Michaels Companies Inc
Q1 2019 Earnings Call Transcript

Published: 6 Jun 2019

[Operator:]

Good morning, my name is Cole and I will be your conference operator today. At this time, we’d like to welcome everyone to the Michaels Company first 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.Now I’d like to turn the conference over to your host today, Elaine Locke, Vice President, Investor Relations and Treasurer. Ms. Locke, you may begin the conference.

[Elaine Locke:]

Thank you, Cole. Good morning and thank you for joining us today. Early this morning we released our financial results for the first quarter of fiscal 2019. A copy of the 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 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, June 6, 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 restructuring charges primarily related to the Aaron Brothers and Pat Catan store closures, severance charges related to the departure of our former CEO, a write-off of an investment in a liquidated business, and tax adjustments related to the 2017 Tax Act 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, interim CEO, and Denise Paulonis, CFO. Following our prepared remarks, we will open the call for questions.Now I’d like to introduce Mark Cosby for some initial comments. Mark?

[Mark Cosby:]

Thank you, Elaine, and good morning everyone. This morning, we reported results for the first quarter that were within guidance range we provided on our last earnings call. Comp store sales declined 2.9%, adjusted operating income was $101 million, and adjusted diluted earnings per share was $0.31. While these results were within our expectations for the quarter, we are not satisfied with these results and are proactively taking steps to improve our performance.Our team is intensely focused on three areas

[Denise Paulonis:]

