Michaels Companies Inc
Q2 2017 Earnings Call Transcript

Published: 24 Aug 2017

[Operator:]

Good morning. My name is Anita and I will be your conference operator today. At this time, we'd like to welcome everyone to The Michaels Companies Earnings Conference Call for the Second Quarter of Fiscal 2017. All lines have been placed on mute to prevent any background noise. [Operator Instructions]. Please note this event is being recorded. Thank you. And now, I'd like to turn the call over to your host, Kiley Rawlins, Vice President of Investor Relations and Communications. Ms. Rawlins, you may begin the conference.

[Kiley Rawlins:]

Thank you, Anita. Good morning everyone and thank you for joining us today. Earlier this morning, we released our second quarter financial results. 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 statement 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 24, 2017. 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. In today's earnings release, we have presented non-GAAP financial measures such as adjusted EBITDA, as defined in our credit agreement; adjusted operating income; adjusted net income; and adjusted diluted earnings per share. Adjusted operating income, adjusted net income and adjusted diluted earnings per share have been presented to reflect our view of our ongoing operations by adjusting for non-recurring inventory related purchase accounting adjustment and non-recurring integration costs and benefits associated with the February 2016 acquisition of Lamrite West. A reconciliation of these measures to the corresponding GAAP measures can be found in today's earnings release. Our call today will begin 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, the call will be opened for questions. As a reminder, we would appreciate it if participants could limit themselves to one question and one follow-up question. I'll now turn the call over to Chuck Rubin. Chuck?

[Chuck Rubin:]

