Good day everyone and welcome to Kirkland's second quarter 2018 earnings conference call. All participants will be in listen-only mode. [Operator Instructions]. After today's presentation, there will be an opportunity to ask questions. [Operator Instructions]. And please note that today's event is being recorded. I would now like to turn the conference over to Jeff Black with SCR Partners. Please go ahead.

Thank you. Good morning and welcome to the Kirkland's conference call to review results for the second quarter of fiscal 2018. On the call this morning are Mike Cairnes, Acting CEO and Nicole Strain, Interim Chief Financial Officer. The results as well as the notice of the accessibility of this conference call on a listen-only basis over the internet were announced earlier this morning in a press release that has been covered by the financial media. Except for historical information discussed during this conference call, the statements made by company management are forward looking and made pursuant to the Safe Harbor 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 3, 2018. I will now turn it over to Mike.

Thank you Jeff and good morning to everyone joining us on the call. We made progress on our key priorities on the second quarter. We tested Buy Online, Pickup in store and we are encouraged with the initial results. We significantly enhanced our infrastructure. We improved the overall efficiency of our supply chain, brought on a trend team that was integrated with merchandising and advanced our technical capabilities and capacity. Overall, we are on a stronger footing to deal with the immediate industry challenges while making progress on strategic initiatives. The leadership team has galvanized around our strategy in getting stronger as we move forward. Second quarter results were largely as anticipated when we last spoke with you in May. Revenues in the second quarter were driven by double digit increase in our e-commerce channel. We experienced healthy trends with solid comparative sales growth in fragrance and floral. Our wall and lamp categories underperformed putting pressure on our overall sales. The merchandise margin improved versus year ago levels. We benefited from higher IMU and more disciplined promotional activity with better analytics versus the year ago quarter. Operating expenses remained well controlled and the balance sheet is in good shape with no debt and ample cash to fund our plan. When you add our performances for Q1 and Q2, we are right were we wanted to be for the first half. Many of the issues that impacted Q2 will be behind us as we move into the second half. Sales for the third quarter are off to a strong start and we are on track to deliver the financial performance we outlined at the start the year. The response to our fall seasonal assortment has been quite encouraging and that in combination with the new line of licensed products is driving…

Thank you Mike. Net sales for the second quarter increased approximately 2% compared to the same period in the prior year. Consolidated comparable store sales decreased 3.9% which included an approximately 15% increase in e-commerce revenue on top of a 40% increase in the prior year. In our brick-and-mortar stores, we continue to see a higher average ticket which partially offset negative traffic and conversion during the quarter. As Mike mentioned, we attribute this decline in trend to a lack of product newness and relevance. We opened six new stores and closed five, ending the quarter with 426 stores, which is a net year-over-year gain of 20 stores, or just under 5%. We have opened 16 new stores through the second quarter and are projecting to open an additional nine stores in the third quarter of this year. It's still early, but we continue to be pleased with the 2018 class performance, which is performing well above our comp store base. We do continue to refine our analytics around new store performance and the optimal new store model. E-commerce generated $17.1 million in revenue during the quarter or just under 13% of our total revenue. This increase was driven by a combination of increases in website traffic and ticket. Our third-party drop ship initiative accounted for approximately a fourth of our e-commerce revenue in Q2 compared to 15% in Q2 of 2017. In addition to BOPUS, we continue to see sales and profitability growth potential in the third party drop ship e-commerce channel. And now moving on to margin. Gross profit margin in Q2 decreased 140 basis points from the prior year to 27.5%.The comparisons for the gross margin, merchandise margin and store occupancy cost all exclude favorable adjustments in the prior year related to shrink results and a one-time…

[Operator Instructions]. And our first questioner today will be Jeff Van Sinderen with B. Riley FBR. Please go ahead.

Hi everyone. Just a question and clarification first. Did you say merchandise margin was up 530 basis points? Did I catch that right?

It's up 50 basis points and that's after you take the one-time adjustment out of the prior year. We had favorable shrink results last year of roughly $1 million that was included in merchandise margin.

Okay. Got it. So I think kind of may be a little bit more detail on inventory would be helpful. I guess, how should we think about the timing shifts? Maybe you guys can tough on those? And then anything that relates to the change in the overall calendar, the 5third week thing? Just any color on that, I think would be helpful maybe to start.

