The Michaels Companies. (NASDAQ:MIK) Q3 2018 Earnings Conference Call December 6, 2018 9:00 AM ET
Kiley Rawlins - VP, IR & Communications
Chuck Rubin - Chairman & CEO
Denise Paulonis – CFO
John Heinbockel - Guggenheim
Seth Sigman - Credit Suisse
Christopher Horvers - JP Morgan
Simeon Gutman - Morgan Stanley
Mike Baker - Deutsche Bank
Laura Champine - Loop Capital
Liz Suzuki of Bank - America Merrill Lynch
Good morning. My name is Denise and I will be your conference operator today. At this time, we’d like to welcome everyone to The Michaels Company's Earnings Conference Call to discuss results for the Third Quarter of Fiscal 2018. All lines have been placed on mute to prevent any background noise. [Operator Instructions] Please note this event is being recorded. Thank you.
And now, I'd like to turn the call over to your host, Kiley Rawlins, Vice President of Investor Relations and Communications. Ms. Rawlins, you may begin the conference.
Thank you, Denis. Good morning everyone and thank you for joining us today. Earlier this morning, we released our financial results for the third quarter of fiscal 2018. A copy of this press release is available in the Investor Relations section of our website at www.michaels.com.
Before we begin our discussion, let me remind you that today's press release and the presentations made by our executives on this call may constitute forward-looking statements and are made pursuant to and within the meaning of the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995, as amended.
While these statements address plans or events which we expect will or may occur in the future, a number of factors as set forth in our SEC filings and press releases could cause actual results to differ materially from our expectations. We refer you to, and specifically incorporate the cautionary and risk statements contained in today's press release and in our SEC filings.
You are cautioned not to place undue reliance on these forward-looking statements, which speak only as of today, December 6, 2018. We have no obligation to update or revise our forward-looking statements except as required by law, and you should not expect us to do so.
On today’s call, we will reference non-GAAP financial measures, including adjusted operating income, adjusted net income and adjusted diluted earnings per share. All adjusted for the Aaron Brothers restructuring charge and unexpected inventory write-down related to a third-party which should not meet our quality standards, losses on early extinguishments of debt and refinancing cost, and provisional tax adjustments as applicable. A reconciliation of these measures to the corresponding GAAP measures are detailed in today's earnings release.
We'll begin this morning with highlights from Chuck Rubin, Chairman and CEO; then Denise Paulonis, our CFO; will review our financial results and outlook in more detail. Following our prepared remarks, we will open up the call for questions.
Now, I'd like to turn the call over to Chuck Rubin. Chuck?
Thank you, Kiley. Good morning everyone. Happy holidays. This morning we reported better-than-expected third quarter results driven by strong comp sales growth, good expense management, and the impact of our ongoing share repurchase program.
For the quarter, comp store sales increased 3.8% or 4.3% on a constant currency basis. Adjusted operating income was $141 million and adjusted diluted EPS was $0.48. The increase in comp store sales was driven by an increase in average ticket partially offset by a slight decline in customer transactions. On a calendar shifted basis, comp sales increased 1.1%.
The improved trend in comp store sales in the quarter was a result of better merchandise in stocks, increased marketing support, and a strong focus on value and key items. Key events this quarter including back-to-school, our fall lowest price of the season promotional event, and Halloween all delivered good results.
We again produced very strong e-commerce sales this quarter driven by enhanced searchability and expanded online assortment and increased digital marketing. While still a very small part of our total revenues, online sales in the third quarter were nearly double the online sales in the third quarter last year.
This was driven by double-digit increases in traffic and higher conversion rates. Buy Online Pick-up In Store or BOPIS continues to perform very well, accounting for roughly a third of our e-commerce transactions in the quarter.
From a category standpoint, our seasonal business was very strong this quarter, supported by a compelling fall, Halloween, and holiday assortment, more stores with the Flexible Merchandise Area or FMA as we call it, and increased marketing efforts including a new fall decor guide.
Our seasonal business also benefited from the calendar shift, which resulted in more sales of Halloween and Christmas Trees in Q3 than last year. Technology and tools also delivered -- also continued to deliver strong sales growth, reflecting the ongoing trend of personalization and the popularity of Cricut machines, and craft storage outperformed driven by our stack-out store merchandising programs.
As I've indicated in the past, we manage a portfolio of distinct businesses, and each quarter some businesses exceed our expectations while others are not as strong as planned. So while many of our categories performed well this quarter, ready-made frames, jewelry, and scrapbooking categories underperformed.
Custom framing delivered another positive comp this quarter, reflecting improvements we've made in the selling model, new digital capabilities, and the addition of new substrates that we produce. We continue to see good transference from the closed Aaron Brothers stores and believe we have opportunity to capture more of these sales.
In summary, the investments we have made this year to make it easier for customers, including the expansion of our FMA stores and our efforts to create a better and more integrated omnichannel experience, combined with a strong seasonal assortment and enhanced marketing support delivered positive comp growth in Q3 in both Michaels brick-and-mortar stores and online, and we expect these improvements will serve us well in Q4 in the peak selling weeks.
As we turn to the fourth quarter, our concerns about the challenges facing the Arts and Crafts channel from stagnant growth and increased distribution points have not changed. But we are navigating our way through the choppy environment and expect the drivers of our business in Q3 will continue to drive our performance in Q4.