Good morning. Thank you, Kiley. This morning we reported record sales and earnings per share for the second quarter which was above our original guidance. For the total quarter, total sales increased 1.2% or 1.3% on a constant currency basis. Comparable store sales increased 0.6% or 0.8% on a constant currency basis and diluted earnings per share increased 12% to $0.19 per share. Our second quarter results demonstrate that we’re seeing an impact from our strategic initiatives while we still have opportunities to get better, I am encouraged by the quality of these results, in particular our transaction driven comp increase which was delivered with accompanying gross margin expansion. We believe that our efforts to create a more experiential Omni channel shopping experience, improve our value perception and leverage our customer analytics are gaining traction. These programs combined with our ongoing sourcing benefits and efforts to better utilize our extensive customer transactional data to develop more targeted offers are helping us to grow gross profit dollars. From a customer segment standpoint, we continue to see strong performance from our more frequent customers and importantly we’re increasing our customer retention. Drilling into our sales for the quarter, we saw comp momentum build as the quarter progressed. For the quarter customer transactions increased while our average ticket was slightly lower than the second quarter last year. During the quarter, we opened five new Michael stores, relocated one Michael store and closed three Aaron Brothers stores. At the end of Q2 our total store count for all brands was 1,366 stores. Operationally we again saw our best sales performance in Canada which delivered a positive 4% constant currency comp. E-commerce while still a very small part of our business continued to deliver very strong double-digit sales growth. As we’ve discussed in the past we manage our portfolio of businesses and every quarter some businesses exceed our expectations and some businesses underperform. This quarter Paper crafting, kids and seasonal products were our best performing categories. We also saw nice improvements in key businesses like craft paint, yarn and jewelry. We believe these increases resulted from our strong trend right assortment reinforced by a stronger value statement. Challenges on the sales front included the anticipated headwind from the coloring trend last year and custom framing in all channels including our Aaron Brothers business. Let me spend a moment on custom framing. We’re confident we remain the largest custom framer in the world. We also know this business continues to be very profitable for us reflecting our vertical manufacturing foundation. Despite the sales headwinds the industry is experiencing, we remain committed to this business and are taking additional steps to improve our performance. These steps include the testing of an expanded frame assortment, a more focused management and selling model and a more targeted marketing program all for the Michaels brand. Additionally, this fall we will launch framerspoint.com a new online custom framing platform which will target the entry custom framing customer who wants a lower cost simplified experience. With a curated assortment of high quality moldings and maps we will offer customers the ability to frame a digital asset of their own where they can select and frame artwork from a library of more than 10,000 art images. Leveraging our proprietary design technology framerspoint.com will provide customers with an easy way to design and view their creation online and easily share with their friends and family. We are excited to launch this new platform and believe our expertise and vertical integration will position us very well to compete in the fragmented online framing space. Now returning to Q2. Our performance benefitted from key initiatives that all tie back to our vision 2020 strategy which I would remind you includes the following five key pillars. One, delivering a customer centric Omni channel experience; two, curating our offering based on trend and value; three, speaking to our customers where, when and how they want; four, expanding into new businesses; and five, delivering fuel for growth through productivity improvements and strict cost disciplines. Let me touch on a few recent wins. First, we made a number of digital and in-store enhancements to create a more integrated omni-channel experience for customers. At michaels.com, we improved our navigation and search functionality. We expanded our assortments in areas like wedding, fine art and paper crafting compared to what is found in our stores. And we expanded our ship-from-store capability to cover the entire US which will allow us to better control our fulfillment costs. We also recently launched our new Michaels app. The enhancements are significant and the customer is responding well with millions of downloads in an attractive sales conversion rate. This new app is all about making it easier for our customers to find product in their local store by telling them what aisle their desired product is in. We also make it easier for our customer to organize projects, manage shopping lists, manage coupons and ultimately make a purchase. We are very excited about this launch and believe we have the best app in the making industry. We also made progress in making our brick and mortar Michaels stores which delivered a positive comp and positive transaction growth in Q2 more experiential. We continue to make it easier for customers to see and feel product by reducing product packaging and improving our displays. For example, our new marker bar allows her to mix and match her styles and our new Martha Stewart paint display allows her to see and feel the various finishes and textures. In terms of customer engagement, we saw a 50% year-over-year increase in customers coming to a Michaels store to make something, either in a class, a kids’ event or a make event. In-store events help to differentiate the Michaels brands and build customer loyalty and we believe there are many opportunities for this to continue to grow. A second area of improvement is around our value offering. Based on recent general retail industry results, it’s clear to us that value continues to be important to consumers. As we’ve previously discussed, we introduced our Every Day Value program or EDV for a variety of key core crafting items. These items are priced aggressively every day and are not eligible for discounts. This program has expanded to around 1,000 SKUs accounting for less than 5% of our overall sales and we are very pleased with the sales and margin dollars this program has generated. Additionally, we have expanded the use of whole dollar price points on a broader assortment of key items. This was especially prevalent in our kids and seasonal areas and we believe this strategy has contributed to strong sales in these categories during the quarter. Our third area to call out is loyalty and CRM. We continue to grow loyalty program Michaels Rewards. At the end of the second quarter, Michaels Rewards included 19 million active members making up about 50% of our sales for the quarter. With this data, along with other means of customer identification, we can now link the majority of our sales and transactions to an identified customer. And while the arts and crafts channel is characterized by low transaction frequency, over time we will continue to improve our customer targeted communications and promotions. We still have a lot of learning to do as I previously said. But as evidenced by our higher margins in Q2, we are making good progress. Our fourth area to call out is our Lamrite West business which includes a well-established B2B platform in Darice and a small but well-regarded chain of retail stores in the upper Midwest operated under the Pat Catan’s banner, both provide us with longer term growth opportunities to increase our business. On the B2B side the Darice team continues to expand and diversify their customer base by adding new customers. We’re excited about the opportunity these relationships will add to our long-term revenue and profit growth, but it is important to note that the wholesale business has a longer order cycle than our retail business. On the retail side Pat Catan stores are serving as a good learning lab for the broader Michaels chain. With 35 stores and a geographically concentrated area, Pat Catan allows us to test new ideas with minimal risk and fully support them with marketing. This past quarter we added fabric to all Pat Catan stores and began testing an expanded party assortment in select stores. We are encouraged by the early results of both tests. And the final initiative update is around our sourcing program which realize results both from our ongoing efforts to reduce product acquisition costs and from the expansion of our Darice sourcing group. Our sourcing team here in Dallas along with the Darice sourcing group in China have worked very well to realize not only cost savings but also to ensure we have the highest quality of product. Given the lack of national brands in this industry, this sourcing capability combined with our product development skills both at Michaels and Darice give us a strong advantage over our competitors. Looking to the second half of the year we believe the progress we’ve made in support of our vision 2020 strategy combined with our merchandising and marketing plans will position us for a stronger second half. The steps we’ve taken in the first half of the year to strengthen our core basic assortment including planogram resets in key categories like jewelry and craft paint should continue to drive momentum in the second half. In addition, we are adding new paper crafting tools from cricket including the recently launched cricket maker. In new paper crafting products by Martha Stewart crafts developed exclusively for Michaels by Darice. We will also introduce a new Karin [ph] Cake Shop consolidating all the best-selling Karin [ph] cake yarn varieties into one engaging fixture, all again, exclusive to Michaels. We will have the biggest invest holiday assortment we've ever presented to the customer this fall. We have expanded our fallen Halloween offering and increased our use of compelling even dollar price points to create a strong value message. We’ve increased our selection of Halloween essentials including life sized skeletons, skulls and grace domes. We have also added new exclusives from Lemax collectibles and we’re leveraging our artistry manufacturing capabilities to offer customized craft pumpkins to enable customers to personalize their Halloween décor. For holiday, we’ve again expanded our selection of trees with a focus on offering customers a tree for every space. So, whether a customer wants a mini tree or a nine-foot tree or something in between, we’re confident we’ll have a tree that fits their need. And to help decorate that tree we’ve broadened our assortment of ornaments and [indiscernible] supplies. We’ve added new beans and collectible ornaments, increased our assortment of [indiscernible] ornaments and expanded our assortment of do-it-yourself ornaments. And for those customers who prefer a do-it-for me solution, we have new décor styles which are merchandized online and in stores in an easy way to mix and match. So, no matter the customers’ experience level in making that special holiday look, Michaels will make it easier. We’ve also expanded our holiday assortment online including more of what we offer in store as well as a selection of online only SKUs and we are making product available online earlier than last year. This is good especially for the enthusiast maker but has historically been difficult for us to do in our physical plan given the constraints of a 20,000-square foot store. Additionally, we plan to provide greater visibility to in-store inventory available in stores which will enable us to begin testing buy online, pick-up in store in a select number of markets for this holiday season. To support our strong seasonal assortment, we are expanding our digital efforts and testing new marketing vehicles, all grounded in our brand message that Michaels makes it easier for everyone to make. To support this messaging, we will leverage our partnership with Good Morning America and accelerate our use of digital content by partnering with key Facebook and YouTube influencers and by leveraging our exclusive partnerships with Darby Smart and Craftsy. And we are expanding our very successful digital series the The Make-Off look for fun new videos this fall with more unexpected celebrity makers. In addition to our digital content and media integrations, we will continue to expand our direct marketing vehicles with the introduction of a new Michaels holiday guide and we will offer even greater value to our customers through a number of gift [ph] purchase offers and new bounce back programs. In closing, we have made meaningful progress in the pursuit of our Vision 2020 strategy and our customers are responding well to the improvements we have made. As we move into the second half of fiscal 2017, we will continue to build on these efforts with more value, more newness and more trend right merchandise. In addition, we will anniversary a number of unique headwinds we experienced in the second half of fiscal 2016 including disruption created from store layout changes made in our third quarter last year and the US election which should provide for easier comparisons in the second half of this year. With that, let me turn the call over to Denise for a more detailed discussion of our financial performance. Denise?

