Michaels Companies Inc
Q1 2015 Earnings Call Transcript

Published: 4 Jun 2015

[Operator:]

Good day ladies and gentlemen, my name is Saeed and I will be your conference operator today. At this time, I'd like to welcome everyone to Michaels First Quarter 2015 Earnings Conference Call. [Operator Instructions] Thank you. And now, I would like to turn the call over to your host, Elaine Locke, Director of Treasury and Investor Relations. Ms. Locke, you may begin your conference.

[Elaine Locke:]

Thank you, Saeed and good morning, everybody. Welcome to our first quarter 2015 conference call. Earlier this morning, we released our first quarter financial results. A copy of the press release is available on our website at www.michaels.com. I need to remind you that certain comments made during 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. Such forward-looking statements are subject to both known and unknown risks and uncertainties that could cause actual results to differ materially from such statements. Those risks and uncertainties are described in the press release and Michaels' 2014 10-K filings. A copy of this filing is available on our website. The forward-looking statements made today are as of this date of this call and we do not undertake any obligation to update our forward-looking statements. On the call with me today is our Chairman and Chief Executive Officer, Chuck Rubin, our Chief Financial and Administrative Officer, Chuck Sonsteby and our VP of IR, Treasury and Corporate Finance, Denise Paulonis. I will now turn the call over to Chuck Rubin. Chuck?

[Chuck Rubin:]

