Michaels Companies Inc
Q4 2015 Earnings Call Transcript

Published: 17 Mar 2016

[Operator:]

Good day, ladies and gentlemen, and welcome to The Michaels Companies Fourth Quarter and Year-End Earnings Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to introduce your host for today's conference, Ms. Kiley Rawlins. Ma'am, you may begin.

[Kiley Rawlins:]

Thank you, Kylie, this is – all right – and good morning, everyone. Thank you for joining us today. Earlier this morning, we released our fourth quarter and year-end financial results. A copy of the press release is available on the Investor Relations section of our website at www.michaels.com. Before we begin our discussion, let me remind you that today's press release and the presentations made by our executives on this call may constitute forward-looking statements and are made pursuant to and within the meaning of the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995 as amended. While these statements address plans or events, which we expect will or may occur in the future, a number of factors that set forth in our SEC filing and press releases could cause actual results to differ materially from our expectations. We refer you to and specifically incorporate the cautionary and risk statements contained in today's press release and in our SEC filing. You are cautioned not to place undue reliance on these forward-looking statements which speak only as of today, March 17, 2016. We have no obligation to update or revise our forward-looking statements except as required by law and you should not expect us to do so. In today's earnings release, we have presented non-GAAP financial measures such as adjusted EBITDA as defined in our credit agreement, adjusted operating income and adjusted net income. 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 cost and the timing of our initial public offering, which closed on July 2, 2014. A reconciliation of these measures to the corresponding GAAP measures can be found at the end of today's earnings release. Our call this morning will begin with fiscal 2015 and fourth quarter highlights and a discussion of our plans for fiscal 2016 from Chuck Rubin, Chairman and CEO; then Chuck Sonsteby, Chief Administrative and Chief Financial Officer will review our financial results and fiscal 2016 outlook in more detail. Denise Paulonis is also on the call with us for the Q&A session. As we have a lot to discuss today, our prepared comments maybe longer than usual. Following our prepared remarks, the call will open for questions. As a reminder and due to time, we would appreciate if the participants could limit themselves to one question and one follow up. I'll now turn the call over to Chuck Rubin. Chuck?

[Carl Rubin:]

Thank you, Kiley, and good morning, everyone. A few years ago, we introduced Vision 2020, our long-term strategy to grow our sales and profits in the fragmented $30 billion arts and crafts industry. This strategy is built on five key pillars

[Charles Sonsteby:]