[Denise Paulonis:]

Thanks. And good morning. As Chuck indicated, our sales and earnings results for the quarter were higher than our initial guidance. We are particularly pleased with the flow through of profitability in the quarter. While the second quarter is a historically our lowest sales volume quarter of the year, our Q2 performance gives us confidence that the steps we have taken to improve our performance will continue to deliver results in the second half of the year. Second quarter net sales increased 1.2% or 1.3% on a constant currency basis to $1.07 billion compared to $1.06 billion in sales last year. The increase in net sales was primarily due to the operation of 10 net additional stores during the period and the increase in comparable store sales. These were partially offset by lower wholesale revenue reflecting timing differences related to new customer acquisition and the expected attrition with legacy customers. Gross profit dollars for the quarter grew 3% to $403 million and our gross profit rate for the quarter increased 70 basis points to 37.5% of sales versus 36.8% of sales last year. The increase in Q2 gross profit rate was primarily a result of increase in our product margin driven by benefits from our ongoing sourcing efforts and more disciplined discount management. Additionally, we saw some benefit in the quarter related to distribution related costs, a majority of which was anticipated in our Q2 outlook. These benefits were partially offset by higher inventory shrinkage and the impact of a $1.4 million benefit in Q2 last year from non-recurring inventory related purchase accounting adjustments related to the acquisition of Lamrite West. Similar to what we experienced in Q1 we saw an increase in inventory shrinkage and store's inventory in the second quarter. As we indicated on our last call, we’re taking steps to address the trend but embedded in our annual guidance is an expectation that shrink will remain a headwind for the rest of the year. Total store rent expense for the quarter was $98 million versus $97 million last year with the increase due to a net 10 additional stores. Selling, general and administrative expense in the quarter including store preopening costs increased 3.6% to $315 million compared to $304 million in the quarter last year. As a percentage of sales, SG&A expense increased 70 basis points to 29.3% of sales compared with 28.6% of sales in Q2 last year. The increase in SG&A expense as compared to last year was primarily due to an increase in performance based compensation. In addition, we have some incremental expense associated with the operation of 10 net new stores, incremental marketing investments and higher healthcare expenses related to higher claims. These increases were partially offset by lower professional fees related to our sourcing efforts as compared to the second quarter of last year and the anniversary of $2 million of integration expense recorded in the second quarter of fiscal 2016 related to the acquisition of Lamrite West. Also as a reminder, last year we recorded a credit card assessment of $3 million related to the 2014 data breach. As a result, we delivered a 1% increase in operating income to $88 million or 8.2% of sales. For the quarter, interest expense was $31 million which was $1 million lower than the second quarter of last year. This decrease was due to interest savings from the refinancing of our term loan credit facility last year. The effective tax rate for the quarter was 36% compared to 35.5% in Q2 last year and was slightly higher than our initial guidance of 34% to 35%. The increase in effective tax rate was primarily a result of a $1.4 million charge related to the reduction of certain federal tax credit which was partially offset by ongoing benefits from our direct sourcing imitative which has lowered our consolidated tax rate. Excluding the impact of the $1.4 million charge, our effective tax rate for the quarter would have been about 34%. As we previously discussed, our expanded sourcing operations in China and Hong Kong give us more control over the manufacturing process, allows for more efficient and effective cost negotiation and will enable us to deliver even more value to our customers. Reflecting the impact of these factors, we delivered net income for the quarter of $36 million or $0.19 per diluted common share based on 188 million diluted weighted average common shares outstanding. Now turning to the balance sheet, total merchandise inventory was $1.2 billion, up 4% from the end of Q2 last year. On a per store basis, inventory levels were 2% higher than last year, reflecting investments made to support our EDV program, trends like Slime and Cricket a new second half merchandising initiative. Our liquidity position remains strong. At the end of the quarter, cash on the balance sheet was $134 million. Total debt was $2.8 billion and our revolver availability was $681 million. Capital expenditures for the quarter were $27 million compared to $24 million in the second quarter of fiscal 2016. We continue to expect capital expenditures for 2017 will be between $125 million and $135 million reflecting our POF upgrade and other technology investments. Finally, we continue to utilize our strong cash flow and balance sheet to return value to shareholders. In Q2, we purchased 5.4 million shares for about $101 million as part of our previously announced share repurchase program. Given the timing of purchases, there was minimal EPS benefit to the second quarter. At the end of the quarter we had about $399 million left under the current repurchase authorization. As a reminder, the share repurchase program does not have an expiration date and the timing and number of repurchased transactions under the program will depend on market conditions, corporate considerations, debt agreements and regulatory requirements. As we turn to the balance of the year, we have updated our guidance to reflect three factors. First, we have updated our full year ‘17 EPS guidance to reflect approximately $0.03 of favorable impact related to the share repurchases in Q2. Second, we have updated our full year EPS guidance by about $0.02 to reflect favorable impact from foreign exchange. The value of the Canadian dollar has improved since our last call and we now expect the Canadian exchange rate will average $1.31 for the full year which effectively eliminates the difference between our reported and constant currency results. Any change from this assumption will have an impact on our performance. Finally, we have tightened our annual guidance range to reflect our year-to-date performance, increased visibility into the cadence of our wholesale sales and some modest margin impact from a lower mix of custom frame sales. For fiscal 2017 we now expect net sales to increase between 2.8% and 3.8% reflecting the timing of wholesale sales and comp store sales to increase 0.5% to 1.5%. As a reminder, fiscal 2017 is a 53-week year and the sales impact of the 53rd week a non-comp week is planned to be approximately $80 million. We are narrowing our range for operating income and now anticipate operating income to be between $735 million and $750 million. As noted on prior calls, this guidance includes approximately $40 million to $50 million in sourcing benefits and the impact of anniversarying a $46 million decrease in performance based compensation in 2016. We are planning interest expense to be approximately $131 million reflecting benefit from the refinancing of our asset based lending credit facility and the successful amendment of our term loan credit facility in fiscal 2016. We expect the effective tax rate for the full year will be between 34% and 35% and we are tightening our EPS guidance and now expect the diluted EPS will be in the range of $2.11 to $2.16 based on approximately 187 million diluted weighted average common shares for the full year. As we announced at our investor conference in June, our Aaron Brothers division is currently undergoing a strategic review. This guidance does not contemplate any potential changes to this business. Now, turning to Q3, we expect comp store sales will increase between 1.2% and 2.2%. This expectation includes some sales impact from the shift of Halloween further into Q4 as well as some benefit from anniversarying the challenges we faced in the third quarter last year, including the disruption of the 2016 U.S. election and the disruption associated with certain layout changes we made in 280 stores last year. We plan to open nine new Michael stores, relocated five Michael stores, opened one Pat Catan store and close four Aaron Brother stores during the third quarter. We expect operating income for the quarter will be between $150 million and $155 million. This guidance reflects an expectation that the positive impact of sourcing benefit will be partially offset by higher shrink. Also as a reminder, the third quarter last year benefitted from a give back of about $14 million related to incentive compensation. Our Q2 guidance for fully diluted earnings per common share is $0.41 to $0.43 based on a diluted weighted average common share count of 184 million shares. Given the encouraging trends we experienced in Q2, the national tailwinds to comp sales as we lap challenges from last year, and our focus on disciplined cost management, we remain confident our trends will continue to improve in the second half of 2017. And with that, I would like to open up the call to take your questions. Aneeda?

