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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Form 10-K

Commission file number 000-49885

Kirkland’s, Inc.

Registrant’s telephone number, including area code:

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

      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 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 an accelerated filer (as defined in Rule 12b-2 of the Act).     Yes þ          No o

      The aggregate market value of the common stock held by non-affiliates of the registrant as of August 1, 2003, the last business day of the registrant’s most recently completed second fiscal quarter, was approximately $128,204,800 based on the last sale price of the common stock as reported by The Nasdaq Stock Market. This calculation excludes 10,486,316 shares held by directors, executive officers and one holder of more than 10% of the registrant’s common stock.

      As of April 7, 2004, there were 19,186,466 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 2, 2004, are incorporated by reference into Part III of this Form 10-K.

TABLE OF CONTENTS

FORM 10-K

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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.

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PART I

General

      We are a leading specialty retailer of home decor in the United States, operating 280 stores in 34 states as of January 31, 2004. Our stores present a broad selection of distinctive merchandise, including framed art, mirrors, candles, lamps, picture frames, 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 over the last six fiscal years.

      During the past six fiscal years, we have more than doubled our store base, principally through new store openings. We intend to continue opening new stores both in existing markets and in new markets. We anticipate our growth will include mall and non-mall locations in major metropolitan markets, middle markets and selected smaller communities. We currently anticipate that a majority of the new stores opened in fiscal 2004 will be located in non-mall venues. During the 52 weeks ended January 31, 2004 (“fiscal 2003”), we opened 42 new stores and closed 11 stores. We believe there are currently more than 750 additional locations in the United States that could support a Kirkland’s store.

      Kirkland’s was co-founded in 1966 by our current Chairman, Carl Kirkland. We opened our first store in Jackson, Tennessee, and have grown steadily thereafter. Although originally focused in the Southeast, primarily in enclosed malls, we have expanded beyond that region and have begun to open stores in selected non-mall venues. Currently, approximately 50% of our stores are located outside the Southeast.

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 distinguishes us in the marketplace and enhances our margins.

      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

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      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.

      Flexible approach to real estate. Our stores operate successfully across a wide spectrum of different regions, market sizes and real estate venues. We operate our stores in 34 states, and although originally focused in the Southeast, approximately 50% 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. In addition, although our stores are predominantly located in enclosed malls, we also operate successfully in non-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.

Growth Strategy

      Our growth strategy is to continue to build on our position as a leading specialty retailer of home decor in the United States by:

      Opening new stores using our proven store model. Over the past six 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 mall and non-mall locations in major metropolitan markets, middle markets and in selected smaller communities. We believe there are currently more than 750 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 40 stores during the 52 weeks ending January 29, 2005 (“fiscal 2004”) and target a long-term growth rate in the store base of 15-18% annually.

      Our proven store model produces strong store-level cash flow and provides an attractive store-level return on investment. In fiscal 2003, our average store generated net sales of approximately $1.4 million. Our stores typically generate a positive store contribution in their first full year of operation.

      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.

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      Increasing store productivity. We plan to increase our sales per square foot and store profitability by leveraging recent investments in information systems and central distribution. We believe that the sales productivity of our stores will benefit from our strong existing customer franchise and our continuing efforts to enhance the Kirkland’s brand. Our distinctive and often proprietary merchandise offering, together with carefully coordinated in-store marketing, visual presentation and product packaging, enable us to establish a distinct brand identity and to solidify our bond with customers, further enhancing our store-level productivity. We believe our comparable store sales will continue to benefit from the discretionary income available to consumers in their prime earning years as well as other consumer and demographic trends favoring home-oriented purchases.

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. We believe that this strategy creates a shopping experience that appeals to shoppers, both style-conscious and price-conscious. Although we do not attempt to be a fashion leader, we identify and capitalize on existing or emerging trends when identifying or developing merchandise for sale.

      Our information systems permit close tracking of individual item sales, which enables us to react quickly to market trends and best sellers. As a result, we minimize the accumulation of slow-moving inventory and resulting markdowns. 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 2,500-3,000 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 200 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 improve our net sales and gross margin. We market a substantial portion of our exclusive or custom-packaged merchandise assortment under the Cedar Creek private label brand and other proprietary names. Our strategy is to continue to grow our exclusive and proprietary products and custom-packaged products within our merchandise mix.