Well, thanks, and good morning. Before I discuss our financials, I want to take a moment to thank Elaine Locke for her efforts to develop and lead our Investor Relations efforts since our IPO in 2014. Elaine is shifting her focus to Treasury full-time, and I want to welcome Kiley Rawlins, who joined our team in January, in a new role to lead our internal and external communications including Investor Relations. Today, when discussing full-year results, I'll focus on our adjusted results, which back out the impact of our 2014 IPO and subsequent debt refinancing. On a full-year basis, adjusted operating income reflects our operating income excluding IPO expenses and related party or sponsor fees. The term adjusted net income reflects net income excluding IPO fees, related party or sponsor fees, and all prior IPO debt refinancing costs and the associated tax impact. It also adjust the interest expense from the second quarter 2014 debt refinancing as if it had occurred at the beginning of Q2 2014. And finally, adjusted earnings per share divides adjusted net income by a share count that assumes the IPO shares were issued and outstanding for our reported period. Please reference our press release for all definitions and a reconciliation of GAAP numbers to these adjusted numbers. As Chuck said, we are proud of our results. We delivered against each of the annual financial targets we established at the beginning of 2015 including revenue growth, operating income growth, and EPS growth despite stronger-than-expected headwinds from foreign exchange rates. The stronger-than-forecasted results in the fourth quarter certainly contributed to our outperformance. Our fourth quarter net sales increased 4.6% to $1.7 billion, up from $1.6 billion last year. And on a local currency basis, net sales grew 6.4%. Our same-store sales increased 3.1% and constant currency comps were up an impressive 4.7%. Comp performance was again driven by growth in both transactions and ticket, something that's become increasingly rare for retailers. Normalizing for FX and Rainbow Loom, our two-year stock comp accelerated from approximately 6% in the first quarter of 2015 to more than 12% in Q4, reflecting the success of the strategies Chuck outlined and further illustrating the consistency and resiliency of Michaels. During the fourth quarter, we added one new Michaels store, closed one Michaels store and closed one Aaron Brothers store. So, our total store count was 1,313 stores as of January 30, 2016. Gross profit dollars for the quarter grew 3.7% to $688 million and our gross profit rate for the quarter was 40.9% versus 41.2% last year, a decrease of 30 basis points. Now, this decrease, as a percent of sales, was driven by clearance, which was tied to our normal reset activity and the negative impact of foreign exchange associated with our Canadian business, also, a shift in the mix of product sales, which was largely related to the strong growth in coloring books. Additionally, as Chuck mentioned earlier, in the quarter, we made an investment to improve our store environment specifically the refresh of 75 stores to, first, create flexible merchandise space in the front of the stores, showcasing newness and relevant merchandise. And second, to help us reduce the variations of store layout, in other words, our snowflakes. All of these impacts were mostly offset by the benefit of improved sourcing and pricing efficiencies. As context, excluding the negative impact of foreign exchange rates and the investment in store environment, gross margin as a percent of sales would have been flat for the fourth quarter of fiscal 2014. Store rent expense for the quarter was $93 million versus $90 million last year with the increase due to a net 25 additional Michaels and Aaron Brothers stores. In the fourth quarter, selling, general and administrative expense, including store preopening costs decreased 1.5% to $363 million from $369 million despite operating 25 additional stores. As a percent of sales, SG&A improved 140 basis points to 21.6% from 23% last year. This decrease was driven by a difference in cadence of performance-based compensation accruals versus the prior year, which we talked about last year, as well as lower benefits and payroll-related costs. Additionally, we saw leverage on higher comp sales due to good cost controls emanating from our Fuel for Growth initiative and the benefit from Canadian operating costs due to lower exchange rates. These benefits were partially offset by about 30 basis points of increased marketing costs in the quarter. Part of the marketing expense increase was due to the timing of marketing spend year-over-year and the remainder was investment associated with our new TV advertising campaign. Operating income increased 10.3% to $324 million and operating margins expanded 100 basis points to 19.3% of sales. This compares to operating income of $294 million for an operating margin of 18.3% last year. This outstanding performance in Q4 2015 is even more impressive considering the results include approximately $15 million in FX-related operating income headwinds. For the quarter, interest expense was $33 million, down $6 million from $39 million in Q4 of last year. The benefit comes from our ongoing deleveraging efforts including paying down an additional $356 million in debt in 2015. We paid off our PIK note in May of 2015, and we made a voluntary payment of $150 million on our term debt in December 2015. As a result of this pay-down of the term debt in Q4, we recognized $2.4 