Thank you Elaine, good morning everyone. On today's call I will review the highlights of our first quarter performance, as well as comments on a couple of our key initiatives and the progress we have made against them. Chuck Sonsteby will then go through our financial results in more detail and discuss our outlook before I provide some closing comments and we open the call up for your questions. For Q1 we delivered total sales of $1.1 billion, an increase of 2.4% or 3.6% on a local currency basis versus last year, and a comparable store sales increase of 0.3% or 1.4% on a local currency basis. Our Q1 operating income increased 3.4% over the last year to reach $144 million with an operating margin rate of 13.4% versus 13.2% last year. Going into the quarter we knew we had to lap a 300 basis point comp impact from Rainbow Loom in Q1 2014. We also faced the same FX and West Coast port impacts that you had heard about from other retailers. The FX impact was as we anticipated, however the delays and receipts of goods resulting from the impact of the West Coast port slow down was somewhat greater than we had expected. Finally with the earlier Easter compared to last year, our big event of the quarter, our LPOS event or lowest price of the season event occurred post Easter, which historically has not been as strong and that did curtail some of our poor sales. So while we did not achieve the high-end of our guidance, we delivered a solid quarter with comps when adjusted for the above that were higher than our long-term guidance. Additionally, due to our financial discipline we grew our operating margin while still investing in our long-term vision 2020 growth strategy. Let me share some additional details about the quarter. We continue to improve our exclusive on trend merchandise to better serve and inspire our customers. Very visible in our stores and in our marketing was the Make Market offering. This is a private brand collection of burlap, chalk, cork, galvanized metal and denim products. The display includes décor and do it yourself items ready to be personalized by our shoppers. This was launched in Q4 2014 and expanded during Q1 and customer response has been very strong. Our private brand program expanded also with new markers in craft paint introductions, a new line of paper crafted products and new lifestyle frame and home décor collections, all ready to make a statement for our customer. Our private brand continues to be a strong performer for Michaels across almost every product category. Our best-in-class private brand capabilities allow us to design and source products that deliver both a very good customer value in price, quality, and style, as well as an attractive margin for Michaels. Private brand product sales grew to slightly over 50% of our sales during the quarter. Outside the private brand, we were proud to launch an exclusive Cricut Air Bundle that included a Cricut Machine, 23 projects for Michaels' makers and a free month subscription to Cricut design space. In marketing, we continued our efforts to balance our mass and personalized marketing messaging. The latter saw us continue to leverage what we believe to be the industry leading customer database with more email and more direct mail than ever before. We’re still very early in our CRM efforts to leverage our customer data, but we’re making progress. In the last 12 months alone, we have extended our email database by more than 10%. As we've previously discussed, offering our customers occasional store wide marketing events is key to our strategy. During the first quarter we had two such events inspiring customers to come shop at Michaels. In March we had our first spring time in Paris event. We used all of our different marketing channels to connect with our customer. For example, we had a dedicated website for the event that we see it almost 4,000 visits. Customers also share their ideas with us using Facebook, Pinterest, Twitter and Email. And in the store we had several classes that tied in with the spring time in Paris theme. One highlight of the event for our customers was their ability to create a personalized piece of art something that resulted from their individual creativity, and send us a picture to enter driving for a free trip to Paris. Over 11,000 entries were submitted for the contest. Our second big event to the quarter was LPOS, the lowest price of the season sale. As I mentioned, while being post Easter limited our sales performance to what our expectations were, it was still our largest week of the quarter. These two marketing events show the range of what we will offer our customers from promotional to inspirational. Overall, we believe we continue to gain market share by offering even more reasons to shop Michaels. As mentioned before we believe in the importance of educating the customer both the novice and the enthusiast. More people take a class with us at Michaels than any other arts and crafts retailer. This quarter we had another very successful class open house event in our stores and we continue to grow our class enrollment year-over-year. In an effort to make our training more accessible to customers we are now offering online video classes. The online education component is important to our omnichannel presence, as it allows the customer the flexibility per classes to fit her schedule. During the year we will continue to offer new classes in the store and online. Turning to our new business channels, we've now reached the one year mark since our launch of e-commerce. It has performed as expected and we believe it continues to be an important part of our omnichannel presence. Traffic to our website is up and we have enabled to maintain an average ticket on the website of about $50. The product offering online will continue to expand and improve over time with some products available online only when that makes sense. We also will continue to tweak the site to improve interactions in sales. Improvements to our mobile site will continue to be a focus during this year. At the end of the first quarter we added way finding to the mobile app. Now you can find where a particular category is located in your local Michael store using this feature on the Michaels App. This will make it easier for our customers to navigate the very big assortment of skews that they will find in our stores. Now let's take a few minutes to discuss the second quarter. While in the cadence of quarters this is certainly our lightest revenue quarter of the year, we remain focused on increasing our market share and expanding our customer base. In the second quarter we are planning to open seven new Michael stores and relocate three additional stores. No closures are expected at this time. Our initiatives to refresh our stores continue with an expectation that we will have touched the majority of the chain by later this year. As a reminder, our refresh initiative focuses on improving the look and feel of the store to improve the customer shopping experience. This includes enhancing signage for ease in locating product, improving site lines through lowering drive out fixtures, making product features more prominent through lower site counter sets, improving cleanliness in the store, and implementing the dress code to make it easier for customers to find our associates. Our customers are noticing these improvements in our customer service scores as measured by a third-party continue to improve over last year. During Q2 and into early Q3 our refresh initiative will continue as we rollout the major portions of our new signage package in approximately 800 stores and address a number of store infrastructure opportunities like updating, selected stores rest rooms. Also during Q2, we will leverage the insights from our Boston and St. Louis market remodels to test a lower intensity remodel effort that we are calling a reset. This will occur in the Baltimore market. These resets complement refresh work already completed or in the process of being completed and focus on improving product adjacencies and space allocation by product category. A reset is more cost effective than a full scale remodel as we do not fully replace fixtures or change any of the physical structure of the store. Over years and years, our chains of stores has evolved into chain of snow flex with many different product space allocations and adjacencies. This can make it confusing for shoppers who visit multiple stores and hard for our merchants to implement changes in product uniformly across the chain of stores. Our reset initiatives objective is to over time reduce the number of snow flex in our chain. By having fewer variations of product space allocations and space adjacencies we hope to improve the flexibility to expand or contract the different parts of our product offering portfolio in a faster and more cost efficient way than we're able to do today. In fact, there are too many times where we've had new products that have been successfully tested in a limited number of stores that we have not been able to economically place across the entire chain due to the snow flex challenge. So in Q2 we're excited to be moving forward with the resets in the Baltimore market. If our Baltimore effort is successful we believe it will allow us to materially simplify our store snow flex in a very cost efficient manner and allows us the opportunity - and will allow us the opportunity to reserve the need for future more extensive and expensive remodels to special situations. It will take several quarters of reviewing the results of this reset in Baltimore before we are ready to discuss the learnings. We have a number of exciting new product in assortment test plan including new party merchandise in select stores and new wedding and floral presentation and you do it yourself home décor offering and a new frame and home décor presentation. We believe having exclusive and trend right product is key to differentiating Michaels from our competitors. During Q1, we began to execute an expanded partnership with Pinterest. This relationship includes advertising opportunities for Michaels, as well as the ability to learn about the behavior of crafters on Pinterest. Other exciting news was the announcement earlier this week that Pinterest will start working with limited retailers to allow purchasing the products directly on the Pinterest App through buyable pins. A Pinner who sees arts and crafts product in certain pins will be able to seamlessly purchase by using the buy it button, or can click through the purchase the item in michaels.com. In keeping with our views regarding e-commerce shopping in the arts and crafts space, we can believe that this will not be a major revenue driver. This is more about completing the omnichannel presence for Michaels and will hopefully generate more excitement towards completing arts and crafts projects and lead people to the industry leader in arts and crafts which is Michaels. In addition to Pinterest we have a full presence on social media. We believe we have the largest following the arts and craft space for each of the four major platforms of Facebook, Pinterest, Instagram and Twitter. We also have a program with more than 30 bloggers that will continue to increased later this summer. We continue to look for ideas to reach out to our customer and give her ideas to personalized for a home in her life. So in summary, it has been a busy Q1 and we are making good progress on all of our initiatives which positions us well to deliver against our goals for fiscal 2015 and beyond. Now let me turn it over to Chuck Sonsteby, for some more detailed financial information. Chuck?