      Product assortment. Our major merchandise categories include wall decor (framed art, mirrors, and other wall ornaments), lamps, decorative accessories, candles and various holders, textiles, garden accessories and floral products. Our stores also offer an extensive assortment of holiday merchandise, as

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      The following table presents the percentage of fiscal 2003 and fiscal 2002 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 31, 2004, we operated 280 stores in 34 states, all but one of which are open seven days a week. In addition to corporate management, six Regional Managers and 33 District Managers (who generally have responsibility for eight to 10 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 ten 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.

      Format. The prototype Kirkland’s store is between 4,200 and 5,200 square feet, of which approximately 70% typically represents selling space. Merchandise 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

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      During fiscal 2003, we opened 42 new stores and closed 11 stores. Of the 42 new stores, 25 are located in enclosed malls and 17 are located in non-mall venues. All of the 11 closings in fiscal 2003 were mall stores. As of January 31, 2004, we operated 35 of our 280 stores in a variety of non-mall venues including “lifestyle” strip centers, “power” centers and outlet centers. Non-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 a majority of the new stores opened in fiscal 2004 will be located in non-mall venues.

      Visual merchandising. 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, weekly 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 Managers 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 expansion program depends on our ability to promote and/or recruit qualified District and Store Managers and maintain quality sales associates. To date, the majority of our District Managers previously have been Kirkland’s Store Managers. An intensive nine-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 full-time recruiter. 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, District and Store Managers with a base salary plus a quarterly performance bonus based on store sales and store-level profit contribution. Sales associates are compensated on an hourly basis. In addition, we regularly run a variety of contests that reward associates for outstanding sales achievement.

      Briar Patch. We operate 22 stores under the name “Briar Patch by Kirkland’s.” These stores are operated and merchandised in the same fashion as our stores operated under the “Kirkland’s” name and generate store-level operating results comparable to our “Kirkland’s” stores. In 1998, we acquired the 35-store Briar Patch operation, and we have since converted seven of those stores to “Kirkland’s” stores and have closed six of them. As the remaining stores are remodeled or relocated, we intend to change the name of these stores to “Kirkland’s.”

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.

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      Site selection. We locate our stores in enclosed malls or non-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 non-mall real estate alternatives. During fiscal 2003, we opened 42 new stores and closed 11 stores. Of the 42 new stores, 25 are located in enclosed malls and 17 are located in non-mall venues. All of the 11 closings in fiscal 2003 were mall stores. Of our 280 stores as of January 31, 2004, 35 were in a variety of non-mall venues including “lifestyle” strip centers, “power” centers and outlet centers. Non-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 a majority of the new stores opened in fiscal 2004 will be located in non-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 since the beginning of our fiscal year ended December 31, 1999 (“fiscal 1999”).

(1)	Also includes the period beginning on January 1, 2001 and ending on February 3, 2001.
(2)	Excludes our warehouse outlet store located adjacent to our central distribution facilities in Jackson, Tennessee.
(3)	Calculated using gross square footage of all stores open at both the beginning and the end of the period. Gross square footage includes the storage, receiving and office space that generally occupies approximately 30% of total store space.

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 200 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

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      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. If necessary, we can shift slow-moving inventory to other stores for sell-through prior to instituting corporate-wide markdowns. 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.

      In April 2001, we installed a state-of-the-art merchandise management system, improving the efficiency of our planning and allocation process. This system provides our buyers and planners with daily information on sales, gross margin and inventory by category, classification and item. This information is available for each store, permitting our planners to assess merchandise trends and manage inventory levels and flow at the individual store level.

Distribution and Logistics

      Prior to the 12 months ended December 31, 2000 (“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.

      We have expanded our central distribution operations during the past four years, as our store base has grown and we have improved our distribution practices. We currently distribute approximately 75% of our merchandise purchases through three separate buildings occupying a total of approximately 658,000 square feet in Jackson, Tennessee. We utilize third-party carriers to transport merchandise from our Jackson facilities to our stores. The majority of our merchandise deliveries are handled by less-than-truckload (LTL) carriers, which we have 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 stores located where LTL service is not optimal, we have begun to employ full truckload deliveries to regional “pool points”, with local delivery agents handling the actual store delivery function.

