KIRKLAND'S, INC - Quarter Report: 2005 October (Form 10-Q)

 

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended: October 29, 2005				Commission file number: 000-49885

KIRKLAND’S, INC.

(Exact name of registrant as specified in its charter)

Tennessee (State or other jurisdiction of incorporation or organization)		62-1287151 (IRS Employer Identification No.)
805 North Parkway Jackson, Tennessee (Address of principal executive offices)		38305 (Zip Code)

Registrant’s telephone number, including area code: (731) 668-2444

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES þ NO o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934). YES þ NO o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES o NO þ

As of November 29, 2005, 19,343,643 shares of the Registrant’s Common Stock, no par value, were outstanding.

 

 

KIRKLAND’S, INC.
TABLE OF CONTENTS

				Page
PART I — FINANCIAL INFORMATION:
Item 1.		Financial Statements
		Consolidated Balance Sheets at October 29, 2005 (unaudited), October 30, 2004 (unaudited), and January 29, 2005			3
		Consolidated Statements of Operations for the 13-week and 39-week periods ended October 29, 2005, and October 30, 2004 (unaudited)			4
		Consolidated Statement of Shareholders’ Equity for the 39 weeks ended October 29, 2005 (unaudited)			5
		Consolidated Statements of Cash Flows for the 39 weeks ended October 29, 2005, and October 30, 2004 (unaudited)			6
		Notes to Consolidated Financial Statements (unaudited)			7
Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations			13
Item 3.		Quantitative and Qualitative Disclosures About Market Risk			23
Item 4.		Controls and Procedures			24
PART II — OTHER INFORMATION:
Item 6.		Exhibits			25
SIGNATURES					26
EX-31.1 SECTION 302 CERTIFICATION OF THE CEO
EX-31.2 SECTION 302 CERTIFICATION OF THE CFO
EX-32.1 SECTION 906 CERTIFICATION OF THE CEO
EX-32.2 SECTION 906 CERTIFICATION OF THE CFO

KIRKLAND’S, INC.

		October 29,				October 30,				January 29,
		2005				2004				2005
						(restated)
ASSETS
Current assets:
Cash and cash equivalents		$	463			$	6,208			$	17,912
Inventories, net			57,811				50,308				37,073
Income taxes receivable			7,544				6,049				2,124
Prepaid expenses and other current assets			8,722				7,154				6,278
Deferred income taxes			1,656				1,813				1,265
Total current assets			76,196				71,532				64,652
Property and equipment, net			70,018				61,578				64,020
Other assets			1,599				2,166				1,465
Total assets		$	147,813			$	135,276			$	130,137
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Revolving line of credit		$	3,674			$	16,210			$	—
Accounts payable			35,476				27,715				22,199
Accrued expenses			16,997				14,729				14,936
Total current liabilities			56,147				58,654				37,135
Deferred income taxes			2,263				—				2,376
Deferred rent and other			33,061				23,068				25,506
Total liabilities			91,471				81,722				65,017
Shareholders’ equity:
Common stock, no par value; 100,000,000 shares authorized; 19,339,224, 19,260,048 and 19,264,412 shares issued and outstanding at October 29, 2005, October 30, 2004, and January 29, 2005, respectively			139,034				138,594				138,607
Loan to shareholder			—				(612	)			(619	)
Accumulated deficit			(82,692	)			(84,428	)			(72,868	)
Total shareholders’ equity			56,342				53,554				65,120
Total liabilities and shareholders’ equity		$	147,813			$	135,276			$	130,137

The accompanying notes are an integral part of these financial statements.

KIRKLAND’S, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)

		13 Week Period Ended								39 Week Period Ended
		October 29,				October 30,				October 29,				October 30,
		2005				2004				2005				2004
						(restated)								(restated)
Net sales		$	90,200			$	82,815			$	261,683			$	250,127
Cost of sales (exclusive of depreciation and amortization as shown below)			64,516				58,231				189,692				177,286
Gross profit			25,684				24,584				71,991				72,841
Operating expenses:
Compensation and benefits			17,147				16,556				50,712				46,832
Other operating expenses			8,767				9,320				26,720				24,915
Depreciation and amortization			3,843				3,065				10,919				8,425
Non-cash stock compensation charge			—				77				—				211
Total operating expenses			29,757				29,018				88,351				80,383
Operating loss			(4,073	)			(4,434	)			(16,360	)			(7,542	)
Interest expense:
Revolving line of credit			80				178				153				368
Loss on early termination of indebtedness			—				364				—				364
Amortization of debt issue costs			6				38				16				143
Total interest expense			86				580				169				875
Interest income			—				(8	)			(90	)			(46	)
Other income			(60	)			(61	)			(201	)			(153	)
Loss before income taxes			(4,099	)			(4,945	)			(16,238	)			(8,218	)
Income tax benefit			(1,620	)			(1,953	)			(6,414	)			(3,246	)
Net loss		$	(2,479	)		$	(2,992	)		$	(9,824	)		$	(4,972	)
Earnings (loss) per share:
Basic		$	(0.13	)		$	(0.16	)		$	(0.51	)		$	(0.26	)
Diluted		$	(0.13	)		$	(0.16	)		$	(0.51	)		$	(0.26	)
Weighted average number of shares outstanding:
Basic			19,336				19,253				19,309				19,214
Diluted			19,336				19,253				19,309				19,214

The accompanying notes are an integral part of these financial statements.

KIRKLAND’S, INC.

		Common Stock								Loan to				Accumulated				Total
		Shares				Amount				Shareholder				Deficit				Equity
Balance at January 29, 2005			19,264,412			$	138,607			$	(619	)		$	(72,868	)		$	65,120
Exercise of employee stock options and employee stock purchases			74,812				403												403
Tax benefit from exercise of stock options							24												24
Repayment of shareholder loan, net of interest accrued											619								619
Net loss															(9,824	)			(9,824	)
Balance at October 29, 2005			19,339,224			$	139,034			$	—			$	(82,692	)		$	56,342

The accompanying notes are an integral part of these financial statements.

KIRKLAND’S, INC.

		39 Week Period Ended
		October 29,				October 30,
		2005				2004
						(restated)
Cash flows from operating activities:
Net loss		$	(9,824	)		$	(4,972	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation of property and equipment			10,919				8,425
Amortization of tenant allowance			(2,999	)			(1,722	)
Amortization of debt issue costs			15				143
Loss on early termination of indebtedness			—				139
Non-cash stock compensation charge			—				211
Loss on disposal of property and equipment			724				171
Deferred income taxes			(504	)			(165	)
Changes in assets and liabilities:
Inventories, net			(20,738	)			(8,734	)
Prepaid expenses and other current assets			(2,444	)			416
Other noncurrent assets			(137	)			—
Accounts payable			13,277				7,720
Income taxes receivable			(5,396	)			(12,432	)
Accrued expenses and other noncurrent liabilities			12,662				7,135
Net cash used in operating activities			(4,445	)			(3,665	)
Cash flows from investing activities:
Capital expenditures			(17,641	)			(23,929	)
Net cash used in investing activities			(17,641	)			(23,929	)
Cash flows from financing activities:
Borrowings on revolving line of credit			139,000				40,554
Repayments on revolving line of credit			(135,326	)			(24,344	)
Refinancing costs			(12	)			(95	)
Exercise of stock options and employee stock purchases			356				256
Repayment of shareholder loan, net of interest accrued			619				8
Net cash provided by financing activities			4,637				16,379
Cash and cash equivalents:
Net decrease		$	(17,449	)		$	(11,215	)
Beginning of the period			17,912				17,423
End of the period		$	463			$	6,208

The accompanying notes are an integral part of these financial statements.