million in losses on early extinguishment of debt. The effective tax rate was 36.2% for the fourth quarter of fiscal 2015 compared to 36.4% for the fourth quarter of fiscal 2014. Net income for the quarter increased 17.3% to $184 million or $0.87 per diluted common share, up from $157 million of net income or $0.75 per diluted common share in the fourth quarter of last year. Now, there's one complex accounting issue that we need to know. We award restricted stock that contains the right to participate in dividends. And as such, we're required to allocate net income between our outstanding common shares and those restricted shares when calculating earnings per share. This is otherwise known as the two-class method. We have used the two-class method for years, but it's been relatively immaterial, not resulting in any rounding impact to EPS previously. This was the first quarter where the two-class method resulted in a meaningful difference and it had a negative impact of about $0.01 for the quarter. And Q4 is the quarter most likely to be impacted because net income is larger than in other quarters. So, we've included a schedule in this morning's press release that provide a detail on the EPS calculation. Now, as Chuck discussed earlier, 2015 was a record year for Michaels on many fronts. Net sales increased 3.7% to $4.9 billion; comp sales for the fiscal year increased 1.8%, and excluding foreign exchange rates, they increased 3.2%. For the full year, adjusted operating income increased 8.5% to $721 million or 14.7% of sales, reflecting a 70 basis point margin expansion over fiscal year 2014 as we leveraged higher comp store sales and drove efficiencies in our cost structure that helped overcome approximately $37 million in operating income headwinds from exchange rates. Adjusted net income for fiscal 2015 increased 19.4% to $363 million or $1.72 per diluted common share from $304 million or $1.46 per diluted common share in fiscal 2014. For the full year, we generated free cash flow, which is defined as cash flow from operations less capital expenditures, of $380 million compared to $304 million in fiscal 2014. This allowed for additional debt repayments during the year and our acquisition of Lamrite West early in fiscal 2016 with cash on hand. Over the past five years, we've generated almost $1.5 billion in free cash flow. Now, turning to our balance sheet. Consistent with the outlook we provided on the Q3 call, our per-store inventory level was back in line with sales, up 2.9% at the end of the quarter versus last year and total merchandise inventory was $1 billion. For the last few quarters, our inventory balance had been higher than the prior year, reflecting our strategic decision to add core basic inventory and a pull-forward delivery of seasonal and standard assortment products to ensure in-stock positions. Given our high penetration of private brands and the corresponding longer lead times, our pull-forward decision accelerated receipts in Q2 and Q3. We ended the year in a clean inventory position and had no significant pack-away seasonal inventory once again this year. Total debt was $2.8 billion, and there was $587 million of revolver availability at year-end. Our debt-to-EBITDA, which we define as total debt divided by adjusted EBITDA, continues to strengthen. We ended Q4 at 3.2 times versus 3.5 times at the end of Q3, and this was driven by opportunistic debt pay-down and also healthy EBITDA growth. Cash on the balance sheet at January 30 was $409 million. Cash capital expenditures for the fourth quarter of fiscal 2015 were $34 million, flat with Q4 of 2014. Approximately $20 million was invested during the quarter in the build-out and maintenance of our stores. Now, I wanted to talk a little bit about capital allocation. Michaels has a long history of strong and consistent cash generation, demonstrated in a range of economic environments. And this strength is the foundation of our capital allocation strategy. The guiding principle of our capital allocation strategy is to maintain a balanced and disciplined approach to our use of cash while preserving flexibility to deliver the greatest return to stakeholders including investment in the growth of the business, debt pay-down and share repurchase. Our first priority is to invest in our ongoing business to support our strategy and maintain our industry leadership. Every year, we evaluate the amounts needed to make sure we provide the right level of investment in the company in order to support our growth. In fiscal 2016, we expect capital expenditures to be $125 million to $135 million, consistent with 2015 investments. Although we will continue to assess the potential for partnerships and acquisitions like the recently announced acquisition of Lamrite West, we will be highly disciplined and selective when evaluating these opportunities if presented. And then if we're presented an opportunity to increase our leadership in the industry by enhancing our capabilities, unlocking new business channels or better serving our customers, we would evaluate and act in a disciplined manner. However, we don't anticipate additional transactions in the near term. And on February 2, 2016, we acquired Lamrite West for approximately $150 million or about 9 times their 2015 adjusted EBITDA, and we're excited about the value and growth opportunities created by combining the two companies. Since our IPO, we've consistently reduced our debt. In December of 2015, we continued this trend, making a voluntary payment of $150 million