      As our central distribution operation has grown, we have 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. It also involves the 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

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      The commencement of operations in the new distribution center will be 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. We do not expect to gain meaningful operational efficiencies from the new distribution center and related investments in fiscal 2004. However, in fiscal 2005 and beyond, our goal is to achieve better labor productivity, better transportation efficiency, leaner store-level inventories and reduced store-level storage costs.

      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.

E-Commerce

      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

      We have invested significant resources developing an information systems infrastructure to support our business. Since fiscal 1999 we have completed projects including the installation of new point-of-sale (POS) software in all stores and integrated retail management software at our home office, an upgrade of the POS hardware in all of our stores, and the implementation of additional POS applications such as debit and gift card processing.

      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 automated 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 installed in April 2001. 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. Our distribution center currently employs certain elements of the GERS software package. We will deploy a new warehouse management system simultaneous with our move to a new distribution center in the second quarter of 2004. We utilize a Lawson Software package for our payroll and human resource functions.

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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 local newspaper advertisements to promote specific events in our stores, including our semi-annual clearance events. We also employ magazine advertising to build awareness of the Kirkland’s brand.

Trademarks

      All of our stores operate under the name “Kirkland’s” other than 22 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” 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. We believe that these marks have become 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, 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 and presenting it in a visually appealing manner.

      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.”

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Employees

      We employed approximately 3,725 employees at April 3, 2004. 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 April 15, 2004, and position of each of our executive officers are as follows:

      Carl Kirkland, 63, has been Chairman of the Board since June 1996. Mr. Kirkland co-founded Kirkland’s in 1966 and served as Chief Executive Officer from 1966 through March 2001 and President from 1966 through November 1997. He has over 30 years of experience in the retail industry. Mr. Kirkland also serves on the board of directors of Hibbett Sporting Goods, Inc.

      Robert E. Alderson, 57, has been a Director of Kirkland’s since September 1986, President of Kirkland’s since November 1997 and Chief Executive Officer of Kirkland’s since March 2001. He served as Chief Operating Officer of Kirkland’s from November 1997 through March 2001 and as Senior Vice President of Kirkland’s since 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, he was a senior partner at the law firm of Menzies, Rainey, Kizer & Alderson.

      Reynolds C. Faulkner, 40, 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.

      Chris T. LaFont, 43, has been Senior Vice President of Merchandising and General Merchandise Manager since February 2003. He served as Vice President of Merchandising — Product Development from September 1997 through February 2003. From 1988 to September 1997, he served as Vice President of Visual Merchandising for Kirkland’s. Mr. LaFont started his career with Kirkland’s in 1981 as a management trainee.

      C. Edmond Wise, Jr., 53, has been Senior Vice President of Store Operations since joining Kirkland’s in December 2000. Prior to joining Kirkland’s, Mr. Wise was a Director of Retail Operations for Payless ShoeSource from October 1998 to November 2000. Prior to that, Mr. Wise had 26 years of retail operations experience, including eight years with Edison Brothers Stores and 16 years with J. Riggings, a division of U.S. Shoe Corporation.

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      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.

Risk Factors

      One of our strategies is to open new stores by focusing on both existing markets and by targeting new geographic markets. During fiscal 2003, we opened 42 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 50-55 new stores and close approximately 10-15 stores in fiscal 2004. We also have an ongoing expansion, remodeling and relocation program. We expanded, remodeled or relocated nine stores in fiscal 2003 and anticipate 5-10 such projects in fiscal 2004.

      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:

	•	obtain adequate capital resources for leasehold improvements, fixtures and inventory on acceptable terms, or at all;
	•	locate and obtain favorable store sites and negotiate acceptable lease terms;
	•	construct or refurbish store sites;
	•	obtain and distribute adequate product supplies to our stores;
	•	maintain adequate warehousing and distribution capability at acceptable costs;
	•	hire, train and retain skilled managers and personnel; and
	•	continue to upgrade our information and other operating systems to control the anticipated growth and expanded operations.

