Michaels Companies Inc
Q3 2017 Earnings Call Transcript

Published: 30 Nov 2017

[Operator:]

Good morning. My name is Rachel and I will be your conference operator for today. At this time, we would like to welcome everyone to the Michaels Company’s third quarter earnings conference call. All lines have been placed on mute to prevent any background noise. If you need assistance during the conference call, please press star then zero and an operator will assist you. Please note this event is being recorded. Thank you. 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, Rachel. Good morning everyone and thank you for joining us today. Earlier this morning, we released our third quarter financial results. A copy of the press release is available on 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, November 30, 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 operating income, adjusted net income, and adjusted diluted earnings per share. Adjusted operating income, adjusted net income, and adjusted diluted earnings per share for comparable periods in 2016 have been presented to reflect our view of ongoing operations by adjusting for last year’s non-recurring inventory-related purchase accounting adjustments and non-recurring integration costs and benefits associated with the February 2016 acquisition of Lamrite West, as well as losses on early extinguishment of debt and refinancing costs less related tax adjustments. 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, we will open the call for questions. As a reminder, we’d appreciate it if participants could limit themselves to one question and one follow-up. I’ll now turn the call over to Chuck. Chuck?

[Chuck Rubin:]

Thank you, Kiley. Good morning everyone and happy holidays. This morning, I’ll review some highlights of our Q3 performance and then give an update on our plans for the fourth quarter. Starting with the third quarter, this morning we reported sales and operating income that were within our guidance for the quarter when we adjust for the disruptions from Hurricanes Harvey and Irma, and diluted earnings per share that were slightly above our initial guidance. We estimate the hurricanes negatively impacted net sales by about $10 million and diluted EPS by about $0.01. For the quarter, comparable store sales increased 1% or 0.5% on a constant currency basis inclusive of sales lost due to the hurricanes. We estimate the hurricanes impacted more than 100 stores and resulted in more than 400 lost store days, impacting overall comps in the quarter by an estimated 80 basis points. Excluding the estimated impact of the hurricanes, comparable store sales increased 1.8% or 1.3% on a constant currency basis. In addition to the impact on sales, Hurricane Irma also caused disruption in our Jacksonville, Florida distribution center both in receiving shipments into the facility as well as in shipping inventory out to stores. Our teams reacted quickly and worked hard to get back on track. Thankfully our team members are safe and our stores experienced minimal property damage. I am extremely proud of the way our team members worked together to support customers in hurricane impacted communities. Our stores hosted numerous free events to provide fun distractions for families displaced by the hurricanes, and our employee hardship fund, Michaels Cares, provided support for more than 400 affected Michaels’ team members. My deepest thanks to the dedicated team members and field leadership team who worked tirelessly to reopen stores and help their local communities recover from the storms. Geographically, Canada was the best performing region in the quarter, delivering constant currency comps of about 5%. This strong performance includes the impact of headwinds we experienced towards the end of the quarter which we believe is related to the Sears Canada liquidation process. Recently, we have seen some stabilization but sales trends may continue to be volatile until the Sears liquidation is complete. We did see similar sales trends when Target exited the Canadian market in 2015. In the United States, comp performance was fairly consistent across regions with the exception of areas impacted by the hurricanes. From a product category standpoint, seasonal, paper crafting and kids delivered the strongest sales in the quarter. Halloween sales were strong versus last year, driven by newness and exclusives. We also saw some benefit in the quarter from the response to our Christmas assortment, which was set in stores and online earlier than last year. Sales results in the paper crafting category continued to reflect the popularity of new technology, including the Cricut Maker in the recently introduced Easy Press and Bright Pad, as well as strong growth in the project materials used with these devices, including our expanded assortment of iron-ons and vinyls. Planners and storage were also good standouts in the quarter. Our kids category also delivered positive comps in the quarter driven largely by school projects and the continued popularity of Slime. As expected, custom frame underperformed for the quarter. This quarter, we refreshed the design collections and introduced more tiered pricing to enable customers to achieve their desired price points more easily. In addition, we continue to test various management and production models which increase focus on the selling nature of this high touch transaction. It is still early, but we are starting to see some positive impact from these changes. Turning now to our online sales, while still a very small part of our overall business, our growth continued to accelerate this quarter as expected. Online sales in Q3 were roughly double the level of online sales in Q3 last year, driven by increased traffic and higher conversion rates. As we have previously stated, we continue to believe that it is highly unlikely that ecommerce will grow to be a double digit penetration of sales in this channel as it is for many other retail formats. The tactile nature of the product, the general lack of national brands, and a low average price point make this channel less attractive to pure play online platforms; however, we do believe ecommerce is an important complement to our brick and mortar experience, and while our current penetration remains very low, we continue to believe that our ecommerce penetration will grow to be in the mid to upper single digit range of our total sales over the next several years. In summary, we are generally pleased with our Q3 performance. We delivered positive comp growth in our Michaels brick and mortar stores, we doubled our Michaels.com business, and importantly we delivered higher operating profit dollars driven primarily by improved product margins. Operating income in the quarter increased 5% to $154 million, in line with our guidance, and diluted EPS increased 19% to $0.44, slightly above our expectations. Denise will provide more color on the P&L in a few moments. Now turning to the fourth quarter, we are well positioned to continue this momentum. We have the largest, strongest holiday assortment we have ever offered, both online and in stores. We have a compelling marketing plan to communicate the value and solutions we offer and we have made tangible enhancements to better link our physical stores, digital storefronts and digital applications into a more integrated shopping experience to make it easier for customers to make. Starting with our holiday assortment, we’re making it easier for customers to celebrate the season with more newness and exclusive product, in-store and online presentations that are easier to shop, and strong and clear value messaging. We have expanded our selection of holiday décor and gifts, creating the largest, strongest holiday assortment we have ever offered both online and in stores. We have expanded our Christmas tree selection to include more pencil trees, more mini trees, and an artificial tree that actually grows. We have increased our assortment of glass, collectible and DIY ornaments and we have increased our assortment of home and tabletop décor to reflect exclusive designs available only at Michaels. We have also strengthened our selection of creative gifts for kids and adults which we think will encourage customers to unplug from their devices and express their creativity in new ways. On Michaels.com, we’ve expanded our assortment by nearly 30% to include more of the seasonal and core basic products that are available in our brick and mortar store, as well as more online-only SKUs as part of our endless aisle efforts. Also important to note is that behind the scenes, we have been diversifying how we deliver product to customers to improve the customer experience and ultimately reduce our fulfillment costs. Let me provide a bit more detail on this. When we launched ecommerce in 2014, our priority was speed. To get the functionality up quickly, we focused on a limited assortment and