From a customer standpoint, we continue to do very well with our enthusiast customers who shop with us more often and spent more with us in Q3. As expected, we also saw more casual customers shop with us Q3 as seasonal decor, school projects, and holiday drove more trips with these customers.
We know from our customer data that in Q4 the mix of customers generally over indexes to the casual customer as the holiday selling season picks up. Each year, our merchandising teams enhance the quality, value, and presentation of our holiday assortment.
We again expanded our selection of trees, ornaments, and decor and also added a limited number of new oversized pieces, including a life-sized sleigh and nutcracker. We continue to simplify our in-store seasonal presentations to make it easier for customers to shop for the holiday. For example, we’ve consolidated all of our garland, tree skirts, stockings, and holiday pillows together, so that the customer can see the breadth and depth of the assortment we offer.
We created a gift wrap drive aisle fixture to create a one-stop shop priced at $5 or below so that customers can get everything they need to wrap up their gifts this holiday season. And throughout our holiday presentations, we’ve increased our use of clear, simplified price points to create a compelling value message.
We now have more than 700 stores with the FMA layout as compared to 420 stores last year to enhance our seasonal presentation to the customer. 238 stores we converted in Q2 have ramped up quickly and have consistently outperformed the control group since their conversion driven by strong sales in seasonal categories.
In the third quarter, we used this space to present more impactful statements for back-to-school, Halloween, and holiday decor with strong results. And soon, we will transition this space to highlight our assortment of creative gifts for kids.
We’ve made a number of investments this year to create a more integrated omnichannel experience for customers. On michaels.com, we’ve simplified the navigation and improved discoverability for both desktop and mobile platforms.
We’ve added geolocation for store selection, simplified our coupon presentation, and added inventory availability information for local stores, so that customers have information that is relevant to their needs.
We also expanded our online assortment by more than 35% and now offer more than 100,000 items, including expanded fabric and bulk quantity buys through michaels.com. We've improved The Michaels app. We know shopping at Michaels with more than 45,000 SKUs in a store can be a challenge, so we continue to enhance our Michaels app to make it easier for customers to find what they need when they are in our stores.
Today, more than 6.5 million customers have the Michaels app, and we’re especially pleased that our average rating in the Apple Store is 4.8 stars. Both visual and verbal search capabilities, customers can use the app this holiday season to find projects or products to fulfill their decor and gift needs.
We’ve also enhanced our messaging capabilities to highlight current promotions when the customer uses the app in-store and can reach more than 4 million customers through push notifications within The Michaels app.
We’ve launched BOPIS in all of our stores earlier this year making it easier and more convenient for the customer to get their online purchases. BOPIS is a the great enabler of our business as it leverages the convenience of an online purchase and also drives a trip to the brick-and-mortar store presenting an opportunity to drive increase sales through an add-on purchase.
In fact, we are seeing add-on purchases when customers come to the store to pick up their e-commerce orders. Although we believe we have an opportunity to increase these additional transactions.
As expected we have seen an increase in BOPIS utilization since the start of the holiday season and I'm very proud of how our store teams have managed the growth and demand. In anticipation of strong e-commerce sales this holiday season we have diversified our e-commerce fulfillment capabilities.
In addition to launching BOPIS we've also doubled the number of stores in our ship-from-store program. With more than 450 stores available to fulfill e-commerce orders this holiday season we are able to leverage store level inventories, deliver online orders to customers faster and better control our fulfillment costs.
Although we are still in the early weeks of the holiday season we are pleased with our ship-from-store performance. We also retrofitted our Dallas-Fort Worth distribution center to support e-commerce fulfillment thereby reducing our reliance on a third-party provider to fulfill online orders this holiday season.
We recall that last year our third-party fulfillment provider failed to meet plan customer demand throughout the holiday season resulting in higher than planned fulfillment costs and increased customer frustration.
Our Dallas-Fort Worth facility is up and running, the team is ramping up well and we are on track to be out of the third-party fulfillment center by spring of 2019. We continue to evolve our media mix reducing spend for print and increasing investments in television including addressable TV and digital marketing.
In Q4 we will offer more targeted incentives to drive trips and baskets including gift with purchase offers, bounce back coupons and exclusive loyalty offers, and we will host more make breaks in stores and create more digital content including Facebook live videos to highlight our assortment and how easy it is to make with Michaels.
Using newly acquired tools we will also leverage our extensive customer analytics to target our email messaging more effectively. Today, we can link 74% of our transactions and 83% of our sales to unique customer.
This holiday season we are leveraging these insights to personalize our email communication to customers based on where they are on the customer lifecycle and are tailoring our messaging depending upon whether they are new customer who has just made their first purchase, an active customer who shops with us regularly or a customer we haven't seen in a while.
We’re also creating customized messaging based on purchase history. For example, if you bought a tree for Michaels this year during our annual tree event you likely received a follow-up email from us highlighting adjacent categories like ornaments and tree skirts including a link to our holiday decor guide.
Or if you purchased Christmas product last year but we haven't seen you yet this year you may have received an email from Michaels highlighting our 2018 holiday decor collections with an enticing offer to encourage you to make a holiday purchase this year.
While we are still early in the CRM journey, we are encouraged by what we're seeing in terms of customer engagement. Open rate and click rates for these more personalized emails are meaningfully higher than what we’re seeing with our more general emails.