[Chuck Sonsteby:]

Well, thanks and good morning. Our first quarter net sales increased 2.4% to $1.08 billion from $1.05 billion last year, an increase of 3.6% on a local currency basis. The strong U.S. dollar continues to have a negative impact on same-store sales and despite the headwind we delivered 0.75% increase. Without the 1.1% impact of foreign exchange rates, constant currency comps were 1.4% positive. We’re proud of the broad based strength in our various product categories. As in Q3 and Q4 this strength grow a successful lap of the almost $30 million contribution from Rainbow Loom in Q1 last year. Gross profit dollars for the quarter grew 3% to $442 million and our gross profit rate for the quarter increased by 20 basis points to 41% versus 40.8% last year. And this benefit reflects leverage and occupancy cost from lapping the remodels in Boston last year and there was also a benefit in merchandized margin as our sales mix shifted due to lower sales of Rainbow Loom and higher private brand product sales. As Chuck stated, our private brands and the viable threat of private brands continued to expand providing better margin opportunities. These margin benefits were partially offset by increased promotional activity related to the flow of product receipts from the port slowdown, the timing of LPOS marketing promotions and a shorter Easter selling season. Finally, as previously communicated we recognized higher costs to deal with the ports and gaps and merchandise availability but those issues are behind us from a customer perspective and we will still see some transportation cost impact in the second quarter. Store rent expense for the quarter reflected our new store growth totaling $90 million versus $87 million last year, due to a net 33 additional Michaels and their brother stores. Selling, general and administrative expenses including share-based compensation, related party and store reopening costs for the first quarter was $298 million versus $290 million last year. As a percent of sales, SG&A increased slightly to 27.6% up from 27.5% in the first quarter of 2014. The dollar increase is from operating 33 net additional stores, also approximately $4 million in legal expenses related to the data breach case and final settlement with the Canadian competition Bureau. Timing of performance based compensation, we saw some increased insurance and other benefit costs as well. And these were offset by a reduction in sponsor fees, post-IPO. Stores were difficult to manage and to get cost leverage given the increased need to expedite product to stores and get it on the shelves that are available for sale and our team did a fabulous job dealing with those issues. And now that the ports are resumed normal operations our systems and processes have become more routine and will provide a more seamless operation for our customers and associates. Operating income increased 3.4% to $144 million or 13.4% of sales compared with a $139 million or 13.2% of sales in the first quarter of last year. For the quarter, interest expense was $38 million which is significantly lower than the $57 million in Q1 of last year. Much of the benefit comes from the debt restructuring and the pick note pay down in the second quarter of fiscal 2014. The effect of tax rate was 37% for the first quarter compared to 44.7% for the first quarter of fiscal 2014. Last year's tax rate was higher due to a change in the status of our Canadian subsidiary which resulted in the write-off of certain deferred tax assets. Net income for the quarter increased 47% to $67 million or $0.32 per diluted share despite incurring more than a penny a legal cost and that's up from $45 million or $0.25 per diluted share in the first quarter of last year. So to be clear, we would have had $0.33 of EPS had it not been for that $4 million of legal costs. Now turning to our balance sheet, total merchandised inventory was $985 million at quarter end up 5.9% from the end of Q1 2014. And we said at our last call, that in transit inventory was up due to the backlog in the ports and once it cleared out we would still expect to see inventories increased. There have been strategic additions to our basic inventory in order to support our event-based marketing and to increase our safety stock. Our average Michaels inventory on a per store basis including inventory in transit at distribution centers and for e-commerce was $810,000 compared to $783,000 per store at or and an increase of about 3.4% and that's a trend we expect to continue throughout the year. Total debt at the end of the quarter was $3.14 billion and revolver availability was $590 million. Cash on the balance sheet on May 2 was $273 million. In early April, we announced that on May 6, we would redeem the remaining $181 million in principle of the 7.5 to 8.25 senior PIK toggle notes due in 2018, otherwise known as the PIK notes and that caused them to be treated as current debt on the balance sheet. The redemption priced required a 2% premium which will add $3.6 million of debt extinguishment costs in the second quarter. Additionally there will be $2.4 million of unamortized debt issuance cost related to the early redemption of principle included in the debt extinguishment costs for our total charge in the quarter of $6 million. In the second quarter, the charges will be partially offset by interest expense savings with the net effect lowering, our second quarter 2015 diluted EPS a penny and this penny reduction is included in our guidance, meaning we have lower guidance due to that penny for calling the PIK notes. For the year, there will be about $10 million in interest savings related to this early redemption, on expense savings of $4 million net of the $6 million in redemption related costs and charges. Cash, capital expenditures for the quarter was $35 million up from $31 million last year. In the first quarter approximately $25 million was invested in the build out and maintenance of our stores. This quarter we’ve opened 10 and closed one Michael store and closed two Aaron Brother stores. At the end of the quarter we operated 1,295 stores including 1,177 Michaels and 118 Aaron Brothers. We’ve seen nothing in our first quarter or as we look to the balance of the year that would change our full year 2015 guidance. The business is on track, our cost management is delivering results and the port issues and calendar shift of Q1 are behind us. Our view of comparable store sales continuous to be in the range of 1.5% to 2% or 2.7% to 3.2% on a constant currency basis and a total sales range to be between 3.2% and 3.7% or approximately 4.4% to 4.9% on a constant currency basis. We anticipate operating income for the year to be $700 million to $720 million up 11.6% to 14.8% from the GAAP operating income of $627 million in 2014. So on the last call we discussed three items which are included in our full year guidance. First, there were two quarters of Rainbow Loom impact last year. In the first quarter of 2014, we had Rainbow Loom sales of approximately $30 million and $14 million in Q2. So the biggest impact occurred in Q1. Second, the currency impact of our Canadian sales was anticipated at approximately $57 million for the year, decreasing operating income by $17 million for the year or approximately a nickel per share for 2015. In Q1, we saw an impact of $13 million in sales and about a penny in EPS from currency, which was inline with those estimates. And then finally as expected $3 million of higher supply chain costs were about a penny a share from the slowdown in the West Coast ports. About half the costs have already been reflected in Q1 with the remainder to be realized in Q2. Many other challenges we outlined last quarter are now in the rear view mirror and we look forward to the balance of the year. Our outlook assumes interest expense of $141 million, which includes the acceleration of the PIK Notes. In part, we were able to repay the remaining balance because our restricted payments basket was increased with Q4 2014 net income. The restricted payments basket increases at the end of the each quarter by 50% of consolidated net income as defined in the credit agreements. The Q2 pay-off has nearly exhausted the net income restricted payments basket for our term loan. We now expect the effective tax rate to be approximately 37% for the full year. This translates to a fully diluted EPS range of a $1.65 to a $1.71 for fiscal 2015, which now assumes a higher diluted weighted average share count of $211 million for the full year. We continue to expect cash, capital expenditures for 2015 of approximately $120 million to $130 million. Turning to Q2, we anticipate comp store sales to be 1% to 2%. The impact of exchange rates will be a headwind of approximately $14 million. So the comps on a local currency basis are expected to increase 2.3% to 3.3%. We expect operating income for the quarter to be between $88 million and $92 million. Included in the EPS estimates are $4 million operating profit headwind or approximately a penny impact from exchange rates and an additional penny of EPS impact related to the PIK notes payment, as well as about a half penny residual impact from the West Coast port disruption. The store resets in Baltimore will be in Q2 and those costs are included. And there will be some favorability in performance based compensation, but the balance of the year should be flat to favorable year-over-year as we move to the back half. So the all in guidance for fully diluted earnings per share in Q2 fiscal 2015 is $0.14 to $0.16 with the diluted weighted average share count of $211 million. In summary, there are lot of things to overcome and our Q1 results still fell within the range of our expectations. And now that the calendars move to the summer months I feel good about our focus on a strong financial and capital allocation discipline, continue to investment in our business and growth initiatives to drive sales and profit improvements, and growing earnings per share. Now I’ll turn it back to Chuck Rubin for the closing comments.