outsourced fulfillment to a third party. Over the past couple of years we have added Ship from All Michaels Distribution Centers and introduced more vendor drop ship. This year, we have expanded our capabilities when we launched Ship From Store in hundreds of geographically diverse Michaels stores, enabling us to leverage store-level inventory, deliver online orders to customers faster, and better control our fulfillment costs. For those customers who want their purchases sooner, we have added in-store inventory visibility to Michaels.com and are currently testing Buy Online Pick-Up In Store in a number of markets. Our learnings on BOPIS this holiday season will support a chain-wide rollout in all stores in 2018. Finally, customers can buy online and return to any Michaels store today. With all of these enhancements, we are reducing our dependence on third party fulfillment services and are well on our way to having more than 50% of online orders fulfilled through our own channels. Again, this will reduce our fulfillment expenses and provide faster delivery to our customers. In addition to expanding our assortment of décor and gifts, we’ve also improved our in-store presentations to make the product easier for customers to shop and easier for our teams to restock and recover. With a focus on clarity and simplification, we have more key item presentations, cleaner signage, more streamlined packaging, and fixturing that allows customers to touch the product. Online, we have made investments to make it easier for customers to navigate, search and ultimately purchase on Michaels.com, including new search as you type functionality, improved filtering capabilities, and new messaging for product recommendations. We know that value continues to be important to the customer, especially during the holiday season, and we have taken additional steps to reinforce the values we offer. In addition to offering our low price guarantee and everyday value program, this holiday season we’re leveraging more even dollar price points on drive aisle fixtures and end caps to clearly communicate the values we offer, and new this year we’ve introduced a variety of gift with purchase programs. To communicate all these improvements to customers, we are leveraging television, print and digital platforms with a focus on offering customers solutions while also continuing to reinforce our value, trend leadership, and omni-channel benefits. A year ago, we launched Make, an integrated brand campaign intended to leverage the growing consumer trends of DIY and personalization while also positioning Michaels in a more contemporary light. Our goal was to differentiate the Michaels brand, broaden our reach, and drive increased customer engagement. Since Q3 of last year, we have created eight make-off videos with celebrity makers entertaining more than 65 million viewers. We have released 33 Facebook Live videos using our own experts as well as key influencers to highlight trends and Michaels exclusives, and we have hosted 13 integrations with the ABC morning program, Good Morning America to show that making can be fun and fast. Our brand metrics and customer data suggest that these investments are delivering initial results. Our top of mind and unaided awareness has increased and our CRM analysis suggests that we are successfully driving increased shopping frequency with our core existing customers, resulting in very healthy comp increases for this group of customers. While we have made progress, we know we have opportunity to capture and retain more new customers. Recognizing that the holiday season is a big opportunity to attract these new customers, we are introducing new marketing vehicles and expanding our in-store experiences to drive more customer engagement. We continue to expand our extensive customer database and today we can identify 70% of transactions to a specific customer versus 65% a year ago. The growth of our Michaels Rewards program has been an integral contributor to this growth. Today, more than 21 million customers are enrolled in Michaels Rewards compared to just 10 million at the end of the third quarter last year. As we head into the holiday season, we intend to leverage the insights from this data to customize our messaging and target promotional offers to drive sales while protecting gross profit dollars. This holiday season, we have introduced new marketing vehicles to engage the novice and new customer, including a new holiday décor guide that highlights both pre-made décor collections as well as project ideas for customers who would prefer to DIY. We’ve also introduced new Gift With Purchase promotions to drive traffic and average transaction values, and we have increased our use of digital search to drive traffic to Michaels.com and support our holiday messaging. We are also expanding our exclusive Make Breaks in stores, giving more customers more opportunities to try simple projects and make for themselves. So far this year, more than 1.3 million customers have participated in a kids club, Make Break or more structured class, all of this representing an increase of 56% over the first nine months of 2016 in customers taking some kind of event-based class at a Michaels store. Finally, the progress we have made to link our physical stores, digital storefronts and digital applications into a more integrated shopping experience continues to improve and we believe positions us well to build on the momentum we saw in Q3. In August, we launched our new Michaels app to more effectively connect our brick and mortar and online experience. With this refresh, we’ve made it easier for customers to organize projects, manage shopping lists, manage coupons, join Michaels Rewards, and ultimately make a purchase. With more than 50,000 SKUs in an individual store, we know finding specific items for a certain project can be difficult. Using the app’s store-specific way finding, we can now direct a customer to an exact aisle within her particular store to help her find exactly what she needs to complete her project. We’ve recently added information about inventory availability, so if the item she is looking for isn’t in her store, she can search nearby stores to determine additional in-stock availability. This new functionality has also been well received by Michaels team members who can access the app on an in-store handheld device, enabling them to help more customers and drive increased conversion. We have also recently added beacons in all our stores to support more personalized interactions with customers. When in store mode, the app will welcome the customer to the store and will automatically update the information to reflect that specific store’s layout, assortment and inventory levels. Customers are responding very well to this new functionality and providing great feedback. Our weekly app downloads are averaging more than double the pace of last year and we’re seeing more customer engagement with almost twice as many unique users using the app each week when compared to last year. We’re particularly excited that more customers are showing interest in shopping and projects versus only coupons. Even as we work to position Michaels stores and Michaels.com for a good holiday season, we are also investing in other platforms that build on our industry-leading capabilities and create new opportunities to engage with customers. Two examples of these efforts are framerspoint.com and consumercrafts.com. At the end of the third quarter, we launched framerspoint.com. This online framing solution targets the entry level custom frame customer who wants a low cost, easy way to frame digital assets, including personal photos or a selection from our library of more than 10,000 art prints. With the efficiencies provided by our artistry division, our integrated custom frame manufacturer, framerspoint.com offers customers a selection of unique frames with a simple, competitive, everyday low pricing approach. We also recently refreshed and re-launched consumercrafts.com, an EDLP consumer-facing website we acquired as part of the Lamrite West acquisition. With a focus on core crafting categories, consumercrafts.com provides us with a stronger platform to compete against other EDLP competitors in the online space. Leveraging the strength of our product development capabilities, we have doubled the assortment available on the site, adding new Darice and Michaels developed product and refreshed the look and feel to make it more appealing to customers. Additionally, we are investing in new digital marketing support to drive traffic to the site. While we do not expect consumercrafts.com to be as large as Michaels.com, we are encouraged by the customer response to the enhancements we have made. Finally, I’d like to give you an update on our Lamrite West operations. When we acquired Lamrite West in 2016, we indicated that the transaction supported our Vision 2020 strategy in three key ways