on our term loan. And as I mentioned, our EBITDA leverage was 3.2 times at the end of fiscal 2015, which is a significant improvement compared to the 4.5 times EBITDA leverage we had in the first quarter of 2014 before the IPO, and as compared to 3.8 times at the end of fiscal 2014. Debt pay down remains an opportunity in our capital allocation strategy. Finally, as we announced in today's press release, the board of directors has authorized $200 million for share repurchases. The share repurchase program does not have an expiration date and the timing and number of repurchase transactions under the program will depend on market conditions, corporate considerations, debt agreements, and regulatory requirements. As we look forward to fiscal 2016, we believe the headwinds we faced in 2015 from FX will moderate, but the choppy retail environment will continue. In addition, we face a more challenging calendar with the timing of Easter, Halloween moving to a Monday, and Christmas on Sunday. All in all, we believe the resiliency of the Michaels model will deliver comparable store sales growth in the range of 2.2% to 2.7% or 2.8% to 3.3% on a constant currency basis for fiscal year 2016. We're planning for total sales to increase between 8% and 9% or approximately 8.6% to 9.6% on a constant currency basis. Now, this guidance includes revenues from Lamrite West of between $225 million and $250 million, excluding Michaels product sales bought through the Lamrite West. For modeling purposes, approximately half of Lamrite West's revenues, excluding the Michaels business, are attributable to the wholesale business. We expect annual operating income to be up 5.5% to 9% or $761 million to $786 million. These numbers include Lamrite West, but exclude an estimated $10 million to $12 million of the integration costs and purchase accounting adjustments. Because of the slow turn nature of our business, both the profit Lamrite West previously recorded from selling to Michaels and the benefits from the combination will be recognized more at the end of 2016 and then into 2017. In addition, the integration of a lower margin rate wholesale business and the investments needed to expand Lamrite West's global sourcing capabilities to support the Michaels business will create some operating margin pressure in the first half of the year. As we move into the second half, we should begin to see some of the benefits of the new vertical business model on profitability. We've modeled in our estimates a constant monthly Canadian exchange rate of $1.34 for 2016. If the $1.34 exchange rate holds, we expect $13 million of sales and $6 million of operating income pressure or about $0.02 negative impact on EPS. Any further move, up or down, will have additional impacts on performance. The outlook reflects opening approximately 33 net new and/or relocated stores including three new Pat Catan's stores. We expect our new store returns will be consistent with historical averages, but the mix will be slightly different with more fill-in, less urban and more weighted toward the second half. Therefore, new store contribution to sales growth will be about 1.3%, slightly lower than our historical trend. Interest expense is expected to be approximately $129 million with LIBOR under 1% throughout 2016 and does not anticipate any benefit of additional debt pay down. Of note, starting with 2016, we'll exclude from our EPS guidance any costs associated with debt extinguishment and debt restructuring to better reflect the EPS associated with operations. Our earnings outlook assumes an effective tax rate for the full year of approximately 37%. So, these assumptions translate to a fully-diluted EPS range of $1.88 to $1.96 for fiscal 2016 on approximately 210 million diluted weighted average common shares for the year, and includes the impact of the two-share method of accounting. Our outlook does not include the potential benefit of any share repurchases that might be competed in 2016. Now, turning to Q1, we anticipate comp store sales to increase 1.9% to 2.4%, or 2.8% to 3.3% on a constant currency basis. As a reminder, Easter is earlier in 2016 than 2015, which is a shorter selling season and is a sales headwind for us. We plan to open 11 net new stores in the quarter including one new Pat Catan's store. We expect the operating income for the quarter to be $145 million to $153 million, inclusive of FX headwind of approximately $3 million. If you excluded that impact of FX, this translates to operating income growth of 4% to 9% in the first quarter. And these numbers exclude the integration and purchase accounting adjustments from Lamrite West. The Q1 guidance for fully-diluted earnings per common share is $0.34 to $0.36, which includes $0.01 of pressure from FX and about $0.01 of headwind from the seasonality of the Lamrite West business including the timing associated with the recognition of profit on products that Michaels procures from Lamrite West. This outlook assumes a diluted weighted average common share count of 200.5 million shares. In summary, Q4 was another good quarter and demonstrated the consistency of our business model. As we begin fiscal 2016, we're focused on maintaining our strong financial discipline and investing in our business and growth initiatives to drive sales, improve profitability and grow earnings per share. And in keeping with the St. Patrick's Day tradition, we're proud that we can deliver some greeting to our shareholders. With that, I'll open it up for Q&A. [Operator Instructions]

