FORM 10-Q

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

KIRKLAND’S, INC.

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

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

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

As of September 3, 2004, 19,251,927 shares of the Registrant’s Common Stock, no par value, were outstanding.

KIRKLAND’S, INC.
TABLE OF CONTENTS

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KIRKLAND’S, INC.

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

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KIRKLAND’S, INC. KIRKLAND’S, INC.

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

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KIRKLAND’S, INC.

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

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KIRKLAND’S, INC.

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

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KIRKLAND’S, INC.

Note 1 – Basis of Presentation

     We are a leading specialty retailer of home décor in the United States, operating 289 stores in 36 states as of July 31, 2004. Our consolidated financial statements include the accounts of Kirkland’s, Inc. and our wholly owned subsidiaries. All significant intercompany accounts and transactions have been eliminated.

     The accompanying consolidated financial statements have been prepared without audit. The January 31, 2004 balance sheet was derived from audited financial statements. In our opinion, the financial statements contain all adjustments, consisting only of normal recurring accruals, which are necessary to present fairly and in accordance with generally accepted accounting principles (GAAP) our financial position as of July 31, 2004, and January 31, 2004; the results of our operations for the 13-week and 26-week periods ended July 31, 2004, and August 2, 2003; and our cash flows for the 26-week periods ended July 31, 2004, and August 2, 2003. It should be understood that accounting measurements at interim dates inherently involve greater reliance on estimates than those at fiscal year-end. In addition, because of seasonality factors, the results of our operations for the 13-week and 26-week periods ended July 31, 2004, are not indicative of the results to be expected for the entire fiscal year. Our fiscal year ends on the Saturday closest to January 31, resulting in years of either 52 or 53 weeks. All references to a fiscal year refer to the fiscal year ending on the Saturday closest to January 31 of the following year.

     The accompanying unaudited consolidated financial statements have been prepared in accordance with the requirements for Form 10-Q and do not include all the disclosures normally required in annual financial statements prepared in accordance with GAAP; however, we believe that the disclosures are adequate to make the information presented not misleading. These financial statements should be read in conjunction with the audited financial statements included in our Annual Report on Form 10-K filed with the Securities and Exchange Commission on April 15, 2004.

Note 2 – Recent Accounting Standards

     In January 2003, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 46 (“FIN 46”), Consolidation of Variable Interest Entities – an interpretation of Accounting Research Bulletin No. 51, Consolidated Financial Statements to improve financial reporting of special purpose and other entities. In accordance with the interpretation, business enterprises that represent the primary beneficiary of another entity by retaining a controlling financial interest in that entity’s assets, liabilities, and results of operating activities must consolidate the entity in their financial statements. Prior to the issuance of FIN 46, consolidation generally occurred when an enterprise controlled another entity through voting interests. Certain variable interest entities (“VIEs”) that are qualifying special purpose entities (“QSPEs”) subject to the reporting requirements of Statement of Financial Accounting Standard (“SFAS”) No. 140, Accounting for Transfer and Servicing of Financial Assets and Extinguishment of Liabilities, will not be required to be consolidated under the provisions of FIN 46. The consolidation provisions of FIN 46 apply to all VIEs created or entered into after January 31, 2003. Originally, the provisions of FIN 46 applied to all pre-existing VIEs in the first reporting period beginning after June 15, 2003. In December of 2003, the FASB issued Interpretation No. 46 – revised 2003 (FIN 46R). This deferred the effective date of the interpretation until the first reporting period ending after December 15, 2003 for special purpose entities and until the first reporting period ending after March 15, 2004 for all other entities. If applicable, transition rules allow the restatement of financial statements or prospective application with a cumulative effect adjustment. In addition, FIN 46 expands the disclosure requirements for the beneficiary of a significant or a majority of the variable interests to provide information regarding the nature, purpose and financial characteristics of the entities. The adoption of FIN 46 did not have any impact on our financial statements.