Okay. So on the timing pieces, the 5third week last year did create a calendar shift this year. So we had Christmas receipts come in, in Q2 of this year, when historically or at least for the last year was in Q3. So that's a piece of it. Another piece of the timing was, last year at end of Q2 we were dealing with system issues at our West Coast transload facility that caused their systems to be down for an extended period of time. So we had receipts that were sitting that weren't able to be received into their inventory. So the timing is on both sides and does account for half of our inventory increase. The remaining amount is in line with the store growth and our comp for the back half of the year. I will say that we have cut some receipts out of the core categories in Q3 for some of the inventory that starts rolling over to make sure that we adjust back down to a normalized increase by the end of the third quarter.

And then, Jeff, I will bolt-on, when you add all that up, that puts us in a reasonable shape with inventory. I can tell you, currently our current clearance bucket is less than last year which speaks to the general health of our inventory and confidence that it's not going to impact Q3 margins.

Okay. Good. And I think people know that Q2 was not really your business, Mike and it wasn't really your choice of all of the assortment and the lack of newness and all that, but maybe there is more color you can share just sort of directionally in terms of some of the merchandise content changes, the lower receipts and so forth, some of the seasonal merchandise, the gifting that you have coming in for Q4? Maybe just walk us through a little bit more, that would be helpful.

Sure Jeff. Well, I would start by just reiterating, we are off to a very solid start and we do believe it's sustainable and there is a number of shifts that we made in merchandising. So the first I would illustrate is merchandising mix. Sometimes what happens in merchandising is you just tend to drive in to the same level of category buys and same space. What we did going into Q3 is, we rationalized our space and category assortments to lean in on our strengths. And so far it's working. Secondly, we have really been addressing our underperforming categories. And I am really pleased to say that many of those categories have stabilized and I believe in the future, there is even some upside in some of those. And then third, we have been punctuating and documenting trends as part of our merchandise process and bolting that on into our flow. So that's the first thing that we now do before any of the buyers build their category strategies and build their assortments going forward. And we are all leveraging third-party experts to help us with that. And then finally, what you will now start to see in stores are clear points of view around our collection and categories that make it easier for the customer to shop. So when you combine all that together, I feel really good about our prospects for Q3, Q4 and I think it's going to be even stronger as we go into 2019.

Okay. That's helpful. And then, Mike, maybe you can just touch also on how your marketing is evolving? Maybe changes for second half of this year especially around holiday? What you are doing in digital? Anything there that's new to add?

Yes. I would say that we continue to build out a great merchandising team and we are continuing to build out our digital capabilities in marketing and bolting on new capabilities as we move along. We are seeing good traction with our affiliate programs. We are getting good traction on our retargeting efforts. And all of that is going to be helpful as we go forward into the second half of the year. We continue to dial-in our performance on direct mail and get really strong ROI on that. In the future, you will see us evolve the branding piece of marketing. So this has been a 10-month process. The objective is to bring along our core customer and at the same time add on a millennial customer. And we are going to reestablish our brand position to be offering more stylish, unique, affordable home décor assets. And the customer's words, not mine, where she has referred to us as her mother store and what you will see is a creative look and a fresh feel. And we will be actually standing that up in our new next generation store that will be coming up in literally a few weeks. And once we get a read on that, we will have something that we can then start to roll out to the chain.

And Mike, have you said where that store is? That test store?

Yes. They are tearing it up right now. It's in Cool Springs, Brentwood. So it's close to our home office. And I am walking it almost day-by-day as it's building out and we are really excited about the look of that, but mostly excited about the future of our chain.

Okay. Great. And then maybe a refresh of how much your digital business is connected to a store at this point? And I guess, how you are thinking about true BOPUS versus ship to store and how that can benefit your business going forward? I think that's going to be turned on for holiday this year. And then also just maybe touching on e-com omni profitability, because I think there might be a little bit of a misconception out there about Kirkland's in general in terms of how you are competing and but maybe you are not just trying to be like a pure e-com player competing with Wayfair and Amazon, because I don't think that's the case? Any more that you can share there might help.

