General
We are a specialty retailer of home décor in the United States, operating 291 stores in 32 states as of August 1, 2009. Our stores present a broad selection of distinctive merchandise, including framed art, mirrors, wall décor, candles, lamps, decorative accessories, accent furniture, textiles, garden accessories and artificial floral products. Our stores also offer an extensive assortment of holiday merchandise as well as items carried throughout the year suitable for gift-giving. In addition, we use innovative design and packaging to market home décor items as gifts. We provide our predominantly female customers an engaging shopping experience characterized by a diverse, ever-changing merchandise selection at surprisingly attractive prices. Our stores offer a unique combination of style and value that has led to our emergence as a recognized name in home décor and has enabled us to develop a strong customer franchise.

During the 13-week period ended August 1, 2009, we opened five new stores and closed six stores. The following table summarizes our stores and square footage under lease by venue type:

                            Stores                             Square Footage              Average Store Size
            8/1/09                 8/2/08                  8/1/09          8/2/08          8/1/09        8/2/08
Mall             79        27 %        111        34 %       374,234         540,782          4,737        4,871
Off-Mall        212        73 %        213        66 %     1,357,969       1,342,027          6,406        6,301

Total           291       100 %        324       100 %     1,732,203       1,882,809          5,953        5,811

13-Week Period Ended August 1, 2009 Compared to the 13-Week Period Ended
August 2, 2008
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):

                                         13-Week Period Ended
                             August 1, 2009               August 2, 2008                   Change
                             $             %              $             %             $              %

Net sales                 $ 87,688        100.0 %     $  87,684        100.0 %     $      4            0.0 %
Cost of sales               54,119         61.7 %        59,815         68.2 %       (5,696 )         (9.5 %)

Gross profit                33,569         38.3 %        27,869         31.8 %        5,700           20.5 %

Operating expenses:
Compensation and
benefits                    16,641         19.0 %        16,896         19.3 %         (255 )         (1.5 %)
Other operating
expenses                     8,474          9.7 %         8,236          9.4 %          238            2.9 %
Depreciation of
property and equipment       3,678          4.2 %         4,473          5.1 %         (795 )        (17.8 %)

Total operating
expenses                    28,793         32.8 %        29,605         33.8 %         (812 )         (2.7 %)

Operating income
(loss)                       4,776          5.4 %        (1,736 )       (2.0 %)       6,512         (375.1 %)

Interest expense, net           30          0.0 %            13          0.0 %           17          130.8 %
Other income, net              (63 )       (0.1 %)          (64 )       (0.1 %)           1            1.7 %


Income (loss) before
income taxes                 4,809          5.5 %        (1,685 )       (1.9 %)       6,494         (385.4 %)
Income tax provision         1,365          1.6 %             9          0.0 %        1,356        14879.4 %


Net income (loss)         $  3,444          3.9 %     $  (1,694 )       (1.9 %)    $  5,138         (303.3 %)

Net sales. Net sales were flat at $87.7 million for the second fiscal quarter of 2009 compared to $87.7 million for the prior year period despite operating 34 fewer stores on average during the second fiscal quarter of 2009. We opened 5 new stores during the second quarter of fiscal 2009 and 3 new stores in fiscal 2008, and we closed 6 stores during the second quarter of fiscal 2009 compared to 39 stores in fiscal 2008. During the second quarter of fiscal 2009, comparable store sales increased 6.1% as compared to a 2.8% increase in the prior year period. Comparable store sales in our off-mall store locations were up 6.3% for the second quarter, while comparable store sales for our mall store locations were up 5.5%. The comparable store sales increase was primarily due to a slight increase in customer traffic coupled with an increase in the conversion rate and an increase in the average ticket. The increase in the average ticket was the result of a higher average retail selling price, partially offset by a decline in items per transaction. The strongest performing merchandise categories were decorative accessories, wall décor, frames and gifts.