[Denise Paulonis:]

Thanks, and good morning. Third quarter net sales increased 1.1% to $1.24 billion. As we indicated in the earnings release, we estimate that the hurricane impact hurt net sales by approximately $10 million. Comp store sales increased 1% or 0.5% on a constant currency basis inclusive of approximately 80 basis points of impact from the hurricane. When adjusting for this impact, our overall comp sales performance of 1.8% or 1.3% on a constant currency basis was within our original Q3 guidance range. The increase in net sales was primarily due to the increase in comparable store sales and the operation of three net additional stores opened since the third quarter of 2016. The comparable store sales increase was driven by an increase in average ticket which was partially offset by a slight decline in customer transactions. We believe the disruption from the hurricanes adversely impacted transaction counts during the quarter. Excluding the impact of the hurricane, we estimate that transactions were slightly positive. The net new store number includes 18 new Michaels stores, one new Aaron Brothers store, and one new Pat Catan store, which was offset by 15 Aaron Brothers store closings and two Michaels store closings during the 12 months since the third quarter of fiscal 2016. As expected, these increases were partially offset by lower wholesale revenue. As Chuck discussed, the revenue decline in our wholesale business reflects timing differences related to new customer acquisition and the expected attrition of legacy customers. While the sales cycle is taking longer than we expected, we are encouraged by what we see in the sales pipeline. Gross profit dollars for the quarter grew 4% to $484 million and our gross profit rate for the quarter increased 100 basis points to 39% of sales versus 38% of sales in the third quarter last year. The increase in the third quarter gross profit rate was primarily a result of our increase in product margin driven by benefits from our ongoing sourcing efforts. Additionally, we saw modest benefit from the timing of distribution related costs and the comparison against $700,000 of net non-recurring inventory-related purchase accounting adjustments recorded last year related to the acquisition of Lamrite West. These benefits were partially offset by higher inventory shrinkage. Our sourcing efforts, including both our work to reduce product cost as well as leveraging our China office and our efforts to buy more direct from factory are delivering material cost savings. We believe the 2017 benefit of our sourcing work will be at the lower end of the $40 million to $50 million range we shared when we started the year, driven largely by sales mix and seasonality. We recognize the benefit of these savings as we sell through the inventory and we expect the remainder of the benefit will shift into 2018. As a reminder, similar to our sourcing benefit, we recognize supply chain costs when product is sold. During the quarter, the modest benefit from the timing of distribution-related costs was driven by lower international freight rates negotiated last year. Of note, in the second half of this year we have experienced some supply chain headwinds that we anticipate will flow through our P&L in early 2018. As Chuck mentioned, we incurred some unexpected supply chain costs related to hurricane disruption to our Jacksonville DC. Additionally, we have experienced higher domestic and international transportation costs as capacity has tightened. Overall, our inventory shrink as a percent of sales remains low; however, this year we have seen shrink increase as compared to last year. As we have previously discussed, we’re taking steps to address the trend including investments in new equipment and fixtures, but embedded in our annual guidance is an expectation that shrink will remain a headwind. Total store rent expense for the quarter was $100 million versus $98 million last year with the increase primarily due to a net 16 additional Michaels stores. Selling, general and administrative expense in the quarter, including store pre-opening costs, increased 3% to $330 million compared to $320 million in the quarter last year. As a percent of sales, SG&A expense increased 50 basis points to 26.6% of sales compared to 26.1% of sales in the third quarter last year. The increase in SG&A expense as compared to last year was primarily due to an increase in accrued incentive-based compensation. Recall that in the third quarter last year, we saw a $14 million reduction in accrued incentive based compensation. In addition, this year we had incremental marketing investment and higher healthcare expenses related to higher claims. These increases were partially offset by the anniversarying of about $1.6 million of integration expenses recorded in the third quarter of fiscal 2016 related to the acquisition of Lamrite West. As a result, operating income increased 5% to $154 million or 12.4% of sales, in line with our initial guidance for the quarter. For the quarter, interest expense was $33 million, about $1 million higher than the third quarter of last year. This increase was primarily due to higher interest rates on both our ABL and term loan credit facility and a higher average balance on our ABL during the quarter. The effective tax rate for the quarter was 34.3% compared to 29% in the third quarter last year. The increase in the effective tax rate was primarily a result of anniversarying a benefit in