Brand House Collective Inc (TBHC) 2004 Q2 法說會逐字稿

Good day and welcome to the Kirkland's Inc. conference call. Today's call is being recorded. At this time for opening remarks and introductions, I would like to turn the call over to Mr. Tripp Sullivan. Please go ahead.

Good morning and welcome to the Kirkland's Inc. second-quarter conference call. On the call this morning will be Robert Alderson, President and Chief Executive Officer, and Rennie Faulkner, Executive Vice President and Chief Financial Officer.

The results as well as noted to the accessibility of this conference call on a listen-only basis over the Internet were released earlier this morning in a press release that has been covered by the financial media. Therefore, historical information discussed during this conference call and the statements made by company management are forward-looking and made pursuant to the Safe Harbor provisions 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, including the Company's annual report on Form 10-K filed on April 15, 2004.

With that said, I will turn the call over to you, Robert.

Good morning everyone and thanks for joining us. Today Rennie and I will comment on Kirkland's sales and earnings results for the second quarter of fiscal 2004, as well as update you on current business trends and our outlook for the third quarter. We also will discuss the changes taking place inside the company as we focus on improving near-term sales and positioning the business for sustained success.

Clearly we're disappointed with the recent financial performance as described in our press release this morning and specifically with current sales and margin trends. We anticipate that business will remain tough for at least the next two quarters. However, our team is making good decisions that we believe will affect business positively beginning in the fourth quarter.

For the second quarter, we had a net loss of 14 cents per diluted share, the midpoint of the revised guidance we issued on July 12. As previously announced, comp store sales for the quarter decreased 3.4 percent following a comp decrease of 9/10 of 1 percent for the second quarter of 2003.

The quarter began with a slow Mother's Day weekend despite what we felt was a good merchandise assortment and in-store presentation. Business trends weakened further as we moved through the month of May and we failed to see the sales surge in June that we historically had experienced with our June big sale event. In response we adopted an aggressive markdown stance throughout June and July to derive sales and clear unproductive inventory. While we had brief periods of better sales during July and a noticeable lift from our proprietary credit card introduction, overall sales came at lower margins contributing to a net loss for the quarter.

We did experience comps sales increases for the quarter in lamps, garden, textiles and the novelty gift categories. Several other key categories including wall decor, candles, decorative accessories and furniture posted comp declines for the periods.

The better performing categories benefited from strong style trends and solid inventory commitments. Conversely under performing categories generally were characterized by a combination of inventory and balances that prevented us from maximizing our best opportunities and the lack of a steady flow of merchandise receipts during the quarter that would have helped us to anniversary prior year numbers.

A case in point was our wall decor category where our merchandise mix for most of the quarter was weighted to heavily toward higher price point framed art. Further, our comparative inventory position versus last year in framed mirrors, alternative wall decor and lower price point art was not sufficient to make a strong statement in our stores and drive positive sales increases. Inventory in these groups was adversely affected by the failure of a major supplier in the case of framed mirrors and the version of open-to-buy dollars to the categories. Clearly the transition to our new distribution center did create some interruption in merchandise flow during June and July, but overall we do not feel that the impact was material to second-quarter results. Our best judgment is that the negative sales effect attributable to the DC startup transition was approximately 1 percentage point on comp sales.

Sales for the second quarter generally were characterized by higher average retail prices and lower transaction volumes, similar to the trends we saw in the first quarter when strength of the business was higher average retail prices in categories including wall decor, decorative accessories and textiles. Yet transaction volume declined, and overall pure items were sold at substantially lower margins in wall decor and decorative accessories which accounted for the failure to capitalize on the higher average retail.

Continued weak customer traffic led to the lower transaction volumes. Our customer conversion rate was relatively stable during the quarter and actually somewhat higher than first quarter. Our non mall stores did not experience the weak traffic trends as much as our mall stores. Comparable store sales for the 19 non mall stores in our comparable store base were positive for the quarter.

We opened 15 new stores during the quarter and closed four stores ending the quarter with 289 stores in 36 states. Year-to-date and as of today we have opened 19 new stores and have closed nine stores. 14 stores are currently under construction. As of today, we have 49 leases signed for 2004. We remain on target to open a total of 55 new stores for the fiscal year and expect them to open prior to December 1 of this year. We estimate a total of 15 store closings for the year that should place our store base at 320 stores as of fiscal year-end.

The 2004 class continues to perform very well. However, late openings for the bulk of the class and uncertain business trends suggest continued caution in grading this class. The strong performance of the class continues to support our venue diversification to non mall locations. To date we have 32 stores committed for 2005, all off mall. We only have five leases signed for the period, so great flexibility is present.

We achieved a milestone on June 9 when we completed the move into our new distribution center and commenced operations. As anticipated with a project of this magnitude, the first couple months have proved challenging as our team identified and addressed key functionality and operational problems and issues. Since that initial "Go Live" phase, we have seen steady improvement in the operation as our team has adjusted to a new facility, new processes and new technology. The operation is functioning well today, and while we will be refining the operation for the next several months, we are encouraged by the enhanced distribution capabilities that we are starting to see.

At this point, Rennie will take you through the second-quarter financial statements that were included in the press release and provide some commentary on our third-quarter outlook.

Thanks, Robert. Good morning everybody. I will begin with the review of the second-quarter income statement.

Net sales increased 7.3 percent, and comparable store sales decreased 3.4 percent for the quarter. We operated approximately 30 more stores during the second quarter of 2004 as compared to last year's second quarter. Gross margin for the second quarter decreased to 25.4 percent of sales from 29.7 percent in the second quarter of 2003, primarily due to higher markdowns and a lower merchandise margin compared to prior year. We also experienced a deleveraging effect on the occupancy component of gross margin due to the lower sales, as well as increased costs related to the transition to our new distribution center which we had planned.

