Good morning, and welcome to Kirkland's Fourth Quarter 2020 Earnings Call. All participants will be in listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note this event is being recorded.

I would now like to turn the conference over to Tripp Sullivan of SCR Partners. Please go ahead.

Tripp Sullivan - President

Thank you. Good morning, and welcome to Kirkland's conference call to review results for the fourth quarter of fiscal 2020. On the call this morning are Woody Woodward, Chief Executive Officer; and Nicole Strain, Chief Financial Officer. The results as well as notice of the accessibility of this conference call on a listen-only basis over the Internet were announced earlier this morning in a press release that has been covered by the financial media.

Except for historical information discussed during this conference call, the statements made by Company management are forward-looking and made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements involve known and unknown risks and uncertainties which may cause Kirkland's actual results in future periods to differ materially from forecasted results. Those risks and uncertainties are more fully described in Kirkland's filings with the Securities and Exchange Commission.

I'll now turn it over to Woody.

Steven C. Woodward - President and Chief Executive Officer

Good morning. As we begin, I want to thank the entire Kirkland's team for their commitment throughout this year and how they work together, wherever they were and doing whatever it takes to produce the results we'll discuss today. This is a crazy year in many respects, and we were focused, forced to innovate. Our people were more than ready to meet the challenge.

We always want to finish the year strong in our most important quarter and 2020 was no exception. We had momentum coming into the holidays with a robust November, then some disruptions in December related to the new wave of COVID, and then when our new product sets hit the stores and online, we saw double-digit gains we previously disclosed. February started off strong as well with a two-week period where we were impacted with the winter storms, but we've come back from that as well.

For the quarter, we generated a comp increase of 1.8%, which reflects the decline in the store count but a 36% increase in e-commerce growth. GAAP earnings for the quarter were $1.36 and adjusted earnings were $1.40 that brought us to $1.09 and $0.93, respectively for the year and reversed sizable losses from a year ago.

We are continuing to evolve into a value-oriented specialty retailer. We've been very deliberate about this pace of our transformation, but we expected differences we are making and our assortments will be even more evident in 2021 than it was in the past two years. I want to walk through the four components of this strategy and describe how we're bringing our customers along with us, plus the investments we're making in technology and infrastructure to support this strategy.

Let's start with direct sourcing. We are continuing to mature our direct importing business and achieved our multi-year growth plan, despite this pandemic-related cancellations in 2020. Until these cancellations and the impact from COVID, we were on pace to exceed our goal of 20% penetration in 2020. That being said, some of our categories, such as mirrors, textiles, floral, outdoor and gifts, exceeded our goals. For 2021, our goal is to achieve 30% direct sourcing, and we have the potential to exceed that.

Our agents are really hitting their stride and the products look great from Vietnam, China and India. We've been able to diversify our products by moving our core furniture program from China to Vietnam. We also consolidated our basic mirror program to a direct from factory business. As you've heard us describe before, we are investing some of this benefit from sourcing in margin and some of it in design and quality improvements.

With pricing, we continue to elevate style and quality, allowing us to gradually increase our overall pricing threshold in key categories such as furniture. We've experienced an increase in AUR with these improvements and a sustained trend here, plus the larger penetration of furniture should keep that growth on a steady path for the next several years. While we've kept our opening price points, we are slowly growing our better and best offerings. Our customers are voting yes on the upgrades in style and quality, allowing us to be less promotional.

We've also made progress on reducing discount layering, which was hard for customers to understand, and rationalizing price points to make sense to the customers and improve our margins. We are constantly benchmarking our competitors and the general market to ensure Kirkland's is still a strong value player with more style to bring to our customers along with us on this journey.

As it relates to design, our cohesive brand style point of view has allowed us to streamline the esthetic of our brand, so the customers can mix and match with confidence. We have invested in specific design projects with an eye towards improved design, efficiency and function. We're also setting a trend forward color palette each season that across all facets of the business. Additionally, we're partnering with third-party design support to continue to bring unique yet timeless designs and graphic to our assortments as we evolve.

And on quality, we continue to raise the bar at each category, improving materials and make. Furniture has seen the most significant increase as we have redesigned and resourced the best-selling items to give the customer more style and quality at the same value. Direct sourcing has allowed us to have more control over the craftsmanship of our assortment while still allowing us to be competitive in pricing. We've also invested in improved packaging to reduce damaged product.

If we look back where we were two years ago, as compared with the rest of the home furnishings landscape, we were in the wrong place in the spectrum. We had the value pricing, but the quality and style were sorely lacking and we certainly didn't have a point of view about where we fit in and what could help our customers. While I'm hesitant to pinpoint exactly where we are today in the broader home furnishing spectrum, we can still say we offer tremendous value but with a much higher level of quality, design, style of our merchandise.

