Michaels Stores, Inc. Q3 2008 (Quarter End 11/1/08) Earnings Call Transcript

Michaels Stores, Inc. (MIKL)

Q3 2008 Earnings Call

December 2, 2008 5:00 pm ET

Executives

Lisa K. Klinger - Senior Vice President of Finance, Treasurer

Brian C. Cornell - Chief Executive Officer

Elaine D. Crowley - Chief Financial Officer, Executive Vice President

Analysts

[Greg Jordan]

[Bill Luter]

[Caru Martinson]

[Mary Gilbert]

[Colleen Burns]

[Emily Shanks]

[Karen Eldridge]

[Mike Shretgaf]

[Ron Rich]

[Duncan Fisk]

[Ellen Ixplikit]

[Ann Willin]

[Jeff Kobelatch]

Presentation

Operator

My name is [Tikay] and I will be your conference operator today. At this time I would like to welcome everyone to the third quarter earnings release conference call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks there will be a question and answer session. (Operator Instructions) Ms. Lisa Klinger, you may begin your conference now.

Lisa K. Klinger

I’m Lisa Klinger, Senior Vice President of Finance and Treasurer for Michaels Stores, and I’m here with Brian Cornell, Chief Executive Officer, and Elaine Crowley, Chief Financial Officer. Welcome to our third quarter 2008 earnings conference call.

Earlier today we released our third quarter financial results. For those of you who have not already seen a copy of this press release it is available on our website under the Corporate Information section. This call is also being webcast from our corporate website. For those who cannot listen to the entire live broadcast a replay will be available for 30 days. It may be accessed at www.michaels.com or by phone at 1-800-642-1687 PIN 9430846.

I need to remind you that comments made today include forward-looking statements which are subject to the Safe Harbor statement found in our SEC filings. These statements reflect our expectations about future events and therefore are subject to risks and uncertainties. Because actual events could differ from our current expectations you are urged to view all forward-looking statements with caution.

I would also like to point out that the company has presented adjusted EBITDA to provide investors with additional information to evaluate our operating performance and our ability to service our debt. As adjusted EBITDA is not a measure of operating performance or liquidity calculated in accordance with the US GAAP, this measure should not be considered in isolation of or as a substitute for net income as an indicator of operating performance or net cash provided by operating activities as an indicator of liquidity. It should be noted that our computation of adjusted EBITDA may differ from similarly titled measures used by other companies. Adjusted EBITDA excludes certain financial information compared with net income and net cash provided by operating activities from those directly comparable GAAP financial measures and users of this financial information should consider the types of events and transactions which are excluded. A reconciliation of adjusted EBITDA to the most closely related GAAP measure may be found at the end of today’s press release and on our website.

Now I’ll turn the call over to Brian.

Brian C. Cornell

I’d like to welcome everyone to our third quarter conference call. The Michaels’ report and message will sound very familiar to those of you who follow US retail and consumer markets. We are facing many of the same issues that have been reported by retailers week after week for the last few months.

Michaels is marketing to US consumers who have seen their credit squeezed and their home values decline while their concerns for the future continue to increase. The results have been very clear: More disciplined spending, fewer shopping trips and an increased focus on value and discount shopping.

For Michaels [inaudible] and continued declines are higher ticket, home décor and seasonal categories. Fortunately our core arts and crafts businesses continue to perform well with kids’ crafts, bake ware and apparel crafts performing especially well. These categories offer tremendous value and would appear to be well positioned even during these tough economic times. This performance gives us confidence that we can still drive consumer traffic if we provide our Michaels shopper exciting new products combined with the inspiration she’s looking for.

Unfortunately the positive performance of these three categories along with the very stable performance in many of our traditional craft categories were not enough to offset the continued softness in our seasonal and home décor categories.

However despite the economic headwinds we faced during the quarter, we continue to make substantial progress on global sourcing, pricing and promotional effectiveness, piloting our new next generation store prototype and most importantly improving our internal productivity.

I will discuss each of these later in the call but now I’d like to turn the call over to Elaine for the financial update.

Elaine D. Crowley

First looking at the quarter, total sales for the third quarter were $906 million, a 3% decrease over last year’s total of $934 million. Same-store sales for the period declined 6.5% compared to the same period last year. A decrease of 2.8% in the average ticket and a 3.9% decrease in transactions partially offset by a 0.2% increase in custom framing deliveries contributing to the same-store sales decline. The Canadian dollar translation negatively impacted the average ticket for the third quarter by approximately 0.7%.