[Operator:]

We'll now begin the question-and-answer session. [Operator Instructions] The first question comes from Chris Horvers with JPMorgan. Please go ahead.

[Christopher Horvers:]

Thanks, and good morning. As you can think about how the quarter played out I think a lot of question that we get is hey, you can always exclude something from last year so excluding the coloring book gets us to a certain comp level and that’s fine but you’re ignoring the rest of the mix, as you think about this quarter was the coloring book headwind as expected and as you go forward does the performance in the rest of the mix, has it changed in terms of your outlook for your confidence around the back half?

[Chuck Rubin:]

Yeah, Chris the coloring was an impact against last year in Q2 that’s why we called it out. But, we were really pleased about in our performance in the second quarter as we saw broad based strength. So, we saw improvements in a lot of our core product categories. We saw improvement in some of our marketing spend, we saw improvement in our in-store events, we saw improvement in e-commerce. So, the quality and breadth of improvement throughout our business in the second quarter was what we’re excited about. We also recognized the smallest volume quarter of the year, but we’re very pleased with the progress and it wasn’t our performance and our beat [ph] wasn’t reliant upon anyone particular product or marketing event it was a whole bunch of little things and that’s what we’re very happy about.

[Christopher Horvers:]

And so, as you laid out the outlook for the back half obviously there is the distinct reset impact that you thought about and there is a distinct election impact that you thought about. Did you -- are they sort of those growth amounts as you create any sort of not conservatism or uncertainty? Did you offset those distinct tailwinds as you lap them for any sort of uncertainty around the consumer or uncertainty around the environment? Just trying to get an understanding of the thought process that went into the guidance for the back half?