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Note 3 – Stock Compensation

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

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Note 4 – Earnings Per Share

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

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

     The calculation of diluted earnings per share for the 13-week period ended July 31, 2004, excludes stock options of 575,407 as the effect of their inclusion would be anti-dilutive.

     The calculations of diluted earnings per share for the 26-week periods ended July 31, 2004, and August 2, 2003, exclude stock options of 580,344 and 45,000, respectively, as the effect of their inclusion would be anti-dilutive.

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Note 5 – Revolving Credit Facility

     We maintain a $45 million revolving credit facility with a bank that bears interest at the prime rate or LIBOR plus 2.25%, at our election. Additionally, we pay a fee to the bank equal to 0.5% per annum on the unused portion of the revolving line of credit. Borrowings under the facility are collateralized by substantially all of our assets. The maximum availability under the facility is limited by a borrowing base formula, which consists of a percentage of eligible inventory less reserves. The facility also contains provisions that could result in changes to the presented terms or the acceleration of maturity. Circumstances that could lead to such changes or acceleration include a material adverse change in the business or an event of default under the credit agreement. The facility matures in May 2005. As of July 31, 2004, there was $11.1 million outstanding under the facility, with approximately $16.2 million available for borrowing.

     As of July 31, 2004, we were in violation of a financial covenant under the credit facility that establishes a minimum level of earnings before interest, taxes, depreciation and amortization (“EBITDA”) less capital expenditures. The covenant required us to maintain a level of EBITDA less capital expenditures of at least $21.0 million for the twelve-month period ended July 31, 2004, whereas the actual level of EBITDA less capital expenditures for the period was $12.4 million. We have obtained a letter from the bank, dated September 1, 2004, waiving the covenant violation. Based on current assumptions, unless the facility is amended or replaced with a new credit facility on more favorable terms, we anticipate that we would be in violation of this covenant again as of the end of our third fiscal quarter. We are currently in the final stages of negotiations with another bank group to replace the current facility with a new five-year, $45 million credit facility, which we believe will close sometime during the third quarter.

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

General

     We are a leading specialty retailer of home décor in the United States, operating 289 stores in 36 states as of July 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.

     Our stores offer a unique combination of style and value that has led to our emergence as a leader in home décor and has enabled us to develop a strong customer franchise. As a result, we have achieved substantial growth 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 and new markets. We anticipate our growth will include mall and non-mall locations in major metropolitan markets, middle markets and selected smaller communities. Our current plan is to emphasize non-mall locations, and a majority of the new stores opened in fiscal 2004 will be located in non-mall venues. We believe there are currently more than 750 additional locations in the United States that could support a Kirkland’s store. We opened 15 new stores in the second quarter of fiscal 2004 and closed four stores. We are on target to achieve a net increase of 40 stores in fiscal 2004, which would represent a 14% increase in the store base over the prior year. Our long-term target for annual growth in the store base is 15-18%.

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

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13 Weeks Ended July 31, 2004 Compared to the 13 Weeks Ended August 2, 2003