[Chuck Rubin:]

Thanks, Chuck. To wrap this up I am pleased with our performance in the first quarter as we navigated a number of obstacles including the weather, the foreign exchange rates, and the West Coast ports situation. We achieved our results through the hard efforts of our associates who work throughout the company and driving revenue and managing costs. We are the leader in our industry and we remain focused on the customers so that Michaels will continue to be her destination of choice as she is inspired. And with that, we'd like to open up the call for your questions. Operator?

[Operator:]

[Operator Instructions] The first question comes from John Heinbockel from Guggenheim Securities. Your line is open. Please go ahead.

[John Heinbockel:]

Good morning. A couple of things. On the reset, have you been able to get the cost of that down? Is it about $100,000 a project? And do you think at that level of spend in what you're doing with the stores, will you get much of a comp lift, or it's really more of a holistic branding in those markets?

[Chuck Rubin:]

So a few things, John. First of all, we're not going to put an absolute number on it because it's still in a test mode. What we have said before is that the remodels that we were doing were costing about $250,000, half of that expense half of that capital. We were seeing lifts from those, but when you look at the money that we have spend on our refresh program in upgrading the entire fleet of stores, we put in practice a test store here in Dallas on this reset were we've moved product and adjusted space allocations and we are seeing encouraging results on that. So we are doing this within - with a focus on improving our revenue and improving our margins in the stores. One of the inherent benefits of this business is that we have this large portfolio of products that do operate somewhat independently. So bakeware and jewelry and yarn and art supplies allow us enormous flexibility to adjust a customer demand. Unfortunately our fleet of stores being what we call snowflakes doesn't allow that flexibility. So the objective of the reset is in a very cost efficient way build on top of the things that we have already done to refresh the entire fleet, incorporate some of the learning from the remodels that we did, but do it in a way that it is cost efficient as possible so as we move to Baltimore and hopefully have a success in our hand, we can accelerate the expansion of this through the chain which will give us a lot of flexibility to expand and contract that portfolio of departments better than we’re able to do it now.

[John Heinbockel:]

Okay. And then just on Make Market, and I know it's very early, but your early impressions on the awareness of Make Market, that name and what it stands for with the customer, your thoughts on space allocation. Do you have the right allocation in most of the stores? And then just in terms of project turnover, or the rapidity with which you're offering new projects in that department, are you where you want to be with that or would you like to turn that over a little quicker and see if you can drive more average items into the basket?

[Chuck Rubin:]

Not sure if I followed the last question, but let me crack it certainly the first two. The awareness on Make Market on the name, I am not so sure that our awareness is all that great right now. In terms of success of the product that has been really well we see by customers, they really like what we are putting forth. And when you look at this it's clearly true in Make Market, but if you walk through the entire store, our assortments are really reflecting trend significantly better than they had in the years past and if you compare us to a lot of our big box competitors, I think we’re operating and lead by ourselves. So the space allocation for Make Market will extend a contract. We introduced new product later this year again. But our trend presence overall has seen significantly more space allocated to it whether it's Make Market or other parts of the trend product in kids or art supplies, or frames. So walking through our store is - what the customer see is walking through our store today I think is not slightly better, its materially better than what they would find two years ago. In terms of the new projects we have lots of projects available out there. Our challenge is not actually getting new projects where we are working on this continuing to solicit projects but trying to organizing those in a way that that are bit more intuitive for customers to find what they are looking for.