Operating expenses were below plan for the quarter due primarily to modest incentive compensation accruals for store and corporate personnel. As a result of the weak sales trends for the quarter, operating expenses as a percentage of sales rose 2 percentage points for the quarter. Depreciation and amortization rose 40 basis points for the quarter, reflecting the sales trends as well as increases in capital investment related both to new stores and the new distribution center.

Interest expense was relatively flat for the period as borrowings under our revolving credit facility were comparable to prior year. We reported a net loss for the quarter of $2.7 million or 14 cents per diluted share, the midpoint of the guidance we issued on July 12.

Let us look for a minute at the balance sheet. We ended the period with $5.3 million in cash and a balance of $11.1 million under our revolving credit facility. Total inventories at July 31st, 2004 were 42 million, roughly even with the prior year and approximately 19 percent less than our total inventory level at May 1, 2004. Total merchandise inventory at July 31 on a per store basis was $134,000 versus $150,000 at August 2, 2003. These quarter-ending inventories reflected the significant clearance activity that took place in our stores during June and continuing into July.

Further, in accordance with our Christmas flow plan, these inventories reflect lower amounts of seasonal Christmas items versus last year. As of today, we have about $4000 per store versus $11,000 per store last year. Our goal is to flow these goods more appropriately to need and sales rate and also to convert our stores to a Christmas look somewhat later in the fall.

The June and July clearance has enabled us to begin the second half with fresh inventory with approximately 96 percent of our inventory less than six months old and virtually identical to 2003 in terms of percent active and not in markdown status.

While our sales and margin underperformance has led to a loss for the quarter and the second-half outlook remains uncertain, we still are positioned to produce strong cash flow for the balance of fiscal 2004. We will finance all of our activities for the remainder of 2004 with cash flow from operations and borrowings under our revolving credit line.

The final topic I want to cover today is our guidance for third quarter and our updated guidance for fiscal 2004. On the heels of a tough second quarter, August has also started with a double-digit negative comparable store sales trend. Customer traffic is still a concern, especially in our mall stores, and we are facing difficult comparisons in August and September as we anniversary successful merchandise events in art and lamps from a year ago.

Furthermore, several circumstances have combined to put our inventory in a position that we do not feel will support positive comps during third quarter. First, we have experienced sourcing problems specifically related to our import mirror program. These issues will not be resolved in the short-term. We are moving to other sources. The timing of delivery will still be a problem for the rest of the year.

Second, we currently have inventory mix imbalances across several categories including the categories of wall decor, candles and decorative accessories. Over the course of the second quarter and even more intensely in recent weeks, we have carefully evaluated our business and have identified several factors that we believe are contributing to the current sales weakness. Robert will address these issues in more detail in a moment, especially relating to the important initiatives that we were undertaking in our merchandising and marketing areas. Our current expectation is that comparable store sales will decline for the third quarter in the range of 10 to 15 percent below last year's third quarter. Comparable store sales for the third quarter of 2003 rose 2.7 percent.

Although this sales trend is worse than we experienced in second quarter, several key issues contributing to this trend are identifiable and are being addressed aggressively. The plan is to have inventories in an improved position as to level end content including better balancing across categories by October 30. Due to our lean current inventory levels and significant new merchandise receipts for the rest of the quarter, the outlook for merchandise margin is somewhat better than it is for sales. We expect merchandise margins in Q3 to return to more normalized levels; however, the negative comp will impact both gross margin and the operating expense ratio leading to the estimate that our third-quarter net loss will range from 10 to 15 cents per diluted share. We earned 10 cents per diluted share for the third quarter of fiscal 2003.

As we mentioned in the press release, we will spend the next two months working hard to position our stores for a successful fourth quarter. However, prudence dictates a cautious fourth-quarter outlook as we have failed to produce significant sales or gross margin momentum since March of this year. We are adjusting downward our estimate for full-year fiscal 2004 earnings to a range of 45 to 55 cents per diluted share. Our full-year estimate for comparable store sales is now a range of negative 2 to negative 5 percent.

Robert will now share some thoughts on our current merchandising and marketing plans.

Thank you, Rennie. As Rennie mentioned, we have taken a hard look at our business over the last few weeks in order to understand the persistent sales weaknesses that we have seen since Mother's Day. Clearly our traffic and transaction data suggest a lack of consumer appetite for certain of our merchandise, but our 37 years experience tells us that when we have periods of weak sales there are usually multiple causes.

So why isn't the customer responding? Here is our best assessment.

Number one, the assortment has been too broad, which we believe has been confusing to our customer and at the same time hard to execute visually and operationally in our stores. An overly broad assortment also impedes our ability to maintain consistency in our visual presentation across the store base.

Number two, with sales challenges we have been seeking new trends in hot items and have thereby branched more deeply into fashion and novelty programs than we historically have during the first half of this year. Again, this is confusing to our customer and distracts from our core home decor message.

Number three, we failed to replenish and replace some key item programs and, therefore, have missed sales. We have not had the product. Whether by planning failures or alternative product decisions, we just did not have what the customer expected and wanted so she went elsewhere.

Fourth and last, our core female customers increasingly shopping in non mall locations. This currently represents a minority of our store base, although we are successfully transitioning more of our stores to non mall venues, a process which will accelerate dramatically going forward.

So what actions are we taking? Our evaluation today of what is right and wrong with our business has pointed us to a short list of actions that we will be emphasizing in the coming weeks. Taken individually some of these may seem basic and simple, but we believe that the collective benefit of doing these things well will make a significant difference in our sales and margin results, number one.

Emphasize our core merchandise strengths in home decor categories like wall decor and lamps, furniture, textiles, garden and floral. Stylish and high-quality home decor at great prices is our bread and butter. While our customers enjoy the fun element of shopping Kirkland's that partly comes from unique or trendy novelty items, we may have gone too far in this direction in recent months, and we will move both our inventories and our floor sets to more effectively highlight the great home decor values that we offer.

