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MICHAELS STORES INC
10-Q, 2000-09-12
HOBBY, TOY & GAME SHOPS

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549

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FORM 10-Q

(Mark One)

/x/	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 (NO FEE REQUIRED)

For the quarterly period ended July 29, 2000

OR

/ /	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 (NO FEE REQUIRED)

For the transition period from                to                

Commission file number 0-11822

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MICHAELS STORES, INC.
(Exact name of registrant as specified in its charter)

8000 Bent Branch Drive
Irving, Texas 75063
P.O. Box 619566
DFW, Texas 75261-9566
(Address of principal executive offices, including zip code)

(972) 409-1300
(Registrant's telephone number, including area code)

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    Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes /x/  No / /

    Indicate the number of shares outstanding of each of the Registrant's classes of Common Stock, as of the latest practicable date.

Title		Shares Outstanding as of September 8, 2000
Common Stock, par value $.10 per share		36,264,579

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MICHAELS STORES, INC.
FORM 10-Q
PART I—FINANCIAL INFORMATION

Item 1.  Financial Statements.

MICHAELS STORES, INC.

CONSOLIDATED BALANCE SHEETS

(In thousands, except share data)

				July 29, 2000			January 29, 2000
				(Unaudited)
ASSETS
Current assets:
	Cash and equivalents			$	88,102		$	77,398
	Merchandise inventories				646,840			615,065
	Prepaid expenses and other				20,772			19,026
	Deferred income taxes and income taxes receivable				18,192			11,498
		Total current assets			773,906			722,987
Property and equipment, at cost					493,874			455,285
Less accumulated depreciation					(236,328	)		(209,552	)
					257,546			245,733
Costs in excess of net assets of acquired operations, net					123,141			124,766
Other assets					3,448			3,217
					126,589			127,983
Total assets				$	1,158,041		$	1,096,703
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
	Accounts payable			$	109,040		$	124,828
	Accrued liabilities and other				124,406			136,375
	Income taxes payable				—			9,773
		Total current liabilities			233,446			270,976
Senior notes					125,000			125,000
Convertible subordinated notes					—			96,940
Deferred income taxes					17,990			17,990
Other long-term liabilities					19,484			18,999
		Total long-term liabilities			162,474			258,929
					395,920			529,905
Commitments and contingencies
Stockholders' equity:
	Common stock, $.10 par value, 150,000,000 shares authorized; 36,039,340 and 31,573,113 shares issued, respectively				3,604			3,157
	Additional paid-in capital				549,516			401,414
	Retained earnings				209,001			194,138
	Treasury stock, at cost, no shares and 1,509,000 shares, respectively				—			(31,911	)
		Total stockholders' equity			762,121			566,798
Total liabilities and stockholders' equity				$	1,158,041		$	1,096,703

See accompanying notes to consolidated financial statements.

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MICHAELS STORES, INC.

CONSOLIDATED STATEMENTS OF INCOME

(In thousands, except per share data)
(Unaudited)

				Quarter Ended
				July 29, 2000			July 31, 1999
Net sales				$	438,392		$	359,124
Cost of sales and occupancy expense					294,721			244,859
Gross profit					143,671			114,265
Selling, general and administrative expense					127,971			104,425
Store pre-opening costs					2,225			3,214
Operating income					13,475			6,626
Interest expense					4,858			5,449
Other (income) and expense, net					(847	)		(368	)
Litigation settlement					—			1,500
Income before income taxes					9,464			45
Provision for income taxes					3,785			17
Net income				$	5,679		$	28
Earnings per common share:
	Basic			$	0.17		$	0.00
	Diluted			$	0.16		$	0.00

See accompanying notes to consolidated financial statements.

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MICHAELS STORES, INC.

CONSOLIDATED STATEMENTS OF INCOME

(In thousands, except per share data)
(Unaudited)

				Six Months Ended
				July 29, 2000			July 31, 1999
Net sales				$	910,940		$	747,668
Cost of sales and occupancy expense					607,115			507,406
Gross profit					303,825			240,262
Selling, general and administrative expense					264,729			215,308
Store pre-opening costs					4,948			5,477
Operating income					34,148			19,477
Interest expense					10,378			10,887
Other (income) and expense, net					(1,836	)		(1,331	)
Litigation settlement					—			1,500
Income before income taxes					25,606			8,421
Provision for income taxes					10,243			3,200
Net income				$	15,363		$	5,221
Earnings per common share:
	Basic			$	0.48		$	0.18
	Diluted			$	0.45		$	0.17

See accompanying notes to consolidated financial statements.