[John Heinbockel:]

Okay. Thank you.

[Operator:]

[Operator Instructions] Our next question comes from Matthew Fassler from Goldman Sachs. Your line is open. Please go ahead.

[Matthew Fassler:]

Thanks a lot and good morning. My first question I think a pretty simple one on the numbers, you talked about the totality of the legal expenses and their impact on Q1. And I think you sized that at about $4 million. Was there any comparable number for the prior year?

[Chuck Sonsteby:]

No. This was a onetime where we had some amounts to settle the date of reach in the quarter, so it did not have a comparable amount in the first quarter last year.

[Matthew Fassler:]

Got it. And then my follow-up relates to traffic and ticket. I know you haven't been giving out the specific numbers recently but I'm interested, as you think about the trend in the business, traffic, and you think about the ticket, with Rainbow Loom obviously distorting that a bit, how does the cadence of the business feel today in terms of the underlying drivers of same-store sales versus what it looked like in 2014?

[Chuck Sonsteby:]

The both ticket and if you adjust for Rainbow Loom, both our ticket and transaction kind of were up in Q1 inclusive of Rainbow Loom how big it was last year in the first quarter, our transactions were down, but adjust that out in both ticket and transaction were up, which was really a positive outcome when you think about the shorter Easter season for us, that's the worst calendar that we can have Q1 and so to deliver that up in transactions in plus good weather we thought was really a pretty good outcome for us.

[Matthew Fassler:]

And was the ticket positive excluding FX or even including the impact of FX?

[Chuck Sonsteby:]

FX would be included in that ticket average.

[Matthew Fassler:]

So, then backing out FX which was dilutive to ticket, presumably ticket up even further.

[Chuck Sonsteby:]

Yes, correct.

[Matthew Fassler:]

Thank you, guys. Appreciate it.

[Chuck Sonsteby:]

Thanks Matt.

[Operator:]

Thank you. Our next question comes from Chris Horvers from JPMorgan. Your line is open. Please go ahead.

[Chris Horvers:]

Thanks, good morning, everybody. How are you thinking about the underlying tenor of the business and how that's changing? You talked about the near 300 basis point Loom portion but it seems like you have an idea of how the port impacted your business and the shift of Easter and LPOS. So, any quantification around those other items and what the true underlying tenor is would be great.

[Chuck Rubin:]

Chris when you start to adjust for certain things like FX and like Rainbow Loom, in first quarter we had better than a poor comp. This is a business that that we've said on the long-term is with a comp at 2% to 3%. So, we navigated a whole bunch of challenges in the first quarter. Since we’ve been public and as we go forward, we’re not going to stand behind a lot of excuses when things are thrown our way that cause some challenge. But the underlying current of our business we're quite pleased with. Chuck called out on a lot of the issues around the port, we were a bit more promotional in the first quarter some of it was competitive, but some of it is - we had seasonal product that got delayed in getting to our stores. And our inventory is up over a year ago due to the some of the investments Chuck mentioned, but it’s a very clean inventory, we’re not stuck with seasonal product despite the fact that it hit us later than we had wanted due to the port issue, because we flushed that out. So we feel good about coming out of the first quarter. I think genuinely love to see the consumer overall feeling a bit healthier, I don’t think you've seen great retail numbers from anybody, but relative to the general retail marketplace we’re quite pleased with where we are right now.

[Chris Horvers:]

Understood. And also you mentioned, both in the release and your prepared comments, you seem to emphasize that Q2 is a low volume quarter. So, just understanding what the message or what the thinking is behind that emphasis.

[Chuck Sonsteby:]

Nothing Chris, we’re just again as a company who is going through their first second quarter outlook as a public company, we’re just trying to make sure that people understand those things. There's no hidden agenda or anything behind that, that's just simply the fact of life on Q2.

[Chris Horvers:]

Thanks very much. Good luck guys.

[Operator:]

Thank you. Our next question comes from Simeon Gutman from Morgan Stanley. Your line is open. Please go ahead.

[Simeon Gutman:]

Thanks. I want to focus on promotion and gross margin. Can you give us a little color on what you meant? I think in the press release you mentioned the word cadence. And, then, are you satisfied with the return you saw in the promotions? And then I presume the posture for the second quarter is going to be less promotional?

[Chuck Rubin:]

I’ll take that promotional question Simeon, so a couple of points no, the general retail world as I just commented and as you know all too well is not as healthy as all would like. So there is a lot of promotion out there in this industry as well as in other industries. At this point, we don’t necessarily see that changing a lot. The part of the promotion that we did have some impact from in the first quarter where we had to liquidate seasonal product that arrived late due to the labor issue on the ports, I don’t see that continuing. So we moved through that, but that did have a negative impact on our first quarter margin.

[Chuck Sonsteby:]

And then also, because LPOS are lowest price of the season one of our biggest events, so after Easter we had to shut it out, because when it falls before Easter there’s a natural time for the customer to come in and buy Easter product. When, because of the calendar it has to fall after Easter, we got to be more promotional to get people in stores. So, and that was expected I think the only anticipated part was the part Chuck talked about where we didn’t have ports and we didn’t have the product coming on time from the ports and so we had to be a little bit more promotional to get rid of that product. But the LPOS that was anticipated in the quarter, but when you look at it year-over-year we’re more promotional so that’s just the fact.

