Michaels Companies Inc
Q2 2015 Earnings Call Transcript

Published: 27 Aug 2015

[Operator:]

Good morning, ladies and gentlemen. My name is Sade and I will be your conference operator today. At this time, we’d like to welcome everyone to the Michaels Second Quarter 2015 Earnings conference call. All lines have been placed on mute to prevent any background noise. If you should need assistance during the conference call, please press star then zero and an operator will come back online to assist you. Thank you. Now I’d 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, Sade, and good morning everybody. Welcome to our second quarter 2015 conference call. Earlier this morning, we released our second 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’ Form 10-K for the fiscal year ended January 31, 2015. A copy of this filing is available on our website. The forward-looking statements made today are as of the date of this call and we do not undertake any obligation to update our forward-looking statements. In today’s earnings release, we have presented non-GAAP financial measure such as adjusted EBITDA as defined in our credit agreement, adjusted operating income, adjusted net income, and adjusted earnings per share. Both adjusted operating income and adjusted net income have been presented to reflect our view of our ongoing operations and to make our financials more comparable by adjusting for costs and the timing of our initial public offering that closed on July 2, 2014. A reconciliation of these measures to the corresponding GAAP measures can be found at the end of our second quarter earnings release. 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?

[Carl Rubin:]

Thanks Elaine, and good morning everyone. On today’s call, I will review the highlights of our second quarter performance as well as comment on our preparations for the fall and holiday seasons. 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 for questions. I’m pleased with our results for this quarter. In Q2, we delivered total sales of $984 million, an increase of 3.8 or 5.2% on a local currency basis versus last year, and on a comparable store sales increase of 1.6% or 2.9% on a local currency basis. Our Q2 operating income increased 13.1% to $96.6 million over last year’s adjusted operating income of $85.4 million, with an 80 basis point improvement in adjusted operating margin rate of 9.0% last year to 9.8% in Q2 this year. From a product perspective, we saw general sales strength across the business with fine arts and paper crafting doing particularly well. As it relates to our kids’ business in Q2, we were lapping $14 million in sales of Rainbow Loom in Q2 of fiscal 2014. This is the last quarter we will be calling out the lapping of Rainbow Loom sales. As of Q3 last year, the product was a normalized part of our kids’ category. We previously said the FX impact to sales would be a headwind of about $14 million, and it ended up being approximately $15 million. We expect to continue to see foreign exchange rates impact our P&L throughout the balance of the year. The $1.6 million of higher supply chain costs related to the west coast port issues were recognized in our expenses this quarter, as expected. This is a result of our matching expenses with the timing of when the related products are sold. This is the last quarter we anticipate needing to talk about the west coast port issues from earlier this year. Overall, we once again delivered a solid quarter of comp store sales which, when adjusted for the FX rate pressure and Rainbow Loom, were higher than our long-term comp guidance of 2 to 3%. Additionally, due to our financial discipline, we continued to grow our operating margin dollars and rate when compared to last year’s adjusted operating margin. I do want to briefly mention our inventory. Inventory per store was up 12.5% over last year, or $880,000 per store compared to $782,000 last year. As previously discussed, this was planned and Chuck will provide more details; however, I do want to emphasize that we feel good about the quality and quantity of inventory which will help support our merchandising and marketing plans for the back half of the year. Now for some additional details about the quarter, starting with improving the customer experience in our stores. We have continued to grow our store footprint with nine openings in Q2, which brought our total Michaels and Aaron Brothers store count to 1,304 stores. For the full year, we still expect to open approximately 30 Michaels stores. We also relocated three Michaels stores during Q2. These relocations allow us to reposition our sites where necessary to improved locations. We have made very good progress in our refresh initiative to improve the shopping environment in our stores and are continuing to get good feedback from our customers. As a reminder, as part of this refresh focus, we significantly improved our store cleanliness standards, lowered main aisle fixtures to allow improved customer sightlines, reduced extraneous signage and product clutter to create a more impactful merchandising statement, and implemented a consistent associate dress code to make our team more visible to our customers. We also have added Wi-Fi to all stores along with a new product finder on our mobile app to help customers navigate our store. In Q2, we continued rolling out an improved store signage and graphics package to make the store easier to shop and improve the overall environment. This program will continue to roll out through approximately October 1, at which point about 800 stores will be complete. In our last earnings call, we announced that we would be performing resets in our Baltimore stores during the second quarter. Now that the refresh program has taken care of much of the visual environment items I just discussed, we can focus more on reducing the snowflake footprints found in our stores. This reset is intended to give us more accordion-like flexibility to cost effectively expand and contract the various product categories in our broad offering based on customer demand and the selling season. This reset is being done as a test, and it will be some time before we are ready to discuss the results or perform other resets. During the quarter in our