Our initial focus is on leveraging our extensive database of 30 million email addresses, but over time we intend to extend this approach to other communication channels like push notifications and website personalization.
The Arts and Crafts channel is known for employing high low pricing strategies with various coupons and regular category discounts and we like our Arts and Crafts peers invest in discounts to drive sales. Thus far the promotional environment this holiday is consistent with our expectations and we are excited to have some new tools to employ this holiday season to make our promotional offers more effective.
In the past, we’ve been limited by our technology to only broad-based universal offers. But earlier this year we stood up a new promotion module as part of our POS platform. This new module gives us enhanced capabilities including the ability to create serialized coupons, more capacity to run more targeted offers simultaneously and more flexibility to create new offers.
Let me give you some examples. With the ability to offer serialized coupons we can now email and offer to a specific customer that can only be used by that customer and we can limit the number of times the offer can be used.
During the holiday season last year we had little control over customers sharing offers across their social networks are using offers multiple times. In addition as we tailor our customer communications we can now manage multiple indistinct offers in-flight simultaneously.
And finally we can be more creative with the offers we make. For example we can now create an offer like buy a new cricket machine, get any accessory for 50% off. In the past our promotional capabilities were more limited. These enhanced capabilities should enable us to improve the effectiveness of the discounts we offer over the longer term.
In closing, we are making progress and making Michaels easier to shop. In fact, I’m proud to share we were recently recognized by two independent organizations for our customer experience and customer service.
Reputation.com recently recognized Michaels as one of the top retailers most trusted by consumers to deliver a great overall customer experience. In Newsweek recently recognized Michaels is having the best customer service in the Arts and Crafts industry.
With that, let me turn the call over to Denise for more detailed discussion of our third quarter financial performance and outlook. Denise?
Thanks Chuck. Good morning everyone and happy holidays. This morning I’ll review highlights of our Q3 performance, discuss our outlook for Q4 and share some considerations for 2019.
Starting with Q3 sales, net sales for the quarter increased 2.7% to $1.27 billion. For modeling purposes our Aaron Brothers stores generated sales of $25 million in the third quarter last year.
Excluding the impact of Aaron Brothers, total sales for the quarter increased 5%. The net sales increase was written by 3.8% increase in comp store sales, the operation of 19 net additional Michaels stores opened since the third quarter last year and a modest increase in wholesale revenues.
The increase in comp store sales was driven by an increase in average ticket partially offset by a slight decline in customer transactions. As a reminder, fiscal 2017 was a 53 week year and we are not restating our comp sales reporting periods.
In other words, our Q3 comp sales reflect the comparison of August 5 through November 3 this year versus July 30 through October 28 last year. If we compare the 13-week period ending November 3rd of this year to the comparable 13-week period ending November 4th of last year comp store sales would have increased approximately 1.1%.
During the quarter the company opened six new Michaels stores, closed one Michaels store and relocated four Michaels stores. At the end of the quarter we operated 1,256 Michaels stores and 36 Pat Catan stores.
Q3 gross profit was $479 million compared to $484 million in the third quarter of fiscal 2017. As a percentage of sales our gross profit rate for the quarter was 37.6% versus 39% last year, a decrease of about 140 basis points.
Included in this year's Q3 result is approximately 30 basis points of negative impact due to a one time inventory write-down of $4 million related to a product we purchased from a third-party supplier for both Michaels and Darice customers, which did not meet our quality standards.
This new product initially passed all of our testing requirement and we believe the supplier altered the formulation of the product without authorization after the initial testing, resulting in performance issues. As a result, we have pulled the product from our stores and DCs as well as from our wholesale customers. We are pursuing legal action against the manufacturer.
Excluding the impact of the inventory write-down, gross profit as a percentage of sales decreased approximately a 110 basis points in line with our expectation, the decrease in gross profit as a percentage of net sales was primarily due to higher distribution related costs and an increase in inventory reserves recorded in the quarter.
These increases were partially offset by occupancy cost leverage, less promotional activity and benefits from our ongoing sourcing initiatives. Higher distribution related costs in the quarter were driven by three factors which we previewed on our last earnings call.
First, we’ve experienced higher domestic transportation expense this year related to our transition to a dedicated carrier model. While this approach should provide us with more cost predictability and service reliability over time, we haven't incurred higher rates this year as we have transition to the new model with some additional pressure from higher fuel costs.
Second, we are incurring higher small parcel shipping costs related to e-commerce reflecting both higher rates and increased volumes. Finally, while a smaller impact in the first two factors we have experienced some pressure from international freight rate.
During the quarter we reported a planned increase in inventory reserves primarily related to the timing of actions tied to our seasonal and clearance inventories this year. We’re comfortable with the quality of our inventory and for the full-year expect our inventory reserves expense will be in line with 2017.
Total store rent expense for the quarter was $99 million versus $100 million last year. The decrease in store rent expense was due to the Aaron Brothers store closures partially offset by the impact of a net 19 additional Michaels stores.
SG&A expense including store pre-opening costs was $342 million or 26.8% of sales, compared to $330 million or 26.6% of sales last year. As expected the increase in SG&A was primarily due to a $7 million increase in performance-based compensation related to the timing differences in Q2 and Q3 last year, a $5 million increase in marketing expenses due to increased television advertising and digital marketing.