the third quarter last year from discrete items related to a certain federal tax credit. We also experienced higher state taxes in the quarter this year. These increases were partially offset by the benefit from our global sourcing initiative, which has lowered our consolidated effective tax rate. As we’ve previously discussed, our global sourcing operations give us more control over the manufacturing process and an opportunity to initiate lower costs and deliver even more value to our customers. Reflecting the impact of these factors, we delivered net income for the quarter of $80 million or $0.44 per diluted common share based on 182 million diluted weighted average common shares outstanding. We estimate the negative EPS impact of the disruptions from the hurricanes was about $0.01. Now turning to the balance sheet, total merchandise inventory at the end of the quarter was $1.4 billion, up slightly from the end of the third quarter last year. On a per-store basis, inventory levels were down about 1% compared to last year. We feel good about our in-stock levels for the holiday season. Our liquidity position remains strong. At the end of the quarter, cash on the balance sheet was $177 million, total debt was $2.9 billion, and our revolver availability was $676 million. Capital expenditures for the quarter were $30 million, bringing our total through the first nine months of the year to $73 million. Based on changes in project timing, we now expect that capital expenditures for 2017 will be approximately $120 million. Finally, we continue to utilize our strong cash flow and balance sheet to return value to shareholders. In the third quarter, we purchased 2.4 million shares for about $48.6 million as part of our previously announced share repurchase program. Note that the third quarter cash flow statement includes about $11 million for shares purchased in Q2 that settled in Q3. Given the timing of purchases, the EPS benefit was minimal to the third quarter. At the end of this quarter, we had about $350 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 repurchase 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’ve updated our guidance to reflect our Q3 results and our expectations for Q4, including a more favorable Canadian exchange rate. For modeling purposes, we now expect the Canadian exchange rate will average $1.29 for the full year. Any changes from this assumption will have an impact on our results. For fiscal 2017, we have tightened our sales guidance and now expect net sales to increase between 2.9% and 3.2%. This guidance is based on the expectation that comp store sales will increase 0.6% to 0.9%, or 0.4% to 0.7% on a constant currency basis. 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 now anticipate operating income will be between $735 million and $745 million. This guidance now includes the expected benefit of approximately $40 million in sourcing benefits which I discussed earlier and the headwind of anniversarying a $46 million decrease in accrued performance-based compensation in 2016. We continue to plan for interest expense to be approximately $130 million and the effective tax rate to be between 34% and 35% for the full year. Based on these expectations, we expect that diluted EPS will be in the range of $2.13 to $2.16 based on approximately 186 million diluted weighted average common shares for the full year. As previously discussed, this guidance does not contemplate any potential changes to the Aaron Brothers business. Now turning to Q4, we anticipate comp store sales will increase between 1.5% and 2.5%, or 1% to 2% on a constant currency basis. We also plan to open one new Michaels store and close four Aaron Brothers stores during the fourth quarter. We expect operating income for the quarter will be between $354 million and $364 million. This guidance reflects our expectation for continued benefit from our sourcing efforts. Also as a reminder, SG&A in the fourth quarter last year benefited from a give-back of about $28 million related to accrued performance-based compensation. Based on these expectations, our Q4 guidance for fully diluted earnings per common share is $1.15 to $1.18, based on a diluted weighted average common share count of 182 million. In closing, we are pleased with our performance this quarter. Excluding the disruption from the hurricanes, we are seeing nice momentum in our business both online and in stores, and our efforts to increase direct sourcing, reduce product costs and manage promotions helped to offset expected headwinds from accrued incentive compensation and additional marketing investments. The result was nice operating margin expansion and EPS growth. With that, I’d like to open the call to take your questions. Rachel?

[Operator:]

[Operator instructions] The first question comes from Matt Fassler with Goldman Sachs. Please go ahead.

[Matt Fassler:]

Thanks so much, and good morning.

[Chuck Rubin:]

Good morning, Matt.

[Matt Fassler:]

My primary question relates to some of the omni-channel innovation that you’re implementing, particularly Buy Online Pick-Up In-Store. You have the benefit of doing this after a number of peers in different verticals have implemented this strategy. Can you talk about what the economics of this would look like compared to, I guess, a typical store-based transaction, and as you think about your ticket and margin structure, etc., is this margin accretive, is it margin dilutive relative to the base business?