merchandise offering, we continued to drive excitement. First in paper crafting, there were a number of successes. Fuji instant cameras in new exclusive colors performed well, as did our exclusive bundle from Cricut, and Marquee Letters from Heidi Swapp that are easily personalized by our customer also did well. Second in the fine art department, canvas and paint, driven by our Artist’s Loft private brand, did very well and our top-selling paint was from Craft Smart, also a private brand. Third, our private brand collection of burlap, chalk, cork, galvanized products, and denim that supports the personalization trend continued to receive a strong response from customers. Another of our strategic focuses is our Fuel for Growth program, which is an important part of our Vision 2020 strategy. This program is intended to reduce costs throughout the company which can then be reinvested into our corporate strategies or taken to the bottom line. We have seen hundreds of ideas identified by our associates as a result of their focus on simplifying and streamlining our business. I’m very pleased to say that we have rewarded many of our associates for the very best of those impactful ideas. This program, while having been a strong contributor to our performance over the past year, still has plenty of runway ahead. Now moving on to what you can expect for the back half of the year, we recognize that we will anniversary strong underlying comps in Q3 and Q4 of 2014 when adjusting out for Rainbow Loom. Additionally, we continue to face an FX headwind in the back half of this year; however, with that said, we feel good about our merchandising, marketing and operational plans for the back half. We also believe we have good momentum in our business and believe we are taking share from our competitors. In Q3, the slate of new products coming in is larger than what we saw in the second quarter. We have introduced back into the stores Raw Bar, which was successful last year. This exclusive offering is a presentation of unfinished products that includes chalk, cork and galvanized metal and is merchandised with project ideas that our customer can use to personalize her creation. In addition to the Raw Bar, we will have our largest fall and Halloween assortments ever, both primarily comprised of private brand product. In other departments, we will add to our art technology products that have been selling well. This includes expansion of our Fuji instant cameras, Cricut cutting products, and the 3D Doodler. In another first for Michaels, we are excited to introduce our comprehensive home décor do-it-yourself offering which is made up of stains and finishes for different types of surfaces that allow our customers the ability to personalize different types of décor for their homes. Finally in terms of our customer offering, we are re-merchandising our custom frame department. As many of you know, we are the largest custom framer in North America, and in fact we believe in the world. This third quarter, we are going to update the presentation of our exclusive frame moldings by creating collections tied in with different lifestyle trends. This will make it easier for the customer to find the right style and price for their custom frame. Additionally, given that custom frame can be a bit pricey for some of our customers, we are repositioning our package pricing as a bundle and save offering, which we believe will project a stronger value impression to some of our customers. In our customer communications during the third quarter, we will continue to improve the effectiveness and excitement of our marketing. We will be repeating the strong fall events from last year, including arts and craft hall, fall market, lowest price of the season, and of course Halloween. We still believe that by integrating our merchandising, marketing and promotional efforts, we can create events or reasons to shop for our customers. We will continue the evolution of our marketing program by testing new media. Some of you by now have already seen our new TV marketing campaign. This is a test that is run in only select markets, and while very early, we are hopeful about the potential here. Additionally, we continue to make progress in our CRM program where we are leveraging our industry-leading database to personalize both direct mail and email marketing based on customers’ shopping history and preference. Last quarter, we announced our relationship with Pinterest to leverage the unique marketing and insights we can gain from partnering with them on analyzing their viewer behavior. This relationship continues to highlight new opportunities to reach our customers. Michaels is also participating in Pinterest’s buyable pins program, which is still in its infancy. In August, we expanded our Michaels Makers blogging program from 30 to 50 bloggers. This program, which was started last year, features bloggers who participate in monthly craft challenges and share inspiration and simple project ideas that anyone can make. We also hosted our Michaels Makers in California for our first blogger conference. This three-day event brought together some of the industry’s most influential makers to share the newest creative ideas. We were pleased with the event, which resulted in more than 50 blog posts which were viewed by over 11 million potential customers. To further our exposure in the Maker movement, we recently partnered with Darby Smart, an online-only company. They have tapped the Maker community in a unique way to make crafting simpler and more accessible to everyone. Their relationship with designers can increase our exposure to millions more novice and enthusiast customers. With the addition of Michaels, our partnership expands the supplies available for the designers to use in their creations, thereby increasing the types of projects the designers can make. The Maker movement is all about combining creation with inspiration, and we believe that once someone is inspired, Michaels is the place to shop. So again before I turn it over to Chuck, we feel good about our performance in Q2 and believe that we have strong plans in place for the back half of the year. Now with more information on our detailed financials, let me turn it to Chuck Sonsteby. Chuck?