      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 non-mall locations may require greater marketing costs in order to attract customer traffic. These factors, together with increased pre-

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      The success of our growth plan will be dependent on our ability to promote and/or recruit enough qualified 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 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. There is also no assurance that consumers will continue to focus on their homes or on home-oriented products or that trends in favor of “cocooning” and new home purchases will continue.

      Approximately 50% 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 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 200 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 2003. 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

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      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. While we believe that buying from importers instead of directly from manufacturers reduces or eliminates the risks involved with relying on products manufactured abroad, our vendors are subject to those risks, 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

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      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. On September 26, 2003, we signed a Sublease with Lexington Jackson LLC (“Landlord”), and a Development Agreement with Landlord and with H+M Company, Inc. (“Developer”). Pursuant to the Development Agreement, Developer is building a new 771,000-square-foot distribution center in Jackson, Tennessee. Pursuant to the Sublease we have leased this new distribution center for an initial term of 15 years, with two five-year renewal options. We expect to commence operations in the new facility in the second quarter of fiscal 2004. The new facility will replace the three buildings in Jackson, Tennessee, that currently support our central distribution effort. Any significant delays in the construction of this new facility, any complications resulting from the transition to this new facility and the commencement of operations at this new facility, or significant disruption in the operations of our existing facilities 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 with a mall concentration and

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      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:

	•	incur additional indebtedness;
	•	create liens;
	•	pay dividends or make other distributions;
	•	make investments;
	•	sell assets;
	•	enter into transactions with affiliates;
	•	repurchase capital stock; and
	•	enter into certain mergers and consolidations.

      The senior credit facility has two financial covenants. One covenant requires us to maintain earnings before interest, taxes, depreciation and amortization (“EBITDA”) net of capital expenditures, at levels varying between $17.2 million and $26.7 million each fiscal quarter based upon our projections taking into account the seasonality of our business. The other covenant requires us to keep our senior debt within a specified ratio of our EBITDA ranging from 1.0:1.0 to 1.8:1.0 each fiscal quarter based upon our projections taking into account the seasonality of our business and our anticipated utilization of the revolving credit facility. Any failure to comply with these or other covenants would allow the lenders to accelerate repayment of their debt, prohibit further borrowing under the revolving portion of the credit 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.

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      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 31, 2004, approximately 88% of our existing stores were located in enclosed malls. As a result, we largely rely 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:

	•	fire, flood and other natural disasters;
	•	power loss, computer systems failures, internet and telecommunications or data network failure, operator negligence, improper operation by or supervision of employees, physical and electronic loss of data or security breaches, misappropriation and similar events; and
	•	computer viruses.

      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, especially Carl Kirkland, our Chairman, and Robert E. Alderson, our President and Chief Executive Officer. Our success will depend on our ability to retain our current management 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. Although we maintain key man insurance in the amount of $3 million on each of Messrs. Kirkland and Alderson, the loss of the services of either of these

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      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

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      As of the date of this filing, our current directors, executive officers and their affiliates, in the aggregate, beneficially own approximately 42% 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.

      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 non-mall stores typically provide for terms ranging from 5 to 10 years. The leases typically 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 three central distribution facilities, consisting of a combined 658,000 square feet, also located in Jackson, Tennessee. 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. A developer is currently building this new facility which we will lease for an initial term of 15 years, with two five-year renewal options. We expect to commence operations in the new facility in the second quarter of fiscal 2004. The new facility will replace the three buildings that currently support our central distribution effort.

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      The following table indicates the states where our stores are located and the number of stores within each state as of January 31, 2004:

Item 3.     Legal Proceedings

      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.

Item 4.     Submission of Matters to a Vote of Security Holders

      We did not submit any matters to a vote of security holders in the fourth quarter of fiscal 2003.

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 April 7, 2004, there were approximately 72 holders of record, and 1,880 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.

(1)	We commenced trading on The Nasdaq Stock Market on July 11, 2002.

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. No dividends have been paid on our common stock subsequent to 1995. 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.

