Michaels Companies Inc
Q3 2015 Earnings Call Transcript

Published: 3 Dec 2015

[Operator:]

Good morning, my name is Candice and I’ll be your conference operator today. At this time we’d like to welcome everyone to the Michaels Third Quarter 2015 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. [Operator Instructions] Thank you. And 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, Candice, and good morning everybody. Welcome to our third quarter 2015 conference call. Earlier this morning, we released our third 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 measures, such as adjusted EBITDA as defined in our credit agreement. A reconciliation of these measures to the corresponding GAAP measures can be found at the end of our third quarter earnings release. On the call with me today is our Chairman and Chief Executive Officer, Chuck Rubin; our Chief Administrative and Financial Officer, Chuck Sonsteby; and our Senior Vice President of 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 give the highlights of our third quarter performance as well as comments on our plans for the holiday season and fourth quarter. Chuck Sonsteby will then go to the financial details in more detail and discuss our outlook before I provide some closing comments. And we open the call for your questions. I am generally pleased with our results for the third quarter. We delivered total sales of $1.2 billion, an increase of 3.4% or 5.1% on a local currency basis versus last year and on a comparable store sales increase of 1.5% or 3.1% on a local currency basis. Our Q3 operating income increased 9.4% to $156 million over the last year’s operating income of $143 million with a 70 basis point improvement in operating margin rate from 12.6% last year to 13.3% in Q3 this year. Across all major geographies we saw positive comps for last year including in Canada on a local currency basis. In our product categories we saw strength again from fine arts, seasonal and paper crafting. We previously said that the FX impact to sales in the third quarter would be a headwind of $19 million, and it ended up being higher about $20 million. This quarter we also felt more of an impact from FX on our operating margin as we start to cycle through Canadian inventory purchased earlier this year at different FX rates. In total, the FX negative impact operating profit was about $10 million. We expect to continue to see foreign exchange rates negatively impact our P&L in the fourth quarter. A wide range of retailers have commented recently on the volatility of consumer spending in Q3, we experienced this as well while we stop positive lift from our promotional events they did not consistently provide the lift we have experienced in more recent quarters and we feel that is a reflection of the broader uneven consumer spending environment. Additionally, our custom frame category didn’t not perform as well – as expect. As a result of both of these our sales came in at the lower end of the Q3 guidance we previously provided. Nonetheless, we delivered a solid quarter of comp store sales which when adjusted for the FX rate pressure we’re once again above the top end of our long-term comp guidance of 2% to 3%. Additionally, due to our financial discipline, we continue to grow both our operating margin dollars and rate when compared to last year’s adjusted operating margin. Let me give you an update to the inventory position, we discussed last quarter. Inventory per store at the end of Q3 was $1 million, up 12.8% over the $923,000 per-store inventory level last year. As we discussed on our Q2 earnings call, most of this was planned and is due to almost entirely to us accelerating these seats of merchandise versus last year. We still expect our year-end inventory on a per store basis to be up in the low to mid-single-digit percentage range from the prior year period. Chuck will provide more details in a movement. Now for some color on Q3, starting with the improved customer experience in our stores. We have made good progress on our store refresh program, which is intended to upgrade the physical shopping environment in our stores. Our customers are noticing the improvements in our customers service scores as measured by an independent third-party continue to improve over last year. Part of the store enhancements is a new store signage and graphics package to make the store easier to shop and to enhance the overall environment. Approximately 800 stores have now been completed. We’re building upon these refresh enhancements by actively working on ways to optimize our store product layouts or reducing the number of planogram snowflakes that currently comprise our chain. Our objective is clear, to cost effectively be able to expand and contract pieces of our portfolio product offering to more effectively reflect customer demand. Last Q4, we made solid progress on this by consolidating holiday seasonal product, instead of spreading it across multiple locations in the store. The results were very strong across the roughly 800 stores completed last year. And for Q4 this year, we have expanded that program into another approximately 200 stores. This and other changes have come from the learnings of our Boston and St. Louis store RESET tests. And we believe that contributed to our positive sales trends throughout the chain over the past number of quarters. Last quarter, we told you about our Baltimore market test, this test builds further upon our earlier learnigns and is one of the ways we are continuing to work on streamlining and simplifying our store sets. This Baltimore test is only a few months old and therefore it is too soon to report results. During Q3, we continue to grow our store footprint with ten openings, which brought our total Michaels and Aaron Brothers store counts to 1,314 stores, as of October 31. There was one more store to open in Q4 to complete our 2015 new store openings and that store has now opened. For the fiscal 2015 year, we have opened 29 net new Michael stores; we also relocated four Michael stores during Q3. During the third quarter, we infused a lot of new units into our merchandized offering, a big trend during the quarter were coloring books for adults. As is core to our 2020 strategy, we recognized this trend very quickly and responded very aggressively. We were amongst the first retailers to capitalize on this trend and believe our offering of over 175 titles is the largest across any brick and mortar retailer. We know we have significant market share in this hot trend to our broad assortment in the full use of our whole suite of marketing vehicles, including print and digital. We also had a little fun with the category, when we highlighted these and all of Michaels offerings, during a special segment on the The Ellen DeGeneres Show. We expect coloring books for adults – excuse me – to be a terrific holiday gift. We also had strong sales in our seasonal product offering, during the third quarter, but like other retailers, it came late. For Halloween, we offered our largest product offering ever, with a lot of new products introduced in party, costumes and accessories and novelty décors, such as tombstones, flying ghosts, spiderwebs and half pumpkins. All in, we were very pleased with our Halloween product sales. Also selling well, were two key trend products statements. The first Raw Bar was an update on our previous strong selling collection. This update included decorative, colored and raw metal leathers, wood leathers, galvanized