KIRKLAND’S, INC.

Note 1 — Basis of Presentation

     We are a leading specialty retailer of home décor in the United States, operating 334 stores in 37 states as of October 29, 2005. Our consolidated financial statements include the accounts of Kirkland’s, Inc. and our wholly owned subsidiaries. All significant intercompany accounts and transactions have been eliminated.

     The accompanying consolidated financial statements, except for the January 29, 2005 consolidated balance sheet, have been prepared without audit. In our opinion, the financial statements contain all adjustments, consisting only of normal recurring accruals, which are necessary to state fairly and in accordance with generally accepted accounting principles (GAAP) our financial position as of October 29, 2005, October 30, 2004, and January 29, 2005; the results of our operations for the 13-week and 39-week periods ended October 29, 2005, and October 30, 2004; and our cash flows for the 39-week periods ended October 29, 2005, and October 30, 2004. It should be understood that accounting measurements at interim dates inherently involve greater reliance on estimates than those at fiscal year end. In addition, because of seasonality factors, the results of our operations for the 13-week and 39-week periods ended October 29, 2005, are not indicative of the results to be expected for the entire fiscal year. Our fiscal year ends on the Saturday closest to January 31, resulting in years of either 52 or 53 weeks. All references to a fiscal year refer to the fiscal year ending on the Saturday closest to January 31 of the following year.

     The accompanying unaudited consolidated financial statements have been prepared in accordance with the requirements for Form 10-Q and do not include all the disclosures normally required in annual financial statements prepared in accordance with GAAP; however, we believe that the disclosures are adequate to make the information presented not misleading. These financial statements should be read in conjunction with the audited financial statements included in our Annual Report on Form 10-K filed with the Securities and Exchange Commission on April 14, 2005.

Note 2 — Restatement of Prior Financial Information

     We restated our consolidated balance sheet at October 30, 2004, our consolidated statements of operations for the 13-week and 39-week periods ended October 30, 2004, and our consolidated statement of cash flows for the 39-week period ended October 30, 2004. The restatement also affected periods prior to fiscal 2004. The restatement corrected our historical accounting for operating leases, specifically our treatment of the store construction or “build-out” period and store construction allowances. For information with respect to the restatement, see “Note 2” to the consolidated financial statements contained in our Annual Report on Form 10-K for fiscal 2004. Throughout this Form 10-Q, all referenced amounts for affected prior periods and prior period comparisons reflect the balances and amounts on a restated basis.

     As a result of this restatement, our financial results have been adjusted as follows (in thousands, except per share data):

		As Previously
		Reported								As Restated
		October 30,								October 30,
		2004				Adjustments				2004
Selected Balance Sheet Data:
Property and equipment, net			$61,578				$    —				$61,578
Other assets			1,475				691				2,166
Deferred rent and other			20,967				2,101				23,068
Accumulated deficit			(83,018	)			(1,410	)			(84,428	)
Total shareholders’ equity			54,964				(1,410	)			53,554

Note 2 — Restatement of Prior Financial Information (Continued)

		13 Week Period Ended
		As Previously
		Reported								As Restated
		October 30,								October 30,
		2004				Adjustments				2004
Net sales		$	82,815			$	—			$	82,815
Cost of sales (exclusive of depreciation and amortization as shown)			58,092				139				58,231
Gross Profit			24,723				(139	)			24,584
Total other operating expenses			25,953				—				25,953
Depreciation and amortization			3,065				—				3,065
Operating loss			(4,295	)			(139	)			(4,434	)
Total interest expense			580				—				580
Other income, net			(69	)			—				(69	)
Loss before income taxes			(4,806	)			(139	)			(4,945	)
Income tax benefit			(1,898	)			(55	)			(1,953	)
Net loss		$	(2,908	)		$	(84	)		$	(2,992	)
Earnings (loss) per share:
Basic		$	(0.15	)		$	(0.01	)		$	(0.16	)
Diluted		$	(0.15	)		$	(0.01	)		$	(0.16	)

		39 Week Period Ended
		As Previously
		Reported								As Restated
		October 30,								October 30,
		2004				Adjustments				2004
Net sales		$	250,127			$	—			$	250,127
Cost of sales (exclusive of depreciation and amortization as shown)			176,868				418				177,286
Gross Profit			73,259				(418	)			72,841
Total other operating expenses			71,958				—				71,958
Depreciation and amortization			8,425				—				8,425
Operating loss			(7,124	)			(418	)			(7,542	)
Total interest expense			875				—				875
Other income, net			(199	)			—				(199	)
Loss before income taxes			(7,800	)			(418	)			(8,218	)
Income tax benefit			(3,081	)			(165	)			(3,246	)
Net loss		$	(4,719	)		$	(253	)		$	(4,972	)
Earnings (loss) per share:
Basic		$	(0.25	)		$	(0.01	)		$	(0.26	)
Diluted		$	(0.25	)		$	(0.01	)		$	(0.26	)

Note 2 — Restatement of Prior Financial Information (Continued)

		39 Week Period Ended
		As Previously
		Reported								As Restated
		October 30,								October 30,
		2004				Adjustments				2004
Selected Cash Flow Data:
Cash flows from operating activities		$	(3,665	)		$	—			$	(3,665	)
Cash flows from investing activities			(23,929	)			—				(23,929	)
Cash flows from financing activities			16,379				—				16,379
Net decrease in cash		$	(11,215	)		$	—			$	(11,215	)

Note 3 — Stock Compensation

     We apply Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related Interpretations, in accounting for our stock compensation plans. Compensation cost on stock options is measured as the excess, if any, of the fair value of our common stock at the date of the grant over the exercise price. Pursuant to SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure—an Amendment of FASB Statement No. 123,” the following table illustrates the effect on net income and earnings per share had we applied the fair value recognition provisions of SFAS No. 123, “Accounting for Stock-Based Compensation.”

		13 Weeks Ended								39 Weeks Ended
		October 29,				October 30,				October 29,				October 30,
		2005				2004				2005				2004
		($ in thousands, except per share amounts)
						(restated)								(restated)
Net loss as reported		$	(2,479	)		$	(2,992	)		$	(9,824	)		$	(4,972	)
Add: Stock-based compensation cost, included in determination of net loss			—				77				—				211
Deduct: Stock-based compensation cost, net of taxes, determined under the fair value based method for all awards			(146	)			(168	)			(549	)			(538	)
Pro forma net loss		$	(2,625	)		$	(3,083	)		$	(10,373	)		$	(5,299	)
Earnings (loss) per share:
Basic, as reported		$	(0.13	)		$	(0.16	)		$	(0.51	)		$	(0.26	)
Basic, pro forma		$	(0.14	)		$	(0.16	)		$	(0.54	)		$	(0.28	)
Diluted, as reported		$	(0.13	)		$	(0.16	)		$	(0.51	)		$	(0.26	)
Diluted, pro forma		$	(0.14	)		$	(0.16	)		$	(0.54	)		$	(0.28	)

Note 4 — Earnings Per Share

     Basic earnings per share are based upon the weighted average number of shares outstanding. Diluted earnings per share are based upon the weighted average number of shares outstanding plus the shares that would be outstanding assuming exercise of dilutive stock options and warrants.