[Chuck Rubin:]

And also just to add into Q1 and again we think that most of this if not all of this is behind us. We’re talking about the margin - the product margin implication of the ports slow down, there were other margin implications though because it cost us more through our supply chain, and it cost us more in store payroll to manage this inventory, because it was less predictable in terms of when it would arrive and there we would have to manage the peaks and valleys of labor to marry that up to the peaks and valleys as the merchandise would finally get released to us. So that's why as you look out to an earlier question, we feel good about how we navigated a lot of these challenges in the first quarter when we think a lot of that is behind us. As I said love to see a better consumer that's more fluid in her spending overall across all retail, but we feel good about our plans for the balance of the year and especially as we get into the third and fourth quarter with bigger volumes, because a lot of these external issues affecting us we think are behind us now.

[Simeon Gutman:]

And just to clarify that point, and then I have my follow-up question, the promotional cadence of the business is what it is and that will continue, but there was were some clear exogenous things that won't repeat.

[Chuck Rubin:]

Correct. We don’t anticipate having - I’ll give real life example, Valentine's Day product came in later than we wanted and on February 15 Valentine's product isn’t so valuable anymore, and we did not pack anything away we don't philosophically believe in that, so we had to liquidate product. It was unfortunate, because the product we got in sold really well, they just went in up days between when it arrived in Valentine's Day - on the date of Valentine's Day.

[Simeon Gutman:]

Got it, okay. And then my follow-up is, to the extent there's enough of a store base where you have, I don't know what you're calling it, whether it's next-gen formats or updated signage, packages, can you talk about sales performance in those stores? And I don't know if it's more of a sales enhancer or it is just reduced snowflakes and ease of the flow of your business, but curious how the base that you have in place of what the future will look like, how that's performing.

[Chuck Rubin:]

Simeon, that’s a really hard question. So first of all next gen is the term of the past, forget all of that, we’re trying to simplify our store formats, we’re trying to simplify the names of our store formats. We have overall in virtually every store in the chain, we have significantly improved the environment in that store and that’s all part of the refresh program, things that I talked about in my script the clearer drive isles, the improved signage, the dress code for the associates, now the way finding on the mobile app. You can quantify those by looking at the overall operating performance of Michaels. So when you look at the comp trend over the past number of quarters we believe that a part of that is due to the enhancements through this refresh program. We didn’t hold out some stores and say let’s not clean them and see if they don’t perform as well as the stores we clean. We did at everywhere and we’re very convinced that its connected to the performance we’re seeing. As far as the remodels that we did, we have not quantified the performance of those and will not quantify the performance of those. Beyond what I just said, we did see lifts in those stores but our challenge right now is in valley numbers we have 1200 stores and in those 1200 stores we have almost as many unique store layouts, all these snowflakes. So the prospect of spending $250,000 to remodel a store, times 1200 is just not all that attractive to us. So that’s the premise of this reset. Build on the advantages that we put in place across the entire chain by cleaning it up and put a much lower cost reset program in place. And as I said, we’ve done one store, one store does not make a successful test. One store gives you an indicator to then continue the test and that's why we’re doing Baltimore. So to be more precise on the numbers, it's just too premature. We just trying to continue to learn through this but the objective what we are after to be really clear about it, is yes provide a better shopping environment for the customer but better as to find as she wants to come to Michaels more and therefore our sales in our margins go up. And if we have a simpler portfolio of stores that we can merchandise into, it gives our merchants the ability to expand and contract different departments in our portfolio based on customer demand. We’ve talked before on these calls that, as our overall sales have been good, we still our business that haven’t performed well. Bakeware as an example has not been a good performing business for quite an extended period of time. We would love to more aggressively flex our flow space to reflect customer demand and we hope that that's what this reset program is leading us to.

[Simeon Gutman:]

Okay. Thanks for the color.

[Operator:]

Thank you. Our next question comes from Seth Sigman from Credit Suisse. Your line is open. Please go ahead.

[Seth Sigman:]

Great, thanks very much, and good morning, guys. A couple of follow-up questions here, first just on the gross margin. You guys have been very clear on some of the drivers in the quarter and quantified the supply chain costs. Just wondering if you can quantify some of those more temporary product margin issues that you just alluded to, just as we think about the next couple quarters. You were pretty clear that it's not going to continue. Just wondering if you could quantify this past quarter.

[Chuck Sonsteby:]

We broke out the port cost that came through gross margin but as we look to the balance of the year, we have a small piece coming through in Q2, we'll see about an equal amount related to the port slowdown in Q2. But other than that, we'll see a more like year-over-year comparison as we move forward on cost and sort of extraneous items.

[Seth Sigman:]

Okay. But any way to just quantify those promotional costs that you mentioned and the impact that had on the first quarter?

[Chuck Sonsteby:]

No, I think trying to isolate that is pretty difficult, we didn’t do a week-by-week comparison as to how much extra, we had to spend a promotional but we do anticipate lower promotional cost overall.

