Michaels Companies Inc
Q2 2018 Earnings Call Transcript

Published: 30 Aug 2018

[Operator:]

Good morning. My name is Nicole and I will be your conference operator today. At this time, we'd like to welcome everyone to The Michaels Company's Second Quarter Earnings Conference Call. [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, Nicole. Good morning everyone and thank you for joining us today. Earlier this morning, we released our financial results for the second quarter of fiscal 2018. 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, 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, August 30, 2018. We have no obligation to update or revise our forward-looking statements except as required by law, and you should not expect us to do so. On today's call, we will reference non-GAAP financial measures, including adjusted EBITDA as defined in our credit agreement, and adjusted operating income, adjusted net income, and adjusted diluted earnings per share, all adjusted for the restructuring charge, losses on early extinguishments of debt and refinancing cost, and provisional tax adjustments as applicable. A reconciliation of these measures to the corresponding GAAP measures are detailed in today's earnings release. We'll begin this morning with highlights from Chuck Rubin, Chairman and CEO; and then Denise Paulonis, our CFO; will review our financial results and outlook in more detail. Following our prepared remarks, we will open up the call for questions. Now, I'd like to turn the call over to Chuck Rubin. Chuck?

[Chuck Rubin:]

Thank you, Kiley, and good morning everyone. As we've discussed for a few quarters now, all of our data continues to suggest that the growth trends in core arts and crafts products remain soft. Despite this challenging environment we delivered operating income in EPS for the second quarter that were slightly better than the guidance we provided in June. Before we dig into the specific results for Q2 I want to talk about what we're seeing in the arts and crafts industry as we know our recent comp performance hasn't been as robust as other retail industries. As I've said before, it's difficult to get real-time industry data and while we're the only public company in the space we believe sales trends for our big box arts and crafts competitors have also been stagnant. When we triangulate what we're seeing in our own retail direct-to-consumer brands, what we're seeing in our wholesale business which sells across mass online and/or channels, and what we're hearing from suppliers -- the data suggests that the core arts and crafts industry isn't currently growing total sales. And while other retail industries have seen consolidation of distribution points and/or store closings; we know the distribution points for arts and crafts products supplies are increasing. This is something we anticipated which led us to acquire Lamrite West two years ago. Today, all the arts and crafts big box players go-to-market in a similar way, with almost a singular focus on product and price; and yet we know the consumers in general are demanding more of a solution-based approach. We have done well with the enthusiast maker, and the investments we have made in omni-channel, CRM, and our store layouts have given us more capabilities and a stronger foundation for growth. Our success with this customer continues as we saw good sales growth in Q2. However, our success with the more casual customer has not been as robust and consistent, and we recognize that this customer may want a solution that is more of a do-it-for-me or do-it-partially-for-me instead of our historical focus on a do-it-yourself offering. We know the foundation we have built, one that includes industry leading private brands, a large brick-and-mortar footprint, and emerging digital capabilities as a strong one for the future. However, we also recognize that we need to consider some adjustments to our long-term strategy as it relates to how we think about attracting and retaining more casual customers when there isn't a hot trend to engage for interest. We are confident that our strategic foundation is strong but do expect to make some slight enhancements to better position us for this casual customer and we will continue to update you. Now let's talk about our Q2 results in a little more detail. Comparable store sales for the quarter decreased 0.4% driven by a decrease in customer transactions, partially offset by an increase in average ticket. Importantly, our sales trend improved as the quarter progressed reflecting better merchandise in stocks and enhanced omni-channel capabilities. On a calendar shifted basis, comp sales increased 0.3%. We delivered very strong e-commerce sales driven by enhanced searchability and an expanded assortment. While still a very small part of our total revenues; online sales in the quarter were more than double the level online sales in the second quarter last year driven by increased traffic and higher conversion rates. For reference, our online sales include Buy Online Pick-up In Store commonly known as BOPIS. From a category standpoint, seasonal decor custom framing technology and craft stores delivered strong comp store sales growth while other more traditional arts and crafts categories like jewelry and bakeware underperformed. From an investment perspective, we made good progress in executing our priorities in the second quarter. We successfully converted 238 stores to our flexible merchandising area or FMA format. This year we simplified the reset process and reduced the number of impacted categories making it less disruptive for the customer and easier for our teams to implement. While it's only been a few weeks since the conversion was complete in all stores, these stores are already outperforming the control group. We rebranded all of our Michaels custom framing shops as Aaron Brothers custom framing at Michaels. We've seen good sales transference from the closed Aaron Brother stores and believe we have opportunity to capture more. We upgraded our Canadian POS System and introduced Michaels Rewards to our Canadian customers. Leveraging our CRM data in new POS capabilities, we tested targeted messaging and serialized offers with encouraging results. We expanded the number of stores in our ship-from-store program. We now have more than 400 stores ready to fulfill e-commerce orders this holiday season enabling us to leverage store level inventory, deliver online orders to customers faster and better control our fulfillment costs. Overall, we anticipate that focus in ship-from-store could enable almost half of our online sales this holiday season. And finally, we also completed the retrofit of our alliance distribution center to support the insourcing of our Michaels e-commerce business giving us the foundation to pick-pack and ship items to fulfill a customer order. While we won't shift away completely from our third-party provider this year we will begin to ramp up service from our Alliance DC as an additional fulfillment node to support expected growth this holiday season. Finally, recognizing that the second quarter is the smallest fiscal quarter for us we chose to test a number of different promotions as we get ready for the large volume weeks and months in the second half of our fiscal year. Some of these tests met our expectations, some did not; net-net, we got smarter but we saw increased pressure on our merchandise margin in the quarter. While we are only a few weeks into the third quarter we are encouraged by recent sales results and we are confident that our focused efforts to make it easier for customers combined with what I think is an outstanding seasonal assortment, will deliver stronger trends in the second half of the year. Towards the end of the first quarter, we introduced BOPIS in all of our U.S. stores to make it easier and more convenient for customers to shop. We are pleased with how