KIRKLAND'S, INC - Annual Report: 2006 (Form 10-K)

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

Commission file number 000-49885

Kirkland’s, Inc.

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code:

(731) 668-2444

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, no par value per share

(Title of class)

     Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes þ         No o

     Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes o         No þ

     Note — Checking the box above will not relieve any registrant required to file reports pursuant to Section 13 or 15(d) of the Exchange Act from their obligations under those Sections.

     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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.    o

     Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):    Large accelerated filer o         Accelerated filer þ         Non-accelerated filer o

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

     The aggregate market value of the common stock held by non-affiliates of the registrant as of July 30, 2005, the last business day of the registrant’s most recently completed second fiscal quarter, was approximately $54,317,472 based on the last sale price of the common stock as reported by The Nasdaq Stock Market. This calculation excludes 12,748,183 shares held by directors, executive officers and one holder of more than 10% of the registrant’s common stock.

     As of March 24, 2006, there were 19,515,134 shares of the registrant’s common stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

     Portions of the proxy statement for the Annual Meeting of Shareholders of Kirkland’s, Inc. to be held June 5, 2006, are incorporated by reference into Part III of this Form 10-K.

TABLE OF CONTENTS

FORM 10-K

FORWARD-LOOKING STATEMENTS

      This Form 10-K contains forward-looking statements within the meaning of the federal securities laws and the Private Securities Litigation Reform Act of 1995. These statements may be found throughout this Form 10-K, particularly under the headings “Business” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” among others. Forward-looking statements typically are identified by the use of terms such as “may,” “will,” “should,” “expect,” “anticipate,” “believe,” “estimate,” “intend” and similar words, although some forward-looking statements are expressed differently. You should consider statements that contain these words carefully because they describe our expectations, plans, strategies and goals and our beliefs concerning future business conditions, our results of operations, financial position and our business outlook or state other “forward-looking” information based on currently available information. The factors listed below under the heading “Risk Factors” and in the other sections of this Form 10-K provide examples of risks, uncertainties and events that could cause our actual results to differ materially from the expectations expressed in our forward-looking statements.

      The forward-looking statements made in this Form 10-K relate only to events as of the date on which the statements are made. We undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which the statement is made or to reflect the occurrence of unanticipated events.

      The terms “Kirkland’s,” “we,” “us,” and “our” as used in this Form 10-K refer to Kirkland’s, Inc.

PART I

General

      We are a leading specialty retailer of home decor in the United States, operating 347 stores in 37 states as of January 28, 2006. 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. In addition, we use innovative design and packaging to market home decor items as gifts. We provide our predominantly female customers an engaging shopping experience characterized by a diverse, ever-changing merchandise selection at surprisingly attractive prices. Our stores offer a unique combination of style and value that has led to our emergence as a leader in home decor 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.

      Our growth in recent years has consisted principally of new store openings. We intend to continue opening new stores both in existing markets and in new markets, including major metropolitan markets, middle markets and selected smaller communities. We believe there are currently more than 650 additional locations in the United States that could support a Kirkland’s store. During the 52 weeks ended January 28, 2006 (“fiscal 2005”), we opened 59 new stores and closed 32 stores. All of our fiscal 2005 new stores are located in off-mall venues, and all but one of our fiscal 2005 closed stores were located in malls. We anticipate that all of our new store openings during fiscal 2006 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.

Business Strategy

      Our goal is to be the leading specialty retailer of home decor in each of our markets. We believe the following elements of our business strategy differentiate us from our competitors and position us for profitable growth:

      Item-focused merchandising. While our stores contain items covering a broad range of complementary product categories, we emphasize key items within our targeted categories rather than merchandising complete product classifications. Although we do not attempt to be a fashion leader, our experienced buyers work closely with our vendors to identify and develop stylish merchandise reflecting the latest trends. We take a disciplined approach to test-marketing products and monitoring individual item sales, which enables us to identify and quickly reorder appropriate items in order to maximize sales of popular products. We also evaluate market trends and merchandise sales data to help us develop additional products to be made by our vendors and marketed in our stores, frequently on an exclusive basis. In most cases, this exclusive merchandise is the result of our buying team’s experience in interpreting market and merchandise trends in a way that appeals to our customer. We estimate that over 60% of our merchandise is designed or packaged exclusively for Kirkland’s, which provides us an opportunity to distinguish ourselves in the marketplace.

      Ever-changing merchandise mix. We believe our ever-changing merchandise mix creates an exciting “treasure hunt” environment, encouraging strong customer loyalty and frequent return visits to our stores. The merchandise in our stores is typically traditionally styled for broad market appeal, yet it reflects an understanding of our customer’s desire for newness and freshness. Our information systems permit close tracking of individual item sales, enabling us to react quickly to both fast-selling and slow-moving items. Accordingly, we actively change our merchandise throughout the year in response to market trends, sales results and changes in seasons. We also strategically increase selling space devoted to gifts and seasonal merchandise in advance of holidays.

      Stimulating visual presentation. Our stores have a distinctive, “interior design” look that helps customers visualize the merchandise in their own homes and inspires decorating and gift-giving ideas. Using multiple merchandise arrangements to simulate home settings, we group complementary merchandise creatively throughout the store, rather than displaying products strictly by category or product type. We believe this cross-category merchandising strategy encourages customers to browse for longer periods of time, promoting add-on sales.

      Strong value proposition. Our customers regularly experience the satisfaction of paying noticeably less for items similar or identical to those sold by other retail stores or through catalogs. This strategy of providing a unique combination of style and value is an important element in making Kirkland’s a destination store. While we carry items in our stores that sell for several hundred dollars, most items sell for under $50 and are perceived by our customers as affordable luxuries. Our longstanding relationships with vendors and our ability to place large orders of a single item enhance our ability to attain favorable product pricing from vendors.

      Broad market appeal. Our stores operate successfully across a wide spectrum of different regions and market sizes. We operate our stores in 37 states, and although originally focused in the Southeast, approximately 44% of our stores are now located outside that region. We operate successfully in major metropolitan markets such as Houston, Texas, and Atlanta, Georgia; middle markets such as Birmingham, Alabama, and Buffalo, New York; and smaller markets such as Appleton, Wisconsin, and Panama City, Florida. As of January 28, 2006 we operated the majority of our stores in enclosed malls. In recent years, we have expanded our presence in off-mall venues, including selected “lifestyle” and “power” strip centers. The flexibility of our concept enables us to select the most promising real estate opportunities that meet requisite economic and demographic criteria within our target markets. All of our new store openings during fiscal 2005 were in off-mall venues, and our current growth plan is to continue emphasizing off-mall stores in the future.

Growth Strategy

      Our growth strategy is to open new stores in existing and new markets. Over the past three years, we have expanded our store base at an average annual rate of 11.7%, net of store closings. During that same period, total square footage growth has averaged 15.8%. New stores, especially those opened in fiscal 2004 and fiscal 2005, generally have been larger, off-mall stores, while store closings mostly have consisted of smaller mall stores. We anticipate that we will open substantially all of our new stores in off-mall locations in major metropolitan markets, middle markets and in selected smaller communities. We believe there are currently more than 650 additional locations in the United States that could support a Kirkland’s store. Assuming the continued availability of adequate capital, we expect a net increase of approximately 30 stores during the 53 weeks ending February 3, 2007 (“fiscal 2006”).

      Our store model produces strong store-level cash flow and provides an attractive store-level return on investment. Of the 155 new stores opened during the past three fiscal years, 120 of these are located in off-mall venues. Among the group of 61 new off-mall stores that have been open a full twelve months, the average first-year sales volume was approximately $1,356,000. These stores typically generate a positive store contribution in their first full year of operation. Since fiscal 2003, when we began to focus our growth on off-mall opportunities, we have experienced better sales and store contribution from our off-mall new store openings as compared to mall stores.

      We use store contribution, which consists of store gross profit minus store operating expenses, as our primary measure of operating profitability for a single store or group of stores. Store contribution specifically excludes the allocation of corporate overhead and distribution costs, and therefore should not be considered comparable to operating income or other GAAP profit measures that are appropriate for assessing overall corporate financial performance. Store contribution also excludes depreciation and amortization charges. We track these non-cash charges for each store and for Kirkland’s as a whole. However, we exclude these charges from store contribution in order to more closely measure the cash flow

produced by each store in relation to the cash invested in that store in the form of capital assets and inventory.

Merchandising

      Merchandising strategy. Our merchandising strategy is to (i) offer distinctive and often exclusive, high quality home decor at affordable prices, (ii) maintain a breadth of product categories, (iii) provide a carefully edited selection of key items within targeted categories, rather than merchandising complete product classifications, (iv) emphasize new and fresh merchandise by continually updating our merchandise mix and (v) present merchandise in a visually appealing manner to create an inviting atmosphere which inspires decorating and gift-giving ideas.

      Our information systems permit close tracking of individual item sales, which enables us to react quickly to market trends and best sellers. This daily sales and gross margin information helps us to maximize the productivity of successful products and categories, and minimize the accumulation of slow-moving inventory. While our core merchandise assortment is fairly consistent across the chain, regional differences in home decor are addressed by tailoring inventories to geographic considerations and store sales results.

      We continuously introduce new and often exclusive products to our merchandise assortment in order to (i) maintain customer interest due to the freshness of our product selections, encouraging frequent return visits to our stores, (ii) enhance our reputation as a leader in identifying or developing high quality, fashionable products and (iii) allow merchandise which has peaked in sales to be quickly discontinued and replaced by new items. In addition, we strategically increase selling space devoted to gifts and holiday merchandise during the third and fourth quarters of the calendar year. Our flexible store design and layout allow for selling space changes as needed to capitalize on selling trends.

      Our average store generally carries approximately 2,300-2,500 SKUs. We regularly monitor the sell-through on each item, and the number and make-up of our active SKUs is likewise constantly changing based on changes in selling trends. New and different SKUs are introduced to our stores on a weekly or more frequent basis, and a substantial portion of the inventory carried in our stores is replaced with new SKUs every few months.

