The Michaels Companies, Inc. (MIK) Q4 2018 Results - Earnings Call Transcript

About: The Michaels Companies, Inc. (MIK)
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Earning Call Audio

The Michaels Companies, Inc. (NASDAQ:MIK) Q4 2018 Results Conference Call March 19, 2019 9:00 AM ET

Company Participants

Kiley Rawlins - VP of Investor Relations and Communications

Mark Cosby - Interim CEO

Denise Paulonis - CFO

Conference Call Participants

Simeon Gutman - Morgan Stanley

Steve Forbes - Guggenheim Securities

Laura Champine - Loop Capital

Peter Keith - Piper Jaffray

Zack Fadem - Wells Fargo

Seth Sigman - Credit Suisse


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 Fourth Quarter Earnings Conference Call. 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.

Kiley Rawlins

Thank you, Denise. Good morning everyone and thank you for joining us today. Earlier this morning, we released our fourth quarter and fiscal 2018 financial results. A copy of the press release is available in the Investor Relations section of our Web site at

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, March 19, 2019. 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 restructuring charge primarily related to the Aaron Brothers and Pat Catan's store closures, and unexpected inventory write-down in the third-party related to a third party product, which does not meet our quality standards, losses on early extinguishments of debt and refinancing costs and 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 prepared remarks from Mark Cosby, our new Interim CEO and Denise Paulonis, our CFO. Following our prepared remarks, we will open up the call for questions.

Now, I'd like to introduce Mark Cosby for initial comments. Mark?

Mark Cosby

Thank you, Kiley and good morning everyone. I’m pleased to be with you this morning for my first earnings call with Michaels. I’m excited about the opportunity to join the Michaels team as Interim CEO before transitioning into a longer term role on the Board of Directors. Michaels is the market leader in the arts and crafts industry with a strong financial position and a bright future. And I’m proud to join the team I have long admired from afar as a customer. Let me tell you why I’m so excited to be part of the Michaels team.

First, with 1,258 stores, Michaels is the largest player in a very fragmented $36 billion industry. And with attractive profit margins and strong cash flow generation, Michaels is a financially stable retailer. Second, Michaels has tremendous brand equity with the strongest brand awareness in the arts and crafts space and the largest social footprint with more than 5 million followers across various social platforms, including Facebook, Twitter, Instagram, and Pinterest. Third, Michaels has a vast collection of valuable customer data with transactions information for more than 75 million active customers. We can link more than 80% of our sales to a specific customer. As we ramp up our CRM efforts, I believe we can leverage these insights to personalize our messaging and drive stronger customer loyalty and sales growth.

Fourth, Michaels has built an impressive sourcing capability to support a collection of strong private brands that today account for about 60% of sales. This infrastructure, combined with strong product development capabilities, also positions us to be a strong B2B player in the arts and crafts world. And finally, Michaels has an underpenetrated digital business with very attractive e-commerce growth potential and an opportunity to further leverage to drive sales growth in a seamless omnichannel way.

As just a little background about me, I bring to the role more than 30 years of leadership experience across retail, consumer goods, and restaurants. Through my work in these challenging and ever evolving industries, I have learned how to drive profitable sales, leverage digital and personalized marketing, and build strong omnichannel businesses. I look forward to applying this expertise to help Michaels solidify and expand its role as the market leader. My primary goal as Interim CEO is to lead the team to deliver our sales and profit goals for the year. I will also work closely with the team to develop a growth strategy for 2020 and beyond. My priority in the early days will be to get to know all aspects of the business, the team, and the customer. I will spend time in stores interacting with customers and our store teams to learn more about what excites our customers and how our stores operate. I will do deep dives with key functions including e-commerce, merchandising, marketing, talent sourcing as each of these areas are critical to our long-term growth and success. And I will spend time with the leadership team as well as our team here at the Michaels support center to learn more about the Michaels' culture and what makes Michaels a great place to work.

Before I introduce Denise to discuss the recent results, I want to share a little color about the board's search process for a permanent CEO. While the company's financial growth over the last few years has been challenged, the board continues to believe strongly in the longer-term growth opportunity for this business. In fact, we believe the larger consumer trends of personalization and convenience represent a significant opportunity for Michaels to leverage our stores and digital platforms together to engage customers, drive stronger sales, and make creativity happen. The board has decided to initiate an outside search for a permanent CEO to deliver the largest pool of talent. In the interim, I will remain focused on ensuring we deliver our financial goals for the year as well as leading the way toward developing a longer term growth plan.

Now, I would like to turn the call over to Denise.

Denise Paulonis

Thank you, Mark and welcome to The Michaels team. Before we dive into financial results, I want to highlight some of our 2018 operational accomplishments.

As we shared with you at the beginning of the year, in 2018, we plan to proactively invest some of the benefits from tax reform to accelerate investment for long-term growth. Reflecting this commitment, we invested in our digital platforms, our stores, and in technology to support new capabilities and drive increased productivity. E-commerce was a big focus for us in 2018. We refreshed to deliver a simplified shopping experience and added new functionality, including enhanced search capabilities, in-store product availability, and personalized offers based on the customers' preferred store. We introduced new micro sites, expanded key categores such as fabric and increased our assortment of bulk buys.