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MICHAELS STORES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)
(Unaudited)

						Six Months Ended
						July 29, 2000			July 31, 1999
Operating activities:
	Net income					$	15,363		$	5,221
	Adjustments:
		Depreciation					30,203			25,235
		Amortization					2,054			2,081
		Other					650			462
		Change in assets and liabilities, excluding acquisitions:
			Merchandise inventories				(30,749	)		(78,956	)
			Prepaid expenses and other				(1,746	)		(2,200	)
			Deferred income taxes and other				3,412			(2,973	)
			Accounts payable				(15,788	)		40,670
			Income taxes payable				(9,773	)		(12,623	)
			Accrued liabilities and other				(9,007	)		(2,640	)
				Net change in assets and liabilities			(63,651	)		(58,722	)
				Net cash used in operating activities			(15,381	)		(25,723	)
Investing activities:
	Additions to property and equipment						(40,735	)		(41,843	)
	Net proceeds from sales of property and equipment						96			85
	Acquisitions						(2,182	)		—
				Net cash used in investing activities			(42,821	)		(41,758	)
Financing activities:
	Payment of other long-term liabilities						(3,011	)		(2,934	)
	Redemption of convertible subordinated notes						(4,206	)		—
	Proceeds from stock options exercised						75,695			6,759
	Proceeds from issuance of common stock and other						428			(60	)
				Net cash provided by financing activities			68,906			3,765
Net increase (decrease) in cash and equivalents							10,704			(63,716	)
Cash and equivalents at beginning of period							77,398			96,124
Cash and equivalents at end of period						$	88,102		$	32,408

    See accompanying notes to consolidated financial statements.

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MICHAELS STORES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

For the Six Months Ended July 29, 2000
(Unaudited)

Note A—Basis of Presentation

    The accompanying consolidated financial statements are unaudited (except for the Consolidated Balance Sheet as of January 29, 2000) and have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Because of the seasonal nature of the Company's business, the results of operations for the three and six months ended July 29, 2000 are not indicative of the results to be expected for the entire year. These interim financial statements should be read in conjunction with the consolidated financial statements and footnotes thereto included in the Company's Annual Report on Form 10-K for the year ended January 29, 2000.

Note B—Earnings Per Share

    The following table sets forth the computation of basic and diluted earnings per common share:

				Quarter Ended						Six Months Ended
				July 29, 2000			July 31, 1999			July 29, 2000			July 31, 1999
				(In thousands, except per share data)
Numerator:
	Net income			$	5,679		$	28		$	15,363		$	5,221
Denominator:
	Denominator for basic earnings per share—weighted average shares				34,035			28,748			32,316			28,666
	Effect of dilutive securities:
		Employee stock options			1,382			1,699			1,551			1,177
	Denominator for diluted earnings per share—weighted average shares adjusted for dilutive securities				35,417			30,447			33,867			29,843
Basic earnings per common share				$	0.17		$	0.00		$	0.48		$	0.18
Diluted earnings per common share				$	0.16		$	0.00		$	0.45		$	0.17

Note C—Redemption of the Convertible Subordinated Notes

    On June 9, 2000, the Company called for the redemption on June 29, 2000 of the convertible subordinated notes due January 15, 2003 (the "Securities"). The aggregate principal amount of the Securities outstanding was $96,935,000. The holders had the option to convert their Securities into shares of Michaels common stock prior to 5:00 p.m., Eastern Time, on June 22, 2000, at a price of $38.00 per share. Alternatively, holders could have their Securities redeemed on June 29, 2000 at a total redemption price of $1,051.25 per $1,000 principal amount of Securities, including a premium for early redemption and accrued interest.

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    As a result, the majority of the Securities were surrendered by the June 22, 2000 conversion date and were converted into 2,445,565 shares of the Company's common stock. The remaining Securities were redeemed at a total redemption price of $4,206,051 on June 29, 2000. The loss from the redemption was not material.