      We purchase merchandise from approximately 260 vendors, and our buying team works closely with many of these vendors to differentiate Kirkland’s merchandise from that of our competitors. We estimate that over 60% of our merchandise assortment is designed or packaged exclusively for Kirkland’s, generally based on our buyers’ experience in modifying certain merchandise characteristics or interpreting market trends into a product and price point that will appeal to our customer. For products that are not manufactured specifically for Kirkland’s, we may create custom packaging as a way to differentiate our merchandise offering and reinforce our brand names. Exclusive or proprietary products distinguish us from our competition, enhance the value of our merchandise and provide opportunity to improve our net sales and gross margin. We market a substantial portion of our exclusive or custom-packaged merchandise assortment under the Kirkland’s private label brand. Our strategy is to continue to grow our exclusive and proprietary products and custom-packaged products within our merchandise mix.

      To date, the merchandising strategy and product assortment for our off-mall stores have been similar to the approach we have used in mall stores. With 137 off-mall stores now in operation, we have begun evaluating opportunities to differentiate the merchandise assortment in our off-mall stores from the assortment presented in our mall stores. Our efforts have included customer research, sales analysis, and testing of different visual merchandising techniques. We recently opened two stores utilizing a newly-developed, 6,500 square-foot prototype store design. We are monitoring the performance of these stores and gathering feedback so that we can ensure a design for future new stores that best serves our customers.

      Product assortment. Our major merchandise categories include wall decor (framed art, mirrors and other wall ornaments), lamps, decorative accessories, candles and related items, textiles, 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. Consistent with our item-focused strategy, a vital part of the product mix is a variety of home decor and other assorted merchandise that does not necessarily fit into a specific product category. Decorative accessories consist of such varied products as sconces, vases and clocks. Other merchandise includes housewares, picture frames and other miscellaneous items. Throughout the year and especially in the fourth quarter of the calendar year, our buying team uses its experience in home decor to develop products that are as appropriate for gift-giving as they are for personal purchase. Innovative product design and packaging are important elements of this effort.

      The following table presents the percentage of fiscal 2005 and fiscal 2004 net sales contributed by our major merchandise categories:

      Value to customer. Through our distinctive merchandising, together with carefully coordinated in-store marketing, visual presentation and product packaging, we continually strive to increase the perceived value of our products to our customers. Our shoppers regularly experience the satisfaction of paying noticeably less for items similar or identical to those sold by other retail stores or through catalogs. Our stores typically have two semi-annual clearance events, one in January and one in July. We also run category promotions periodically throughout the year. We believe our value-oriented pricing strategy, coupled with an adherence to high quality standards, is an important element in establishing our distinct brand identity and solidifying our connection with our customers.

Store Operations

      General. As of January 28, 2006, we operated 347 stores in 37 states, with stores generally operating seven days a week. In addition to corporate management, three Regional Directors and approximately 30 District Managers (who generally have responsibility for 10 to 12 stores within a geographic district) manage store operations. A Store Manager and one or two Assistant Store Managers manage individual stores. The Store Manager is responsible for the day-to-day operation of the store, including sales, customer service, merchandise display and control, human resource functions and store security. A typical store operates with an average of eight to 10 associates including a full-time stock person and a combination of full and part-time sales associates, depending on the volume of the store and the season. Additional part-time sales associates are typically hired to assist with increased traffic and sales volume in the fourth quarter of the calendar year.

      Formats. We operate stores in both mall and off-mall venues. As of January 28, 2006, we operated 210 stores in enclosed malls and 137 stores in a variety of off-mall venues including “lifestyle” strip

centers, “power” centers, outlet centers and freestanding locations. Off-mall stores tend to be larger than mall stores, primarily due to the lower occupancy cost per square foot that is typically available for these stores. The average size of our mall stores is approximately 4,700 square feet, and the average size of our off-mall stores is approximately 5,600 square feet. The average size of the new stores we opened in fiscal 2005 was approximately 6,500 square feet, and we expect our fiscal 2006 new stores to be of similar size.

      Visual merchandising. Merchandise in both mall and off-mall stores is generally displayed according to display guidelines and directives given to each store from the Visual Merchandising team with input from Merchandising and Store Operations personnel. This procedure ensures uniform display standards throughout the chain. Using multiple types of fixtures, we group complementary merchandise creatively throughout the store, rather than displaying products strictly by category or product type.

      Because of the nature of our merchandise and our focus on identifying and developing best-selling items, we believe adherence to our visual merchandising standards is an important responsibility of our store and field supervisory management. We emphasize visual merchandising in our training efforts, and our dedicated team of visual merchants provides valuable leadership and support to this aspect of Store Operations. The Visual Merchandising team provides Store Managers with recommended display directives such as photographs and drawings, placement guides and display manuals. In addition, each Store Manager has some flexibility to creatively highlight those products that are expected to have the greatest appeal to local shoppers. The Visual Merchandising team also assists Regional Directors and District Managers in opening new stores. We believe effective and consistent visual merchandising enhances a store’s ability to reach its full sales potential.

      Personnel recruitment and training. We believe our continued success is dependent in part on our ability to attract, retain and motivate quality employees. In particular, the success of our growth plan depends on our ability to promote and/or recruit qualified District and Store Managers and maintain quality sales associates. A six-week training program is provided for new District Managers. Store Managers and Assistant Managers, many of whom begin their Kirkland’s career as sales associates, currently complete a formal training program before taking responsibility for a store. This training program includes five to 10 days in a designated “training store,” working directly with a qualified Training Store Manager. District Managers are primarily responsible for recruiting new Store Managers. Store Managers are responsible for the hiring and training of new sales associates, assisted where appropriate by a Regional Human Resources Manager. We constantly look for motivated and talented people to promote from within Kirkland’s, in addition to recruiting from outside Kirkland’s.

      Compensation and incentives. We compensate our Regional Directors, District and Store Managers with a base salary plus a quarterly performance bonus based on store sales, gross margin, and expense control. Sales associates are compensated on an hourly basis. In addition, we regularly run a variety of contests that reward associates for outstanding achievement in sales and other corporate initiatives.

Real Estate

      Strategy. Our real estate strategy is to identify retail properties that are convenient and attractive to our target female customer. The flexibility and broad appeal of our stores and our merchandise allow us to operate successfully in major metropolitan markets such as Houston, Texas, and Atlanta, Georgia, middle markets such as Birmingham, Alabama, and Buffalo, New York, and smaller markets such as Appleton, Wisconsin, and Panama City, Florida.

      Site selection. Our current strategy is to locate our stores in off-mall venues which are destinations for large numbers of shoppers and which reinforce our quality image and brand. To assess potential new locations, we review financial and demographic criteria and analyze the quality of tenants and competitive factors, square footage availability, frontage space and other relevant criteria to determine the overall acceptability of a property and the optimal locations within it.

      Until recent years, we preferred to locate stores in regional or super-regional malls with a history of high sales per square foot and multiple national department stores as anchors. Beginning in fiscal 2003, we began to explore more off-mall real estate alternatives. During fiscal 2004, we intensified that effort, and in fiscal 2005, all of our 59 new store openings were located in off-mall venues. All but one of the 32 closings in fiscal 2005 were mall stores. Of our 347 stores as of January 28, 2006, 137 were in a variety of off-mall venues including “lifestyle” strip centers, “power” centers and outlet centers. Off-mall stores tend to be slightly larger than mall stores, primarily due to the lower occupancy cost per square foot that is typically available for these stores. We currently anticipate that all of the new stores opened in fiscal 2006 will be located in off-mall venues.

      We believe we are a desirable tenant to developers because of our long and successful operating history, sales productivity, ability to attract customers and our strong position in the home decor category. The following table provides a history of our store openings and closings for the last five fiscal years.

Purchasing and Inventory Management

      Merchandise sourcing and product development. Our merchandise team purchases inventory on a centralized basis to take advantage of our technology and our consolidated buying power and to closely control the merchandise mix in our stores. Our buying team selects all of our products, negotiates with all of our vendors and works closely with our planning and allocation team to optimize store-level merchandise mix by category, classification and item. We believe the level of experience of our buying team gives us a competitive advantage in understanding our customer and identifying or developing merchandise suitable to her tastes and budget. We estimate that over 60% of our merchandise assortment is designed or packaged exclusively for Kirkland’s, generally based on our buyers’ experience in modifying certain merchandise characteristics or interpreting market trends into a product and price point that will appeal to our customer. The amount of exclusively designed or packaged merchandise continues to grow annually. Non-exclusive merchandise is often boxed or packaged exclusively for Kirkland’s utilizing Kirkland’s proprietary brands.

      We purchase merchandise from approximately 260 vendors. Approximately 75% of our total purchases are from importers of merchandise manufactured primarily in the Far East and India, with the balance purchased from domestic manufacturers and wholesalers. For our purchases of merchandise manufactured abroad, we have historically bought from importers or U.S.-based representatives of foreign manufacturers rather than dealing directly with foreign manufacturers. This process has enabled us to maximize flexibility and minimize product liability and credit risks. As we execute our growth strategy, we are continually evaluating the best ways to source and differentiate our merchandise while attaining our sales and gross margin objectives. For certain categories and items, the strategic use of domestic manufacturers and wholesalers enables us to reduce the lead times between ordering products and offering them in our stores.

      Planning and allocation. Our merchandise planning and allocation team works closely with our buying team, field management and store personnel to meet the requirements of individual stores for appropriate merchandise in sufficient quantities. This team also manages inventory levels, allocates merchandise to stores and replenishes inventory based upon information generated by our information systems. Our inventory control systems monitor current inventory levels at each store and our operations as a whole. We also continually monitor recent selling history within each store by category, classification and item to properly allocate further purchases to maximize sales and gross margin.

      Each of our stores is internally classified for merchandising purposes based on certain criteria including store sales, size, location and historical performance. Although all of our stores carry similar merchandise, the variety and depth of products in a given store may vary depending on the store’s rank and classification. Inventory purchases and allocation are also tailored based on regional or demographic differences between stores.

Distribution and Logistics

      Prior to fiscal 2000, we distributed our products primarily through direct shipments from our vendors to each of our individual stores. Inventory backstock was held both in the store’s stockroom and in local storage facilities managed by each Store Manager. We maintained a modest central distribution capability in Jackson, Tennessee through a collection of low-cost warehouses to process certain merchandise shipments and to hold inventory for new store openings. As our store base grew, this legacy distribution system became cumbersome and inefficient, and we recognized the need to develop a more scalable central distribution strategy to permit greater inventory control and to control freight costs. Between fiscal 2000 and fiscal 2003, we expanded our central distribution operations in order to support store growth and to begin capturing the financial benefits of centralized distribution and freight management.