Number two, we will narrow our product assortments and reduce the overall number of SKUs on our sales floor. This strategy is one that will be good for customers and also good for our stores. It is a very fine line to walk between being too broad in a good way in the sense of offering variety or selection versus being overly broad or scattered in our merchandise offering and presentation which makes the store difficult to shop and understand and might even make the great product ideas at great values difficult to find. We see significant opportunity as we do a better job editing and focusing our assortments on the best categories and the best items within those categories.

Number three, market more aggressively to our customer and make her excited about coming to visit Kirkland's. We believe that we can make our stores look better and be more shopable, but we also need to do a better job driving customer traffic. We have talked about this all year, but we now have a team in place that is putting some substance behind the strategy. Plans are still forming, but they include utilization of our growing database of Kirkland's credit card holders, more extensive use of e-mail marketing and enhanced coordination between merchandising, marketing, visual and stores to ensure a clear presentation of the Kirkland's brand and message to our customers.

Number four, seek feedback on a more formal and regular basis from stores and customers to ensure that we understand the thinking and preferences that underlie the numbers we see everyday. We are currently conducting a comprehensive survey of our stores, and we will also be undertaking efforts to obtain direct feedback from customers. We want to know what customers like and don't like about our stores. We want to be graded on how we are doing. Our systems already tell us everyday what is selling and what isn't, but we also want to do a better job of understanding the critical question of why.

Number five, raise the standard of product knowledge and selling skills among our store managers and associates. We have also talked about this point before, but it takes on increasing importance when we go through a period of slow traffic. At the same time, we are working to bring more shoppers into our stores, we must also work to convert more shoppers into purchasing customers.

As we create a more focused product assortment and store presentation, we will also equip our people with the tools and knowledge to highlight and sell our great merchandise. Our emerging new and improved logistics effort will play a role here also as we enhance supply chain efficiency, control, inventory flow and allocate more of our associates time to the selling floor and satisfying customers.

In conclusion, the balance of this year may be tough. We have faithfully described our problems and challenges, which we are confronting with positive changes. Our team is united and working unselfishly across all disciplines to produce better results as soon as possible. We have a plan. We have resources. We have new team members and more on the way. Most of all, we have an unyielding commitment to win more customers and return this company to being an elite performer in this sector.

That concludes our prepared remarks, operator, so we would be pleased to take questions.

(OPERATOR INSTRUCTIONS). Robin Murchison, Jefferies & Co..

I've got a few questions here. First of all, why continue with a relatively aggressive unit expansion program next year when you really have a lot of things to sort through on the merchandise side?

Do you want to do them one at a time?

Yes.

Okay. Actually right now we don't feel the growth is our problem. It is certainly something we are thinking about, and as you will notice in our prepared remarks, we have commitments in 2005, but we have actually executed very few leases. We are certainly going to watch this very carefully and watch what happens throughout the third and fourth quarter, and actually we will be very very cautious about how quickly we go into a very aggressive 2005 expansion.

We don't really think that is our problem right now. We think our problem is centered in the merchandising and marketing piece of the business, and we think we can devote the resources to that and continue to put our stores in better position.

Also I would say that it is distinctly to our advantage to convert these mall stores to non mall stores. We have decidedly better results both from sales and from profitability in those stores, and the quicker that we make this transition and rationalize that store base the better off we will be.

Just to chime in and put my spin on this or editorial, I agree with everything Robert said. I think there are two things that we can point to factually. Number one, the news stores that we are opening are performing well. Number two, the off mall stores comped positively in the second quarter and the mall stores did not. Both of those are consistent with the continuation of the expansion plan. The third point is more subjective. It is our view that if we did not think our problems were identifiable and solvable, we would be slowing down right now.

You have got some new merchandising guys. What is their assessment of what needs to be done beyond the comments that you made? Plus, if you would elaborate a little bit on, you do have new merchandise in the stores, and there certainly are some trends in the market that are a little more contemporary, maybe a little more minimalist. It would seem to me that one of the challenges you have is sort of identifying who your core customer is right now. Is it an older, more traditional customer, or how much are you drawing from a younger customer base that might not be as traditional? And then how do you mitigate -- how do you balance the demand of the two? Who wins there?

Well, I don't think that either one has to win. I think you can have a very balanced inventory mix. Our testing of those more contemporary items in that global trend that you're talking about has actually been very good. So we are very carefully introducing those. You will see those in some vases and lamp vases, (multiple speakers) and some decorative accessories. You won't see that take over our store in 2004 or I think early 2005.

I think this is one of those things that if it has legs we will do as we have always done, is exploit that trend very fully. But I think we're putting our foot in it. It looks okay right now, and so we're expanding that offering. I don't think that is -- that means that that is to the exclusion of our traditional customer at all.

Then lastly, rather somewhat implicit in the guidance I think at 45 or 55 cents for the year and then with your guidance on the third quarter, is the fourth quarter that albeit down, not as down as certainly the difference of what we saw in Q2 and Q3. Given your comments about business being tough over the next two quarters, do you think you are -- how comfortable are you with guidance on the year 45 to 55 cents?

I think the answer is we are comfortable. We always attempt to give our best guidance, and obviously back at the beginning of the second quarter, we did not do a very good job forecasting the second quarter and we had to re-guide. So those facts are what they are. But we are comfortable, and I guess I would just point to a couple of observations.

Number one, there are a number of things that we can do based upon the initiatives that Robert described. There are a number of things we can do to make a difference in what our stores look like and what our merchandise content and mix is by November 1. There is a lot we can do and it is being done. So that is number one.

Number two, I will just remind you that last year we were negative 5 in the fourth quarter and we still grew earnings. Now I am not telling you that if we go negative 5 again we are going to grow earnings, but I am telling you that there is a lot of earnings power in this business and there is a lot of leverageability in this business in the fourth quarter. If things unfold as we hope they will, it is not crazy at all to think that we will see some stabilization of trends beginning in November and continuing into December.