At the end of 2018, our assortment at had expanded to more than 100,000 SKUs, an increase of 48% over 2017. We also launched Buy Online Pick-up In Store or BOPIS in all our U.S. stores and added new capabilities to the Michaels app launching both visual and verbal search capabilities. We also made improvements to, enhancing user experience with new search functionality and personalization features, expanding our assortment of seasonal items and opened the site for non-tax exempt purchasers.

As a result of these investments, sales from our collective e-commerce channels grew 77% to $210 million in 2018 or 4% of total sales. To support future e-commerce growth, we accelerated efforts to bring e-commerce fulfillment in house, building a new order management system and retrofitting our Alliance distribution center to support e-commerce fulfillment. Our Alliance e-commerce fulfillment center opened in Q3 of fiscal 2018, and we’re pleased with how the team ramped up to support e-commerce in the fourth quarter. Importantly, we’re on track to be out of our third-party fulfillment center by the end of the first quarter.

During the year, we opened 24 new Michaels stores, relocated 21 Michaels stores, closed four Michaels stores, and closed 36 Pat Catan stores. We also closed 97 Aaron Brothers stores and repositioned our Aaron Brothers brand as the omnichannel solution for custom framing services in all Michaels stores and on We converted an additional 238 stores to our flexible merchandise area or FMA format, which leverages space in the front of the store to showcase newness and seasonal statements. At the end of 2018, roughly 700 stores utilized this layout , making it easier for customers to shop trend and seasonally relevant items.

We continue to invest in store systems, upgrading our POS system in all our convenient stores to provide customers with a faster check out experience and launched a new promotional tool to manage discounts more effectively through the use of targeted offers and serialized coupons. We launched our loyalty program, Michaels Rewards, in Canada and continue to expand membership in the U.S. Today, more than 34 million customers are enrolled in our loyalty program, compared to 24 million at the end of 2017. Important to our CRM efforts, these customers account for about two-thirds of total Michaels' sales. We invest in data analytics to drive additional actionable insights and leverage new tools to customize and target our email messaging more effectively. Finally, but importantly in 2018, we were certified as a great place to work by an independent authority in workplace culture. We were also recognized by two different independent organizations, and Newsweek for our customer experience and customer service. These accomplishments were made possible by the hard work and dedication of nearly 50,000 team members across the company, and I want to recognize their commitment and thank them for their efforts.

Now, let’s talk about the financial results. For discussion purposes this morning, I will focus my comments on adjusted results for fiscal 2018 and fiscal 2017 where applicable. Adjusted results for 2018 exclude restructure charges, primarily related to the closing of the Aaron Brothers and Pat Catan’s retail chains and inventory write-down in the third quarter related to a third party products that does not need the company’s quality standards, losses on early extinguishments of debt and refinancing costs and tax adjustments booked in fiscal 2018 related to the 2017 tax act. Adjusted results for fiscal 2017 also exclude tax adjustments related to the tax act. A full reconciliation of GAAP to adjusted metrics is included in our earnings release. In addition, fiscal 2017 was a 53-week year. And as such, the fourth quarter of last year included an extra week in the reporting period. The extra week in fiscal 2017 contributed approximately $79 million in sales, approximately $27 million in operating income, approximately $16 million in net income and approximately $0.09 in diluted income per share.

This morning, we reported fourth quarter results that were near the lower end of our initial guidance range. For the quarter, comp store sales decreased 0.4% or flat on a constant currency basis. Adjusted operating income was $333 million and adjusted diluted EPS was $1.44 per share. As expected we saw nice momentum this quarter, resulting from the investments we made earlier in the year. On a calendar shifted basis, Q4 comp store sales increased approximately 1.4%, our best quarterly comp performance this year. And on a 13 week versus 13 week basis, we grew adjusted operating income by 2%, adjusted net income by 13% and adjusted diluted EPS by 30%.

Now, let’s dig into the results in more detail. Starting with sales, fourth quarter net sales were $1.79 billion compared to $1.89 billion last year. The decrease in net sales was; primarily due to the anniversary of the extra weak last year; the closure of our Aaron Brothers stores, which delivered $32 million in the fourth quarter of last year; and the 0.4% decrease in comparable store sales, driven by a decrease in customers transactions, mostly offset by an increase in average ticket. The sales decrease was partially offset by sales from the operation of 20 net new Michaels' stores during the quarter. In Q4, the company opened two net new Michaels' stores, relocated one Michaels store and closed 36 Pat Catan stores.

From a category perspective, holiday and seasonal décor, tools and technology and craft stores were our strongest categories this quarter, while more traditional paper crafting supplies, packaging and party supplies and kids' crafts were more challenged. Custom framing delivered its fourth consecutive quarter of positive comps, reflecting improvements we've made in the selling model, new digital capabilities and the addition of new substrates. Sales from were very strong quarter again this quarter. While still a very small part of our overall revenues, online sales in Q4 were nearly double the level of online sales in Q4 last year, driven by increased traffic and higher conversion rates. We’re especially pleased with customers' acceptance of BOPIS, which accounted for a little more than a third of online sales and nearly two third of online orders in Q4.