[Chuck Rubin:]

Yes, well we certainly recognize that the retail environment continues to be turbulent. That’s why we are so very pleased with the improvement we saw in the second quarter. It was a good quality quarter, very happy with the transaction trend that we saw. So, we included the initiatives, the things that we control within our company. In the back half of the year we recognized there was a lapping of some of the things that went on last year. We did throw in a component of an uncertain retail environment in general. And all of that’s reflective in the guidance that Denise walked through.

[Operator:]

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

[Simeon Gutman:]

Thanks. Good morning. Question on the framing business, just a couple of parts. So, I believe the narrative up until this quarter was that it’s still tough but beginning to see some signs of stabilization. The margin comment that you made, lower mix than originally planned suggests maybe it’s performing worse than what you planned. Any way can you share with us how that business performed as far as comp, I mean this way we could exclude it and see how well the core business performed. Can you distinguish between sort of how the self-search side of framing is performing? And then if there is any improvement built into your second half assumptions for comp with respect of framing?

[Chuck Rubin:]

Yes, Simeon. So, I can help on some of that but may be not every piece. So custom frame did not improve in the second quarter as we had hoped that it would. So, it continues to be a disappointing top-line business for us. It is a very profitable part of our business because we are vertical. We have our artistry manufacturing back end. And it is still a nice part of our business. So, we are very much committed to it. But we have taken a more conservative view. We are trying a lot of different things to get this thing going. But we have taken a conservative view for the back half of the year. We are confident this is industry wide because we saw custom framing under the Michaels banner, the Aaron Brothers banner, the Pat Catan banner and we see consistency there, and from what we hear from other people. So that’s not unique to us. It wasn’t -- we didn’t see the improvement that we hoped for and we have been conservative in our expectation for the back half.

[Simeon Gutman:]

Okay. I guess different question for a follow-up. The outlook that you provided in June, operating income growth is supposed to be mid to single 5% to 7% I think. And so, this quarter we saw a slight increase that we made adjustments and I think the back half has implied to be a up a little bit. Is the realization of that 5% to 7%, should that occur in 2018 or is there -- is this a heavier investment period and more competitive retail environment thus it is more like a 2019 or do you think you get close to those -- that type of performance as early as next year?

[Chuck Rubin:]

Well let me start and then I will see if Denise wants to add anything. A couple of things. The guidance that we gave at the investor conference was over a multiple year time horizon. I don’t think we are sitting today prepared to communicate publicly our guidance on 2018. I would remind people 2018 goes back to a 52-week year after a 53-week year this year. So, we will talk about our guidance in ‘18. But nothing in our outlook long-term for a business has changed from what we communicated at our investor meeting in June.

[Operator:]

The next question comes from Matt Fassler with Goldman Sachs. Please go ahead.

[Matt Fassler:]

My first question relates to gross margin was just substantially better than our forecast and consensus and really drove a lot of the beat. How would you put the better merchant margins in the context of your private label and own brand sourcing effort and look back to the acquisition of a couple years back? Is this an acceleration in the traction for that effort or is it -- or is the reduced in store discounting and discount discipline more of a factor in driving this improvement?

[Denise Paulonis:]

Good morning, Matt. When we think about what we’ve done on the gross margin line both of the factors that you stated are part of what is driving our results. In the quarter, our gross margin results were generally in line what we had anticipated them to be and we’re very pleased with that [indiscernible] upside with high quality and that the flow through of the gross margin happened as we did see. On the sourcing front, we continue to realize the sourcing benefit those from the changes in the sourcing program we’ve made and had a continuing to push the barriers there about how we go to market and how we negotiate as well as the benefits associated with our re-sourcing group in China. So, the combined of those are really playing out the way that we anticipated them to be and are a good contributor. In addition, what we’re seeing on the discount management side is an ability to get better at leveraging that customer relationship data that we do have and we are learning through to our customer rewards program to just be able to be more targeted in how we give those discounts. So, while in general anybody getting a given email might feel as though where is the same cadence of discounting as we did in prior years, the reality is that different people are now seeing different offers and that’s allowing us to control that discount management just a little bit more sharply than we used to be able to do. So, both of those are nice factors to what’s going on. As we mentioned we have some offsets to that in the quarter as well and that strength is a bit of a headwind for us that we’re going to need to keep overcoming as we work through the year.

[Matt Fassler:]

That’s super helpful. And then just by way of quick follow up. I know that incentive compensation was a driver of higher SG&A in the quarter. Now, we’ve talked about incentive comp a lot because of the degree to which you’ve reversed it in prior years and I know that you’ve been modeling an increase in the second half of this year. With so many increases in incentive compensation sort of front loading, would have come in the second half and shift the aggregate amounts through the year is the same just less painful in the second half of the year, or I should say less impactful in the second half of the year or is your expectation of the magnitude of the increase in incentive comp in the third and fourth quarters [indiscernible].