Total gross profit decreased $21 million from $343 million for the third quarter of fiscal 2007 to $322 million for fiscal 2008. As a percentage of sales our total gross margin rate including occupancy costs contracted 120 basis points to 35.5% from 36.7% last year. Contraction in the gross margin rate for the third quarter was driven by the deleveraging of occupancy costs which were partially offset by an increase of approximately 10 basis points in merchandise margins versus the prior year period.

For the quarter selling, general and administrative expense was $247 million, a decrease of $14 million from fiscal 2007’s third quarter $261 million. As a percentage of sales our SG&A expense decreased 60 basis points to 27.3% versus 27.9% for the same period last year primarily due to the reversal of the year-to-date bonus accruals.

Third quarter operating results increased $1 million to $68 million from $67 million in fiscal 2007. As a percentage of sales operating income increased from 7.2% in the third quarter of 2007 to 7.5% in the third quarter of 2008 primarily due to reduced SG&A expense.

For the quarter interest expense was down $18 million from $95 million for the third quarter of fiscal 2007 to $77 million. Total cash interest paid during the quarter was $39 million.

During the third quarter of fiscal 2008 the company recorded a tax provision of $8 million for the period. The expense relates primarily to the company’s limited ability to recognize foreign tax credits related to its profitable Canadian operations. Cash paid for taxes during the quarter was $6 million.

We recorded a net loss of $20 million for the quarter. Adjusted EBITDA for the quarter was down $6 million from $118 million in the third quarter of fiscal 2007 to $112 million in fiscal 2008. As a percentage of sales adjusted EBITDA decreased 20 basis points to 12.4% from 12.6% of sales in the third quarter of fiscal 2007.

With respect to our year-to-date results, total sales for the nine months were $2,549,000 a $12 million decrease from last year’s total of $2,561,000. Same-store sales decreased 4.1% for the same period in fiscal 2007 on a 1.2% decrease in average ticket and a 2.9% decrease in the number of transactions as favorable Canadian currency translation partially offset the decline in average ticket by approximately 0.3%.

Total gross profit decreased $33 million from $959 million in the first nine months of fiscal 2007 to $926 million for the same period in fiscal 2008. As a percentage of sales our total gross margin rate reduced by 110 basis points to 36.3% from 37.4% last year driven primarily by deleveraging of our occupancy costs and a 30 basis point reduction in merchandise margins during the first half of the fiscal year.

Year-to-date SG&A expense was $765 million an increase of $7 million over fiscal 2007 year-to-date expenses of $758 million. As a percent of sales our SG&A expense increased 40 basis points year-over-year resulting primarily from a deleveraging in store expenses, same in-store investments, corporate payroll and employee severance costs.

Operating income for the first nine months decreased $11 million from $154 million for the same period last year. Adjusted EBITDA for the nine months was $282 million or 11.1% of sales versus $321 million or 12.5% for the same time period of fiscal 2007.

Year-to-date interest expense was down $54 million to $231 million resulting primarily from a favorable interest rate environment on a floating rate debt. Cash interest paid during the first nine months was $199 million. The effective tax rate was 43.3% and the income tax benefit was $34 million with total year-to-date cash taxes paid of $17 million.

Net loss for fiscal 2008 was $70 million as compared to a net loss of $85 million for the first nine months of fiscal 2007.

Looking at the balance sheet and cash flow, we are just now entering our primary cash generating time of the year and have a strong liquidity position. Since we paid so much for the following holiday inventories during late summer and late fall months, sales in the latter part of the second half drive tremendous positive cash flow.

At the end of the third quarter the company had $92 million in cash and there was $510 million availability under its revolving credit facility compared to $57 million in cash and $510 million of availability under the credit facility as of the end of the third quarter last year. As of December 1, 2008 availability under the credit facility increased to approximately $630 million.

Third quarter debt levels totaled $4.183 billion which is essentially flat to last year’s quarter-ending balance of $4.181 billion. During the quarter the company made a $5.9 million amortization payment on its senior secured term loan.

Average inventory per Michaels store at the end of the third quarter of fiscal 2008 was relatively flat to last year at $1.02 million.

Capital spending for the nine months ending November 1, 2008 totaled $66 million with $40 million attributable to real estate activities such as new, relocated, existing and remodeled stores and $26 million attributable to strategic initiatives and maintenance requirements.

As of December 1 we had a total of 1,000 full team Michaels stores and 163 Aaron Brothers stores for a total of 1,176 stores. Year-to-date we opened 60 stores and relocated nine Michaels stores. We also relocated one store and closed three Aaron Brothers stores. Store pre-opening costs were approximately $5.8 million this year versus $5.9 million last year.