our teams executing and how well our customers are responding to this new convenience. About one-third of our e-commerce sales in the second quarter were picked up in stores. We're also pleased with the trend of add-on purchases when customers come to the store to pick up their e-commerce order. We continue to enhance The Michaels app to make it easier for customers to find what they need in our stores. In the first quarter we added visual search capabilities to enable customers to use their smartphone camera and pictures to search our library of products and projects. This quarter we're launching verbal search to make it easier for customers to search for what they want, and we're beginning to leverage messaging and The Michaels app to highlight current promotions when the customer uses the app in-store. We know kids are a big trip driver for the casual customer, so we are making it easier for customers to find family friendly toys, activities and supplies at Michaels. Our goal is to be the preferred destination for screen-free creative play. Taking an omni-channel approach we are rebranding our in-store presentation and launching a new microsite called michaelskids.com with more than 3x the number of in-store SKUs michaelskids.com will offer customers an expanded breath of what we offer in-stores, as well as new categories that inspire creativity and imaginative play. To make it easier to shop our online assortment customers can search by category or age and similar to michaelsweddings.com customers can use Michaels coupons, utilize an integrated shopping cart, leverage BOPIS or take advantage of free shipping on thousands of items. In-stores we are adding 600 new SKUs and are resetting the kids category to create more intuitive product adjacencies based on a specific shopping mission. We've added a new basic craft section and expanded our assortment of compounds, stem kits, and national brands like Lego. We've created a new school project session to include everything a parent needs to create a diorama or foam solar system, and for teachers who represent nearly 4% of our customers and an even greater percent of our sales; we've launched a new classroom decor program in an expanded assortment of storage. Building on the improvements we've made in custom framing in the second half of fiscal 2018, we will add new capabilities to make it easier for customers to custom frame their pictures and artwork. On aaronbrothers.com we're offering new substrates to print-on including wood, metal and acrylic, and we have introduced BOPIS for custom framing, so customers can pick up their projects in their local Michaels store. In-stores customers will be able to upload pictures from their smartphones into our proprietary design system where one of our personal custom frame designers can work with them to create a custom frame. We remain focused on strengthening our value perception, customers continue to respond well to our Everyday Value or EDV program which delivers great prices on basic crafting items every day without the need for a promotion. Based on customer response we have expanded this program. Today our EDV program includes nearly 1,500 items across multiple categories and continues to drive nice sales and gross profit dollar growth. In-stores we've recently created new merchant stackouts to highlight key basic items like bulk canvas where wood crates at clear sharp prices. We've also expanded our assortment of bulk buys, both in-stores and online. We know from our customer analytics that our casual customers who generally only shop us once or twice a year are more likely to shop us in the third or fourth quarter when seasonal décor, school projects, and holiday are more likely to drive trips. This year we have expanded our seasonal assortment and presentation, both in-stores and online, and made it easier for all customers whether they are enthusiast or novice makers to find and get what they need. Each year we have improved our holiday assortment and this year we have the biggest and best holiday assortment whatever [ph] offer the customer; and with more than 700 stores leveraging the flexible merchandise area format we will be positioned to present stronger, more cohesive seasonal statements to customers and more stores this holiday season. Starting with Fall and Halloween, we've expanded our offering of home decor adding new exclusives from Lee Max [ph] and Martha Stewart, and increased our use of compelling even dollar price points throughout the store to create a compelling value message. For holiday, we've again expanded our selection of trees, ornaments and home décor, all with clear even dollar price points to reinforce value and we've simplified our in-store presentations to make it easier for customers to shop. Online all the enhancements we've made this year to michaels.com to improve navigation and discoverability combined with the assortment expansions like Hancock Fabric, Bulk Buys, michaelsweddings.com, and michaelskids.com help us deliver more convenience and value for the customer this season. And the addition of BOPIS on all stores gives us another way to make it easier for customers during this busy time of the year. To communicate our compelling seasonal assortments and the benefits of all the customer facing investments we've made, we have strong marketing support planned for the second half of the year. We are not increasing our overall marketing spend but are shifting dollars away from traditional print circulars to other media including television and digital to target customers better. We plan to increase our use of television advertising to support key events like our lowest price of the season and holiday, we will continue to use mass market platforms like Good Morning America, and we will offer more digital content including new make-ops with Busy Philips, new videos with Martha Stewart, and more Facebook live videos to highlight our assortment and how easy it is to make with Michaels. In addition, we have produced new decor guides for fall and holiday, as well as a new kids' focused gift guide, and we will offer even greater value to our customers through a number of new gift with purchase offers. Finally, we will leverage our extensive CRM capabilities to target our messaging and drive sales and traffic. Today we can link 74% of our transactions and 83% of our sales to a unique customer who are expanding customer analytics, we are starting to identify specific customer insights and will continue to improve in using these insights to target customers with more personalized or effective communications based on their previous shopping habits and preferences. In closing, while comps for the first half of the year were flat we remain confident our trend will improve in the second half. We have an outstanding seasonal assortment with strong marketing support, we will have more omni-channel platforms to meet customer needs including michaelsweddings.com, michaelskids.com, and enhanced offerings on michaels.com and consumercrafts.com. We have BOPIS on all stores offering customers an easy and convenient way to shop. We have more than 700 of our stores with the flexible merchandising area format as we head into the most important seasonal period of the year. We have more EDV items, more clear even dollar price points, and more bulk buys to reinforce the value we offer. We have stronger CRM capabilities to target our customer communications and we have 50,000 engaged team members who are excited to help make it easier for our customers this holiday season. We are encouraged by recent sales trends and believe the investments we have made this year to make Michel's easier to shop will help us deliver our revenue and earnings expectations for the second half of fiscal 2018. Now, I'll turn the call over to Denise for a more detailed discussion of our second quarter financial performance and outlook. Denise?