     The computations for basic and diluted earnings per share are as follows (in thousands, except for per share amounts):

		13 Weeks Ended								39 Weeks Ended
		October 29,				October 30,				October 29,				October 30,
		2005				2004				2005				2004
						(restated)								(restated)
Numerator:
Net loss		$	(2,479	)		$	(2,992	)		$	(9,824	)		$	(4,972	)
Denominator:
Denominator for basic loss per share — weighted average number of common shares outstanding			19,336				19,253				19,309				19,214
Effect of dilutive securities			—				—				—				—
Denominator for diluted loss per share			19,336				19,253				19,309				19,214
Earnings (loss) per common share:
Basic		$	(0.13	)		$	(0.16	)		$	(0.51	)		$	(0.26	)
Diluted		$	(0.13	)		$	(0.16	)		$	(0.51	)		$	(0.26	)

     The calculation of diluted earnings per share for the 13-week period ended October 29, 2005, and October 30, 2004, excludes stock options of 1,127,510 and 554,312, respectively, as the effect of their inclusion would be anti-dilutive.

     The calculations of diluted earnings per share for the 39-week period ended October 29, 2005, and October 30, 2004, exclude stock options of 1,005,195 and 570,938, respectively, as the effect of their inclusion would be anti-dilutive.

Note 5 — Revolving Credit Facility

     Effective October 4, 2004, we entered into a new, five-year senior secured revolving credit facility with a revolving loan limit of up to $45 million. The revolving credit facility bears interest at a floating rate equal to the 60-day LIBOR rate (4.20% at October 29, 2005) plus 1.25% to 1.50% (depending on the amount of excess availability under the borrowing base). Additionally, we pay a fee to the bank equal to a rate of 0.2% per annum on the unused portion of the revolving line of credit. Borrowings under the facility are collateralized by substantially all of the Company’s assets and guaranteed by our subsidiaries. The maximum availability under the credit facility is limited by a borrowing base formula, which consists of a percentage of eligible inventory less reserves. The facility also contains provisions that could result in changes to the presented terms or the acceleration of maturity. Circumstances that could lead to such changes or acceleration include a material adverse change in the business or an event of default under the credit agreement. The facility has one financial covenant that requires us to maintain excess availability under the borrowing base, as defined in the credit agreement, of $3 million at all times. As of October 29, 2005, we were in compliance with this covenant. The facility matures in October 2009. As of October 29, 2005, there was approximately $3.7 million in outstanding borrowings under the credit facility, with approximately $32.8 million available for borrowing (net of the $3 million availability block as described above).

Note 6 — Related Parties

  Shareholder Loan

     On May 4, 2002, we loaned $217,000 to our Executive Vice President and Chief Financial Officer. The note bore interest at the rate of 4.75% per year, and was payable over the term of the note. On April 10, 2003, we advanced an additional $381,401 to the borrower in accordance with the original terms of the note. This additional

Note 6 — Related Parties (Continued)

principal amount was subject to the same interest rate and principal repayment terms as the original principal amount. The loan was collateralized by marketable securities having a value of no less than the original principal amount of the loan together with 125,526 shares of our common stock owned by the borrower. The loan was approved by our Board of Directors and Audit Committee. The note principal and accrued interest was repaid in full during the first quarter of 2005.

Note 7 — Recent Accounting Standards

     In November 2004, the FASB issued SFAS No. 151 (“SFAS 151”), “Inventory Costs,” which clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material. The statement is effective for fiscal years beginning after June 15, 2005. We do not believe that the adoption of SFAS No. 151 will have a material impact on our financial statements.

     In December 2004, the FASB issued SFAS No. 123 (Revised) (“SFAS 123R”), “Share-Based Payment,” a revision of SFAS No. 123, “Accounting for Stock-Based Compensation.” SFAS No. 123R requires the fair value measurement of all stock-based payments to employees, including grants of employee stock options, and recognition of those expenses in the statement of operations. SFAS No. 123R is effective at the beginning of the next fiscal year after June 15, 2005. We will continue to account for stock-based compensation using the intrinsic value method until adoption of SFAS No. 123R on January 29, 2006. SFAS No. 123(R) permits public companies to adopt its requirements using one of the following methodologies.

	i)		a “modified prospective” approach wherein compensation cost is recognized beginning with SFAS No. 123R’s effective date (a) based on the requirements of SFAS No. 123R for all share-based payments granted after the effective date and (b) based on the requirements of SFAS No. 123 for all awards granted to employees prior to the effective date that remain unvested on such date, or
	ii)		a “modified retrospective” approach that includes all of the requirements of the modified prospective method and also permits entities to restate their financial statements based on the pro forma amounts previously disclosed pursuant to SFAS No. 123 in either (a) all prior periods presented or (b) prior interim periods in the year of adoption.

     As permitted by SFAS No. 123, we currently account for share-based payments to employees using the intrinsic value method under APB Opinion No. 25 and, as such, we recognize no compensation cost for employee stock options. Therefore, our adoption of the fair value method under SFAS No. 123R will have a significant impact on our results of operations; however, it will have no impact on our consolidated financial position. The precise impact of the adoption of SFAS No. 123R cannot be predicted at this time because it will depend on the levels of share-based payments we grant in the future (we are currently evaluating the utilization of stock options as a component of our employee compensation and retention strategies). Had we adopted SFAS No. 123R in prior periods, the impact of such accounting pronouncement would have approximated that which is described in the SFAS No. 123 pro forma disclosures at Note 3.

     In December 2004, the FASB issued Statement No. 153 (“SFAS 153”), “Exchanges of Nonmonetary Assets,” an amendment of APB Opinion No. 29 (“APB 29”), “Accounting for Nonmonetary Transactions.” SFAS 153 amends APB 29 to eliminate the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. A nonmonetary asset exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. SFAS 153 is effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. We do not anticipate that SFAS 153 will have a material impact on our financial statements.

     In March 2005, the FASB issued Interpretation No. 47 (“FIN 47”), “Accounting for Conditional Asset Retirement Obligations,” an interpretation of FASB issued Statement No. 143 (“SFAS 143”), “Accounting for Asset Retirement Obligations.” FIN 47 clarifies that the term “conditional asset retirement obligation” as used in SFAS 143 refers to a legal obligation to perform an asset retirement activity in which the timing and (or) method of settlement are conditional on a future event that may or may not be within the control of the entity. The obligation to

Note 7 — Recent Accounting Standards (Continued)

perform the asset retirement activity is unconditional even though uncertainty exists about the timing and (or) method of settlement. FIN 47 also clarifies when an entity would have sufficient information to reasonably estimate the fair value of an asset retirement obligation. FIN 47 is effective no later than the end of fiscal years ending after December 15, 2005. Retrospective application for interim financial information is permitted but is not required. We do not anticipate that FIN 47 will have a material impact on our financial statements.