On a GAAP basis, gross profit dollars for the quarter were $715 million compared to $775 million last year. As a percent of sales, our gross profit rate for the quarter was 40% versus 41% last year, a decrease of about 100 basis points. Compared to last year, the decrease in the Q4 gross profit rate was primarily a result of several factors, including higher distribution-related costs and adverse sales mix resulting from soft strong sales of lower margin categories like technology and storage. Occupancy cost deleveraged due to the extra week last year and increase in product costs related to tariffs and higher inventory shrink. These increases were partially offset by benefits from our ongoing sourcing initiatives and less promotional activity.

Distribution related costs continued to pressure gross margin this quarter, driven primarily by higher domestic transportation expense related to our transition to a dedicate carrier model with some additional pressure from higher fuel costs flowing through the quarter. In addition, we experienced higher small parcel shipping costs related to e-commerce, resulting from those higher rates and increase volumes. While distribution related costs continued to negatively impact gross margin in Q4, I’m pleased to share that the year-over-year headwind was less than what we experienced in the first three quarters of the year. Inventory strength has been a challenge due primarily to higher levels of theft. To address and reverse this trend, we've increased and refocused our team member training, implemented new tools to help us identify and resolve issues sooner and invested in new technology, including cameras at the store level. Total store rent expense for the quarter was $99 million versus $101 million last year. The decrease in store rent expense was due to the Aaron Brothers store closures, partially offset by the impact of the net 20 additional Michael stores.

Turning to SG&A, SG&A expense, including store preopening costs, was $382 million or 21.3% of sales compared to $420 million or 22.2% sales last year. The decrease in SG&A expense was primarily due to an $11 million decrease in expenses related to the closure of all 94 full-sized Aaron Brothers' store and lower advertising expense. Additionally, this year we had lower expenses during the quarter due to the extra week last year. Adjusted operating income was $333 million for the 13 week period this year compared to $354 million for the 14 week period last year. Excluding the impact of the extra week last year, adjusted operating profit increased 2% and adjusted operating profit margin increased 56 basis points. For the quarter, interest expense was $38 million, about $3 million higher than the fourth quarter last year. This increase was primarily due to higher LIBOR rates associated with our variable-rate term loan and settlement payments associated with our interest rate swaps. The effective tax rate in the quarter was 22.9% compared to 36.6% in the fourth quarter last year. The lower effective tax rate was primarily due to a reduction in the federal statutory tax rate from 35% to 21% in connection with the announcement of the tax act.

Adjusted net income for the 13 week period this year was $227 million or $1.44 per diluted share compared to adjusted net income of $218 million or $1.19 per diluted share for the 14 week period last year. Excluding the impact of the extra week last year adjusted net income increased 13% and adjusted diluted EPS increased 30%. Diluted weighted average share for the quarter were 158 million shares compared to 182 million last year.

Now turning to the full year. Net sales were $5.3 billion compared to $5.4 billion in fiscal 2017 and comp sales increased 0.8% or 0.9% on a constant currency basis. For the full year, GAAP operating income was $564 million compared to $735 million in fiscal 2017. Adjusted operating income was $672 million or 12.7% of sales compared to $735 million or 13.7% of sales in fiscal 2017. Excluding the impact of the extra week last year, operating profit for fiscal 2017 was $708 or 13.4% of sales. On a GAAP basis, the decrease in operating income was primarily due to $104 million of restructure charges, primarily related to the closure of the Aaron Brothers and Pat Catan stores, higher distribution related costs and adverse sales mix, the extra week in fiscal 2017 and higher inventory shrink. The negative impact of these factors was partially offset by benefits from our ongoing sourcing initiatives and a decrease in expenses related to the Aaron Brothers store closures.

This year, we generated approximately $40 million in sourcing savings from our first cost effort, which help to offset higher product costs, resulting from tariffs implemented in 2018. Of note, as we look to 2019, we expect to generate $35 million to $40 million in additional sourcing benefits before any impact from tariffs. Adjusted net income was $404 million or $2.35 per diluted share compared to adjusted net income of $405 million or $2.17 per share in fiscal 2017. Excluding the impact of the extra week last year, adjusted net income increased 4% and adjusted diluted EPS increased 12%. Diluted weighted average shares for the year were 171 million shares compared to 186 million shares last year.

Turning to the balance sheet. Total merchandise inventory was $1.1 billion, down 1.3% from the end of 2017, reflecting the impact of the Aaron Brothers and Pat Catan store closures. Average inventory from Michael store, including e-commerce and distribution centers at the end of 2018 was 2.7% higher than at year end last year. The increase in average inventory per store was primarily the result of increased receipts due to an earlier Chinese New Year and higher product costs due to tariffs. At the end of the year, cash on the balance sheet was $246 million, total debt was $2.7 billion and revolver availability was $743 million. Total debt to adjusted EBITDA was 3.2 times.

In fiscal 2018, we generated free cash flow defined as cash from operations less capital expenditures of $299 million. Cash flow from operations was $444 million this year, a decrease of $79 million from fiscal 2017. The decrease was primarily due to increased inventory purchases associated with our wholesale business, lower operating income, including the impact of the 53rd week in 2017 and higher duties resulting from increased tariffs. The decrease was partially offset by a reduction in cash paid for taxes.