I would also say we may certainly on the next call or in between we will talk about fourth quarter. But we have not backed away or ceded anything to believe that we are just going to automatically have terrible business in the fourth quarter. We have got a different marketing plan, and we have what we think is some good merchandise and we're going after it hard.

Okay, thank you very much. Good luck.

Rob Wilson, Tiburon Research Group.

How much of this is basically more of just a fundamentally more competitive environment in your space versus some of the initiatives that you guys are undertaking internally to turn the business around? I mean we are seeing a lot of other people in your space that are struggling right now. Is it safe to say or a fair assessment that this could be something larger than simply Kirkland's?

Well, I will start and I think Rennie has maybe some certainly comments about this. On the last call or so, we have all been talking about external influences, and we know they are out there and we know that the pain in the sector is not just at Kirkland's. But I think our view of it is, there is not much that we can do about that. So we have to stay totally focused within what we think can improve our business, improve our relationship with customers and drive the traffic that is available to our stores. We think there is large room for improvement there. So we are trying not to be in a position where we are hoping, but instead we are trying to help.

So with that comment, I will turn it to Rennie because he has some comments on it.

I guess I have got two thoughts. Thought number one is, to the extent we have been able to do it, we have looked at our second-quarter numbers and we have looked at our August performance year-to-date and we have tried to make some judgments about the extent to which whatever shortcomings or misses we might have had, i.e. things we might have controlled better, which we have tried to quantify what those sort of might have or should have done in terms of making numbers better. Okay? That is a difficult exercise, but we've made an attempt at doing that.

When you look at that, I will tell you that when you view that against the August softness that we have seen -- this is an opinion, okay -- but I believe that you cannot account for all of the negative comp trend in August simply by saying that we have done everything perfect we would all of the sudden be up 5 or something. I don't think you can do that. I think it feels notwithstanding the issues that we have identified, that we are serious about and that we are addressing, it feels like August has softened compared to July and June. Okay? Now that is not a one-on-one competitive comment, but it is a comment on what we seem to be feeling as a sector or as it relates to home decor generally.

The second comment I will make is we have made an effort to look at how our stores perform when we are in market against major competitors. Bed, Bath; Pier 1; Cost Plus; Bombay; Target; etc.. We have done that.

Nothing that we have seen in our analysis so far suggests that we have taken a step back in terms of our competitiveness against those companies. This is obviously something we will continue to watch, but I think really when you talk about competitive issues it really comes a much more full circle to the issues of what we're showing in our store, how clearly we're presenting it and quite honestly how well we are executing it because we think when we do that well we win.

Okay. Last time I chatted with you, you guys had talked about hiring a couple of new buyers and starting a product development team in there at Kirkland's. Could you speak more to that today and where those initiatives stand?

I think we have hired -- I think we did announce that we hired Al Oliver from Neiman Marcus, who joined us as Vice President of Merchandising. We also hired two financial planners, and also augmented our allocation staff. We are currently in negotiations with another buyer, a senior buyer, which we hope will reach fruition within the next few days. We have a search. We announced we have a search underway for a senior leader in our merchandising group, and we don't have anything to say about that right now beyond that the search is underway. But we will certainly talk to you when we know something definitive.

But the building and reorganizing of this team has been underway throughout most of this year, and the most encouraging thing to me about it is the confidence, the thoughtful way in which these guys are looking at everything related to our merchandise, the coordination with our new Marketing Vice President, Andrew Gallina, also from Neiman Marcus. With our very confident team that is in place, we're going forward. We will be happy for the extra help when the new guy get here, but this team is confident and thoughtful and moving forward with a plan.

Could you speak more specifically related to product development? Any initiatives there?

There is really at this point, Al came into the business about three and half months ago really to help our existing general merchandise manager with product projects. Since he has taken a more active role in leading the merchandise group and teaming with our VP of Planning and our VP of Allocation, what has really happened here is that the whole buying team has coalesced around Al Oliver, so that everyone is working in product development. We have a support for these guys in planning and allocation that allows them to put a great deal more of their effective working time in working directly with vendors on product development. So I would say as we are approaching it now it is a very focused team effort.

Okay. And, Rennie, one last question. Can we speak about liquidity and whether you have signed a new credit agreement and your availability today?

Sure. We have something like I don't know $19 million or something of availability on our credit agreement right now. We have reached an agreement in principle so to speak or a handshake term sheet agreement with a new credit facility. We are pressing towards closing right now, and that ought to be closed here in the next couple of weeks. So that will be a good thing to do. That will take us out. It's actually a five-year deal. But even if that gets delayed a little bit, the existing liquidity we have is sufficient to take us into the fall and through the year if necessary. But we are excited to have a new deal done because right now the asset-based loan market is very favorable for borrowers like us.

Well, thank you.

Jeff Kulca (ph), Area Partners.

I was hoping you could just tell me how many people you guys have in the database right now which you are able to touch by direct-mail, etc.?

We really started about trying to get this database up and running for regular e-mail (inaudible) customers about three months ago, and when we combine our credit card and our database, it would be something under 200,000 customers now. Our goal is to be at a million customers as soon as possible, and we hope that will be within the next six to 10 months.

How many people have the credit card right now? I know that was just launched.

About 30,000.

Okay. Going forward, is there any color you can give on what type of marketing strategies they will be? Will they be e-mails? Will they be postcard? What kind of stuff are you guys kind of targeting?

Well, it will be -- I think the direction of the marketing group -- and we are in a relatively preliminary stage right now. But I think it's going to be a much more coordinated effort across merchandising, visual and stores, and to try to make sure that everything we do in marketing is absolutely geared up to something that is happening positive with the merchandise in the stores, we will be doing some promotional things. But I think you will see less price promotion and more things directed toward encouraging customers to come see exciting different things and to create a little bit different message with them.