surfaces, chalkboards and easels. The second key trend statement was an expansion of our home décor do-it-yourself offering. This assortment of paint and accessories allowed customers to personalize home décor accessories such as wooden crates, frames, and storage containers. This has been a hot trend seen in many places including Pinterest. Like Raw Bar this home décor do-it-yourself product sold well and is part of our private brand offering. One area that did not meet our expectations was our custom framing category. We believe there was some indication that Q3 saw an industry wide slowdown. Additionally, at Michael’s, we believe three programs we undertook negatively affected our performance. First, we implemented a new product presentation and promotion strategy with the intention of creating framing collections that aligned to specific lifestyles such as modern or classic. The change was not well received by our customers and during this Q4, we essentially reverted back to our previous store presentation and promotional approach that allows a customer to choose a variety of styles types on sale, during every promotional event. Second, during Q3, we introduced a bundle and save option, where a customers could buy a bundle combination of any molding, two standard mats and conservation clear glass, all priced at an everyday value retail. This offer had a smaller impact to our overall sales than expected. However, we believe long-term it will provide an attractive option for our customers. And third, we reduced the frequency in discount debt of some of our custom frame promotions. We believe this had a negative effect on our custom frame sales given the heightened consumer sensitivity to promotions we have seen across much of our business, as well as most of retail during the third quarter. Let me make it clear, we are committed to this custom frame business. We believe we are the largest customer frame retailer in the world. We have a unique vertically integrated manufacturing business model and thousands of certified framing experts in our stores to assist our customers. Let me give you an update on ecommerce. We continue to believe that the penetration of the ecommerce channel within the arts and crafts category will remain low. There are several reasons for this, such as the low unit average prices, there are very few well known national brands and the fact that our industry is a tactile shopping experience as our customers are matching colors and textures when assembling the components for their projects. Nonetheless, we are pleased with our site and continue to expand both our online capabilities and our offering. In September, we started the test for online fabric sales through a third party partner. We are pleased with our initial results and look forward to expanding this test. New this year we have added more seasonal product to our online assortment including an expanded Christmas tree collection. Additionally, a new operational capability is our ability to – capability is our ability to ship select products directly to the customer from one of distribution centers. This augments our third party e-com fulfillment partner. Our site continues to perform well and remains a key part of our strategy to deliver an omni-channel experience for our customers. Now let me share with you some of our plans for this fourth quarter and holiday season. As you know, Q4 is all about holiday in our business. Before I start discussing details let me put the quarter into context. Q4 2015 is the anniversary of a very strong quarter last year with close to a 7% positive comp when adjusting for both FX and Rainbow Loom. Additionally, it was the benefit of virtually no bad weather. Now with that said, while we face the same uncertainty regarding consumer spending in the quarter as other retailers, we feel very good about the condition of our stores, our product assortments and the quality of our marketing plans to engage our customers and give her reasons to shop us during the busiest season of the year. And while we will not be making a habit of commenting on intra-quarter performance, I am happy to share that we were quite pleased with our results over the Black Friday weekend and are hopeful that our customers’ positive response to our plans continues through the quarter. Now let me give you a few details on what we have planned in the fourth quarter. This year we are offering our largest Christmas assortment ever. We have a collection of basic Christmas trees along with slim trees which are very trendy this year. All of our trees are easier to shop this year with a cohesive look in packaging, product signing and ad size. We have expanded our assortment of crafting lights, of Lemax collectible houses, and of ribbon where we offer guests 100 feet of ribbon including an increased selection of jumbo ribbon. New holiday decor has been added that is embellished with fur, chalk and metallic accents as well as holiday themed wall art and light up marquee letters. In addition to the holiday items I mentioned, we are continuing to feature coloring books for adults which are in high demand. We have expanded our offering of technology items based on successful sales earlier this year. Fuji cameras, many an exclusive to Michaels colors, the 3Doodler 3-D pen and a wide selection of sewing machines. Which we offer exclusively online, all present appealing quality gift items. Coming in late December and early January, will be a new marketing and product event, focused on helping our customers organize their life with style, using stores and space saving items, all offered in trend right colors. Also in January, we will have a new floral presentation and we will bring back Make Market with new products. Our merchandizing team has done a terrific job of bringing new, exclusive, trend right, value priced product into the store for our customer. Our marketing theme this holiday season is more jolly, less jingle. We think the message around holiday spirit and value will resonate with the customer. We're using an integrated approach to reach the customer using a consistent message in our digital, print and social outreach. In early November we hosted a live streaming event called Made With Michaels Live, where we demonstrated how to transition tablescapes from fall to winter, and shared creative ideas for ornaments, handmade Christmas gifts and tree decoration. Our gift-giving guide has moved online as we continue our migration to more digital content. Once again, we are repeating the Dream Christmas tree challenge, which is our largest monthly blogger contest with all 50 bloggers participating. Each blogger has created a tree with a different theme to help inspire our customers with ideas of instruction for decorating the season. Additionally this event kicked off our tree – sweeps where anyone could submit photos of their decorated tree to enter a $1,000 shopping spree at Michaels. We're also excited to share that based on the success of earlier tests we're running national television in Q4. We believe this will both attract enthusiasts and introduce the novice crafter to Michaels, inspiring her to make creativity happen for herself. Finally, we continue to leverage a full media plan including print, digital and in-store events. So again after a solid Q3 financial performance we have strong plans in place for the last quarter in 2015. Now, let me turn over to Chuck Sonsteby for more information on the detailed financials. Chuck?