Cash capital expenditures for year were $145 million compared to $128 million last year. This year, we increased our investment in technology to support our e-commerce business, promotional capabilities and data analytics capabilities. Additionally, we have some incremental investment in new stores and relocations, inclusive of funding for some projects that will open in 2019. For the full year, we purchased approximately 25 million shares of our common stock or approximately $452 million. At the end of the year, we had approximately $398 million left under our current share repurchase authorization.

In summary, in 2018, we made the decision to leverage the benefits from tax reform to accelerate investment in the business from long-term growth proactively investing approximately $16 million in operating expense. And these investments have started to deliver results. However, overall 2018 was more challenging than we initially expected. The core arts and crafts industry has traditionally been more of a low growth industry. And over the last year, we have seen an increase in distribution points, resulting from the expansion of arts and crafts big box stores and increased channel blurring. Additionally, supply chain related headwinds were more challenging than we initially expected, resulting from both the macro factors outside our control, such as small parcel shipping rates and fuel costs, as well as decisions we made for our business, including the transition to a dedicated carrier model. Despite these challenges, we made good progress against our key operational priorities this year, and believe that we’ve positioned a strong foundation for the future profitable growth.

Now, I would like to turn the call over to Mark for some color and our priorities for 2019.

Mark Cosby

Thank you, Denise. As Denise mentioned, the team made good progress in 2018 and invested in new capabilities to drive longer term profitable growth. Building on this foundation, in 2019, we will sharpen our focus on driving profitable growth and increasing our market share. Our priorities this year are; one, expand our assortment in key growth driving categories; two, grow e-commerce and enhance our digital platforms; three, leverage our customer data to drive more sales; four, review our current pricing strategy; and five, refresh our longer term strategic roadmap to ensure we have growth strategy for 2020 and beyond.

Let me share with you a little more color about each of these priorities. First, this year, we will expand our assortment in key growth driving categories. While there hasn’t been a strong universal trend in the arts and crafts industry since the coloring for adults-trends in 2015 and '16, we have seen category specific trends drive nice growth in certain areas. Responding to growing customer interest, this summer we plan to expand and highlight key growth categories like technology, storage, celebrations in our supplies. We will downsize and take advantage of new fixturing to manage space in categories where customer interest has been less robust like traditional paper crafting supplies, jewelry and bakeware. We will also shift our marketing and improve our in-store presentations to support these growth categories. The results should be a nice sales lift this summer.

Our second priority this year is to continue to grow e-commerce and enhance our digital platforms. As I noted in my opening comments, I believe Michaels has an underpenetrated digital business with a very attractive profitable e-commerce growth potential. To address this potential, in 2019, we will continue to invest in usability enhancements to to make searching and browsing easier for our customers. This spring we will make enhancements to our proprietary custom-framing software to facilitate a better omnichannel experience between and Aaron Brothers custom framing in stores. And later this summer, we plan to launch e-commerce in Canada, facilitated by expanded ship from store capabilities.

In addition to these shorter-term enhancements, we will also work to improve the profitability of the e-commerce business, so we can aggressively expand the business over time. One real strength we can leverage is that our customers love our buy online pickup in store capabilities, and we will continue to enhance and leverage this strength in the omnichannel way. As we work to create a seamless omnichannel experience for our customers, how we allocate our marketing spend will continue to evolve. This year, we plan to prudently shift investment away from higher funnel mass focused marketing levers like circulars, invest more in digital and direct marketing tactics, like email and addressable TV. Our goal is to drive sales and improve the return on our marketing investments.

Our third priority is to leverage our wealth of customer data to drive trips and sales. To-date, we possess a large and robust data set, including more than 75 million customer records, more than 30 million active email addresses and more than 34 million customers on our rewards program. And we can link more than 80% of our sales to a specific customer. This customer link is a big advantage for us, particularly given how passionate our customers are about making in Michaels. In 2018, we began to use this data, combined with new sales force marketing tools, to support new customer relationship management strategies. In the second half of fiscal 2018, we customized a small sample of our emails with a narrow focus on three customer journeys; new customers, who purchase something from us for the first time; existing customers who made a recent purchase; and existing customers who hadn't seen in a while.

Overall, we were very encouraged by the results, which included much higher open rates and higher click through rates when compared to the general file. This year, we intend to build on these successes and develop new capabilities and CRM strategies that take into account not only transaction data, but also other customer interactions and preferences to drive stronger customer loyalty. The resulting personalization is intended to drive both brick-and-mortar and e-commerce growth. In 2018, we built the center repository to help sales and inventory information. In 2019, we will look to add new information about customer behavior to get a comprehensive view of our interest and engagement with Michaels; for example, did she opened the last email we sent her; what should she add to her cart the last time she was on; and did she checkout or abandon the cart. Of course, all of our customer information is secured through our third-party partners to protect personal information.