We will certainly use e-mail. E-mail on the preliminary plan is in support of every single thing we are doing through the end of this fiscal year. We will do some experimentation with direct-mail in certain markets where it is economical and it makes sense. You will probably see less in-store collateral that screams this or that to the customer, and hopefully that message will be much more streamlined and more effective.

So a little bit of difference in the way that we go about it. I think it is going to be fun. I think it is going to be really the first time we have ever had really professional marketing people here to coordinate all this, and it is kind of exciting. Then, they are also going to be using survey work to try to figure out how to best direct this.

So that is about all I can tell you. We will have a lot more to say about this I think as we get into -- probably on the next call.

I guess I will ask one final question and then I will turn it over. Do you have any preliminary data which shows that the average spend of a person whose e-mail address you don't have is actually the person whose e-mail address you do have? What's --

No.

Are you willing to release -- you don't have that?

We don't have that now.

Okay. Thanks, guys.

We are not far enough along. Thank you.

Peter Benedict, CIBC World Markets.

A couple of questions I guess first for Rennie. Rennie, can you give us a feeling for CapEx where you think it will flush out to this year and also where you think your cash flow from operations would be given your new guidance? And with the revolver, do you expect to pay back down by the end of the year, or with the new guidance, do you think you will have some still sitting on the books at the end of the year? That is the first question.

Okay, first of all on CapEx, no change there, Peter. I think the last time we talked we probably said something like 21 to 22 million, and that is still where we are tracking. Second on the revolver, we still anticipate and expect to clean that revolver down at year-end as we traditionally have. What was the final piece? (multiple speakers)

Cash flow from operations.

Yes, cash flow from operations. Well, the guidance for the year of 45 to 55 cents, when you flush that through, that is going to give you an EBITDA number of $30 million or maybe a little bit less than that. So let's just pick a number and call it $28 or $29, call it $29 million. You have got CapEx of 21 or 22 and probably not a lot of growth on the working capital side.

Okay. On the operating expenses, I basically had them flat on a per store basis in the second quarter. Can you talk about how should we should think about that metric going forward given some of the initiatives that Robert outlined, some of the trying to enhance the selling skills of the store managers, etc.? Should we be expecting that to go up, or is the lack of profits going to bring that actually down given the incentive compensation stuff?

Well, let me answer it this way because that could be a long discussion, but let me try to hit the main point. When you look at the overall operating expense budget for the back half of the year, I am talking about dollars instead of percent right now, it is really not going to change that much, Peter. We may try some new things here or there, and I think we will try a few things here or there in the marketing area, but nothing that is going to be just terribly dramatic.

We are certainly going to try to be fiscally responsible as far as perhaps moving some dollars from one area of the budget into another. I will give you an example. We have spent a significant portion of our to date marketing budget really with in-store collateral emphasizing the in-store visual presentation banners and the like. While we think that is important, we think we can maybe accomplish the same thing with a little more of an understated approach in terms of the in-store collateral, allocate some of those dollars incrementally to some of these traffic-driving strategies Robert was talking about, and come out not a whole lot worse in terms of the overall marketing spend. So I really think that the overall budget is not going to get reinvented on the operating expense line, and as to the ratio, it will all depend on how successful we are in getting the sales going back the right direction.

One thing you need to bear in mind also is, and I would view second quarter as a reasonable proxy for that, is that we do have within our operating expense structure a fair amount of incentive-based compensation both at store and corporate level. So when the business is not performing, that is not good news for bonuses, and that naturally creates a cushion of sorts inside that operating expense line and you can anticipate that for the last half as well if our forecast is correct.

I would also say one other thing, when we are talking about doing selling, training and the like in stores, we already are underway with an interactive CD program. And then also how you allocate the use of supervisory field time when they are in-stores, in-store meetings and in-store visits. So a lot of this is going to be done with existing resources and without the expenditure of a great deal of money.

Okay, that is helpful. One last question. I guess, Robert, this would go to you. You think back historically you guys went through a period when you reduced the SKU count in the stores and it ended up being very successful in terms of driving business. Can you talk about where the SKU count has been, where it maybe migrated to recently, and then where do you think you want to get it given some of the comments you have made today?

Well, I am actually as we work with the merchandising group and they try to focus the assortment -- you know it really looks like the SKUs have been about roughly 2500 or more per store on an average basis, and we would like to see those naturally come down over the next six months to around a couple of thousand SKUs. Take it down 20, 25 percent. We think that is going to be very helpful to the store manager because they are really dealing with how many prime and optimal selling locations and how many overall selling locations do you have in the store. So it is all about how that ties also to overall inventory levels.

That is going to allow us to accomplish one of our primary goals, and the focus is about more depth in our key items and the ability to present more impactful displays in the prime selling areas of the store. So there is a lot going on here. It is like peeling back the onion. We were successful with this in 2001. I think we can be hopefully at least modestly successful with it now. We are confident that this is going to make a difference.

Robert, in 2001 remind me where the SKU count was and where you took it to? Is 2500 where you're sitting today up a little bit from where you were about a year ago or kind of ballpark that for me if you would?

You know I don't remember the numbers, Peter. Honestly I would tell you if I did. I just don't know.

Okay. One last question and I will get off. Rennie, inventory per store is down about I think 10 percent in the second quarter. Should we think about similar declines in the back half of the year, or should we think more flattish? Could you help me with that? Thanks.

Let me grab something here, Peter. Let me look it up. I think in terms of per store inventories, you should continue to think of that as trending below prior year. Maybe not as much as 10 percent all the way through the fall. That gap will probably narrow a little bit. But we expect to run the stores with lower on-hand inventory levels through the season.