[Denise Paulonis:]

Thanks Chuck, and good morning everyone. Starting with sales; net sales for the second quarter were $1.05 billion, $19 million less than net sales in the second quarter last year. After considering the $27 million decrease in sales related to the closure of 94 of our [ph] Aaron Brothers stores in the quarter, total sales increased $8 million and comp store sales decreased 5.4%. The ex-Aaron Brothers sales increase was driven by the operation of 21 net additional Michael stores opened since the second quarter of fiscal 2017 and an increase in wholesale revenues. As a reminder, fiscal 2017 was a 53-week year and we are not restating our comp sales reporting period. In other words, our Q2 comp sales reflect the comparison of April 30 through July 29 last year versus May 6 through August 4 this year. As Chuck mentioned earlier, if we compare the 13-week period ending August 4 this year to the comparable 13-week period ending August 5 of last year, comp store sales would have increased 0.3%. During the quarter the company opened nine new Michaels stores, closed one Michaels store, and relocated seven Michaels stores. I want to note that included in the count of new Michaels stores are three small-format Aaron Brother stores which have been integrated into the Michaels stores organization. So at the end of the quarter we operated 1,251 Michaels stores and 36 packet-hand [ph] stores. Gross profit was $373 million compared to $403 million in the second quarter of fiscal 2017. As a percentage of sales, our gross profit rate for the quarter was 35.4% versus 37.5% last year, a decrease of about 210 basis points. To learn what we saw in Q1, the decrease as a percentage of net sales was primarily due to expected factors including higher distribution related costs and occupancy cost deleverage. In addition, we saw merchandised margin pressure from higher promotional activity and a higher mix of technology products would generally have a lower merchandise market. As Chuck discussed, we saw an opportunity to test different promotional vehicles during the quarter to help us learn more about what motivates our customers. Partially offsetting these factors our sourcing initiatives continue to deliver nice benefit. As we discussed last quarter, we recognize supply chain costs when product is sold, we expected increase in distribution related costs in Q2 reflects the remaining flow through of higher supply chain costs incurred in the second half of fiscal 2017 related to the hurricane destruction to our Jacksonville D.C., as well as higher transportation costs reflecting tighter overall capacity and higher spot rate. Total store rent expense for the quarter was $101 million versus $98 million last year. The increase in store rent expense was primarily due to a net 21 additional Michaels stores, partially offset by a decrease in rent associated with the Aaron Brothers store closures. SG&A expense including store pre-opening costs was $302 million or 28.7% of sales compared to $315 million or 29.3% of sales last year. The decrease in SG&A was primarily due to an $11.5 million decrease in performance based compensation and a $9 million decrease in expenses related to the closure of 94 full-sized Aaron Brothers stores. The decrease was partially offset by $4 million in higher marketing expenses in the quarter resulting from increased digital marketing, partially offset by decrease in print advertising. For the full year, we continue to expect advertising expense will be approximately flat as a percentage of sales. Regarding performance-based compensation, we're lapping some timing differences in the second quarter and third quarter of last year related to our bonus accruals. For the full year, we expect performance-based compensation will become comparable to last year. However, in Q2 performance-based compensation was a benefit to SG&A compared to last year, and in Q3 we expect it will be more of a headwind. Operating income was $74 million compared to $88 million in the second quarter last year. During the quarter, we recognized a $3 million gain primarily related to the settlement of lease obligations associated with the closure of 94 full-sized Aaron Brother stores in the first quarter. Excluding the $3 million gain, adjusted operating income for the quarter was $71 million. Interest expense increased $6 million to $37 million from $31 million last year due to higher LIBOR rates assisted with our variable rate term loan, as well as settlement payments associated with our interest rate swaps. Recall that early in the second quarter, we amended our term loan to reduce the interest rate to LIBOR plus 2.50% from LIBOR plus 2.75%. As a result of this transaction we recognized a loss on the early extinguishment of debt of approximately $2 million in the quarter. The effective tax rate was 24% compared to 36% in the second quarter of last year, primarily due to a reduction in the federal tax rate in connection with the enactment of the Tax Act. Net income was $27 million or $0.15 per diluted share compared to $36 million or $0.19 per diluted share in the second quarter last year. Excluding the gain related to the settlement of lease obligations associated with the closure of 94 full sized Aaron Brother stores and the losses on early extinguishments of debt and refinancing costs, those net of taxes, adjusted net income was $26.4 million or $0.15 per diluted share. Diluted weighted average common shares during the quarter were 178 million shares compared to 188 million shares last year. During the quarter we entered into an accelerated share repurchase agreement commonly referred to as an ASR to purchase approximately $250 million of our common stock. Pursuant to this agreement, we paid $250 million and received an initial delivery of approximately 10.7 million shares. We expect the final settlement of the ASR transaction including receipt of the remaining shares will occur in the third quarter. Once the ASR is complete, we expect to have approximately $100 million remaining under our current share repurchase authorization. As expected, total merchandise inventory at the end of the quarter increased 7% to $1.28 billion compared to $1.2 billion last year. The increase in inventory was primarily due to inventory associated with the operation of 21 net additional stores and increased inventory to facilitate stronger in-stocks and better inventory flow for the holiday season. As we discussed last quarter, we pulled forward some core item received into the second quarter just to move out the flow of freight into stores for the holiday season. The increase was partially offset by a decrease in inventory related to the closed Aaron Brother stores. Average inventory per Michaels store including inventory for e-commerce, inventory in distribution centers, and inventory in transit was 6.6% higher than at the end of Q2 last year. We continue to expect inventory at the end of Q3 will be back to a more normal level. We entered Q2 with $123 million in cash on our balance sheet and $645 million available under our revolver. Total debt at the end of the quarter was $2.8 billion, our total debt to adjusted EBITDA on a trailing 12-month basis was 3.3x, and our trailing 12-month interest coverage was 5.1x. Our return on invested capital adjusted of the restructuring charge for the trailing four quarters was approximately 27%, well above our cost of capital of approximately 6%. Capital expenditures year-to-date through the second quarter totaled $70 million reflecting