Tuesday, February 22, 2011

Kirkland's: The Falling Knife Turns Upward

Just three months ago, shares of Kirkland's (KIRK) fell 17% to nearly $10/share. At that price, the stock was brought up as a potential stock idea as its P/E was only 6 after subtracting out the company's net cash position. Last week, however, the shares traded up close to $16/share, resulting in a very strong return over a very short period. The lesson for investors is simple: catch the falling knife, and sell it to Mr. Market once it's no longer falling.

There is a multitude of research that suggests that stocks that underperform the market tend to outperform the market in subsequent periods. Despite this, the mainstream media and analysts continually advise against buying a stock that is falling. This is terrible advice. Panic-selling can often create just the opportunity the value investor is waiting for.

Of course, this doesn't mean one should buy just any falling knife. All investments must be studied and vetted carefully. A company's current financial position and future earnings power must always be considered relative to its asking price. But "falling knives" should be welcomed as potential opportunities, and not situations to be avoided.

Near $16/share, Kirkland's stock is no longer the steal it was just three months ago. The company's P/E (now near 10) faces upward pressure as same-store sales are declining in the high single-digits. However, the company's financial position remains strong, as Kirkland's has $60 million of cash against no balance sheet debt. Nevertheless, the company likely trades a lot closer to fair value than it did when it was identified as a potential value opportunity. (And even if it is still slightly undervalued, it is likely better to be approximately right than precisely wrong.) This offers value investors a chance to get out and deploy their capital towards the next opportunity.

Disclosure: No position


Wilhelm said...

I, unfortunately, got in before the big drop. But doubled up after the drop and still got a nice profit out of it.

So, thanks for the tip and maybe this'll teach me to be more patient next time.

E said...

I always wondered about those statistics and studies that show underperformers subsequently outperform. Do those studies take into account survivorship bias? I know a lot of Net-Net studies are screened and show a false positive skew because they don't take into account those that were frauds or went out of business. Nice work on Kirkland's!

rayhan said...

hey saj ,
4give me but u alive?
24 hours and no blog update!

Saj Karsan said...

Hi E,

I don't think a study done today would survive any scrutiny if it did not account for survivorship bias, as that was advanced as a criticism for this type of study at least a couple of decades ago.

Hi Rayhan,

Thanks for checking in! I'm not sure why the post did not publish as it should have! I'll have to monitor that in the coming days.

Paul D said...

Hi Raj,

Longtime reader here...

Your Lexmark posting made me think back to this Kirkland one. Much like Lexmark has to be seriously innovative to keep pace with a competitive industry (leading to a high potential for hit-or-miss earnings years), Kirkland is the same way with its merchandise selection and -- ultimately -- gross margins.

Their sales rely on having sufficiently fashionable products at value prices. They import, so lead times for buying to shelving a product can be months, requiring some pretty good insights (lucky guesses?) from their buying teams. If they get it right, you see a year like FY 2010. If they get it wrong...2007-8.

While it was good to get them when they were low, the outcome was anything but certain. Management claims a turnaround was completed, and while I agree that Kirkland has done a fine job reducing expenses (especially occupancy costs) over the past 2-3 years, its ability to consistently procure merchandise that will move (without discounting) is highly questionable. Thus, the large fluctuation in gross margins over the years.

This could be an excellent company if they were great merchants (a la early Wal-Mart days or early Home Depot days...the REAL go-getters that created true "merchant cultures"), but I suspect they're more hit or miss. They will have a good year or two, but then they'll buy stuff that the customers just don't like for another year or two.

And the fortunes of investors will rise or fall with savvy merchandise decisions. If you bought at $10 and the company was still in a "down" merchandise cycle, you could have easily seen your investment drop pretty far.

And for the most recent quarter, with nearly 10% comp store drops, I think you'll find another miss on the merchandising front. It could be the start of another cycle that sees Kirkland's stock get hurt badly and its cash pile dwindle.

Much like you wouldn't bet on Lexmark being a consistent innovator, able to stay ahead of a hungry pack of print competitors...I wouldn't bet on Kirkland's merchandising abilities to keep it very far in front of customers' quickly closing wallets.

Though in this investing business, you can always get lucky.

I love your posts! Keep up the great thinking!

Saj Karsan said...

Hi Paul D,

I like your arguments and I tend to agree in principal with what you're saying. However, for me there are two differences between Kirkland's and Lexmark which make the situations different.

First, I think the risks in technology (obsolescence, patents etc.) are greater than in retail, where I feel copying the competition is easier. Unless you're overleveraged, you won't be made obsolete, you just need time to copy the competition. I could be wrong about this, but it's my view.

Second, there was a large valuation difference (on a multiple basis, of maybe 30%) between the two companies (at the time of write-up). Obviously, there is some price at which I'd be interested in Lexmark. If Lexmark fell further, to say a P/E of 5 (which is where KIRK was ex-cash) or lower, then it becomes more compelling.

Hope that helps to give you the reasons for the differences in my tones in the two articles.

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