      During this period, we recognized the need for a more comprehensive approach to the management of our merchandise supply chain. This approach entails the thorough evaluation of all parts of the supply chain, from merchandise vendor to the store selling floor, and the development of strategies that incorporate the needs and expertise of many different parts of the Company including logistics, merchandising, store operations, information technology and finance. To support our effort to build a modern, efficient supply chain, during fiscal 2003 we reached an agreement to lease a new, 771,000-square-foot distribution center in Jackson, Tennessee. This building was built to our specifications and opened in May 2004.

      The commencement of operations in the new distribution center was accompanied by the implementation of a new warehouse management system as well as investments in material handling equipment designed to streamline the flow of goods within the distribution center. In fiscal 2006 and beyond, our goal is to achieve better labor productivity, better transportation efficiency, leaner store-level inventories and reduced store-level storage costs.

      In addition to making improvements to our distribution center operation, we have taken important steps to improve our efficiency in transporting merchandise to stores. We currently utilize third-party carriers to transport merchandise from our Jackson distribution center to our stores. In the past, the majority of our merchandise deliveries were handled by less-than-truckload (LTL) carriers, which we had found to be a cost-effective means of distribution for stores in reasonable proximity to our central

distribution facilities. In an attempt to improve store service levels and cost efficiencies, for many stores we now employ full truckload deliveries to regional “pool points”, with local delivery agents handling the actual store delivery function. For many other stores, we have now introduced a third alternative whereby we use less frequent, full truckload deliveries. The optimal delivery method for a given store depends on the store’s sales volume, square footage, geographic location and other factors.

      An important part of our efforts to achieve efficiencies, cost reductions and net sales growth is the continued identification and implementation of improvements to our planning, logistical and distribution infrastructure and our supply chain, including merchandise ordering, transportation and receipt processing. We also need to ensure that our distribution infrastructure and supply chain keep pace with our anticipated growth and increased number of stores.

Internet

      We believe the Internet offers opportunities to complement our “brick-and-mortar” stores, increase sales and increase consumer brand awareness of our products. We maintain a web site at www.kirklands.com, which provides our customers with a resource to locate a store, preview our merchandise and purchase a limited array of products online. We currently sell a modest amount of merchandise through our web site and maintain a small customer service department to handle e-mail and phone inquiries from our store and e-commerce customers. The information contained or incorporated in our web site is not a part of this annual report on Form 10-K.

Information Systems

      Our store information systems include a server in each store that runs our automated POS application on multiple POS registers. The server provides managers with convenient access to detailed sales and inventory information for the store. Our POS registers provide price look-up (all merchandise is bar-coded), time and attendance, and automated check, credit card, debit card and gift card processing. Through nightly two-way electronic communication with each store, we upload SKU-level sales, gross margin information and payroll hours to our home office system and download new merchandise pricing, price changes for existing merchandise, purchase orders and system maintenance tasks to the store server. Based upon the evaluation of information obtained through daily polling, our planning and allocation team implements merchandising decisions regarding inventory levels, reorders, price changes and allocation of merchandise to our stores.

      The core of our home office information system is the integrated GERS retail management software. This system integrates all merchandising and financial applications, including category, classification and SKU inventory tracking, purchase order management, automated ticket making, general ledger, sales audit and accounts payable. We moved into a new distribution center during the second quarter of 2004. Concurrent with this move, we implemented a new warehouse management system (WMS) designed by High Jump Software. The WMS was tailored to our specifications and provides us with a fully automated solution for all operations within the distribution center. We utilize a Lawson Software package for our payroll and human resources functions.

Marketing

      Our marketing efforts emphasize in-store signage, store and window banners and displays and other techniques to attract customers and provide an exciting shopping experience. Historically, we have not engaged in extensive media advertising because we believe that we have benefited from our strategic locations in high-traffic shopping centers and valuable “word-of-mouth” advertising by our customers. We are actively evaluating ways to enhance our marketing to customers through direct mail and e-mail communications. We supplement our in-store marketing efforts with periodic free-standing newspaper inserts to promote specific events in our stores, including our semi-annual clearance events.

      As part of our effort to reach out to customers, in fiscal 2004, we introduced our Kirkland’s private-label credit card. This program is administered by a third-party, who bears the credit risk associated with

the card program without recourse to us. As part of being a cardholder, customers are automatically enrolled in a loyalty program whereby they earn loyalty points for their purchases in our stores. Customers attaining specified levels of loyalty points are eligible for special discounts on future purchases in our stores. We believe that customers using the card visit our stores and purchase merchandise more frequently and spend more per visit than our customers not using the card. As of January 28, 2006, there were approximately 217,000 Kirkland’s private-label credit card holders.

Trademarks

      All of our stores operate under the names “Kirkland’s”, or “Kirkland’s Home” other than 14 stores, which operate under the name “Briar Patch by Kirkland’s.” We acquired these stores in 1998. As these stores are remodeled or relocated, we intend to change the name of these stores to the “Kirkland’s Home” name.

      We have registered several trademarks with the United States Patent and Trademark Office on the Principal Register that are used in connection with the Kirkland’s stores, including KIRKLAND’S^® logo design, THE KIRKLAND COLLECTION^®, HOME COLLECTION BY KIRKLAND’S^®, KIRKLAND’S OUTLET^®, KIRKLAND’S HOME^®, as well as several trademark registrations for Kirkland’s private label brand, the CEDAR CREEK COLLECTION^®. In addition to the registrations, Kirkland’s also is the common law owner of the trademark BRIAR PATCH^tm. These marks have historically been very important components in our merchandising and marketing strategy. We are not aware of any claims of infringement or other challenges to our right to use our marks in the United States.

Competition

      The retail market for home decor is highly competitive. Accordingly, we compete with a variety of specialty stores, department stores, discount stores and catalog retailers that carry merchandise in one or more categories also carried by our stores. Our product offerings also compete with a variety of national, regional and local retailers, including such specialty retailers as Bed, Bath & Beyond, Cost Plus World Market, Linens ’n Things, Michael’s Stores, Pier 1 Imports and Williams-Sonoma. Department stores typically have higher prices than our stores for similar merchandise. Specialty retailers tend to have higher prices and a narrower assortment of products than our stores. Wholesale clubs may have lower prices than our stores, but the product assortment is generally considerably more limited. We believe that the principal competitive factors influencing our business are merchandise quality and selection, price, customer service, visual appeal of the merchandise and the store, and the convenience of location.

      The number of companies offering a selection of home decor products that overlaps generally with our product assortment has increased over the last five years. However, we believe that our stores still occupy a distinct niche in the marketplace: traditionally styled merchandise, reflective of current market trends typically offered at a discount to catalog and department store prices. We believe we compete effectively with other retailers due to our experience in identifying a broad collection of distinctive merchandise, pricing it to be attractive to the target Kirkland’s customer, presenting it in a visually appealing manner and providing quality customer service.

      In addition to competing for customers, we compete with other retailers for suitable store locations and qualified management personnel. Many of our competitors are larger and have substantially greater financial, marketing and other resources than we do. See “Risk Factors — We face an extremely competitive specialty retail business market, and such competition could result in a reduction of our prices and a loss of our market share.”

Employees

      We employed approximately 4,878 employees at March 17, 2006. The number of employees fluctuates with seasonal needs. None of our employees is covered by a collective bargaining agreement. We believe our employee relations are good.

Availability of SEC Reports

      We file annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K and other information with the SEC. Members of the public may read and copy materials that we file with the SEC at the SEC’s Public Reference Room at 450 Fifth Street, N.W., Washington, D.C. 20549. Members of the public may also obtain information on the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC also maintains an Internet web site that contains reports, proxy and information statements and other information regarding issuers, including Kirkland’s, that file electronically with the SEC. The address of that site is http://www.sec.gov. Our annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K and other information filed by us with the SEC are available, without charge, on our Internet web site, http://www.kirklands.com, as soon as reasonably practicable after they are filed electronically with the SEC. Copies are also available, without charge, by written request to: Secretary, Kirkland’s, Inc., 805 North Parkway, Jackson, TN 38305.

Executive Officers of Kirkland’s

      The name, age as of March 31, 2006, and position of each of our executive officers is as follows:

      Robert E. Alderson, 59, has been a Director of Kirkland’s since September 1986. He served as President and Chief Executive Officer of Kirkland’s from February 2006 to March 2006 and as President from November 1997 to May 2005 and Chief Executive Officer from March 2001 to May 2005. He also served as Chief Operating Officer of Kirkland’s from November 1997 through March 2001 and as Senior Vice President of Kirkland’s upon joining in 1986 through November 1997. He also served as Chief Administrative Officer of Kirkland’s from 1986 to 1997. Prior to joining Kirkland’s, Mr. Alderson was a senior partner at the law firm of Menzies, Rainey, Kizer & Alderson.

      Catherine A. David, 42, joined Kirkland’s as President and Chief Operating Officer in March 2006. Prior to joining Kirkland’s, from July 2004 to September 2005, Ms. David was employed with Sears Holding Corporation leaving as Senior Vice President and General Manager of Sears Essentials, Sears Grand, and The Great Indoors. Prior to that, she was President of the Burnes Group, formerly a division of Newell-Rubbermaid. Ms. David also enjoyed a successful 13-year career at Target Corporation, where she performed in a variety of buying, merchandise planning and store operations roles culminating in her leadership of Target’s website strategy and e-commerce business as Vice President and General Manager of target.direct.

      Reynolds C. Faulkner, 42, has been a Director of Kirkland’s since September 1996 and joined Kirkland’s as Senior Vice President and Chief Financial Officer in February 1998. He was promoted to Executive Vice President in February 2002. Prior to joining Kirkland’s, from July 1989 to January 1998, Mr. Faulkner was an investment banker in the corporate finance department of The Robinson-Humphrey Company, LLC, most recently serving as a Managing Director and head of the retail practice group. In this capacity, Mr. Faulkner was involved in numerous public and private financings and mergers and acquisitions of companies in the retail industry.