Remember that really notwithstanding the sales trends we have been talking about, that has been the plan all year long. We want to be guarded about getting crazy about that, but with the new DC, that is part of the strategy.

John Lawrence, Morgan Keegan.

Robert, to follow on that question about SKU reductions, looking at the fourth-quarter plan, you say that you will have everything you need in the store by November 1. Can you walk through that process and help me -- you had this problem with a vendor delivery. How is that going, and remind us about the leadtimes involved for holiday, please?

Well, we said we have some imbalances, and there are some things that are not going to rationalize. For example, the mirrors are not going to rationalize I don't think through the balance of this year. We are about $1 million worth and a significant number of pieces short, and I don't think that is going to resolve. It is going to take us -- we said that we thought we would be in better shape in terms of depth and key items and addressing some of these imbalances especially in the wall decor category and in decorative accessories. We thought we would be by the end of this quarter in much better shape.

The seasonal is bought. We either have it or it is in route. It has already begun to go to stores. We started shipping that about the 16th of August. They have a few key items now, and you will see that in I think probably the back of our store right now, and you will not see it in the front of our store probably until the early part of October. So there is really not an issue in our minds at least at this point about whether we have the seasonal.

We still have some open-to-buy left for the month of December, and we are trying to plan how to use that most effectively to provide the depth and key items to replenish bestsellers and to provide the extra opportunities that may present themselves as we go into the fall, deeper into the fall season.

And secondly, should you decide would you wait and see fourth quarter before you made a decision on '05 openings?

I think that will be a decision that will be constantly on our minds through the second half of the year. You know I think as I said earlier, as we sit here today, I think we are adequately staffed to open our stores. I think we have a good process in place to get the people that we need to run them. We have a huge focus on training them better. The essentials that are in place to execute a solid growth plan we think are still there, and we still think that that is not a distraction to what is going on on the other part of our business.

If we reach that conclusion, we will tell you very quickly what is going on and what we plan to do about it. As I have said, we are very flexible at this moment.

The last question, you consolidated I guess three buildings into one for the new DC. I realize sales have been tough, but are you seeing anything from that outlay of capital for that facility that is driving the process -- I mean any success from that that you're seeing that you could tell us about?

I think the answer to that, John, is yes. We started that building on June 9th. We had planned and forecasted that we would have slower outbound shipments in the immediate weeks following "Go Live," because new processes, new technology. We anticipated that things would happen, fixes and things would happen that we would need to deal with. That is, in fact, what did happen. But I think it is still as I think we might have even said in some of our public stuff, every week has been better.

Is it all good news? No. We are still in the startup phase there, and we will be through the end of the year. But it is two steps forward one step back is how I would characterize it, but we're moving ever forward. When you just look at the basic fundamental principle of, is the operation inside that building working well; are people learning the processes; are we gaining efficiency week-to-week; are we getting goods in; are we getting goods out -- all the answers to all those questions are yes. And I think we are getting to the point right now -- let's see we have been live nine or 10 weeks.

We're getting to the point right now which I think for two months out is actually very encouraging, which is the point we are at now instead of just worrying about day-to-day can I get it done? I think that what they are focusing on out there in terms of our Head of Logistics and the gentleman who runs our distribution center and all of their team, they are focusing on driving efficiency. I think they are very confident about the time fiscal '05 rolls around here that we will be humming.

John, I don't think anything has changed about how we feel about what is the potential for this facility is in terms of improving our capability, and I don't think it has changed our view of how we're going to supply our stores next year. So all that remains solidly in place.

David Magee, Robinson-Humphrey.

Just a couple of questions. One is you talk about the same-store sales for the off mall locations being positive. Can you comment about the gross margins for those stores and the variance you might have seen there compared to the variance at the mall stores? Are you seeing any stability there that you have not seen in the malls on the gross margin side?

I don't know that we have actually looked at that calculation, and maybe you could call us later, but what I would say is, sales have been better and profitability year-to-date is better. That would suggest to you that margins have been pretty good.

Secondly, as you talk to your best customers out there or your store managers talk to your best customers, one is they come to your store by routine, what are they telling you as far as what they are seeing in the store versus what they like to see in the store? Whether it is price points or assortments or breadth, what are your best customers telling you right now?

David, we are in the process right now of surveying the store managers for exactly that information. I don't have a great deal to say about that at the moment. I think we can certainly talk about that after we get the results of this back. I don't mean not to answer you, but I think will have something hopefully fairly definitive to say. We are asking them about a lot of things, and that is about frequency and about the things they like and the things that they don't like about the style and a number of things that are certainly key to buying decisions and how we position those stores.

David, I was looking around to see if I had anything at the ready on that gross margin question, and I don't. But let me say this -- there is nothing especially in the mix to suggest that because of the mix within a non mall store versus a mall store might move margin one way or the other. So what you are kind of left with really is sales rate. Because all things equal, if the non mall stores are experiencing better sales rates and better sales rates relative to their inventory, which they are, then what that really means is you are selling through items at full margin at a higher rate than the mall stores. So basically even if markdowns are taken across the chain, they are not going to impact those non mall stores as much. I'm giving you a theory instead of numbers because I cannot find a number right now, but conceptually that is what I believe the case to be. We can certainly speak further to find real numbers.

Why don't you call us and we will get that number for you.

Kevin Foll, Next Generation Equity.

Just in terms of your guidance for the back half of the year going back to that, if I kind of dump in on the low-end of your comp guidance for the year, that still kind of implies an acceleration of trends in the fourth quarter. On a two-year basis, a pretty decent acceleration of trends in the fourth quarter, quarter to quarter from the third. Given that you said you want to take a more conservative stance, I am just wondering why not set the bar potentially lower and work up from there given the recent trends?

Like we said earlier, we can talk about how low is low. Everyone can have their opinion, and I would obviously encourage everyone to think independently on that. But we're giving our best judgment. The reasons that I gave earlier I will just repeat them.