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      The selected “Statement of Operations Data” for the fiscal years ended January 31, 2004, February 1, 2003, and February 2, 2002, and the selected “Balance Sheet Data” as of February 1, 2003, and January 31, 2004, have been derived from our audited consolidated financial statements included in this annual report on Form 10-K. The selected “Balance Sheet Data” as of December 31, 2000 and 1999 and the selected “Statement of Operations Data” for the 34-day period ended February 3, 2001 and for the years ended December 31, 2000 and 1999, have been derived from our audited consolidated financial statements not included in this annual report on Form 10-K. The “Store and Other Data” for all periods presented below have been derived from internal records of our operations. The selected consolidated financial data should be read 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.

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(1)	Effective January 1, 2001, we changed our fiscal reporting year from a calendar year to a 52/53-week retail calendar ending on the Saturday closest to January 31, resulting in a 34-day stub period as presented.
(2)	We include new stores in comparable store net sales calculations after the store has been in operation one full fiscal year. We exclude from comparable store net sales calculations each store that was expanded, remodeled or relocated during the applicable period. Each expanded, remodeled or relocated store is returned to the comparable store base after it has been excluded from the comparable store base for one full fiscal year. The comparable store net sales increase for fiscal 2001 reflects the increase in comparable store net sales for the 52-week period ended February 2, 2002, compared to the 53-week period ended February 3, 2001.
(3)	Our store count excludes our warehouse outlet store located adjacent to our central distribution facilities in Jackson, Tennessee.
(4)	Calculated using net sales of all stores open at both the beginning and the end of the period.
(5)	Calculated using gross square footage of all stores open at both the beginning and the end of the period. Gross square footage includes the storage, receiving and office space that generally occupies approximately 30% of total store space.

      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.

Introduction

      We are a leading specialty retailer of home decor in the United States, operating 280 stores in 34 states as of January 31, 2004. Our stores present a broad selection of distinctive merchandise, including framed art, mirrors, candles, lamps, picture frames, 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 31, 2004, we recorded net sales of $369.2 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 over the last six fiscal years. During this period, we have more than doubled our store base, principally through new store openings. We intend to continue opening new stores both in existing

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      Our fiscal year is comprised of the 52 or 53-week period ending on the Saturday closest to January 31. Accordingly, fiscal 2003 represented 52 weeks ended on January 31, 2004. Fiscal 2002 represented 52 weeks ended on February 1, 2003. Fiscal 2001 represented 52 weeks ended on February 2, 2002.

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 2003 increased by 8.1% to $369.2 million from $341.5 million in fiscal 2002, reflecting sales from the 42 new stores we opened in fiscal 2003 as well as sales increases from the 16 stores we opened in fiscal 2002. Comparable store sales declined 0.2% for fiscal 2003, primarily due to a 4.7% decline in comparable store sales for the fourth quarter. We use comparable store sales to measure our ability to achieve sales increases from stores that have been open at least one full fiscal year. 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 three distinct components: product cost (including 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 three elements. Product cost is 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 2003, gross profit increased by 3.8% to $125.6 million from $120.9 million for fiscal 2002. Gross margin for fiscal 2003 decreased to 34.0% of net sales from 35.4% of net sales for fiscal 2002, 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 the overall profitability of the Company. 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 the operating performance of the Company, 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.

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

(1)	Net sales increase for fiscal 2001 represents the change between net sales for the 52-week period ended February 2, 2002, and the fiscal year ended December 31, 2000. We changed our fiscal year from a calendar year ended December 31 to a 52/53-week retail calendar ending on the Saturday closest to January 31. Sales results from the 34-day stub period ended February 3, 2001, have been excluded for purposes of this comparison.
(2)	The comparable store net sales increase for fiscal 2001 reflects the increase in comparable store net sales for the 52-week period ended February 2, 2002, compared to the 53-week period ended February 3, 2001.
(3)	Calculated using net sales of all stores open at both the beginning and the end of the period indicated.
(4)	Calculated using the gross square footage of all stores open at both the beginning and the end of the period. Gross square footage includes the storage, receiving and office space that generally occupies approximately 30% of total store space.
(5)	Inventory yield is defined as gross profit divided by average inventory for each of the preceding four quarters.
(6)	Return on assets equals net income (loss) allocable to common shareholders divided by total assets.