[Operator:]

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

[Matthew Fassler:]

Good morning and thank you so much. My question focuses around Lamrite West. Thanks a lot for the color on the game plan and financial impact. Can you sort of frame for us in the context of your capital allocation options and your strategic imperatives, what it was that rendered this in acquisition you felt you really needed to do at this point in time? What does it bring you that you couldn't have gotten on your own or what kind of return does it get you that debt pay down or some of the buybacks you just authorized wouldn't bring to the company? Thank you.

[Carl Rubin:]

Matt, it's Chuck. It was a long-term investment. Just as we said in the prepared comments, they have very strong product development capabilities that complement what we have. The B2B business is very attractive for growth in the future. The China sourcing office, which handles most of what they do today, will scale up and handle ours. So, in theory, could these all have been things that we could build over the very long term? I guess you could say yes, but there's all kinds of risks of building those things out and it shortens the duration of getting the benefits from them, from doing it on our own considerably. So, we think we paid a fair price and we think that, as Chuck said, set aside the timing on some of the profit recognition, we think that as we move into 2017 and beyond, this is a very attractive, accretive acquisition for us.

[Matthew Fassler:]

That's helpful. Then my follow-up also with the deal. What kind of assumptions have you made about retention for some of your wholesale customers? You assume that you hold that business, you're assuming some attrition for it?

[Carl Rubin:]

Yeah. A couple of parts to that. We've assumed some conservative attrition that goes along with that – that part of the business, the Darice business, which is the wholesale side, we are maintaining very strict confidentiality. And that's what I think some of the customers are concerned about between what happens at Darice and at Michaels. The business is based outside of Cleveland and will continue to be based outside of Cleveland. The team continues intact. And just like other types of businesses, whether it's sourcing agents or investment firms, consulting firms that sell to multiple types of competing businesses, we know that the confidentiality of what Darice does with their customers will be maintained just tomorrow just as it was yesterday. So, we anticipate – hopefully no attrition, but we have budgeted very slight attrition. At the same time, with some of the capabilities that Michaels to brings to Darice, we think we have an opportunity to expand into new customers, big, small, and non-profit groups like church groups and schools. So, we're quite bullish on every aspect of their business.

[Matthew Fassler:]

Got it. Thank you so much for that.

[Carl Rubin:]

Thanks, Matt.

[Charles Sonsteby:]

Thank you, Matt.

[Operator:]

Our next question comes from the line of Christopher Horvers with JPMorgan. Your line is open.

[Christopher Horvers:]

Thanks. Good morning, everybody.

[Carl Rubin:]

Good morning.

[Christopher Horvers:]

So, wanted to ask about capital allocation. Last year, you talked about discussing a target leverage level. Could you share some thoughts on that? And is the share buyback authorization an indication that you're basically comfortable here or, at least, comfortable naturally deleveraging the balance sheet as you grow the business? And what does that mean for the opportunity on the senior subs? Does that mean maybe we will refi those versus, actually, paying those down?

[Charles Sonsteby:]

So, I think if we start at the top there, Chris, for us, we didn't want to put out a leverage target specifically because we wanted to maintain flexibility. As we announced, the $200 million share repurchase, our stock's been under pressure at points of time this year and we think that that would be an opportunistic time for us to use some of our available cash to be able to buy back shares. In addition, considering and taking a look at where the subs trade and everything else as we get to those call periods, so it will just have to be an analysis of whether that's an opportunity we should take advantage of or not.

[Christopher Horvers:]

Okay. Understood. And then as a follow-up, you mentioned potential debt restrictions on when you can buy back the stock. Is that something that could affect the timing of repurchase, anything that we should think about as we think about potential timing there?

[Charles Sonsteby:]

No, Chris. We have a restricted payments basket that limits the amount of things that we can do with excess cash. Right now, we have about $270 million of availability. That certainly is above $200 million share repurchase, but if something else should happen, that would eat into that basket, that restricted payments basket, that could have an impact. So, that's there merely as hygiene, I would say.

[Christopher Horvers:]

Understood. Thanks very much.

[Operator:]

Our next question comes from the line of Mike Baker with Deutsche Bank. Your line is open.

[Mike Baker:]

Hi. Thanks. I want to focus on buying in 2016 and how currency and/or lower oil prices might impact your ability to buy products better throughout this year.

[Carl Rubin:]

I think, Mike, that's part of what the reason why we did the Lamrite West acquisition was, having a sourcing office in China allows us to have those negotiations and discussions face-to-face with the manufacturers who were there. We've certainly seen a decline in oil prices. It's impacted us on the Canadian business, but should benefit us on our first cost of acquiring product. So, for us, as we start to move into the very latter part of 2016 and into 2017, we anticipate seeing benefits. We don't want to quantify those right now because we're in the process of actually cutting those DOs. And then with a long lead time of our business and the high penetration of private brands, it's going to take a little while for that to come through, but we certainly see that as an opportunity as we move into next year.