We're supporting the rollout of new merchandise in 2021 and our biggest initiative on that front is the launch of our loyalty program, which took place in October. Earlier this month, Newsweek named our loyalty program the Number 1 program of all home decor. Even with that recognition, we believe there are opportunities to continue evolving in 2021 and beyond.

The home furnishings trends have worked in our favor with people staying at home or in shopping online as well as less store-based competition. At some point, there will be headwinds for the industry, but we believe wallet share for home furnishings will remain fairly sizable with consumers if the economy improves.

Another area of our business I want to highlight is our ongoing digital transformation. We've seen the growth - continued growth and profitability of e-commerce all year, and this is a large part of our overall business. E-commerce was 24% of our sales in the quarter, compared to 17% a year ago, and it continues to be profitable as well. The specific improvements we are making in our merchandise requires that we also make specific investments in our technology and infrastructure in addition to the direct ship from vendor group and the e-commerce hubs I noted last quarter.

For 2021 and beyond, we are prioritizing our capital expenditures to continue to fuel our digital transformation. To help lead these efforts, we've recently brought on Mike Holland as Senior Vice President, Chief Technology Officer. He has a vast experience in leading similar digital and technology transformations.

One item to note on our direct ship from vendor channel, before I talk about stores. We gave a preview last quarter that we expected to add some select brands this year to extend where we've been strong in kitchen and table-top. I'm pleased to report that we partnered with brands such as Cuisinart, KitchenAid and Viking, which will be added to our website. These leading brands will only be available on our website, and we're very excited about the potential these brands have on the e-commerce business. Nicole will get into this in more detail, but I want to call out how successful she's been on leading the charge with rationalizing the store base, negotiating our landlords and ensuring that the new cost structure we've put in place is sustainable.

During the fourth quarter, we had 59 less stores than a year ago and total net sales were only down 7%. We've clearly rationalized the base through more productive stores and the strength of e-commerce business is helping to offset the continued challenges in store traffic. Our stores remain a critical component of our omni-channel strategy and the maximum expression of the Kirkland's brand and our assortments. That being said, we believe we can improve performance in the stores and that will be an opportunity we will continue to pursue in 2021 and beyond.

The strong merchandising, the efficiencies in our infrastructure and costs, direct sourcing, and the growth of e-commerce all create substantial leverage in our business model.

The earnings posted during the quarter and for the year were above what we had planned this time a year ago, but the improvements in cash and liquidity were equally impressive. A portion of this liquidity at year-end was related to the inventory orders we canceled early on in the pandemic. As Nicole will describe in a moment, we will put some of that liquidity back to work with our inventory. The majority of this improvement in cash flow and liquidity, however, was due to operating costs that we pulled out of the business through cost containment and efficiencies, and changes in our labor costs and staffing model.

We will look - we will look to benefit from the embedded leverage in the business in 2021 and will continue to actively explore the best ways to allocate our capital to fuel additional growth and returns to our shareholders.

Nicole, why don't you walk us through some of the activity in more detail and the adjustments we've made to our strategic and financial goals?

Nicole A. Strain - Executive Vice President and Chief Financial Officer

Thank you, Woody. Before I get into the details of the quarter, I also want to thank the entire Kirkland's team, including those on the frontlines in our stores and in our distribution centers. It's been a pivotal role - a pivotal year in the transformation of Kirkland's and although we are far from the end of our journey, we were able to accelerate many aspects of our strategy in the past year and it is directly attributed to the dedication of our team.

Although sales trends were inconsistent during the quarter, improvement and landed product margin and occupancy cost and operating expense reductions drove the most profitable quarter in our history as a public company. Many of the changes to our model were made in the second quarter and we have shown our ability to sustain and refine them throughout the second half of the year.

Breaking down sales within the quarter. We had a comp increase of 5.3% in November, which included early sell-through of holiday product, driven by a 49% increase in e-commerce sales, which helped to offset the historical volume in stores on Black Friday.

In December, our comp sales declined by 7.5%, driven by a double-digit decline in stores and slower e-commerce growth. Impacting December was the early sell-through of holiday inventory, the effect of the rise of COVID cases on store traffic and slower e-comm sales due to the early cut-off of guaranteed ship windows from parcel carrier limitations and a drop in fulfilled in-store online sales.

In January, with the seasonal sales timing shift behind us and a new floorset of everyday merchandise, we had a strong sales month with positive store sales and e-commerce growth of 60%, which resulted in an overall comp increase of 15.7%. That strong sales trend continued to start the month of February until we hit the second and third week which included significant store closures and weather impact across more than half of our store footprints. Sales picked back up at the end of February, resulting in a low-single-digit comp decline. We expect comp sales to continue to accelerate throughout the first quarter as we compare against the beginning impact of the pandemic on the economy, followed by our store closures in mid-March.