Using this information, we look to develop proprietary models to help us predict customer preferences towards specific products and categories. And we will use these models to customize communication across a variety of digital channels with the goal of driving higher conversion engagement. We will also leverage the power of our customer data to explore ways to enhance the sales driving power of our rewards program. In addition to using our proprietary data to help us tailor and target our customer communications, we are also mining the data to identify actionable customer segments. For example, based on our data analytics and customer research, we know that teachers love Michaels. Last year, they represented nearly 4% of our identified customers and an even greater percentage of our sales. While teachers often think of us first for classroom and student supplies. We haven't specifically targeted our assortment or marketing to directly address their needs.

In 2019, we will work to make Michaels more valuable and relevant for this critical customer segment with personalized content, unique events and assortment changes in an omnichannel way. In short, we believe we have a big opportunity to leverage our extensive customer data in a personalized way to drive both short and long-term sales growth. Our fourth priority this year is to review and enhance our pricing strategy. Over the last few years, we have made incremental changes to improve our value perception. We created our Everyday Value program, or EDV to deliver everyday prices on basic crafting items. We increased our use of key even dollar price points to reinforce the values we offer and introduced our price match guarantee program. And yet, our value perception is not as strong as we want it to be.

The arts and crafts channel is known for employ high low pricing strategies with various coupons and regular category discounts. And we continue to believe that promotions will be a critical part of our pricing strategy. We also believe we have an opportunity to take a more holistic view of our mix of promotions, coupons and regular price to determine how we can simplify the customer experience and offer value to the customer in ways that are easy and meaningful to her. The goal is to define a path to both improve our value perception and to find ways to eliminate unproductive discounting.

Finally, this year we will refresh our longer-term strategic roadmap to ensure we have a growth strategy for 2020 and beyond. Michaels has a strong financial foundation with attractive profit margins and strong cash flow. But over the last few years, growth has stalled. While the team is laser focused on achieving our 2019 goals and deliver profitable sales growth. We are also taking a fresh look at our longer-term strategy to ensure we are optimally positioned to drive the next phase of growth. To assist with this effort, we have engaged third-party support to help us identify and prioritize the most valuable customer segments, trip missions and categories with the greatest potential to drive stronger profitable growth. We plan to incorporate these insights into our longer-term planning process as we update our growth strategy for 2020 and beyond.

In closing, I am excited about the opportunity to join the Michael team. Michael's is the market leader in the arts and crafts industry, and continuously look for ways to inspire and enable customers to unlock, enhance and share their creativity. I believe that we have a significant opportunity to expand this leadership position by leveraging our wealth of customer data and creating an integrated omnichannel shopping experience that helps customers make creativity happen. As interim CEO, my primary focus is to lead the team to deliver our sales and profit goals for this year and work closely with the team to develop a growth strategy for 2020 and beyond.

Now, Denise will share some additional color about our outlook for fiscal 2019.

Denise Paulonis

Before I get into our outlook for fiscal 2019, I want to note that our guidance excludes the impact of any remaining restructure costs associated with the closing of our Pat Catan stores and the CEO transition. As previously discussed, in Q4 of fiscal 2018, we closed all 36 Pat Catan stores and booked a restructuring charges related to the closing of approximately $44 million net of taxes. The charge was primarily related to cost associated with the termination of meaning lease obligations, the write-off of fixed assets, cost associate with liquidation and the employee -related expense. As we complete the closure process, we anticipate that we will incur approximately $4 million in additional charges net of taxes, primarily sometime time in the first half of 2019.

Reflecting proceeds from the inventory liquidation process, we expect the one-time after cash benefit of the changes in fiscal 2019 will be in the range of $20 million to $25 million. For modeling purposes, fiscal 2018 net sales for Pat Catan’s was approximately $110 million with no material impact on the consolidated company's adjusted operating income. Additionally, we estimated currently known CEO transition costs, including salary, incentive bonus and benefits will be between $5 million and $6 million before taxes and will be incurred in the first quarter of 2019. Additional costs associated with the disposition of equity based compensation and the on-boarding of a permanent CEO likely later this year are unknown at this time.

With that as context, let me walk you through our fiscal 2019 guidance. Of note, our expectation for the business assumes the 10% tariffs enacted in 2018 remain in place. For fiscal 2019, we expect total sales will be between $5.19 billion and $5.24 billion and comp store sales will be flat to up 1%. This guidance includes our plans to relocate 13 Michaels' stores and open 24 new Michaels' stores, inclusive of up to 12 Pat Catan’s stores we plan to rebrand and reopen as Michaels' stores.

Adjusted operating income for the year is expected to be between $640 million and $665 million. To give you a little more color on the expected puts and takes driving our operating income expectation. We expect the gross margin will be flattish versus GAAP of gross profit margin in 2018 with continued benefits from our ongoing sourcing initiatives and better management of promotions, offset by pressure from the impact of tariffs, ongoing transportation headwinds, the deleverage of occupancy costs given the comp guidance and continued strong e-commerce growth. Additionally, we expect to leverage SG&A expense versus GAAP SG&A expense in 2018, driven primarily by the favorable impact of anniversarying the restructure charges in 2018 and $16 million of investment spending in 2018, partially offset by modest pressure from higher IT expense, reflecting our investments and a move to more hosting arrangements.