So let me start with BOPUS, Jeff. We are on track to completely roll out buy online, pick up in store by the end of September which will make us a true omni-channel player connecting the in-store and the online channel. Right now, we are up in 44 stores, three markets, approximately 200 SKUs. We have been pleasantly surprised by the sales that we are generating already in this pilot program without any marketing ever other than the signs that we have in stores. And we were very conservative in terms of what we would build into our plan for second half of the year. So our hope is that, it will provide a nice tailwind for us. And what it will do is, it will help us increase profitability within the e-commerce channel because the customer is going to be picking up items in inventory that has already flowed through our supply chain channels. So from a margin standpoint, it will be very much in line with what you would see in brick-and-mortar. In addition to, we believe that it's going to increase footsteps in the door as well, having the new capability. And further, we think it's going to increase differentiation and start to build a moat around us versus other competitors who are true brick-and-mortar or just true e-commerce players. So we are extremely excited about that. Now further, we are continuing to build out our ship direct channel. And so what we are saying is, is that we are leveraging third-party vendors to take on the shipping of a lot of our larger items. And in Q2, it was approximately 20% of our sales, but on the back of some very, very rapid growth. And we believe that's the channel that we want to continue to expand so that it does not put pressure on our supply chain and it stands out to be relatively profitable or more profitable type of model than you would on a direct to consumer where you are shipping goods directly to the consumer and bearing all that freight. So we are long really excited about the future of our e-com channel and how it's tying into the overall architecture and the strategy of the business.

And I think I would add, Jeff, to that on just overall profitability. Currently, e-com is profitable for us. It's less profitable than stores and a piece of that is, the least profitable is our direct to consumer business. So we really think as we rollout BOPUS, as we push the third party drop ship, there is a lot of opportunity there to continue to increase the profitability of that channel as we grow it.

Jeff, I would add one more point. This is kind of the third leg of the stool as we continue to look at e-commerce. We are continuing to see more and more customers drive their traffic through mobile and we have a lot of work that's in progress right now to enhance the mobile performance of our platform, specifically to increase the page load speed and you see that will start to take effect in Q3 as well. So we have got a lot of good things lined up for e-commerce as it relates to the profitability and the ability to continue to methodically expand this channel.

Okay. Great to hear. And then just one more for me. Any update you can give us on your direct importing plans? And maybe just touch on how that can benefit you?

Yes. So we are really now starting to speed that up. We have already put our big toe in the water. We will have some products that will start to come in Q4 that is direct imported. It will not have a material impact on the overall margin. We have contracted with a third-party expert.. We are beginning to hire a team. We have a very clear plan in place and we really believe that we will be in a position to start to really impact the overall margin as it relates to direct importing second half of next year.

Okay. So that's really, it sounds like that's an element that's going to accelerate into next year pretty significantly.

Yes.

Yes. I think where we are currently looking at it is, it won't have a significant effect until Q3 and mainly Q4 of next year. But we are in a position after that to ramp-up relatively quickly.

Okay. Good. All right. I will take the rest offline. Thanks for taking my questions. And best of luck and hope you do great.

Thank you Jeff. Appreciate that.

[Operator Instructions]. And we have a question from John Lawrence with Coker and Palmer. Please go ahead.

Yes. Thanks. Good morning.

Good morning.

Hi John.

Mike, would you comment a little bit or maybe Nicole, I am sorry, just a little clarity, I think would be helpful a little bit. Going back and I just want to make sure I get it right. Those pieces of gross margin, obviously confusing last year with the changes and the one-time. Nicole, would you mind just running over that once again just sort of comparisons the way we should look at it without the one time last year?

Yes. I think we mentioned before when we were talking about our expected performance in Q2 that there was roughly $0.10 in last year's Q2 related primarily to one-time items that we didn't expect to reoccur. One of those being significantly favorable shrink results and that hit in the merchandise margin line. And I think about these two as totaling $2.3 million and roughly half in each of these. So the first one being the shrink, the second affected store occupancy costs which hit in gross profit. And that was that a one time accounting adjustment, where we just reclassified the way we were treating our accounting entries or at least expenses.

Great.