While we still outperformed our segment of ShopperTrak, our comp store traffic sequentially worsened from Q3 levels, particularly in December due to the reasons I noted a moment ago. We continued to see the sales benefit of the changes we have made to improve the quality and design of our merchandise, as well as category shift towards higher ticket items. We did lose some ground on conversion in both store and online, due to inventory shortages in some key categories.

Our e-commerce comp increase continued to be driven by the direct-to-consumer channels with our third-party dropship revenue of 111% and our own product shipped directly to customers up 45%. Both of these were offset by the in-store fulfilled channels.

Our fulfilled in-store for the quarter was just over 36% of e-commerce sales, compared to 52% in the prior year, which is a function of consumer preference, store traffic and lower in-store inventory. There is profitability upside in our model as the percent fulfilled in-store normalizes closer to 45% to 50%.

During the quarter, we closed eight stores resulting in a count of 373 stores. During 2020 we opened no new and closed 59 underperforming stores or 14% of the store base since the start of the year.

Gross profit was 37.7% of sales, compared to 29.8% in the prior year quarter. The 790 basis point improvement in our gross profit margin marked the second quarter in a row we have seen a similar level of year-over-year gains. Of this increase, 730 basis points was driven by landed product margin from direct sourcing benefits, simplifying our promotional methods and also reducing the depth of offers and the inherent stacking of entire store couponing.

Throughout the quarter and continuing into the first quarter of 2021, inbound freight rate premiums, specifically on products sourced from China, have negatively impacted our landed product margins. Within the fourth quarter, the elevated freight cost accounted for approximately 200 basis points of margin. We expect to see that impact double in the first quarter of 2021, but still expect a year-over-year landed margin growth.

Lower store occupancy costs from the closure of underperforming stores and negotiated rent reductions contributed 130 basis points of the improvement. We expect to see an additional 100 basis point to 150 basis point improvement in occupancy costs in 2021. This is excluding the much larger benefit in the first quarter due to the uncomparable sales base.

Lower freight costs from our DC to our stores, driven by fewer routes from lower inventory levels and store closures, along with the rate decline compared to 2019, added another 70 basis points of improvement. DC costs remained relatively flat year-over-year. On the prior call, I mentioned that the 150 basis points of unfavorability in the third quarter due to the timing of inventory capitalization should reverse in the fourth quarter with improved inventory levels. That reversal will instead happen throughout the first half of 2021.

We continued to see productivity and infrastructure improvements offset the incremental cost to pick-and-pack e-commerce orders. We saw continued improvement in the output and efficiency of the two e-comm hubs we added in 2020 throughout the quarter and are pleased with their performance. Lastly, other adjustments impacting gross profit made up another 50 basis points. E-commerce shipping negatively impacted gross profit in the quarter by 190 basis points due to the increase in ship-to-home channels.

Operating expenses, excluding impairment, improved to 23.3% of sales compared to 26.6% in the fourth quarter of 2019. We continued to see the benefit of our cost reductions with a decline in operating expenses of 330 basis points or $10.3 million, driven by the more efficient store labor model, corporate headcount reductions and a justification exercise for all overhead expenses. Excluding current year performance related compensation accruals, this represents a 21% reduction in operating expenses which we continue to expect to be largely sustainable.

A large portion of the reduction in store labor expenses was reducing our minimum staffing and lower volume periods and at lower volume stores. The result is a lower basis point improvement in the higher volume fourth quarter, but a similar dollar improvement. This is in line with our expectations when we shared the $45 million of operating cost reduction and even as we look to accelerate topline growth over the coming years, we will remain disciplined in our cost control.

Store operating expenses decreased 330 basis points as a percent of total sales, driven by the store labor model changes noted and leverage from closing underperforming stores. As we discussed on the prior call, we expanded our store operating hours during the peak holiday period and then returned to the reduced hours in January. The expanded hours, along with the store sales deleverage and nature of our store labor model changes, resulted in a lower benefit than in prior quarters, which again was expected.

E-comm operating expenses increased 10 basis points as a percent of total sales, but leveraged 120 basis points as a percent of e-comm sales, as dollars increased by only $100,000 year-over-year on the $12.3 million growth in revenue. Advertising expense increased by $300,000 or 30 basis points compared to the prior year and we continued to shift our spend heavily towards digital channels.

Corporate operating expenses decreased by $2 million or 50 basis points, driven by reduced headcount, reduced corporate office space and the overall expense review. Performance-related comp accruals in the current year account for an additional 70 basis points.

EBITDA excluding impairments and other minor non-operating expenses for the quarter was $34 million or 17.4% of sales, compared to $16.9 million in the prior-year quarter or an improvement of $17.1 million. For the quarter, our tax rate was 25.4%, compared to 4.7% in the prior year period. Both periods were impacted by a valuation allowance. A normalized rate of 26% was used in the non-GAAP adjusted calculations for the current year and 21.3% for the prior year period.