[Denise Paulonis:]

So the magnitude of our overall incentive comp has not changed materially. What we did see is with the beat our expectations in Q2, we did need to accrue a bit higher performance based comp in there. The additional factor and as you mentioned the timing of bonus flow through versus last year because of the atypical bonus accrual with all of the give back we had last year is just a bit of noise quarter over quarter. For everyone’s edification I think it’s important to know that when we accrue bonus we accrue based on a percentage of our EBIT target earned in a given quarter, you saw that come through in our results. And so that really is what’s going on.

[Matt Fassler:]

So, if we had a particularly onerous risk burden in the second half of the year would we pull that back a bit because you booked some of that already in Q2 or is it possible that the dollars go higher for the year than originally planned if the business remains on the track that it is.

[Denise Paulonis:]

I mean if our business remains strong and we see more benefit come through the second half, of course that would mean that we would have some more bonus accrual coming through. Your expectations for the midpoint of the guidance we gave are in line with what we have. So, we need to exceed what we are expecting right now for there to be a significant change in the bonus compensation.

[Operator:]

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

[John Heinbockel:]

It’s John Heinbockel on for Steve. So, Chuck, let me start with the Every Day Value program. Where do you think the size of that program goes like either SKUs or percent of sales near term and long-term? And when you analyze the basket of people who have at least one of those items in their basket, none of their basket compare basket size into a shopping frequency to people who don’t buy Every Day Value item.

[Chuck Rubin:]

Good morning, John. The first part of your question, as I said in my prepared comments, it’s less than 5% of our business, about 1,000 SKUs. Right now, for the near term, we think it’s kind of reached its level that we are comfortable with. It’s really hard as you know how retailers have demonstrated that it’s very hard to convert to an EDLP environment and that is not our intent. So, I think it’s kind of at the level that we foresee for a while. I do think there’s opportunities for us to go to this whole price point strategy more than we have thus far. So, you will see us pick that up further in the back half of this year and expect more in 2018. As far as the basket's concerned, it kind of varies all over. We have seen the top of our FILO customers we continue to grow very nicely with. And we are seeing more activation of customers who had gone dormant on us that we are doing a better job of reengaging with them. So, I don’t know that there is a lot of difference between the different customer types and their participation in this EDV program. So, I guess I would leave it at that for the moment.

[John Heinbockel:]

And then just second topic. Obviously, you are getting a lot of the benefit here from Lamrite. And in a perfect world, you probably would like to have may be a gross up less and a better comp. From your perspective and an analytical standpoint, do you think is there a room in the second half to make some more targeted investments to try to drive comp right around some of these normal events or not really, there’s not enough confidence analytically to do that?

[Chuck Rubin:]

I am not sure -- if I think I understand what you are asking. We feel pretty good about the investments we have been making. We have been really investing a lot into our technology platform, our digital assets, are in a heck of a lot better shape this year. We offer a lot more to the customer as well as capabilities internally for our own team than we had a year ago. We have investments sounds -- it's a very broad term. We feel really good about our marketing programs. We feel good about the conditions of our stores. The investment that I want to touch on is sometimes people will include promotional activity and we feel good about where we are in the promotional activity in the second quarter as evidenced on the gross margin, Denise said, as she said, we’ve got good benefit from our sourcing effort, but we continue to get smarter on our use of promotional dollars. So right now, we feel set up pretty well for the back half of this year and we think we’re planning we hope that the environment is better than it was a year ago when sales were tough overall given a lot of things going on in the retail industry and a lot of people including us having to clear inventory that didn’t sell in a season that turned out to be more disappointing. So, I think that that’s an investment that we’ve properly planned this year. But to your earliest comment, we feel good that we drove transactions both in total as well as in brick and mortar. So, all our transaction growth didn’t simply come from e-commerce I think that’s an important point. So, the investments we’re making right now for our business in the second quarter at least, we’re quite pleased with how these things started to show up a little bit faster than we had originally anticipated. Hope I am answering your questions, John.

[John Heinbockel:]

Yeah, I was wondering just the balance right between gross and confidence, it sounds like you’re not leaving anything on the table in terms of either price or promotion. So.

[Chuck Rubin:]

Right now, we feel good about it. I don’t feel as though we pulled back too much on promotion in the second quarter I think we got smarter about it and as Denise touched on we’ve talked about multiple times before, we’re still very much in a learning and implementing from that learning stage, but we’re going from a place of the past where one discount was applied to everybody to a place where we can start to target those discounts smarter than we had before. It’s not an easy process and it’s going to take a long time because the frequency of shopping as you know in this industry is low and you need data, you need multiple shopping experiences from the same customer to get a better sense of what products and what discounts he response to. So, we’re early in the game, but we’re making progress and as I say I am very pleased with progress that we’ve made across the board in the second quarter.

[Operator:]

The next question comes from Michael Baker with Deutsche Bank. Please go ahead.

[Michael Baker:]

Thanks. A couple here. Just on your stance for sales outlook even to the mid even higher end of what you’re just talking about for the third quarter what I think it implies for the fourth quarter it is down a little bit on a two-year stock basis given the easy comparisons, wondering if there is anything to that that you’re concerned about or is it just sort of being conservative and not going ahead of yourself?