      Dwayne F. Cochran, 44, has been Executive Vice President and Director of Stores since November 2004. Prior to joining Kirkland’s, Mr. Cochran was East Zone Vice President for Pier 1 Imports from 1997 to 2004 and a regional manager for Pier 1 Imports from 1995 to 1997. Prior to that, Mr. Cochran held various supervisory positions at Brookstone for 5 years and Johnston and Murphy for 7 years.

      No family relationships exist among any of the above-listed officers, and there are no arrangements or understandings between any of the above-listed officers and any other person pursuant to which they serve as an officer. All officers are elected to hold office for one year or until their successors are elected and qualified.

      Investing in our common stock involves risk. You should carefully consider the following risks, as well as the other information contained in this 10-K, including our consolidated financial statements and the related notes, before investing in our common stock.

Risks Related to Our Business

      One of our strategies is to open new stores by focusing on both existing markets and by targeting new geographic markets. During fiscal 2005, we opened 59 new stores, and our future operating results will depend to a substantial extent upon our ability to open and operate new stores successfully. We plan to open approximately 60 new stores and close approximately 30 stores in fiscal 2006. We also have an ongoing expansion, remodeling and relocation program. We remodeled one store in fiscal 2005 and may expand, remodel or relocate additional stores during fiscal 2006.

      There can be no assurance that we will be able to open, expand, remodel and relocate stores at this rate, or at all. Our ability to open new stores and to expand, remodel and relocate existing stores depends on a number of factors, including our ability to:

      The rate of our expansion will also depend on the availability of adequate capital, which in turn will depend in large part on cash flow generated by our business and the availability of equity and debt capital. There can be no assurance that we will have adequate cash flow generated by our business or that we will be able to obtain equity or debt capital on acceptable terms, or at all. Moreover, our senior credit facility contains provisions that restrict the amount of debt we may incur in the future. In addition, the cost of opening, expanding, remodeling and relocating new or existing stores may increase in the future compared to historical costs. The increased cost could be material. If we are not successful in obtaining sufficient capital, we may be unable to open additional stores or expand, remodel and relocate existing stores as planned, which may adversely affect our growth strategy resulting in a decrease in net sales. As a result, there can be no assurances that we will be able to achieve our current plans for the opening of new stores and the expansion, remodeling or relocation of existing stores.

      There also can be no assurance that our existing stores will maintain their current levels of net sales and store-level profitability or that new stores will generate net sales levels necessary to achieve store-level profitability. New stores that we open in our existing markets may draw customers from our existing stores and may have lower net sales growth relative to stores opened in new markets. New stores also may face greater competition and have lower anticipated net sales volumes relative to previously opened stores during their comparable years of operations. New stores opened in new markets, where we are less familiar with the target customer and less well known, may face different or additional risks and increased costs

compared to stores operated in existing markets. Also, stores opened in off-mall locations may require greater marketing costs in order to attract customer traffic. These factors, together with increased pre-opening expenses at our new stores, may reduce our average store contribution and operating margins. If we are unable to profitably open and operate new stores and maintain the profitability of our existing stores, our net income could suffer.

      The success of our growth plan will be dependent on our ability to promote and/or recruit enough qualified regional directors, district managers, store managers and sales associates to support the expected growth in the number of our stores, and the time and effort required to train and supervise a large number of new managers and associates may divert resources from our existing stores and adversely affect our operating and financial performance. Our operating expenses would also increase as a result of any increase in the minimum wage or other factors that would require increases in the compensation paid to our employees.

      Our net sales are also subject to a number of factors relating to consumer spending, including general economic conditions affecting disposable consumer income such as unemployment rates, business conditions, interest rates, levels of consumer confidence, energy prices, mortgage rates, the level of consumer debt and taxation. A weak retail environment could impact customer traffic in our stores and also adversely affect our net sales. Purchases of home decor items may decline during recessionary periods, and a prolonged recession may have a material adverse effect on our business, financial condition and results of operations. In addition, economic downturns during the last quarter of our fiscal year could adversely affect us to a greater extent than if such downturns occurred at other times of the year.

      Approximately 56% of our stores are located in the southeastern region of the United States. Consequently, economic conditions, weather conditions, demographic and population changes and other factors specific to this region may have a greater impact on our results of operations than on the operations of our more geographically diversified competitors. In addition, changes in regional factors that reduce the appeal of our stores and merchandise to local consumers could reduce our net sales.

      Our success depends on our ability to anticipate and respond to changing merchandise trends and consumer demands in a timely manner. If we fail to identify and respond to emerging trends, consumer acceptance of the merchandise in our stores and our image with our customers may be harmed, which could reduce customer traffic in our stores and materially adversely affect our net sales. Additionally, if we misjudge market trends, we may significantly overstock unpopular products and be forced to take significant inventory markdowns, which would have a negative impact on our gross profit and cash flow. Conversely, shortages of items that prove popular could reduce our net sales. In addition, a major shift in consumer demand away from home decor could also have a material adverse effect on our business, results of operations and financial condition.

      We purchase our products from approximately 260 vendors with which we have no long-term purchase commitments or exclusive contracts. None of our vendors supplied more than 10% of our merchandise purchases during fiscal 2005. Historically, we have retained our vendors and we have generally not experienced difficulty in obtaining desired merchandise from vendors on acceptable terms.

However, our arrangements with these vendors do not guarantee the availability of merchandise, establish guaranteed prices or provide for the continuation of particular pricing practices. Our current vendors may not continue to sell products to us on current terms or at all, and we may not be able to establish relationships with new vendors to ensure delivery of products in a timely manner or on terms acceptable to us.

      We may not be able to acquire desired merchandise in sufficient quantities on terms acceptable to us in the future. Also, our business would be adversely affected if there were delays in product shipments to us due to freight difficulties, strikes or other difficulties at our principal transport providers or otherwise. We have from time to time experienced delays of this nature. We are also dependent on vendors for assuring the quality of merchandise supplied to us. Our inability to acquire suitable merchandise in the future or the loss of one or more of our vendors and our failure to replace any one or more of them may harm our relationship with our customers resulting in a loss of net sales.

      Many of our vendors are importers of merchandise manufactured in the Far East and India. Our vendors are subject to the risks involved with relying on products manufactured abroad, and we remain subject to those risks to the extent that their effects are passed through to us by our vendors or cause disruptions in supply. These risks include changes in import duties, quotas, loss of “most favored nation” (“MFN”) trading status with the United States for a particular foreign country, work stoppages, delays in shipments, freight cost increases, terrorism, war, economic uncertainties (including inflation, foreign government regulations and political unrest) and trade restrictions (including the United States imposing antidumping or countervailing duty orders, safeguards, remedies or compensation and retaliation due to illegal foreign trade practices). If any of these or other factors were to cause a disruption of trade from the countries in which the suppliers of our vendors are located, our inventory levels may be reduced or the cost of our products may increase.

      We currently purchase a majority of our merchandise from importers of goods manufactured in China. China has been granted permanent normal trade relations by the United States effective January 1, 2002, based on its entry into the World Trade Organization (“WTO”), and now enjoys MFN trading status. China’s entry into the WTO potentially stabilizes the trading relationship between it and the United States, but the possibility of trade disputes concerning merchandise currently imported from China continues to create risks. These risks could result in sanctions against China, and the imposition of new duties on certain imports from China, including products supplied to us. Any significant increase in duties or any other increase in the cost of the products imported for us from China could result in an increase in the cost of our products to our customers which may correspondingly cause a decrease in net sales or could cause a reduction in our gross profit.

      Historically, instability in the political and economic environments of the countries in which our vendors obtain our products has not had a material adverse effect on our operations. However, we cannot predict the effect that future changes in economic or political conditions in such foreign countries may have on our operations. Although we believe that we could access alternative sources in the event of disruptions or delays in supply due to economic, political or health conditions in foreign countries on our vendors, such disruptions or delays may adversely affect our results of operations unless and until alternative supply arrangements could be made. In addition, merchandise purchased from alternative sources may be of lesser quality or more expensive than the merchandise we currently purchase abroad.

      Countries from which our vendors obtain these products may, from time to time, impose new or adjust prevailing quotas or other restrictions on exported products, and the United States may impose new duties, quotas and other restrictions on imported products. This could disrupt the supply of such products to us and adversely affect our operations. The United States Congress periodically considers other

restrictions on the importation of products obtained for us by vendors. The cost of such products may increase for us if applicable duties are raised or import quotas with respect to such products are imposed or made more restrictive.

      We are also subject to the risk that the manufacturers abroad who ultimately manufacture our products may employ labor practices that are not consistent with acceptable practices in the United States. In any such event we could be hurt by negative publicity with respect to those practices and, in some cases, face liability for those practices.

      An important part of our efforts to achieve efficiencies, cost reductions and net sales growth is the continued identification and implementation of improvements to our planning, logistical and distribution infrastructure and our supply chain, including merchandise ordering, transportation and receipt processing. We also need to ensure that our distribution infrastructure and supply chain keep pace with our anticipated growth and increased number of stores. In particular, we may need to expand our existing infrastructure to the extent we open new stores in regions of the United States where we presently do not have significant concentrations of stores. The cost of this enhanced infrastructure could be significant. In addition, a significant portion of the distribution to our stores is coordinated through our distribution facility in Jackson, Tennessee. Any significant disruption in the operations of this facility would have a material adverse effect on our ability to maintain proper inventory levels in our stores which could result in a loss of net sales and net income.

      The retail market is highly competitive. We compete against a diverse group of retailers, including specialty stores, department stores, discount stores and catalog retailers, which carry merchandise in one or more categories also carried by us. Our product offerings also compete with a variety of national, regional and local retailers, including such specialty retailers as Bed, Bath & Beyond, Cost Plus World Market, Linens ’n Things, Michaels Stores, Pier 1 Imports and Williams-Sonoma. We also compete with these and other retailers for suitable retail locations, suppliers, qualified employees and management personnel. One or more of our competitors are present in substantially all of the markets in which we have stores. Many of our competitors are larger and have significantly greater financial, marketing and other resources than we do. This competition could result in the reduction of our prices and a loss of our market share. Our net sales are also impacted by store liquidations of our competitors. We believe that our stores compete primarily on the basis of merchandise quality and selection, price, visual appeal of the merchandise and the store and convenience of location. There can be no assurance that we will continue to be able to compete successfully against existing or future competition. Our expansion into the markets served by our competitors and the entry of new competitors or expansion of existing competitors into our markets may have a material adverse effect on our market share and could result in a reduction in our prices in order for us to remain competitive.