We expect interest expense will be approximately $155 million, reflecting the expectation of one additional rate increase as was implied by the current LIBOR curve. Based on market conditions and upcoming maturity, we intend to refinance our senior subordinated notes sometime this year. Our guidance does not include the impact of any refinancing efforts, and we will share more information with you on our progress as appropriate. Our earnings outlook assumes an effective tax rate of between 23% and 24% for the full year. These assumptions translate to an adjusted diluted EPS range of $2.34 to $2.46 for fiscal 2019 on approximately 158 million diluted weighted average shares for the full year. Our fiscal 2019 capital expenditure plan is to invest approximately $135 million to support longer-term growth, including technology investments, new source and relocations.

Turning to Q1, we expect comp store sales will be down in the low single digit range. While later Easter has historically been positive for first quarter comps as it allows for a longer spring selling season, February was soft. We believe some of the softness was a result of increased sequential weather during the month, which impacted traffic and sales of seasonal products. We plan to open four new stores, close two stores and relocate five stores in the quarter.

For comparison purposes, in Q1 last year, we opened five net new stores and relocated nine stores. We expect adjusted operating income for the first quarter will be between $96 million and $106 million this guidance includes the expectation of gross margin deleverage as compared to the GAAP gross margin in Q1 last year from higher distribution related costs, one-time costs associated with completing the transition of our e-commerce fulfillment from our third party provider, occupancy deleverage and the impact of tariffs, partially offset by sourcing benefits and discount management. Additionally, we expect to leverage SG&A expense as a percent of sales versus GAAP SG&A expense in Q1 2018, primarily driven by favorable impact of anniversarying the restructure charges in 2018 and investment spending in 2018, partially offset by modest pressure from higher IT expense, reflecting recent investments and a move to more hosting arrangements. Our Q1 guidance for adjusted diluted earnings per share is $0.28 to $0.33, assuming a diluted weighted average share count of $158 million.

Now, I would like to open the call to take your questions. Operator?

Question-and-Answer Session


Thank you. We will now begin the question-and-answer session [Operator Instructions]. And the first question will be from Simeon Gutman of Morgan Stanley. Please go ahead.

Simeon Gutman

I will ask one long question. My first one is to Mark. I wanted to get your opinion on how the board is thinking of growing this business faster, both sales and profits. It sounds like you talked about adjusting some product categories going bigger on some and maybe shrinking others. You talked about pricing and then maybe targeting some key customer groups. To me, it sounds more incremental than transformational. I wanted to get your opinion on that. And then just the second part of the question and then I will stop. The guidance for the first quarter, Denise mentioned soft February. Are you basically just guiding with the imputed run rate from February? Or you are still expecting some improvement to just February was that weak? And that’s it, thanks.

Mark Cosby

So, thank you first for the question. And in terms of the growth opportunities, we will start with that and then we'll go to Denise after that. But first to start with this, this is my third week here. So, I've learned a lot in the three weeks, and I know I will learn a lot more as we go forward. But one thing I do know is that Michaels' is in a very strong financial position. And I do believe, as I mentioned, the company has a very bright future. We are talking about three pretty big ideas to drive both the short-term and the long-term sales growth. One is this expansion of our digital strategy and our e-commerce capabilities with a particular focus on our omnichannel. And if you were looking for something that I was surprised about in the early stages, that would be it. This BOPIS capability that we have is beyond what you typically see, and I think we have a tremendous opportunity to grow as a result of that. This capability we have around our customer data and the ability to use CRM in a personalized way to drive our sales growth is also a tremendous advantage for us. You don't typically see a company with this much customer data, and it does enable us some tremendous capability. And then the third that I alluded to was around our pricing strategy. We know we have to be high-low, because that's the history of the company. But there are ways to optimize the discounts and the customer value and profit that results from that.

As you indicated, I would say those are short and medium-term kind of growth opportunities. We are in the process of working on a strategy to drive our longer-term growth in both 2020 and beyond. We’re looking at customer segments, evaluating categories, and expanding into new categories that we think fit with our business. And the result should be a comprehensive roadmap for how we can grow this business over time. So in summary, I would say that we're pretty bullish on the strengths that we have as a company, and we’re bullish on opportunities for our future growth.

Denise Paulonis

And Simeon, to address your Q1 question, particularly around sales and the guide that we had for sales in Q1. We did see a softer February. But I want to step back and point out a few other things about the quarter. One, with Easter later in the quarter, we do expect that sales will be weighted later in the quarter, that’s just a natural cycle that happens, and this has happened. When you kind of go back over the years, we see that that’s what happened. The other things that are going on are a little different and some are caused by us and some might have some macro forces. So one, we have seen worse weather than we saw last year, no surprise, lots of folks are talking about it, not an excuse but a bit of reality of what we saw. Two, we have a change in the cadence this year with how we are rolling out our product resets.

Mark talked a lot about -- in his script -- about how we’re going to address expanding space in the store for technology, storage, celebrations, art supplies, and that’s happening later in the year than when a lot of our POG resets would have happened earlier in the year last year. What’s the real implication of that for Q1 sales, it actually means we have less clearance sales. As we turned over less product, we’re eliminating less products to then be able to transition the business. So we would call that out as another item. And then finally, the seasonal business itself, it’s been an interesting start to the quarter with a little bit of weather, a later Easter, what might or might not be some impact from tax refund timing. We've just seen a little bit slower uptake in seasonal year-to-date than what we would have anticipated seeing. I will stress that we have our lowest price for the season sales coming up, and we have Easter coming up both later in the quarter. So we feel good about our inventory, but we do think that that’s an opportunity and understanding where seasonal was earlier in the year.