Strategic Areas of Emphasis

      The increase in our store base during fiscal 2003 reflected a renewed commitment to growth following 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 2003 were $15.8 million, of which $7.8 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 2004. We plan on opening 50-55 new stores and closing 10-15 stores in fiscal 2004. Our stores historically have operated primarily in enclosed malls, but in fiscal 2003 we opened 17 of our 42 new stores in a variety of non-mall venues including “lifestyle” centers, “power” centers and outlet centers. At January 31, 2004, we operated 35 of our 280 stores in non-mall venues, and we anticipate that the majority of our new store openings in fiscal 2004 will be in non-mall venues. Although our sample of non-mall stores is still relatively small, typically these stores have been able to achieve equivalent sales volumes with lower total occupancy costs than our mall stores.

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      The following table summarizes our stores and square footage under lease in mall and non-mall locations as of January 31, 2004:

      Another important area of emphasis will be improving the effectiveness of our supply chain. We expect to commence operations in a newly built distribution center in the second quarter of fiscal 2004. This new facility will replace the three buildings that currently support our central distribution effort. The commencement of operations in the new distribution center will be 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. We do not expect to gain meaningful operational efficiencies from the new distribution center and related investments in fiscal 2004. However, in fiscal 2005 and beyond, our goal is to achieve better labor productivity, better transportation efficiency, leaner store-level inventories and reduced store-level storage costs.

      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 increased to $17.4 million at January 31, 2004 from $4.2 million at February 1, 2003. We expect that capital expenditures for fiscal 2004 will range from $20.0 to $22.0 million, primarily to fund the construction of 50-55 new stores and 5-10 store remodels, the investments in automation and information systems as part of our move to a new distribution center and the completion of several ongoing information technology projects, including the rollout of a wide-area network for our stores.

Critical Accounting Policies and Estimates

      The discussion and analysis of our financial condition and the results of our operations are based upon our consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles. The preparation of these financial statements requires us to make estimates that affect the reported amounts contained in the financial statements and related disclosures. We based 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 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 near our fiscal year end. We also evaluate the cost of our inventory in relation to the estimated sales price. This evaluation is performed to ensure that we do not carry inventory at a value in excess of the amount we expect to realize upon the sale of the merchandise. We believe we have the appropriate merchandise valuation and pricing controls in place to minimize the risk that our inventory values would be materially misstated.

      Depreciation and recoverability of long-lived assets — Approximately 32% of our assets at January 31, 2004, 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.

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

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

      Insurance reserves — Workers’ compensation, general liability and employee medical insurance programs are partially self-insured. It is our policy to record a self-insurance liability using estimates of claims incurred but not yet reported or paid, based on historical claims experience and trends. Actual results can vary from estimates for many reasons, including, among others, inflation rates, claim settlement patterns, litigation trends and legal interpretations. We monitor our claims experience in light of these factors and revise our estimates of insurance reserves accordingly. The level of our insurance reserves may increase or decrease as a result of these changing circumstances or trends.

      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 — 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

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Fiscal 2003 Compared to Fiscal 2002

      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 8.1% to $369.2 million for fiscal 2003 from $341.5 million for fiscal 2002. The net sales increase in fiscal 2003 resulted primarily from the opening of new stores. We opened 42 new stores in fiscal 2003 and 16 new stores in fiscal 2002, and we closed 11 stores in fiscal 2003 and one store in fiscal 2002. 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 somewhat by a decline of 0.2% in comparable store net sales for fiscal 2003. During fiscal 2002, comparable store net sales increased 8.4%. The comparable store net sales decline was primarily the result of a weak fourth quarter, during which comparable store net sales declined 4.7%. Key categories that outperformed the prior year included wall decor, candles, textiles and housewares. These increases were offset by declines in lamps, garden, decorative accessories and holiday. In response to weak sales in the holiday category in the fourth quarter of fiscal 2002, we purchased less holiday merchandise for the fourth quarter of fiscal 2003. However, sales in our non-holiday categories were not sufficient to make up for the lower sales of holiday merchandise. The comparable store sales performance was characterized by relatively flat unit sales along with a slight decrease in the average retail price per item.