Our earnings per share excluding non-cash impairment, normalized tax rate and other minor non-operating adjustments was $1.40, compared to $0.62 in the prior year. The GAAP earnings including these items was $1.36, compared to a loss of $0.35 in the prior year.

We ended the quarter with $100.3 million in cash and no outstanding debt, which is a build of $63.1 million from the Q3 level and an increase of $70.2 million year-over-year. Combined with availability on our revolving credit facility, which is based on our inventory position, we had total liquidity of $139.8 million. We ended the year with a higher cash balance than we expected, which is partially due to a lower inventory position than expected. We anticipate a use of cash of $30 million to $35 million in the first half of 2021, as we return to planned inventory levels and more typical working capital timing, but otherwise we expect to remain at a consistent level of cash and no borrowings throughout the year and to our normal cash build in the fourth quarter.

Inventory at the end of the quarter was $62.1 million, compared to $94.7 million in the prior year or 34% lower. We have 14% fewer stores, but were down approximately $18 million to our inventory plan. We continued to work through vessel and port shipping constraints and see gradual improvements in our inventory position, but now expect the disruptions in our assortment to continue through the first half of fiscal 2021. The inventory shortages have been in our core everyday products and have been much deeper in some key product categories.

For the fourth quarter, we estimate a comp sales impact of approximately 500 basis points from those key category inventory gaps. We expect to continue to see a sales impact in those categories in the first half of the year, but expect it to be less than - less than the fourth quarter and sequentially improving month to month.

Year-to-date cash provided by operations was $78.6 million, compared to cash used of $8.3 million in the prior year or a change of $86.8 million. The improvement is due to better operating performance in the last three quarters of the year, which made up a net improvement of $54.9 million and changes in working capital which made up $32 million. The working capital changes are primarily driven by lower inventory levels, offset by lower related accounts payable. Additionally, we received a $12.3 million income tax refund from the CARES Act NOL carrybacks in the second quarter.

Capital expenditures were $8.7 million, compared to $15.7 million in the prior year and were primarily driven by investments in supply chain and e-commerce. Share repurchases during the quarter were minimal, but we can - we will continue to take an opportunistic approach to share repurchases in the future. We exceeded our progress towards our initial goals set for fiscal 2020. As you'll note in our earnings release, we have increased our profitability target as we execute the transformation of our business over the next two years to three years.

In addition to driving topline growth, we expect continued margin gains and disciplined cost control over this multi-year period to improve our gross profit rate to the mid-30% range, improve EBITDA margin to the high-single to low-double digit range, and improve operating income margins to the mid-to-high single-digit range. Related to topline growth, we expect e-commerce to grow annually at a rate of 25% to 35% during this period and average ticket improvement in stores is expected to offset declining traffic. We expect direct sourcing to grow from the 20% in fiscal 2020 to 50% within this timeframe, with the growth spread evenly over the two to three years.

We continue to believe that our ideal store count is in the range of 300 stores to 350 stores. Where we land within that range depends on store profitability and performance, as well as consumer shopping preferences post-pandemic, but we do expect future store closures to be with the natural lease expirations as we address the majority of underperforming stores this year. We continue to strongly believe that our stores are an integral part of our strategy and allow us to represent our style point of view but also enable us to fulfill a significant percent of our e-comm sales in-store more profitably than shipping to home.

And lastly from a liquidity perspective, our main goal continues to be maintaining a healthy balance sheet. Within this model, we expect to generate excess cash annually and we'll allocate first to projects to drive growth and/or reduce costs, but also will prioritize options to return excess cash to our shareholders.

And now, we are ready for questions.

Question & Answers

Operator

We will now begin the question-and-answer session. [Operator Instructions] Our first question today comes from Jeremy Hamblin with Craig-Hallum Capital Group.

Jeremy Hamblin - Craig-Hallum Capital Group - Analyst

Thanks and congratulations on an impressive year and managing through the pandemic. I wanted to just start actually with the last thing you were mentioning in the call which was the lease expirations in 2021. I wanted to know how many are up this year and if you have a sense or kind of a range on potential store closures for 2021, and then the timing of potential closures.

Nicole A. Strain - Executive Vice President and Chief Financial Officer

Yeah. We still have about 20% to 25% of our leases that will come up for renewal and part of that is because we continue in some cases to do shorter-term leases on some properties that we are continuing to evaluate their performance. What I would say is that we've made a lot of progress in improving margin, improving the labor model and in seeing average ticket increases in the store. So the way I look at that - if I were to give an estimate now, I think the range of closures could be from five to 15. Again, we're going to look as the natural lease expirations come up. I think there is also the opportunity that we may relocate a handful of stores. So I would say a safe number is probably net 10 closures, but we'll continue to give updates as we move throughout the year.

