaining lease life. The key assumptions used to determine the estimated cash flows for these stores include net sales and gross margin performance, payroll and related items, occupancy costs and other costs to operate. We calculate the fair value of long-lived assets using the age-life method. Under this method, the replacement cost of an asset is estimated and reduced by depreciation based on the effective age of the asset and its expected useful life. This method takes into consideration the fact that we will continue to use these assets based on a presumed investment decision where the expected cash flows from operating the store are greater than the expected cash flows that result from not operating the store. If the estimated fair value is less than the carrying value of the assets, we record an impairment charge equal to the difference, if any, between the assets' fair value and carrying value. We have not made any material changes to our impairment loss assessment methodology in the financial periods presented. Additionally, we do not believe that there will be a material change in the estimates or assumptions we use to calculate long-lived asset impairment losses. However, if actual results are not consistent with our estimates and assumptions used in estimating future cash flows and asset fair values, we may be exposed to losses that could be material. Insurance reserves - Workers' compensation, general liability and employee medical insurance programs are predominately self-insured. It is our policy to record a self-insurance liability using estimates of claims incurred but not yet reported or paid, based on historical claims experience and trends. As of February 1, 2014, our self-insurance reserve estimates totaled $4.1 million, of which $928,000 was reflected as a current liability in accrued expenses and $3.2 million was reflected as a noncurrent liability in other liabilities on the consolidated balance sheet. As of February 2, 2013, $1.1 million was reflected as a current liability in accrued expenses and $3.2 million was reflected as a noncurrent liability in other liabilities on the consolidated balance sheet. The assumptions made by management in estimating our self-insurance reserves include consideration of historical cost experience, judgments about the present and expected levels of cost per claim and retention levels. We utilize various methods, including analyses of historical trends and actuarial methods, to estimate the cost to settle reported claims, and claims incurred, but not yet reported. As we obtain additional information and refine our methods regarding the assumptions and estimates we use to recognize liabilities incurred, we will adjust our reserves accordingly. Actuarial methods are used to develop estimates of the future ultimate claim costs based on the claims incurred as of the balance sheet date. Management believes that the various assumptions developed and actuarial methods used to determine our self-insurance reserves are reasonable and provide meaningful data and information that management uses to make its best estimate of our exposure to these risks. Arriving at these estimates, however, requires a significant amount of subjective judgment by management; and, as a result, these estimates are uncertain and our actual exposure may be different from our estimates. For example, changes in our assumptions about health care costs, the severity of accidents, the average size of claims and other factors could cause actual claim costs to vary materially from our assumptions and estimates, causing our reserves to be understated or overstated. For instance, a 10% change in our self-insurance liabilities would have affected pre-tax income by approximately $432,000 for fiscal 2013. Income taxes - We record income tax liabilities utilizing known obligations and estimates of potential obligations. A deferred tax asset or liability is recognized whenever there are future tax effects from existing temporary differences and operating loss and tax credit carryforwards. We record a valuation allowance to reduce deferred tax assets to the balance that is more likely than not to be realized. We must make estimates and judgments on future taxable income, considering feasible tax planning strategies and taking into account existing facts and circumstances, to determine the proper valuation allowance. When we determine that deferred tax assets could be realized in greater or lesser amounts than recorded, the asset balance and income statement reflects the change in the period such determination is made. Due to changes in facts and circumstances and the estimates and judgments that are involved in determining the proper valuation allowance, differences between actual future events and prior estimates and judgments could result in adjustments to this valuation allowance. We use an estimate of our annual effective tax rate at each interim period based on the facts and circumstances available at that time while the actual effective tax rate is calculated at year-end. Additionally, our income tax returns are subject to audit by U.S. federal, state and local tax authorities, which include questions regarding our tax filing positions including the timing and amount of deductions and the allocation of income among various tax jurisdictions. In evaluating the tax exposures associated with our filing positions, we record reserves for probable exposures. We adjust our tax contingencies reserve and income tax provision in the period in which actual results of a settlement with tax authorities differs from our established reserve, the statute of limitations expires for the relevant tax authority to examine the tax position or when more information becomes available. Our tax contingencies reserve contains uncertainties because management is required to make assumptions and to apply judgment to estimate the exposures associated with our various filing positions and whether or not the minimum requirements for recognition of tax benefits have been met. We do not believe that there is a reasonable likelihood that there will be a material change in the reserves established for tax benefits not recognized. Although we believe our judgments and estimates are reasonable, actual results could differ, and we may be exposed to losses or gains that could be material. A 10% change in our unrecognized tax benefit reserve at February 1, 2014 would have affected net earnings by approximately $31,000 in fiscal 2013. 32-------------------------------------------------------------------------------- Stock-based compensation - We have stock-based compensation plans which include incentive and non-qualified stock options, restricted stock units, and an employee stock purchase plan. See Note 7, Employee Benefit Plans, to the Notes to the Consolidated Financial Statements included in Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K, for a complete discussion of our stock-based compensation programs. We recognize stock-based compensation expense based on the fair value of the respective awards. We estimate the fair value of our stock option awards as of the grant date based upon a Black-Scholes-Merton option pricing model. We estimate the fair value of our restricted stock units as of the grant date utilizing the closing price of our stock on that date. The compensation expense associated with these awards is recorded in the consolidated statements of income with a corresponding credit to common stock. The Black-Scholes-Merton option pricing model requires the input of highly subjective assumptions. These assumptions include estimating the length of time employees will retain their stock options before exercising them ("expected term") and the estimated volatility of our common stock price over the expected term. Changes in the subjective assumptions can materially affect the estimate of fair value of stock-based compensation and, consequently, the related amount recognized in the consolidated statements of income. We update our assumptions at each grant date. Historically, there have not been significant changes in our estimates or assumptions used to determine stock-based compensation expense. However, in fiscal 2013, we did experience a significant increase in the estimated fair value of awards granted ($9.51 per share in 2013 compared to $5.79 per share in 2012) because of the increase in our stock price during 2013 when compared to the previous year, and the related impact to the computation of fair value. Consequently, if actual results are not consistent with our estimates or assumptions, we may be exposed to changes in stock-based compensation expense that could be material. A 10% change in our stock-based compensation expense for the year ended February 1, 2014, would have affected pre-tax income by approximately $280,000. |