[Chuck Sonsteby:]

Well, thanks and good morning. As Chuck said, we’re pleased with our results. Our third quarter net sales increased 3.4% to $1.2 billion, up from $1.1 billion last year from 5.1% on a local currency basis. Our same-store sales increased 1.5%, although without the negative 1.6% impact of foreign exchange rates, constant currency comps were 3.1%. Normalizing for FX and Rainbow Loom, our two-year stack comp accelerated from approximately 6% in Q1 and Q2 to close to 8% in Q3, showing the resiliency of Michaels. Gross profit dollars for the quarter grew 3% to $466 million and our gross profit rate for the quarter was 39.8% versus 40% last year. The 20 basis point decline was due to promotional activity as a result of the continued competitive retail environment, as well as a shift in sales mix due primarily to the success of our trend right but lower margin coloring books. Also, the impact of Canadian FX rates continues to be a drag on our merchandise margin, particularly on seasonal goods. The decline was partially offset by targeted pricing changes and the benefits from sourcing efficiency. As Chuck said, and many other retailers have mentioned, we saw our customer increase for use of coupons and focus more of her spending on deals. Including waiting closer to the holiday season to make purchases. Our larger penetration in private brands allows us to compete effectively and maintain margin in this economic environment. Store rent expense for the quarter primarily reflected our new store growth. Increasing just over 2% and totaling $92 million, versus $90 million last year due to a net 27 additional Michael’s and Aaron Brothers stores. Selling, general, and administrative expense improved 90 basis points as a percent of sales to 26.5% from 27.4% last year. SG&A, including store pre-opening costs for the third quarter was flat on a dollar basis over last year at $310 million, despite operating 27 additional stores. Those costs were offset by the benefits of our fuel for growth initiatives, which continue to drive efficiencies and planned lower year-over-year marketing costs. While, we’ve often talked about the very real headwinds from exchange rates on sales and gross margin, we do see a benefit from the lower Canadian dollar from the operation of our Canadian stores on the SG&A line. Operating income increased 9.4% to $156 million. And the operating margins expanded 70 basis points to 13.3% of sales. This compares to operating income of $142 million with an operating margin of 12.6% last year, despite us absorbing approximately $10 million in FX related operating income headwind in Q3 2015. This consistent performance is a testament to the Michaels model. With an efficient fixed cost base and high private brand merchandise penetration we are able to expand margins and grow operating income with modest increases in same-store sales. For the quarter, interest expense was $34 million, which is better by $8 million from the $41 million in Q3 of last year. The benefit comes from our ongoing deleveraging efforts using free cash flow from operations to make extra principal payments on the PIK note in December 2014 and paying it off in May of 2015. The effective tax rate was 37% for the third quarter of fiscal 2015, compared to 36.1% for the first – for the third quarter of fiscal 2014, which is 20 basis points higher than we had originally anticipated. Net income for the quarter increased 19.9% to $77 million or $0.37 per diluted share, up from $64 million of net income or $0.31 per diluted share in the third quarter of last year. All in all it was a quarter to be proud of on many fronts. Now turning to our balance sheet, total merchandise inventory was $1.3 billion at quarter end. We've been communicating a strategic plan to add core basic inventory and to pull forward delivery of seasonal and standard assortment products to ensure in-stock positions for the peak selling season. Given our high penetration of private brands and their correspondingly longer lead times, our pull forward decisions were made early this year and accelerated receipts in Q2 and Q3. Almost all of the increase in our per store inventory is due to those accelerated receipts. As a result, our receipts in November and those scheduled for December are significantly lower than a year ago, and will drive per store inventory significantly lower than where we ended Q3. We’re comfortable with both the level and the composition of our inventory position heading into the fourth quarter. The expectations for inventory at year end is to be higher than last year on a per store basis, but at the low end – at the low to mid single-digit level consistent with our previously stated desire to add inventory. We ended the quarter with total debt of $2.9 billion and $587 million of revolver availability. Our debt to EBITDA continues to improve. We ended Q3 at 3.5 times better than the 3.6 times in Q2. Cash on the balance sheet at October 31, was $115 million. We are a strong cash generating business and there is continued interest in how we will use our excess cash flow. As previously stated, our intent is to discuss our capital allocation expectations in the first quarter of fiscal 2016. Cash capital expenditures for the quarter were $26 million, down from $40 million last year, primarily due to the timing of new stores and investments made last year in lighting retrofits and enhanced data security in stores. In the third quarter approximately $18 million was invested in the build out and maintenance of our stores. As we look to the last quarter of the year, the FX rate and the uncertain consumer environment remain as primary issues. Our updated full-year outlook includes our view of the current consumer environment, the sales quarter-to-date and the positive performance of our first three quarters in fiscal 2015. The currency impact on our Canadian sales in the first three quarters of the year was approximately $45 million in sales and $0.06 of EPS, including both currency translation and cost of goods sold margin impacts, which was higher than previously assumed, when guidance was initiated and updated. Our full-year outlook now, assumes $69 million of sales headwinds and approximately $0.09 to $0.10 of EPS reduction from the exchange rate translations and cost of goods sold impacts. Our view of the expected increase in 2015 comparable store sales is now in the range of 0.9% to 1.2% or 2.3% to 2.6% on a constant currency basis. And remember we lapped Rainbow Loom in the first half of last – of the year. We expect total sales to increase between 2.9% and 3.2%, or approximately 4.3% to 4.6% on a constant currency basis. We are tightening the range for expected annual income and expect it to be up 2.3% – 12.3 to 14% or $704 million to $715 million versus GAAP operating income of $627 million, last year. In summary, the higher FX costs in previous quarters this year and continued pressure in Q4 account for the change in operating income guidance. We are forecasting interest expense to be $140 million, which includes the additional expense and interest savings from the early redemption of the PIK notes. We are expecting the effective tax rate for the fourth quarter and for the full year to be 36.9%, 20 basis points higher than previously estimated. This rate is exclusive of any benefits from the tax credit extensions being contemplated by Congress. This translates to a fully diluted EPS range of $1.68 to $1.71 for fiscal 2015 on approximately 210 million diluted weighted average shares for the full year. Despite stronger pressure from rates and the softened consumer spending environment, our updated EPS outlook remains within the original guidance range provided earlier this year. Cash capital expenditures for 2015 will be around $120 million. The full year guidance implies fourth quarter comp store sales will be up 0.5% to 1.5% and we do feel good about our Black Friday weekend performance, but the noise around the overall retail promotional environment and a large portion of holiday sales still to come keep us conservative in our outlook. One thing to note, this range still anticipates a two-year stack of comparable sales excluding Rainbow Loom and FX to have accelerated each quarter this year. The fourth quarter impact of exchange rates on sales will be a headwind of approximately $24 million which is about $9 million higher than we expected earlier in the year. Excluding the 140 basis point FX impact comps on a local currency basis are expected to increase 1.9% to 2.9% and as Chuck said that’s against an adjusted 7.5% last year. And the only scheduled Michaels store opening as already occurred. Operating income for the quarter is expected to be between $308 million and $319 million and Q4 diluted earnings per share are in a range of $0.82 to $0.85, with the diluted weighted average share account of approximately 210 million shares. In summary, Q3 was a very solid quarter and demonstrated the strength of our business model. We saw a good top line results, which offset most of the headwinds. Demonstrated leverage in SG&A producing an expansion in operating income margins, and more importantly delivered an almost 20% increase in net income. As we finish out the year we’re optimistic about our strategies for the quarter, our ability to continue to generate strong cash flow, to drive continued earnings growth and our internal commitment to strong financial discipline. And with that I’ll turn it back to Chuck Rubin for closing comments.