Thank you, Mark. Before we discuss our first quarter results, I want to mention that we adopted ASU 2016-02 , which relates to lease accounting, at the beginning of this fiscal year. This new guidance now requires us to include right-of-use asset and lease liabilities associated with our leasing obligations on our balance sheet. There was no material impact on our income statement.As Mark said at the beginning of his comments, our Q1 results were within our initial guidance range. As expected, revenues were challenged during the quarter. Due to timing differences of plan-o-gram changes this year, we had lower levels of clearance products in our stores as compared to the first quarter last year, creating a sales headwind. Additionally, winter weather was a challenge at the start of the quarter, which we believe impacted traffic and sales of seasonal product. As expected, the sales trends improved as the quarter progressed.First quarter net sales were $1.09 billion compared to $1.16 billion last year. The decrease in net sales for the quarter was primarily due to the closure of our Pat Catan stores in Q4 of fiscal 2018 and the closure of our Aaron Brothers stores in the first quarter of 2018, which cumulatively delivered approximately $39 million in sales in the first quarter of last year, and the 2.9% decrease in comparable store sales which was driven by a decrease in customer transactions partially offset by an increase in average ticket. The sales decrease was partially offset by sales from operation of 17 net new Michaels stores during the quarter. In Q1, the company opened four new Michaels stores, closed two Michaels stores, and relocated seven Michaels stores. Sales from Michaels.com were very strong again this quarter, driven by increased traffic and higher conversion rates. From a category perspective, tools and technology, craft storage, and holiday and seasonal décor were our strongest categories this quarter while more traditional paper crafting supplies and kids crafts were more challenged.Gross profit dollars for the quarter were $418 million compared to $457 million last year. As a percentage of sales, our gross profit rate for the quarter was 38.2% versus 39.5% last year, a decrease of about 130 basis points. As expected, the decrease in the Q1 gross profit rate was primarily a result of several factors, including higher distribution related costs including the one-time costs associated with the transition away from our third party ecommerce provider, occupancy cost deleverage, and an adverse sales mix resulting from the strong sales of lower margin categories like technology and storage. These increases were partially offset by less promotional activity during the quarter and benefits from our ongoing sourcing initiatives.Of note, we did start to see the impact of tariffs flow through our cost of goods in the quarter.Distribution-related costs continued to pressure gross margin this quarter, driven primarily by higher domestic transportation expense related to our transition to a dedicated carrier model. In addition, we experience higher small parcel shipping costs relate to ecommerce resulting from both higher rates and increased volumes.Total store rent expense for the quarter was $98 million versus $100 million last year. The decrease in store rent expense was due to the Pat Catans and Aaron Brothers store closures, partially offset by the impact of a net 17 additional Michaels stores.For the quarter, SG&A expense, including store preopening costs, was $322 million or 29.4% of sales, compared with $330 million or 28.6% of sales last year. The decrease in SG&A expense was primarily due to an $11 million decrease in expenses related to the closure of Pat Catans and Aaron Brothers stores during fiscal 2018 and lower payroll related expense, reflecting good expense control in a challenging sales environment. These decreases were partially offset by $5.6 million of severance costs associated with the departure of our former CEO.Additionally, in the first quarter of 2019 we recorded a restructuring charge of $3.1 million related to the closure of all of our Pat Catans stores during the first quarter of fiscal ’18. As a reminder, in the first quarter of fiscal 2018, we recorded a restructuring charge of $47.5 million primarily related to the closure of substantially all of our Aaron Brothers stores during the same quarter.GAAP operating income was $93 million compared to $79 million in the first quarter of fiscal 2018. Excluding the restructuring charge and CEO severance costs, adjusted operating income for Q1 of fiscal 2019 was $101 million.For the quarter, interest expense was $37 million, about $3 million higher than the first 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.Other expense increased $5 million in the first quarter of fiscal 2019 related to a write-off of an investment in a liquidated business. Let me take a minute to provide some more color on the write-off.In 2015, we made a small investment in Darby Smart, an online company focused on designing and selling project kits. The mission and focus of Darby Smart evolved over the last few years away from arts and crafts and project kits, and early this year the company was sold. Unfortunately, the proceeds from the sale went to creditors and debt holders. As a result, in the first quarter of fiscal 2019, we booked a write-off of about $5 million for the Darby Smart investment.The effective tax rate was 27.9% compared to 41.6% in the first quarter last year. The effective tax rate in Q1 of this year includes $2 million of tax expense primarily related to the vesting of restricted shares. Recall that last year, we booked $8 million of adjustments in the quarter related to repatriation taxes on the accumulated earnings of foreign subsidiaries. Excluding the impact of this tax adjustment, the effective tax rate for Q1 of fiscal 2018 was 24%.On a GAAP basis, net