This concludes my comments regarding our third quarter and year-to-date 2008 financial performance. I’ll now turn the call back over to Brian for his concluding remarks.

Brian C. Cornell

It goes without saying that we’re anticipating a challenging fourth quarter. Our team is focusing on basic retail fundamentals: Running efficient stores and delivering our customers what they want at the value they expect.

As we enter into this holiday shopping season we are focused on four primary areas of short-term execution to effectively deal with the current environment.

First. Improving gross margin dollars and proper execution of marketing strategies. By remaining flexible and responsive and utilizing our pricing and promotional tools we will increase the depth of promotions when it will drive profitable traffic and also decrease the depth of non-elasticity categories. We are also carefully managing the promotion of seasonal items to maximize their overall profitability during this important holiday season.

Second. We placed heightened attention to controlling operating costs throughout the organization; both the in-store process re-engineering and corporate G&A activities. From store payroll optimization and general operating expenses to corporate travel restrictions and tougher headcount controls, nothing is off the table.

Third. Capital spending will be under increased scrutiny. Maintenance activity will be a priority and long-term strategic initiatives will be kept to a highly focused area of investments. Real estate activity for 2009 is currently being re-evaluated and we expect to significantly scale back our new store opening program focusing on the best opportunities available in the market place.

Finally, we have recently launched our new value campaign: Endless Creativity and Endless Savings. This message emphasizes the creativity and value we offer our shoppers. We’re providing them great value to decorate their homes, make hand-crafted items or buy gifts at Michaels.

Despite our current short-term challenges, our long-term initiatives remain the same. Global sourcing continues its rapid growth rate filling a 2009 pipeline beyond our preliminary expectations. Our consumer insight initiative is producing data that we’re using in new and existing marketing channels and is allowing us to connect with our consumer in new innovative and rewarding ways.

Our next generation test stores have just been launched. While the stores have just recently opened, we’re pleased with the early results. We’re looking forward to analyzing the many facets of this new store prototype with an eye towards finding the areas that can be rolled across our system as quickly and cost effectively as possible in order to drive positive EBITDA growth in 2009.

I want to reiterate to everyone that we are just now entering our primary cash generating time of the year. Last year we generated nearly $300 million in operating cash flow in the second half of the year. Since we pay for inventories during the late summer and early fall months, sales in the latter part of the second half drive tremendous positive cash flow. As Elaine mentioned, our cash balance at the end of the quarter was approximately $92 million.

In addition to the strong cash flow generation and the cash on our balance sheet at the end of the third quarter, we had over $510 million in cash available under our revolving credit facilities and as of yesterday availability had increased to approximately $630 million.

As a privately held company we have the benefit of being able to focus on making the right decisions for the long-term profitability and success of this company while it has been focusing simply on short-term ways to impact quarterly earnings. Given our strong liquidity position we can continue to pertinently invested in our growth and strategic initiatives.

In addition given the current economic and pertinent environment, we’re making the necessary expense changes to ensure that Michaels continues to perform well and to weather this difficult economic downturn.

We’re now ready to open up the call and take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from [Greg Jordan].

[Greg Jordan]

My questions focus on two main areas. One, you mentioned that the merchandise margin was up due in part to the sourcing. If you can just give us the magnitude of some of the moves in the merchandise margin that caused it to be up? I was surprised given the 6.5% drop in same-store sales to see a positive move in the merchandise margin.

Elaine D. Crowley

We usually have not broken out specifically what is attributable to sourcing. We did want to give a flavor to the group though that we are seeing positive merchandise margin performance.

[Greg Jordan]

Was it all sourcing or was some of it mix?

Elaine D. Crowley

Actually it’s a combination of several things but it’s primarily the sourcing offset by some other activities.

[Greg Jordan]

As we think about going forward, should we expect to see some more benefits from sourcing?

Brian C. Cornell

I think as we go forward into 2009, as I mentioned in my prepared comments, we are clearly filling up the pipeline. Our sourcing team has made significant progress. We think we’re going to start to see more and more of those benefits in 2009. You should expect to continue to see sourcing benefits in 2009 and beyond.

[Greg Jordan]

On the bonus accrual in SG&A, how much was that?

Elaine D. Crowley

It was approximately $15 million.

[Greg Jordan]

I assume there would not be a similar benefit in the fourth quarter?

Elaine D. Crowley

You are correct. There would not be a similar benefit during the fourth quarter.

[Greg Jordan]

Not looking for specific guidance but if you can give us any idea as to what you’re seeing as we get into the holiday period or consumers responding with emotions differently than what you would have expected or just kind of give us the overall health of your consumer?