[Chuck Rubin:]

Thanks, Chuck. In closing we are pleased with our third-quarter performance. And before we open for questions I want to thank all of our associates across our company, our stores, our distribution centers, our artistry facilities et cetera. All 50,000 strong we've worked hard through the third quarter and into the fourth quarter to get us ready for customers shopping for holiday. We are ready. We are excited about what we have to offer and we look forward to the rest of the fourth quarter. With that operator, we will open it up for questions, please.

[Operator:]

Thank you. [Operator Instructions] And our first question comes from Matthew Fassler of Goldman Sachs. Your line is now open.

[Matthew Fassler:]

Thanks so much for taking my question and good morning.

[Chuck Rubin:]

Good morning, Matt.

[Chuck Sonsteby:]

Hey Matt.

[Matthew Fassler:]

So my first question and these will be kind of financial nitty-gritty, my first question relates to SG&A. You spoke in your release about the timing of marketing spend having helped the third quarter SG&A. Was that timing into Q2 or is that SG&A – is that marketing spend going to be somewhat backend loaded into the fourth quarter?

[Chuck Rubin:]

Actually it relates to last year, Matt. Just based on where Halloween fell last year we did some direct mail, some additional direct mail in Q3. That was intended to give us a strong weekend ending up Q3 and into Q4. So those costs hit Q3 of last year. So we had a more normalized marketing schedule this year, so that is what provided that benefit. It had been planned all along. It's just a difference in timing between quarters of last year, not this year.

[Matthew Fassler:]

So that has no implications for fourth quarter marketing spend or SG&A?

[Chuck Rubin:]

No.

[Matthew Fassler:]

Great. And my second question, so this is the second year in a row when your third-quarter sales run rate kind of accelerated better than typical seasonality. And I wonder if you feel like the seasonality of your business is changing? That the thrust of some of the things you are doing are helping the third quarter disproportionately, whether it's some of the seasonal efforts that you focused on. Obviously the business is run well overall but third-quarter seems to be a period when kind of year-in, year-out you're pushing the productivity benchmark higher.