$3 million of increased payroll expenses reflecting expenses associated with insourcing our e-commerce fulfillment. And finally $3 million of additional expenses related to the operation of 19 net additional Michaels stores. These increases were partially offset by $9 million decrease in expenses related to the closure of 94 full-size Aaron Brothers stores.
Operating income was $137 million compared to $154 million in the third quarter last year, excluding the $4 million inventory write-down; adjusted operating income for the quarter was $141 million, slightly about our Q3 guidance range.
Interest expense increased $5 million to $38 million, from $33 million last year due to higher LIBOR rate associated with our variable-rate term loan and $2 million of settlement payments associated with our interest rate swaps.
The effective tax rate in the quarter was 16% compared to 34% in the third quarter last year. The lower effective tax rate was primarily due to a reduction in the federal statutory tax rate in connection with the enhancement of the Tax Cuts and Jobs Act of 2017 from 35% to 21%.
In addition, we continue to get further clarification from tax authorities regarding the application of the Tax Act. Reflecting this updated guidance we booked $4 million of provisional adjustments related to the revaluation of deferred tax assets and $3 million of provisional adjustments related to repatriation taxes for accumulated earnings of foreign subsidiaries in the third quarter this year.
Excluding the benefit of the $7 million of provisional adjustments the effective tax rate for Q3 was 23%. Net income for the quarter increased 5% to $84 million or $0.50 per diluted share compared to $80 million or $0.44 per diluted share in the third quarter last year.
Excluding the one-time inventory write-down in the provisional tax adjustments, adjusted net income for Q3 with $80 million or $0.48 per diluted share, diluted weighted average common shares for the quarter were 167 million shares compared to 182 million shares last year.
During the quarter, we settled the accelerated share repurchase agreement for ASR we put in place in Q2 and received an additional 1.7 million shares bringing the total shares purchased through the ASR to 12.4 million shares.
In addition, we purchase 11 million shares in the open market for about $184 million during the third quarter and purchased 1 million shares or $17.6 million in November, all is part of our previously announced share repurchases program. As of today our total authorization remaining for future repurchases is approximately $398 million.
As a reminder, our share repurchase program does not have an expiration date and the timing and number of repurchase transactions under the program will depend on market conditions, corporate considerations, debt agreements and regulatory requirements.
As expected total merchandise inventory at the end of the third quarter increased 3% to $1.44 billion compared to $1.4 billion at the end of third quarter last year. The increase in inventory was primarily due to inventory to support our wholesale business, inventory associate with the operation of 19 net additional stores and the increased inventory to facilitate stronger in stock and better inventory flow for the holiday season.
This increase was partially offset by a decrease inventory related to the closed Aaron Brothers stores. Average Michaels’ inventory on a per store basis inclusive of distribution centers in transit and inventory for michaels.com increased about 1%.
We ended Q3 with $103 million in cash on our balance sheet and $567 million available under a revolver. Total debt at the end of the quarter was $2.9 billion. Our total debt to adjusted EBITDA on a trailing 12 month basis was 3.4 times and our trailing 12 month interest coverage was 4.8 times.
I would note, as of December 3rd we had no borrowings on the ABL. Capital expenditures year-to-date through the third quarter totaled $120 million compared with $73 million last year reflecting increased investments in technology projects including investments to support the insourcing of our e-commerce fulfillment and investments in new and relocated stores.
Year to-date we've opened 21 new Michaels stores and relocated 20 Michaels stores compared with 16 new Michaels stores and 12 Michaels store relocations last year. For the full year we expect to invest approximately $160 million in capital expenditures.
Now, let me walk through our guidance for the fourth quarter and full-year. As a reminder our guidance assumes that Aaron Brothers stores were closed at the start of the fiscal year and excludes any restructuring charges, the one-time inventory write-down, provisional tax adjustments and any one-time costs associated with debt refinancing.
Let's start with the full year. We’ve tightened our expectations for the full year to reflect our third quarter actual performance and enhance visibility into the fourth quarter. For fiscal 2018, a 52-week year we expect total sales will be between $5.26 billion and $5.28 billion and comp store sales will increase between 0.7% and 1.1%.
This guidance includes our plans to open 20 net new Michaels’ stores and relocate 21 Michaels stores. We expect adjusted operating income for the year will be between $670 million and $680 million.
We expect total interest expense will be approximately $147 million reflecting an expectation for one additional rate increase this year as implied by the current LIBOR curve. We expected this to be partially offset by approximately $3 million in interest income which flows through the other income and expense line on the P&L.
We estimate that our effective tax rate will be approximately 23%. However effective tax rate may differ from this estimate if there are changes in the interpretation or additional guidance is issued related to the tax act.
All of these assumptions translate to an adjusted diluted EPS range of $2.35 to $2.39 for the fiscal 2018 on approximately 172 million diluted weighted average common shares for the full year.
This expectation for the share count includes the anticipated full impact of shares purchased this year to-date, but does not include the impact of any additional shares we may repurchase this year. The impact of share repurchases completed in Q3 and early Q4 is approximately $0.06.
Now, turning to the fourth quarter; as a reminder we have not received last year's comps store sales reporting period to align with this year's calendar. Our Q4 comp -- reported comp this year will reflect the 13-week period ending February 2, 2019 compared to the 13-week period ending January 27, 2018.