[Denise Paulonis:]

I think you said it well at the end of your statement there Mike, I think we will due remain uncertain about the consumer environment we feel good about our position. We were really encouraged by Q2 but it is the smallest quarter of the year and we don’t want to get ahead of ourselves. You do have to note in Halloween there is a bit of a headwind -- around Halloween there is a bit of a headwind in Q3 as it shifts a little further into Q4 so Q3 on two-year stack might look a little lighter than Q4 and that’s a reason driving that. In our minds if we see upside then there will be good flow through but we don’t want to get ahead of ourselves.

[Michael Baker:]

Yeah, that makes perfect sense. One more thing I want to ask about is customer framing, you did talk about that a little bit, but I am wondering if you’re willing to share any bigger picture ideas in terms of the [indiscernible] estimates, but percent of sales or may be different than that how long it’s been down are we going to start to lap any of the declines? Are the declines accelerating, sort of anything that can lead us to believe that that might start to flatten out?

[Chuck Rubin:]

We’re not going to provide a lot more detail Mike, we’re anniversarying declines now though. So, it is down on a two-year stack as well. What I can tell you is that we’ve planned it conservatively. We are working like crazy to get this thing moving in the right direction. We have planned top-line conservatively. And I can tell you, as I’ve said so many times before; we’re very committed to the business. It’s a still a good business. It’s still a very profitable business. It’s a very different type of business in the sense of it’s a full sales effort, it’s not customer driven. In the sense of self-service, it’s really a full assistance model. So, we are testing a lot of things. We have not unlocked the formula yet. But we are working hard at it, we are going to stay committed. We’ve planned it conservatively. We are moving online to provide that alternative for the customer as well. And we will give you updates as we go forward.

[Operator:]

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

[Seth Sigman:]

Thanks. Good morning. A couple of follow-up questions. First on the incentive comp. Can you just remind us the benefit last year in the second quarter and then the headwind that you faced this quarter? And then just to clarify, I think you had a $46 million reduction last year, how much of that comes back this year, like what’s baked into the guidance assuming that you hit your targets as we just try to understand what the normalized operating earnings for it looks like? Thanks.

[Denise Paulonis:]

So, Seth, and let me provide a bit of color on incentive comp to clarify your numbers. In the second half of last year we did give back approximately $45 million in incentive comp, so factored into all the guidance we’ve offered this year is that we need to refill that bucket. So, when we talked about the need that we are going to have SG&A deleverage for the full year this year, a vast majority of that deleverage is associated with refilling that bucked for the full year. That $46 million give back did occur in the third and fourth quarter last year. So, when you look at Q2 and where we are, the impact in Q2 was a bit of mix shift, just in how we’re going to earn income through the year as we better performed in the second quarter than what our original expectation was. But there is also just a little noise in the lapping of the incentive comp because of all of the give back that we had last year.

[Seth Sigman:]

Okay, great. That’s helpful. And then my follow-up question is around the average ticket. I mean the focus on value and refining your pricing has been very clear. In some cases, that means lower prices. Is it fair to assume that these type of efforts puts some pressure on the ticket early on as you make these changes and that’s part of what we are seeing on the average ticket this quarter? But overtime as you lap that, you actually start to see some favorability if anything may be more unit growth and you could start to see the comps ramp again. Is that the right way to be thinking about that?

[Chuck Rubin:]

That could happen, Seth. I think some of what we are seeing in the average ticket is some of the mix changes that we’ve had. So as in samples, we sell more bulk packed items than we used to. So, a customer may be buying a packet has 10 of something in it versus last year we sold them in single pieces. So that changes the units per transaction part of the ticket equation. Additionally, we have changed some of our promotions in the sense that again last year we would sell -- we would promote a certain number of units for a certain price and we may have changed that a little bit. So just a [indiscernible] 10 pieces of paper for a $1 and this year may be eight pieces of paper for $1. So that’s what’s having some impact on the unit per transaction component of ticket. EDV, I think we will cycle through this, but again I would remind everyone that previously we’ve said that we will try to balance transactions and ticket quarter by quarter. So, I wish that the ticket hadn’t been down although I would just to be sure to point out it was down very slightly in the second quarter, so I don’t want to over exaggerate it. But we’re not overly concerned about that. We don’t think that’s a problem going forward. We were very pleasantly -- we are very pleased with how the transaction number for the quarter turned out though.

[Operator:]

The next question comes from Alan Rifkin with BTIG. Please go ahead.

[Unidentified Analyst:]

Hi this is Marvin [indiscernible] on for Alan. Just a question on first on Canada. You called out that it is now a $0.02 benefit to your outlook. Can you remind us what that was before and is there any sort of relationship or [indiscernible] you can give us so we can sort of track the impact as the exchange rate changes?

[Denise Paulonis:]

Canada is about 10% of our business overall. On the last quarter call we had been seeing the foreign exchange rate trend higher than where we sit now so it was trending at about a $1.35, $1.36 and it’s clearly trending down from that now and believe that the average for the year will be $1.31. So, when we look at $0.02 benefit we’re just applying that differential between those two rates on the balance of the volume from the Canadian business in the second half of the year. I hope that helps.