[Chuck Rubin:]

Matt, there’s lots of nodes of delivering online purchases to customers, so today we use a third party fulfillment arm for part of it, we use our own DCs for part of it, part of it is drop shipped, part of it we ship from store, and now BOPUS as you described. BOPUS, we believe will be the most profitable of those nodes of shipping online orders. With that said, because there’s the additional pick in the store, it likely is less profitable than the brick and mortar only purchase that the customer goes in and services herself. But we’re excited about BOPUS because today when you look at our online sales and the pace at which they are growing, it will be a more profitable node because it eliminates the fulfillment costs that are just a tough number given the price points on our items. It’s a tough number for us to absorb, so it will be less profitable than brick and mortar but it will be the most profitable for ecommerce.

[Matt Fassler:]

My follow-up, Chuck, relates to incentive comp. You quantified the reversal or the decline in incentive comp you had last year in the third quarter. How much of that $14 million did you restore to the P&L, and I think you had a $26 million or a $28 million number in the fourth quarter last year, how much of that gets put back in the budget that drives the guidance you gave us here?

[Denise Paulonis:]

So Matt, included in the number that is in the third quarter is a $5 million increase in incentive-based compensation. As we’ve been sharing quarter by quarter as that number has moved, we accrue that number based upon our current business results versus our entire EBIT planned for the year, so in the third quarter it was $5 million.

[Matt Fassler:]

And Q4, the guide, would it be the whole 28 or 26, whatever that number was, or some piece of it that gets us to the guide for the fourth quarter?

[Denise Paulonis:]

We have not shared that level of precision, but directionally we recover most of what we gave back last year.

[Matt Fassler:]

Super helpful. Thank you so much, guys.

[Chuck Rubin:]

Thanks Matt.

[Operator:]

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

[Steve Forbes:]

Good morning.

[Chuck Rubin:]

Good morning Steve.

[Steve Forbes:]

You called out marketing expense as a headwind, and I think we all knew that was going to be; but as you prepare for the upcoming holiday season, I know you mentioned some new marketing vehicles, but what are you most excited about as you think about the opportunity set out there to capitalize on some of the marketing investments and merchandising changes, like everyday values, that you have made this year, and is the holiday about growing trips, is it about driving new customer acquisition, is it both? I mean, really, how great is the opportunity set as you think about this upcoming holiday season?

[Chuck Rubin:]

Steve, I’m excited about the plan that we have in place. There’s a number of things that I’ve very enthusiastic about. Just to touch on a few of them, I think we have just a terrific holiday assortment. Our merchant team in our seasonal business is really strong and we’ve taken a really good balance of trend, key item and value and put it together and we’re very excited about our results so far and we’re excited about what’s still to come. We’re hopeful that weather holds off for us this year. We’re also excited about the efforts that we have with our core customers. We’re seeing very nice growth from them. Our CRM efforts that we’ve talked about so many times and we have stated before, and I would state again now, that this is a long-term effort to collect customer data and get more refined in how we’re talking to that individual customer, but we’re seeing very good performance from them. It’s the new customer part of it that we continue to work very hard on. Crafting can be a very intimidating activity, and shopping within our store or in any of our competitors, whether it’s online or in-store, can be very intimidating as well, so we’ve done a lot of things both digitally and in-store to try to make it easier. I’m not sure that we’re all the way there yet, but we’re excited about the progress that we’re making and the fourth quarter is usually a very good spot for us, because we have become very good in the seasonal offering and we do see a lot of customers who come in who are less intimidated about decorating their home for Christmas, for instance, than they might be in knitting or painting, so our opportunity this quarter is to try to get more of those new customers in, service them well while they’re in our store or online, and then pick them up in 2018 and try to convince them to come back more.

[Steve Forbes:]

Thank you. As a follow up, you gave some color on the build-out of Lamrite West in China, Hong Kong, in Dallas, those resources. I don’t know if you ever quantified the expense drag associated with that build-out, but if you can, can you share it; and then, is there more investment on the horizon here or is the team basically in place and now it’s really time to leverage those assets, infrastructure and so forth?

[Chuck Rubin:]

Well we haven’t broken out the cost of building the team out, but remember as we’re building our team out, we’re also spending less on third party agents. We are leveraging the team now. We’ve gone from very little direct import--in 18 months, we’ve gone to a high portion of what we do that’s direct importing, so this team both in China and in Hong Kong, as well as here in Dallas, has done just a terrific job of getting scaled up. We think that there are still some additional things that we’re working on to improve, but we’re getting good leverage on it right now.

[Denise Paulonis:]

And I’d add one point of note on the P&L, the costs for that China office and that build-out is included in our gross margin.

[Steve Forbes:]

Thank you.

[Chuck Rubin:]

Thanks Steve.

[Operator:]

The next question comes from Christopher Horvers with JP Morgan. Please go ahead.

[Christopher Horvers:]

Thanks, good morning. A couple questions. First, can you talk about as you think about the gross margin, how is the promotional environment on a year-over-year basis, and related to the $40 million of sourcing benefits, does that benefit pick up from a gross margin rate benefit in the fourth quarter, sort of given the mix of seasonal and the weight of sales in the fourth quarter?

[Chuck Rubin:]

Chris, on the promotional aspect, we’ve talked before, this is a really promotional industry. It’s remarkably promotional. We haven’t seen it step up, though. I know we have not stepped up our promotion. We’re trying to get smarter about the promotions so not all customers see the same promotion at the same time. We also have tried to get smarter about how we market the promotions, so there were certain times that we do an event that we’re marketing it in a way to make it look bigger, but in fact compared to what we may have done in the past, it may be a narrower offering that’s being presented on promotions. So overall, we don’t see a lot of changes in the industry, and I know from our standpoint we continue to make some progress in managing our discount dollars smarter, but we were not more promotional in the third quarter. I would remind everyone that when we’ve talked about these sourcing benefits in the past, we did say that it gave us some fuel to be able to go out and be aggressive in our pricing efforts in the third quarter, as evidenced by our improvement in margin. We were able to balance all of our objectives reasonably well.