     In May 2005, the FASB issued Statement No. 154 (“SFAS 154”), “Accounting Changes and Error Corrections,” a replacement of APB Opinion No. 20 (“APB 20”), “Accounting Changes,” and FASB issued Statement No. 3 (“SFAS 3”), “Reporting Accounting Changes in Interim Financial Statements.” SFAS 154 requires retrospective application to prior periods’ financial statements of changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. This statement requires that retrospective application of a change in accounting principle be limited to the direct effects of a change. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005.

Note 8 — Subsequent events

     On November 15, 2005, the Compensation Committee of our Board of Directors approved the accelerated vesting of certain unvested stock options that had exercise prices exceeding the closing market price of $7.05 at October 29, 2005, by more than 100% and that were granted more than two years ago. Only one stock option grant met this condition, which was the August 28^th, 2003 grant to certain management employees which had an exercise price of $18.55 per share. As a result of the vesting acceleration, 15,582 options from this grant became immediately exercisable. These options were scheduled to vest over the first two quarters of fiscal 2006. The effect of the vesting acceleration will be the recognition of approximately $116,000, net of tax, of additional stock-based employee compensation in our pro forma footnote disclosure for the fourth quarter of fiscal 2005, which would otherwise have been recognized in our income statement as compensation expense over the first two quarters of fiscal 2006 after the adoption of FAS 123(R). Because these stock options have exercise prices significantly in excess of our current stock price, we believe that the future charge to earnings that would be required under FAS 123(R) for the remaining original fair value of the stock options is not an accurate reflection of economic value to the employees holding them and that the options are not fully achieving their original objectives of employee motivation and retention. FAS 123(R) is effective for the Company at the beginning of fiscal year 2006.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

General

     We are a leading specialty retailer of home décor in the United States, operating 334 stores in 37 states as of October 29, 2005. Our stores present a broad selection of distinctive merchandise, including framed art, mirrors, candles, lamps, accent furniture, accent rugs, garden accessories and artificial floral products. Our stores also offer an extensive assortment of holiday merchandise, as well as items carried throughout the year suitable for giving as gifts.

     Our stores offer 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 and have expanded our store base into different regions of the country. During the past seven years, we have more than doubled our store base, principally through new store openings. We intend to continue opening new stores both in existing and new markets. We believe there are currently more than 650 additional locations in the United States that could support a Kirkland’s store. We opened 26 new stores in the third quarter of fiscal 2005 and closed 5 stores. We plan on opening 59 new stores and closing 32 stores in fiscal 2005. All of our new store openings during fiscal 2005 will be in off-mall venues, while substantially all of our closings will be stores located in mall venues. Our results to date in our off-mall stores indicate that this venue provides the better opportunity for growth in our store base.

     The following table summarizes our stores and square footage under lease in mall and off-mall locations:

		Stores								Square Footage								Average Store Size
		10/29/05				10/30/04				10/29/05				10/30/04				10/29/05				10/30/04
Mall			211				241				984,024				1,105,194				4,664				4,586
Off-Mall			123				64				682,590				317,071				5,550				4,954
Total			334				305				1,666,614				1,422,265				4,990				4,663

Restatement of Prior Financial Information

     We have restated the consolidated balance sheet as of October 30, 2004, the consolidated statements of operations for the 13 and 39 weeks ended October 30, 2004, and the consolidated statement of cash flows for the 39 weeks ended October 30, 2004 in this Quarterly Report on Form 10-Q. The restatement also affected periods prior to fiscal 2004. The restatement corrected our historical accounting for operating leases. The restatement adjustments were non-cash and had no impact on revenues, comparable store sales or operating cash flows. For information with respect to the restatement, see “Note 2” to the consolidated financial statements contained in our Annual Report on Form 10-K for fiscal 2004. We did not amend our Quarterly Reports on Form 10-Q for the periods before the end of fiscal 2004 to reflect the restatement. Throughout “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” all referenced amounts for affected prior periods and prior period comparisons reflect the balances and amounts on a restated basis.

13 Weeks Ended October 29, 2005 Compared to the 13 Weeks Ended October 30, 2004

     Results of operations. The table below sets forth selected results of our operations in dollars expressed as a percentage of net sales for the periods indicated (dollars in thousands):

		13 Week Period Ended
		October 29, 2005								October 30, 2004								Change
		$				%				$				%				$				%
										(restated)
Net sales		$	90,200				100.0	%		$	82,815				100.0	%		$	7,385				8.9	%
Cost of sales			64,516				71.5	%			58,231				70.3	%			6,285				10.8	%
Gross profit			25,684				28.5	%			24,584				29.7	%			1,100				4.5	%

		13 Week Period Ended
		October 29, 2005								October 30, 2004								Change
		$				%				$				%				$				%
Operating expenses:
Compensation and benefits			17,147				19.0	%			16,556				20.0	%			591				3.6	%
Other operating expenses			8,767				9.7	%			9,320				11.3	%			(553	)			(5.9	%)
Depreciation and amortization			3,843				4.3	%			3,065				3.7	%			778				25.4	%
Non-cash stock compensation charge			—				0.0	%			77				0.1	%			(77	)			(100.0	%)
Total operating expenses			29,757				33.0	%			29,018				35.0	%			739				2.5	%
Operating loss			(4,073	)			(4.5	%)			(4,434	)			(5.4	%)			361				(8.1	%)
Interest expense, net			86				0.1	%			580				0.7	%			(494	)			(85.2	%)
Other income			(60	)			(0.1	%)			(69	)			(0.1	%)			9				(13.0	%)
Loss before income taxes			(4,099	)			(4.5	%)			(4,945	)			(6.0	%)			846				(17.1	%)
Income tax benefit			(1,620	)			(1.8	%)			(1,953	)			(2.4	%)			333				(17.1	%)
Net loss		$	(2,479	)			(2.7	%)		$	(2,992	)			(3.6	%)		$	513				(17.1	%)

     Net sales. Net sales increased by 8.9% to $90.2 million for the third quarter of fiscal 2005 from $82.8 million for the third quarter of fiscal 2004. The overall increase in net sales was due to the growth in our store base. We opened 45 new stores during the first three quarters of fiscal 2005 and 54 stores in fiscal 2004, and we closed 31 stores during the first three quarters of fiscal 2005 and 14 stores in fiscal 2004. We ended the third quarter of fiscal 2005 with 334 stores in operation compared to 305 stores as of the end of the third quarter of fiscal 2004, representing a 9.5% increase in the store base. The impact of these changes in the store base was offset by a decline of 3.4% in comparable store sales for the third quarter of fiscal 2005. During the third quarter of fiscal 2004, comparable store sales decreased 13.5%. The growth in the store base along with sales from expanded, remodeled or relocated stores accounted for an increase in net sales of $9.8 million over the prior year quarter. This increase was partially offset by the negative comparable store sales performance, which accounted for a $2.4 million decrease from the prior year quarter.