increased investments in technology projects, including investments to support the insourcing of our e-commerce fulfillment, and investments in new and relocated stores. For the full year, we continue to expect to invest $160 million to $170 million in capital expenditures. Now let me walk you our guidance for the third quarter and full year. As a reminder, our guidance of -- the Aaron Brother stores were closed at the start of the fiscal year and excludes any restructuring charges, provisional tax adjustments, and any onetime costs associated with debt refinancing. So let's start with the full year; our expectations for comp store sales growth have not changed. However, we have increased our full year EPS guidance by $0.10 to reflect three changes. First, higher than anticipated distribution related costs which we anticipate realizing primarily in the third quarter; we expect this will negatively impact full year diluted EPS by about $0.04. Second, a lower effective tax rate which we expect will benefit full year diluted EPS by about $0.02. And third, the estimated full share impact of the ASR which we expect will benefit full year diluted EPS by about $0.12. Let me take a minute to talk about our expectations for distribution related costs. While we initially contemplated $10 million to $15 million in incremental transportation expense in fiscal 2018 related to increased international rates and higher domestic carrier rates, we are seeing additional pressure from rising fuel costs and increased small partial shipping costs, as well as more impact from higher domestic carrier rates than we originally planned. In addition, as we've moved higher levels of inventory through our system to facilitate better in-stocks and inventory flow, and also manage key supply chain initiatives including the retrofit of our alliance distribution center to support e-commerce fulfillment. We've incurred higher than planned D.C. and transportation costs. We now expect distribution and transportation costs will be approximately $10 million or $0.04 per diluted share higher than our initial expectations for fiscal '18. With that as context for fiscal 2018 a 52-week year, we continue to expect total sales will be between $5.2 billion and $5.3 billion, and comp store sales will be flat to up 1.5%. This guidance includes our plans to open 19 net new Michaels stores and relocate 21 Michaels stores. We expect adjusted operating income for the year will be between $667 million and $700 million. As a reminder, this guidance includes a temporary headwind of $23 million of investment to support longer term profitable growth facilitated by the Tax Reform benefit. We expect net interest expense will be approximately $144 million reflecting an acceptation for two additional rate increases as implied by the current LIBOR curve. We continue to receive additional clarification on the Tax Act and now estimate that our go-forward effective tax rate will be close to 23% compared to the 24% we had previously estimated. However, our effective tax rate may differ from this estimate if there are changes in interpretation or additional guidance issued related to the Tax Act. All of these assumptions translate to an adjustment diluted EPS range of $2.29 to $2.42 for the fiscal 2018 on approximately 176 million diluted weighted average common shares for the full year. This expectation for the share count includes the anticipated full impact of the ASR which will settle in the third quarter but does not include the impact of any additional shares we may repurchase this year. For the third quarter we expect comp store sales will increase between 1.5% and 3%. As a reminder, we have not restated last year's comp store sales reporting period to align with this year's calendar; so our Q3 comp this year will reflect the 13-week period ended November 3, 2018 compared to the 13-week period ended October 28, 2017. As a result, sales from the Halloween and our Annual Holiday Tree event which kicks-off on October 28 will fall into the third quarter this year; conversely, Q4 comp sales will be negatively impacted by the timing shift. We plan to open five net new Michaels stores, and relocate another five stores in the third quarter. Last year in Q3 we opened seven new Michaels stores, one new [indiscernible] store and relocated four stores. For modeling purposes; Aaron Brothers delivered approximately $25 million in sales in the third quarter last year. We expect adjusted operating income for the third quarter will be between $131 million and $138 million. For modeling purposes we expect Q3 gross margin rate will be lower than last year reflecting higher distribution related costs and the continued execution of our investment agenda partially offset by sourcing benefits. Our Q3 guidance for adjusted diluted earnings per common share is $0.42 to $0.45 assuming diluted weighted average common shares of $171 million. While we're not providing exclusive Q4 guidance today our full year guidance implies operating margin expansion in Q4 on a comparable 13-week basis. This reflects less incremental spending to support our investment agenda in Q4 and less margin pressure from distribution related costs than earlier in the year as we anniversary the flow through of higher distribution and transportation costs in Q4 last year. As previously disclosed, the extra week in the fourth quarter last year contributed approximately $79 million in sales and approximately $27 million in operating income. Before we take questions, I'd like to make a comment about the latest round of proposed tariffs that are scheduled to take effect in October. To this point, the number of SKUs impacted by the first two rounds of trying to tariff impacted less than 1% of our cost of goods; so as it relates to fiscal 2018 we don't expect much financial impact. However, the expanded list of proposed tariffs which are scheduled to be implemented in October will impact more of our assortment. Based on our analysis of the products we currently sell that are manufactured in China, both what we source directly and what we buy from domestic suppliers, we estimate that approximately $400 million of our product costs would be subject to the tariffs as currently proposed. Given the timing of their potential implementation, we expect only minimal financial impact to our fiscal 2018 results. However, it's difficult to quantify with certainty their impact beyond this year as these tariffs have not been finalized. We are closely monitoring the tariff discussions and are actively working on mitigation strategies. In general, we continue to believe that our size and scale, our sourcing capabilities, the low average item price and the high penetration of private brands in our assortment gives us a number of levers to manage the impact of commodity costs increases and tariffs. Our larger concern is the longer term impact on consumer spending as consumers will likely have to spend more overall for everyday consumer goods. In closing, when we started the year we shared our plans to leverage some of the benefits of tax reform and accelerate our investment into the business. Half way through the year, we're doing just that and have delivered operating income at the high end of our guidance and EPS that has exceeded our guidance. As we turn the second half of the year, we're focused on continuing to execute our plan and look forward to serving our customers throughout our peak selling season. Now, I'd like to open up the call to take questions. Operator?