      We have experienced, and expect to continue to experience, substantial seasonal fluctuations in our net sales and operating results, which are typical of many specialty retailers and common to most retailers generally. Due to the importance of the fall selling season, which includes Thanksgiving and Christmas, the last quarter of our fiscal year has historically contributed, and is expected to continue to contribute, a disproportionate amount of our net sales, net income and cash flow for the entire fiscal year. We expect

this pattern to continue during the current fiscal year and anticipate that in subsequent fiscal years, the last quarter of our fiscal year will continue to contribute disproportionately to our operating results and cash flow. Any factors negatively affecting us during the last quarter of our fiscal year, including unfavorable economic or weather conditions, could have a material adverse effect on our financial condition and results of operations, reducing our cash flow, leaving us with excess inventory and making it more difficult for us to finance our capital requirements.

      Our quarterly results of operations may also fluctuate significantly based upon such factors as the timing of new store openings, pre-opening expenses associated with new stores, the relative proportion of new stores to mature stores, net sales contributed by new stores, increases or decreases in comparable store net sales, adverse weather conditions, shifts in the timing of holidays, the timing and level of markdowns, changes in fuel and other shipping costs, changes in our product mix and actions taken by our competitors.

      Our senior credit facility contains a number of covenants requiring us to report to our lender or to obtain our lender’s consent in connection with certain activities we may wish to pursue in the operation of our business. These requirements may affect our ability to operate our business and consummate our business and growth strategy and may limit our ability to take advantage of potential business opportunities as they arise. These requirements affect our ability to, among other things:

      The senior credit facility has one financial covenant. This covenant requires us to maintain “excess availability,” as defined in our credit agreement, of at least $3 million. Any failure to comply with this or other covenants would allow the lenders to accelerate repayment of their debt, prohibit further borrowing under the facility, declare an event of default, take possession of their collateral or take other actions available to a secured senior creditor.

      If compliance with our debt obligations materially hinders our ability to operate our business and adapt to changing industry conditions, we may lose market share, our revenue may decline and our operating results may suffer. This could have a material adverse effect on the market value and marketability of our common stock.

      Numerous factors affect our comparable store net sales results, including among others, weather conditions, retail trends, the retail sales environment, economic conditions, the impact of competition and our ability to execute our business strategy efficiently. Our comparable store net sales results have experienced fluctuations in the past. In addition, we anticipate that opening new stores in existing markets may result in decreases in comparable store net sales for existing stores in such markets. Past comparable

store net sales results may not be indicative of future results. Our comparable store net sales may not increase from quarter to quarter and may decline. As a result, the unpredictability of our comparable store net sales may cause our revenues and operating results to vary quarter to quarter, and an unanticipated decline in revenues or comparable store net sales may cause the price of our common stock to fluctuate significantly.

      As of January 28, 2006, approximately 60% of our existing stores were located in enclosed malls. As a result, we rely heavily on the ability of mall anchor tenants and other tenants to generate customer traffic in the vicinity of our stores. Historically, we have not relied on extensive media advertising and promotion in order to attract customers to our stores. Our future operating results will also depend on many other factors that are beyond our control, including the overall level of mall traffic and general economic conditions affecting consumer confidence and spending. Any significant reduction in the overall level of mall traffic could reduce our net sales.

      We rely upon our existing information systems for operating and monitoring all major aspects of our business, including sales, warehousing, distribution, purchasing, inventory control, merchandise planning and replenishment, as well as various financial functions. These systems and our operations are vulnerable to damage or interruption from:

      Any disruption in the operation of our information systems, the loss of employees knowledgeable about such systems or our failure to continue to effectively modify such systems could interrupt our operations or interfere with our ability to monitor inventory, which could result in reduced net sales and affect our operations and financial performance. We also need to ensure that our systems are consistently adequate to handle our anticipated store growth and are upgraded as necessary to meet our needs. The cost of any such system upgrades or enhancements would be significant.

      We have benefited substantially from the leadership and performance of our senior management team. Our success will depend on our ability to retain our current senior management members and to attract and retain qualified personnel in the future. Competition for senior management personnel is intense and there can be no assurances that we will be able to retain our personnel. The loss of a member of senior management would require the remaining executive officers to divert immediate and substantial attention to seeking a replacement.

      Our charter authorizes the issuance of “blank check” preferred stock with such designations, rights and preferences as may be determined from time to time by our Board of Directors. Accordingly, the Board of Directors is empowered, without shareholder approval, to issue preferred stock with dividend, liquidation, conversion, voting or other rights that could materially adversely affect the voting power or other rights of the holders of our common stock. Holders of the common stock do not have preemptive

rights to subscribe for a pro rata portion of any capital stock which may be issued by us. In the event of issuance, such preferred stock could be utilized, under certain circumstances, as a method of discouraging, delaying or preventing a change in control of Kirkland’s. Although we have no present intention to issue any new shares of preferred stock, we may do so in the future.

      Our charter and bylaws contain certain corporate governance provisions that may make it more difficult to challenge management, may deter and inhibit unsolicited changes in control of Kirkland’s and may have the effect of depriving our shareholders of an opportunity to receive a premium over the prevailing market price of our common stock in the event of an attempted hostile takeover. First, the charter provides for a classified Board of Directors, with directors (after the expiration of the terms of the initial classified board of directors) serving three year terms from the year of their respective elections and being subject to removal only for cause and upon the vote of 80% of the voting power of all outstanding capital stock entitled to vote (the “Voting Power”). Second, our charter and bylaws do not generally permit shareholders to call, or require that the Board of Directors call, a special meeting of shareholders. The charter and bylaws also limit the business permitted to be conducted at any such special meeting. In addition, Tennessee law permits action to be taken by the shareholders by written consent only if the action is consented to by holders of the number of shares required to authorize shareholder action and if all shareholders entitled to vote are parties to the written consent. Third, the bylaws establish an advance notice procedure for shareholders to nominate candidates for election as directors or to bring other business before meetings of the shareholders. Only those shareholder nominees who are nominated in accordance with this procedure are eligible for election as directors of Kirkland’s, and only such shareholder proposals may be considered at a meeting of shareholders as have been presented to Kirkland’s in accordance with the procedure. Finally, the charter provides that the amendment or repeal of any of the foregoing provisions of the charter mentioned previously in this paragraph requires the affirmative vote of at least 80% of the Voting Power. In addition, the bylaws provide that the amendment or repeal by shareholders of any bylaws made by our Board of Directors requires the affirmative vote of at least 80% of the Voting Power.

      Furthermore, Kirkland’s is subject to certain provisions of Tennessee law, including certain Tennessee corporate takeover acts that are, or may be, applicable to us. These acts include the Investor Protection Act, the Business Combination Act and the Tennessee Greenmail Act, and these acts seek to limit the parameters in which certain business combinations and share exchanges occur. The charter, bylaws and Tennessee law provisions may have an anti-takeover effect, including possibly discouraging takeover attempts that might result in a premium over the market price for our common stock.

      The price at which our common stock trades may be volatile. The market price of our common stock could be subject to significant fluctuations in response to our operating results, general trends and prospects for the retail industry, announcements by our competitors, analyst recommendations, our ability to meet or exceed analysts’ or investors’ expectations, the condition of the financial markets and other factors. In addition, the stock market in recent years has experienced extreme price and volume fluctuations that often have been unrelated or disproportionate to the operating performance of companies. These fluctuations, as well as general economic and market conditions, may adversely affect the market price of our common stock notwithstanding our actual operating performance.

      As of the date of this filing, our current directors, executive officers and their affiliates, in the aggregate, beneficially own approximately 45% of our outstanding common stock. As a result, these shareholders are able to exercise a controlling influence over matters requiring shareholder approval, including the election of directors and approval of significant corporate transactions, and will have

significant control over our management and policies. These shareholders may support proposals and actions with which you may disagree or which are not in your interests.

      None

      We lease all of our store locations and expect to continue our policy of leasing rather than owning. Our leases for mall stores typically provide for 10-year terms, many with the ability for us (or the landlord) to terminate the lease at specified points during the term if net sales at the leased premises do not reach a certain annual level. Our leases for off-mall stores typically provide for terms ranging from 5 to 10 years. Many of our leases provide for payment of percentage rent (i.e., a percentage of net sales in excess of a specified level) and the rate of increase in key ancillary charges is generally capped.

      As current leases expire, we believe we will be able either to obtain lease renewals if desired for present store locations or to obtain leases for equivalent or better locations in the same general area. To date, we have not experienced unusual difficulty in either renewing leases for existing locations or securing leases for suitable locations for new stores. A majority of our store leases contain provisions permitting the landlord to terminate the lease upon a change in control of Kirkland’s.

      We own our corporate headquarters in Jackson, Tennessee, which currently consists of approximately 40,000 square feet of office space. We currently lease one central distribution facility, consisting of 771,000 square feet, also located in Jackson, Tennessee. This lease has a 15-year initial term, with two five-year options.

      The following table indicates the states where our stores are located and the number of stores within each state as of January 28, 2006:

      We are involved in various routine legal proceedings incidental to the conduct of our business. We believe any resulting liability from existing legal proceedings, individually or in the aggregate, will not have a material adverse effect on our operations or financial condition.

      We did not submit any matters to a vote of security holders during the fourth quarter of fiscal 2005.

PART II

      Our common stock is listed on The Nasdaq Stock Market under the symbol “KIRK.” We commenced trading on The Nasdaq Stock Market on July 11, 2002. On March 17, 2006, there were approximately 87 holders of record, and approximately 1,700 beneficial owners, of our common stock. The following table sets forth the high and low last sale prices of our common stock for the periods indicated.

Dividend Policy

      We intend to retain all future earnings to finance the continued growth and development of our business, and do not, therefore, anticipate paying any cash dividends on our common stock in the foreseeable future. In addition, our senior credit facility restricts the payment of cash dividends. There have been no dividends declared on any class of our common stock during the past two fiscal years. Future cash dividends, if any, will be determined by our Board of Directors and will be based upon our earnings, capital requirements, financial condition, debt covenants and other factors deemed relevant by our Board of Directors.