Reason number one is, we are in a position where we can affect fourth-quarter business a whole heck of a lot more than we can affect third-quarter business sitting here on August 26.

Number two is, there is a significant amount of leverage we can get in the fourth quarter when you take into account the fact that we have really had two fourth quarters in a row where sales have been a little bit down to mid single digit down. I understand that arithmetically a two-year trend might show an acceleration in trends, but I guess we don't really look at it that way.

Okay, particularly given that you are going to be having fewer SKUs in the stores as well. I was trying to reconcile that you said you are going to be down about 25 percent in SKUs in the back half of the year, but then only down about 10 percent in inventories, and I was just trying to reconcile the difference there.

We are actually not going to be overnight down 25 percent in SKUs. I think as I was saying I think the gradual process and what we are trying -- rather than just hitting that with a meat cleaver, we're trying to look at that very thoughtfully across every category as we go through the second half of the year and very surgically and precisely massage each of those.

Let me just give you a thought, just a thought to ponder on this whole SKU question. It is like a lot of things in our business. There are these fine lines to walk, okay, but here is the thought on the SKUs.

The thought is on the one hand inferring from what you are saying there about SKUs were down and it is harder to produce the sales, I would acknowledge that if you narrowed the SKUs that in a sense you are not as broad and, therefore, maybe limit your ability to capture sales because you're not giving as many choices to the customer. But I would tell you that inside a 5000 foot box what you also do by having an assortment that is too broad is, you make it more difficult de facto to maximize and drive sales in each individual item.

So it is kind of a balancing act. It is a question of providing endless choice at one extreme versus at the other extreme maximizing each individual opportunity. That is the line we have to walk, and the judgment that we are telling you, we're giving you an opinion. Our opinion is that we are not doing a sufficient job of maximizing the item opportunities at store level.

It's just about how many great ideas can you show and execute on? One thing, we have only had about three merchandise managers in the history of this company, and none of them have ever been without great ideas and the ability to bring those into the store. But you can certainly have 100 great ideas and only the ability to show a few of those. So you burn up a lot of opportunity there. So just like Rennie said, it is all about how do you maximize what you have. So we're going to try to focus a little better.

Okay and then lastly in terms of I think someone touched on a pretty good point that this is definitely in my opinion a pretty competitive industry right now, and I think customer loyalty becomes increasingly important. I just want to benchmark what you guys are doing in terms of customer loyalty relative to what some of the other key players like Pier 1 or a Bombay or someone else would be doing right now? I know recognizing the credit card rollout is helping that. Can you just give us some feedback on that? What is the sign-up rate currently for that credit card as well? The response rate.

Sure. On customer loyalty, simultaneous with the launch of the credit card, we made sure that the program includes a loyalty program as part of it. So not only do you have the convenience of the new way of paying for your purchases at Kirkland's, but for every $150 you spend, you get a $10 coupon really, you know discount towards your next visit, your next purchase, which is actually mailed as part of your monthly mailer that comes with your credit card. So we will obviously be using that. We will be using the credit card mailers to highlight certain opportunities inside the store, and we think it's a very competitive program.

Statistically while I would probably shy away from giving a lot of specific numbers, what I can tell you is that GE who is a very experienced provider of these programs has been pleased with the launch as we have, and we have exceeded GE's internal expectations for rate of application and sign-up.

Justin Moher (ph), Lord Abbott.

Robert, just a little bit more relative to the comp trend. I don't know, you guys don't count traffic do you? Do you have traffic counters in the stores?

We do. We got those installed toward the beginning of the fourth quarter last year, so we don't have at this point year-over-year baseline to compare against. But we do have sequential numbers. So yes, we do, so do you want to follow up with that?

What is the traffic versus ticket kind of sense that you are getting in terms of the comp? You mentioned traffic being tough. Particularly now in August that you said traffic seems to really slow down. Any sense or order of magnitude, first quarter, second quarter now that we are in August?

Rennie is pulling the traffic numbers. I don't think there is any? So far I don't think there is any major difference in rate of traffic in August versus prior months. I think when it dropped toward the end of the first quarter, it has stabilized and stayed about right there.

It has kind have been the same story all year. First quarter and second quarter very similar. Average retails have been up. Our traffic has been -- although we don't have year-over-year data, when you correlate traffic to transaction volume, it is pretty clear the traffic has been below what we would want and transaction volume has been down. So on the issue of dollar retail versus -- or dollar transaction versus transaction volume or whatever, it is mostly the traffic and transaction side.

When you have higher average retail, you frequently and in our case this was the case, when you have higher average retails you frequently see a little bit of an erosion in the actual units per transaction just because your average retails are going up and we did see that. But compared to the transaction volume, it is the transaction volume that is the driver to the negative comp.

I guess what I am trying to get a sense for within the call it conversions and the traffic how much of it is macro versus micro? Meaning if you guys do get some of the merchandise stuff fixed later by November 1st or whatever going into next year, is that going to be enough to help you, or do you guys feel like there's enough macro squishiness going on right now that even with your best efforts, things will certainly improve, but maybe not as much as you would like until the micro side of things improve for this space?

Well, that is certainly possible. I would not for a moment tell you that we think if we fix everything inside the company overnight that that is going to take care of everything because there are some issues out there, and I don't know how quickly interest rates are going. It looks like the housing sales were not terribly affected by the recent rise. The recent numbers look pretty good. You know, job stuff is pretty spotty. Consumer confidence numbers are all over the place. I don't know what is happening with the election or the war in Iraq and a lot of other things that seem to be on the world's mind right now.