[Operator:]

[Operator Instructions] Our first question comes from Simeon Gutman of Morgan Stanley.

[Simeon Gutman:]

My first question for you Chuck is; you talked about that through your channel knowledge the industry looked soft. Curious, if you can maybe diagnose why do you think it's soft if -- I guess customers are just looking elsewhere other categories, it's just not enough product trend at the moment; any diagnosis would be helpful.

[Chuck Rubin:]

I think it's a little bit of what you said and more. We do think it's overall rather stagnant industry, there is no hot trend -- you know, using the terminology we've used before, we don't see any home runs or triples this trends within individual departments that the enthusiast is reacting to but nothing that's broad-based for the casual customer. As I mentioned in the prepared comments, we are seeing more distribution points, we have through our wholesale business either opened or expanded the number of accounts, we knew that the high margin and nature of this business would likely make it attractive for others to skim pieces, no one is getting into the full assortment but people are skimming pieces. So you have a stagnant industry, more distribution points, and it's causing some challenge. The other point that I talked about is, the segmentation of our customers. We continue to do very well with the enthusiast, that person is really into making homemade products, we're doing very very well with her, it's the more casual customer; and while we're making progress on some of the convenience aspects to make it easier for her, we're increasingly of an opinion that while some casual customers want a DIY solution there is certainly a portion of them that are looking for things that have more of a do-it-for-me or do-it-partially-for-me orientation, and I think that's what we've got to step up. As we do that we think that we'll be able to take some additional business with this casual customer.