[Denise Paulonis:]

Then Chris, in answering the second part of your question, which was about the impact of sourcing in Q4 versus Q3, we don’t break out in a great level of detail what that’s going to look like, but directionally you would expect it to be in line with the third quarter.

[Christopher Horvers:]

From the rate benefit?

[Denise Paulonis:]

From a rate perspective, correct.

[Christopher Horvers:]

Understood. Can you talk about--just on the capital structure, can you talk about how you think about the economics of paying down debt versus share repurchases? It’s one of the questions that we sometimes get in terms of leverage on the business. It is expensive [indiscernible] that you hold and just the economics of share repurchase would make more sense? Just the overall thought process there would be helpful, thank you.

[Denise Paulonis:]

So Chris, I’d step us back one and go back to what we talked about on prior calls. When we think about the capital allocation overall, we are primarily focused on investing in the business where we believe that the returns are there to do so. Over the course of the first few years of being public, we substantially reduced our debt over that period of time and we believe that that was the prudent thing to do to get us into a debt level area where we feel really comfortable sleeping at night. I think you know our numbers well, but our cash flow generation every year leaves us incredibly comfortable in covering the level of interest expense we have. Very simply, when you look at the share price that exists today and the value that we believe exists in the company, we believe the efficiency of doing share buybacks is a great choice for us.

[Christopher Horvers:]

Thanks very much.

[Operator:]

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

[Joshua Siber:]

Good morning, it’s Joshua Siber on for Simeon today.

[Chuck Rubin:]

Morning Josh.

[Joshua Siber:]

Good morning. On the sourcing initiatives beyond the initial $40 million to $50 million of savings that you’ve laid out, what do you believe is the potential long-term opportunity there?

[Denise Paulonis:]

Josh, when we think about it, this process is an ongoing process for us. We’ve worked through the first wave of many of the sourcing categories we’ve had with some of the process changes as well as leveraging the China office. We believe that there is still significant room to run and are using both those tactics and strategies to go back through and continue to drive cost out of the business. We’re also experimenting with some new approaches as well to see where else we can create opportunity, so we feel good that that pipeline continuing into 2018 is a robust pipeline.

[Joshua Siber:]

And with respect to the savings, would you expect to deploy that more towards promotion and focus on value, or actually let the gross margin expand back to that 40% range?

[Chuck Rubin:]

You know, Josh, we’ve talked before that it gives us a lot of flexibility, so we’re going to use it to grow our business. Right now, we see a promotional environment that’s pretty stable, and in the third quarter we were able to bring the sourcing benefits to the bottom line for the most part. We would hope that that would continue, but it does give us a lot of flexibility that we’re very pleased on.

[Joshua Siber:]

Okay, and as a follow-up to Steve’s question earlier, the marketing costs are up the last three quarters. Are you seeing the returns that you’re hoping for on marketing?

[Chuck Rubin:]

Well, yes. I mean, some of this--firstly, the marketing spend is up incrementally, so it’s not a material increase - I want to clarify that. When you look at it, we’re very good at measuring the return of our marketing spend, but there is some parts of it that we’ve got to invest in the long term, and when we’ve been building out some of these digital assets and when we’ve been building out search capabilities, as an example, we’re spending some more money on that, that we think is going to have a longer tail in terms of the return. In total, we’re pleased with how much we’re spending, but the near term return on every dollar spent, on some parts of it we’re recognizing that you can’t measure it the day after you’ve spent and look at that return. This is going to be a longer term effort, especially as we continue to try to attract new customers, try to explain to them that Michaels can make making easier for them. It’s going to involve some portions of our spend being a longer term return.

[Joshua Siber:]

Okay, thanks so much.

[Operator:]

Again, please remember to limit yourself to one question with one follow-up question. If you have additional questions, you may re-enter the question queue. The next question comes from Elizabeth Suzuki with Bank of America. Please go ahead.

[Curt Nagle:]

Hi, this is Curt Nagle on for Liz. Just a quick one on the loyalty program. I think you had increased the number of members by about 2 million quarter over quarter. Is it still about 50% of total sales are attributable to the program, and where do you see that going over the next couple years in terms of penetration?

[Chuck Rubin:]

It’s somewhere in that mid-50 range. I came from a company that loyalty was 90% of the sales, so I’m not quite sure that it gets quite that high for us, but we still see a lot of room to grow here.

[Curt Nagle:]

Got it, okay. That was my only question. Thanks very much.

[Chuck Rubin:]

Thank you.

[Operator:]

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

[Mike Baker:]

Hi, thank you. In your press release, you talked about--I don’t remember the exact quote, being pleased with the start of the holiday season. Could you provide some color on that? Is that in reference to Black Friday, or we know you had very easy comparisons earlier in the month when we were cycling the election from last year, so can you just give us some more color on what you’re seeing in November? Thanks.