[Chuck Rubin:]

Matt, our business has evolved a bit so we carry a bit more seasonal product than we did before. So we are more closely aligned to some of the calendar holidays that are out there like Halloween was, as I mentioned in our prepared comments, quite good for us. So between the natural seasonal component as well as some of the trend product that we have, we have augmented what we carried and build that on top of our core inventory. So I do think that, that has improved. Plus in my comments I discussed some of the things that we continue to evolve in our store presentation. We’re making better presentations. We think we look better and we make a more cohesive and impactful presentation of some of these seasonal things than we were a couple of years ago. And if you walk into our stores today we are very proud of our holiday presentation. And we are very proud of our Halloween presentation. And we think that, that will continue. We still have room for continued improvement next year.

[Operator:]

Thank you. And our next question comes from John Heinbockel of Guggenheim Securities. Your line is now open.

[John Heinbockel:]

So the first question on categories Chuck. So, was the bulk of the shortfall versus the midpoint, was the bulk of that custom framing and whatever you lost in custom framing, do you think the bulk of that was self-inflicted? And then on the coloring books I was going to say, can you dimensionalize that opportunity, that Rainbow Loom but is it a tenth of Rainbow Loom’s potential, is it a fifth? How do you think about that relative to Loom?

[Chuck Rubin:]

Yes. Good morning John. Let me answer the second one first. So when we had Rainbow Loom people talked about well, are there more Rainbow Looms? And I categorized Rainbow Loom as a grand slam. And it was, and staying with that baseball metaphor I guess, I said that it had taught us how to be faster and capture trends and jump all over that. We have had a lot of singles. Coloring books for adults I would say is a double. It’s not at the level of what Rainbow Loom was but it has been a nice bolster to us. It’s interesting. They’ve been around for years. But they have really come into their own over the past couple of months. So it’s been bigger than some of our other trend things, but it is not at the caliber of Rainbow Loom. We do think it will continue certainly through the fourth quarter and we think it continues with a nice, some nice trajectory into 2016. As far as custom frame, I think it is a combination of two things. We are a big part of this market. We did some things that we tried that we thought made sense that the customer told us didn’t. So we have had to go back and reverse that. But we do have some indications that there is somewhat of a general slowdown in the industry. And it is something that we will work aggressively on. It’s a very promotional industry in the discount levels have, when you start getting into the 60%, 70% off it gets kind of crazy. So we’re going to have to manage that discounting in a very strategic way. So, short answer to your question, I think its combination of both. It is some industry-wide issue and a couple of things that we stumbled on that we've corrected now.

[Chuck Sonsteby:]

John, one thing I do want to point out on coloring books, it is absolutely a great trend and very good to us but it does carry a lower margin. So again, similar to Rainbow Loom we are working for gross margin dollars, not rate. So we are giving up rate through this product and in fact it impacted us probably 20 basis points on merch margin. But again, we are trying to chase dollars not rate. So we think it's a great product, we are excited to have the sales, but we did have that impact.

[John Heinbockel:]

And then just secondly, can you remind us the comp you need to leverage expenses is what? And is there anything left notably at store level where you can be more efficient, right, whether its product put away or how you allocate service labor, or is it really a lot of saving an hour here and an hour there?

[Chuck Rubin:]

It is, there is still room for us to improve. And really those ideas are coming from our associates. We talk about our fuel for growth program and really what that is, is that’s where we reward associates for giving us ideas on how we can improve cost efficiencies and labor efficiencies. And anything else that anyone can think of. And we have quarterly awards to folks who come up with best ideas. This fuel for growth program has still legs to it. We think there is continues to be operational opportunities for us to get margins better. We did make some technology investments over the last couple of years to help make us more efficient in stores. We added RF guns. We've done a few things to improve efficiency and we still think there is room to grow in terms of those operational leverage.

[Operator:]

Thank you. And our next question comes from Christopher Horvers of JPMorgan. Your line is now open.

[Christopher Horvers:]

Thanks, good morning, guys.

[Chuck Rubin:]

Good morning, Chris.

[Christopher Horvers:]

So following up on the gross margin or merchandise margin question, was it versus your own plan was the framing largely the driver of the merchandise margin shortfall? I mean presumably you would have expected coloring books to perform as they did. And then as you think about into the fourth quarter with the promotional environment should we think, and lapping very strong gross margin last year do you think gross margin will be likely be down in 4Q at a similar trend to what you saw in the third quarter?

[Chuck Rubin:]

Chris, we never breakout our gross margin expectations when we give guidance because it can flip between gross margin and SG&A on a quarter-to-quarter basis. I would say we aren't very far off of what we expected through the quarter. Custom framing was certainly a detriment. That is a nice margin business and we did see some softness, as Chuck said. We’d also saw that the dollar benefit of the coloring books which did hurt rate. I would say it wasn’t dramatically different. Some of the seasonal product that we are now selling will impact rate. As we have a higher proportion of seasonal product it drives dollars and we are doing well on our seasonal sales. But it comes at a lower gross margin. We’re competing with everybody in the world on that seasonal product. So it doesn’t carry the very nice benefits that we see on our regular SPA business. So again we’re focused on growing dollars not growing rate.

[Christopher Horvers:]

Understood. I’m just trying to right size expectations.