[Simeon Gutman:]

My follow-up is two parts; first, why do you think growth has rebounded in the third quarter? Is it more of what you're doing or does the industry seem a little stronger and realizing it's only a few weeks? And then the second part is just on freight; I don't know if we've talked about this in the past but can you just give us some parameters -- what percentage of your sourcing or distribution is third-party? I think of significant amount how much you contract first the spot market, the length of your contracts? And then outside of fuel, are you -- what gives you comfort that this is the -- this won't be a recurring surprise?

[Chuck Rubin:]

I will take the first part and I think Denise will step in on the second. So we go into the back half of the year, we've seen this movie before in many ways; the casual customer we ask when either there is a need for a hot trend or a solution to something that she can do easily. So right now our back-to-school business is quite good, we're pleased with how that's going; so there is that need opportunity if you will that she's getting ready for that back-to-school window. Our seasonal business is kind of that do-it-for-me or do-it-partially-for-me solution, it's an easier creative solution when you're decorating your home for Halloween or for fall or for Christmas, and we've gotten exceedingly good at that type of business, and it fits with that casual customer. So you know, our challenge continues to be for us in that casual segment much more in the first half and the back half because we have the natural calendar to help with that casual customer and it matches with the product and the solutions that we put forth. So that gives us great confidence. On the second part, Denise?

[Denise Paulonis:]

Simeon, let me talk about freight a little bit. You asked a lot of questions, so I'm just going to step back one and give you the broader view of how we see freight. Up through most of the second quarter of this year, we were primarily using spot rate freight shipments going through, so we did not have dedicated carriers carrying our product, and in general, that had served us quite well in terms of being able to be efficient and how we would go and contract for carriers. By the end of the second quarter and now coming into the third quarter, we have a dedicated fleet going into place and so plus 80% of our volume going forward is going to flow through dedicated fleet where at least for the cost of the capacity itself we're going to have much more predictability about what that point to be than what we had through most of Q2 and all of last year. With that said, there is two other pieces that are also weighing a bit on transportation. First is fuel costs; so fuel costs are not necessarily built into those contracts associated with the dedicated fleet, and so we do still have exposure to fuel costs as they might rise or fall. We continue to look at plans on how we might offset that a bit but we're still at the mercy of a bit [ph] where fuel costs will go. And then finally, we have also continued to see pressure on small parcel [ph] rates; that shouldn't surprise any of us as that many more things continue to get shipped around the U.S. but we have just gone through a recent negotiation and settled on a set of new rates with our small parcel carriers, so we now have more predictability about what those will be going forward but they do continue to increase as well. Hopefully that covers off all the points on freight you're looking to understand.

[Operator:]

Our next question comes from Steve Forbes of Guggenheim.

[Steve Forbes:]

Over the focus on the second half gross margin outlook; so you talked about the $10 million increase in distribution costs, how much of that hits in the third quarter? And then as we move to the fourth quarter, should we expect the steep change in the trajectory of the gross margin profile? I think the guidance implies that but wanted to see if we can get some color here just given the three pressures you called out within the release.

[Denise Paulonis:]

Starting with the third quarter; when we think about the third quarter most of the increase in the supply chain cost that we indicated we do expect to see come through in the third quarter and that's a bit of new news compared to the last time we provided an update. More broadly than that gross margin for the third quarter while we don't expect it to be the drag that it was in the second quarter, as we mentioned in our prepared comments, we do still believe that it will be slightly negative. So that's going to reflect the supply chain costs, some of the continued investments that we're putting through the business but it's going to be nicely offset by the sourcing benefit; so we still do believe that there will be a lot of sourcing benefit come through not only in the third quarter but also in the fourth. And then if you look at where we're trending for Q4 versus Q3, there is a couple of important things that happen. One, as we mentioned our investments; our $23 million in investments are front weighted into the year, so those investments are lower in the fourth quarter versus the third quarter. And then as I mentioned on the call and the script; our third quarter -- we are also still incurring those higher supply chain costs, as we move into the fourth quarter, we're going to start lapping the increasing costs from last year, or so from Q4 2017, and so while strange to think about it that way, it's actually a bit more of a tailwind versus the headwind that it's been year-to-date simply because we're lapping those expenses.

[Steve Forbes:]

You mentioned trying to reengage the casual consumer, so are there any changes to this year's resets as early as the holiday, are you going to bring in earlier to try to drive engagement with the casual consumer? And then, how do you plan on incorporating some of those promotional test that you ran this past quarter?

[Chuck Rubin:]

So the additional FMA pads, so we now have close to 700 -- about 700 stores with the FMA pad. So that is up give or take a third of what -- actually close to 50% over what we had last year. The FMA pad is an easier pad, it shows seasonal product better than a traditional set; so that's one point. We have tried to simplify our pricing, we have a lot more rounded price points, even price points we have stack-out programs on higher velocity items that also are set up in the stores now. So each of these are things that from a product standpoint we think connect better with the casual customer, and we're also going back and revisiting some of our marketing approach; both in the type of copy that we send out to a customer, and sometimes our copy is very attuned to an enthusiast but not as understandable by a casual customer, so how we're doing that. And some of our media shift that we talked about, we're spending a little more money on some mass market to speak to that casual customer maybe in a different way than a Sunday newspaper tab has been able to do. So a lot of levers that we're pulling for the back half of this year and we anticipate there will be some additional things as we look into 2019 that we'll talk about on a later call.