income was $38 million or $0.24 per diluted share, compared to $27 million or $0.15 per diluted in the first quarter of fiscal 2018. Excluding the restructuring charge associated with the closing of our Pat Catan stores, costs associated with the departure of our former CEO, and the write-off of Darby Smart, adjusted net income was $49 million or $0.31 per diluted share.Total merchandise inventory at the end of the quarter decreased 1.8% to $1.1 billion compared to $1.12 billion last year. The decrease in inventory was primarily due to the Pat Catan store closures partially offset by additional associated with the operation of 17 net additional Michaels stores. Average inventory for Michaels stores, including inventory for ecommerce, inventory in distribution centers, and inventory in transit was 1% higher than at the end of Q1 last year, inclusive of a 70 basis point drag from the 10% incremental duties incurred on List 3 tariff products.We ended Q1 with more than $900 million in liquidity, including $247 million in cash on our balance sheet and $677 million available under our revolver. Total debt at the end of the quarter was $2.7 billion. Our total debt to adjusted EBITDA on a trailing 12-month basis was 3.3 times, and our trailing 12-month interest coverage was 4.3 times.Capital expenditures for the quarter were $25 million, reflecting investments in technology projects, including investments to support ecommerce and our digital platforms and investments in new and relocated stores. For the full year, we continue to expect to invest approximately $135 million in capital expenditures.With that as context, let me walk you through our guidance for the second quarter and full year. As a reminder, our guidance excludes the impact of any remaining restructuring costs associated with the closing of our Pat Catan stores, any additional costs associated with the departure of our former CEO, the one-time write-off of our Darby Smart investment, and any potential one-time costs associated with debt refinancing.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 20 net new Michaels stores, inclusive of up to 12 Pat Catan we plan to rebrand and reopen as Michaels stores. Adjusted operating income for the year is expected to be between $625 million and $650 million. This revision includes the P&L impact of increasing List 3 tariffs from 10% to 25%. As we previously discussed coming into the year, we estimate approximately $400 million of our product costs would be subject to higher duties. We’re aggressively working on our tariff mitigation plan that includes sourcing actions, vendor negotiation, product reengineering, and selective price increases. Of note, we are pleased that we’ve been successful in shifting some of purchases out of China.Clearly, the situation remains fluid and if List 4 China tariffs are implemented, we will continue to use all available resources to reduce the dollar impact. Of note, with the recent news of pending tariffs on products from Mexico, I did want to share that we do not source a meaningful amount of product from Mexico. Also, remember given the pace we turn our inventory, there is delayed effect to recognizing expense to match when the item is sold.With the impact from the additional duties, we now expect gross margin to be slightly down versus GAAP gross margin in 2018. Beyond the impact of tariffs as discussed on the last call, we do expect to see continued benefits from our ongoing sourcing initiatives and better management of promotions, offset by pressure from ongoing transportation headwinds, the deleverage of occupancy costs given the comp guidance, and continued strong ecommerce growth.We continue to expect to leverage SG&A expense versus GAAP SG&A expense in 2018, driven primarily by the favorable impact of anniversarying the restructuring charges in 2018 and $15 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 now expect interest expense will be approximately $153 million, reflecting the expectation of no additional rate increases this year. Based on market conditions and upcoming maturity, we intend to refinance our senior subordinate notes sometime this year. Our guidance does not include the impact of any refinancing effort, and we will share more information with you on our progress as appropriate.Our earnings outlook assumes an effective tax of between 23 and 24% for the full year. These assumptions translate to an adjusted diluted EPS range of $2.29 to $2.41 for fiscal 2019 on approximately 158 million diluted weighted average shares for the full quarter.Our fiscal 2019 capital expenditure plan is to invest approximately $135 million to support longer term growth, including technology investments, new stores, and relocations.Turning to Q2, we expect comp store sales will be flat to down 1.5%. We plan to open three new stores, close two stores, and relocate two stores in the quarter. For comparison purposes, in Q2 last year we opened eight net new stores and relocated seven stores.We expect adjusted operating income for the second quarter will be between $65 million and $75 million. This guidance includes the expectation that gross margin will be flattish as compared to GAAP gross margin in Q2 last year, netting higher distribution related costs, occupancy deleverage and the impact of tariffs with sourcing benefits and discount management. Additionally, we expect SG&A expense as a percent of sale will also be flattish versus GAAP SG&A expense in Q2 2018, driven primarily by the favorable impact of anniversarying the investment spending in 2018, partially offset by modest pressure from higher IT expense, reflecting our recent investments in a move to more hosting arrangements.Our Q2 guidance for adjusted diluted earnings per share is $0.13 to $0.16, assuming a diluted weighted average share count of 158 million shares.With that, I’d like to open up the call to take your questions. Operator?