[Seth Sigman:]

Okay. And then just separately, as you think about customer engagement, you guys are doing a number of things including classes in the stores, you recently launched classes online. Can you speak to the increase in engagement that maybe you're seeing? Is there a way to measure that for us, and whether it's translating into sales or traffic? And how are you actually trying to convert that traffic into sales?

[Chuck Rubin:]

Well, it is not a light switch so the engagement doesn’t overnight translate into sales. The engagement we are seeing is very encouraging, so you look at the variety of metrics that are very tangible so, amount of traffic to our websites. The number of followers we have in the various social media, the number of people who are taking classes in store and now online those are all up significantly. The voice of customer which is what we call our customer shopping, our third party surveys of our stores, they were all up and for the most part they were all up very materially. Because we’re trying to not only win more share with this enthusiast customer but gain more business with this novice customer, its going to take a little bit of time before its starts to translate we think into material dollars, where we are able to see a connection we’re very encouraged, that’s why we are very committed to doing this. When you look at our whole strategy it all ties together, more trend right product, more exclusive product, a cleaner better easier more fun shopping experience in the store, digital enhancements to try to make this an omni-channel experience for the customer. It's all intended to improve engagement and we believe it will be lead to higher sales and margins again when you look over the past number of quarters where we have delivered higher sales and margins we believe some part of that is due to these efforts, its just hard at this point beyond number of followers on Facebook as an example, where the number of people we have on Pinterest, its hard to actually quantify the sales that are resulting from that engagement.

[Seth Sigman:]

Got it, all right. Well, thanks very much.

[Operator:]

Thank you. Our next question comes from Denise Chai from Bank of America. Your line is open. Please go ahead.

[Denise Chai:]

Thank you. I just wanted to ask about the expanded Pinterest partnership. Could you tell us when this starts and is it exclusive?

[Chuck Rubin:]

Various parts of the relationship are exclusive. We have an ability to work with Pinterest to better understand their shopping, customer shopping behavior on Pinterest. The buying on the pin that is not exclusive to us, they don't have exclusivity with any retail partners but our relationship with Pinterest has continued to expand pretty dramatically. So I think I will leave it at that for the moment but I would watch closely what we do with them in the future.

[Denise Chai:]

Okay. So, the ability to work with them to understand shopping behavior, that is already in the works, that's happening now?

[Chuck Rubin:]

That's correct. As far as the buying that was just announced yesterday from Pinterest and that goes live, I think later this month, later in June, the very end of June.

[Denise Chai:]

Okay, got it, thanks. And you also mentioned that private label is over 50% of sales. Could you comment on the growth there and how much was due to Make Market?

[Chuck Rubin:]

No, it was over 50% of the sales, Make Market is part of it. Remember, we do well over $2 billion in sales in private brand products, so Make Market is a very nice piece of that business but our private brand offering goes far beyond that. So no, we wouldn’t breakout this specific piece of it, just like we won't breakout other private brand sales but one thing that we have said before that I'll remind all of the about is, this is an industry with very few national brands and in fact our individual private brands within the category of products that they represent are usually the highest volume, the highest sales volume brand in that industry. So compared to those national brands that exist or any other private brands that our competitors might have, so we are the - there are private brands but they are the leading brand in that piece of the arts and crafts industry.

[Denise Chai:]

Okay, thanks. And just a quick one -- how long does it typically take to see results from a test like Baltimore before you decide if this is something you want to expand?

[Chuck Rubin:]

Well, on average it's a year because it's really nice to go through things and see a full cycle, that's why we did St. Louis two springs ago, we did Boston last spring, and we are doing Baltimore now. You really want to live with these things and get that full cycle.

[Denise Chai:]

Got it. Thank you very much.

[Operator:]

Thank you. Our next question comes from Mike Baker from Deutsche Bank. Your line is open. Please go ahead.

[Mike Baker:]

Thanks, guys. I wonder if you could tell us how much the items like the port issue, the early Easter, and the early or, I guess, late lowest price of the season impacted the comps. You said that they would be 4% if you took out all of those in currency so can you break those down a little bit?

[Chuck Sonsteby:]

Mike, the 4% was merely Rainbow Loom plus currency. All those other items, we didn’t quantify but had those not happen, I think we would had an even better sales performance. So I think that's the one thing we're trying to get across is yes, we put up 0.3 comp, we had literally 400 basis points of headwinds just related to FX and to Rainbow Loom. So outside that given the ports slowdown, given the change in the calendar, we feel like we had a really good quarter and we feel real good about the tone of the business. We printed $0.32 had we not had the legal cost, we would have printed $0.33, that was not anticipate when we gave guidance in March. So all those things add up to, we feel like it was a really good quarter in terms of topline and bottom-line performance.

[Mike Baker:]

So, then a follow-up to that, the guidance for the COGS for the second quarter is a little bit more than 1 percentage points better than what you did in the first quarter. You do have a slightly easier comparison. Is that the reason for that guidance? Or is it because these things are behind you and you're starting to see some of the comps improve? And part of that question is talk about the trend through the quarter and into early second quarter.

[Chuck Sonsteby:]

Sure, we feel good about where the business is. Part of the reason why it's higher is the fact that we had $30 million Rainbow Loom comparison in the first quarter and will have a substantially less $14 million comparison in Q2. That gives us the uptick in the guidance from Q1 to Q2. But we feel good about where the business is. I think Chuck talked about a lot about strategies, the things that are happening in our stores, customer response those give us confidence as we move through and into Q2 that business is performing well.