[Charles Sonsteby:]

Thanks and good morning. My discussion of the second quarter results today will focus on comparing this quarter’s reported numbers to last year’s Q2 adjusted results. The term adjusted operating income reflects our operating income excluding the IPO expenses and related party or sponsor fees in the second quarter last year. The term adjusted net income reflects net income excluding IPO fees, related party or sponsor fees, all debt refinancing costs in 2014 and the associated tax impact, but includes the cost of the PIK note redemptions in the fourth quarter of fiscal 2014 and the second quarter of fiscal 2015. Finally, adjusted earnings per share divides the adjusted net income by a share count that assumes the IPO shares were issued and outstanding for all reported periods, so please reference our press release for all definitions and for a reconciliation of GAAP numbers to these adjusted numbers. Our second quarter net sales increased 3.8% to $984 million, up from $948 million last year, growing 5.2% on a local currency basis. Our same store sales increased 1.6% despite the headwind from a strong U.S. dollar. Without that 1.3% negative impact of foreign exchange rates, constant currency comps were 2.9%. In addition, the Rainbow Loom sales of $14 million last year provided a headwind of 1.3%, so adjusting for FX and Rainbow Loom sales last year, our comps were 4.2%, a very strong performance. Gross profit dollars for the quarter grew 4.5% to $373 million, and our gross profit rate for the quarter expanded 20 basis points to 37.9% versus 37.7% last year. This improvement is due primarily to the timing of distribution expenses, and they were partially offset by a planned increase in costs compared to last year to exit select merchandise as part of our ongoing department resets that occurred later due to the west coast port slowdown, and unfavorable shrink expense. We continue to see leverage in gross margin rate at a modest absolute comp level. Store rent expense for the quarter primarily reflected our new store growth, totaling $92 million versus $88 million last year due to a net 40 additional Michaels and Aaron Brothers stores, and modest increases in rent related to lease extensions. Selling, general and administrative expense, including store pre-opening costs, for the second quarter was $277 million versus $272 million last year, after removing last year’s IPO transaction costs. Our Fuel for Growth program continues to provide benefits as we gained leverage this quarter. As a percent of sales, SG&A decreased 60 basis points to 28.1% from 28.7% versus last year, and the dollar increases related to operating 40 net additional stores and higher incentive-based compensation. Operating income increased 13.1% to $97 million and margins expanded 80 basis points to 9.8% of sales, compared with adjusted operating income of $85 million or 9% of sales last year. Interest expense was $34 million, which is significantly lower than the $61 million in Q2 of last year. Much of the benefit comes from our debt de-leverage accomplished via debt restructuring and paying off the PIK note during various times over the last 12 months. The final payment of the PIK note was made on May 6, 2015. The redemption price required a 2% premium, which added $3.6 million of debt extinguishment costs in the quarter, plus there was $2.5 million of unamortized debt issuance costs related to the early redemption of principal included in debt extinguishment costs for a total charge of $6.1 million. While many exclude these charges in the interest expense benefit in their earnings estimates, we’re including them in the adjusted net income numbers. The effective tax rate was 36.6% for the second quarter compared to 37.3% for the second quarter of fiscal 2014. The lower current year tax expense is due to the positive impact of tax planning strategies. Adjusted net income for the quarter increased to $36 million from $29.8 million, and adjusted earnings per share were $0.17, up 21.4% despite including the net $0.01 per share of PIK costs. This compares to $0.14 adjusted earnings per share in the second quarter of last year. All in all, it was a good quarter on many fronts. Now turning to our balance sheet, total merchandise inventory was $1.1 billion at quarter end, and this reflects a planned increase to strategically add to core basic inventory and to pull forward delivery of approximately $45 million of seasonal and standard assortment products to ensure in-stock positions for the peak selling season. Last year, our core inventory levels in Q3 and into Q4 were at historical lows, which we believe was too low. Given our high penetration of private brands and their corresponding lead times, our pull forward decisions were made prior to the west coast port slowdown being resolved. Our average Michaels inventory on a per-store basis, including inventory and transit, at distribution centers and for ecommerce was $880,000 compared to $782,000 per store last year, or an increase of about 12.5%. Excluding the accelerated receipts, this per-store increase was 7.8%, which corresponds more closely to the constant currency sales increase. We’re comfortable with both the level and composition of our inventory position heading into the back half of the year. With the port activity back to normal, the expectation is for inventory increases on a per-store basis to generally reflect constant currency sales gains at the end of the fiscal year. We ended the quarter with total debt of $2.98 billion and $564 million of revolver availability. Our debt to EBITDA continues to improve. We ended Q1 at 3.87 times and now we’re at 3.6 times, a meaningful improvement. Cash on the balance sheet at August 1 of this year was $70 million. We’re a strong cash generating business, and there is continued interest in how we’ll continue to use our excess cash flow. We’ll be working with our board, and the current plan is to give more guidance into our capital allocation policy in the first quarter of fiscal 2016 when excess cash becomes available. Cash capital expenditures for the quarter were $28 million, down from $34 million last year primarily due to the timing of new store openings. In the second quarter, approximately $15 million was invested in the build-out and maintenance of our stores, including new, relocated and existing stores. This quarter we opened nine Michaels stores and at the end of the quarter we operated 1,304 stores, including 1,186 Michaels and 118 Aaron Brothers. As we look to the back half of the year, we don’t see anything that meaningfully changes our full-year fiscal 2015 guidance. The business is on track, our strategies are resonating with our customers, producing healthy constant currency comps, and coupled with our cost management we’re delivering good bottom line results. With Rainbow Loom and west coast port cost impacts now behind us, the FX raised the primary headwind we face in the back half. The currency impact on our Canadian sales in the first half was approximately $27 million in sales and $0.03 in EPS, which was higher than originally anticipated. Our back half outlook is updated for the current market conditions and assumes an additional $9 million in sales headwind and $0.01 of EPS reduction from the exchange rate in the second half of 2015 versus the full-year guidance we provided last quarter. Despite a stronger U.S. dollar than we anticipated, both when the year began and last quarter, our view of 2015 comparable store sales continues to be in the range of 1.5% to 2%, or 2.7% to 3.2% on a constant currency basis, and total sales to be between 3.2% and 3.7% or approximately 4.4 to 4.9% on a constant currency basis. We expect 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 last year. In summary, despite higher FX costs in the second quarter and expected for the balance of the year, our operating income guidance range is unchanged. We’re forecasting interest expense to $141 million, which includes the additional expense and interest savings from the redemption of the PIK notes. In part, we were able to repay the remaining balance because our restricted payments basket was increased with the Q4 of 2014 net income. The restricted payments basket increases at the end of each quarter by 50% of consolidated net income, as defined in the credit agreement. The Q2 payoff nearly exhausted that basket for our term loan. We’re now updating the annual and third quarter effective tax rate to be lower at approximately 36.7% for the full year from 37%. This translates to a fully diluted EPS range of $1.66 to $1.72 for fiscal 2015 on a diluted weighted average share count of 210 million for the full year, which means we’re raising our fully diluted EPS guidance by $0.01 due to better visibility to factors below the operating income line. We continue to expect cash capital expenditures for 2015 of about $120 million to $130 million. For Q3, we anticipate comp store sales to be 1.5 to 2.5%. The impact of exchange rates will be a headwind of approximately $19 million, which is about $4 million higher than we expected earlier in the year. Excluding the 170 basis point impact, comps on a local currency basis are expected to increase 3.2 to 4.2%, and there are plans to add approximately nine more new stores in Q3. Operating income for the quarter is expected to be between $150 million and $158 million, which produces fully diluted earnings per share in the range of $0.35 to $0.37 with a diluted weighted average share count of about 210.5 million shares. In summary, Q2 was a very solid quarter, especially after considering the headwinds from Rainbow Loom, west coast ports, and foreign exchange. We saw good top line results, expansion in gross margin, leverage on SG&A, and despite the additional costs of redeeming the PIK notes, a 21.4% increase in adjusted diluted earnings per share. As we move into the back half of fiscal 2015, I feel good about our initiatives to drive sales, the commitment to strong financial discipline, and the resulting gains in profits and earnings per share. With that, I’ll turn it back to Chuck Rubin for closing comments.