[Operator:]

[Operator instructions]Our first question today comes from Tami Zakaria with JP Morgan. Please go ahead.

[Tami Zakaria:]

Hi, good morning. So, my first question is are you embedding any price increase for the tariffs that’s in your comp sales guide of 2019 that’s flat to 1%, expected to be up plus 1%, is there any price increase embedded in there?

[Denise Paulonis:]

The way we think about it when we think about tariffs overall, there’s a number of levers that we’re really pulling to try to mitigate those tariffs. First and foremost, we’re trying to offset the costs by moving production outside of China, thinking about renegotiating with our vendors, other value engineering that we might be able to do with our products. We do and have embedded in our guidance some selective price increases that we are taking or have taken in both cases, but it is a modest amount of price increases overall compared to the tariffs that we’re seeing.

[Tami Zakaria:]

Got it. My second question is, you pointed out lower promotion as a benefit to gross margin this quarter, but it hurt sales, so as we look into the rest of the year, how do you plan to balance these two, and how does that play out in terms of gross margin versus sales for the rest of the year?

[Denise Paulonis:]

Let me separate out the value proposition discussion that Mark led from promotion efficiency in the quarter. When we think about promotion efficiency overall, we’re thinking about the breadth of discount management that we can do, which is just being smarter about some of the promotions, so running more promotions that have a better return for us, which we continue to do and continue to see benefit. I think that’s different than the impact of the coupon changes that we had coming into the quarter and the role that everyday value program had on restraining the use of some of those coupons, as well as other coupon constraints that were out there. While they both play into what that promotion number would be, the signalling is more -- she wants her choice about how she can go get her discounts more than the view that our absolute value is overpriced. What she signaled to us is, I like a high-low business, I like the ability to use my coupon on what I choose to do, and we really constrained that piece more than we should. But that still lets us have other promotional levers to pull on better discount management in terms of category promotions and just the overall level of discounting we’re doing in the business.

[Tami Zakaria:]

Got it, thank you so much.

[Operator:]

Our next question comes from Steve Forbes with Guggenheim Securities. Please go ahead.

[Steve Forbes:]

Good morning. I wanted to start with the first quarter gross margin profile. You mentioned a couple headwinds here in the release and in the call, but can you quantify the impacts or at least just quantify the one-time costs of bringing ecommerce in-house? On that as well, second quarter looking for a flat margin profile with comps flat to down, maybe just some color around the puts and takes, the offsets to the occupancy deleverage and so forth, and what you’re seeing from sourcing thus far this year.

[Denise Paulonis:]

Sure. Steve, I think you know we don’t quantify the individual components, but I’ll give you the sense for the bigger drivers of the gross margin performance in Q1, and then happy to bridge what that change is versus Q2.So in Q1, we actually delivered a positive merchandise margin driven by the sourcing benefits and discount management that we were able to do. The big offset to that was continued transportation expense, which is core transportation but it’s also just the higher penetration of our e-comm business as part of the mix. The one-time e-comm exit costs, I would say not material in total numbers for the quarter but was a real cost for us to exit, but the piece I’d most point to, to think about and where the change will come in versus Q2, is in Q1 we had significant operating deleverage on our occupancy line associated with the low comp sales, and that is a key pivot that as you go into Q2, we’re going to see that bleed off. The other part that was in Q1 that we mentioned on the call was the mix effect of just the shift of categories in our business to some naturally low margin categories.Those were the big drivers, and when I pivot to Q2, some things aren’t changing, so sourcing discount management and delivering that positive scan margin is still something we are very focused on, but the things that do abate a bit, occupancy deleverage becomes less of a headwind for us, transportation costs become less of a headwind to us. A portion of the costs that are about the dedicated carrier model start to bleed off as we’re going through the second quarter, so those are two of the biggest drivers that really caused the shift.

[Steve Forbes:]

Thank you for that. Just a quick follow-up on Michaels’ Rewards - you mentioned 37 million members, but then you also were talking about sort of the segregation of your customer, instead of enthusiast first beginner or novice, into this maker. Can you talk about the membership base as it stands today? Have you segregated the members into these new groups, per se, and what are they telling you they want from the brand broadly that’s not there today?