[Mike Baker:]

Okay. So, presumably, from those comments, as my follow-up, it doesn't sound like there's necessarily a lot built into the 2016 guidance.

[Carl Rubin:]

I wouldn't say there's no big step change put into 2016, no. We've been experiencing lower costs and that slight benefit has been put into 2016. But I think you'll see more benefit as we move out into 2017.

[Charles Sonsteby:]

So, again, just to reinforce Chuck's point. That's the structural part of the business in that pipe. We have a long lead time private brand and we have a slow-turn business. So, it takes time for that lower cost to work its way through our inventory turn and get recognized in our margin.

[Mike Baker:]

Understood. Okay. Thanks. Understood. Thanks.

[Charles Sonsteby:]

Sure. Yeah. I mean, we turn about 2 times, 2.3 times per year, Mike. So, the product we buy today, we wouldn't really see a lower cost until six months or so from now.

[Mike Baker:]

Right. Yeah. That makes sense. Okay. I'll turn it over to someone else. Thank you.

[Carl Rubin:]

Thanks, Mike.

[Operator:]

Our next question comes from the line of Steven Forbes with Guggenheim. Your line is open.

[John Heinbockel:]

This is actually John and Steve. Chuck, strategically...

[Carl Rubin:]

Steven (sic) [John] (48

[John Heinbockel:]

Can you hear us?

[Carl Rubin:]

Very, very low.

[John Heinbockel:]

Can you hear us now?

[Carl Rubin:]

That's better.

[Charles Sonsteby:]

Better.

[John Heinbockel:]

Okay. It's John and Steve. One strategic question with regard to Lamrite, how would you assess the brand awareness of Darice, right, both with your business customers and then the end consumer? And how would you dimensionalize or size the B2B opportunity long term?

[Carl Rubin:]

I think the Darice name is recognized by both those groups, very highly recognized by the B2B customer because of their strong capabilities. They recognized by the end consumer probably to the degree that our private brands, which are amongst the most recognized in the industry. But I'd remind you that this is not an industry of incredible brand strength in the consumers' mind for individual product brand. So, good on the consumer side, very good on the wholesale customer side. The other part of question was what?

[John Heinbockel:]

Well, how would you size the long-term B2B opportunity?

[Carl Rubin:]

Yeah. We haven't quantified that. We'll potentially do that later on as we continue to work with the Darice team, but it was very attractive and we think over time it will be meaningful to us. But part of the integration that we're doing, John, is we actually are going out sizing the opportunities, see what kind of growth and see what areas that we could expand into that Darice maybe hasn't done in the past. So, we do have some costs that we'll be incurring as part of this integration to go out and get a good view of how much that business could be over the longer term. I would just – I would remind you that there's multiple layers of this B2B customer target. There's certainly the retail aspect from big retail to small retail in it, and they have customers that are outside of the arts and crafts space today and we believe that that can continue to expand. But there's also a very attractive layer of customers that Michaels, historically, has not been in a position to serve as well. And those are those for-profit and not-for-profit groups. Things like church groups or summer camps where they come in and they need a 100 of something for kid's camp activity. Michaels, we just have not, historically, been in a position to well serve those customers and Darice is very well structured to do that. So, that's another layer of that B2B customer target that we are assessing now and – but we have, again, we have very – we're very optimistic about what this presents for us.

[Steven Forbes:]

Thanks. Now, it's Steve. Just really a real quick follow-up regarding the Lamrite retail business, how does the Pat Catan's store profitability compare to Michaels? And is there an opportunity there?

[Carl Rubin:]

The profitability for Pat Catan's store is lower than Michaels. I would remind you that the Michaels store profitability is obviously very high amongst the highest across most any type of retail. So, we think that there's some opportunities that the Pat Catan's stores could improve upon. And as I said in the prepared comments, they have 30-odd stores. It becomes a very good testing ground for programs for Michaels to then bring back to the Michaels portfolio of stores. So, we're – again, just as we're evaluating what we can do on the Darice side, we're going through that same process on the Pat Catan's. But improving their four-wall profitability, which is already profitable, but improving it a bit closer to a Michaels standard is an opportunity.