Gross profit. Gross profit increased $5.7 million, or 20.5%, to $33.6 million for the second quarter of fiscal 2009 from $27.9 million in the prior year period. Gross profit expressed as a percentage of total revenue increased to 38.3% for the second quarter of fiscal 2009, from 31.8% in the prior year period. The increase in gross profit as a percentage of total revenue was primarily driven by improved merchandise margins, which increased from 50.9% in the second quarter of fiscal 2008 to 53.8% in the second quarter of fiscal 2009. Merchandise margin is calculated as net sales minus product cost of sales and inventory shrinkage. Merchandise margin excludes outbound freight, store occupancy and central distribution costs. The increase in merchandise margin was the result of higher initial markups and a lower markdown rate. Initial markups increased primarily due to significantly lower ocean freight costs. Strong sell-through of merchandise resulting from a more compelling merchandise mix led to lower markdown rates. Store occupancy costs also decreased as a percentage of net sales. This decline resulted from favorable lease renewal terms, comparable store sales leverage, the closure of underperforming stores, and our continued shift to more productive off-mall real estate locations. Outbound freight costs decreased as a percentage of sales reflecting a decline in diesel costs and leverage from the comparable store sales increase.
Compensation and benefits. At the store-level, the compensation and benefits expense ratio decreased for the second quarter of fiscal 2009 as compared to the second quarter of 2008 primarily due to the positive comparable store sales performance. At the corporate level, the compensation and benefits ratio increased for the second quarter of 2009 as compared to the second quarter of 2008 primarily due to higher bonus accruals and increased stock compensation expense.
Other operating expenses. The slight increase in these operating expenses as a percentage of net sales was primarily the result of increased marketing expenses in the second quarter of fiscal 2009 as compared to the prior year period. This increase was partially offset by the positive comparable store sales performance and the leveraging effect on the fixed components of store and corporate operating expenses.
Depreciation and amortization. The decrease in depreciation and amortization as a percentage of sales reflects the large reduction in capital expenditures during fiscal 2008 and the overall decline in store count. Income tax provision. We recorded income tax expense of approximately $1.4 million, or 28.4% of pretax income during the second quarter of fiscal 2009, versus approximately $9,000 tax expense recorded in the prior year quarter. Based on the results of the first half of fiscal 2009, we anticipate generating sufficient pre-tax income during fiscal 2009 to allow us to reverse the remaining valuation allowance that is recorded related to our deferred tax assets. During the 13-week period ended August 1, 2009, income tax expense was reduced $0.6 million as a result of reducing the valuation allowance during the period. The ultimate effective rate that is recorded for fiscal 2009 will depend on our operating performance for the remaining two quarters of the year. Net income and earnings per share. As a result of the foregoing, we reported net income of $3.4 million, or $0.17 per diluted share, for the second quarter of fiscal 2009 as compared to a net loss of $1.7 million, or ($0.09) per share, for the second quarter of fiscal 2008.

26-Week Period Ended August 1, 2009 Compared to the 26-Week Period Ended
August 2, 2008
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):

                                         26-Week Period Ended
                              August 1, 2009               August 2, 2008                    Change
                              $             %              $             %              $              %

Net sales                 $ 171,008        100.0 %     $ 171,761        100.0 %          (753 )         (0.4 %)
Cost of sales               105,265         61.6 %       116,984         68.1 %       (11,719 )        (10.0 %)

Gross profit                 65,743         38.4 %        54,777         31.9 %        10,966           20.0 %

Operating expenses:
Compensation and
benefits                     33,092         19.3 %        32,836         19.1 %           256            0.8 %
Other operating
expenses                     16,361          9.6 %        17,346          9.9 %          (985 )         (5.7 %)
Depreciation of
property and equipment        7,486          4.4 %         9,156          5.3 %        (1,670 )        (18.2 %)

Total operating
expenses                     56,939         33.3 %        59,338         34.5 %        (2,399 )         (4.0 %)

Operating income
(loss)                        8,804          5.1 %        (4,561 )       (2.7 %)       13,365         (293.0 %)

Interest expense, net            68          0.0 %            12          0.0 %            56          466.7 %
Other income, net              (134 )       (0.1 %)         (336 )       (0.2 %)          202          (60.1 %)


Income (loss) before
income taxes                  8,870          5.2 %        (4,237 )       (2.5 %)       13,107         (309.3 %)
Income tax provision          1,948          1.1 %             9          0.0 %         1,939        21279.1 %


Net income (loss)         $   6,922          4.0 %     $  (4,246 )       (2.5 %)    $  11,168         (263.0 %)