Item 2.  Management's Discussion and Analysis of Financial Condition and Results of Operations.

    Certain statements contained in this discussion and analysis which are not historical facts are forward looking statements that involve risks and uncertainties, including, but not limited to, customer demand and trends in the arts and crafts industry, related inventory risks due to shifts in customer demand, the effect of economic conditions, the impact of competitors' locations or pricing, the effectiveness of advertising strategies, the availability of acceptable real estate locations for new stores, difficulties with respect to new information system technologies, supply constraints or difficulties, the results of financing efforts, and other risks detailed in our Securities and Exchange Commission filings.

Results of Operations

    The following table sets forth the percentage relationship to net sales of each line item of our Consolidated Statements of Income. This table should be read in conjunction with the following discussion and with our Consolidated Financial Statements, including the related notes.

			Quarter Ended				Six Months Ended
			July 29, 2000		July 31, 1999		July 29, 2000		July 31, 1999
Net sales			100.0	%	100.0	%	100.0	%	100.0	%
Cost of sales and occupancy expense			67.2		68.2		66.6		67.9
Gross profit			32.8		31.8		33.4		32.1
Selling, general and administrative expense			29.2		29.1		29.1		28.8
Store pre-opening costs			0.5		0.9		0.6		0.7
Operating income			3.1		1.8		3.7		2.6
Interest expense			1.1		1.5		1.1		1.5
Other (income) and expense, net			(0.2	)	(0.1	)	(0.2	)	(0.2	)
Litigation settlement			—		0.4		—		0.2
Income before income taxes			2.2		0.0		2.8		1.1
Provision for income taxes			0.9		0.0		1.1		0.4
Net income			1.3	%	0.0	%	1.7	%	0.7	%

Quarter ended July 29, 2000, compared with the quarter ended July 31, 1999

    Net sales for the three months ended July 29, 2000 increased $79.3 million, or 22%, over the three months ended July 31, 1999. At the end of the second quarter of fiscal 2000, we operated 597 Michaels and 104 Aaron Brothers stores. The results for the second quarter of fiscal 2000 included sales from 68 Michaels and 22 Aaron Brothers stores that were opened or acquired during the 12-month period ended July 29, 2000, more than offsetting lost sales from 7 Michaels and no Aaron Brothers store closures. Sales at the new stores (net of closures) during the second quarter of fiscal 2000 accounted

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for $52.7 million of the increase in net sales. Same-store sales increased 8% in the second quarter of fiscal 2000 from the second quarter of fiscal 1999, which contributed $26.6 million to the net sales increase. The improvement in same-store sales was due to a strong performance in our core categories of ribbon, general crafts, art supplies, seasonal and framing. Going forward, we expect to achieve same-store sales increases for the remainder of fiscal 2000, taken as a whole. Our ability to continue to generate same-store sales increases is dependent, in part, on our ability to continue to maintain store in-stock positions on the top-selling items, to properly allocate seasonal merchandise to the stores based upon anticipated sales trends utilizing POS rate of sale information, and the success of our sales promotion efforts.

    Cost of sales and occupancy expense, as a percentage of net sales, for the second quarter of fiscal 2000 was 67.2%, a decrease of 1.0% compared to the second quarter of fiscal 1999. This decrease was primarily attributable to improved initial markup on inventories and improvements from our promotional strategy resulting in a decrease in promotional markdowns, partially offset by higher occupancy costs associated with new and relocated stores.

    Selling, general and administrative expense, as a percentage of net sales, increased by 0.1% in the second quarter of fiscal 2000 compared to the second quarter of fiscal 1999. This increase resulted principally from expenses associated with our supply chain initiative and increased advertising expenses, as a percentage of net sales, partially offset by improved expense leverage in depreciation and amortization expenses.

    Store pre-opening costs, as a percentage of net sales, decreased by 0.4% in the second quarter of fiscal 2000 compared to the second quarter of fiscal 1999, as we opened, acquired or relocated 19 Michaels and 8 Aaron Brothers stores in the second quarter of fiscal 2000 compared to 29 Michaels and 2 Aaron Brothers stores in the second quarter of fiscal 1999.