Brian C. Cornell

We’re currently summarizing the important Black Friday holiday. As we sit here today we are actually quite pleased with the traffic we generated. We think our new value message certainly connected with the consumer but as we’ve learned in the third quarter, we certainly expect this to be a consumer that’s going to shop with increased discretion and may wait later and later into the season to make those final purchases. It’s very early for us right now but we were generally pleased with the traffic we generated over this important holiday weekend.

Operator

Our next question comes from [Bill Luter].

[Bill Luter]

In terms of the adjustments to EBITDA can you talk about what the other category was?

Elaine D. Crowley

For the quarter really the biggest components are going to be remodel expense which was about $2 million dollars and that relates back to Brian’s comments regarding our next gen prototype; we had change in control, severance expense of about the same amount; we mentioned our pre-opening expense number; and then there’s about $2.9 million of foreign exchange. Those are really the big pieces.

[Bill Luter]

Then in terms of the deleveraging of occupancy expenses, can you talk a little bit about or give me some sort of data point about what sort of same-store sales increase we need so that we wouldn’t be seeing that deleveraging?

Elaine D. Crowley

It really depends. There are so many variables out there today. In the past we said that you needed to get somewhere close to around a positive 2 comp but again with wild variables out there with freight and gasoline surcharges, they come, they go but that gives you a ballpark.

[Bill Luter]

If you could talk a little bit about, and I’m not sure whether you’ll be wanting to comment at all, but one, how the performance may have changed in November and two, whether you guys have seen any change in the performance of the non-home décor and the non-seasonal stuff; whether you’ve seen any change in the performance there?

Brian C. Cornell

I think our overall summary of the business is very consistent. Our traditional arts and crafts categories performed very well in the third quarter. They’ve continued to perform well throughout the year. We would certainly hope that we’ll see stability in those categories through the balance of this year as this value minded consumer turns back to home-related activities. We certainly continue to be concerned about all the seasonal and home décor categories.

As you’ve seen from Michaels over the last three quarters and many other retailers, we’re just not seeing a consumer right now that’s investing discretionary dollars in their homes. We’re going to watch these categories carefully. We think we’ve got a great message and some great merchandise to support our Christmas holiday season but we’re going to watch this one very carefully. We expect the consumer to shop with the utmost discretion.

Operator

Our next question comes from [Caru Martinson].

[Caru Martinson]

In terms of the cap ex here for 2009, I was wondering if you could step back and look at the $110 million that you guys had said for this year. Is that all pretty much spent and that’s how we should look at that, correct?

Elaine D. Crowley

No. We’ll probably come in favorable to the $110 million number.

[Caru Martinson]

Out of that is it right to think of it kind of 2/3 new real estate, 1/3 for strategic and maintenance or how should we look at that?

Elaine D. Crowley

No. It’s really been 1/3, 1/3, 1/3 in the past.

[Caru Martinson]

Given the second half of the year and your strong cash flow position, what are your thoughts on the ability to buy back bonds in the open markets here?

Elaine D. Crowley

At this point we’re really focusing on liquidity and focusing on operations and making sure that we have adequate liquidity in the business, and currently we don’t have any plans to repurchase.

[Caru Martinson]

But you have the ability if need be or if that desire arose, correct?

Elaine D. Crowley

At the current time we’re not restricted by our debt agreements on the seniors.

[Caru Martinson]

On the seniors?

Elaine D. Crowley

Right.

[Caru Martinson]

Then just in terms of when we look at the competitive landscape, the consumer is being much more price selective as you said and then much more discretionary. Are you seeing a competitive response from your traditional peers but then also from others outside of your field going after that consumer?

Brian C. Cornell

I think right now we’re seeing a fairly national market place and certainly there’s been some great value out there in front of the consumer. But as we sit here today and we enter this important holiday season, I think there’s one general rational promotion that has been out there from most of our competitors.

Operator

Our next question comes from [Mary Gilbert].

[Mary Gilbert]

I thought maybe you could give us a little more clarification on the liquidity. How much was actually drawn on the revolver? Were there any LCs outstanding? And that availability I’m assuming includes the $75 million of required availability, right?

Elaine D. Crowley

It does include the $75 million. At quarter end we had $407 million drawn underneath the revolver and then we had about $72 million of a combination of trade and standby letters of credit.

[Mary Gilbert]

Where does it stand today when you said that you had your availability increase to $630 million? Actually that might have included cash in that number. [Inaudible] quarter of the revolver availability plus the cash of $92 million, right?

Elaine D. Crowley

Well, the $92 million was at the end of the quarter. That’s not as of December 1.

[Mary Gilbert]

Right. But the $510 million of revolver availability at the end of the third quarter [inaudible].