     The comparable store sales decline for the quarter was primarily due to a continuation of weak customer traffic trends. Sales were also negatively affected by the series of hurricanes that disrupted business and caused store closings in Louisiana, Mississippi, Alabama, and Texas. We estimate the sales loss due to the hurricanes to be approximately $1.3 million, or 0.7% in comparable store sales for the quarter. The decline in customer traffic led to a decrease in the number of transactions despite an increase in customer conversion rates. Offsetting this decline, we experienced an increase in the average dollar transaction due to increases in the number of items sold per transaction and in the average retail selling price. Prominent categories that experienced comparable store sales decreases included framed art and lamps. Categories showing positive sales results were alternative wall décor, furniture, decorative accessories, mirrors, floral and candles. Sales performance was noticeably better in our off-mall stores in comparison to our mall stores. Comparable store sales for off-mall stores increased 0.9% for the quarter compared to a comparable store sales decrease of 4.7% for mall stores. Average sales volumes in comparable off-mall stores were 26% higher than those of comparable mall stores during the quarter.

     Gross profit. Gross profit increased $1.1 million, or 4.5%, to $25.7 million for the third quarter of fiscal 2005 from $24.6 million for the third quarter of fiscal 2004. Gross profit expressed as a percentage of net sales decreased to 28.5% from 29.7% for the third quarter of fiscal 2004. The decrease in gross profit as a percentage of net sales was primarily the result of a decrease in product margin due to increased promotional discounts and markdowns. These strategies were employed in an attempt to improve sales and customer traffic. Occupancy costs increased slightly as a percentage of net sales due to the de-leveraging effect of the comparable store sales decline. The shift to more off-mall stores with lower occupancy costs per square foot helped to mitigate the impact of the sales decline on this ratio. Freight costs decreased as a percentage of sales as we continued to realize freight savings due to the implementation of changes in our store delivery methods. Central distribution costs as a percentage of sales remained unchanged compared to the prior year quarter.

     Compensation and benefits. Compensation and benefits, including both store and corporate personnel, was $17.1 million, or 19.0% of net sales, for the third quarter of fiscal 2005 as compared to $16.6 million, or 20.0% of net sales for the third quarter of fiscal 2004. The decrease in the compensation and benefits expense ratio was primarily due to tighter control over store-level payroll dollars in response to the sales trend. At the corporate level, the expense ratio was relatively flat versus the prior year quarter.

     Other operating expenses. Other operating expenses, including both store and corporate costs, were $8.8 million, or 9.7% of net sales, for the third quarter of fiscal 2005 compared with $9.3 million, or 11.3% of net sales, for the third quarter of fiscal 2004. The decrease in these operating expenses as a percentage of net sales was primarily the result of reductions in store-level storage costs and related equipment rental expense due to lower inventory levels and the increasing prevalence of off-mall stores. Advertising expenses were lower than prior year due to decisions to shift advertising dollars to focus on the fourth quarter. Further, we also experienced decreases in professional fees and travel expenses.

     Depreciation and amortization. Depreciation and amortization expense was $3.8 million, or 4.3% of net sales, for the third quarter of fiscal 2005 compared to $3.1 million, or 3.7% of net sales, for the third quarter of fiscal 2004. The increase in the ratio was the result of the negative comparable store sales performance, along with the growth in our store base. Additionally, lease terms for many of our recent off-mall store openings have been shorter than the historical lease term for a mall store, resulting in higher amortization expense on the associated leasehold improvements for these stores.

     Non-cash stock compensation charge. During the third quarter of fiscal 2004, we incurred a non-cash stock compensation charge of $77,000, or 0.1% of net sales in each period, related to certain stock options granted to employees in November 2001 that had an exercise price that was less than the fair value of the underlying common stock on the date of the grant. There was no such charge incurred during the third quarter of 2005, as these options are now fully-vested.

     Interest expense, net. Net interest expense was $86,000, or 0.1% of net sales, for the third quarter of fiscal 2005 as compared to net interest expense of $580,000, or 0.7% of net sales, for the third quarter of fiscal 2004. During the prior year quarter, we refinanced our bank line of credit and incurred a one-time early termination charge and write-off of issue costs totaling $364,000. Additionally, revolver borrowings were below prior year levels throughout the quarter.

     Income tax benefit. Income tax benefit was $1.6 million, or 39.5% of the loss before income taxes, for the third quarter of fiscal 2005 as compared to a benefit of $2.0 million, or 39.5% of loss before income taxes, for the third quarter of fiscal 2004.

     Net loss and loss per share. As a result of the foregoing, we reported a net loss of $2.5 million, or ($0.13) per share, for the third quarter of fiscal 2005 as compared to net loss of $3.0 million, or ($0.16) per share, for the third quarter of fiscal 2004.

39 Weeks Ended October 29, 2005 Compared to 39 Weeks Ended October 30, 2004

     Results of Operations. The table below sets forth selected results of our operations in dollars and expressed as a percentage of net sales for the periods indicated (dollars in thousands):

		39 Week Period Ended
		October 29, 2005								October 30, 2004								Change
		$				%				$				%				$				%
										(restated)
Net sales		$	261,683				100.0	%		$	250,127				100.0	%		$	11,556				4.6	%
Cost of sales			189,692				72.5	%			177,286				70.9	%			12,406				7.0	%
Gross profit			71,991				27.5	%			72,841				29.1	%			(850	)			(1.2	%)
Operating expenses:
Compensation and benefits			50,712				19.4	%			46,832				18.7	%			3,880				8.3	%

		39 Week Period Ended
		October 29, 2005								October 30, 2004								Change
		$				%				$				%				$				%
										(restated)
Other operating expenses			26,720				10.2	%			24,915				10.0	%			1,805				7.2	%
Depreciation and amortization			10,919				4.2	%			8,425				3.4	%			2,494				29.6	%
Non-cash stock compensation charge			—				0.0	%			211				0.1	%			(211	)			(100.0	%)
Total operating expenses			88,351				33.8	%			80,383				32.1	%			7,968				9.9	%
Operating loss			(16,360	)			(6.3	%)			(7,542	)			(3.0	%)			(8,818	)			(116.9	%)
Interest expense (income), net			169				0.1	%			875				0.3	%			(706	)			(80.7	%)
Other income			(291	)			(0.1	%)			(199	)			(0.1	%)			(92	)			46.2	%
Loss before income taxes			(16,238	)			(6.2	%)			(8,218	)			(3.3	%)			(8,020	)			(97.6	%)
Income tax provision (benefit)			(6,414	)			(2.5	%)			(3,246	)			(1.3	%)			(3,168	)			(97.6	%)
Net income (loss)		$	(9,824	)			(3.8	%)		$	(4,972	)			(2.0	%)		$	(4,852	)			(97.6	%)