      The selected “Statement of Operations Data” and “Balance Sheet Data” have been derived from our consolidated financial statements for the periods indicated. The “Store and Other Data” for all periods presented below have been derived from internal records of our operations. This selected financial data should be read in conjunction with our consolidated financial statements and related notes, and with

“Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this Annual Report on Form 10-K.

      The following discussion should be read with our consolidated financial statements and related notes included elsewhere in this annual report on Form 10-K. A number of the matters and subject areas discussed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Business” and elsewhere in this annual report on Form 10-K are not limited to historical or current facts and deal with potential future circumstances and developments and are accordingly “forward-looking statements.” You are cautioned that such forward-looking statements, which may be identified by words such as “anticipate,” “believe,” “expect,” “estimate,” “intend,” “plan” and similar expressions, are only predictions and that actual events or results may differ materially.

      Our fiscal year is comprised of the 52 or 53-week period ending on the Saturday closest to January 31. Accordingly, fiscal 2005 represented 52 weeks ended on January 28, 2006. Fiscal 2004 represented 52 weeks ended on January 29, 2005. Fiscal 2003 represented 52 weeks ended on January 31, 2004.

Introduction

      We are a leading specialty retailer of home decor in the United States, operating 347 stores in 37 states as of January 28, 2006. 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. For the fiscal year ended January 28, 2006, we recorded net sales of $415.1 million.

      Our stores offer a unique combination of style and value that has led to our emergence as a leader in home decor 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 anticipate our growth will include primarily off-mall locations in major metropolitan markets, middle markets and selected smaller communities. We believe there are currently more than 650 additional locations in the United States that could support a Kirkland’s store. We plan on opening 60 new stores and estimate closing 30 stores in fiscal 2006.

Overview of Key Financial Measures

      Net sales and gross profit are the most significant drivers to our operating performance. Net sales consists of all merchandise sales to customers, net of returns and exclusive of sales taxes. Our net sales for fiscal 2005 increased by 5.2% to $415.1 million from $394.4 million in fiscal 2004, reflecting sales from the 59 new stores we opened in fiscal 2005 as well as sales increases from the 54 stores we opened in fiscal 2004. Comparable store sales declined 6.9% for fiscal 2005. We use comparable store sales to measure our ability to achieve sales increases from stores that have been open for at least 13 full fiscal months. Increases in comparable store sales are an important factor in maintaining or increasing the profitability of existing stores.

      Gross profit is the difference between net sales and cost of sales. Cost of sales has four distinct components: product cost, freight cost, store occupancy cost and central distribution cost. Product cost comprises the majority of cost of sales, while central distribution cost is the least significant of these four elements. Product and freight cost are variable, while occupancy and distribution costs are largely fixed. Accordingly, gross margin (gross profit expressed as a percentage of net sales) can be influenced by many factors including overall sales performance. For fiscal 2005, gross profit decreased 1.0% to $125.5 million from $126.8 million for fiscal 2004. Gross margin for fiscal 2005 decreased to 30.2% of net sales from 32.1% of net sales for fiscal 2004, primarily due to heavier than anticipated markdown activity that resulted in higher product cost as a percentage of net sales.

      Operating expenses, including the costs of operating our stores and corporate headquarters, are also an important component of our operating performance. Compensation and benefits comprise the majority of our operating expenses. Operating expenses contain fixed and variable costs, and managing the operating expense ratio (operating expenses expressed as a percentage of net sales) is an important focus of management as we seek to maintain or increase our overall profitability. Operating expenses include cash costs as well as non-cash costs such as depreciation and amortization. Due to the significant fixed cost component of operating expenses, as well as the tendency of many operating costs to rise over time, increases in comparable store sales are typically necessary in order to prevent meaningful increases in the operating expense ratio. Operating expenses can also include certain costs that are of a one-time or non-recurring nature. While these costs must be considered to understand fully our operating performance, we typically identify such costs separately on the consolidated statement of operations so that we can evaluate comparable expense data across different periods.

      A complete evaluation of our financial performance incorporates not only operating results, but also an assessment of how effectively we are deploying our capital. We believe that a high return on capital is an indicator of a financially productive business. Accordingly, we evaluate our earnings in relation to inventories and total assets in order to determine if we are achieving acceptable levels of return on our capital. Inventory yield (gross profit divided by average inventories) and return on assets (net income divided by total assets) are two of the measures we use.

      We use a number of key performance measures to evaluate our financial performance, including the following:

Strategic Areas of Emphasis

      The downturn in our financial performance for the last two fiscal years has primarily resulted from declining comparable store sales and decreases in our merchandise margin. Accordingly, a central area of emphasis for fiscal 2006 is improving the productivity of our merchandise assortment. This effort encompasses customer research, assessment of merchandising personnel and department structure, and evaluation of competitive and other factors.

      The increase in our store base during fiscal 2005 reflected a continued commitment to growth, which accelerated upon completion of our initial public offering in July 2002. That transaction enabled us to reduce our debt significantly, which led to a significant reduction in interest expense and the ability to allocate more of our cash toward capital expenditures and working capital for new stores. Capital expenditures for fiscal 2005 were $24.1 million, of which $21.0 million was related to leasehold improvements, equipment and fixtures for new stores.

      The construction of new stores will continue to be an important part of our strategy in fiscal 2006. We plan on opening 60 new stores and closing 30 stores during the upcoming year. Our stores historically have operated primarily in enclosed malls, but in fiscal 2004 we opened 44 of our 54 new stores in a variety of off-mall venues including “lifestyle” centers, “power” centers and outlet centers. In fiscal 2005, all 59 of our new stores were located in these off-mall venues. At January 28, 2006, we operated 137 of our 347 stores in non-mall venues, and we anticipate that substantially all of our new store openings in fiscal 2006 will be in off-mall venues. Typically these off-mall stores have been able to achieve higher sales volumes with lower total occupancy costs than our mall stores.

      The following table summarizes our stores and square footage under lease in mall and off-mall locations as of January 28, 2006 and January 29, 2005:

      Another important area of emphasis will be improving the effectiveness of our supply chain. We commenced operations in a new distribution center in the second quarter of fiscal 2004. This facility replaced the three buildings that previously supported our central distribution effort. The commencement of operations in the new distribution center was accompanied by the implementation of a new warehouse management system as well as investments in material handling equipment designed to streamline the flow of goods within the distribution center. In fiscal 2006 and beyond, our goal is to achieve better labor productivity, better transportation efficiency, leaner store-level inventories and reduced store-level storage costs as a result of this move and our continued improvement in distribution practices.

      Our objective is to finance all of our operating and investing activities with cash provided by operations and borrowings under our revolving credit line. Our cash balances decreased to $15.0 million at January 28, 2006 from $17.9 million at January 29, 2005. We expect that capital expenditures for fiscal

2006 will range from $25 to $27 million, primarily to fund the construction of 60 new stores and maintain our investments in existing stores, our distribution center and information technology infrastructure.

Critical Accounting Policies and Estimates

      The discussion and analysis of our financial condition and the results of our operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates that affect the reported amounts contained in the financial statements and related disclosures. We base our estimates on historical experience and on various other assumptions which are believed to be reasonable under the circumstances. Actual results may differ from these estimates. Our critical accounting policies are discussed in the notes to our consolidated financial statements. Certain judgments and estimates utilized in implementing these accounting policies are likewise discussed in 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 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 by category and class of merchandise in relation to the estimated sales price. This evaluation is performed to ensure that we do not carry inventory at a value in excess of the amount we expect to realize upon the sale of the merchandise. 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 49% of our assets at January 28, 2006, 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.

      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

during each fourth quarter or more frequently when events and circumstances indicate that an impairment may have occurred.

      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.

      Income taxes — We record income tax liabilities utilizing known obligations and estimates of potential obligations. A deferred tax asset or liability is recognized whenever there are future tax effects from existing temporary differences and operating loss and tax credit carryforwards. We record a valuation allowance to reduce deferred tax assets to the balance that is more likely than not to be realized. We must make estimates and judgments on future taxable income, considering feasible tax planning strategies and taking into account existing facts and circumstances, to determine the proper valuation allowance. When we determine that deferred tax assets could be realized in greater or lesser amounts than recorded, the asset balance and income statement reflects the change in the period such determination is made. Due to changes in facts and circumstances and the estimates and judgments that are involved in determining the proper valuation allowance, differences between actual future events and prior estimates and judgments could result in adjustments to this valuation allowance. We use an estimate of our annual effective tax rate at each interim period based on the facts and circumstances available at that time while the actual effective tax rate is calculated at year-end.

      Stock options and warrants — The Company applies Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations, in accounting for its stock compensation plans. These plans are more fully described in Note 7 of the financial statements. Compensation cost on stock options is measured as the excess, if any, of the fair value of the Company’s common stock at the date of the grant over the exercise price. 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.

Fiscal 2005 Compared to Fiscal 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):

      Net sales. Net sales increased by 5.2% to $415.1 million for fiscal 2005 from $394.4 million for fiscal 2004. The net sales increase in fiscal 2005 resulted primarily from the opening of new stores. We opened 59 new stores in fiscal 2005 and 54 new stores in fiscal 2004, and we closed 32 stores in fiscal 2005 and 14 stores in fiscal 2004. Our net sales also benefited from sales increases from expanded, remodeled or relocated stores, which are excluded from our comparable store base. The impact of these changes in the store base was offset by a decline of 6.9% in comparable store sales for fiscal 2005. During fiscal 2004, comparable store sales decreased 5.0%. Comparable store sales in our mall store locations were down 8.5% for the year, while comparable store sales for our off-mall store locations were down 0.6%. Lower customer traffic was the primary reason for the decrease in comparable store sales. We attributed the traffic declines to a combination of the challenging competitive environment in the home decor sector as well as our inability to present a compelling merchandise assortment to our customer base. Declines in customer traffic were most evident in our mall stores, as malls generally have been attracting fewer of our core female customers. Key categories that outperformed the prior year included candles, furniture, alternative wall decor, mirrors and textiles. These increases were offset by declines in art, lamps, garden, gift/novelty and seasonal. The growth in the store base along with sales from expanded, remodeled or relocated stores accounted for an increase of $44.2 million over the prior year. This increase was partially offset by the negative comparable store sales performance, which accounted for a $23.5 million decrease from the prior year. The comparable store sales performance was characterized by a higher average dollar transaction offset by lower transaction volumes.