[Carl Rubin:]

Thanks Chuck. In closing, as Chuck said and I’ve said, we are pleased with our performance in the second quarter. We believe we continued our strong momentum and feel good about our plans for the back half. As always, I want to thank all of our associates across our stores, distribution network, and in our support center that worked hard to remain focused on driving top line revenue while improving our margins. We are the leader in our industry and we will remain focused on reaching the customer in new ways so she can be inspired and trust Michaels to be her source of products and services. With that, Operator, we’ll open up the call for questions, please.

[Operator:]

[Operator instructions] Our first question comes from the line of Christopher Horvers from JP Morgan. Your line is open.

[Christopher Horvers:]

Thanks, good morning. That was pretty funny.

[Carl Rubin:]

Yeah, we thought we lost you there, Chris. Thank God you’re there.

[Christopher Horvers:]

So, a few questions. On the SG&A side, can you quantify the impact of the incentive comp difference; and bigger picture, you generated nearly 60 basis points of leverage on a 1-6 comp. Was there any unusual items in there, and is this a level of leverage that per point of comp, so to speak, that you think is sustainable?

[Charles Sonsteby:]

Well, we had a very good Q2. Some of the benefit was related to some of those resets we talked about affecting gross margin that will carry over to Q3, so there’s a little shift of payroll there. We also are getting leverage from the costs related to operating our Canadian stores. We talk a lot about the headwind on the top line. It is helping us de-lever a little bit in some of our fixed expense and some of our variable expenses as we go through the P&L. The incentive comp was a little bit higher year over year, about 20 basis points, and that just has to do with the timing of this year’s income versus last year, and will start to normalize as we get to the back half of the year. But really, Chuck talked a little bit about our Fuel for Growth program, and it continues to provide us benefits throughout the P&L, so we feel like we can continue to gain leverage on a modest comp, and I think that’s really the key highlight there.

[Christopher Horvers:]

So was it fair to say that the incentive comp, that pressure of 20 sort of offset the benefit of some of those other items that you referred to, like the leverage in Canada?

[Charles Sonsteby:]

Yes, but I would say the leverage in Canada and the leverage on payroll was higher overall than what we saw as a headwind from the incentive comp.

[Christopher Horvers:]

Understood. Then currency is a negative as it relates to your top line, but as you think about the recent move in the Chinese currency and the amount of private label and how much you source from China, is that ultimately a 2016 opportunity for you?