     Net sales. Net sales increased by 4.6% to $261.7 million for the first three quarters of fiscal 2005 from $250.1 million for the prior year period. The net sales increase resulted primarily from the growth in our store base. We opened 45 new stores during the first three quarters of fiscal 2005 and 54 stores in fiscal 2004, and we closed 31 stores during the first three quarters of fiscal 2005 and 14 stores in fiscal 2004. We ended the third quarter with 334 stores in operation compared to 305 stores as of the end of the third quarter of fiscal 2004, representing a 9.5% increase in the store base. Comparable store sales decreased 8.1% for the first three quarters against a 5.4% decrease in comparable store sales for the prior year period. The comparable store sales decline for the period was primarily the result of a difficult sales environment characterized by slow customer traffic and a weaker than expected response to our merchandise offering and the home décor sector in general. The decrease in comparable store sales accounted for a sales decline of $17.4 million as compared to the prior year period. This decrease was offset by the effect of the net increase in the store base along with sales from expanded, remodeled or relocated stores that collectively accounted for approximately $29.0 million. Prominent categories that experienced comparable store sales increases for the period included textiles, floral, candles, furniture, and alternative wall decor. These increases were offset by declines in gift/novelty, framed art, lamps, garden, and housewares. Sales for the first three quarters of fiscal 2005 were characterized by declines in customer traffic and transaction volumes offset by a slight increase in the average dollar transaction. Sales performance was noticeably better in our off-mall stores in comparison to our mall stores. Comparable store sales for off-mall stores declined 1.4% for the first three quarters of fiscal 2005, while comparable mall stores were down 9.5%.

     Gross profit. Gross profit decreased $850,000, or 1.2%, to $72.0 million for the first three quarters of fiscal 2005 from $72.8 million for the prior year period. Gross profit expressed as a percentage of net sales decreased to 27.5% from 29.1% for the prior year period. The decrease in gross profit as a percentage of net sales was primarily the result of increased markdowns and promotional activity, particularly in the second quarter and early third quarter, to clear unproductive merchandise and in response to weakening sales trends and a decline in customer traffic. Additionally, store occupancy costs increased as a percentage of sales due to the impact of the negative comparable store sales performance on the ratio. Freight costs decreased as a percentage of sales as we realized savings from changes made to our store delivery methods and overall transportation structure. Central distribution costs were up only slightly versus the prior year period, which represented an improvement in distribution center efficiency as shipments from the distribution center to stores were 32.3% higher in the current year.

     Compensation and benefits. Compensation and benefits, including both store and corporate personnel, was $50.7 million, or 19.4% of net sales, for the first three quarters of fiscal 2005 as compared to $46.8 million, or 18.7% of net sales for the first three quarters of fiscal 2004. The increase in these expenses as a percentage of net sales was primarily the result of the lack of expense leverage due to the comparable store sales decrease. The increase also reflects corporate headcount additions that have been made over the last year in various key departments.

     Other operating expenses. Other operating expenses, including both store and corporate costs, were $26.7 million, or 10.2% of net sales, for the first three quarters of fiscal 2005 compared to $24.9 million, or 10.0% of net sales, for the first three quarters of fiscal 2004. The increase in these operating expenses as a percentage of net sales

was primarily the result of the negative comparable store sales performance. Key categories of operating expense showing increases as a percentage of sales over the prior year were utilities, telecommunications, professional fees, personnel recruitment, and relocation expenses. These increases were partially offset by reductions in store-level storage costs and related equipment rental expense due to lower inventory levels and the increasing prevalence of off-mall stores.

     Depreciation and amortization. Depreciation and amortization expense was $10.9 million, or 4.2% of net sales, for the first three quarters of fiscal 2005 compared to $8.4 million, or 3.4% of net sales, for the prior year period. This increase was the result of growth in the store base and completion of our move to a new distribution center in June 2004. Additionally, the negative comparable store sales performance contributed to an increase in the ratio to net sales.

     Non-cash stock compensation charge. During the first three quarters of fiscal 2004 we incurred a non-cash stock compensation charge of $211,000, or 0.1% of net sales in each period, related to certain stock options granted to employees in November 2001 that had an exercise price that was less than the fair value of the underlying common stock on the date of the grant. No such charge was taken during the first three quarters of fiscal 2005.

     Interest expense (income), net. Net interest expense was $169,000, or 0.1% of net sales, for the first three quarters of fiscal 2005 as compared to expense of $875,000, or 0.3% of net sales, for the prior year period. During October 2004, we refinanced our bank line of credit and incurred a one-time early termination charge and write-off of issue costs totaling $364,000. Additionally, the decrease was the result of lower average borrowings under our revolving line of credit this year as compared to the prior year.

     Income tax benefit. Income tax benefit was $6.4 million, or 39.5% of the loss before income taxes, for the first three quarters of fiscal 2005 as compared to a benefit of $3.2 million, or 39.5% of loss before income taxes for the prior year period.

     Net loss and loss per share. As a result of the foregoing, net loss was $9.8 million, or ($0.51) per share, for the first three quarters of fiscal 2005 as compared to a net loss of $5.0 million, or ($0.26) per share, for the prior year period.

Liquidity and Capital Resources

     Our principal capital requirements are for working capital and capital expenditures. Working capital consists mainly of merchandise inventories, which typically reach their peak by the end of the third 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 or 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 used in operating activities for the first three quarters of fiscal 2005 was $4.4 million compared to $3.7 million for the prior year period. The increase in the amount of cash used in operations as compared to the prior year quarter was primarily the result of the decline in our operating performance resulting from the 8.1% decrease in our comparable store sales. Inventories increased $20.7 million during the first three quarters of fiscal 2005 as compared to an increase of $8.7 million during the prior year period. Inventory levels at the beginning of fiscal 2005 were lower than in the prior year, resulting in a more pronounced buildup during fiscal 2005 as compared to fiscal 2004. Accounts payable increased $13.3 million for the first three quarters of fiscal 2005 as compared to an increase of $7.7 million for the first three quarters of fiscal 2004, reflecting this build-up of inventory.

     Cash flows from investing activities. Net cash used in investing activities for the first three quarters of fiscal 2005 consisted principally of $17.6 million in capital expenditures as compared to $23.9 million for the prior year period. These expenditures primarily related to the opening of new stores. During fiscal 2004 we completed our move into a new distribution center and therefore incurred significant capital expenditures during the first two quarters. During the first three quarters of fiscal 2005, we opened 45 new stores. We expect that capital expenditures for fiscal 2005

will range from $27 million to $29 million, primarily to fund the opening of 59 new stores, and to complete certain information technology asset purchases and projects. We anticipate that capital expenditures, including leasehold improvements and furniture and fixtures, for new stores in fiscal 2005 will average approximately $350,000 to $375,000 per store. We anticipate that we will continue to receive landlord allowances, which help to reduce our cash invested in leasehold improvements. These allowances are reflected as a component of cash flows from operating activities within our consolidated statement of cash flows.

     Cash flows from financing activities. Net cash provided by financing activities for the first three quarters of fiscal 2005 was $4.6 million compared to $16.4 million in the prior year period. The decline in cash provided by financing activities was primarily due to a decrease in the level of borrowings under our revolving line of credit during the first three quarters of fiscal 2005. As of October 29, 2005, we had net borrowings of $3.7 million under our revolving line of credit compared to $16.2 million in the prior year period.