[Steven Forbes:]

All right. Thanks, guys.

[Operator:]

Our next question comes from the line of Simeon Gutman with Morgan Stanley. Your line is open.

[Simeon Gutman:]

Good morning. I'll be Simeon today. Nice result, guys

[Carl Rubin:]

Good morning, Simeon.

[Charles Sonsteby:]

Good morning, Simeon.

[Simeon Gutman:]

Good morning. So, one follow-up on Lamrite. I don't think you said, but how much Lamrite sells into Michaels. And then you mentioned – I think you said $17 million of EBITDA for Lamrite. And if I do the math right, it looks like it's going to be mixing out at about a 40-basis-point drag on the overall margin? I want to see if that's roughly right and what's you're assuming for the core Michaels business for EBIT margin.

[Carl Rubin:]

So, couple of different questions there, I think. First of all, there was about $40 million of sales from Lamrite West to Michaels that will now be just intercompany sales. It does have an impact on margins to us by acquiring that. If you look at the Michaels margins overall, excluding Lamrite West, we would anticipate that margins would get better as we go through next year.

[Simeon Gutman:]

Okay. Okay. Thanks. And then my follow-up is on the comp outlook for next year. Can you share with us – are you planning for the custom framing to be a drag or is it neutral to – not – just not contributing to your comp? And can you remind us what's the custom framing mix within the total framing business?

[Charles Sonsteby:]

So, Simeon, we're not going to answer those explicitly. What we have said before is that in our financials, we put out that framing is, I think, about 17% of our business. That is both custom frame as well as ready-made frame. So, custom frame is a good-sized part of our business but far less than that 17%. And, I think, we said in our prepared comments, we think that there is something broader than just what we're doing in our store that's going on with custom frame. You see some luxury retailers having some choppiness. This is kind of our version of a luxury product given the high price point. So, we've been conservative in how we have forecasted it for the year, but we wouldn't be more specific just like we don't break out any other piece of our financial detail. The thing that we have stressed before, we stress today, we'll continue to stress is one of the beauties of this business is it's a portfolio. And as both Chuck and I said, we're very proud of fourth quarter's results, but we still have businesses that had real strong headwinds. And we're confident in 2016 that we'll have underperformers as well as overperformers. But the one thing I will tell you that I want to be sure that we're clear on is that we believe we're the world's biggest custom framer. We are committed to this business. And we will continue to work to make it as good as we possibly can.

[Simeon Gutman:]

Okay. Thanks. Good luck.

[Charles Sonsteby:]

Thanks, Simeon.

[Carl Rubin:]

Thanks.

[Operator:]

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

[Seth Sigman:]

Thanks. Good morning and nice quarter, guys.

[Carl Rubin:]

Thank you.

[Seth Sigman:]

I wanted to follow up on the seasonal categories. It sounds like some of the [indiscernible] in the fourth quarter came from the focus there. Can you elaborate on what may have helped there incrementally? And then as you think about the comps' outlook outside of the fourth quarter, do you see incremental opportunity during the other quarters by increasing the focus on relevant seasonal categories during those other periods, or is there something unique about Q4?

[Carl Rubin:]

A few points. There is something unique about Q4, and that seasonal is a bigger part of our business in the fourth quarter than it is the other times of the year. When you look at the things that we did in seasonal for this past fourth quarter – and most explicitly, when you look at Christmas – in the fourth quarter, you have fall, you have Thanksgiving, but Christmas is the biggest driver. I don't know if there was one single thing but there was a whole bunch of little things. And that's essentially most of retail boils down to doing the little things well. So, the merchants did a fantastic job upgrading the quality of the product without inflating the retail price as a result of that. Things like how we tag the product. We've reduced our hang tags off the product so that you see the product as opposed to a price tag. How we merchandise the product in our stores so the product becomes the hero more than the fixture that holds the product. That's different than what we've done before, down to the creative that we used in our advertising. Our print and our digital advertising and it carried through to TV. All of those things I think combined really upgraded the presentation that we had. It looked terrific in the store. We're really proud of how it worked out. And we would be remiss if we didn't point out that this is the second fourth quarter in a row that we had very, very little bad weather, much less than during a typical year. So, that helped our Christmas sell thorough as well. But the seasonal product, as you go forward, there's a fine line between seasonal and trend product, it's newness. It's the newness and the reason to shop right away, that is what we think we're really gaining traction on with our customers. It's most extreme in the fourth quarter but there are opportunities in the other three as well.