Elaine D. Crowley

It’s pure availability.

[Mary Gilbert]

Yes. That was revolver availability so that’s still good. So when you said that your total liquidity, I can’t remember if you were referring to your total liquidity of $630 million did not include cash and revolver availability?

Elaine D. Crowley

No. That’s simply the availability in the revolver.

[Mary Gilbert]

The $630 million was just revolver availability?

Elaine D. Crowley

Correct.

[Mary Gilbert]

How much was drawn at that point in time?

Elaine D. Crowley

We don’t comment intra-quarter on our drawings. If you know that the revolver’s the only variable piece of our debt so you can [inaudible].

[Mary Gilbert]

Yes. That’s obviously going to come down.

Elaine D. Crowley

Correct.

[Mary Gilbert]

In talking about the trends that you’re seeing in November, is it fair to say that the 6.5% comp store sales decline is continuing in November?

Brian C. Cornell

At this point we’re not going to offer guidance on our comps in the quarter.

[Mary Gilbert]

Also when you were talking about some of the investments going through the $11 million, I’m sorry I think I missed it but you said the remodel expense was how much?

Elaine D. Crowley

About $2.5 million.

[Mary Gilbert]

Then the severance piece was $2.5 million as well?

Elaine D. Crowley

Correct. I’m sorry; it’s $2.1 million and $2.1 million.

[Mary Gilbert]

The severance is $2.1 million?

Elaine D. Crowley

Yes and the remodel is $2.1 million.

[Mary Gilbert]

Then the remodel expense you said that this is for your next generation prototype, but is this a recurring expense?

Elaine D. Crowley

No. These are our multi-year initiatives that are defined in the agreement.

[Mary Gilbert]

So it’s based on that but it’s real cash spent and you do expect to continue to spend on the remodel side?

Elaine D. Crowley

Correct.

[Mary Gilbert]

Then the $2.9 million foreign exchange, is that -

Elaine D. Crowley

It’s related to our Canadian operations.

[Mary Gilbert]

Looking at cap ex spend for 2009, if you come under $110 million this year, could we look at cap ex being under like $50 million or are you going to be spending closer to the maintenance level?

Brian C. Cornell

We’re currently evaluating our plans for cap ex for 2009. As I mentioned during my earlier comments, we’re clearly scrutinizing cap ex. We certainly expect to open up fewer stores in 2009 but we haven’t finalized those decisions at this point.

[Mary Gilbert]

How should we look at changes in working capital? Because if we look at the sales trends, inventory on a per store basis is running flat. So are there opportunities in ’09 where we could see cash generated from working capital as you get inventories more in line with sales trends? Is that fair to assume?

Elaine D. Crowley

Certainly as we go forward with our 2009 planning those are things we’ll be looking to do and address.

[Mary Gilbert]

On your cash position of $92 million, how much is the amount of cash that you need in operations at all times? I guess it’s that $92 million, isn’t it? Because that reflects the float; otherwise everything flows through the revolver.

Elaine D. Crowley

No. Actually if you go back and look at our balance sheet, it’s always been in that sort of $40 million to $50 million range which incorporates all the cash in transit and the cash that we have in the stores.

[Mary Gilbert]

So the fact that you had a higher cash balance is purposeful just to keep more liquid?

Elaine D. Crowley

Correct.

Operator

Our next question comes from [Colleen Burns].

[Colleen Burns]

With regards to inventory, can you give some color around how you’re planning inventory at year end? Do you expect to have inventory down on per store basis by the end of this year?

Elaine D. Crowley

We really haven’t been providing guidance on that. Our goal would be to make sure that we come out of the holiday clean as it relates to our seasonal products and really keeping the focus on that.

[Colleen Burns]

As you look at the store piece, do you see opportunities for store closures?

Brian C. Cornell

We’re constantly as part of our real estate process evaluating our store base and certainly looking at opportunity for store closures. I think traditionally, Elaine if you could correct me, we closed 10 to 15 stores a year. We’ll certainly be evaluating our asset base as we plan for 2009 and taking the same approach that we’ve taken traditionally to real estate.

[Colleen Burns]

I don’t know if you said this, but what’s in front of your stores that aren’t profitable today?

Brian C. Cornell

A very select few. The majority of our stores are quite profitable.

Elaine D. Crowley

We’re talking like a handful.

[Colleen Burns]

You talked a little bit last quarter about your private label initiative and I believe you were going to roll a lot of those I think out later this year. Can you update us on where you stand on the private label initiative?