[Operator:]

Our next question comes from Matt Fassler of Goldman Sachs.

[Matt Fassler:]

For my first question, I would like to follow-up on the comments you made on promotional activity. If you could talk about the timing of when you decided to pursue a stepped-up program and perhaps talk about the efficacy of the price cuts to the promotions when you chose to take them?

[Chuck Rubin:]

A good number of them were post the call -- post our last earnings call. Q2 being a low volume quarter getting ready for the higher volume times later in the year, we thought it was an appropriate time to try a few things; we had a version of our lowest price of the season event that we run in the spring and the fall that we kind of a scaled down version but we did something for the summer timeframe, we had another event where we gave out a gift card. So we tried some of these things recognizing that the upside or the downside wouldn't be huge but the learning could be quite valuable for the balance of the year. And net-net, while we learned a lot of things it was more of a dream than a help on our second quarter performance.

[Matt Fassler:]

So is that -- is it something that you're going to pursue going forward, it sounds your inclination would be not to continue any promotional program?

[Chuck Rubin:]

I wouldn't say it's stepped out, I guess in some ways we stepped up a couple of things but we were trying to look at different ways of running a promotion with a customer to see what -- how a customer would respond. I wouldn't categorize our approach in Q2 or the industry overall as being a whole lot more promotional than it has been, it remains a very promotional industry. So these were different ways of trying to attract the customer that -- as I say, we learned a lot and as we have done in the past, when we've done something that hasn't worked we don't go back and do the same thing again, we either make an adjustment or we kill it; and that's what I would expect out of those couple of events that we did in the second quarter.

[Matt Fassler:]

You mentioned marketing a screen-free program that you develop for Michaels Kids and also we haven't spoken much in the context of Michaels about the Toys R Us liquidation but what was that -- really the headquarters for kids markets from a consumer perspective is now gone. If you think more broadly about the market opportunity on the kids side, I know kids have always driven lots of your business; in any event is there an opening here for you to step into that role at least for a piece of the mix that Toys may have once served?

[Chuck Rubin:]

Yes, I think a lot of retailers are going to be looking to pick up a piece of it but our view is, our place should be in that creative piece of the kids industry; so I wouldn't expect for customers to see video games for instance from Michaels. But -- I think our assortment will skew on the younger age of the spectrum, it will focus more on educational creative elements of the toy market, it will introduce some brands like Lego that we haven't historically carried in the past. So more along the proverbial stem-type products but much more on the creative educational side of the spectrum as opposed to the true video or toy kind of spectrum -- into the spectrum.

[Operator:]

Our next question comes from Christopher Horvers of JP Morgan.

[Christopher Horvers:]

Sort of a clarification question and then a bigger picture question. So the first question is to verify the decline in the operating income guidance for the year; it's all distribution cost, it's nothing related to the promotional pressures or the promotional outlook for the back half as you just talked about? And then checking our math, does the comp outlook for 3Q in the year imply about 0.7 comp for the fourth quarter? And could you quantify the potential weak shift impact in the third and fourth quarter?

[Chuck Rubin:]

I will take the first part, I want to make sure there's no confusion. The margin pressure that we're having is distribution related, these are supply chain pressures. We are not anticipating a more intense promotional environment, our testing in the second quarter was not an intent to step up what we planned on doing in the back half for the year, the intent on our promotions in the second quarter were to get smarter on the type of promotion, not on the quantity of promotion.

[Denise Paulonis:]

And then, the second part of your question which really got to an implied guide for Q4 comp given what we've put out for Q3. The way that I would really characterize this is Q3 does have this one week timing shift that is beneficial to the third quarter, and so that is both where Halloween fits but also our Holiday Tree event that is a pretty sizeable event for us, and that's shifting as goodness in the third quarter from the fourth quarter. We're not going to give explicit guidance to where we are with the fourth quarter but directionally, the math at the midpoint of our guidance would say the fourth quarter would be slightly positive which is I think in line with the direction that you were headed but we would just kind of keep the range that we had it there; so you can think about that really as being the comp shift between the quarters. I think the other important part that I'd mention is what we're bit more focused on is; if there is a bit of a change in trajectory from the first half of the year to the second half of the year, and that second half of the year where we feel better in total about worse is where we were in the first half. We pick up a bigger portion of seasonal as part of our business and our novice customer still responds quite strongly to that seasonal process. FMA and the set of all the additional stores that we have done gives us a source of advantage there, and we've talked about this omni-channel and kids activity which is also a change for us as we move into the back half of the year. You combine that with new capabilities like Buy Online Pick-up In Store, more value messaging, and more capabilities tied to our CRM efforts and marketing; and so what we really want people to understand is why since the beginning of the year we've communicated that H1 is going to be a little bit lighter and in H2 you will see an in-aggregate pick-up. So with that it's just that timing difference of the third quarter/fourth quarter weak shift that is really causing a bit of a noise between the two quarters.