[Chuck Rubin:]

Yes Mike, I hate to disappoint you - we’re not going to give a lot more color, but we’re a month into the quarter now, we’re pleased with what we’ve seen so far. I think it’s been widely reported that the Black Friday weekend was generally good across retail, and we felt good about--inclusive of Cyber Monday, we felt good about how it all shook out, but our guidance is predicated based on what we’ve seen in the first roughly four weeks of the quarter now. The meat of the quarter is still ahead of us - I can’t stress that enough, so Black Friday is not generally a good predictor of the overall quarter but we do feel good about what we’ve seen in the first part of the quarter, and we feel good about our plans and the controllables that we have. But again, the lion’s share of our sales are still ahead of us.

[Mike Baker:]

Okay, thank you. Then as a follow-up, just talking about ticket and traffic a little bit, the ticket, how did your promotional activity impact your ticket; in other words, what drove the higher ticket? We presume you were low on price because you were a little bit more promotional. Does that mean that the mix is impacting the ticket?

[Chuck Rubin:]

I’m not sure if I heard you correctly. We were not more promotional. I think you may have just said we were, but--if I misheard you, I apologize. We were not more promotional. The ticket is somewhat influenced by the mix of product that we have out there, so seasonal--you know, we had a very good seasonal business in the third quarter, and seasonal tends to run at a slightly higher ticket. Also, the technology items, Cricut is one of our vendors that sells big ticket technology items, big ticket defined as it could be a couple hundred dollars for a Cricut machine, and we have between the machine and the accessories that go with it, it’s kind of the razor blade kind of scenario for us. We’ve done really well with that and believe that--I think we’re the number one retailer for Cricut at this point, so that’s driving the ticket up.

[Mike Baker:]

Understood, thank you.

[Chuck Rubin:]

Thank you.

[Operator:]

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

[Seth Sigman:]

Thanks, good morning. Nice quarter. Just a couple of follow-up questions from me. As you take a step back, over the last couple of quarters you have seen an improvement in comps. We had gone through a period where there was a lot more volatility week to week. I think that’s something that you had talked about in the past. As you look at Q3 outside of the hurricane, do you feel like you’re seeing more consistency now, and do you think that’s a function of the environment, do you think it’s a function of some of the internal initiatives that are working? Just any more color on that would be helpful.

[Chuck Rubin:]

You know, that’s a good question, Seth. There was--you know, the hurricane provided enough volatility, if you would, to exclude that. On a week-by-week basis, I guess it was reasonably stable. Within the week, you still see volatility. I believe still that while we’re pleased with the performance of our business, the customer is still shifting. She wants value and she wants convenience and she wants something easy, and I think we’re well positioned for all of that; but the day-to-day fluctuation of when she’s shopping, and even within the day--you know, there are days that we’re seeing within the day, the time frames of her shopping is changing from evening to day, or day to evening. But generally, we’ve seen more stability and we feel good about--as I said, we feel very good about how we’re positioned for the fourth quarter, and we think that she’s--you know, our customer’s in a pretty good mind frame as well, so I think that translates to greater stability.

[Seth Sigman:]

Okay, that’s helpful. Then my follow-up question is around the online growth. I’m just trying to better understand the growth that you’re seeing versus the tactile and in-store nature of shopping in the category as you discussed earlier. Obviously that growth is coming off of a low base, but can you just help us, maybe give us a sense of what is actually growing online in your business and what do you know about the customer online? Is it a different customer, is it incremental, is it a different type of shopper? Any more color, thank you.

[Chuck Rubin:]

Yes, as you said, our online business is growing very quickly. We doubled it in third quarter. It’s still a very small portion of our business, but we’re very pleased with the progress that it’s making and it’s tracking pretty darn close to where we thought it would be at this stage, and it gives us confidence for our plan in the future. The mix of products that we sell online is a little bit different than what we sell in store. It tends to be--you know, we tend to sell somewhat higher ticket items online than we have in the store. As far as the customer, we are seeing new customers. Now, when we define new, in some cases because we’re still in the process of identifying customers, there’s a segment of them that we see them as new but they may have been unidentified in the past for us, so they may have come in and paid cash or we may not have been able to track their credit card number, as an example. But you know, we’re pleased that it does look like we are still seeing a segment of new customers. We know that the customer who is buying online and in store for us is turning out to be a very valuable part of our customer base. She does shop more often, she is spending more money with us, so that omni-channel offering of being able to buy online, return it in store, we think we’re seeing customers that are using our app to help direct them within the store. We think that this cross-channel technology enhancement that we’ve put in place, that we’re seeing the beginning of better value for those customers who are taking advantage of it, and we think it will continue for us. But again, this is an industry that we think will be underpenetrated compared to other industries for online sales, but the use of digital to make her experience better in store as well as that occasional ecommerce offering or transaction, we think is the more exciting part for us.

[Denise Paulonis:]

And if you relate it back to analyst day, we talked quite a bit about where we believed that the industry was in the mid single digit penetration and that we were so much below that, so in some cases what you’re seeing now in the rapid growth that we have is from us kind of starting from zero in 2014. We’re really catching up more to where the industry level is versus going beyond that, as Chuck has alluded to.

[Seth Sigman:]

Great. Thanks for the color, and happy holidays.

[Chuck Rubin:]

Thanks, you too.

[Operator:]

The next question comes from Dan Wewer with Raymond James. Please go ahead.

[Dan Wewer:]

Thanks. Chuck, you sounded more upbeat on the framing business following some of the changes you’ve implemented the last four to six months. If that continues, what’s the sales opportunity, the incremental sales opportunity in 2018 - is it one, two percentage points, less or--? If you could help us get our arms around that?