[Charles Sonsteby:]

We have been having continued dialog over the last couple weeks, talking about just exactly that, Chris, and we do think that there is an opportunity to go back to our vendors in China and talk a lot about not just currency but also where commodity prices have gone. So we can’t quantify what that amount will be yet, but I can assure that you that teams here are working very hard to try and gain some of those benefits into next year and actually beyond that.

[Christopher Horvers:]

Understood. Last one - so you recently received a credit upgrade. Understanding what’s in the RFP basket aside, is there an opportunity to renegotiate the term loan and to change the amount of cash that you need will be available to pay down debt in any particular period, and how much do you think perhaps the savings could be on the rate side? Thanks.

[Charles Sonsteby:]

Yes, there is an opportunity. If you just look at where our senior notes are trading now, they’re trading at about 4.5%, I think, on a coupon of 5.75, so I think if we wanted to go in and do some sort of refinancing, we might be able to get some advantages to that. The only difficulty on the notes is they are not callable until October, and I realize you asked about the term loan but we think there might be some opportunity on the term loan as well. They are trading a little bit above par, too.

[Christopher Horvers:]

Understood. Thanks very much.

[Carl Rubin:]

Thanks, Chris. Operator, next question please?

[Operator:]

Our next question comes from the line of Matthew Fassler from Goldman Sachs. Your line is open.

[Matthew Fassler:]

Thanks a lot - I am here too, and good morning. A quick question on capital allocation. Just curious - you know, this is done well, the leverage has come down to some degree. Philosophically, how are you all thinking about target leverage and the point at which you might want to start to use your cash flow for things other than debt pay down and taking the leverage ratio lower?

[Charles Sonsteby:]

That’s a great question, Matt. We hear that a lot from investors. As we said in the script, we’re working with our board right now as we go through our update of our strategy to talk about what our capital allocation policy should be and will be. Honestly, we’ll generate excess cash as we get through fourth quarter, so it’s a bit of a moot point until we get to that point in time, at least for anything meaningful. So as part of our update of 2016 guidance, we’ll include also some visibility into how we’re looking at the balance sheet and capital allocation.

[Matthew Fassler:]

So it sounds like there are some open questions as to where the target is and whether the single-minded focus is on debt reduction at this point - not to put words in your mouth.

[Charles Sonsteby:]

I would say that we have not talked about our capital allocation policy, and we’ll do that as we lead into 2016.

[Carl Rubin:]

Yes and Matt, just to add, we haven’t talked about it externally. I know everybody is anxious to understand this. As Chuck said in the script and just now, we’ll talk about this, we anticipate, as part of the fourth quarter earnings call.

[Matthew Fassler:]

Got it. Thank you so much, guys.

[Operator:]

Thank you. Our next question comes from the line of John Heinbockel from Guggenheim Securities. Your line is open.

[John Heinbockel:]

So Chuck, you mentioned merchandise exits, so I’m curious, is that going item by item, kind of cherry picking all of the departments, or is there more a concerted effort to pull back in certain areas? Then to the degree that that might be the case, what’s getting incremental space? As you think about new items and changing space allocations, what’s getting that space?

[Carl Rubin:]

Yes John, I wouldn’t describe them as any massive changes. I think it’s the ongoing resets that we do on a regular basis. Just with the port issues, it slowed us down in this past quarter, so there’s no real businesses that are dramatically expanding, although we would like to do some. But this goes back to the snowflake issue that we’ve talked about repeatedly.

[John Heinbockel:]

To follow up on that, if you think about businesses that have struggled more recently - take bakeware, are there businesses you’d like to strategically pull back on? And then I think about others, like party - and wanted to get an update on the party test - and I know those are sort of--in some stores, right, those are adjacent categories. Are there opportunities to do that - you know, pull back on one, expand others where they might have some adjacencies?

[Carl Rubin:]

Yes, there are opportunities to do it, they’re just more limited than we want them to be, and they tend to be harder than we like them to be. Harder usually describes as a bit more costly, so last year we were able to expand our Christmas seasonal presentation in many stores, and in fact this year we’ve kind of reengineered how we did it last year and improved it, we believe, and we’re going to be able to reach even more stores this year. That is a rather large undertaking that our merchants and our operators have done a really good job of figuring out. When you describe individual departments like party and wedding--like bakeware, those are great examples where in a subset of stores we can expand and contract that somewhat more easily; but as a chain, we have more trouble. That’s why we’re working really hard on trying to figure out how to become more flexible, more this accordion-style expansion and contraction. But clearly we believe one of the benefits of our business from an investor standpoint is, just as you all have portfolios of different companies, we have portfolios of different businesses that can run in different cycles. Our business is good now, but even within that we do have some departments that are underperformers that we’d like to cut back on. We have to a degree, but we’re hopeful in the future we’ll have a little more flexibility to expand and contract.

[John Heinbockel:]

All right, and is too early to take anything away from the party test, which does look dramatic where you’ve done it well?