But again I think what we are trying to do is focus inside the store to try to get our merchandise at what we think is optimal level, and then a big effort inside the stores we really have not talked about to get our people to really focus on the IPT part of this and drive the business that way. We are coming out of our own manual manager's meeting that we had just last week. We have a very strong incentive-based program for them to drive the items per transaction and try to help us there. It is all part of optimally converting the customers that you have. So I think you take advantage of what you have, try to get as many as you can in the door, and do the best you can to be the best retailer you can be, and then it is going to be what it is going to be.

It is probably even tough to quantify to say, well, it's half because of traffic, half because of conversions. Because even in that case, if the customers walk out of the store disappointed, that may lead to traffic problems in the next visit or lack there of pickup. So you cannot necessarily blame a certain percent on traffic or a certain percent on conversions, because you don't know.

Let us be real clear here. I think we have attempted to be clear, but to be very clear about it. We have been talking about traffic all year and the data support that. But I think it is a fair assumption that the actions we are taking that are so clearly directed towards things we can control are in part a statement of our belief but the slow tropic is partly us. That is what we're saying. We're not trying to assign percentages, but we are saying it is not all external. Walk around the building here and I think the encouragement and the confidence you would sense with people around here is that if you can identify issues to address that sure is nicer than not. We believe we have a number of issues that are identifiable and addressable.

Relative to the SKU reduction, I apologize if I missed it, but in terms of is it specific categories or is it trending a little bit across each category, or where do you see the biggest opportunity there?

Well, I think it's across all categories. I think as I said earlier we're going to try to look at everything, and we are going to try to make this -- maybe it won't be 20 percent. Maybe as we look at it, it is 16 or 12 or maybe it is 22. I don't know exactly where it is going to go. I think it is a little unfair to settle the guys as they really go hard and look at this with a number. But they know what the goal is, and that is to coordinate that effort will the visual and with stores to make sure that we optimized the assortment.

Okay and then just (inaudible), Rennie, how many stores today are in the off-mall comp base?

In the comp base, there are 19. So standing here right here today, we have 289 stores, and 48 of those are all small.

Just wondering to your point about the off-mall comps being up, I suspect most if not all of those are within the last two years? Right? Do you guys get any -- what has your experience been with new stores? Do you get a honeymoon period, particularly in off-mall locations, where it may be up a little bit the first year into it and then it settles down? Or is it the converse where you start to see a nice slow build over five years?

Well, that is a good question. It is also a little bit of a tough one because so many of the openings, so many of the 48 openings have really been in the last two years. I will just give you a judgment based on the stores we have looked at. Our judgment is that -- based on the examples we have looked at, our judgment is that off-mall stores provide a great opportunity for a steady build.

Thanks, guys. Good luck.

David Rabinowitz, Kirkwood Capital.

I will try to be brief. You mentioned a conversion toward off-mall and the outperformance of off-mall stores. Have you changed your timeline and your idea of the ultimate split between on mall and off-mall stores and maybe the rate of mall store closures over the next few years?

Well, I think what we have -- the goal that we have developed internally and which we have stated to the public markets is that we would like to rationalize that store base to about equal mall and non mall as rapidly as possible. You know if we took advantage of every opportunity, that would be somewhere in 2006/2007.

I would say that what we really try to do is look at every deal very very carefully to see what the cost structure would be going forward if we renewed in a mall or as that compares to what an alternative deal would be. How that affects the market. Where we think big growth is. There are so many things that go into a real estate decision that it is really very difficult to say. I think what we have always tried to say is we are trying to put our stores where our customers are. That could be a mall. Right now in most cases it is non-mall, and we do like the occupancy cost structure of the non-mall better. Our customers are saying good things to us about shopping and visiting in those stores about the ease inconvenience.

So there are a lot of good things that we like and we also get a great co-tenancy in our sector because we are out there with the best of the home decor operators and also with very good fashion, which has the female shopper that we like. So it is great synergy and co-tenancy also.

To the extent that merchandising issues have contributed to he negative comps, does it surprise you that the off-mall stores which I assume are merchandised similarly are comping up?

Does it surprise us? I guess it would not surprise you if you believed that there has been somewhat flat or very slightly a decline in mall traffic and if you're putting your new stores in non-mall locations in some very active and highly productive locations.

Got you. Looking at your guidance for comps and in earnings for the second half of the year, is it fair to say that they are assuming fourth-quarter comps of flat to negative 5 percent and maybe slightly lower than last year's merchandise margin?

No. We gave full-year guidance, and everyone is going to do their math on the fourth quarter. I don't think your -- I think you are in the ballpark there.

Okay. Thank you.

Rob Wilson, Tiburon Research.

Just real quickly, Rennie, what did you say merchandise margins -- what happened to those in the second quarter? Where they lower, and did you give a basis points number there?

No, I don't think we gave a basis points number. But were they lower? Yes, they were.

Slightly or materially?

They were -- before I speak, let me just look at something here. They were the predominate reason for the shortfall on the GAAP gross margin line.

And mirrors as a percentage of your wall decor business approximately?

Let us look here and get the dollar amount so we can give you the percentage. Roughly 20 percent.

Got it. Thanks, guys.

Peter Benedict, CIBC.

One quick one. Rennie, other current assets were up a little over 100 percent year-over-year again, or I think that was even slightly more in the first quarter. I was just wondering what is driving that line? Thanks.

Most of that is taxes because the way our tax payments flow, Peter, basically we had estimates that were paid in the first half of the year. But the way the GAAP accounting works for the tax line, the fact that we had a loss in the second quarter creates in effect a receivable for income taxes at midyear. So when that gets broken out -- and I think that in the Q, it will be a little more than expanded balance sheet and you will be able to see it.

Great. Thank you.

Ladies and gentlemen, we are standing by with no further questions at this time. I would like to turn the conference back over to the speakers for any additional or closing comments.

We would just like to thank you everybody for joining us today, and we look forward to telling you about the Company's progress on the next call.

Once again, ladies and gentlemen, that concludes today's call. Thank you for your participation. You may disconnect at this time.