[Mark Cosby:]

That’s a great question around the shift here to the core customer. As I mentioned earlier, we feel great about the strategy work that’s been done to date, and we’re heading down the right path. We did define this core customer. The beauty of this core customer is they like Michaels, and there’s also a considerable amount of room to gain more share from them over time. What that means is certainly shifts in how we prioritize categories. It does not mean wholesale changes in any way, and seasonal business is an example we tend to use. People think of the seasonal business as maybe a novice business, but it tends to be more as much focus for the core customer or maker customer as it does for this more novice customer.The beauty of the CRM program, as you mentioned, is it enables us to target all of our customers, but particularly our core customers because by definition, we have more data on the core customers in terms of what they’ve bought recently and what they’ve bought over time, so as a result we can better target their needs and see better results with them over time, better engagement with them over time. So this whole CRM piece ties perfectly into our core customer strategy, and as I mentioned, we believe the CRM initiative in the second half will be a big growth driver for us, and it will continue into next year. As I mentioned, we will work on our loyalty program and continue to enhance that as we turn into next year.

[Steve Forbes:]

Thank you.

[Operator:]

Our next question comes from Simeon Gutman with Morgan Stanley. Please go ahead.

[Unidentified Analyst:]

Hi guys, this is [indiscernible] on for Simeon. When I’m thinking about 2Q guidance of flat to down 1.5, was that always within your plan, or has anything changed there? I guess adding onto that, what gives you confidence in the implied inflection in the back half?

[Denise Paulonis:]

When you think about the Q2 comp, it reflects what we learned in Q1 as well as what we continue to believe the full year guide for zero to plus-1 comp for the full year will be. The key pivots that start to really play out in Q2 from where we were in Q1, all our product resets that Mark mentioned will be active by the end of Q2 or very early into Q3. Our technology reset has already happened in May, and the other resets follow as we work our way through the quarter, which is a nice uptick and lift for Q2.We also in Q2 experience the beginning of the back-to-school season at the end of the quarter, and while we plan that strictly from an arts and crafts space, we know that it’s also a nice traffic driver for us to the stores, so all of those things are reflected in the pivot of where we’re starting.When you pivot that even further into the second half of the year and the inflection that we see, two additional factors, so those category changes still matter quite a bit, but what we also see coming through is the CRM efforts that Mark talked about. The enablers of that, which were the system investments that we made last year as well as the work we’ve been doing this year to really institutionalize the use of this data out of a more data lake-based system, we do believe will come online in the second half and be of benefit.The second half for us, as you guys know, is also a period of time where our seasonal business gets a lot of traction, and every year we’re able to continue to expand that business against a wide variety of customers who shop our store, but importantly our core makers as well who tell us they love the assortment that we bring to bear for them to celebrate these important times of life. So that pivot that we’ve seen over the last few years of a natural tailwind of the strength of that business, we also do believe will come through in the second half of the year.

[Unidentified Analyst:]

Got it, thanks. If I could just squeeze in another one on gross margins, you mentioned tariffs are going to be a headwind, but underlying gross margins, you’re lapping a step-up in freight, you still have the sourcing benefits. Should that underlying gross margin start to expand starting in Q2?

[Denise Paulonis:]

I would say the souring and discount management is going to be a continued source of strength in Q2, but more so as you get to the second half of the year. The distribution costs, we really will be lapping that step-up from last year and that will also start to abate as well, and I think the final one to mention is that with the positive trajectory of comps as we move through the quarters of the year, that occupancy cost deleverage will become less of a pressure point.So simple answer to your question - yes, but hopefully that color provides you with a little bit of the individual components that we see moving as you go through the year.

[Unidentified Analyst:]

Okay, thanks. Thanks guys.

[Operator:]

Our next question comes from Laura Champine from Loop Capital. Please go ahead.

[Laura Champine:]

Thanks for taking my question. It’s about the balance sheet. Can you comment on your current liquidity and comfort with the composition of the balance sheet and what your balance sheet goals are for this year?