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      Gross profit. Gross profit increased $4.6 million, or 3.8%, to $125.6 million for fiscal 2003 from $120.9 million for fiscal 2002. Gross profit expressed as a percentage of net sales decreased to 34.0% for fiscal 2003, from 35.4% for fiscal 2002. The decrease in gross profit as a percentage of net sales resulted from higher product cost of sales, which includes freight expenses. Product cost of sales, including freight expenses, increased during fiscal 2003 as a percentage of sales, primarily due to heavier markdown activity in response to a sluggish sales environment and the underperformance of certain merchandise categories, particularly in the first and second quarters. Store occupancy costs also increased as a percentage of sales due to the comparable store net sales decline. Consistent with our strategic plans, central distribution costs increased slightly as a percentage of net sales as we continued to build the infrastructure to support a higher level of activity in our central distribution centers. We expect to continue to experience cost increases in central distribution as we move into a new distribution center and begin to handle a greater percentage of merchandise purchases in this new facility.

      Compensation and benefits. Compensation and benefits, including both store and corporate personnel, was $57.6 million, or 15.6% of net sales, for fiscal 2003 as compared to $53.9 million, or 15.8% for fiscal 2002. The decline in these expenses as a percentage of net sales was primarily the result of lower levels of incentive compensation this year as compared to the prior year due to underperformance versus our plan during fiscal 2003. Tight payroll management at the store-level in response to a difficult sales environment also helped us to produce a reduction in payroll as a percentage of net sales despite the negative comparable store net sales performance.

      Other operating expenses. Other operating expenses, including both store and corporate costs, were $28.9 million, or 7.8% of net sales, for fiscal 2003 as compared to $25.1 million, or 7.3% of net sales, for fiscal 2002. 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. In addition, the increase in these expenses as a percentage of net sales was partially due to expenses incurred in connection with our accelerated store expansion plan. Furthermore, corporate insurance costs increased as we experienced a full year of impact from the enhancements in directors and officers coverage that were made upon completion of the initial public offering in July 2002.

      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 these early terminations. No such charge was recorded during fiscal 2002.

      Depreciation and amortization. Depreciation and amortization expense was $7.5 million, or 2.0% of net sales, for fiscal 2003 as compared to $6.7 million, or 2.0% of net sales, for fiscal 2002. The increase in depreciation and amortization was the result of the growth of the store base and the completion of various information technology projects.

      Non-cash stock compensation charge. During fiscal 2003, we incurred non-cash stock compensation charges related to stock options granted to certain employees in November 2001. During fiscal 2002, we incurred non-cash stock compensation charges related to these options as well as certain stock options granted to a consultant in July 2001, and certain re-priced employee stock options for which variable accounting methods were required. Charges related to these stock option arrangements amounting to $0.3 million, or 0.1% of net sales, were recorded for fiscal 2003, a decrease from $2.6 million, or 0.8% of net sales, for fiscal 2002. See Note 8 of the notes to our consolidated financial statements. We will continue to incur an approximate $70,000 charge related to the November 2001 grant of employee stock options each quarter through the third quarter of fiscal 2004.

      Interest expense, net. Net interest expense was $0.7 million, or 0.2% of net sales, for fiscal 2003 as compared to $6.2 million, or 1.8% of net sales, for fiscal 2002. The decrease was the result of a combination of factors including our May 2002 debt refinancing, our July 2002 initial public offering, strong cash flow from operations and low interest rates. During fiscal 2002, we recorded interest expense associated with our mandatorily redeemable Class C Preferred Stock of $1.1 million, or 0.3% of net sales.

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      Income taxes. Income tax provision was $11.7 million, or 39.2% of income before income taxes, for fiscal 2003 compared to $10.8 million, or 40.3% of income before income taxes, for fiscal 2002. The decrease in the effective tax rate for fiscal 2003 was primarily the result of fewer non-deductible stock compensation charges during 2003 as compared to fiscal 2002.

      Net income. As a result of the foregoing, income before accretion of preferred stock and dividends accrued was $18.1 million, or 4.9% of net sales, for fiscal 2003 compared to $15.9 million, or 4.7% of net sales, for fiscal 2002 During fiscal 2002, preferred stock accretion and dividends of $5.6 million were recorded, resulting in net income allocable to common shareholders of $10.3 million.

Fiscal 2002 Compared To Fiscal 2001

      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):