    Operating income, as a percentage of net sales, increased by 1.3% in the second quarter of fiscal 2000 compared to the second quarter of fiscal 1999. This improvement represents a 103% increase in operating income over the second quarter of fiscal 1999, on a 22% increase in net sales during the same period, to $13.5 million for the second quarter of fiscal 2000 compared to $6.6 million for the second quarter of fiscal 1999.

    Interest expense (net of interest income), as a percentage of net sales, decreased by 0.5% in the second quarter of fiscal 2000 compared to the second quarter of fiscal 1999. This decrease resulted from a leveraging of interest expense on expanded sales and the conversion and redemption of the convertible subordinated notes in June 2000.

    The effective tax rate for the second quarter of fiscal 2000 was 40% compared with 38% in the second quarter of fiscal 1999, due to the Company's reduction in the valuation allowance for net operating losses utilized in fiscal 1999.

Six months ended July 29, 2000, compared with the six months ended July 31, 1999

    Net sales for the six months ended July 29, 2000 increased $163.3 million, or 22%, over the six months ended July 31, 1999. At the end of the first six months of fiscal 2000, we operated 597 Michaels and 104 Aaron Brothers stores. The results for the first six months of fiscal 2000 included sales from 68 Michaels and 22 Aaron Brothers stores that were opened or acquired during the 12-month period ended July 29, 2000, more than offsetting lost sales from 7 Michaels and no Aaron Brothers store

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closures. Sales at the new stores (net of closures) during the first six months of fiscal 2000 accounted for $109.2 million of the increase in net sales. Same-store sales increased 7% in the first six months of fiscal 2000 from the first six months of fiscal 1999, which contributed $54.1 million to the net sales increase. The improvement in same-store sales was due to a strong performance in our core categories of ribbon, general crafts, art supplies, seasonal and framing.

    Cost of sales and occupancy expense, as a percentage of net sales, for the first six months of fiscal 2000 was 66.6%, a decrease of 1.3% compared to the first six months of fiscal 1999. This decrease was primarily attributable to improved initial markup on inventories and improvements from our promotional strategy resulting in a decrease in promotional markdowns, partially offset by higher occupancy costs associated with new and relocated stores.

    Selling, general and administrative expense, as a percentage of net sales, increased by 0.3% in the first six months of fiscal 2000 compared to the first six months of fiscal 1999. This increase resulted principally from expenses associated with our supply chain initiative and increased advertising expenses, as a percentage of net sales, partially offset by improved expense leverage in depreciation and amortization expenses.

    Store pre-opening costs, as a percentage of net sales, decreased by 0.1% in the first six months of fiscal 2000 compared to the first six months of fiscal 1999, as we opened, acquired or relocated 49 Michaels and 10 Aaron Brothers stores in the first six months of fiscal 2000 compared to 55 Michaels and 5 Aaron Brothers stores in the first six months of fiscal 1999.

    Operating income, as a percentage of net sales, increased by 1.1% in the first six months of fiscal 2000 compared to the first six months of fiscal 1999. This improvement represents a 75% increase in operating income over the first six months of fiscal 1999, on a 22% increase in net sales during the same period, to $34.1 million for the first six months of fiscal 2000 compared to $19.5 million for the first six months of fiscal 1999.

    Interest expense (net of interest income), as a percentage of net sales, decreased by 0.4% in the first six months of fiscal 2000 compared to the first six months of fiscal 1999. This decrease resulted from a leveraging of interest expense on expanded sales and the conversion and redemption of the convertible subordinated notes in June 2000.

    The effective tax rate for the first six months of fiscal 2000 was 40% compared with 38% in the first six months of fiscal 1999, due to the Company's reduction in the valuation allowance for net operating losses utilized in fiscal 1999.

Liquidity and Capital Resources

    Cash flow used in operating activities during the first six months of fiscal 2000 was $15.4 million, compared with cash flow used in operating activities of $25.7 million during the first six months of fiscal 1999. This improvement was principally due to a much smaller increase in merchandise inventories, which increased 5% since January 29, 2000, primarily because of the addition of 40 Michaels and 9 Aaron Brothers stores during the first six months of fiscal 2000. Inventories per Michaels store at July 29, 2000 decreased 1% from July 31, 1999. This decrease in average inventory per store resulted at the same time as we achieved same-store sales increases by maintaining a good store in-stock position. Our plans are to continue to refine our basic inventory levels carried in our

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distribution centers and stores, striving to find the right balance of safety stock. By year-end, we believe our per store inventories will be approximately 5% below fiscal 1999 year-end levels.