[Chuck Sonsteby:]

Yes.

[Christopher Horvers:]

As you think about the long-term plan and the underlying 2% to 3% comp algorithm, you’re guiding to that again in the fourth quarter, is there anything that you’re seeing over the past few months that makes you concerned that this algorithm won’t be intact as you look to the future? In other words, is the consumer changing and is that change in your view of a comp potential of the business longer-term?

[Chuck Rubin:]

No, I think over the longer-term, again this is a very steady business and really positive performance, we fluctuate 25 basis points or 50 basis points outside of currency and I think we see an outsized reaction to that. We are cognizant than in the shorter-term we are hearing lots of noise around a promotional environment. But on the long-term, we have not changed our expectations of this business and its potential.

[Chuck Sonsteby:]

I could just add, I always stress this, we have a portfolio business. So every quarter in this company we have a business that is not tracking as well as we would like. But we have other businesses that are tracking better. And the mix of them and how we can manage that mix is essential to what we do. We have been doing that pretty well. So even in the third quarter, even with the challenge in custom frame we had lots of businesses that were very strong. And that’s one of the core business strengths of this model, we’ve got a lot of categories that we sell and our ability to ebb and flow between those is essential.

[Operator:]

Thank you. And our next question comes from Simeon Gutman of Morgan Stanley. Your line is now open.

[Simeon Gutman:]

Thanks, good morning.

[Chuck Rubin:]

Good morning.

[Simeon Gutman:]

Following-up on a couple of the questions regarding gross margin I guess and SG&A. So you sent out a promotional plan I’m sure every year and then by quarter tactically move it around. You can’t control how often the consumer is going to use the coupon or use one promotion. If the environment does continue to do – to go in that direction, does the complexion of how you manage the EBIT margin change? Are there enough levers on the SG&A side if we do see some continued pressure on the gross margin side to get you back to whatever stated EBIT dollar growth that you manage to?

[Chuck Rubin:]

Yes, I think as Chuck said that’s sort of the magic of the Michael’s brand. We have a lot of private brand products that are basically not susceptible to show-rooming and so what that – we have an average item price that’s relatively low. So I think it allows us to try and move the business around without worrying about people doing price comparisons or having to sell branded products. In other words, we have to be more promotional on our products. We have the opportunity to maybe take pricing or it’s strategically makes sense to try and move the customer into the items that are selling well. I think there is an opportunity for us to manage those margins and still deliver what our long-term expectations are.

[Simeon Gutman:]

And then shifting to marketing and marketing effectiveness, do you feel that the communication you’re having with customers and then understanding the payback, are you getting better at it, conversion improving, how are you tracking it, do you feel like you're becoming more effective at it?

[Chuck Rubin:]

So the answer is we’re becoming – yes, we are becoming more effective. We track almost everything that you can track. We measure our lives. We measure our conversion. We have developed – this is a longer journey. We have made very good progress in the effectiveness and the efficiency of our marketing. We track it very closely, but we have a long way to go. We were – I would consider not all that good before and I think we’ve – I think we’re pretty good now, but over the next couple of years we’re going to get quite good.

[Operator:]

Thank you. Your next question comes from Mike Baker of Deutche Bank. Your line is now open.

[Mike Baker:]

Thanks. So With the metrics you gave on the impact of currency, it looks like the negative operating margin impact was 70 basis points. Is that more on the gross margin line from some of the cost of goods sold, or is it more on the SG&A due lack of leverage on lower sales metric?

[Chuck Rubin:]

It's going to impact us more on the gross margin line. And the reason being, particularly in the fourth quarter, we bought that merchandise almost a year ago. And so, when we bought that product, we bought in U.S dollars. So there has been a significant decline in the – or there has been a significant difference in the Canadian dollar and what we could sell that product for and what we bought versus our SBA product which turns relatively faster. So Mike we’re going to see an outsized margin impact in the fourth quarter due to just that product flowing through our cost of good sold.

[Mike Baker:]

Okay and thanks. There is a follow up question would be, does that continue into the first half of next year or will you have worked through most of that inventory? And then related to that in the fourth quarter, so this would be a gross margin issue, but I believe you cycle some pretty big incentive comp increases from a year ago in the fourth quarter as well right?

[Chuck Rubin:]

Yes we do cycle some incentive comp issues in Q4 of last year. This is a problem in terms of the FX headwinds that impact us much more in Q4 and will abate, because we will have much less seasonal sales as a percentage of our total sales as we start to move into 2016. And in addition with our normal SBA inventory, we’re buying that on a regular basis. So the gap between when we purchased it at, when we sell it at is much shorter for our SBA business. That’s why we had an outsized impact in gross margin in Q3 and in Q4 versus what we saw in Q1 into this year and what we’ll see in Q1 and to next year.

[Operator:]

Thank you. And our next question comes from Seth Sigman of Credit Suisse. Your line is now open.

[Seth Sigman:]

Great, thanks good morning guys.

[Chuck Rubin:]

Good morning, Seth.

[Seth Sigman:]

A lot of talk about the volatility of the business in the third quarter and it sounds like that is the expectation for Q4 as well. But also embedded in the guidance is, as you noted an acceleration in the two year comps particularly when you adjust for Rainbow Loom and FX. Can you help us understand that a little bit more and what drives that acceleration?

[Chuck Rubin:]

We feel very good about our plans. I mentioned we have the biggest Christmas presentation that the Company has ever had. We have made merchandising changes in the store to highlight that better to our customers. From an earlier question our marketing is more targeted and we're spending where we're getting better returns in marketing. In essence, the strategy that we've talked about before we believe is working. Now with that, we know we operate in a broader environment. When some other retailers are out as they have been talking about our promotional they are going to be moved inventory specifically, in the apparel world. We have to have some sensitivity that while apparel doesn’t directly compete with what we sell, it is a shared wallet play. So the customer is out spending $100 and there are great sweaters on sale at department stores, we have to be at least somewhat sensitive to what potential impact that has to us. With all of that said, we feel really good about how we are positioned. Our inventory, the quality of it, the presentation in the stores, our marketing, our associates and we provided more training to them this year than we've ever done in the past. So we feel as though we are ready to go. It's trying to balance both our internal plans that we control but recognizing there are external factors that we don’t.

[Seth Sigman:]

Got it, okay. And then maybe just more specifically on the custom frame business. You laid out the internal and external drivers weighing on the business this quarter. Maybe on the external side, when you look at the industry slowdown that you pointed to any more color on what you think is driving that? Is there a broader theme there? Is there any relationship or leading relationship perhaps with other aspects of the business that we should be considering?

[Chuck Rubin:]

I don’t think there are leading aspects to other parts of our business. We don’t see that kind of direct correlation between custom frame and other things that we sell. Quite honestly, we are still trying to figure this out. We are more hopeful, look at some other industries when you look at how well home sales have been, and home-improvement has been, we actually thought that our custom frame business would be better than it is given that, for the lack of a better word, the cocooning that seems to be going on as people invest more in their homes. So we’re still trying to figure that out. But it is a very attractive business for us. We will figure this out. We believe that this is some short-term turbulence that we’re navigating. But again, the nice part about our businesses, we’ve got a portfolio, so even while we’re navigating that turbulence we’ve got lots of other parts of our business that are very smooth.

[Operator:]

Thank you. And our next question comes from Matt Nemer of Wells Fargo Securities. Your line is now open.

[Matt Nemer:]

Thanks so much good morning. Two questions, first could you talk about the increased promotional activity that you mentioned? Is that in response to activity in the specialty category mass, or maybe just more of a general strategy to drive traffic? And then secondly, you mentioned national TV advertising in the fourth quarter. Does that cause marketing cost to shift in Q4 and sort of work against your SG&A leverage? Thanks.

[Chuck Rubin:]

So Matt, second question first. No we’ve included the marking TV in our overall forecast, overall guidance that we’ve given out today. Back to an earlier question, as we continue to get more analytical about our marketing spend we’ve been able to shave some spends off in other places and we have reinvested that into the TV. So – and based on our earlier testing we have obviously saw initial good results and that’s why we made this decision on national TV. On the promotional aspect of it, it’s a little bit of everything you just said. Clearly in this industry, this is a promotional industry, and we’ve got some competitors, some big box competitors that in our opinion doing crazy things. They are just promoting far more aggressively. We have stepped up some of our promotion, but we are not at the level that they have gone to. In some ways we believe it’s a sign that we are taking share and you’ve got other players who are acting in some level of desperation. So as I say, we have stepped up little bit but not to the degree that some of our other competitors have. And just the overall industry, the retail industry, you guys see it as well as we do. You’ve got all kinds of different challenges out there amongst different retailers. So we stepped up somewhat, I’m please to say that our comp in the third quarter, our traffic was essentially flat to a year ago. Which compared to most other retailers is a big win. So with traffic essentially flat, ticket being up slightly and that’s what drove the comp. We think we have treated this promotional aspect pretty well in the third quarter. Back to what Chuck Sonsteby said earlier, we are playing for dollars. We gave up a litter rate, but we are playing for the dollars and at the end of the day that’s what we delivered in third quarter.

[Matt Nemer:]

Thanks so much, very helpful.

[Chuck Rubin:]

Thank you.

[Operator:]

Thank you. And our next question comes from Denise Chai of Bank of America. Your line is now open.

[Denise Chai:]

Great, thank you. I wanted to ask a question about your fabric and sewing machines. I mean, how are you positioning yourselves in that category, given your assortment I think is quite limited compared to peers. Is it just a test at this point or are you targeting perhaps the novice or small project samestores?

[Chuck Rubin:]

It is a test. It’s only a couple months of old. They are both online only. We don’t have either one of them in our stores. The fabric aspect is more fabric around a little bit closer to our crafting customer. We don't have as much fabric for home décor, for instance. And we will continue to monitor it. But I will tell you that we are pleased with what we have seen so far, it’s a nice augmentation to what we do. And as we continue to expand it, we will revisit whether we test it potentially even in a few stores.

[Denise Chai:]

Okay, thanks. And I'm not sure if you said this before, but can you actually quantify the Canadian dollar benefit on SG&A and also the comp impact from custom framing and coloring books?

[Chuck Sonsteby:]

We rather not get into that level of detail, Denise. It is really hard for us to parse out each and every line item on both of those.

[Chuck Rubin:]

And again we've talked about this before, we're the only public company in the industry, we prefer not to share more with our competitors than we need to. The reason we called out custom frame is only because we came in the lower end of the guidance on the comp. We traditionally would not call it out. But we wanted to give you a sense of when we gave guidance what we were thinking and what changed since then. So we do have a fine line to walk of trying to keep you guys up-to-date on what is happening and the inner workings of our business, but not sharing more than we need to with competitors, who I mentioned before we believe we’re taking share from, and would love to understand our game plan so they could copy it that much closer.

[Operator:]

Thank you. And our next question comes from Dan Wewer of Raymond James. Your line is now open.

[Dan Wewer:]

Thanks. Chuck I want to ask about the impact of the 12% inventory growth at the store level. And the potential gross margin benefit from that. Given your distribution costs are amortized over a lot more inventory unit. So, what kind of benefit did you achieve from that in the third quarter and then as you begin to unwind the inventory levels because of the slower receipts, can that actually give some type of a margin headwind going forward?

[Chuck Sonsteby:]

So we haven’t quantified the benefit that’s in gross margin due to carrying more inventory. But as I said in my prepared remarks, our receipts are substantially below last year in November and will continue to be in December. So, our receipts are about $100 million less in those two periods than they were a year ago. So that’s essentially going to bring us well back in line with where our expectation is. And when you talk about there being a headwind, that’s all baked into our guidance that we gave for Q4. So, we have a very good visibility to where receipts are right now and a pretty good idea of where inventory is going to be at the end of the year, and all of that is in our guidance.

[Dan Wewer:]

Okay. The second question, a number of other companies we cover that are doing business outside the U.S. are attempting to push through price increases to help offset the impact of foreign exchange rates. Is there an opportunity for Michaels to adjust pricing in Canada? Or is the competitive situation such where that’s just not that feasible?

[Chuck Sonsteby:]

We have adjusted pricing throughout our chain in a very strategic way. So back again to the earlier question about marketing, we do, we measure our effectiveness. We’ve gotten a lot more analytical throughout the company, that applies to marketing it applies to pricing as well. So we’ve learned a lot about elasticity of items and pricing on both every day pricing as well as promotional pricing. And as a result of that work we have adjusted some retails, in many cases up and a couple of cases down. And we will continue to get smarter about that. So it’s not just limited to Canada, it’s throughout the chain.

[Operator:]

Thank you. And our next question comes from David Magee of SunTrust. Your line is now open.

[Mitch Van Zelfden:]

Hey, good morning guys, this is actually Mitch Van Zelfden [ph] in for David.

[Chuck Rubin:]

Good morning.

[Mitch Van Zelfden:]

Most of my questions have been answered but was there any notable comp variance between stores vintages in the quarter?

[Chuck Sonsteby:]

Store what vintage is?

[Mitch Van Zelfden:]

Right, right, or how did your mature stores fare?

[Chuck Sonsteby:]

I just like the word vintage, I've never have thought of our stores as fine wine, but that’s…

[Chuck Rubin:]

No we really haven't seen wide variations either geographically or by age of store. The Michaels business is just a business. If you look across all those different dynamics and metrics, probably the only thing that we have seen where we have seen some softness is along the border stores of Mexico. The exchange rate there between the peso and the U.S. dollar has really limited cross-border shopping. So we’ve seen some slowdown in those territories, but other than that the business has been relatively consistent throughout the U.S. and throughout those age [ph] categories.

[Mitch Van Zelfden:]

Okay, great. Thank you, that is all I have.

[Chuck Sonsteby:]

Sure, thank you, Mitch.

[Operator:]

Thank you and our next question comes from Christina Fernandez of Tesley Advisory Group. Your line is now open.

[Christina Fernandez:]

Hi, good morning. I wanted to go back to inventory of the 12.8% increase per store. How much of that is seasonal goods versus core inventory?

[Chuck Sonsteby:]

Really if we go back through, I don't have that down between seasonal and direct.

[Christina Fernandez:]

Okay, then I will do my follow-up. On the custom framing business since you changed the presentation have you seen any improvement there or is it too early to tell?

[Chuck Sonsteby:]

Yes that is all reflected in our guidance for the fourth quarter and in our comments the Black Friday was quite strong. So again, we don’t want to make a habit of intra quarter updates. We do not plan on doing that in the future. The reason we did it today is the Black Friday weekend is obviously of great interest and there has been lots of conflicting news stories out there from different retailers. But beyond that we’re not going to comment on what’s happening within the quarter. But what we are seeing, we are about five weeks into quarter, so a long way to go, clearly within our business for the fourth quarter. But everything that we’re seeing so far is reflected into our guidance.

[Christina Fernandez:]

Thank you and good luck this quarter.

[Chuck Sonsteby:]

Thank you.

[Chuck Rubin:]

Thank you.

[Chuck Sonsteby:]

And I think operator that’s going to wrap of our time. So let me thank everybody for participating with us. I appreciate your interest in Michael’s. And we will look forward to talking to you on an update for the fourth quarter after the first of the year. In meantime, I hope everybody has a terrific holiday season.

[Operator:]

Well ladies and gentlemen, thank you for participating in today’s conference. This does conclude the program, and you may all disconnect. Have a great day, everyone.