[Unidentified Analyst:]

Yes, thank you. And just as a follow up, on the last quarter you said that the flexible merchandise layout stores, the 350 stores has started outperforming the control group. Could you give us an update on how that did this last quarter? Is it the improvement get better or stay stable?

[Denise Paulonis:]

So, overall, we continue to be encouraged by the FMA stores in Q2, they performed very similarly to how they did in Q1. Of note, what we see is that specific space that is now dedicated in the front of the store performs particularly well and we’re very pleased that as we have pushed more inventory to those stores for what would fit in that, in that space that we’re seeing good results and good pick up from the customer. You might remember that at the end of last year we actually had a bit of challenge that we probably under inventoried those stores for the positive response we saw from the customer. Where we’re still really learning is what happens to the rest of the box. As you know most of our customer shop fairly and frequently in our stores. And so, when we had to move other products to make space for that specific dedicated area at the front of the store we do still see a little bit of softness in some of the businesses of what we -- of products that got moved. And so, what we’re really wanting to do is get through the full cycle through Q3 and Q4 to understand how all of those things level out, but we remain very encouraged by what’s there and we would hope that it continues to prove out, it could be a continued benefit for us going forward.

[Operator:]

The next question comes from Cristina Fernandez with Telsey Advisory Group. Please go ahead.

[Cristina Fernandez:]

Good morning. I wanted to ask about the competitive environment, in the past few quarters you talked about your direct arts and craft competitors being more aggressive on promotions. Did you see any change on their behavior that you have led to the industry seen their sales growth this quarter?

[Chuck Rubin:]

No, Christina, I remind everybody, we compete against a whole wide swath of people out there, everybody from our big box category killers to the Wal-Mart’s, Target’s online players, Dollar Stores et cetera. So, it really varies based on the category of product that you are talking about. So, we saw that the general environment rather consistent in the second quarter. You can find isolated things depending upon who you are talking about. But it’s a really -- we've talked about these many times; it’s such a fragmented market. But overall, we thought the environment continue to be as we expected and we are planning accordingly for the back half.

[Cristina Fernandez:]

And then I have a follow-up question on a different topic. On your framers point side that you are going to launch this fall, how do you think that this differs from some of the other offerings out there? And is it your understanding that this category is seeing a bigger shift online than perhaps others in your business?

[Chuck Rubin:]

Let me answer the second one first. I don’t think that online is penetrating some disproportionate amount from the custom frame business. What you would have to believe though is, as I mentioned in my comments, I think we do believe the industry is challenged overall. So, when you add new players into it, then you are splitting up on already fragmented business into that many more pieces. So, us getting into the online component of it, we think is a very smart move to actually to make. So, we will fight on that front as well. The offering that we have we think is unique because we are able to offer the types of product and the values to the customer given that we have something that to my knowledge no one else has which is our own backend manufacturing foundation. So, our ability to be -- to control the quality and to control the price and deliver better margins is really attractive for us. So, we are excited to get this launched later this year.

[Operator:]

The last question comes from David Magee with SunTrust. Please go ahead.

[David Magee:]

Hi, good morning. Just a question regarding quite the pricing the discount management which I know has not affected here and it’s good to see gross profit dollar growth. Does this approach work as well or the same way during the holiday period when you have sort of a different composition of customer and a different shopping dynamic?

[Chuck Rubin:]

I don’t think it’s really reliant upon the customer so much as the wide competitive set that we have. Pricing in this industry is really an interesting one. We have firstly tens of thousands of SKUs. So, on an average store we carry call it 50,000 SKUs and so many of them are private brand. So, comparing product between different retailers becomes something that you have to pay close attention to because pack sizes for instance could change. You also have to be sensitive to FILO versus every day pricing. So, our pricing approach is we are going to be competitive every day with all competitors that are out there. Now what that means is that on especially high-profile items we will be competitive and may be better than anybody else out there. On other items, we should be generally competitive. Clearly, there are going to be times when another retailer may have something on sale that we’re not on sale that they may be cheaper than us on that day, but that’s also why we implemented a price guarantee policy earlier this year. So, on any like item across pretty much any retailer, any credible retailer Nash online or in store we will match that price competitively. So, we feel good about our pricing approach going in and we feel as though some of the continued learnings in our targeted promotions is going to set us up well and that’s reflected in our guidance on the back half.

[David Magee:]

Great. Thanks, Chuck.

[Chuck Rubin:]

Thank you, David. So, in closing, we do believe that Michaels companies is a very attractive investment with the number one player in this very fragmented steady growth industry with our stores and our web traffic we’re number one as an omni-channel platform in the industry with a meaningful market share opportunity to still grow. We have the most powerful brands, private brands and strong product development and sourcing capabilities and our strategy and tactics are governed with a very financially disciplined focus which has led to very strong cash flow and a very high ROIC. I am pleased with the tangible progress we’ve made especially in the second quarter in support of our vision 2020 strategy and I want to be sure to thank all of our team members across the Michaels companies who have worked so hard to deliver these results. While there are clearly still work to do, we believe the progress we’ve made positions us well to deliver a strong second half. And I want to thank all of you for joining us today and we look forward to sharing our third quarter results very late in November with you. Thank you.

[Operator:]

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