     Revolving credit facility. Effective October 4, 2004, the Company entered into a new, five-year senior secured revolving credit facility with a revolving loan limit of up to $45 million. The revolving credit facility bears interest at a floating rate equal to the 60-day LIBOR rate (4.20% at October 29, 2005) plus 1.25% to 1.50% (depending on the amount of excess availability under the borrowing base). Additionally, the Company pays a fee to the bank equal to a rate of 0.2% per annum on the unused portion of the revolving line of credit. Borrowings under the facility are collateralized by substantially all of the Company’s assets and guaranteed by the Company’s subsidiaries. The maximum availability under the credit facility is limited by a borrowing base formula, which consists of a percentage of eligible inventory less reserves. The facility also contains provisions that could result in changes to the presented terms or the acceleration of maturity. Circumstances that could lead to such changes or acceleration include a material adverse change in the business or an event of default under the credit agreement. The facility has one financial covenant that requires the Company to maintain excess availability under the borrowing base, as defined in the credit agreement, of $3 million at all times. The facility matures in October 2009. As of October 29, 2005, we were in compliance with the covenants in the facility and there was approximately $3.7 million in outstanding borrowings under the credit facility, with approximately $32.8 million available for borrowing (net of the $3 million availability block as described above).

     At October 29, 2005, our balance of cash and cash equivalents was $463,000 and the borrowing availability under our revolving credit facility was approximately $32.8 million (net of the $3 million availability block as described above). We believe that these sources of cash, together with cash provided by our operations, will be adequate to carry out our fiscal 2005 growth plans in full and fund our planned capital expenditures, interest payments and working capital requirements for at least the next twelve months.

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 generally accepted accounting principles. 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 included in our Annual Report on Form 10-K filed with the Securities and Exchange Commission on April 14, 2005. Certain judgments and estimates utilized in implementing these accounting policies are likewise discussed in each of 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.

     Cost of sales and 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. We estimate net of allowances the amount of shrinkage that has occurred through theft or damage and adjust that to actual at the time of our physical inventory counts which occur throughout the fiscal year. We also evaluate the cost

of our inventory 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. We believe we have the appropriate merchandise valuation and pricing controls in place to minimize the risk that our inventory values would be materially misstated.

     Depreciation and recoverability of long-lived assets — Approximately 47% of our assets at October 29, 2005, represent investments in property and equipment. Determining appropriate depreciable lives and reasonable assumptions in evaluating the carrying value of capital assets requires judgments and estimates.

	•		We utilize the straight-line method of depreciation and a variety of depreciable lives. Land is not depreciated. Buildings are depreciated over 40 years. Furniture, fixtures and equipment are generally depreciated over 5 years. Computer software and equipment is generally depreciated over 3-5 years. Leasehold improvements are amortized over the shorter of the useful lives of the asset or the initial lease term. Our lease terms typically range from 5 to 10 years.
	•		To the extent we replace or dispose of fixtures or equipment prior to the end of their assigned depreciable lives, we could realize a loss or gain on the disposition. To the extent our assets are used beyond their assigned depreciable lives, no depreciation expense is being recognized. We reassess the depreciable lives in an effort to reduce the risk of significant losses or gains arising from either the disposition of our assets or the utilization of assets with no depreciation charges.
	•		Recoverability of the carrying value of store assets is assessed quarterly and upon the occurrence of certain events or changes in circumstances such as store closings or upcoming lease renewals. The assessment requires judgment and estimates for future store-generated cash flows. The review includes a comparison of the carrying value of the store assets to the future undiscounted cash flows expected to be generated by the store. The underlying estimates for cash flows include estimates for future net sales, gross profit and store expense increases and decreases. To the extent our estimates for net sales, gross profit and store expenses are not realized, future assessments of recoverability could result in additional impairment charges.

     Goodwill — We account for our goodwill in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets.” Accordingly, goodwill is not amortized but reviewed for impairment on an annual basis or more frequently when events and circumstances indicate that an impairment may have occurred. We have not recorded an impairment to our goodwill since adopting SFAS No. 142.

     Insurance reserves — Workers’ compensation, general liability and employee medical insurance programs are partially 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. Actual results can vary from estimates for many reasons, including, among others, inflation rates, claim settlement patterns, litigation trends and legal interpretations. We monitor our claims experience in light of these factors and revise our estimates of insurance reserves accordingly. The level of our insurance reserves may increase or decrease as a result of these changing circumstances or trends.

     Stock options and warrants — Certain of our stock options require us to record a non-cash stock compensation charge in our financial statements. The amount of the charge is determined based upon the excess of the fair value of our common stock at the date of grant over the exercise price of the stock options. Other options have been granted to employees or directors with an exercise price that is equal to or greater than the fair value of our common stock on the date of grant. Stock options which have been granted to persons other than employees or directors in exchange for services are valued using an option-pricing model. The fair value of our common stock is a significant element of determining the value of the stock option or the amount of the non-cash stock compensation charge to be recorded for our stock option awards or for non-employee stock option grants. Prior to our initial public offering in July 2002, our common stock was not traded on a stock exchange. To determine the value of our common stock prior to the initial public offering we first considered the amount paid to us for our common stock in recent transactions. Absent a recent sale of our common stock, we obtained a valuation from an independent appraiser. In each case, the determination of the fair value of our common stock requires judgment and the valuation has a direct

impact on our financial statements. We believe that reasonable methods and assumptions have been used for determining the fair value of our common stock.

Recent Accounting Standards

     In November 2004, the FASB issued SFAS No. 151 (“SFAS 151”), “Inventory Costs,” which clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material. The statement is effective for fiscal years beginning after June 15, 2005. We do not believe that the adoption of SFAS No. 151 will have a material impact on our financial statements.

     In December 2004, the FASB issued SFAS No. 123 (Revised) (“SFAS 123R”), “Share-Based Payment,” a revision of SFAS No. 123, “Accounting for Stock-Based Compensation.” SFAS No. 123R requires the fair value measurement of all stock-based payments to employees, including grants of employee stock options, and recognition of those expenses in the statement of operations. SFAS No. 123R is effective at the beginning of the next fiscal year after June 15, 2005. We will continue to account for stock-based compensation using the intrinsic value method until adoption of SFAS No. 123R on January 29, 2006. SFAS No. 123(R) permits public companies to adopt its requirements using one of the following methodologies.

	i)		a “modified prospective” approach wherein compensation cost is recognized beginning with SFAS No. 123R’s effective date (a) based on the requirements of SFAS No. 123R for all share-based payments granted after the effective date and (b) based on the requirements of SFAS No. 123 for all awards granted to employees prior to the effective date that remain unvested on such date, or
	ii)		a “modified retrospective” approach that includes all of the requirements of the modified prospective method and also permits entities to restate their financial statements based on the pro forma amounts previously disclosed pursuant to SFAS No. 123 in either (a) all prior periods presented or (b) prior interim periods in the year of adoption.

     As permitted by SFAS No. 123, we currently account for share-based payments to employees using the intrinsic value method under APB Opinion No. 25 and, as such, we recognize no compensation cost for employee stock options. Therefore, our adoption of the fair value method under SFAS No. 123R will have a significant impact on our results of operations; however, it will have no impact on our consolidated financial position. The precise impact of the adoption of SFAS No. 123R cannot be predicted at this time because it will depend on the levels of share-based payments we grant in the future (we are currently evaluating the utilization of stock options as a component of our employee compensation and retention strategies). Had we adopted SFAS No. 123R in prior periods, the impact of such accounting pronouncement would have approximated that which is described in the SFAS No. 123 pro forma disclosures at Note 3.