[Denise Paulonis:]

Absolutely. Our long-term goal from a leverage perspective is to be between 2.5 and 3 times total debt to EBITDA. We sit slightly ahead of that now, and we feel very comfortable about that, and in total we feel very comfortable about our ability to cover our interest expense and continue to maintain and invest in the business with that level of debt on the books.When you think about the composition of the balance sheet and the debt that is out there, we have an ABL revolver that we have at a very low rate and tap into as we might need to through the year, and that has a maturity that goes out through 2021. We then have our term loan which also has a long maturity, not maturing until 2023, at a good rate. Our senior subordinated note is the closest in maturity, which will become due in December of 2020, so that is the piece of debt that we are looking to take some action on this year and we have a good sense that we won’t have any issue at all in refreshing that debt and moving forward, so our action plan this year is primarily focused on what we’ll do with that senior subordinated note.Then importantly, to move to more of a mix between fixed and floating. Included on the overall capital structure, we have a billion dollar interest rate swap, so that we have a little over 50% of our debt is actually fixed rate debt inclusive of the use of that swap.

[Laura Champine:]

Got it, thank you.

[Operator:]

Our next question comes from Mike Baker with Deutsche Bank. Please go ahead.

[Mike Baker:]

Hi. First, I just want to clarify, the margin outlook, you’re essentially increasing the use of couponing but you didn’t necessarily call that out as an impact to the margins for the year, because that’s going to be offset in your mind by better efficiency in other promotions. Is that the right way to think about it?

[Denise Paulonis:]

I’ll start with the mathematical answer, and then Mark can jump in a little bit more on what we’re working on, if he’d like to do so. From a mathematical answer, it’s less about the increase of couponing driving overall increased promotional activity, it’s really a swap from when we had our everyday value pricing, which effectively we had priced at the out-the-door price, kind of an average mix of the use of coupon on those items when we moved to that everyday price. What we’re really moving back to is a high-low pricing strategy on those items, and now the coupon applies, so the net out-the-door price for those items we don’t view as materially different impact on the P&L. It’s just a different way for the customer to be served up her choice of discounting.

[Mark Cosby:]

I can just give you a little more color on the whole value play. We talked a little bit about it in my comments at the beginning, but the biggest issue with our value is more around the consistency of which we deliver value to the customer, and over the course of the last few months, we’ve been a little bit inconsistent. So what does that mean? That means reducing the number of coupon exclusions, which we’ve done; eliminating EDV, which you heard about, and if you look at our coupon complaints, that was the number one factor driving issues for our customers. We did quite a bit of work on our end cap and aisle presentations to present a better value, and we have more of that coming in the second half of this year and into next year.The serialization thing was a fairly big deal for us. Where we’ve landed will be a tool that will enable us to continue to distribute the coupons, which are an important growth driver for us, but do so in a way that still manages the margin, back to Denise’s comments on there not really being a margin rate issue. Then at the end, we’ve put a step in to make sure that every week as we look at the different ways that we’re delivering value to the customer, that they’re integrated and present one voice.I think most important, the changes have worked. We have had a pretty significant reduction in complaints from our customers and we’ve seen an improvement in both our transaction trends as well as our sales trends.

[Mike Baker:]

Okay, so it sounds like, if I can follow up on that, almost reversing some of the things that have been done over the last couple of years, including the focus away from novice customers and more towards the core customers, which I think is a different strategy than what had been employed. When you think about all those things, how do you think about the long term margin of this company or this category? I mean, it has come down quite a bit. With these changes over time, do you expect the margins to go back up, or are we at a permanently slightly lower margin rate?

[Denise Paulonis:]

I think in terms of commenting on the shifts of the strategy and how that will play over the longer term in the P&L, I think I’d reserve to hold that until we’re going to talk more comprehensively about the strategy changes. That said, when you think about the margin performance over the last few years and the things that have been pressure points on the margin, there has been as many external factors as there might have been internal factors, so when we think about that, when we think about the gross margin and with our gross margin line having transportation in that, the headwinds from transportation have been a drag for the last 18-plus months, the introduction of tariffs has produced another external drag to those margins. I think as we watch the economic cycle over time, we would hope that those would ebb and flow over time, but in hopes of returning to less of a headwind onto the business as you go through the next few years.I think that we do still believe that there’s good potential in all of the sourcing efforts that we have. Every year, we continue to refresh the program and every year we’re able to use that to effectively deliver better value to our customers through that first cost effort, and I think that everything that Mark talked about on value perception and pricing and promotion, at the end of the day we do believe that there is efficiency to be had in the discount management practices that we have. So in total, we have things that are under our control, we have things that might not be directly under our control that are in the environment, but have no reason to believe that there are more big negatives to come in managing the margin.