      Gross profit. Gross profit decreased $1.3 million, or 1.0%, to $125.5 million for fiscal 2005 from $126.8 million for fiscal 2004. Gross profit expressed as a percentage of net sales decreased to 30.2% for fiscal 2005, from 32.1% for fiscal 2004. The decrease in gross profit as a percentage of net sales resulted from higher product cost of sales. Product cost of sales increased during fiscal 2005 as a percentage of sales, as we took significant markdowns in an attempt to improve sales. Store occupancy costs increased slightly as a percentage of sales as the comparable store sales decline negatively affected the occupancy ratio, offsetting the benefits we began to achieve from our shift to more off-mall real estate, the occupancy rates for which tend to be lower than those for enclosed mall properties. Freight expenses decreased as a percentage of sales, despite rising fuel costs, as we realized savings throughout the year due to the

implementation of changes in our store delivery methods. Central distribution costs were unchanged as a percentage of net sales for the year.

      Compensation and benefits. Compensation and benefits, including both store and corporate personnel, was $70.5 million, or 17.0% of net sales, for fiscal 2005 as compared to $66.2 million, or 16.8% for fiscal 2004. The increase in the compensation and benefits ratio was primarily due to the negative comparable store sales performance. At the store level, we were able to leverage payroll costs slightly versus the prior year by employing tight payroll management in a difficult sales environment. This improvement was offset by higher payroll costs at the corporate level due to key additions to the management team that occurred during fiscal 2004 and fiscal 2005. Additionally, employee benefits costs increased slightly as a percentage of sales due to higher costs of health care claims.

      Other operating expenses. Other operating expenses, including both store and corporate costs, were $39.5 million, or 9.5% of net sales, for fiscal 2005 as compared to $36.9 million, or 9.3% of net sales, for 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 and the lack of a positive leveraging effect on the relatively fixed components of store and corporate operating expenses. Store-level operating expenses increased slightly as a percentage of sales due to greater spending on advertising and promotion as well as increases in expenses associated with the increased penetration of our private-label credit card loyalty program. Additionally, utilities costs increased during the year due to rising energy costs and our implementation of a wide-area network during the second quarter of fiscal 2004. These increases were partially offset by decreases in storage and related equipment rental costs due to improved distribution efficiencies. Corporate-level operating expenses were slightly lower as a percentage of sales as compared to the prior year. This decline was due to reductions in professional fees associated with Sarbanes-Oxley compliance efforts and decreases in travel and corporate-level insurance costs.

      Depreciation and amortization. Depreciation and amortization expense was $15.3 million, or 3.7% of net sales, for fiscal 2005 as compared to $12.1 million, or 3.1% of net sales, for fiscal 2004. The increase in depreciation and amortization was the result of the negative comparable store sales performance, along with the growth of the 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 fiscal 2004, we incurred non-cash stock compensation charges related to stock options granted to certain employees in November 2001. The charge related to these stock option arrangements amounted to $0.2 million, or 0.1% of net sales, for fiscal 2004. See Note 7 to our consolidated financial statements. This charge was taken ratably over the vesting period of the November 2001 options. These options were fully vested as of January 29, 2005, therefore there was no charge in fiscal 2005 and there will be no additional charge related to these options in future periods.

      Interest expense, net. Net interest expense was $58,000, or 0.0% of net sales, for fiscal 2005 as compared to $0.8 million, or 0.2% of net sales, for fiscal 2004. During the prior year, 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, our revolver borrowings were below prior year levels throughout the year.

      Income taxes. Income tax provision was $0.2 million, or 47.4% of income before income taxes, for fiscal 2005 compared to $4.3 million, or 39.5% of income before income taxes, for fiscal 2004. Due to the lower levels of pre-tax income during fiscal 2005, the impact of permanent differences between accounting principles generally accepted in the United States of America and tax treatment resulted in a negative effect on the overall tax rate.

      Net income. As a result of the foregoing, net income was $229,000, or 0.1% of net sales, for fiscal 2005 compared to $6.6 million, or 1.7% of net sales, for fiscal 2004. Diluted earnings per share was $0.01 for fiscal 2005 as compared to $0.34 for fiscal 2004.

Fiscal 2004 Compared to Fiscal 2003

      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):

      Net sales. Net sales increased by 6.8% to $394.4 million for fiscal 2004 from $369.2 million for fiscal 2003. The net sales increase in fiscal 2004 resulted primarily from the opening of new stores. We opened 54 new stores in fiscal 2004 and 42 new stores in fiscal 2003, and we closed 14 stores in fiscal 2004 and 11 stores in fiscal 2003. Our net sales also benefited from sales increases from expanded, remodeled or relocated stores, which are excluded from our comparable store base. The impact of these changes in the store base was offset by a decline of 5.0% in comparable store sales for fiscal 2004. During fiscal 2003, comparable store sales decreased 0.2%. The comparable store sales decline resulted from several factors, including a difficult sales environment in the home décor sector. Additionally, our merchandise assortments were not sufficiently compelling to customers, particularly in several of our home décor categories where our inventory mix became overly broad during the second and third quarters of the year. Key categories that outperformed the prior year included primarily novelty/gift items and textiles. These increases were offset by declines in decorative accessories, floral, housewares, frames, and garden. The growth in the store base along with sales from expanded, remodeled or relocated stores accounted for an increase of $41.2 million over the prior year. This increase was partially offset by the negative comparable store sales performance, which accounted for a $15.9 million decrease from the prior year. The comparable store sales performance was characterized by higher average retail prices offset by lower transaction volumes.

      Gross profit. Gross profit decreased $0.5 million, or 0.4%, to $126.8 million for fiscal 2004 from $127.3 million for fiscal 2003. Gross profit expressed as a percentage of net sales decreased to 32.1% for fiscal 2004, from 34.5% for fiscal 2003. The decrease in gross profit as a percentage of net sales resulted from higher product cost of sales. Product cost of sales increased during fiscal 2004 as a percentage of sales, primarily due to heavier markdown activity in response to a difficult sales environment and to correct uneven merchandise assortments and inventory positions. Store occupancy costs also increased as a percentage of sales as the comparable store sales decline negatively affected the occupancy ratio, offsetting the benefits we began to achieve from our shift to more off-mall real estate, the occupancy rates for which tend to be lower than those for enclosed mall properties. Central distribution costs increased slightly as a percentage of net sales due to the transition costs incurred during the second quarter of 2004 in connection with our move into a new distribution center.

      Compensation and benefits. Compensation and benefits, including both store and corporate personnel, was $66.2 million, or 16.8% of net sales, for fiscal 2004 as compared to $57.6 million, or 15.6% for fiscal 2003. The increase in the compensation and benefits ratio was primarily due to the negative comparable store sales performance. In particular, we were not able to reduce hours sufficiently in stores to maintain the ratio at the prior year level. Furthermore, we made several additions to corporate management during 2004 in order to strengthen key departments such as merchandising, marketing and store operations. Finally, and to a lesser extent, we experienced increases in health care costs related to our employee health insurance coverage.

      Other operating expenses. Other operating expenses, including both store and corporate costs, were $36.9 million, or 9.3% of net sales, for fiscal 2004 as compared to $28.9 million, or 7.8% of net sales, for fiscal 2003. The increase in these operating expenses as a percentage of net sales was primarily the result of the negative comparable store sales performance and the lack of a positive leveraging effect on the relatively fixed components of store and corporate operating expenses. Additionally, we increased spending on advertising and promotion by approximately $1.8 million during fiscal 2004 as we experimented with various forms of media advertising and other marketing programs in order to drive traffic to our stores. Furthermore, corporate professional fees increased due to the costs associated with our efforts to comply with the Sarbanes-Oxley Act. These costs totaled approximately $1.0 million for fiscal 2004.

      Lease termination charge. During the fourth quarter of fiscal 2003, we provided notice to our landlords of our intent to terminate the leases on our existing central distribution facilities. Consequently, upon providing that notice, we recorded a one-time charge of $1.1 million related to the penalties associated with those early terminations. No such charge was recorded during fiscal 2004.

      Depreciation and amortization. Depreciation and amortization expense was $12.1 million, or 3.1% of net sales, for fiscal 2004 as compared to $9.3 million, or 2.5% of net sales, for fiscal 2003. The increase in depreciation and amortization was the result of the growth of the store base and the increased capital costs associated with our move to a new distribution center during the second quarter of 2004.

      Non-cash stock compensation charge. During fiscal 2004 and fiscal 2003, we incurred non-cash stock compensation charges related to stock options granted to certain employees in November 2001. The charge related to these stock option arrangements amounted to $0.2 million, or 0.1% of net sales, for fiscal 2004, a decrease from $0.3 million, or 0.1% of net sales, for fiscal 2003. See Note 7 to our consolidated financial statements. This charge was taken ratably over the vesting period of the November 2001 options. These options were fully vested as of January 29, 2005, therefore there was no charge in fiscal 2005 and there will be no additional charge related to these options in future periods.

      Interest expense, net. Net interest expense was $0.8 million, or 0.2% of net sales, for fiscal 2004 as compared to $0.7 million, or 0.2% of net sales, for fiscal 2003. The increase was the result of the October 2004 refinancing of our line of credit facility. As a result of this refinancing, we recorded a charge upon early retirement of our previous facility of $0.3 million. There was no such charge in fiscal 2003.

      Income taxes. Income tax provision was $4.3 million, or 39.5% of income before income taxes, for fiscal 2004 compared to $11.6 million, or 39.2% of income before income taxes, for fiscal 2003.

      Net income. As a result of the foregoing, net income $6.6 million, or 1.7% of net sales, for fiscal 2004 compared to $18.0 million, or 4.9% of net sales, for fiscal 2003. Diluted earnings per share was $0.34 for fiscal 2004 as compared to $0.92 for fiscal 2003.

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, borrowings under our credit facilities and proceeds from the sale of equity securities.