In addition, we expect increased sales volatility between the months in the quarter reflecting the shifts in the holiday weeks this year. With that as context, for the fourth quarter we expect comp store sales for the fiscal period will be flattish.
This includes an estimated 160 to 180 basis points of negative impact from the calendar shift resulting from the 53rd week in fiscal 2017. Plan to open to new Michaels stores and relocate one store in the fourth quarter. For modeling purposes Aaron Brothers delivered approximately $32 million in sales in the fourth quarter last year.
We expect adjusted operating income for the fourth quarter will be between $332 million and $342 million compared to $327 million in the fourth quarter last year adjusted for the extra week.
As previously disclosed, the extra week in the fourth quarter last year contributed approximately $79 million in sales and approximately $27 million in operating income. This guidance implies higher adjusted operating income dollars and higher operating income margin rate as compared to Q4, 2017 reflecting less incremental spending in order to support our investment agenda and less margin pressure from distribution -related costs than what we've experienced year-to-date as we anniversary the flow through higher distribution and transportation costs in Q4 last year.
We expect net interest expense for the quarter will be in line with Q3 and will be approximately $38 million reflecting an expectation for one additional rate increase this year as implied by the current LIBOR curve.
Our Q4 guidance for diluted earnings per common share is $1.42 to $1.47 assuming diluted weighted average common shares of 159 million shares. Before we open up the call for questions I want to share a few thoughts about 2019 related to the impact of tariffs implemented this year.
Clearly, the situation remains fluid. As we discussed our last call we estimate that approximately $400 million of our product costs will be subject to higher duties in 2019. So if the 10% tariff implemented this past September remains consistent for 2019 we would expect about a $40 million headwind to merchandising margin before any mitigation efforts.
Taking a holistic approach our primary objective is to offset the total dollar impact of the tariffs rather than trying to maintain our product margin rate. We believe we have a good plan to mitigate the estimated dollar impact with a number of levers including sourcing from countries other than China, leveraging our negotiation power, reengineering the product and implementing retail price increases, which given our low average ticket should have minimal impact to the customer.
What we don't yet know whether tariff increase will ultimately land for 2019, we do believe will be able to use a variety of levers to mitigate the total dollar impact. In closing we delivered solid performance in the third quarter driven by stronger-than-expected comparables store sales, good expense management and the impact of our ongoing share repurchase program.
As we enter Q4 we feel good about the investments we have made this year to offer an easier, more integrated omnichannel experience for our customers and to build the foundation for increased efficiency in our e-commerce operation with the insourcing of our fulfillment operations. We believe these investments will drive easier, more convenient experience for customers and deliver longer-term shareholder value.
Now, I'd like to open up the call to take our questions. Denise.
Thank you. [Operator Instructions]. And your first question this morning will be from Steve Forbes of Guggenheim Securities. Please go ahead.
Hey, Chuck. It’s Heinbockel in for Forbes. Can you hear me?
We can hear you. How are you?
I’m good. So two questions, right? When you think about third quarter performance and where we are in the fourth. I mean, it looks like your comp momentum has stepped up to a level we haven’t seen in adjusted, right, for all the calendar stuff we haven’t seen in a bit. I know that the enthusiast is still stronger than the casual customer, but the step up maybe parse out those two customer groups where you’ve seen the various step up? And then when you think about, the recent initiative of using your classrooms in partnership with makers, what is the potential for that to move engagement with the casual customer, and how do you think about that?
I’ll take the second one first. On the classroom that’s – you’re talk about the test where we’re opening it up for people to independently -- independent teachers if you will to come in and host a class. That's in a test mode, handful of stores really early. We’ll see what happens. As you know we are always testing a variety of programs for customers across the spectrum from casual to enthusiasts, so too early to read on that. So we'll talk more about that if we see some progress.
As far as the first part of your question, we saw a good progress across enthusiast as well as the casual customer. As you pointed out, we’ve seen strength in the enthusiast consistently. It's that casual customer that continues to be something that we have to continue to work to unlock. Third quarter, she responded well to many of the things that we did. We had a good back-to-school season, made it easier for that casual mom to come in and shop. Our seasonal business was strong. We did benefit obviously from the week calendar shift which benefited Halloween and Christmas sales in the third quarter.
And I've touched in my prepared comments, we continue to get better on some of our targeted marketing, so we're able to shoot our promotional offers in a more targeted fashion. We also are able to coordinate products and promotions to go with them. And then some of the system enhancements that we've made whether it's faster checkout through a new POS system, whether it's BOPUS, which has been a really big part of our e-commerce business. All of these things kind of tie back to making it easier to shop our stores physically or virtually, and that's been good for the casual customer. But we – John, listen we still have a work to do. We feel good about the progress we're making, but we still have a lot of upside opportunity ahead of us.
Okay. Thank you.
The next question will be from Seth Sigman of Credit Suisse. Please go ahead.
Thanks. Hey, guys. Good morning and nice quarter. I wanted to talk a little about the guidance for the fourth quarter, the comp guidance specifically. If you compare your shifted comps, what you're implying here for the fourth quarter versus the 1.1% shifted comp in Q3, it would obviously point to an acceleration and against what seems like a more difficult comparison. So, I realize you're pleased with some of the seasonal drivers, but just anything more you can help us with here, what gives you confidence in that outlook? Thank you.