[Mike Baker:]

Okay, I appreciate the color. Thanks.

[Chuck Rubin:]

Sure, thanks Mike.

[Operator:]

Our next question comes from Matt Nemer from Wells Fargo Securities. Your line is open. Please go ahead.

[Matt Nemer:]

Good morning. Thanks for taking my questions. First I wanted to ask about the promo activity that you talked to. Obviously some of it is port related. But would you say that it was more intense in the specialty or the mass channel during the quarter?

[Chuck Rubin:]

It depends on who you define and which category but Walmart's out there, obviously they’re not really high-low, target is in the space now, Walmart's certainly is represented in this space. The industry was competitive, there were some online competitors out there, so it was pretty broad based. But remember also we are a discretionary category in the creativity space, so we're competing for the dollar that shopping dollar we lots of other types of companies. So it was promotional in this industry but beyond that it was promotional across retail and that does have an impact to us.

[Chuck Sonsteby:]

So one of the things that we are doing, we’re using more emails, we are targeting more customers and included in those targeted emails are offers. And so as we continue to engage customers and continue to get them to come to stores, they are going to come in with the coupon but that's part of our marketing strategy, that's part of what we do. So when we talk about promotional activity, sometimes we're talking about what we have done this year versus what we did last year. And so its not necessarily us responding to a soft sales environment that were promotional, it is part of our targeted marketing effort to engage customers and we're using promotion as part of that vehicle.

[Matt Nemer:]

Understood. Okay, that's helpful. And then as a follow up, the online classes, I'm wondering if you can talk to the profit of an online class versus an in-store class. Obviously there's probably less attach online but maybe a broader reach. Thanks.

[Chuck Sonsteby:]

No, we don’t breakout the profitability of our classes but from an external standpoint I would suggest that's not how you want to look at it. We're not in the business to sell classes or make money on classes as a standalone. We are in the business to sell product, classes is a means to enable customers, to inspire customers, to help them with the expectation that they will buy product in our stores and on our website. So the profitability - we do measure the, obviously the profitability of our class is online and in store but I would encourage you to think more about how it connects to products, because that's what we’re trying to do. We're trying to push that customer through to our stores and online and enable her to the class.

[Matt Nemer:]

Makes sense. Thanks so much.

[Chuck Rubin:]

We probably have time for one last question.

[Operator:]

Thank you. And our final question comes from Jessica Mace from Nomura Securities. Your line is open. Please go ahead.

[Jessica Mace:]

Hi, good morning, and thanks for taking the question. I had a follow-up on the increased customer engagement comments you made earlier. I was wondering if you could talk about the novice customer in particular and in general how you feel about your overall goal of gaining traction with that customer.

[Chuck Rubin:]

When we went public we talked about that in the near-term the enthusiast customer would be where we see greater financial performance in gaining share with that customer. She's the customer that has brought us to the dance to this point. The novice customer is one that I’d remind everybody has interest in creativity, but may not have the knowledge of how to get started what products, how long it will take and I actually do it. So our opportunity is to educate her to reassure her to be there as a resource for her that not only get the products she needs, but also the knowledge. We think we’re making good progress but we recognized when we went into this, that this was a long-term issue, it’s really hard to measure this, but the way we’re measuring up thus far we’re encouraged by what we’re seeing. But as I said I'd remind everybody that there are certain parts of our strategy that are very near-term, there are certain parts that are long-term and this novice is going to be a continued effort and again it ties back if that novice customer sees something on Pinterest and she wants to make it A, it’s helpful when we have a close relationship with Pinterest. It's helpful when that novice customer can come in and find trend-right product that reflects the trends that she is seeing in apparel as an example or she is seeing through a blogger that she might follow. And that’s helpful when we have classes that are available for her to learn how to do something. So all of these things come together, the punch line being we're pleased with the progress we’re making, but we know it’s going to continue to take quite a period of time to get known to become better known than we’re today as that resource for the novice customer, but we’re very committed to continuing that and we will.

[Jessica Mace:]

Great, thank you. And then just a quick one on online, I was wondering if you could share any insights on how the typical basket is of an online shopper and if you see people completing full projects online. Or what are some of the trends of how they're behaving in that channel?

[Chuck Sonsteby:]

So we do see a higher basket online that we do see in stores similar to what other retailers see as well. I think you asked is there anything unusual, we don’t necessarily see people completing total projects mostly because some folks may already have parts of those craft supplies in their closets at home. But again, we really feel very good about how the e-commerce business has done. Our expectation is that even at maturity it's only going to be mid single-digits for us, we haven’t seen anything that has changed our mind. We're seeing more business to business type of activity and we think we’re encouraged by that because those are customers that may not have had the availability of product in store, and that gives us - that does give us some comfort that we are able to fulfill a wedding plan or someone else who may want to come in and buy 20 of an item they couldn't get that in store now can now get it on the website. But we do see as we click through and do see higher click through from project pages to product sales which is really encouraging sign for us as well.

[Chuck Rubin:]

Okay, let me wrap it up there and thank everybody for your interest in Michaels. And we will talk to you next quarter. Thanks so much.

[Operator:]

Ladies and gentlemen, thank you for participating in today's conference. This concludes our program. You may all disconnect and have a wonderful day.