Jeremy Hamblin - Craig-Hallum Capital Group - Analyst

Great. And then in terms of those negotiations, what's the average reduction in rent that you're getting on these stores? Is there - I mean, is it 5%, is it flat, is it 10%? Can you give us a sense of the range of reduction that you're getting on renegotiating leases?

Nicole A. Strain - Executive Vice President and Chief Financial Officer

Yeah. And the ones that come up for renewal that we're able to negotiate, we are getting closer to a 20% reduction and it really does vary. And I think I mentioned on the last call, it is a good center and there is limited vacancy. We're locking in for a longer period without escalations. So in that case, we're not really getting savings year-over-year, but we're not taking the escalations that are embedded in the lease. In some cases where we have more leverage, the decreases that we're getting are closer to 50% - 50%, 60%. So it really does vary, but - and what we've done year - so what we've done so far to-date is about 20%.

Jeremy Hamblin - Craig-Hallum Capital Group - Analyst

Wow. Okay. And then I wanted to come back to clarify something on the near-term trends here that you've seen in Q1. So understand strong start to the month of February, followed by some pretty severe weather in your key geographies. I think you mentioned a low-single-digit comp decline. I wanted to just clarify, was that for the month of February or was that just for the last week of February?

Nicole A. Strain - Executive Vice President and Chief Financial Officer

It was for the month of February, so again, double-digit positive first week, and then really tough two weeks. I mean, over half of our stores were closed for at least a full day and then the halo impact was much larger than that. Returned to positive in the fourth week, so that's for the full month.

Jeremy Hamblin - Craig-Hallum Capital Group - Analyst

Okay. And then do - I was going to ask that question. In terms of the store closures or kind of the disrupted period, can you quantify that of the total potential store days for your 370 and change locations, what number of store operating days were lost in the month of February? Do you have that?

Nicole A. Strain - Executive Vice President and Chief Financial Officer

Yeah. I don't have the actual count, but I do know roughly 175 stores were closed at least one to two days. And outside of that, but doesn't include the partial days that the stores were closed or the fact that a store might open but have very few customers because of weather impact. So don't have a holistic number. I mean, I can say we were going from double-digit positive to a decent double-digit negative comp. So it's a pretty significant gap in those two weeks.

Steven C. Woodward - President and Chief Executive Officer

It seemed to last about seven to 10 days from the holistic point of view, the reduction of people coming into the stores and store closure. So it was - it was like a three-part month. First part good, middle part challenging, last part good.

Jeremy Hamblin - Craig-Hallum Capital Group - Analyst

Understood and I heard that from a lot of your peers as well. In terms of thinking about Q1, I know you didn't put out a formal sales target, but do you have a range of expectations on your topline in Q1?

Nicole A. Strain - Executive Vice President and Chief Financial Officer

I don't know that we want to put out to, what's a little bit crazy with Q1 is the comp because we're comping over six weeks of store closure is not really a meaningful comp increase. I don't know that we want to put out specific guidance. I can say that we, even with fewer store closures, expect to be, from a total sales, at least in line with the first quarter of 2019, if that helps.

Jeremy Hamblin - Craig-Hallum Capital Group - Analyst

I'm sorry. Say that again?

Nicole A. Strain - Executive Vice President and Chief Financial Officer

From just total sales dollar perspective to be at least in line with the first quarter of 2019.

Jeremy Hamblin - Craig-Hallum Capital Group - Analyst

Got you. Okay, that's helpful. 2019, I misheard you. Okay. And then in terms of your capex expectations for 2021, I might have missed that in the summer.

Nicole A. Strain - Executive Vice President and Chief Financial Officer

I don't think I gave that number. I think on previous calls, I've said between $10 million and $15 million. I think right now our 2021 plan would be right in the midpoint of that, so $12 million to $13 million. I think as we move forward, at least at this point, I think that's a safe assumption to make going forward.

Jeremy Hamblin - Craig-Hallum Capital Group - Analyst

Got it. And then what do you - I wanted to ask you about the evolution of your online channel of business, which is increasing consistently. In terms of thinking about the next steps on this business, what are the investments you need to make? Where are the key opportunities in terms of whether it's shipped from vendor, shipped to stores? How do we think about what that business is going to look like, both in 2021 but then also over the next couple of years?

Steven C. Woodward - President and Chief Executive Officer

All right. Well, we, of course, love the fact that this is moving quicker than we had anticipated, mostly driven by customer behavior. We had always wanted to be in the eventual state of being in the 50-50 range between e-commerce and stores, although that's been accelerated right now and every part of it seems to be a benefit for us. So I'm going to start first with our own products, which affect both e-commerce and in-store. We're making a product transformation where we're offering better quality and design and still keeping our value pricing, and that seems to be registering both online equally with in-store experience.