Happy to answer that question, Seth, and thanks for the congratulations. When we think about the shift into the fourth quarter, historically it has been a good performing quarter for us for the reason that you state, which is -- it's a stronger part of our seasonal business, it is when more of this novice customer comes in and we've seen that uptick. I think Chuck just mentioned a few of the additional drivers that we think are pretty important to delivering on that calendar adjusted comp, right?
First and foremost, with FMA in our stores, we're making it even easier for our customers to shop, and with the successful execution of the additional 200-plus stores that we did coming into the third quarter, we put the right inventory behind that. And so the product is there for her to be able to buy. I think additionally the breadth of CRM initiatives we have now to be able to be more targeted to speak to her in the way she wants to hear from us and either draw her back in if she hasn't shopped in a while or remind her that there's additional purchases that go along with what she bought.
Chuck gave the example of, if you bought a Christmas tree, we're now going to remind you of all the great things we have to help you finish out that tree. These methods and these changes that we’re making using our data analytics, which was a big part of the -- one of the investment agendas we had this year are things that we think are really going to help unlock that Q4 inclusive of the casual customer, which we knew is a big opportunity.
Okay. Thank you for that. That's helpful. And then I guess similar question around the margin outlook for the fourth quarter, the guidance does imply an improvement in the trend after some bigger declines in the first couple of quarters of the year, you talked about less incremental spending, less distribution costs, and also some of it is a function of what you're lapping from last year. And I realize there's some unique aspects to Q4 as you just spoke to, but can we assume that what you're talking about here the improvement from Q3 into Q4, some of those drivers of the improvement that could actually continue into 2019 supporting stable maybe even up margins in 2019, just any more color on how you're thinking about that would be helpful. Thank you.
And Seth, I think we don't have a practice of providing any guidance related to the next year until our Q4 earnings call, so I'm going to shy away from specifically addressing 2019. But I do think that there's an important point that you made underneath that. As we had planned and expected this year we are seeing a turn in our performance on operating income rate in the fourth quarter that is the investment agenda falling off. It is continued goodness in our sourcing program which we've said on other calls. We do anticipate we’ll continue into next year. Clearly, there's still the headwind of transportation expenses that we have out there. But we think that we've got good tools in the fourth quarter to deliver the operating income improvement that we've articulated as part of the guidance.
Thank you very much.
And the next question will be from Christopher Horvers of JP Morgan. Please go ahead.
Thanks. Good morning. So can you talk about the total sourcing benefit that you expect this year. Denise, you mentioned that you expect the sourcing goodness to continue. Any sort of guideposts on how much that could be? And could this be an offset on the tariff front such that it could offset the impact to margin rate on tariffs in 2019?
So, Chris, great question. We're very excited about the sourcing efforts that we have in place and we do believe that there is continued goodness from those programs. If you remember in 2017 we delivered about $46 million of benefit to the [Indiscernible] from the sourcing activities, and we remain on track to deliver about $40 million of benefit in 2018. As we've talked before that benefit really flows through, tied to the flow through of sales, so fourth quarter being a bigger sales quarter by default those dollars of sourcing benefit will also be higher in those quarters.
When you turn to next year we still have a great pipeline and we have good visibility into that pipeline because for the length of time it takes for our inventory to turn we work on these projects early and it takes a while for the benefits to come through. So, we do continue to see positive benefits there. In the spirit of what it will or won't offset I think I'd step back and say, broadly we're working at series of things that would help us offset the tariffs. We also know that we need to be working to offset increases in transportation costs which while we hope they will abate, it seems to be that there is still some pressure and inflation in those lines. So all-in-all we think sourcing will be a good contribution, but as I mentioned on the prior question, we're going to stay away from talking about 2019 and at this point which is our typical practice.
So the 40 million, it sounds like that 40 million is less next year?
I’m not sure that’s what -- Denise didn't say that. We got a lot of power in the sourcing effort that we have, but back to the tariff situation I think Denise comments in her prepared comments. There's a lot of levers to pull; negotiation, switching factories, switching countries, retail price adjustments. So the benefit of our size and scale are being number one and being so heavily private brand oriented is there are lots of levers to be pulled. So we'll talk more about 2019, but this sourcing effort has been a really good thing for us for the past couple of years and it has not run its full course. There is still more opportunity.
Understood. And then so as a follow-up you mentioned that you pay down your borrowings and your ABL I think after the quarter ended considering how much that you've bought back year to-date and considering you had to pay that down do you still have dry powder to be able to repurchase stock in the fourth quarter?
Yes. So we -- I guess what I would say is we did pay down the ABL. At the end of the third quarter we had 218 million on the ABL and we are now off of the ABL. We don't provide a forecast of our cash, but this is our highest cash accumulation quarter of the year, so it is the quarter where we will be building cash.
Great. Have a great Christmas and holiday. Thanks.
And the next question will be from Simeon Gutman of Morgan Stanley. Please go ahead.
Good morning. This may have been mentioned. Just to clarify, the 1.1% sort of adjusted for the third quarter. How did that compare relative to how you expected? And are you pleased with how the toy category is going?
Yes. The 1.1 you know overall came in a little bit better. We beat the guidance that we had given to investors last quarter on the call, so the core -- the comp without the seasonal adjustment also came in a little bit better. Kids, we continue to make some progress. Remember our kids business is different than the kind of the mainstream toy business. We're not really a toy retailer. We're -- we sell products that much more revolve around creative play for kids and the way we talk about is it's an opportunity for screen free time for a kid. So I think that there is a longer term a good opportunity for us, but if we saw some improvement, but there's -- we still have more upside to be captured.