[Carl Rubin:]

Yes, it’s not too early to say that we’re very pleased with most of the results. There were certain parts of it that didn’t do as well as we hoped, but overall I would give it a solid B-plus kind of grade. That’s something that you’ll see us selectively expand, but that’s a really good example, John, of something we would like to be more aggressive in expanding, and thus far we’re having a little trouble getting into all of our stores with it.

[Charles Sonsteby:]

Chuck, you might want to talk a little bit about our party and how it might be different than most people might think about party.

[Carl Rubin:]

Yes, you know, our party, for those of you who haven’t seen it, there’s a lot of--there’s a crafting component to it, so there are pieces to the party offering that are finished and ready to use, but there really is for a broader feeling a much more do-it-yourself component to it, where you can mix and match items and you can tailor things that personalize it to your individual party purpose, if you will. So it isn’t--you know, it is quite different for most of it than what you might find in other party stores that are out there, and our customers reacted really well. So to your question, we’re trying to figure out how to get it in more stores, but it’s turning out to be a little challenging.

[John Heinbockel:]

Okay, thank you.

[Operator:]

Thank you, and again ladies and gentlemen, please press star and then one to ask a question. We ask that you limit yourself to one question and then one follow-up question. Our next question comes from the line of Simeon Gutman from Morgan Stanley. Your line is open.

[Simeon Gutman:]

Thanks. I’m in a noisy spot, so I’m just going to ask both questions up front. Comps for the back half of the year - Chuck, you laid out a lot of compelling reasons - merchandising, pricing changes - why you’re confident in the back half of the year. I just wanted to ask on that, how much of the business in general do you think is driven internal, you know, some of the merchandising things you’re doing versus the macro, and then I don’t know, how do you think about macro for your business? That’s the first question. The second question, thinking about snowflakes, are you any closer to formalizing a game plan for standardizing the stores over time? Is there a road map that you’re going to lay out at some point? Then related to that, is it costing you sales to not be standardized, or is it costing you higher labor, and what’s the plan on that end?

[Carl Rubin:]

Yes, let’s take the second one first. The snowflake aspect, we are working it really hard. I mentioned on a couple of earnings calls and just now to, I think, John’s question, we have made progress. We have been able to expand our holiday presentation for a variety of holidays throughout the year, especially for the Christmas season, so we have made real progress. When you look at the individual core departments, though, of our business, we have made less progress - still some, but not as much as we would like. What we are testing in Baltimore is something that a whole lot of analysis has gone into it and individual testing of different pieces has gone into it, and now we have put it into the Baltimore stores. It does not necessarily look different to the average consumer, but it provides a lot of flexibility for our merchants to expand and contract. So to your point about is there a plan? Yes, there is. Part of it has already been implemented. Baltimore is the next stage of it, and we’ll update you as we learn more, but we do continue to work it hard and we’re not waiting just for the full store accordion. We are, where we can, expanding pieces of individual businesses. As far as the comps in the back half, this is a pretty resilient business, which is the good news part of the business, but we’re not unaffected by broader issues. So the huge gyrations in the stock market, the CNN effect that I like to describe where people get wrapped up in that, are we a little bit concerned about that? Yes, but we feel good about our plans. We feel good that this is over years and years and years been a resilient business that generates a lot of cash, and we think we’re well poised, so we feel good.

[Simeon Gutman:]

Okay, thank you.

[Operator:]

Thank you. Our next question comes from the line of Seth Sigman from Credit Suisse. Your line is open.

[Seth Sigman:]

Thanks, hey guys. Just a follow-up question on SG&A. Just wondering - does the guidance for Q3 assume maybe SG&A leverage held back a bit by higher incentive comp? I think last year, you had a lower incentive comp from the prior year, so just wondering where you’re tracking today, if that’s a little bit of a headwind, and then as you look to Q4, does that normalize? Should you see better leverage as you move through the year?

[Charles Sonsteby:]

Well, I think some of that depends upon how well we do. When you talk about specifically incentive compensation, we don’t expect that to be a headwind as we get to the back half of the year. We expect it to be a little bit more normalized versus last year. I do think one of the things we should think a little bit about here when we talk about leverage is Q2 is our lowest volume quarter of the year, so a $1 million or $2 million here and there in the second quarter can be a really massive improvement when it gets to basis points and basis points of improvement. So as we get into Q3 and Q4, volumes go up a lot, so we still continue to believe that our expense control and our expense management will stay solid and we can gain leverage on SG&A, but you won’t see those kinds of gyrations because the sales, the top line sales are higher as we get to the back half of the year. So again, I don’t want to apologize for our good performance in Q2, but I just want to remind everybody when you see a 60 basis point improvement, you should not build that into the model going forward. But we do think we’ll get leverage on those lines in Q3 and Q4.

[Seth Sigman:]

Okay, understood. Then you talked about the TV campaign in select markets. Can you elaborate on the changes you’re making there and any early results in those markets, and does that imply any changes in expenses related to TV advertising or is it kind of baked in?