So one is that our product assortments are migrating and we seem to be bringing our customers along. The second part is this phenomenon of ship from vendor, which is really an exciting part. We've added a team now to support that and we believe that there is substantial growth that we can have for its adding additional layers of opportunity, hence the adding the brands like Cuisinart or KitchenAid, plus our own designed goods that are being held by the vendors. And the vendors are really stepping up to the plate. Now we're the choice person that they come to and say we've got something new for you, which is different from where we were before, but that business continues to grow and it's such an easy model for us because we don't carry the inventory and we carry almost zero risk.

So our risk is just to make sure that the assortment is curated on our website so that the people that are on our website look at the experience online as they would in the store. But like I've said, the store is always going to be our maximum expression of the brand. Those are all the things that we believe represent our style point of view, our price point of view and our quality point of view. And then we take a little bit more flexibility on our online expansion and that gives us a lot of - a lot of potential places to grow.

So yeah, we're really excited. We do need to make, part of this I hope Nicole's take about the digital transformation, we do need to make select investments over the next several years to enhance the experience and make sure that the website works in the most seamless possible way, and then we will start adding some of the creative bells and whistles as we go along the way. Right now, just making sure that functionally it's as efficient as possible.

Nicole A. Strain - Executive Vice President and Chief Financial Officer

Yeah. Just a couple of things to add operationally to support the growth and the merchandise changes, we will over time either add additional hub and/or add ship from store to continue to get closer to the customers. So, we reduced parcel costs, but more importantly improved SLA times of customers. And then also from a marketing perspective this year have had a lot of success in redirecting our spend to digital to acquire new customers, and we'll continue to push that towards digital acquisition as well to support the merchandise changes Woody mentioned.

Jeremy Hamblin - Craig-Hallum Capital Group - Analyst

Great color on that. And I want to come back to your gross margins for a second because you really posted quite a bit better gross margins in Q4 than we expected, nearly 800 basis points of year-over-year improvement, pretty remarkable given the shipping and freight headwinds that are being experienced. But in diving into that, you need to provide a little bit of additional color on expectations around whether it's e-comm shipping, which seems to be running about close to 200 basis point drag, I assume that that's going to continue, but then it sounds like your occupancy is settling into kind of this nice range of a benefit that could be, let's call it, 150 basis points a quarter year-over-year?

And then I just wanted to get that clarification on your commentary on the DC costs and that you did see some improvement from Q3, but do you expect even more improvement as those two new DCs are ramping up? But - just could you highlight that again for us?

Nicole A. Strain - Executive Vice President and Chief Financial Officer

Sure. So, a couple of those pieces. On the e-commerce shipping, you're right, it has in the past two quarters have been about 190 basis points drag. I think part of that is of e-commerce growth that will continue to be a drag on gross profit, but as our mix of fulfilled in-store improves with store traffic, hopefully, in the second half of this year, it should - the percentage drag should decline.

On the store occupancy costs, 100 basis points to 150 basis points is a safe number to use in 2021 on top of the gains that we had in 2020. And then on the DC costs, in Q3, we had a negative timing impact of 150 basis points because our inventory levels dropped and I expected that to flip at the time in Q4 because I thought we'd be back on inventory plan and made a little bit of progress. But the majority of that will flip back positively in the first half of 2021, just as inventory levels get back to our plan.

Jeremy Hamblin - Craig-Hallum Capital Group - Analyst

Okay. Great. And then in terms of thinking about your product margin opportunities this year, your - clearly there has been pretty dramatic change in terms of you're doing much more direct sourcing and there are savings that you are keeping some of and sharing quite a bit with your customers. But in terms of thinking about product margin opportunities this year, you made such incredible gains. I wanted to ask just about what you're seeing from a promotional level across your industry from peers, whether or not that's picking up at all. But any color you can provide on product margin expectations?

Nicole A. Strain - Executive Vice President and Chief Financial Officer

Yeah. So in the first quarter, if I'm looking at last year, last year's Q1 product margin was in the low 50%. So even though we are expecting the impact of inbound to double so to roughly 400 basis points in the first quarter, we still have a fair amount of room to have a 400 basis point to 500 basis point improvement in landed margin in the first half of the year. So what I would say though is because of the tailwind that we had from consumer preference in the back half of the year where - and I think we mentioned this before, but seasonal product we sold out of a - really early without having to go to second or third markdowns, which is part of that part - part of the plan for that product every year.

And so I don't think that's something we can comp next year. So I do think direct sourcing growth will give us some benefit, but it will be tough for us to comp the margins that we had at least in the third quarter this year. And I think it will be - will continue to be disciplined on our promotional offerings, but I think there were just some anomalies this year with the tailwinds that isn't something we should have seen would continue.