[Chuck Rubin:]

Yes Dan, we’re not going to get into 2018 guidance just yet, but I can tell you there’s been lots of questions on the custom framing business. We remain very committed to it. It’s a business that we are just really good at. We are by far the biggest player in the industry. We’re excited about our online offering that we just introduced, although we do believe that online framing gets a lot more press than the sales that the different companies are doing would support, but we do think our online offering is a good extension. It’s a very high margin part of our business because we’re vertical in most of what we sell, but it is a true sales experience, it is not a self service environment within our stores, so we are working really hard to get this turned positive again. It will turn positive, we’re just not sure exactly when it will be. As I mentioned in my prepared comments, we are excited about some of the progress that we’re making. Every step of improvement that we make, given the margin structure of this business, is really good for us from a bottom line and a top line standpoint. Again, I can’t remember what we said about the penetration, but it is a single digit percentage of our overall business, so like we’ve discussed before, we run a portfolio of businesses and custom framing is one of them, so it’s less than 10% of our overall sales, it just happens to be at very attractive margins. So we’re working hard to make it better and we are confident it will turn positive, and when it does we’re confident it will be a nice boost to our bottom line.

[Dan Wewer:]

Okay, and then as a follow-up question, it sounds as if the higher supply chain cost and the increased shrink accrual continues maybe through the first half of 2018. Can you provide just a bit more detail on what’s contributing to the higher shrink? I found it surprising given your inventory levels appear to be so low or so lean at this point.

[Denise Paulonis:]

Dan, as some context, from an industry basis the best that we can tell, we still have incredibly competitive shrink rates overall. We’ve run very low shrink historically, so the uptick that we’ve seen this year, it is more attributable to in-store theft than anything else, but we know a bit why. We’re doing much more in-store to uncage our products to make it easier for the customer to try, to test, to touch what they’re going to buy. An example is we have a marker bar at the front of the store where people can not only test to see the color, they can test to see the thickness of the pen that they’re about to buy. Well by default, that makes that merchandise that much more accessible for someone who might have slightly less positive intentions. But against that, we’re doing some good things. We continue to think about our fixtures and we continue to think about investments in technology to make it a little harder for any of that theft to happen, so we do store counts primarily through the first three quarters of the year, and so it will be into 2018 before we get a read on whether those changes that we’re putting in place will really have a significant impact in changing the trajectory that we have now. But I’d once again remind you that overall, our shrink rates are pretty darn low compared to the industry.

[Dan Wewer:]

Okay, thank you.

[Denise Paulonis:]

Rachel, I think we’ll take one more question.

[Operator:]

Okay, thank you. The final question will come from Alan Rifkin with BTIG. Please go ahead.

[Alan Rifkin:]

Thanks very much. With the Lamrite acquisition now about 18 months old, where are the specific areas where you think future synergies remain, and do you believe, Chuck, that all of the future synergies, whatever they may be, will be realized in calendar ’18? I do have a quick follow-up, please.

[Chuck Rubin:]

Well you know, the back end synergies, most of what we were going to get, we’ve gotten. The synergies in terms of capabilities, we’re tapping all of them. We talked about in the prepared comments that the China offices that we have, the China, Hong Kong offices, it was small when we bought the company. It’s expanded, it will continue to expand, an outstanding part of the investment for us. The product development folks that were part of Lamrite - very talented. They have helped us develop our Martha Stewart line which we now have exclusive in our industry; David Tutera, I mentioned in my prepared comments, so they’re doing very good work there. That’s scalable as well. The Pat Catan stores, it’s a small chain of stores - 35, 36 stores that have allowed us to test new businesses in a very controlled environment, so we’re in fabric in all of our stores in Pat Catan, we’re learning a lot about the fabric business, and we have an expanded party assortment as well. So the synergies, I think I’d pose it differently. I think the scalability of what we have with Lamrite West, and we’re getting really good use out of it and I think it can continue to scale further.

[Alan Rifkin:]

Okay, thank you. As a follow-up, you said that Christmas was set a little bit earlier. I was wondering if you thought that that benefited comps at all, and do you think that the incremental revenues will be accretive to the overall holiday season or will it really just pull revenues forward from later on in the year?

[Chuck Rubin:]

Yes, we said it earlier - both online and in store in the third quarter, it wasn’t a material impact on the third quarter but it gave us a good sense of initial customer response, and we do not think it will be cannibalistic to what happens in the fourth quarter. We think it’s going to be accretive, and I think it’s a good learning for us next year that we’re working on now, that there is some business, especially in this industry where a lot of things we sell, people actually use them to make something for the holiday, and if you can give them a little more time to do that, I think they react well. But we don’t see it as being cannibalistic.

[Alan Rifkin:]

Okay, thank you. Best of luck for holiday season.

[Chuck Rubin:]

Thanks Alan. With that, let me turn to just closing the call. We are seeing nice momentum in our business and we are encouraged by the customers’ response to the improvements we’ve made, both in stores and online. As we begin the fourth quarter, our teams are ready to serve customers both in stores and online as well. As I’ve said, we have the largest holiday assortment we’ve ever offered both in-store and online, we have a compelling marketing plan to communicate the value and solutions we offer, and we have invested to create an integrated omni-channel shopping experience. As I mentioned before, we are pleased with the initial start to the quarter, although we do recognize the heart of the season still lies ahead. We’re excited about our plans, we’re confident in the investments we’ve made in support of our long-term strategy, and we’re confident that they will drive continued momentum and deliver strong, long-term financial results. With that, let me thank you for joining us today. We wish everybody a happy holiday and we look forward to sharing our fourth quarter and full-year results with you in March. Thank you.

[Operator:]

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