And John, if I can pull up more from a bigger picture on margin in terms of where we are and where we are going to continue to grow our merchandise margin. So we have done some very good work in terms of de-stacking of clearance. We have introduced favorable offers like ARPI. We've revamped our loyalty program. All of these are levers that have helped us in the margin. I think the most important one is that we have built out the analytical and forecasting tools so that we can now predict based on the line-up of promotional offers and coupon offers what to expect next week, the ensuing month and the quarter and therefore, we have the opportunity to modulate that to make sure that we drive into the desired result. Now the next step for us is to build out more analysis around the individual effectiveness of individual promotions, particularly as you stack on coupon and we are really starting to ramp up that work right now. And then you combine that with the future impact of direct importing, I think we are on the right road.

Got it. And just Mike, can you give us a sense just quickly, maybe some type of a live example, what's the difference of an order just to get a sense of a difference in margin of one of those orders that goes like you are shipping it today versus that's not as profitable to a BOPUS order and what the difference in that margin can be?

Well, right now with a BOPUS order, we are basically realizing margins that are very much in line with store margin. And you can see differences on the order of over 500 basis points between an e-commerce order that is direct to store versus an order that will be BOPUS. So there is palpable difference there. I actually believe that the bigger benefit is going to be the convenience to the consumer and the ability to drive more footsteps in the door and providing more capability from Kirkland's.

And John just quickly, so once we roll this out we can give you and it largely depends on the volume and the mix of what our shifts is to BOPUS that will change that. So I think we can, in the future, once it's rolled out and we have more results, we can narrow that down.

Great. Last one for me. Mike, can you discuss a little bit, just dig into obviously the start of 3Q, if you said that you are very pleased and maybe a little ahead of plan to the start of this merchandise presentation, what would you point to? Is the traffic a little higher? The reception to the merchandise? What would you point to as sort of being maybe a little ahead of what you thought or the pleasing results so far in 3Q?

Yes. I would say we are firing at all cylinders right now. Because we have the compelling product, we are seeing a change in trajectory of our traffic. Our conversion in store is up. Our average dollar transaction is up compared to where the trends that we are seeing in Q2. And I just believe that we have put ourselves in a high probability position to win for Q3. And then we start to think about Q4. So as I mentioned in what I talked about earlier, we are thinking about Q4 in three phases. You have your consumer that's home, that's decorating her home at the beginning of the season. Then she shifts her mindset to gifting. And then you have a post-Christmas. We have historically done very well with our Christmas decor product and we have got another magnificent lineup again this year. But then we go into gifting and this year, we are really going to bring that to light. We are going to bring that special aspect that we have done in home decorating to gifting. And you will see a very significant presentation of gifting in Kirkland that is going to be very special and it's going to be thematic. And what I mean by that is you will see themes like Poliday, which relates to pets, Rosé All Day, which is a very hot trend and products and gifts that are very unique for the consumer and something that she will be delighted in. And we will have that both online as well as in store. Then BOPUS comes back into play because we now have the ability to be very relevant right up until the last week of the holiday season going into Christmas whereas last year we couldn't do that because she will now be able to pick up products and gifts in-store a day before Christmas. You shift into post-Christmas and this year which is different than last year, we will have beautiful decorative storage and home décor accents. So we will have a reason to bring her in, in addition to the enormous clearance activity that you would have. So the rigor behind second half of this year has really been exceptional. We are very excited about it. So far it's working right to plan and we just can't wait to continue this roll.

Yes. Thanks for that. And just want to clarify, the real trend change here is that there was more relevant merchandise brought into the store, say, in late July, August. Is that the point?

Yes. I will also add, we brought in and I mentioned this as well, in addition to that and this is not, we have also added a licensed product from Rae Dunn and this is just an example of some of inspiration that we are sprinkling in. She has got a very large Instagram following. She is a very large on HGTV. Her work is unique and identifiable. And she has got a strong following. And it's just giving us a little bit of topspin in addition to all of the other exciting assortments that we have in the store, all driving again another new customer into the store.

Great. Thanks for the time. Good luck.

Thank you. Appreciate it John.

Thank you.

And this will conclude our question-and-answer session. I would like to turn the conference back over to Mike Cairnes for any closing remarks.

To all the marvelous associates that are on the line and huddled around speakerphones right now in the offices, I just want to say thank you. Together, we are on a path of something really special. So buckle up. That concludes my remarks, operator. Thank you.

The conference has now concluded. Thank you for attending today's presentation and you may now disconnect.