Okay. And then I don't know if this was said, but I thought it might have been that traffic may have been slightly down on the quarter. And I wanted to ask if that's the right read? Is that about the same run right as the business has been in and does that include online traffic as well? And then just broadly speaking, Chuck, if you think about the industry, would you chalk the traffic decline to sort of Arts and Crafts? Would you chalk it up to retail? And I did sense, I would say for the first time in a while a little more optimism about your ability to control the business drive through marketing and through some other levers. Is that fair? And do you think we could see a turn in the next few quarters?
I think, well, couple points back to Denise's comment. We're not going to give 2019 guidance. We've remained confident assuming on our in our business all along. We have a lot of levers to control. It's been frustrating that the industry as a whole has been stagnant and we've commented before that unlike some of other industries which have seen a consolidation of distribution points to the consumer this industry has actually been the opposite; there's more places to buy the types of things that we sell.
Our transactions first of all, it's getting harder and harder to split the difference between what happens online and in-store because they impact one another. But overall our transactions were down slightly. They have been down slightly for the past couple of quarters, so it's been a reasonably I guess consistent trend. But we do feel good about the levers that we're pulling. We remain really you know feeling really good about our efforts with this enthusiast customer and we're encouraged by the progress we made in the third quarter on the casual customer. That's a really attractive segment for us and we feel good about the levers that we're pulling, but we've got work to do to continue to have that be a sustainable improving piece of our business. But we do feel as though we've got the right things that we're working on.
And the next question will be from Mike Baker of Deutsche Bank. Please go ahead.
Hi. Thanks. In the past you’ve given some color on Black Friday. Wondering if you can tell us how you did there? And maybe related to that at one point you said you're adjusting the fourth quarter guidance, narrowing it -- really based or the full-year guidance based on the third quarter and increased visibility in the fourth quarter. Is that visibility better or worse than you would have thought three months ago?
I guess I'll take the Black Friday. First of all Black Friday is no longer just Black Friday. You have to look at it over a variety of timeframes. So our stores are open on Thursday, obviously our online business is open as well. So there's a Thursday, Friday, Saturday window, most retailers including us started events, the Sunday before Thanksgiving and extended Cyber Monday. All in our performance over that time frame is incorporated into our guidance. We were pleased with our performance over that time window.
The only thing I would quickly add though is performance during the Thanksgiving window is just one piece of the overall fourth quarter and at least in my experience over years and years and years Thanksgiving is not a solid predictor of what happens in the fourth quarter. But with that said we were quite pleased with what our sales and the customer experience both online and in-store. Last year we had some trouble fulfilling our orders online coming out of that Thanksgiving week. This year we were in really good shape. As far as visibility, obviously the closer you get you get better visibility, but I don't know if you want to add Denise?
Yes. And Mike, just add to that. When you think about how we came into the second half of this year, we knew that there were all these puts and takes of the calendar shifts that were out there both because of the fiscal impact of the 53rd week year as well as just the timing between Thanksgiving and Christmas. And so, I think you might have noticed that when we provided our guidance range for sales for Q3 and then with that would have implied for Q4 that range was a little wider than what we typically provide, which really we just looking and understanding that there was some noise with this weekly shift, but what we'd like to believe we can call it perfectly we all know that there's an art as well as a science to that.
So when Q3 fiscal comp did come in a bit above our expectations we took that into account for how we thought about the flow of sales through the rest of the second half. So a bit of that tightening and a bit of that increased visibility really came out of understanding what we delivered in the third quarter and what that shift really was. And then you know on the operating income point we always get a little bit better visibility as we walk closer and closer to the quarter about what pressures might be out there. We did see and we do see a little bit better visibility into three factors, so I’d call out for you. One, tariffs are real. We have a small flow through in the quarter from some duties increasing. And I think we have -- while we feel very positive about our ability to mitigate those over the mid and longer-term, as they just started into the quarter there's a bit of pressure there.
We also as we're serving more wholesale customers and managing the mix of that profitability we’ll see some of our new customers coming in at a slightly lower rate than how some of our legacy customers might have been out there. We think that's a piece that we can manage over time. It's just a little bit of a shift for the quarter. So that's when we say visibility it's a few of those factors, but we'd say nothing particularly new or different other than knowing that we started with a pretty wide comp guidance range just knowing the volatility that was going to happen in this whole second half.
Mike, I’ll just add in just kind of a final point. You know even at the beginning of the year as we were going through some of the investments we had talked about that would pressure our performance the first half of the year. We said we believed our back half for the year would improve. We said that we believe that on a two-year stack our comps would improve. We believe that our operating income for the fourth quarter would be higher than last year. All those things are being reflected both in what we just put out for the third quarter and the guidance that we gave on fourth -- put out for third quarter rather and the guidance that we gave for fourth quarter. So it's a interesting retail market right now, but we're pleased with our performance in the third quarter and we feel good that the levers were pulling into the fourth quarter going to deliver the performance that we just guided on.
Thank you for that. Very complete answer and yes, your guidance did imply a back half acceleration which is still evident there. One, follow-up on the tariffs, you right, they are real and it's almost January 1st so you've talked about having plans in place to attempt to mitigate, but any results yet in terms of those plans. How it’s been able to push back any cost or move any supply points?