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

     Net sales. Net sales increased by 7.3% to $84.7 million for the second quarter of fiscal 2004 from $79.0 million for the second quarter of fiscal 2003. The overall increase in net sales was due to the growth in our store base. We opened 18 new stores during the first half of fiscal 2004 and 42 stores in fiscal 2003, and we closed 9 stores during the first half of fiscal 2004 and 11 stores in fiscal 2003. We ended the second quarter of fiscal 2004 with 289 stores in operation compared to 257 stores as of the end of the second quarter of fiscal 2003, representing a 12.5% increase in the store base. Comparable store net sales decreased 3.4% for the quarter against a 0.9% decrease in comparable store net sales for the second quarter of fiscal 2003. The comparable store net sales decline was primarily the result of slow customer traffic and a weaker than expected response to our merchandise offering. We were negatively affected by inventory imbalances across several categories, the business failure of a key framed mirrors vendor and the temporary supply chain disruption we experienced in connection with our transition to a new distribution center during the quarter. While we are working actively to reallocate our mirror business to other vendors, we expect that mirror inventories will remain low for the remainder of fiscal 2004. As a result, we anticipate that these issues will negatively impact mirror sales for the remainder of the year. Mirrors represented approximately 4.5% of our total net sales for the last six months of fiscal 2003. The decrease in comparable store net sales accounted for approximately $2.4 million in lost net sales. This decrease was offset by the effect of the net increase in the store base along with sales increases from expanded, remodeled or relocated stores that collectively accounted for approximately $8.1 million. Net sales during the second quarter of fiscal 2004 were characterized by higher average retail prices per item as compared to the prior year offset by lower transaction volume and a lower number of items per transaction. Categories showing comparable store sales increases in comparison to prior year were novelty/gift, lamps, garden and textiles. These increases were offset by declines in wall décor, candles, furniture and decorative accessories.

     Gross profit. Gross profit decreased $2.0 million, or 8.4%, to $21.5 million for the second quarter of fiscal 2004 from $23.5 million for the second quarter of fiscal 2003. Gross profit expressed as a percentage of net sales decreased to 25.4% from 29.7% for the second quarter of fiscal 2003. The decrease in gross profit as a percentage of sales was primarily the result of higher product cost of sales resulting primarily from increased markdowns and

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promotional activities. During the second quarter we employed an aggressive approach to markdowns and inventory clearance in response to a continuation of the weak traffic trends we had experienced since late in the first quarter and also in an effort to rationalize our inventory levels in advance of the second half of fiscal 2004. Additionally, store occupancy expenses increased as a percentage of sales due to the negative comparable store sales performance. Furthermore, central distribution costs increased due to the additional costs incurred associated with the transition to our new distribution center.

     Compensation and other operating expenses. Other operating expenses, including both store and corporate costs, were $23.5 million, or 27.7% of net sales, for the second quarter of fiscal 2004 compared with $20.2 million, or 25.6% of net sales, for the second quarter of fiscal 2003. The increase in these operating expenses as a percentage of net sales was primarily the result of the lack of expense leverage due to the comparable store net sales decrease. Additionally, the implementation of a wide-area network linking our stores with the corporate office resulted in incremental expenses of approximately $350,000 during the second quarter of fiscal 2004. Despite the increase as a percentage of sales, these operating expenses were below our internal plan due in part to smaller incentive bonus accruals as a result of our overall sales and earnings performance for the second quarter of fiscal 2004.

     Depreciation and amortization. Depreciation and amortization expense was $2.3 million, or 2.7% of net sales, for the second quarter of fiscal 2004 compared to $1.8 million, or 2.2% of net sales, for the second quarter of fiscal 2003. This increase was the result of the growth in the store base and the completion of certain distribution and information technology projects during 2004.

     Non-cash stock compensation charge. During the second quarters of fiscal 2004 and fiscal 2003, we incurred a non-cash stock compensation charge of $67,000, or 0.1% of net sales in each period, related to certain stock options granted to employees in November 2001 that had an exercise price that was less than the fair value of the underlying common stock on the date of the grant. This charge will continue through the third quarter and part of the fourth quarter of this year, at which time the related options will be fully vested.

     Interest expense, net. Net interest expense was $168,000, or 0.2% of net sales, for the second quarter of fiscal 2004 as compared to $177,000, or 0.2% of net sales, for the second quarter of fiscal 2003. The slight decrease reflects the relatively comparable borrowing levels under our revolving line of credit when comparing this year to the prior year.

     Income taxes. Income tax benefit was $1.7 million, or 39.5% of the loss before income taxes, for the second quarter of fiscal 2004 as compared to an expense of $0.5 million, or 39.5% of income before income taxes for the second quarter of fiscal 2003.

     Net income (loss) and diluted earnings (loss) per share. As a result of the foregoing, we reported a net loss of $2.7 million, or ($0.14) per diluted share, for the second quarter of fiscal 2004 as compared to net income of $0.8 million, or $0.04 per diluted share, for the second quarter of fiscal 2003.

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26 Weeks Ended July 31, 2004 Compared to 26 Weeks Ended August 2, 2003

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

     Net sales. Net sales increased by 9.8% to $167.3 million for the first half of fiscal 2004 from $152.4 million for the prior year period. The net sales increase resulted primarily from the growth in our store base. We opened 18 new stores during the first half of fiscal 2004 and 42 stores in fiscal 2003, and we closed 9 stores during the first half of fiscal 2004 and 11 stores in fiscal 2003. We ended the first half with 289 stores in operation compared to 257 stores as of the end of the second half of fiscal 2003, representing a 12.5% increase in the store base. Comparable store net sales decreased 1.0% for the first half against a 1.9% increase in comparable store net sales for the prior year period. The comparable store net sales decline for the period was primarily the result of a difficult sales environment characterized by slow customer traffic and a weaker than expected response to our merchandise offering and the home décor sector in general. The decrease in comparable store net sales accounted for approximately $1.3 million in lost net sales. This decrease was offset by the effect of the net increase in the store base along with sales increases from expanded, remodeled or relocated stores that collectively accounted for approximately $16.2 million. The net sales increase for the second quarter of fiscal 2004 was driven by an increase in the average retail price per item offset by declines in the number of transactions and in the number of items per transaction. Key categories posting comparable store sales increases for the period were lamps, novelty/gifts, furniture and textiles. These increases were offset by declines in candles, decorative accessories, floral, garden and frames.

     Gross profit. Gross profit increased $0.4 million, or 0.9%, to $47.5 million for the first half of fiscal 2004 from $47.0 million for the prior year period. Gross profit expressed as a percentage of sales decreased to 28.4% from 30.9% for the prior year period. The decrease in gross profit as a percentage of net sales was primarily the result of increased markdowns and promotional activity, particularly in the second quarter, in response to weakening sales trends and in order to correct inventory levels in preparation for the back half of the year. Additionally, store occupancy costs increased as a percentage of sales due to the impact of the negative comparable store sales performance on the ratio.

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Furthermore, central distribution costs increased due to additional costs incurred in connection with the transition to our new distribution facility during the second quarter.

     Compensation and other operating expenses. Other operating expenses, including both store and corporate costs, were $45.8 million, or 27.4% of net sales, for the first half of fiscal 2004 compared with $40.0 million, or 26.2% of net sales, for the prior year period. The increase in these operating expenses as a percentage of net sales was primarily the result of the lack of expense leverage due to the comparable store net sales decrease. The implementation of our wide-area network, which was completed during the second quarter, also contributed to the increase as a percentage of net sales. Despite the increase as a percentage of sales, these operating expenses were below our internal plan due in part to smaller incentive bonus accruals as a result of our overall sales and earnings performance for the quarter.

     Depreciation and amortization. Depreciation and amortization expense was $4.3 million, or 2.6% of net sales, for the first half of fiscal 2004 compared to $3.5 million, or 2.3% of net sales, for the prior year period. This increase was the result of the growth in the store base, the completion of certain distribution and information technology projects, and a higher level of capital spending during fiscal 2003 and the first half of fiscal 2004 as compared to prior years. Additionally, the impact of the negative comparable store sales performance led to an increase in the ratio to net sales.

     Non-cash stock compensation charge. During the first half of fiscal 2004 and fiscal 2003, we incurred a non-cash stock compensation charge of $134,000, or 0.1% of net sales in each period, related to certain stock options granted to employees in November 2001 that had an exercise price that was less than the fair value of the underlying common stock on the date of the grant. This charge will continue through the third quarter and part of the fourth quarter of this year, at which time the related options will be fully vested.

     Interest expense, net. Net interest expense was $257,000, or 0.2% of net sales, for the first half of fiscal 2004 as compared to $318,000, or 0.2% of net sales, for the prior year period. The decrease was the result of lower borrowings under our revolving line of credit this year as compared to the prior year.

     Income taxes. Income tax benefit was $1.2 million, or 39.5% of the loss before income taxes, for the first half of fiscal 2004 as compared to expense of $1.2 million, or 39.5% of income before income taxes for the prior year period.

     Net income (loss) and diluted earnings (loss) per share. As a result of the foregoing, net loss was $1.8 million, or ($0.09) per diluted share, for the first half of fiscal 2004 as compared to earnings of $1.9 million, or $0.10 per diluted share, for the prior year period.

Liquidity and Capital Resources

     Our principal capital requirements are for working capital and capital expenditures. Working capital consists mainly of merchandise inventories, which typically reach their peak by the end of the third quarter of each fiscal year. Capital expenditures primarily relate to new store openings; existing store expansions, remodels or relocations; and purchases of equipment or information technology assets for our stores, distribution facilities or corporate headquarters. Historically, we have funded our working capital and capital expenditure requirements with internally generated cash, borrowings under our credit facilities and proceeds from the sale of equity securities.

     Cash flows from operating activities. Net cash used in operating activities for the first half of fiscal 2004 was $11.6 million compared to $9.6 million for the prior year period. The increase in the amount of cash used in operations as compared to the prior year period is primarily the result of weaker operating performance as compared to prior year and an increase in the amount of income taxes paid, offset by a decrease in the build-up of inventories. We reported a net loss of $1.8 million for the first half of fiscal 2004 as compared to net income of $1.9 million in the prior year period. Our April income tax payments increased as compared to the prior year due to higher taxable income levels in fiscal 2003 versus fiscal 2002. Inventories increased $0.4 million during the first half of fiscal 2004 as compared to an increase of $2.5 million during the prior year period. This smaller growth in inventories was primarily the result of the clearance efforts undertaken during the second quarter in order to position inventories for the second half of the year.

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     Cash flows from investing activities. Net cash used in investing activities for the second quarter of fiscal 2004 consisted principally of $11.9 million in capital expenditures. These expenditures primarily related to purchases of materials handling equipment and information technology assets associated with our anticipated move to a new distribution center in the second quarter of fiscal 2004. These expenditures also included the costs of construction of new stores and selected store remodeling projects. During the second quarter of fiscal 2004, we opened 15 new stores and remodeled four stores. We expect that capital expenditures for fiscal 2004 will range from $21 million to $22 million, primarily to fund the construction of 50 to 55 new stores, complete our move to the new distribution center and finalize several ongoing information technology projects. We anticipate that capital expenditures, including leasehold improvements and furniture and fixtures, for new stores in fiscal 2004 will average approximately $165,000 to $175,000 per store (net of landlord allowances).

     Cash flows from financing activities. Net cash provided by financing activities for the second quarter of fiscal 2004 was $11.3 million compared to $13.6 million in the prior year period. The decline in cash provided by financing activities was primarily due to a reduction in the amount of borrowings under our revolving line of credit during the first half of fiscal 2004. As of July 31, 2004, we had borrowed $11.1 million under our revolving line of credit compared to $12.1 million in the prior year period.

     Revolving credit facility. We maintain a revolving credit facility with a bank that provides for up to $45 million in borrowings ($30 million during the first six months of the year). Amounts borrowed under the facility bear interest at a floating rate equal to the prime rate or LIBOR plus 2.25%, at our election. The maximum availability under the credit facility is limited by a borrowing base which consists of a percentage of eligible inventory less reserves. Our credit lender may from time to time reduce the lending formula with respect to the eligible inventory to the extent our lender determines that the liquidation value of the eligible inventory has decreased. Our lender also from time to time may decrease the borrowing base by adding reserves with respect to matters such as inventory shrinkage. The facility also contains provisions that could result in changes in the presented terms of the facility or the acceleration of maturity. Circumstances that could lead to such changes in terms or acceleration include, but are not limited to, a material adverse change in our business or an event of default under the credit agreement. The facility has two financial covenants, both of which are tested quarterly on a latest-twelve-months basis. The first covenant establishes a minimum level of earnings before interest, taxes, depreciation and amortization excluding certain non-recurring items, or EBITDA, less capital expenditures, and the second covenant establishes a maximum senior debt to EBITDA ratio. The facility terminates in May 2005. As of July 31, 2004, we had $11.1 million in borrowings outstanding under the facility.

     As of July 31, 2004, we were in violation of a financial covenant under the credit facility that establishes a minimum level of earnings before interest, taxes, depreciation and amortization (“EBITDA”) less capital expenditures. The covenant required us to maintain a level of EBITDA less capital expenditures of at least $21.0 million for the twelve-month period ended July 31, 2004, whereas the actual level of EBITDA less capital expenditures for the period was $12.4 million. We have obtained a letter from the bank, dated September 1, 2004, waiving the covenant violation. Based on current assumptions, unless the facility is amended or replaced with a new credit facility on more favorable terms, we anticipate that we would be in violation of this covenant again as of the end of our third fiscal quarter. We are currently in the final stages of negotiations with another bank group to replace the current facility with a new five-year, $45 million credit facility, which we believe will close sometime during the third quarter.

     At July 31, 2004, our balance of cash and cash equivalents was $5.3 million and the borrowing availability under our revolving credit facility was approximately $16.2 million. We believe that these sources of cash, together with cash provided by our operations, will be adequate to carry out our fiscal 2004 growth plans in full and fund our planned capital expenditures, interest payments and working capital requirements for at least the next twelve months.

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Critical Accounting Policies and Estimates

          The discussion and analysis of our financial condition and the results of our operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates that affect the reported amounts contained in the financial statements and related disclosures. We 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 net of allowances the amount of shrinkage that has occurred through theft or damage and adjust that to actual at the time of our physical inventory counts which occur 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 39% of our assets at July 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.

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To the extent we replace or dispose of fixtures or equipment prior to the end of their assigned depreciable lives, we could realize a loss or gain on the disposition. To the extent our assets are used beyond their assigned depreciable lives, no depreciation expense is being 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.

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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.

          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.

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

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Recent Accounting Pronouncements

     In January 2003, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 46 (“FIN 46”), Consolidation of Variable Interest Entities – an interpretation of Accounting Research Bulletin No. 51, Consolidated Financial Statements to improve financial reporting of special purpose and other entities. In accordance with the interpretation, business enterprises that represent the primary beneficiary of another entity by retaining a controlling financial interest in that entity’s assets, liabilities, and results of operating activities must consolidate the entity in their financial statements. Prior to the issuance of FIN 46, consolidation generally occurred when an enterprise controlled another entity through voting interests. Certain variable interest entities (“VIEs”) that are qualifying special purpose entities (“QSPEs”) subject to the reporting requirements of SFAS No. 140, Accounting for Transfer and Servicing of Financial Assets and Extinguishment of Liabilities, will not be required to be consolidated under the provisions of FIN 46. The consolidation provisions of FIN 46 apply to all VIEs created or entered into after January 31, 2003. Originally, the provisions of FIN 46 applied to all pre-existing VIEs in the first reporting period beginning after June 15, 2003. In December of 2003, the FASB issued Interpretation No. 46 – revised 2003 (FIN 46R). This deferred the effective date of the interpretation until the first reporting period ending after December 15, 2003 for special purpose entities and until the first reporting period ending after March 15, 2004 for all other entities. If applicable, transition rules allow the restatement of financial statements or prospective application with a cumulative effect adjustment. In addition, FIN 46 expands the disclosure requirements for the beneficiary of a significant or a majority of the variable interests to provide information regarding the nature, purpose and financial characteristics of the entities. The adoption of FIN 46 did not have any impact on our financial statements.

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

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

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

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If we are unable to profitably open and operate new stores and maintain the profitability of our existing stores, we may not be able to adequately implement our growth strategy, resulting in a decrease in net sales and net income.

•

A prolonged economic downturn could result in reduced net sales and profitability.

•

Reduced consumer spending in the southeastern part of the United States where a majority of our stores are concentrated could reduce our net sales.

•

We may not be able to successfully anticipate consumer trends, and our failure to do so may lead to loss of consumer acceptance of our products, resulting in reduced net sales.

•

We depend on a number of vendors to supply our merchandise, and any delay in merchandise deliveries from certain vendors may lead to a decline in inventory, which could result in a loss of net sales.

•

We are dependent on foreign imports for a significant portion of our merchandise, and any changes in the trading relations and conditions between the United States and the relevant foreign countries may lead to a decline in inventory resulting in a decline in net sales, or an increase in the cost of sales, resulting in reduced gross profit.

•

Our success is highly dependent on our planning and control processes and our supply chain, and any disruption in or failure to continue to improve these processes may result in a loss of net sales and net income.

•

We face an extremely competitive specialty retail business market, and such competition could result in a reduction of our prices and/or a loss of our market share.

•

Our business is highly seasonal and our fourth quarter contributes a disproportionate amount of our operating income and net income, and any factors negatively impacting us during our fourth quarter could reduce our net sales, net income and cash flow, leaving us with excess inventory and making it more difficult for us to finance our capital requirements.

•

We may experience significant variations in our quarterly results.

•

The agreement covering our debt places certain reporting and consent requirements on us which may affect our ability to operate our business in accord with our business and growth strategy.

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•

We are highly dependent on customer traffic in malls, and any reduction in the overall level of mall traffic could reduce our net sales and increase our sales and marketing expenses.

•

Our hardware and software systems are vulnerable to damage that could harm our business.

•

We depend on key personnel, and if we lose the services of any of our principal executive officers, including Carl Kirkland, our Chairman, and Robert E. Alderson, our President and Chief Executive Officer, we may not be able to run our business effectively.

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

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

     As of July 31, 2004, there was $11.1 million in outstanding borrowings under our revolving credit facility, which is based upon a 60-day LIBOR rate or the prime rate, at our discretion.

     We did not have any foreign exchange contracts, hedges, interest rate swaps, derivatives or other significant market risk as of July 31, 2004.

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ITEM 4. CONTROLS AND PROCEDURES

          (a) Evaluation of disclosure controls and procedures. Our Chief Executive Officer and Chief Financial Officer, after evaluating the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) or 15(d)-(e) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) as of the end of the period covered by this report, have concluded, based on the evaluation of these controls and procedures required by paragraph (b) of Exchange Act Rules 13a-15 or 15d-15, that our disclosure controls and procedures were adequate and designed to ensure that information required to be disclosed under the Exchange Act is accumulated and communicated to our management on a timely basis to allow decisions regarding required disclosure.

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

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PART II            OTHER INFORMATION

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

     We held our annual meeting of shareholders on Wednesday, June 2, 2004 (the “Annual Meeting”). At the Annual Meeting, Reynolds C. Faulkner and Murray M. Spain were each nominated for, and elected to, our Board of Directors (the “Board”). These individuals will serve on our Board along with Robert Alderson, R. Wilson Orr, III, Carl Kirkland, David Mussafer and John P. Oswald, each of whose terms continued after the Annual Meeting. The number of votes cast for, and withheld with respect to, each nominee is set forth below:

ITEM 6. EXHIBITS

(a)

Exhibits.

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SIGNATURES

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

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