Brian C. Cornell

We continue to make very good progress on our private label and our proprietary branding. We’ve been rolling out a number of those brands into the market place. As we sit here today a number of those brands such as Creativity, Recollections, Celebrated are currently in our stores and we’ll continue to expand as we go into 2009. It’s part of our sourcing effort and we’ve certainly made great progress on the branding front. You should expect to see more and more of those proprietary brands in store as we enter the first half of 2009.

[Colleen Burns]

Are you stressing them in kind of your value initiative? Is that part of the marketing? I haven’t seen the new marketing?

Brian C. Cornell

Very specifically we’re trying to create proprietary brands specific to our key Michaels categories. So a brand like Creativity is targeted towards our kid shoppers; brands like Recollection are targeted towards our scrapbook shopper; so we’re looking to build the brands that are specific to the categories that we’ll emphasize throughout our stores.

Operator

Our next question comes from [Emily Shanks].

[Emily Shanks]

I wanted to ask around the $15 million bonus accrual. Is that a non-cash item?

Elaine D. Crowley

It would be non-cash. It was an accrual earlier in the year and the accrual’s not needed so it would be non-cash.

[Emily Shanks]

Why is that not excluded then from your adjusted EBITDA number per the definition in the bank agreement?

Elaine D. Crowley

It’s just an accrual. It’s a change in our accrual so a liability on the P&L.

[Emily Shanks]

But it’s a non-cash number that’s benefiting your SG&A this quarter?

Elaine D. Crowley

Had bonuses been earned, they would have eventually been paid in cash. So under the definition it would still continue to be included as a regular operating item.

[Emily Shanks]

Away from the bonus accrual, what percent of your SG&A is variable?

Elaine D. Crowley

We keep evaluating a lot of this stuff. It’s close to a 50/50 mix.

[Emily Shanks]

Did I hear you correctly that in the other bucket for add-backs there’s a couple million that have to do with the remodels the next gen?

Brian C. Cornell

That’s correct.

[Emily Shanks]

How is that an add-back under the definition of the EBITDA? Where does that fall? Is that considered like a pro forma cost save?

Elaine D. Crowley

It’s the multi-year remodel initiative.

[Emily Shanks]

Is that considered like a pro forma cost save in that part of the definition?

Elaine D. Crowley

No. It’s specifically carved out.

Operator

Our next question comes from [Karen Eldridge].

[Karen Eldridge]

You mentioned that your goal is to come out of the holiday with your seasonal inventories clean. How do you feel about trending out of Halloween? Were you clean in there? And how aggressive are you going to get on markdowns? Are you starting earlier? Are you being more aggressive to ensure that you are in that same position? And also what other mechanisms do you have to control your percentage of aged inventory?

Brian C. Cornell

I think the best way to talk about it is to reflect on Halloween. We certainly did take markdowns earlier recognizing that the consumer was shopping with much more discretion for these categories. So we took markdowns earlier. We think we took the right steps and used many of our new pricing and promotional tools and our seasonal optimization tools and managed through that process. And we expect to use the same tools and analytics to guide us through this final holiday season.

[Karen Eldridge]

Is it safe to say that you haven’t seen an increase in aged inventory this year?

Lisa K. Klinger

We don’t really have aged inventory. If you think about our store base, we do have a portion of our business which is seasonal. And as Brian and Elaine both commented earlier, we make a very strong effort to get through those seasonal inventories clean. Then the rest of our business is on automated replenishment.

Operator

Our next question comes from [Mike Shretgaf].

[Mike Shretgaf]

With regards to seasonal inventory, can you comment on what percentage of sales that is? With regards to the margin, would you say that you think margins in seasonal will be flat to the previous year or better or worse?

Brian C. Cornell

We typically don’t break out our mix by quarters. On an annual basis our seasonal home décor business is about 25% of the total mix. It certainly grows during this holiday season but we don’t specifically break out those numbers quarter-by-quarter.

Operator

Our next question comes from [Ron Rich].

[Ron Rich]

You mentioned that you felt good about your next gen stores. I was wondering if you could give us a better sense for what that means?

Brian C. Cornell

It’s very, very early in the process. Some of those stores literally opened up or were actually ready for the consumer last week. So we’ve just been polishing up the first set of remodels. We do have 19 remodels and five new next gen stores. We’re going to monitor the performance during the holidays. We’ll have a much better sense as we get into the start of 2009. But it’s very early right now in the process.

Consumer reaction has been very positive as we’ve interacted with shoppers. We’ve certainly seen a great lift in a number of categories but it’s early days. We need a lot more time to validate the results, and we certainly want to get through the holiday season and into the first half of the year before we make any comments on the performance of next gen stores.