Net sales. Net sales decreased 0.4% to $171.0 million for the first half of fiscal 2009 from $171.8 million for the prior year period. The net sales decrease resulted primarily from the decrease in store count, partially offset by an increase in comparable store sales. We opened 8 new stores during the first half of fiscal 2009 and 3 new stores in fiscal 2008, and we closed 16 stores during the first half of 2009 and 39 stores in fiscal 2008. During the first half of fiscal 2009, comparable store sales increased 5.7% as compared to a 3.5% increase in the prior year period. Comparable store sales in our off-mall locations were up 5.3% for the first half, while comparable store sales for our mall store locations were up 6.8%. The comparable store sales increase was primarily due to a slight increase in customer traffic coupled with an increase in the conversion rate and an increase in the average ticket. The increase in the average ticket was the result of a higher average retail selling price, partially offset by a decline in items per transaction. The strongest performing merchandise categories were decorative accessories, wall décor, frames and gifts.
Gross profit. The increase in gross profit as a percentage of net sales resulted from a combination of factors. The merchandise margin increased from 51.2% in the first half of fiscal 2008 to 54.2% in the first half of fiscal 2009. Merchandise margin is calculated as net sales minus product cost of sales and inventory shrinkage. Merchandise margin excludes outbound freight, store occupancy and central distribution costs. The increase in merchandise margin was the result of higher initial markups and a more compelling merchandise offering, which resulted in fewer markdowns. Initial markups increased primarily due to significantly lower ocean freight costs. Store occupancy costs also decreased as a percentage of net sales. This decline resulted from favorable lease renewal terms, comparable store sales leverage, the closure of underperforming stores, and our continued shift to more productive off-mall store locations. Outbound freight costs decreased as a percentage of sales reflecting a decline in diesel costs and leverage from the comparable store sales increase.
Compensation and benefits. At the store-level, the compensation and benefits expense ratio decreased for the first half of fiscal 2009 as compared to the first half of 2008 primarily due to the positive comparable store sales performance. At the corporate level, the compensation and benefits ratio increased for the first half of 2009 as compared to the first half of 2008 primarily due to higher bonus accruals and an increase in stock compensation expense .

Other operating expenses. The decrease in these operating expenses as a percentage of net sales was primarily the result of the positive comparable store sales performance and the leveraging effect on the fixed components of store and corporate operating expenses.
Depreciation and amortization. The decrease in depreciation and amortization as a percentage of sales reflects the large reduction in capital expenditures during fiscal 2008 and the decline in overall store count. Income tax provision. We recorded income tax expense of approximately $1.9 million, or 22.0% of pretax income during the first half of fiscal 2009, versus approximately $9,000 during the prior year period. Based on the results of the first half of fiscal 2009, we anticipate generating sufficient pre-tax income during the full year to allow us to reverse the remaining valuation allowance that is recorded related to our deferred tax assets. Our effective tax rate of 22.0% for the first half of fiscal 2009 takes into account the reversal of this remaining valuation allowance. During the 26-week period ended August 1, 2009, income tax expense was reduced $1.6 million as a result of reducing the valuation allowance during the period. The ultimate effective rate that is recorded for the full year will depend on our operating performance for the remaining two quarters of the year.
Net income and earnings per share. As a result of the foregoing, we reported net income of $6.9 million, or $0.34 per diluted share, for the first half of fiscal 2009 as compared to a net loss of $4.2 million, or ($0.22) per share, for the first half of fiscal 2008.
Liquidity and Capital Resources
Our principal capital requirements are for working capital and capital expenditures. Working capital consists mainly of merchandise inventories offset by accounts payable, 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 and corporate headquarters. Historically, we have funded our working capital and capital expenditure requirements with internally generated cash and borrowings under our credit facility.
Cash flows from operating activities. Net cash provided by (used in) operating activities was $6.7 million and ($155,000) for the first half of fiscal 2009 and fiscal 2008, respectively. Cash flows from operating activities depend heavily on operating performance, changes in working capital and the timing and amount of payments for income taxes. The change in the amount of cash from operations as compared to the prior year period was primarily the result of the improvement in our operating performance and an increase in accounts payable, partially offset by an increase in income taxes paid. Accounts payable increased approximately $3.6 million during the first half of fiscal 2009 as compared to a decrease of approximately $2.0 million for the prior year period. The change in accounts payable is primarily due to the timing of payments and amount of merchandise receipt flow near period end. Cash tax payments for the first half of fiscal 2009 totaled approximately $9.0 million whereas the Company received refunds of approximately $2.9 million in the prior year period.
Cash flows from investing activities. Net cash used in investing activities for the first half of fiscal 2009 consisted principally of $4.8 million in capital expenditures as compared to $1.9 million for the prior year period. The capital expenditures primarily related to new store construction and the purchase of new point-of-sale software and other information technology assets. During the first half of fiscal 2009, we opened 8 stores. We expect that capital expenditures for all of fiscal 2009 will be approximately $9 to $10 million, primarily to fund the leasehold improvements of approximately 15 to 18 new stores and maintain and improve our investments in existing stores, our distribution center and information technology infrastructure. As of August 1, 2009, we had lease commitments to open 17 new stores, which includes the eight new stores opened during the first half of fiscal 2009. We anticipate that capital expenditures, including leasehold improvements and furniture and fixtures, and equipment for our new stores in fiscal 2009 will average approximately $400,000 to $450,000 per store. We also anticipate that we will receive landlord allowances in connection with the construction of our new stores in fiscal 2009. These allowances are reflected as a component of cash flows from operating activities within our consolidated statement of cash flows.
Cash flows from financing activities. Net cash provided by financing activities was approximately $130,000 and $47,000 for the first half of fiscal 2009 and fiscal 2008, respectively, and were related to the exercise of employee stock options as well as employee stock purchases.