[Mike Baker:]

Okay, thank you for the color.

[Operator:]

Our next question comes from Elizabeth Suzuki with Bank of America. Please go ahead.

[Elizabeth Suzuki:]

Great, thanks guys. How have in-stock levels been trending online since the shift towards managing all of your ecommerce in-house? I think one of the common complaints that we’ve seen in some reviews is that there’s a lot of great product listed online but it’s often out of stock. Is that something that you’ve seen impacting your sales levels?

[Denise Paulonis:]

It’s a great question, Liz. I think there’s a twofold answer to the question. One, when we introduced inventory visibility online about a year or so ago - I won’t get the date exactly right, but about a year or so ago, in part of that we did take a bit of a conservative view of showing the inventory we have online because it affects our Buy Online, Pick-Up In Store orders, and we would never want to disappoint a customer where maybe there was only one item available in the store of the SKU they want, and it’s sold by the time they place the order - that would be a big disappointment. So we do and we have seen some concern from customers that maybe that inventory availability, particularly on the Buy Online Pick-Up in Store piece, might feel a bit light.More broadly on our centralized ecommerce fulfillment, we really haven’t seen a change in in-stock levels in any meaningful way. The great news with our order management system is we have more flexibility on the nodes that we can use to fulfill those orders, so when we think about that more core part of the inventory, we haven’t seen a material change in overall availability. But we are very sensitive to and continue to work through ways to have that BOPUS or in-store level inventory not feel quite as restrictive to the customer as it does today.

[Mark Cosby:]

Just a little added color, that transition from third party to in-house was a significant transition, and generally when you make that type of a move, there are some bumps along the journey, which we did have a few - nothing significant, but a few. We’ve watched and we’ll continue to watch our in-stock levels improve as we get better at managing the DCs, but also managing the transition between store delivery, BOPUS and are omni-channel DC. I’d say we had some issues, but they’ve gotten better and continue to get better as we go into Q2.

[Elizabeth Suzuki:]

Great. Just one follow-up on performance of your main categories. What categories have been outperforming versus those that are underperforming? You mentioned some good trends in lower margin categories like storage and tools, but is there anything in décor, framing or core craft that you could break out?

[Denise Paulonis:]

I don’t think I’d say much more than what I did on the call. The more trending categories, which are the tools and technology space, craft storage, seasonal and décor broadly continue to perform well. Our core fine arts space, so art and drawing, is a nice healthy business. The places where there has always been a little more pressure of late over the quarters, which is core paper crafting, core jewelry making are places that we’ve seen a little bit more softness, but no new shifts in trend over the last few quarters in any meaningful way.

[Elizabeth Suzuki:]

All right, great. Thank you.

[Operator:]

Our next question comes from William Reuter with Bank of America. Please go ahead.

[William Reuter:]

Hi, good morning. I just have one question. You mentioned that you have $400 million of goods which are subject to the current tariffs. In the event that you were to expand the list, or if the list was to be expanded, could you comment on what types of additional products you do get from China that are not subject to the tariffs as of today?

[Denise Paulonis:]

I think the $400 million is well known because the list has very explicitly documented as to what’s covered under the tariff. I think the challenge is in a List 4 tariff - we have no idea what mix of products might or might not end up on that final list. I think that a lot of our private brand product is sourced from China, and that includes our more holiday and seasonal festive product. That would probably be the next biggest area that could have some increased exposure, but it’s not clear what would or wouldn’t potentially be on the list for those--for any future List 4 actions.I think it’s all just more of a fluid situation and we’ll wait and see what, if any, action actually comes to bear.

[William Reuter:]

Okay. I guess maybe asked another way, can you share with us the dollar value of total goods that come from China?

[Denise Paulonis:]

We haven’t shared that. As more information comes out, if there’s material input to provide, we will do that. I think about it more as give or take 60% of our merchandise is private brand and a good portion of that is sourced outside the U.S.

[William Reuter:]

That’s helpful, thank you very much.

[Operator:]

Once again, if you would like to ask a question, please press star then one.Our next question comes from Carla Casella with JP Morgan. Please go ahead.

[Carla Casella:]

Hi. You mentioned the success of BOPUS, and I’m wondering--you also talked about shipping from stores. Have you disclosed what percentage of your shipments today are coming from stores and where you think that could ultimately go?

[Denise Paulonis:]

Carla, we haven’t disclosed it. I think what we have talked about is that within our ecommerce system today, BOPUS penetration--there’s a huge penetration into our overall sales and orders. Give or take, BOPUS has become close to two-thirds of the order volume coming through, and it really is seasonal and dependent upon the time of year and where inventory is, kind of the ship from store versus ship from DC mix. I think the key piece is really the piece about how much the customer is willing to actually pick up in store through the BOPUS model, which is a core portion of the business that we’re really excited about.

[Mark Cosby:]

I think just in general, as you probably heard in the commentary, we’re pretty bullish on online as a growth for us over the long term, and a lot of it comes by the fact that we’re very under-penetrated versus the segment. I think this recent learning around BOPUS would tell us that the opportunity is probably even bigger than what we thought it would be.On the last call, we talked about the fact that the arts and crafts industry is in the high single digits in terms of penetration. In 2018, we’re around 4%, so that certainly tells you that we have a big catch-up opportunity, and then we have a number of initiatives that are in the works right now around improving the profitability, focused on fulfillment, shipping, gross margin.We think one of our big strengths is the fact that we can make the product available to customers in all the different ways, BOPUS being one of those big advantages. The business is performing well, we’re actively investing to grow it, and we feel very bullish about the future of our ecomm world.

[Carla Casella:]

That’s great. Can you also, or have you given any clarity on when you’re looking at the cost of an online purchase, BOPUS is clearly a lot lower cost to fulfill. Do you have a sense for the difference between a fulfillment center, ship from store versus BOPUS, the differential in cost or margin?

[Denise Paulonis:]

Yes, we talked about it more in terms of the tiering of the most profitable to the less profitable online orders, and when you really think about it, the most profitable is a BOPUS order. The next most profitable can be a mix, whether that’s ship from store or ship from DC, simply because you’re limiting the distance that that package has to travel when you’re shipping. Then the one that is more the higher expense is clearly the centralized fulfillment, because while you can get the full assortment that someone needs in general because it’s centralized, you’re going to be shipping across more zones, so that’s the tiering that we generally talked about, about the profitability, and I think just reinforcing why we’re very excited that our customer has responded well to BOPUS. We think that that’s a core part of the ecommerce growth going forward.

[Mark Cosby:]

The initiatives that we have in place targeted around improving the profitability will continue to get better and more impactful over time.

[Mark Cosby:]

In closing here, I want to thank you all for joining us today. I want to leave you with a few key thoughts. First of all, what I’ve learned in my first 90 days at Michaels has reinforced my belief that we have a significant opportunity to expand our leadership position within the arts and crafts channel and drive stronger growth over the longer term. We are not satisfied with our recent performance and we are proactively taking steps to improve the results. At the same time, we are pursuing our 2019 priorities and are confident that they will deliver stronger momentum in the second half, and we are working closely with the board to refresh our long term growth strategy to drive stronger growth in 2020 and beyond.We appreciate your interest in Michaels, and we look forward to talking to you on our second quarter call in early September. Thanks and have a great day.

[Operator:]

The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect your lines at this time and have a great day.