[Ron Rich]

I recall last fourth quarter there had definitely been some issue with regard to high ticket, seasonal and home décor. Going into this fourth quarter relative to last fourth quarter do you feel better positioned given the environment?

Brian C. Cornell

We’ve certainly made some changes to our mix so the products that we purchased in anticipation of this year have been changed. We’ve certainly made some adjustments to our pricing and promotional cadence. But I think we still face the same economic headwinds that we faced last year and in fact they probably only increased as this consumer is certainly shopping high ticket discretionary holiday seasonal items with greater care than ever before.

We think we made the appropriate changes based on the information we had when we started to buy nine to 12 months ago and certainly have amended our mix. We think we’ve done a great job of presenting the products. We think our current value message which focuses on the consumer decorating their home at a great value from Michaels is the right message for today’s market. But we continue to face those same challenges with high ticket discretionary items.

Operator

Our next question comes from [Duncan Fisk].

[Duncan Fisk]

On your SG&A just on the third quarter if you add back the bonus reversals, your SG&A was roughly flat. I guess my question is as we think about the SG&A for your fourth quarter, should we just add back your SG&A reversal that you had last year which I think was $14 million and look at roughly kind of a flat SG&A year-over-year? Is that the right way to look at it or are there initiatives in place just kind of allowing you to cut back on your SG&A?

Elaine D. Crowley

It’s probably a fair approach. We are being, as Brian alluded to, very systematic about going through every expense. So we’re hoping we have favorability. But again from a corporate G&A perspective, that’s a fairly fixed portion of our expense.

[Duncan Fisk]

A lot of the inflation that we saw over the summer, can you just tell us how much of that has actually flowed through your cost of goods sold line in this quarter, and maybe when do you expect most of that inflation to run through your P&L, and will your sourcing initiatives more than offset that?

Brian C. Cornell

Right now we’re certainly spending a lot of time both with our domestic vendors and working through our global sourcing team to try and combat some of the price increases we saw last year. As we sit here today and you’re well aware of the fact that commodity costs have started to drop both for metals and plastics as well as any petroleum-based products, so we’re certainly working aggressively right now.

I’ve got our team in Asia as we speak working with our vendors looking at ways to offset any potential cost increases and in fact look at opportunities for cost decreases as we go into 2009. So it’s work in progress. We’re very active in this arena and we certainly think that we’ll see some benefits in 2009. Our big challenge right now is we’re a two turn slow turn business so it’s managing the pipeline of inventory that we have as we plan for 2009.

Lisa K. Klinger

We’ve mentioned in the past that we always felt like we were in a somewhat enviable position with regard to the situation going on in China and that we were just starting our global sourcing strategy. So as our current vendors approached us with pricing increases that we were able to leverage our global sourcing opportunity, we also took a very proactive approach on pricing when it was necessary, and then we also took a pretty proactive approach on product redesigns. This time last year there weren’t many drags from a pricing standpoint or cost of goods perspective that were coming through.

[Duncan Fisk]

I guess maybe on a net net perspective, do you think that as this inflation flows through your cost of goods sold that you’re going to still be able to offset it? You’re still going to be able to see a higher merchandise margin because of these initiatives that you just mentioned or not? Is it more positive or negative?

Brian C. Cornell

Net net we think we’re going to be in a more favorable position because of our global sourcing efforts.

[Duncan Fisk]

On the cap ex reduction that you mentioned, you classified your cap ex into three buckets: 1/3, 1/3, 1/3. As you reduce your cap ex, obviously it’s not going to come out of maintenance but I guess out of your IT initiatives and your new store openings should that be split evenly between the two or are you going to be more in one bucket versus the other?

Brian C. Cornell

We’re currently going through that exercise and certainly we’re starting with new stores but we’re also scrutinizing our strategic initiatives. We’ll also spend time looking at our maintenance budget.

Operator

Our next question comes from [Ellen Ixplikit].

[Ellen Ixplikit]

But what were the approximate rental expenses for the quarter?

Elaine D. Crowley

$78 million for the quarter.

[Ellen Ixplikit]

And what is it year-to-date?

Elaine D. Crowley

$233 million.

Operator

Our next question comes from [Ann Willin].

[Ann Willin]

Looking at your next generation remodels, I was wondering if you could talk about how disruptive those were to those particular store sales during the time and how long it took you to complete the remodels?

Brian C. Cornell

I think our team did an exceptional job of remodeling the stores and minimizing the disruption for our shoppers. We took a very modular approach to the remodels and I think we got better as we moved down track and got some more experience. I think we really minimized the disruption and on average those took us about 30 days.