    We opened 39 Michaels and 9 Aaron Brothers stores and relocated 9 Michaels and 1 Aaron Brothers stores during the first six months of fiscal 2000. Capital expenditures for the newly opened stores amounted to approximately $25.8 million. Additional capital expenditures of approximately $14.9 million during the first six months of fiscal 2000 related primarily to existing stores and various information systems enhancements. We expect additional capital expenditures during the remainder of fiscal 2000 to total approximately $86 million, related primarily to costs for new stores, store relocations and remodeling, distribution facilities, information systems, and various other projects.

    In fiscal 1999 and 1998, we repurchased 364,000 and 1,145,000 shares, respectively, of our common stock ("Common Stock") for an aggregate purchase price of $11.5 million and $20.4 million, respectively, and placed the shares in treasury. In the first quarter of fiscal 2000, we retired all of the Common Stock held in treasury. Pursuant to a plan approved by the Board of Directors in July 1999 to repurchase up to 5,000,000 shares of Common Stock, subsequent to the end of the second quarter of fiscal 2000 through September 8, 2000, we repurchased and subsequently retired 694,000 shares of our Common Stock for an aggregate purchase price of $26.6 million.

    On June 9, 2000, the Company called for the redemption on June 29, 2000 of the convertible subordinated notes due January 15, 2003 (the "Securities"). The aggregate principal amount of the Securities outstanding was $96,935,000. The holders had the option to convert their Securities into shares of Common Stock by June 22, 2000, at a price of $38.00 per share. Alternatively, holders could have their Securities redeemed on June 29, 2000 at a total redemption price of $1,051.25 per $1,000 principal amount of Securities, including a premium for early redemption and accrued interest. The majority of the Securities were surrendered by the June 22, 2000 conversion date and were converted into 2,445,565 shares of Common Stock. The remaining Securities were redeemed at a total redemption price of $4.2 million on June 29, 2000. The loss from the redemption was not material.

    In the first six months of fiscal 2000, proceeds from the exercise of employee stock options covering 3,515,518 shares of Common Stock amounted to $75.7 million.

    At July 29, 2000, we had working capital of $540.5 million, compared to $452.0 million at January 29, 2000. We currently have a bank credit facility (the "Credit Agreement") providing for an unsecured revolving line of credit of $100 million, which may be increased to $125 million under specific conditions. No borrowings were outstanding under the Credit Agreement at July 29, 2000 or at July 31, 1999. We believe that our available cash, funds generated by operating activities, funds available under our Credit Agreement and proceeds from the exercise of stock options will be sufficient to fund anticipated capital expenditures and working capital requirements.

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MICHAELS STORES, INC.
FORM 10-Q

PART II—OTHER INFORMATION

Item 6.  Exhibits and Reports on Form 8-K.

(a)          Exhibits

               Exhibit 27—Financial Data Schedule.

(b)          Reports on Form 8-K

               (i)  Form 8-K, dated June 9, 2000, reporting Items 5 and 7, and filing Michaels Stores, Inc. Press Release dated
                     June 9, 2000.

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MICHAELS STORES, INC.
SIGNATURES

    Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

		MICHAELS STORES, INC.
		By:	/s/ BRYAN M. DECORDOVA    Bryan M. DeCordova Executive Vice President and Chief Financial Officer (Principal Financial Officer)

Dated: September 12, 2000

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EXHIBIT INDEX

Exhibit Number		Description		Page
27		Financial Data Schedule

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QuickLinks

(Mark One)

MICHAELS STORES, INC. FORM 10-Q PART I—FINANCIAL INFORMATION

Item 1. Financial Statements.

Note A—Basis of Presentation
Note B—Earnings Per Share
Note C—Redemption of the Convertible Subordinated Notes
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.
Results of Operations
Quarter ended July 29, 2000, compared with the quarter ended July 31, 1999
Six months ended July 29, 2000, compared with the six months ended July 31, 1999
Liquidity and Capital Resources

PART II—OTHER INFORMATION

Item 6. Exhibits and Reports on Form 8-K.

MICHAELS STORES, INC. SIGNATURES
EXHIBIT INDEX

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