      Cash flows from operating activities. Net cash provided by operating activities was $20.2 million, $30.3 million and $35.9 million for fiscal 2005, fiscal 2004 and fiscal 2003, respectively. Net cash provided by operating activities depends heavily on operating performance, changes in working capital, the timing and amount of payments for income taxes, and the timing of interest payments on indebtedness. During fiscal 2005, net cash provided by operating activities decreased primarily due to the decline in our operating performance for the year. Additionally, non-cash working capital increased $5.1 million as we continued our store growth which required incremental inventory investment. Inventory levels increased 33% over the prior year due to a combination of growth in our store base, and a return to more normal beginning-of-year store inventory levels as compared to the relatively low levels with which we started fiscal 2005. Operating cash flow for fiscal 2004 decreased compared to fiscal 2003 due to reduced earnings performance. This decline in earnings was offset by a reduction in inventory of $4.5 million as we managed inventory levels tightly in response to a challenging sales environment, and ended the year with lean store inventory levels.

      Cash flows from investing activities. Net cash used in investing activities was $24.1 million, $30.0 million and $22.8 million for fiscal 2005, fiscal 2004 and fiscal 2003, respectively. These amounts consisted entirely of capital expenditures offset slightly by proceeds received from the sale of certain assets. These capital expenditures primarily included investments in new store construction; existing store remodels; information technology assets for stores, the distribution center, and the corporate headquarters; and materials handling and related equipment for our new distribution facility, which was occupied in the second quarter of fiscal 2004. New store construction comprises the large majority of our capital expenditures. During fiscal 2005, we opened 59 new stores. We expect that capital expenditures for fiscal 2006 will range from $25 to $27 million, primarily to fund the construction of approximately 60 new stores and maintenance of our investments in stores, information technology, and the distribution center. We also expect that capital expenditures, including leasehold improvements, furniture and fixtures, and equipment for our fiscal 2006 new stores will average approximately $380,000 to $410,000 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 was $1.0 million and $0.2 million for fiscal 2005 and fiscal 2004, respectively. Net cash used in financing activities was $1,000 for fiscal 2003. Cash flows from financing activities for fiscal 2005 were primarily comprised of borrowings and repayments under our revolving credit facility as well as the repayment of a shareholder loan. The facility was drawn to a peak of $11.9 million and paid down to zero by the end of the fiscal year. During fiscal 2004 and fiscal 2003, cash flows from financing activities also primarily related to bank revolver activity. We borrowed to a peak of $18.7 million and $13.0 million and paid down to zero by the end of the year for fiscal 2004 and fiscal 2003, respectively. Cash flows from financing activities also include cash received for exercises of employee stock options, as well as cash paid for issue costs on indebtedness.

      Revolving credit facility. Effective October 4, 2004, the Company entered into a 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 (4.6% at January 28, 2006) 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 January 28, 2006, we were in compliance with the covenants in the facility and there were no borrowings outstanding under the credit facility.

      At January 28, 2006, our balance of cash and cash equivalents was $15.0 million and the borrowing availability under our facility was $23.7 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 2006 plans in full and fund our planned capital expenditures and working capital requirements for at least the next twelve months.

      Contractual obligations. The following table identifies payment obligations for the periods indicated under our current contractual arrangements. The amounts set forth below reflect contractual obligations as of January 28, 2006. The timing and/or the amount of the payments may be changed in accordance with the terms of the contracts or new contractual obligations may be added.

Seasonality and Quarterly Results

      We have historically experienced and expect to continue to experience substantial seasonal fluctuations in our net sales and operating income. We believe this is the general pattern typical of our segment of the retail industry and, as a result, expect that this pattern will continue in the future. Our quarterly results of operations may also fluctuate significantly as a result of a variety of other factors, including the timing of new store openings, net sales contributed by new stores, shifts in the timing of certain holidays and competition. Consequently, comparisons between quarters are not necessarily meaningful and the results for any quarter are not necessarily indicative of future results.

      Our strongest sales period is the winter holiday season. Consequently, we generally realize a disproportionate amount of our net sales and a substantial majority of our operating and net income during the fourth quarter of our fiscal year. In anticipation of the increased sales activity during the fourth quarter of our fiscal year, we purchase large amounts of inventory and hire temporary staffing help for our stores. Our operating performance could suffer if net sales were below seasonal norms during the fourth quarter of our fiscal year.

      The following table sets forth certain unaudited financial and operating data for Kirkland’s in each fiscal quarter during fiscal 2005 and fiscal 2004. The unaudited quarterly information includes all normal recurring adjustments that we consider necessary for a fair statement of the information shown

Inflation

      We do not believe that our operating results have been materially affected by inflation during the preceding three fiscal years. There can be no assurance, however, that our operating results will not be adversely affected by inflation in the future.

Recent Accounting Pronouncements

      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 released revised FASB No. 123R (“SFAS 123R”), “Share-Based Payment”, which requires companies to expense the fair value of employee stock options and other forms of stock-based compensation. The Company has adopted SFAS 123R beginning January 29, 2006. The Company is using the modified prospective application method of adoption, which excludes restatement of prior periods in the year of adoption. The precise impact of the adoption of SFAS 123R on the fiscal 2006 financial statements has not yet been determined. However, see Note 1 for information related to the pro forma effects on the Company’s reported net income and net income per share of applying the fair value recognition provisions of the previous SFAS 123, “Accounting for Stock-Based Compensation.”

      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. Retrospective application for interim financial information is permitted but is not required. The Company has adopted FIN 47 in fiscal 2005, as required.

      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. The implementation of SFAS 154 is not expected to have a material impact on the Company’s consolidated financial statements.

      Market risks related to our operations result primarily from changes in short-term London Interbank Offered Rates, or LIBOR, as our senior credit facility utilizes short-term LIBOR rates and/or contracts. The base interest rate used in our senior credit facility is the 60-day LIBOR, however, from time to time, we may enter into one or more LIBOR contracts. These LIBOR contracts vary in length and interest rate, such that adverse changes in short-term interest rates could affect our overall borrowing rate when contracts are renewed.

      As of January 28, 2006, we had no outstanding borrowings under our revolving credit facility. All amounts borrowed throughout the year under our revolving credit facility were entered into for other than trading purposes.

      We were not engaged in any foreign exchange contracts, hedges, interest rate swaps, derivatives or other financial instruments with significant market risk as of January 28, 2006.

      The financial statements and schedules are listed under Item 15(a) and filed as part of this annual report on Form 10-K.

      The supplementary financial data is set forth under Item 7 of this annual report on Form 10-K.

      None

Evaluation of Disclosure Controls and Procedures

      We have established and maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) is recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. We carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of the date of such evaluation.

Management’s Report on Internal Control Over Financial Reporting

      Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Exchange Act Rule 13a-15(f). Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we carried out an evaluation of the effectiveness of our internal control over financial reporting as of January 28, 2006 based on the Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Based on this evaluation, our management concluded that our internal control over financial reporting was effective as of January 28, 2006.

      PricewaterhouseCoopers LLP, the independent registered public accounting firm that audited our financial statements included in this Annual Report on Form 10-K, has audited our management’s assessment of the effectiveness of our internal control over financial reporting as of January 28, 2006, as stated in their report which is included herein.

Changes in Internal Control 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.

      None.

PART III

      Information concerning directors, appearing under the caption “Board of Directors” in our Proxy Statement (the “Proxy Statement”) to be filed with the SEC in connection with our Annual Meeting of Shareholders scheduled to be held on June 5, 2006, information concerning executive officers, appearing under the caption “Item 1. Business — Executive Officers of Kirkland’s” in Part I of this annual report on Form 10-K, and information under the caption “Other Matters — Section 16(a) Beneficial Ownership

Reporting Compliance” in the Proxy Statement are incorporated herein by reference in response to this Item 10.

      The Board of Directors has adopted a Code of Business Conduct and Ethics applicable to our directors, officers and employees, including our President and Chief Executive Officer, our Executive Vice President and Chief Financial Officer and our Vice President of Finance and Treasurer/ Controller, which has been posted on the “Investor Relations” section of our web site. We intend to satisfy the amendment and waiver disclosure requirements under applicable securities regulations by posting any amendments of, or waivers to, the Code of Business Conduct and Ethics on our web site.

      The information contained in the sections titled “Executive Compensation” and “Information About the Board of Directors — Board of Directors Compensation” in the Proxy Statement is incorporated herein by reference in response to this Item 11.

      The information contained in the section titled “Security Ownership of Kirkland’s — Ownership of Management and Certain Beneficial Owners” in the Proxy Statement, with respect to security ownership of certain beneficial owners and management, is incorporated herein by reference in response to this Item 12.

Equity Compensation Plan Information

      The information contained in the section titled “Related Party Transactions” in the Proxy Statement is incorporated herein by reference in response to this Item 13.

      The information contained in the section titled “Other Matters — Audit Fees” in the Proxy Statement is incorporated herein by reference in response to this Item 14.

PART IV

      (a) 1. Financial Statements

      The financial statements and schedules set forth below are filed on the indicated pages as part of this annual report on Form 10-K.

      2. Schedules

      None.

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Shareholders of Kirkland’s, Inc.:

      We have completed integrated audits of Kirkland’s, Inc.’s fiscal 2005 and fiscal 2004 consolidated financial statements and of its internal control over financial reporting as of January 28, 2006, and an audit of its fiscal 2003 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.

Consolidated financial statements

      In our opinion, the consolidated financial statements listed in the accompanying index appearing under Item 15(a)(1) present fairly, in all material respects, the financial position of Kirkland’s, Inc. and its subsidiaries at January 28, 2006 and January 29, 2005, and the results of their operations and their cash flows for each of the three years in the period ended January 28, 2006 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

Internal control over financial reporting

      Also, in our opinion, management’s assessment, included in Management’s Report on Internal Control Over Financial Reporting appearing under Item 9A, that the Company maintained effective internal control over financial reporting as of January 28, 2006 based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of January 28, 2006, based on criteria established in Internal Control — Integrated Framework issued by the COSO. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.

      A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of

management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

      Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

Memphis, Tennessee April 10, 2006

KIRKLAND’S, INC.

CONSOLIDATED BALANCE SHEETS

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

KIRKLAND’S, INC.

CONSOLIDATED STATEMENTS OF INCOME

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

KIRKLAND’S, INC.

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY