SECURITIES AND EXCHANGE COMMISSION

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 December 3, 2004, 19,262,385 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.

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 305 stores in 37 states as of October 30, 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 our 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 accounting principles generally accepted in the United States of America (GAAP), our financial position as of October 30, 2004, and January 31, 2004, the results of our operations for the 13-week and 39-week periods ended October 30, 2004 and November 1, 2003, and our cash flows for the 39-week periods ended October 30, 2004, and November 1, 2003. It should be understood that accounting measurements at interim dates inherently involve greater reliance on estimates than those at the end of the fiscal year. In addition, because of seasonality factors, the results of our operations for the 13-week and 39-week periods ended October 30, 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 – Restatement of Financial Statements

     On December 8, 2004, we determined that our accounting for tenant allowances received from landlords in connection with store construction did not comply with FASB Technical Bulletin No. 88-1, “Issues Relating to Accounting for Leases” (“FTB 88-1”). As a result, we have revised the presentation of our financial statements for the quarter to modify the method by which we account for tenant allowances received from landlords in connection with store construction. We historically have accounted for these allowances as reductions to the related leasehold improvement asset on the balance sheet and capital expenditures on the statement of cash flows. Under FTB 88-1, these allowances should be accounted for as lease incentives and reflected as a long-term liability on the balance sheet and as an operating cash flow on the statement of cash flows. Accordingly, we have restated our balance sheet as of January 31, 2004 and the statement of cash flows for the 39-week period ended November 1, 2003. Additionally, this adjustment results in an increase to depreciation and amortization expense and a corresponding decrease to cost of sales as the liability is amortized over the lease term. This change does not have any impact on net income, net sales or shareholders’ equity.

     Following is a summary of the effect of this change on our balance sheet as of January 31, 2004, our statements of operations for the 13-week and 39-week periods ended November 1, 2003, and the statements of cash flows for the 39-week period ended November 1, 2003 (dollars in thousands).

Note 3 – 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

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the nature, purpose and financial characteristics of the entities. The adoption of FIN 46 did not have any impact on our financial statements.

     On March 31, 2004 the FASB issued an exposure draft, Share-based Payment, an Amendment of FASB Statements No. 123 and 95. This proposed change in accounting would replace the existing requirements under Statement of Financial Accounting Standards (“SFAS”) No. 123, Accounting for Stock Issued to Employees. The exposure draft covers a wide range of equity-based compensation arrangements. Under the FASB’s proposal, all forms of share-based payments to employees, including employee stock options, would be treated the same as other forms of compensation by recognizing the related costs in the statement of operations. The expense of the award would generally be measured at fair value at the grant date. The comment period for the exposure draft ended on June 30, 2004 and final rules are expected to be issued in the fourth quarter of calendar year 2004. The standard, if issued in its current form, would be applicable for interim or annual periods beginning after June 15, 2005. We are currently evaluating the impact of the proposed change in accounting but will not know the ultimate impact until the final rules are issued.

Note 4 – 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 5 – 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 October 30, 2004, excludes stock options of 555,963 as the effect of their inclusion would be anti-dilutive. The calculation of diluted earnings per share for the 13-week period ended November 1, 2003 excludes options of 90,659 as the effect of their inclusion would be anti-dilutive.

     The calculation of diluted earnings per share for the 39-week period ended October 30, 2004, excludes options of 572,216 as the effect of their inclusion would be anti-dilutive. The calculation of diluted earnings per share for the 39-week period ended November 1, 2003, excludes options of 38,168 as the effect of their inclusion would be anti-dilutive.

Note 6 – Revolving Credit Facility

     On October 4, 2004, we entered into a new, five-year senior secured revolving credit facility with a revolving loan limit of up to $45 million (the “New Credit Facility”). The New Credit Facility includes a letter of credit subfacility for up to $15 million of the total loan limit. The New Credit Facility bears interest at a floating rate equal to the LIBOR rate (2.04% at 10/30/04) plus 1.25% to 1.50% (depending on the amount of excess availability under the borrowing base) per annum. We also pay an unused line fee of 0.2% per annum based on the excess of the loan limit over actual borrowings.

     Borrowings under the New Credit Facility are subject to certain customary conditions and contain customary events of default, including an event of default upon a material adverse change in the business or a default upon failure to comply with certain covenants. Borrowings under our New Credit Facility are collateralized by substantially all of our personal and real property. The maximum availability under the revolving credit facility is limited by a borrowing base which consists of a percentage of eligible

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inventory and eligible credit card receivables, less reserves. The facility has one financial covenant that requires us to maintain excess availability under the borrowing base of $3 million at all times.

     We used the proceeds of the New Credit Facility to repay existing indebtedness, consisting of indebtedness that had been outstanding under our $45 million secured revolving credit facility dated as of May 22, 2002, which was thereupon terminated. As a result of this early termination, during the third quarter of fiscal 2004 we incurred a prepayment penalty of $225,000 and a write-off of unamortized debt issue costs of $139,000 totaling $364,000 on a pre-tax basis.

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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 305 stores in 37 states as of October 30, 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 have been 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 19 new stores in the third quarter of fiscal 2004 and closed three stores. We are on target to achieve a net increase of 40 stores in fiscal 2004, consisting of 54 openings and 14 closings, which would represent a 14% increase in the store base over the prior year.

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

     The financial information included in this section has been revised to reflect the change in our accounting treatment for tenant allowances received from landlords in connection with store construction. As further discussed in Note 2 to the consolidated financial statements, this change did not impact shareholders’ equity, net sales, net income, or earnings per share in any of the periods presented. We will amend our Annual Report on Form 10-K for the year ended January 31, 2004, and our Quarterly Reports on Form 10-Q for the quarterly periods ended May 1, 2004, and July 31, 2004 to restate the financial statements in those reports as a result of this modification.

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13 Weeks Ended October 30, 2004, Compared to 13 Weeks Ended November 1, 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 decreased 1.5% to $82.8 million for the third quarter of fiscal 2004 from $84.1 million for the third quarter of fiscal 2003. The overall decrease in net sales was the result of a decrease in comparable store sales. Comparable store sales declined 13.8% during the third quarter of fiscal 2004 compared to an increase of 2.7% during the third quarter of fiscal 2003. This decrease was partly offset by an increase in sales due to the growth in the store base. We opened 37 stores during the first three quarters of fiscal 2004 and 42 stores during fiscal 2003, and we closed 12 stores during the first three quarters of fiscal 2004 and 11 stores during fiscal 2003. We ended the third quarter of fiscal 2004 with 305 stores in operation compared to 279 stores as of the end of the third quarter of fiscal 2003, representing a 9.3% increase in the store base. The negative comparable store sales accounted for a $9.6 million decrease in sales from the prior year quarter. The growth in the store base along with sales from expanded, remodeled or relocated stores accounted for an increase of $8.4 million over the prior year quarter.

     Consistent with our year-to-date experience, sales for the third quarter of fiscal 2004 were characterized by higher average retail prices and lower transaction volumes. Entering the third quarter, the quality of our merchandise offering suffered from inventory imbalances across several categories and an overly broad assortment. We believe these factors were the principal reasons for our negative comparable store sales performance. In addition, our stores faced a difficult retail environment due to the continued economic pressures facing our customers in the form of higher fuel and energy costs. The impact of the four hurricanes that affected Florida and other parts of the Southeast during the quarter also had a negative impact on sales. We estimate that the hurricanes impacted sales by approximately $1.3 million to $1.6 million during the quarter, which translates to approximately 1.7% to 2.0% on a comparable store sales basis. We

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sustained only minor damage to a few stores, and all of the affected stores are open and operational today.

     Gross profit. Gross profit decreased $3.5 million, or 12.4%, to $24.7 million for the third quarter of fiscal 2004 from $28.2 million for the third quarter of fiscal 2003. Gross profit expressed as a percentage of net sales decreased to 29.9% from 33.6% for the third quarter of fiscal 2003. The decrease as a percentage of net sales was the result of a lower merchandise margin compared to the prior year, as well as a de-leveraging effect on the occupancy and central distribution components of gross profit due to the decline in comparable store net sales. During the third quarter, markdowns were more prominent than in the prior year as we attempted to respond to the weak sales environment.

     Compensation and other operating expenses. Compensation and other operating expenses, including both store and corporate costs, were $25.9 million, or 31.3% of net sales, for the third quarter of fiscal 2004 compared with $22.7 million, or 27.0% of net sales, for the third quarter of fiscal 2003. The increase in these expenses as a percentage of sales is primarily the result of the comparable store sales weakness. In addition, the implementation of a wide-area network linking our stores with the corporate office resulted in incremental expenses of approximately $330,000 during the third quarter of fiscal 2004. Advertising expenses increased over the prior year due to additional store collateral expenses and marketing efforts. Professional fees also increased due to the additional costs associated with personnel searches and Sarbanes-Oxley regulatory compliance. 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 third quarter of fiscal 2004.

     Depreciation and amortization. Depreciation and amortization expense was $3.1 million, or 3.7% of net sales, for the third quarter of fiscal 2004 as compared to $2.3 million, or 2.7% of net sales, for the third quarter of fiscal 2003. This increase was the result of the continued growth in the store base combined with the completion of certain large distribution and information systems projects during the first half of fiscal 2004. As a percentage of sales, the increase was primarily the result of the weak comparable store sales performance.

     Non-cash stock compensation charge. During the third quarter of fiscal 2004, we incurred a non-cash stock compensation charge of $77,000, or 0.1% of net sales, primarily related to certain stock options granted to employees in November 2001 that had an exercise price less than the fair value of the underlying common stock on the date of the grant. During the third quarter of fiscal 2003, we incurred non-cash stock compensation charges of $68,000, or 0.1% of net sales, related to the aforementioned November 2001 employee option grant.

     Interest expense, net. Net interest expense during the third quarter of fiscal 2004 was $572,000, or 0.7% of net sales, compared with $197,000, or 0.2% of net sales, for the third quarter of fiscal 2003. The increase was primarily the result of the early termination and refinancing of our revolving credit facility that was completed during October 2004. We recorded a charge of $364,000 during the quarter, which included the early termination fee and the write-off of the remaining debt issue costs associated with the previous facility.

     Income taxes. Income tax benefit was $1.9 million, or 39.5% of the loss before income taxes, for the third quarter of fiscal 2004 as compared to income tax expense of $1.2 million, or 39.5% of income before income taxes, for the third quarter of fiscal 2003.

     Net income (loss) and diluted earnings (loss) per share. As a result of the foregoing, net loss was $2.9 million, or $0.15 per diluted share, for the third quarter of fiscal 2004 as compared to net income of $1.9 million, or $0.10 per diluted share, for the third quarter of fiscal 2003.

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39 Weeks Ended October 30, 2004, Compared to 39 Weeks Ended November 1, 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 5.8% to $250.1 million for the first three quarters of fiscal 2004 from $236.4 million during the first three quarters of fiscal 2003. The overall increase is the result of the growth in the store base. We opened 37 stores during the first three quarters of fiscal 2004 and 42 stores during fiscal 2003, and we closed 12 stores during the first three quarters of fiscal 2004 and 11 stores during fiscal 2003. We ended the third quarter of fiscal 2004 with 305 stores in operation compared to 279 stores as of the end of the third quarter of fiscal 2003, representing a 9.3% increase in the store base. This growth in the store base along with sales increases from expanded, remodeled or relocated stores, which are excluded from our comparable store base, accounted for an increase of $24.6 million over the prior year period. Comparable store sales decreased 5.3% for the first three quarters of fiscal 2004 against a 2.2% comparable store sales increase for the first three quarters of fiscal 2003. The comparable store sales decline accounted for a decrease of $10.9 million from the prior year period.

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     The comparable store sales decline for the first three quarters of fiscal 2004 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. Furthermore, we believe the inventory positioning among our merchandise categories was overly broad, which harmed our ability to present a coherent merchandise statement to our customers. Looking forward, reducing overall SKU count and focusing our assortment on the key home décor categories are central themes of our merchandising strategy. Sales during the first three quarters of fiscal 2004 were characterized by a higher average retail price per item offset by lower transaction volumes and lower numbers of items per transaction. Key categories posting comparable store sales increases for the period were textiles and gift/novelty. These increases were offset by declines in wall décor, lamps, candles, decorative accessories, floral, housewares and frames.

     Gross profit. Gross profit decreased $2.9 million, or 4.0%, to $73.3 million for the first three quarters of fiscal 2004 from $76.2 million for the first three quarters of fiscal 2003. Gross profit expressed as a percentage of sales decreased to 29.3% from 32.2% for the prior year period. The decrease in gross profit percentage was primarily the result of increased markdowns and promotional activities, particularly during the second and third quarter, in response to weakening sales trends and in order to reposition inventory levels. Additionally, store occupancy costs increased as a percentage of net sales due to the impact of the negative comparable store sales performance on the ratio. Central distribution costs increased slightly as a percentage of sales due to the additional costs incurred during the transition to our new distribution center.

     Compensation and other operating expenses. Compensation and other operating expenses, including both store and corporate costs, were $71.7 million, or 28.7% of net sales, for the first three quarters of fiscal 2004 compared to $62.7 million, or 26.5% of net sales, for the first three quarters of fiscal 2003. The increase in these expenses as a percentage of net sales is primarily the result of the impact of the negative comparable store sales performance on the expense ratio. The implementation of the wide-area network, which was completed during the second quarter, also contributed to the increase as a percentage of net sales. Increases in advertising expenses, professional fees and store-level payroll and travel costs related to the execution of our growth strategy were additional areas where we experienced increases as a percentage of net sales as compared to the prior year period. Despite the increase as a percentage of net sales, these operating expenses were below our internal plan due in part to lower incentive bonus accruals as a result of our overall sales and earnings performance for the first three quarters of fiscal 2004.

     Depreciation and amortization. Depreciation and amortization expense was $8.4 million, or 3.3% of net sales, for the first three quarters of fiscal 2004 compared to $6.6 million, or 2.8% of net sales, for the first three quarters of fiscal 2003. The increase in depreciation is primarily the result of the growth in our store base and the completion of certain distribution and information technology projects. Additionally, the weak comparable store sales performance had a negative impact on the ratio to net sales.

     Non-cash stock compensation charge. For the first three quarters of fiscal 2004 and fiscal 2003, we incurred a non-cash stock compensation charge of $0.2 million, or 0.1% of net sales, related primarily 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 part of the fourth quarter, at which time the related options will be fully-vested.

     Interest expense, net. Net interest expense was $0.8 million, or 0.3% of net sales, for the first three quarters of fiscal 2004 as compared to $0.5 million, or 0.2% of net sales, for the first three quarters of fiscal 2003. The increase was the result of the early termination and refinancing of our revolving credit facility that was completed during October 2004. We recorded a charge of $364,000 during the third quarter, which included the early termination fee and the write-off of the remaining debt issue costs associated with the previous facility.

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     Income taxes. Income tax benefit was $3.1 million, or 39.5% of the loss before income taxes, for the first three quarters of fiscal 2004 as compared to income tax expense of $2.5 million, or 39.5% of income before income taxes, for the first three quarters of fiscal 2003.

     Net income (loss) and diluted earnings (loss) per share. As a result of the foregoing, net loss was $4.7 million, or $0.25 per share, for the first three quarters of fiscal 2004 as compared to net income of $3.8 million, or $0.19 per diluted share, for the third quarter of fiscal 2003.