Jeremy Hamblin - Craig-Hallum Capital Group - Analyst

Okay, great. And then just last one for me. In terms of direct sourcing, you achieved about 20% last year, you have a two- to three-year target of getting to 40% to 50%. In terms of thinking about the progression, it sounds like that's going to be somewhat evenly split over that timeframe. But are there are more opportunities? Is 40% to 50% the longer-term goal? Or is there - I think you have peers that have even substantially higher portions of their business that are direct sourced. Woody or Nicole, any color that you can add on that…

Steven C. Woodward - President and Chief Executive Officer

Yeah, Jeremy, that is such a good question because it's one of our key opportunities for the next two or three years. So, yeah, last year, as you mentioned, we hit about a 20% penetration. This year, our target is 30%. We'll probably exceed that by 4% or 5%, which is really exciting for us because what's happening is that it takes a while to get an agent structure working around the world and they're just now hitting their stride where we're very impressed with the products that we're seeing from them from main countries like China, Vietnam and India. But we're also looking into other countries and those other countries will just help us expand our horizon on what the direct import ratio should finally be.

When we put that target out there at 50%, it was more just like a guideline. We're going to pause at 50% and say how do we feel like this is working, but we do believe that there's probably upside opportunity to increase that. But reverse side of that is that our - some of our domestic vendors have really done a great job. So they want the business and they've come back in and evened out the playing field in some cases. So, we don't want to put a number out there that forces us to go direct sourcing, but really it's opportunistic.

I want the buying teams to feel like they have the choice of buying the very best product value at the very best style and quality from around the world and sometimes that's here in the U.S. from a direct importer, sometimes it's direct overseas relationship, sometimes that's direct with the factory like we did with our mirror program. So we want to have as much flexibility in our model as possible. And so that 50% direct import is just a guideline and we'll probably exceed that.

Jeremy Hamblin - Craig-Hallum Capital Group - Analyst

Great. Thanks for taking all my questions. I'll hop out so others can ask some. Thank you. Congratulations.

Steven C. Woodward - President and Chief Executive Officer

Thanks, Jeremy.

Nicole A. Strain - Executive Vice President and Chief Financial Officer

Thank you.

Operator

Our next question will come from John Lawrence with Baraboo Growth.

John Lawrence - Baraboo Growth - Analyst

Hi, good morning.

Steven C. Woodward - President and Chief Executive Officer

Good morning.

Nicole A. Strain - Executive Vice President and Chief Financial Officer

Morning.

John Lawrence - Baraboo Growth - Analyst

Yeah, congratulations on the year and all you've been able to accomplish.

Steven C. Woodward - President and Chief Executive Officer

Thank you.

Nicole A. Strain - Executive Vice President and Chief Financial Officer

Thank you.

John Lawrence - Baraboo Growth - Analyst

Woody, would you start the conversation on my question just a fact that - you mentioned the fact that the customer response, we've gotten the loyalty up in October. As you look at the last year or 18 months, what do you think the major pieces are? You've talked about product quality, we've talked about the couponing process and all that, but what do you think the major couple of pieces are from a consumer standpoint of how they relate to the Kirkland brand and maybe what you've seen out of the loyalty program since October?

Steven C. Woodward - President and Chief Executive Officer

Okay. Thanks, John. Yeah, this is of course such - it's dear to my heart because I feel like it's the nucleus of what we could be in the future. It's we are what we sell. And so making these transitions is really an important aspect of our total growth strategy, profitability strategy and kind of like everything we do.

So let's start first with product assortments. We took the opportunity in the last year, year and a half to add some new categories, and some of those categories are really hitting their stride and giving us huge growth opportunities. The standout winner so far has been tabletop. So, we're taking our - that tabletop assortment and expanding it to a 50 store test this year, which almost doubled the space allocation. It really will give us some insight as to how far we can take that - those kinds of assortments.

But really the big win for us over the next several years is redeveloping and re-energizing our core product. Where we're seeing that core product come in early, even with some of our inventory disruptions, we're getting a really good read where the customers like the direction we're going. We're giving them better quality, better point of view from a style standpoint, our stores are very color-directed right now, so when you walk in, you really get an impression of what we stand for. And those core categories, and let me repeat what those might be, those core categories are wall decor, which at one point, we were very dominant in. I mean, I think lost our way a little bit. And so it's coming roaring back, we're getting new assortments, the customers are really responding positively.

The other one is furniture where we had to go through some reallocation of our quality and design to make sure that we had a value proposition, so that when the customer walked in, they really looked at our product has great style and quality, but also at a great value. And then there's other categories that we've also had big wins in, and then also categories that we've had to redevelop.

Textiles is a bit of a huge win for us. Our pillow business, our tabletop textile business, anything to do with textiles, and moving some of that innovative designs in India has really been a great play for us, both in customer acceptance and in product margins. Other ones where we're still in the development cycle, our - we've got a good robust candle business, a business in floral that we're trying to upgrade the quality and make sure that we're offering more of a solution-oriented, dec accessories has done really, really well for us and we think about expanding that.