Yes. We have. So, there's been lots of actions. So, in some cases we have sourced two different -- all the levers that we said we had available to us. Sourcing the different countries, redesigning some of the products, some retail price increases, negotiating with existing factories, all of those levers have been utilized. Remember there's a lag time on some of these things given the nature of our private brand business. So, when you implement an action today given the long lead times you sometimes don't feel it in our business for months to come. But each lever that we talked about that we have in our tool chest to offset the impact of the tariff has been utilized already. And based on where the final tariff number falls out that will dictate somewhat how hard we pull those levers, but while there may be a timing issue of when we feel the impact of the tariff and when we offset it with some of these actions.
We do feel quite comfortable that we'll be able to offset the dollar impact of the tariff. Denise commented before. We're not trying to maintain the rate which would imply you're marking up on the tariff. We're not going to do that. But if we have a dollar impact on tariff, we believe we can offset the dollar in our P&L.
Okay. Understood. I'll pass it on. Thank you.
The next question will be from Laura Champine of Loop Capital. Please go ahead.
Good morning. Thanks for taking my question. It sounds like from your comments that you're seeing some margin pressure from your use of the 3PL and then that will extend into next spring. How much of a dent is that placing on margins? And if you can give us the impact first quarter to the next year that'd be great?
Let me start it with that and turn it to Denise. I think your assumption is actually the reverse. So, we have had a portion of our e-commerce orders fulfilled by a third party since we launched e-commerce a few years ago. We are bringing that in-house. We've started that process. We're not fully transitioned in-house yet, but we did bring up our DFW distribution center to support that along with other means of fulfillment, BOPIS, ship-from-store as an example. So as far as this piece of it is concerned we expect less pressure due to the third-party fulfillment on our e-commerce orders as we go forward than we have historically felt.
And so, Laura, just to clarify, is your question specific regarding because our 3PL really is our fulfillment provider or were you more thinking about transportation?
Transportation is obviously interesting, I'd love for you to comment on that too. But I thought you might be seeing -- might be doubling up on expenses as you transition away from 3PL. So I'm interested in the margin impact of that transition. And if you can comment on what you're seeing from transport cost that would also be great?
No. So I'll stick on the e-commerce topic that you raised. So we aren’t going to provide specifics of the benefit that we'll see in bringing that in-house. We do believe that it will be a good tailwind to the profitability of our e-commerce business, but we haven't explicitly split it out. The comment that I would make just on e-commerce overall is a bit of the pressure that we do see right now is that small parcels rates are up, so that is you know as everybody in the world is shipping more and we face that and so we work to overcome that and things like our insourcing of the fulfillment operations are going to help to offset and mitigate some of that.
But I think to Chuck's point, I'd come back to say the importance for us is the many points in which we can serve someone who places in e-commerce order whether that's through a fulfillment center, whether that's from ship from store or whether that's buy online pick up in store. Those are all ways that the customer is better satisfied and how they get their order, the timeliness of when they might get their order. Those are also ways that help us improve the profitability of the e-commerce business itself.
Let me just provide a little bit of context, because I don't want anybody to have an incorrect impression. We expect the changes that we're making including the insourcing of our fulfillment to improve the profitability of our e-commerce business. That's the first point. The second point as we've said before as is true of most retailers e-commerce is less profitable for us than brick-and-mortar. So that's the second point. The third point is that's why we spend so much time talking about other things like sourcing because we have other levers to pull that help us address the mix ship that's going on in our business.
It's also why we're quick to point out that while e-commerce continues to grow very quickly it is still a very small portion of our business and we have generally not changed our outlook that over the long term e-commerce will not be the same penetration of the Arts and Crafts industry as it is in other industries. The impact of digital is very important. We're seeing a lot of omnichannel benefits of online in brick-and-mortar. But we do and back to the original question, we do see our e-commerce business profitability improving as we make some of these fulfillment changes.
Denis, I think we have time for one more question.
All right, very good. The next question will be from Liz Suzuki of Bank of America Merrill Lynch. Please go ahead.
Great. Thanks for getting me on. And I will just keep it to one question. So could you just discuss the performance of key product categories outside of seasonal this quarter? I mean obviously seasonal was pretty strong partially from the calendar shift. But just any other categories you can call out that were particularly strong?
Yes. Actually, Liz, we had relatively broad-based success. So yes, seasonal was good. Art supplies were good. Yarn was good. Framing was good. Technology was good. Storage was good. There were -- it's easier to call the departments that were more disappointing in this quarter. Jewelry was continued to be disappointing as an example. But broad-based, I'm doing this from – I’m going through our assortment right now. Kids improved as well. So, it was a relatively broad-based improvement in the third quarter which we were also pleased to see.
Great. Thank you.
All right. I think with that we're going to wrap up the call. I appreciate everybody joining us this morning. Before we do leave I do want to extend our thanks to our team of 50,000 strong across the Michaels companies who are energized and ready to serve our customers both in-stores and online. We all wish you a very happy and safe holiday and look forward to talking to you in March about our Q4 performance. Thanks again for joining us.
Thank you, sir. Ladies and gentlemen the conference has concluded. Thank you for attending today's presentation. At this time you may disconnect your lines.