[Carl Rubin:]

Well, the change is that we are running TV. We have not run it before. It’s in a reasonably smaller number of markets. It has fit into our overall marketing budget this year. It has not been incremental to our marketing spend. It is literally just a handful of weeks old, so to draw a conclusion is premature, but so far what we’re seeing, we’re encouraged by, so we’ll update you a little bit more on the next call.

[Seth Sigman:]

Great, thanks very much.

[Operator:]

Thank you, and our next question comes from the line of Michael Baker with Deutsche Bank. Your line is open.

[Michael Baker:]

Thanks. First, just a clarification, and I’m probably just missing something. You pretty much reiterated your full-year guidance in terms of sales exactly as you had it, including the spread between local currency and U.S. dollars, yet you’re saying that you think Canada will hurt by $9 million more than you had thought previously. Can you help me reconcile that?

[Denise Paulonis:]

Hi Mike, this is Denise Paulonis. I think what we thought is as we go through and look at the whole back half of the year, the spread that we have is reasonably wide and more than moving the underlying--the numbers that we provided. We would just hope to be updating those as we come to the end of Q3 and see where things land. So you are right that we could have expanded that spread with constant currency a bit, and we just chose not to do it at this point given that the currency is as volatile as it currently is.

[Michael Baker:]

Okay, fair enough. Just wanted to make sure I wasn’t missing anything obvious. A couple other quick ones here. You said that gross margin, I think you had an impact from timing, I think a benefit from timing. Does that reverse or change as we go forward?

[Charles Sonsteby:]

Yes, that is part of what we’ll see in Q3 and Q4. We’ll start to see some of those costs come through when we sell the inventory that’s on the balance sheet; however, that’s reflected in our guidance and has been anticipated both when we gave Q2 guidance as well as today.

[Michael Baker:]

Can you help us quantify, just so we have some level of expectation for gross margin changes in the next couple quarters?

[Charles Sonsteby:]

I’d prefer not to get that finite.

[Michael Baker:]

Would gross margins have been up without that line item this quarter?

[Charles Sonsteby:]

No, they wouldn’t have been; but I would also say that we also had costs of resets that we expected, so we anticipated both those things happening in Q2.

[Michael Baker:]

Okay, thanks. I’ll pass it on to someone else.

[Charles Sonsteby:]

Thanks, Mike.

[Operator:]

Thank you. Our next question comes from the line of Matt Nemer from Wells Fargo Securities. Your line is open.

[Matt Nemer:]

Hey, good morning guys. First question is, can you talk to the potential benefit to comps in the back half from higher levels of core inventories? Is that something that you’ve baked into your expectations?

[Charles Sonsteby:]

It is. We talked a little bit about last year at Q3, Q4, because of some of the port issues, we felt like we were lower in inventory than we wanted to be. Our expectation is that being better in stock and having some of the ability to be up a little in seasonal should be able to translate to better overall comp performance.

[Matt Nemer:]

Okay. Secondly, I’ll ask the SG&A question a little bit of a different way. You were down about 1.3% per foot, and it’s been up on an annual basis kind of 1. 1.5% per foot the last few years. What should the underlying growth rate be of SG&A per foot, assuming your long-term comp guidance range?

[Charles Sonsteby:]

Well, what we’ve told people--you know, I haven’t gotten that finite into guiding on SG&A. What we have told people is we believe we can get leverage in this business at about a 2% comp. That’s constant currency, so that’s currently below what we’ve been guiding, so we do expect to get leverage on SG&A as we move forward. One of the hard things about making that comparison, Mike, is you’ve got currency flipping all over the place, and that certainly does impact the SG&A rate that you’d see on a year-over-year basis.

[Matt Nemer:]

Got it, okay. Thanks so much.

[Operator:]

Thank you. Our next question comes from the line of Dan Wewer of Raymond James. Your line is open.

[Dan Wewer:]

Yes, thanks. I also wanted to ask about this timing difference impact on margin rate. So the way to think about that is with the 12% increase in inventory per store, the distribution costs were allocated over a lot more inventory and that’s what led to the drop in the cost of goods sold, so that will reverse itself next few quarters as the inventory numbers normalize. Is that a way to think about this?

[Charles Sonsteby:]

That’s correct.

[Dan Wewer:]

So absent that, why did the gross margin rate drop in the quarter, if you pull out that timing difference?

[Charles Sonsteby:]

We also had the timing difference of the resets.

[Dan Wewer:]

And that impacted the cost of goods sold?

[Charles Sonsteby:]

Yes. We also had resets that were done later in the year this year than last year, so we had some higher exit costs. If you look at scan margin, it was relatively flat on a year-over-year basis.

[Dan Wewer:]

Okay. The increase in shrink, is that a function of bringing in the holiday inventory earlier? If you have more 12% more inventory per store, you just have a greater likelihood of something disappearing?

[Charles Sonsteby:]

No, that’s not really related to that.

[Dan Wewer:]

What would have led to it, then?

[Charles Sonsteby:]

We’re just seeing a higher incidence of shrink and damages within our store. Historically, we are very low, so again the other thing you have to remember is it doesn’t take much in Q2 to dramatically move a number up or down. A half million dollars or a million dollars of shrink change is 10 basis points on gross margin, so it doesn’t take very much on a dollar basis to move that around in the second quarter.

[Dan Wewer:]

Chuck, a separate line of question. The competition, Hobby Lobby, according to the price reports is opening--continues to open a lot of stores, I guess over 50 stores a year. Can you remind us how their opening near a Michaels impacts Michaels, either in terms of the sales in that store or a margin rate?

[Carl Rubin:]

Yes, we haven’t quantified that, and we wouldn’t. Hobby Lobby will continue to open. They are a very impressive competitor, but they are a different retailer than we are. They are significantly into the fabric business. They do a lot of home décor. They do a good amount of arts and crafts as well. We do just fine against them, and like any other type of retail, when they open up near us, we certainly see customers go see what they are all about, but our stores bounce back very, very quickly and we view them as a good, credible competitor but our customers stay loyal to us because of our exclusive offering, our trend product, our service in the store, et cetera.

[Dan Wewer:]

Right. Okay, thank you. Appreciate it.

[Operator:]

Thank you, and our next question comes from the line of David Magee from SunTrust. Your line is open.

[David Magee:]

Yes hi, good morning guys. Can you talk a little bit about Halloween? Your stores look well outfitted for the holiday. I’m curious what you might be doing differently this year, and what you’re comparing against with regard to that holiday.

[Carl Rubin:]

You know, all the scary stuff in our Halloween assortment is modeled off of our head merchant, who is a reasonably scary character himself! Halloween is on a Saturday this year, which we believe will translate into good things for us, so our assortment is--to your point, we brought it in earlier, that was part of our inventory load. We’re set now, we feel really good about it. I think that it is a more cohesive assortment of what we have. We think the extra day helps us. We have some fun events planned as we get closer to Halloween, so we feel pretty good about it. Back to the earlier comments about being able to move product around, we were able to realign some of the product in some parts of our stores, some segments of our stores, so the Halloween presence is a more impactful one this year than it has been in the past.

[David Magee:]

Thank you. As a follow-up, and I apologize if I missed this, but any comment about the regional performance of the chain, and specifically in Texas?

[Charles Sonsteby:]

No, we didn’t comment on that. I’ll tell you that we saw positive comps, and I’m looking at Canada on a constant currency, but positive comps throughout the U.S. and Canada, and Texas was just fine. So I don’t know if you’re referring to the--there had been some concerns about the price of oil and the impact in Texas. At least for our business, we haven’t experienced that.

[Carl Rubin:]

It gets back to that steady nature of our business. We seem to be a little bit more immune to the ups and downs that most people might see.

[David Magee:]

Great, thank you.

[Operator:]

Thank you, and again ladies and gentlemen, at this time if you have a question, please press star and then one on your touchtone telephone. Our next question comes from the line of Rick Nelson from Stephens. Your line is open.

[Rick Nelson:]

Thanks, good morning. Can you comment on ecommerce, what sort of sales change we saw there and percentage of sales that you’re generating?

[Charles Sonsteby:]

Yes Rick, we’re not going to go into detail on ecommerce. What we’ve said before is we anticipate that it’ll be a reasonably small penetration of our business over time, and it is now a little bit over a year old and it is turning out to be a reasonably small part of our business. It is an important complement to our brick and mortar business, but given the nature of what we sell, being low price point and being very tactile in nature, we do view ecommerce as an additive, not a pure replacement. So there’s a lot of buzzwords about omni-channel shopping for our customers, that’s truly how we view it. So it’s doing fine, but it is small, as we expected it to be.

[Rick Nelson:]

Okay. Finally, if I could ask you where you stand with the smaller store format?

[Carl Rubin:]

Small format store?

[Rick Nelson:]

Yes.

[Carl Rubin:]

Oh, I’m sorry - the Aaron Brothers custom frame. Yes, we have five of them open in Dallas that we’ve talked about previously. We’ve learned a lot about them. I think we’ll probably talk about them more on our next call or the call after that. We’ve refined a few things, but we’re not ready to go into detail on that just yet. It does leverage our strength around custom framing, our vertical nature of custom framing, so these five stores represent different types of geographic locations, different co-tenants, even different sizes of the stores themselves. So we’ll keep you up to date, but we’re not ready to do that today.

[Rick Nelson:]

Okay, thanks a lot. Good luck.

[Carl Rubin:]

Thank you.

[Operator:]

Thank you. At this time, I’m showing no further questions in queue. I would like to turn the call back over to Mr. Chuck Rubin for closing remarks.

[Carl Rubin:]

Okay, well thank you everyone for joining us. Appreciate your interest in Michaels, and we’ll look forward to speaking with your for our third quarter earnings call in December. Thanks so much.

[Operator:]

Ladies and gentlemen, thank you for your participation in today’s conference. This concludes the program. You may all disconnect.