[Ann Willin]

On the feedback period that you’re looking for, are we looking at six months or a year? How long before you make the decision as to a wider rollout or whether this is a successful initiative?

Brian C. Cornell

I think we’d want a minimum of six months and I think we’d want six months excluding the holiday season. So we’re going to need the first half of 2009 to really determine category-by-category what’s working, understand where we get the best return in investment and importantly think about areas that we can roll-back in the most cost efficient manner to the majority of our stores. But we’re going to clearly need at least six months in the first half of 2009 to assess the results of these stores.

Operator

Our next question comes from [Jeff Kobelatch].

[Jeff Kobelatch]

A question about these next gen stores. The next gen stores the total is five that you’ve opened plus the 19 remodels. Are those 19 remodels also the next gen look?

Brian C. Cornell

Yes, they are. If you were to look at our five new stores versus the 19 we’ve remodeled, they would be very similar.

[Jeff Kobelatch]

Your merchandise margin, in the second quarter it was down 100 basis points and the third quarter it was up 10 basis points. You’d think it would be more promotional in the third quarter versus the second quarter. What was the reason why the merchandise margin was better in the third quarter than the second?

Lisa K. Klinger

I wouldn’t say that we were necessarily more promotional. When you start getting in the third and fourth quarter, we are on add every week essentially. There’s just a week or two in August and September. It wasn’t necessarily more promotional. I think what we are alluding to is that we went a little deeper earlier in the season in order to maximize our gross margin dollars for seasonal items. So not necessarily more promotional in the third quarter.

We did say in the second quarter that we tried new promotional strategies in our dark weeks. Some of them worked; some of them didn’t. The ones that worked we were incorporating going forward and the ones that didn’t we learned our lesson.

Brian C. Cornell

I think that’s really the key. I think as each quarter evolves we’re applying more of our learning to how we manage the business, how we’re utilizing more of our pricing, promotional and seasonal optimization tools. I think that in conjunction with the strides we’re making with global sourcing will continue to enhance our margins going forward.

[Jeff Kobelatch]

Can you qualitatively talk about how much more unique your merchandise is versus Hobby Lobby and A.C. Moore and JoAnne’s? Do you have any feel for that?

Brian C. Cornell

I think [inaudible] in general. I think you’d have to go category-by-category. We’ve certainly focused much more on bringing newness and innovation into our key art and crafts categories. We think we’ve made some tremendous strides in categories like jewelry and beading.

We think some of the results we’re seeing in our core craft categories are linked to the new fresh approach we’re taking with products. And we’ll continue to look at the lull of newness as we go into 2009. We’ve really focused on our core arts and crafts categories, categories like scrapbooking, jewelry and beading, our specialty crafts and we’ll continue to focus on those as we go into 2009.

It would be hard for me to compare our approach to our competitors. Several of them that you’ve mentioned are more focused on the home décor side of the business or on the fabric side. Our focus is on our traditional Michaels categories as well as important categories like framing and art supplies.

[Jeff Kobelatch]

Do you have a feel for if your customers are noticing the uniqueness at your store, the products you’ve brought out in your stores?

Brian C. Cornell

I think it would be a very resounding yes. I think we’re getting very good feedback from our shopper. I think they recognize and appreciate the newness that we’re bringing to many of these categories and we’re going to continue to listen to our shopper and bring our shopper the type of new creative products she’s looking for.

[Jeff Kobelatch]

I heard that you said that you have reorganized your merchants into category management teams. Can you explain how it was set up before and how the new setup will help your results going forward?

Brian C. Cornell

We’ve really spent time aligning our organization around key transformational categories; categories that we think we can own, categories where we’re truly differentiated. So our merchant team is really aligned around the consumer and the key consumer feedback that we’ve received.

We’ve taken a very different approach from the one that we used in the past. We’re really letting the consumer research and insight guide our structure and making sure that we’re aligning our merchant team around the key consumer segments that we service at Michaels. We think that’s going to be a very effective approach for us in the future. We think our merchants will be consumer segment experts and be able to apply the consumer research and insight that we’ve gained to drive their business.

[Jeff Kobelatch]

Were you relying more on the trade to come up with the new products then? Is that kind of the change that you’re talking about?

Brian C. Cornell

No. I think the big change is leveraging much more of the consumer insights, the research we’ve done, our understanding about key demand drivers by consumer segment and really structuring our organization around those different consumer segments that are critically important to Michaels.

Lisa K. Klinger

Operator, we’ll just take one more call.

Operator

There are no questions at this time.

Brian C. Cornell

Thank you for joining our third quarter call and we look forward to talking to you at the end of the year.

Operator

This concludes today’s conference call. You may now disconnect.

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