     In December 2004, the FASB issued Statement No. 153 (“SFAS 153”), “Exchanges of Nonmonetary Assets,” an amendment of APB Opinion No. 29 (“APB 29”), “Accounting for Nonmonetary Transactions.” SFAS 153 amends APB 29 to eliminate the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. A nonmonetary asset exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. SFAS 153 is effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. We do not anticipate that SFAS 153 will have a material impact on our financial statements.

     In March 2005, the FASB issued Interpretation No. 47 (“FIN 47”), “Accounting for Conditional Asset Retirement Obligations,” an interpretation of FASB issued Statement No. 143 (“SFAS 143”), “Accounting for Asset Retirement Obligations.” FIN 47 clarifies that the term “conditional asset retirement obligation” as used in SFAS 143 refers to a legal obligation to perform an asset retirement activity in which the timing and (or) method of settlement are conditional on a future event that may or may not be within the control of the entity. The obligation to perform the asset retirement activity is unconditional even though uncertainty exists about the timing and (or) method of settlement. FIN 47 also clarifies when an entity would have sufficient information to reasonably estimate

the fair value of an asset retirement obligation. FIN 47 is effective no later than the end of fiscal years ending after December 15, 2005. Retrospective application for interim financial information is permitted but is not required. We do not anticipate that FIN 47 will have a material impact on our financial statements.

     In May 2005, the FASB issued Statement No. 154 (“SFAS 154”), “Accounting Changes and Error Corrections,” a replacement of APB Opinion No. 20 (“APB 20”), “Accounting Changes,” and FASB issued Statement No. 3 (“SFAS 3”), “Reporting Accounting Changes in Interim Financial Statements.” SFAS 154 requires retrospective application to prior periods’ financial statements of changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. This statement requires that retrospective application of a change in accounting principle be limited to the direct effects of a change. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005.

Cautionary Statement for Purposes of the “Safe Harbor” Provisions of the Private Securities Litigation Reform Act of 1995

     The following information is provided pursuant to the “Safe Harbor” provisions of the Private Securities Litigation Reform Act of 1995. Certain statements under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this Form 10-Q are “forward-looking statements” made pursuant to these provisions. Forward-looking statements provide current expectations of future events based on certain assumptions and include any statement that does not directly relate to any historical or current fact. Words such as “should,” “likely to,” “forecasts,” “strategy,” “goal,” “anticipates,” “believes,” “expects,” “estimates,” “intends,” “plans,” “projects,” and similar expressions, may identify such forward-looking statements. Such statements are subject to certain risks and uncertainties which could cause actual results to differ materially from the results projected in such statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. We undertake no obligation to republish revised forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.

     We caution readers that the following important factors, among others, have in the past, in some cases, affected and could in the future affect our actual results of operations and cause our actual results to differ materially from the results expressed in any forward-looking statements made by us or on our behalf.

	•		If we are unable to profitably open and operate new stores and maintain the profitability of our existing stores, we may not be able to adequately implement our growth strategy, resulting in a decrease in net sales and net income.
	•		A prolonged economic downturn could result in reduced net sales and profitability.
	•		Reduced consumer spending in the southeastern part of the United States where approximately half of our stores are concentrated could reduce our net sales.
	•		We may not be able to successfully anticipate consumer trends, and our failure to do so may lead to loss of consumer acceptance of our products, resulting in reduced net sales.
	•		We depend on a number of vendors to supply our merchandise, and any delay in merchandise deliveries from certain vendors may lead to a decline in inventory, which could result in a loss of net sales.
	•		We are dependent on foreign imports for a significant portion of our merchandise, and any changes in the trading relations and conditions between the United States and the relevant foreign countries may lead to a decline in inventory resulting in a decline in net sales, or an increase in the cost of sales, resulting in reduced gross profit.

	•		Our success is highly dependent on our planning and control processes and our supply chain, and any disruption in or failure to continue to improve these processes may result in a loss of net sales and net income.
	•		We face an extremely competitive specialty retail business market, and such competition could result in a reduction of our prices and/or a loss of our market share.
	•		Our business is highly seasonal and our fourth quarter contributes a disproportionate amount of our operating income and net income, and any factors negatively impacting us during our fourth quarter could reduce our net sales, net income and cash flow, leaving us with excess inventory and making it more difficult for us to finance our capital requirements.
	•		We may experience significant variations in our quarterly results.
	•		The agreement covering our debt places certain reporting and consent requirements on us which may affect our ability to operate our business in accordance with our business and growth strategy.
	•		Our comparable store sales fluctuate due to a variety of factors and may not be a meaningful indicator of future performance.
	•		We are highly dependent on customer traffic in malls, and any reduction in the overall level of mall traffic could reduce our net sales and increase our sales and marketing expenses.
	•		Our hardware and software systems are vulnerable to damage that could harm our business.
	•		We depend on key personnel, and if we lose the services of any member of our senior management team, we may not be able to run our business effectively.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     Market risks related to our operations result primarily from changes in the prime lending rate and short-term London Interbank Offered Rates, or LIBOR, as our revolving credit facility utilizes both rates in determining interest. Adverse changes in such short-term term interest rates could affect our overall borrowing rate during the term of the credit facility.

     As of October 29, 2005, there was $3.7 million in outstanding borrowings under our revolving credit facility, which is based upon a 60-day LIBOR rate.

     We did not have any foreign exchange contracts, hedges, interest rate swaps, derivatives or other significant market risk as of October 29, 2005.

ITEM 4. CONTROLS AND PROCEDURES

     (a) Evaluation of disclosure controls and procedures. Our Chief Executive Officer and Chief Financial Officer, after evaluating the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) or 15(d)-(e) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) as of October 29, 2005, have concluded, based on the evaluation of these controls and procedures required by paragraph (b) of Exchange Act Rules 13a-15 or 15d-15, that our disclosure controls and procedures were effective.

     (b) Change in internal controls over financial reporting. There have been no changes in internal controls over financial reporting identified in connection with the foregoing evaluation that occurred during our last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II            OTHER INFORMATION

ITEM 6. EXHIBITS

(a) Exhibits.

Exhibit No.		Description of Document
31.1		Certification of the President and Chief Executive Officer Pursuant to Rule 13a-14(a) or Rule 15d-14(a)
31.2		Certification of the Executive Vice President and Chief Financial Officer Pursuant to Rule 13a-14(a) or Rule 15d-14(a)
32.1		Certification of the President and Chief Executive Officer Pursuant to 18 U.S.C. Section 1350
32.2		Certification of the Executive Vice President and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350

SIGNATURES

     Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned hereunto duly authorized.

		KIRKLAND’S, INC.
Date: December 5, 2005		/s/ Jack E. Lewis
		Jack E. Lewis
		President and Chief Executive Officer
		/s/ Reynolds C. Faulkner
		Reynolds C. Faulkner
		Executive Vice President and
		Chief Financial Officer