Liquidity and Capital Resources

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

     Cash flows from operating activities. Net cash used in operating activities for the first three quarters of fiscal 2004 was $3.7 million compared to $2.3 million in cash provided by operating activities for the first three quarters of fiscal 2003. The increase in the amount of cash used in operations as compared to the prior year period was primarily the result of the weaker operating performance as compared to the 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 $4.7 million for the first three quarters of fiscal 2004 as compared to net income of $3.8 million in the prior year period. Our April income tax payments increased as compared to the prior year due to higher taxable income levels for the fiscal 2003 tax year as compared to fiscal 2002. Inventories increased $8.7 million during the first three quarters of fiscal 2004 as compared to an increase of $13.2 million during the first three quarters of fiscal 2003. The smaller growth in inventories was the result of the clearance efforts undertaken during the second quarter in order to position inventories for the second half of the year combined with a slowdown in our receipts during the third quarter. This slowdown was due to delays in processing imported merchandise through the California ports that was evident during the late summer and early fall.

     Cash flows from investing activities. Net cash used in investing activities for the first three quarters of fiscal 2004 consisted principally of $23.9 million in capital expenditures. These expenditures related primarily to the construction of new stores and the purchase of materials handling equipment and information technology assets associated with the move to our new distribution center during the second quarter. During the first three quarters of fiscal 2004, we opened 37 new stores and remodeled 4 stores. As of the end of the quarter, an additional 17 new stores were under construction along with 3 remodeling projects. We expect that capital expenditures for fiscal 2004 will range from $27 to $29 million, primarily to fund the construction of 54 stores, complete the 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 during fiscal 2004 will average approximately $325,000 - $350,000 per store.

     Effective December 9, 2004, we revised the reporting by which we account for tenant allowances received from landlords in connection with store construction. See Note 2 to the Consolidated Financial Statements. Accordingly, capital expenditures for store construction are presented “gross”, before taking into account the tenant allowance contributed by the landlord. The tenant allowance is reflected as an operating cash flow on the statement of cash flows.

     Cash flows from financing activities. Net cash provided by financing activities for the first three quarters of fiscal 2004 was $16.4 million compared to $14.7 million in the prior year period. The increase in cash provided by financing activities was due to an increase in the amount of borrowings under our revolving credit facility as compared to the prior year period. As of October 30, 2004, we had borrowed $16.2 million under our revolving line of credit as compared to $13.1 million in the prior year period.

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     Revolving credit facility. We maintain a revolving credit facility with a bank that provides for up to $45 million in borrowings. Amounts borrowed under the facility bear interest at a floating rate equal to the 60-day LIBOR plus 1.25% or 1.50% per annum depending upon the amount of excess availability under the borrowing base. The maximum availability under the credit facility is limited by a borrowing base that consists of a percentage of eligible inventory and receivables 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 of maturity 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 one financial covenant that requires us to maintain excess availability under the borrowing base of $3 million at all times. The facility terminates in October 2009. As of October 30, 2004, we had $16.2 million in borrowings outstanding under the facility.

     At October 30, 2004, our balance of cash and cash equivalents was $6.2 million and the borrowing availability was approximately $16.5 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 and working capital requirements for at least the next twelve months.

Critical Accounting Policies and Estimates

          The discussion and analysis of our financial condition and the results of our operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates that affect the reported amounts contained in the financial statements and related disclosures. We base our estimates on historical experience and on various other assumptions which are believed to be reasonable under the circumstances. Actual results may differ from these estimates. Our critical accounting policies are discussed in the notes to our consolidated financial statements. Certain judgments and estimates utilized in implementing these accounting policies are likewise discussed in each of the notes to our consolidated financial statements. The following discussion aggregates the various critical accounting policies addressed throughout the financial statements, the judgments and uncertainties affecting the application of these policies and the likelihood that materially different amounts would be reported under varying conditions and assumptions.