[Christopher Horvers:]

So bigger picture question; looking back to when you joined the company Chuck, it looks like the average store carried about 39,000 SKUs. A year ago in this call you talked about 50,000 SKUs and you mentioned you're adding more here. So can you talk about -- is that accurate? And can you talk about your ability to continue to add SKUs, and has that been mainly in seasonal and that's what's really been a big comp driver over the past five years?

[Chuck Rubin:]

So few things; while we're adding SKUs, the greatest SKU count addition is online, we are adding a kids SKUs in-store. I would not equate that to additional SKUs for the total brick-and-mortar store though. They were added to go on elsewhere. There are -- the number of SKUs in a store will vary based on the time of the year, it does tend to range around 50,000 SKUs. I don't anticipate that SKU count getting a lot higher, quite honestly, if anything it will come down maybe slightly but here again, I don't view that as a material shift.

[Christopher Horvers:]

And was that addition over the past five years mainly in seasonal?

[Chuck Rubin:]

You're catching me off-guard, the 30,000 five years ago, I'm not sure that number is -- I'd have to check that number, I don't think we've added -- that would imply roughly one-third increase in SKU count and I don't think that's accurate, but we can follow-up offline, but we have certainly added seasonal SKUs as we've expanded that business but it has in many ways come as a reduction of SKUs in other departments. We have sized down some other core crafting departments that have been challenged in their performance for an extended period of time.

[Operator:]

Our next question comes from Laura Champine of Loop Capital.

[Laura Champine:]

Thanks for taking my question. I wanted to talk to the extent that you can about changes in your store economics with the potential pickup of some business that was going to the Aaron Brother stores and the resets -- what changes do you see as you reset your stores or perhaps pick up some volume from the stores that you've closed?

[Denise Paulonis:]

So overall when you think about the closure with the Aaron Brothers, 94 full-sized stores, we have seen a nice transfer of that sales volume into our Michaels stores, we thought there was real merit in rebranding inside of our Michaels stores for those customers who really understand that Aaron Brothers experience, and we've seen positive transfer there. I think more broadly, what I want to mention is that outside of the Aaron Brothers transfer of custom framed volume into the stores, we have seen our comp sales and custom frame be positive as well. So not only does the Aaron Brothers stance will help us but we've also done two other things; we had made some changes late last year in our pricing and assortment, and we also changed a bit of our selling model and a senior leadership support over that space in the field; both of which we think are also delivering positive results in addition to a bit of the tailwind from Aaron Brothers.

[Laura Champine:]

Got it. And then on the store resets, do you see a significant lift in your sales trends and productivity. Our margins in the store resets…

[Denise Paulonis:]

We've seen nice performance out of those resets. So in the set we just did we're very pleased to see that we've seen a bit of an uptick in our seasonal performance which is primarily what comes into that reset space at the front of the stores this time of year and we have not seen the disruption that we saw when we did last set of stores because we actually chose to move fewer things in the stores to have less disruption for the customer. But if you trace back to the set we did before that that's now been a year plus in running; we still see good performance with those stores. So with over half the chain now in that format, we're pleased with the performance that FMA provides us. Nicole, I think we have time for one more question please.

[Operator:]

Our next question comes from Mike Baker of Deutsche.

[Mike Baker:]

A couple of just our clarifications or quantifications, can you talk about the impact of the change in timing of marketing costs if they are up in the second quarter and flat for the year, does it shift somewhere in there and same on incentive comp please.

[Denise Paulonis:]

Sure, so on the marketing costs for the full year we are expecting it to be flattish, we're talking plus or minus a couple of million dollars by quarter, and so I think we were down a little in the first quarter as we go into the back half of the year or just even itself out, so it's not going to be a material shift on the incentive competitive, it's an important one to call out that when you look at the $11.5 million that was a positive help to SG&A in Q2. A good amount of that we'll reverse in the third quarter. So it's just a timing shift from last year where there was a bit of a different cadence in that accrual last year and this year as we accrue with our operating income you're going to see that that headwind come to us in the third quarter, but for the full year work we're expecting incentive comp to be comparable to last year.

[Mike Baker:]

And so presumably no impact to fourth quarter on a year-over-year?

[Denise Paulonis:]

Minimal, and as you would guess the fourth quarter will be the one where we true-up our full year performance versus our plans. So that would be the larger effect versus any of the laughing of last year's accrual, right.

[Mike Baker:]

And last, but one more if I could. Have you discussed the cadence -- I don't think I heard of the cadence of comps through the quarter. Sounds like from your press release, it did get better through the quarter, but any sort of color or quantification of that?

[Chuck Rubin:]

Each month got better Mike, within the quarter.

[Chuck Rubin:]

Well, I want to thank everybody for joining us this morning. As we close, I do want to extend my sincere thanks to the team of 50,000 dedicated team members that we have that work throughout Michaels to make us the leader in our industry. We are encouraged by our recent sales trends and believe the investments we'd made will help us deliver our revenue and earnings expectations for the second half of fiscal 2018. And we look forward to giving you another update in our progress when we report Q3 in early December. Thanks very much for your interest.

[Operator:]

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.