So overall, I think that both the new products and core products are important for us to make sure that by the end of this year, we're in a position that we really love what we represent. And I can - I'm still critical when I walk through our stores and see all of the things that are wrong, but the customers are walking through the stores and seeing all the things that they like. So I think we have to continue to be extremely critical on ourselves as we make this development. And like I said in the previous call, if we replace three innings in the first couple of years, we're paying it about four innings this year alone. So you'll see some very good substantial progress on our merchandise development and I'm really pleased with the way the customers are accepting that.

John Lawrence - Baraboo Growth - Analyst

Great, thanks. And just on the direct sourcing to go to 30% and exceed that, just give me a sense of the timeline. So to move that to 30%, is that product we're dealing with the fall shipments or would that be spring of '22 shipments?

Steven C. Woodward - President and Chief Executive Officer

Really, all year, we've actually got orders written to hit our 30% penetration. But now we have two more orders to write for the back half of the year, it should help us exceed that. So I would say that right now, 30% in the bag, spread throughout the year, and the upside will come by directing some of our seasonal assortments to a higher percentage of direct import for the back half.

John Lawrence - Baraboo Growth - Analyst

Great. Great, thanks. And on the model side, I mean to follow Jeremy's question as far as not just gross margin, but obviously you're achieving some of these targets a little earlier. What would you say both - I mean, obviously, it has something to do with the topline, but where is the other surprise? Is it the 38% gross margin or is it a - on the cost side that you're really hitting some of these two- to three-year targets only[Phonetic]?

Nicole A. Strain - Executive Vice President and Chief Financial Officer

I think it's across the board. When we initially set the target, so much was unknown about. We made a lot of changes in the second quarter and huge changes to the store staffing model and would there be issues that came out of that that we had to tweak and get back, what would store traffic look like, what would - all of the individual pieces. So I think just across the board, when we initially put those out, we wanted to make sure it was something that we could can and exceed and have actually performed better than even the top end of what we thought at the time.

So it really is just across the board being able to maintain the changes that we've made, seeing that the ticket benefit from all the merchandise changes and all of those things and holistically flowing through in. And obviously, the merchandise changes allow us to pull back on discounting pretty significantly and to have 750 average basis point improvement in landed product margin for two quarters in a row is significant, and it's not something that we thought we'd get that - make up that much ground when we first set those out. But even though the adjusted targets that we put out are lower than we had in the fourth quarter, the first half of our year is a much different model right now because the topline volume is quite a bit less.

As we continue to execute the merchandise evolution, we'll see the topline growth improve in the first half of the year specifically because a lot of the changes we're making are to the core everyday product and having the right offerings in the first half of the year. So I think for now, our model still looks very different in the first half versus the second half, so those updated target take that into account, but that's another piece we're continuing to work on in the model.

John Lawrence - Baraboo Growth - Analyst

Great. Last question for me. Woody, I know it's early on the new loyalty club, but is there any analytics or anything so far through the holiday season of how much more spend you got out of a loyalty club member than non-loyalty?

Steven C. Woodward - President and Chief Executive Officer

Well, what we do know is that the customers are liking it. Like I said it on the call, we've got rated by Newsweek as the Number 1 home furnishings loyalty program, and that's just kind of our initial blush. We've got so many more things that we can do to the loyalty program to make it more enhanced. We are getting some of those analytics and sometimes it's a - it's hard to tell because last year was the year[Phonetic] of volatility where we were closing stores, we were doing a lot of different things, but we're pleased so far with the results.

Nicole, do you have any specifics on…

Nicole A. Strain - Executive Vice President and Chief Financial Officer

Yeah, I think the one thing that I would say that is very encouraging, so we're seeing about - since the reward program, if you accumulate points, you earn a $5 reward. We see about a 50% redemption of those rewards and in order to redeem them, you have to come back within 60 days. So again, too early to really say what that means for trips per customer and spend per customer for the year, but that I think is on trend to really be something meaningful.

John Lawrence - Baraboo Growth - Analyst

Great. Thanks for your time, and congrats again.

Steven C. Woodward - President and Chief Executive Officer

Thanks, John.

Operator

This concludes our question-and-answer session. And I would like to hand the call back over to Mr. Woodward for any closing remarks.

Steven C. Woodward - President and Chief Executive Officer

Well, thank you, operator. And as always, we're available for follow-up questions over the next several days and weeks. And we look forward to seeing you online and in our stores. Thank you very much.

Nicole A. Strain - Executive Vice President and Chief Financial Officer

Thank you.

Operator

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KIRKLAND'S INC

Q4 2020

Earnings Transcript

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