          Cost of sales and inventory valuation - Our inventory is stated at the lower of cost or market net of 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 46% of our assets at October 30, 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 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 periodically 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 undiscounted cash flows expected to be generated by the store. The underlying estimates for cash flows include estimates for future net sales, gross profit and store expense increases and decreases. To the extent our estimates for net sales, gross profit and store expenses are not realized, future assessments of recoverability could result in additional impairment charges.

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

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

     On March 31, 2004 the FASB issued an exposure draft, “Share-based Payment, an Amendment of FASB Statements No. 123 and 95”. This proposed change in accounting would replace the existing requirements under Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock Issued to Employees". The exposure draft covers a wide range of equity-based compensation arrangements. Under the FASB’s proposal, all forms of share-based payments to employees, including employee stock options, would be treated the same as other forms of compensation by recognizing the related costs in the statement of operations. The expense of the award would generally be measured at fair value at the grant date. The comment period for the exposure draft ended on June 30, 2004 and final rules are expected to be issued in the fourth quarter of calendar year 2004. The standard, if issued in its current form, would be applicable for interim or annual periods beginning after June 15, 2005. We are currently evaluating the impact of the proposed change in accounting but will not know the ultimate impact until the final rules are issued.

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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.

	•		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

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			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.
	•		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 Emeritus, and Robert E. Alderson, our Chairman, 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 October 30, 2004, there was $16.2 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 October 30, 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 effective 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.

     Our disclosure controls and procedures specifically include quarterly controls and procedures over financial reporting. These controls and procedures are designed to ensure that (i) our quarterly financial statements are presented in accordance with GAAP, and (ii) our related financial statement disclosures are both complete and not misleading.

     In connection with our preparation of this Quarterly Report on Form 10-Q for the quarter ended October 30, 2004, we followed our customary quarterly controls and procedures including, but not limited to, (i) reviewing the Company’s critical accounting policies, (ii) identifying changes in prevailing accounting standards, (iii) obtaining and incorporating into the Form 10-Q any comments and feedback from key members of Company management concerning disclosures in the Form 10-Q, (iv) holding a meeting of the Company’s Disclosure Controls Committee to discuss the Form 10-Q and to consider the completeness and adequacy of the disclosures therein, including financial statement disclosures, and incorporating any comments of the Disclosure Controls Committee into the Form 10-Q, (v) discussing the Form 10-Q with the Audit Committee of the Board of Directors and answering questions and incorporating any comments from members of the Audit Committee, and (vi) obtaining approval of the Form 10-Q from the Audit Committee.

     On December 8, 2004, we determined that our accounting for tenant allowances received from landlords in connection with store construction did not comply with FTB 88-1. As a result, we have revised the presentation of our financial statements for the quarter for tenant allowances received from landlords in connection with store construction. The revisions are reflected in this Quarterly Report on Form 10-Q. This conclusion differed from the conclusion that we had reached in connection with the preparation of the audited financial statements included in our Annual Report on Form 10-K for the year ended January 31, 2004, at which time we conducted an extensive analysis of our facts and circumstances, accounting standards and industry practice. We concluded that the presentation of reporting for tenant allowances that we were using was appropriate.

     The Chairman of our Audit Committee discussed the foregoing revision in reporting with our independent registered public accounting firm on December 8, 2004, and the Chairman of our Audit Committee and management of the Company discussed the revision in reporting with other members of the Audit Committee on December 9, 2004.

     The Company will amend its Annual Report on Form 10-K for the year ended January 31, 2004 and the Quarterly Reports on Form 10-Q for the quarterly periods ended May 1 and July 31, 2004 to restate the financial statements included in those reports in order to reflect the foregoing change in the accounting method by which we are for tenant allowances received from landlords in connection with store construction. The restatements do not result in any modification to the net income, net sales or shareholders’ equity numbers for any of the periods presented.

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

PART II OTHER INFORMATION

ITEM 6. EXHIBITS

     (a) Exhibits.

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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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