And then finally, I think in the view of an item that we have a bit of control over, we did change a little bit of how we did in-store presentation with some of our seasonal merchandize, and changed a bit of our promo cycle and messaging, as we were testing some new ways to think about communicating to the customer. And we might have gone a little too far in some of that that we did in February. So we've made some tweaks to that as well. But net-net, everything in the guidance reflects still a benefit of the later Easter, but then some of these other factors that just seem to have weighed on us a little heavier as we started the quarter.


The next question will be from Steve Forbes of Guggenheim Securities. Please go ahead.

Steve Forbes

I wanted to focus on really the implications of the guide, right? If you take the 1Q and full year here, it looks like the midpoints essentially imply flat adjusted EBIT on average right 2Q through 4Q after a 20% decline in the 1Q. So just really, Denise, if you can, just try to help us understand the components here. You gave us some color on the first quarter. But what are some of the main drivers of the sequential improvement as we look out to the back half, right? Are you assuming immediate return, right, on some of the category initiatives or really what's going to drive that improvement as we look out?

Denise Paulonis

So let me hit on a couple of points, so one, first on the sales point. Mark mentioned three items. I would reiterate them that we do believe we will drive sales growth as we enter at the end of Q2 and into the second half of the year. That is the product reset around technology, storage, celebrations and art supplies. We do see a near-term lift when we go and do those types of more significant resets and we are anticipating that, also, our investment behind CRM and our investment specifically within that against teacher. We have some new tools that have come online. We have new capabilities tied to some of our data analytics and what we’ve done around the creation of the data lake and easier access to that information that we think is driving some meaningful places we can lean in. And we do anticipate that ramping up as we go through the year. And the third, while a bit more modest on the sales front. We always take a little bit of pricing every year.

We’re taking a little more pricing this year as we’re looking at the tariffs and understanding which levers we can pull. So while modest increases, those won’t really come into play until we move a little bit further into the year as we're executing through some of that in Q1. So from a sales perspective, we’re going to get a little sales ramp. With that come some leverage across a number of our expenses. So you can think about that is helping as you’re going to go through the year on the expense base as well. I would also say that as you go through the year, we continue to believe in both the first quarter end beyond in the goodness of sourcing, so $35 million to $40 million worth of benefit and discount management. So in line with what we can do with CRM and some of our promotional capabilities and in line with some work that Mike was talking about was pricing.

We do see opportunity to continue to improve margins through what we can do on the discount management side. We anticipate that we're going to continue to have some pressures from tariffs coming through and some natural transportation costs as our e-commerce business grows. But we will also not have that we’re having in the first quarter, some of the onetime costs associated with the exit of our third-party e-commerce fulfillment provider and officially moving that fully in-house by the end of Q1. So these are just a number of different puts and takes. The only other one that I would call out that I think you guys are well aware of, the $16 million we invested last year was weighted a bit more to the beginning of the year but all of that bleeds off this year as well, so some is just the pressure from last year to this is going abate a bit.


The next question will be from Laura Champine of Loop Capital. Please go ahead.

Laura Champine

It's really about merchandising changes that you may make. You mentioned desire to bring in more well trending products. What’s leaving the store as you look to make room for fast returning items?

Mark Cosby

Well, as I think Denise mentioned and it was in my comments earlier. We are pretty excited about this category shift that we’re going to do later this year. It actually starts in the backend of the second quarter and moves into the second half of this year. So the categories that we will expand is technology, principally around a cricket product that we have in our stores that is doing very well for us right now. We will close to double the space in that category and do a lot with signage and presentation to call that to light. We are going to increase our space in the storage category, and make that a prominent display than what we have today. And then another category we're very excited about is paints, which obviously core category for Michaels. We do it very well today but we expand the space, make the product a little more central presented in a better way, and we're pretty excited about it. What makes this different is historically we've done a lot of incremental category changes or POG changes over the course of the year. We are stating on those things and doing one big shift through this middle of the year that we're pretty bullish will make a big difference. And the benefit of that is that we can leverage all of our resources around training, signing, product presentation, marketing to make this a really big bang in the second half of the year.

Denise Paulonis

And Laura to make that happen the couple of places in the store where you will see us pull back on space a bit. You will see us pull back on some of our traditional paper crafting. A lot of the technology pieces really displacing some of the core paper crafting. We will pull back a bit on jewelery and we will pull back a bit on bakeware. By no means or any of them existing the store, but it's just the way we’re going to carve up a little bit more of the space to create room for some of these other higher growth potential items.


The next question will be from Peter Keith of Piper Jaffray. Please go ahead.

Peter Keith

I wanted to talk about the free cash flow. So the business does have a healthy amount of free cash flow, and you bought back a fair amount of stock in the last two years. What’s the appetite going forward to buy back stock versus deleveraging the balance sheet?