Revolving credit facility. Effective October 4, 2004, we entered into a five-year senior secured revolving credit facility with a revolving loan limit of up to $45 million. On August 6, 2007, we entered into the First Amendment to Loan and Security Agreement (the "Amendment") which provided the Company with additional availability under our borrowing base through higher advance rates on eligible inventory. As a result of the amendment, the aggregate size of the overall credit facility remained unchanged at $45 million, but the term of the facility was extended two years making the new expiration date October 4, 2011. Amounts outstanding under the amended facility, other than First In Last Out ("FILO") loans, bear interest at a floating rate equal to the 60-day LIBOR rate (0.52% at August 1, 2009) plus 1.25% to 1.50% (depending on the amount of excess availability under the borrowing base). FILO loans, which apply to the first approximately $2 million borrowed at any given time, bear interest at a floating rate equal to the 60-day LIBOR rate plus 2.25% to 2.50% (depending on the amount of excess availability under the borrowing base). Additionally, we pay a quarterly fee to the bank equal to a rate of 0.2% per annum on the unused portion of the revolving line of credit. Borrowings under the facility are collateralized by substantially all of our assets and guaranteed by our subsidiaries. The maximum availability under the credit facility is limited by a borrowing base formula, which consists of a percentage of eligible inventory and receivables less reserves. The facility also contains provisions that could result in changes to the presented terms or the acceleration of maturity. Circumstances that could lead to such changes or acceleration include a material adverse change in the business or an event of default under the credit agreement. The facility has one financial covenant that requires the Company to maintain excess availability under the borrowing base, as defined in the credit agreement, of at least $3.0 to $4.5 million depending on the size of the borrowing base, at all times.
As of August 1, 2009, we were in compliance with the covenants in the facility and there were no outstanding borrowings under the credit facility, with approximately $23.0 million available for borrowing (net of the availability block as described above). We do not anticipate any borrowings under the credit facility during fiscal 2009.
At August 1, 2009, our balance of cash and cash equivalents was approximately $38.5 million and the borrowing availability under our facility was $23.0 million (net of the availability block as described above). We believe that the combination of our cash balances, line of credit availability and cash flow from operations will be sufficient to fund our planned capital expenditures and working capital requirements for at least the next twelve months. Off-Balance Sheet Arrangements
None.
Significant Contractual Obligations and Commercial Commitments Construction commitments
The Company had commitments for new store construction projects totaling approximately $3.6 million at August 1, 2009. Critical Accounting Policies and Estimates There have been no significant changes to our critical accounting policies during fiscal 2009. Refer to our Annual Report on Form 10-K for the fiscal year ended January 31, 2009, for a summary of our critical accounting policies. 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.
• Our Performance May Be Affected by General Economic Conditions and the Current Global Financial Crisis.

• A Prolonged Economic Downturn Could Result in Reduced Net Sales and Profitability.

• 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.

• The Market Price for Our Common Stock Might Be Volatile and Could Result in a Decline in the Value of Your Investment.

• Our Comparable Store Net Sales Fluctuate Due to a Variety of Factors.

• We Face an Extremely Competitive Specialty Retail Business Market, and Such Competition Could Result in a Reduction of Our Prices and a Loss of Our Market Share.

• 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.

• Our Business Is Highly Seasonal and Our Fourth Quarter Contributes a Disproportionate Amount of Our Net Sales, Net Income and Cash Flow, 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 Governing Our Debt Places Certain Reporting and Consent Requirements on Us Which May Affect Our Ability to Operate Our Business in Accordance with Our Business and Strategy.

• We Are Highly Dependent on Customer Traffic in Malls and Shopping Centers, and Any Reduction in the Overall Level of 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 Member of Our Senior Management Team, We May Not Be Able to Run Our Business Effectively.

• Our Charter and Bylaw Provisions and Certain Provisions of Tennessee Law May Make It Difficult in Some Respects to Cause a Change in Control of Kirkland's and Replace Incumbent Management.

• Concentration of Ownership among Our Existing Directors, Executive Officers, and Their Affiliates May Prevent New Investors from Influencing Significant Corporate Decisions.

• Our Ability to Use Our Net Operating Loss Carry Forwards in the Future May Be Limited, Which Could Have an Adverse Impact on Our Tax Liabilities.