Denise Paulonis

Peter, in general, our approach to capital allocation hasn’t changed. It's an approach that we review with the board. So we still do believe in a balanced approach going forward. Early in the days in our IPO, we had paid down debt. Last year, we clearly purchased a fair amount of stock back. We will have another upcoming board meeting in the coming weeks, and we will continue this dialog. But I would say both areas remain in play for the year just as they are in every other year.


The next question will be from Zack Fadem of Wells Fargo. Please go ahead.

Zack Fadem

Could you talk about the sales recapture from Aaron Brothers and the Pat Catan's closures? How much do you think is addressable, what are you expecting? And then second on the $60 million pretax charge for Pat Catan's that was much larger versus the Aaron Brothers charge in Q1 on a per store basis. Could you walk us through the difference this time around? Thanks.

Denise Paulonis

So, first on the Aaron Brothers sales recapture. Overall, if you think about our Aaron Brothers business that we were existing, a good portion of that business was a custom frame business and then the remainder was mixed across some framing as well as some art supplies. We've reported this year and I’m happy to report that our custom frame business overall showed nice positive comps, which we’re really proud about. A part of that is due to some AB sales transfer, but we think there's a lot more potential there. I’m not going to go into the percentage of sales transfer that we captured. But I think that we have created a nice incremental customer base coming into the Michaels stores, and think that there is more that we can do in leveraging that customer. We also leverage our custom frame business through the introduction of a market manager program, which is inherently a more hands-on selling culture and approach that we’re executing through our market leaders in the field. And so combining those really help with that sales transfer. The base volume of the other core items sold in Aaron Brothers, it’s not a huge amount of volume. We did see some sales transfer and think that it is a customer base we can address. But overall in the scheme of the $5 billion Michaels business, it was a small number.

In regards to Pat Catan’s too early to tell. So, the stores are in their liquidation process right now. What is interesting about some of those stores is they are in single store markets. So they do provide us some opportunity as we’re thinking about which stores we might or might not end up keeping open and rebranding as Michaels. But it’s a little too soon to tell. In general, the different in the expense base in the Pat Catan’s versus the AB is these are just higher lease costs or longer lease buildings than what you would've seen in Aaron Brothers where we have been managing a lot of those Aaron Brothers stores on very short lease timing as they were extensively leases, heavily weighted to California. So it's really just a difference for the real estate costs and what we assume to exit. And these are huge stores. So compared to a couple thousand square feet Aaron Brothers store, these are upwards of 30,000 plus square feet, so they are not small boxes to exit.


The next question will be from Seth Sigman of Credit Suisse. Please go ahead.

Seth Sigman

Expanded distribution points was called out a couple times throughout the year as one of the big issues in 2018, or at least incremental. How do you see that evolving in 2019? And does it make you rethink your store footprint anywhere? And I guess the need to be opening up stores as you've guided to here. And then I guess related, Mark. How do you see the wholesale business evolving? What’s the role of that business in the future growth of the company as well? Thank you.

Denise Paulonis

So Seth, I will start off on the first part. The extended distribution points, we do believe that this continues to be an attractive space for other folks to play. So when you think about the two components of that, arts and crafts the big box competitors continuing to open source. We don’t anticipate that that’s going to slow in the near-term. But what we also see is across math, across value, across home improvement, people who wanting to be able to participate more in this higher margin business that we have. Once again, we don’t necessary see it abating as we go through this year. I also wouldn’t argue that we see it being worse than what it is. So I think it's just highly profitable space that you’re seeing more people want to play in versus exit. When you think about our real estate and what we’re doing, we’re being very prudent about the new store openings. As I mentioned, the total potential of 24 new stores for the year, but over half of those would likely be converting in existing Pat Catan’s store in a place where we would just maybe not have had the ability to have a box before. So we’re opportunistic of more specifically looking at where is our place we always wanted to have a store and never could have the real estate to do it and we find that real estate, or places where there is just been a huge population explosion. More broadly than that, we’re taking a very conservative view on new store openings.

And then Mark, I will go ahead and comment on the wholesale business as I’m just running through here. So the wholesale business was flattish in 2018, and we expect it to be relatively flat sales in 2019 as well. We've been learning a lot about this business. We've been learning about what it takes about, where you can gain the most margin, what the product assortment is, what we need to do to play. We've continued to evolve our customer base. We knew we’re going to have some natural fall-off in some existing customers when we had acquired the business that has happened. Since then we've acquired those bigger customers, as well as smaller customers as we've gone through that. At this point, we’re really learning to leverage the capabilities we have to continue to grow our customer base. And probably the smaller customers segment and also interestingly new business models, things like the Carnival Cruise partnership that we announce earlier this year. So you will see us do more of those types of activities, which we think will be good sales foundation for the future, but also increase the profitability of the channel.

Kiley Rawlins

So it is top of the hour, and we didn't get through all of the questions in the queue and I apologize for that. Thank you for joining us today. Thank you for your continued interest in Michaels. I'll be around all week if you have follow-up questions. And we look forward to talking with you on our first quarter call in June. Thanks and have a great day.


Thank you, Ms. Rawlins. Ladies and gentleman, the conference has concluded. Thank you for attending today’s presentation. At this time, you may disconnect your lines.