[Seth Sigman:]

Okay. That's helpful. And then, my follow-up is about the promotional activity. For a few quarters now, you've talked about elevated promotional activity, higher coupon use, et cetera. You didn't really talk about that in this quarter. And I'm wondering, do you see a change or do you feel like the other tools that you have in place are maybe helping you navigate that better? Any insight there and maybe what you're seeing from a consumer perspective would be helpful.

[Carl Rubin:]

You know, fourth quarter was promotional. We anticipated it to be so. I think and actually in some ways it was a bit more controlled than maybe we have seen in previous quarters. We went into the quarter concerned – and I think we may have talked about this on the last call – a little bit less about our industry but a little bit more about the general retail environment with apparel retailers stepping up their promotions considerably and would that steal dollars away from our customer spending at our store. So, we did a really good job managing our promotions. We continue to get smarter and smarter about how to target those two customers as opposed to kind of rifle shot approach as opposed to just a shotgun approach. And we just didn't – we didn't see – clearly, other retailers had a much worse retail season than we did in the fourth quarter. So, we didn't see dollars leaving us to go to them. Maybe the opposite happened. But the overall cadence of promotion in our industry in the fourth quarter was relatively consistent with what we had seen before.

[Seth Sigman:]

Okay. Thanks for that. If I could just sneak in one follow-up on the comp outlook for Q1. You talked about a shorter Easter selling season. Did you quantify the impact from that? Any color there?

[Carl Rubin:]

No. It's baked into our guidance. What we will tell you is we are different than some retailers. Some retailers, the earlier the Easter, the better it is for them. That is not true for us. The earlier the Easter, the worse it is for us. So, we have a number of shifts going on right now, this week, as an example. We are running the biggest event of the quarter. That event shifted around based on the Easter timing. So, there's a lot of moving parts, but all of that is reflected in the guidance that we provided.

[Seth Sigman:]

Got it. Thanks very much.

[Carl Rubin:]

Thanks, Seth.

[Kiley Rawlins:]

So, Kylie, I know it's the top of the hour, but I think we still have quite a few numbers – quite a few folks in the queue. I think we'll go ahead and take two more questions before we wrap up the call.

[Operator:]

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

[Dan Wewer:]

Yeah. Thanks, Kiley. So, the $17 million of EBITDA from Lamrite West, trying to figure out why it doesn't have a positive impact on net income. Was there a significant amount of depreciation...

[Carl Rubin:]

Yeah.

[Dan Wewer:]

... with their business or with their – the higher interest rate you're implying on the acquisition cost?

[Charles Sonsteby:]

So, there is some depreciation but, again, the profitability that they had in that $17 million was in items that they sold to Michaels. So, now that they become part of our consolidated entity, we can't recognize that profitability until it's sold to the final consumer. So, when they sold the product to Michaels, it was immediately included in their EBITDA. Now, we won't be able to get the benefit of that profitability until we sell it to the final consumer in the store. So, again, it's going to help our gross margin overall. We'll still see that benefit in net profitability. There is just a timing shift. And that's why 2016 looks artificially low versus what you'll see as we get into 2017 and beyond.

[Dan Wewer:]

So, the $250 million of revenues from Lamrite, that excludes the $40 million that was...

[Charles Sonsteby:]

That's correct.

[Dan Wewer:]

And then the $17 million will be less because it will be excluding the portion from Michaels?

[Charles Sonsteby:]

In 2016...

[Dan Wewer:]

In 2016.

[Charles Sonsteby:]

... it will. But as you get to 2017 and once you get the full lap, it will come right back. It's just...

[Dan Wewer:]

So, then – so just backing that up, so then we are seeing a meaningful improvement in EBIT margin at Michaels? And thinking about the expense growth, I mean, it was just amazing, the decline that you saw during the fourth quarter, I recognize there are some timing differences. So, what is the sustainable level of expenses in 2016 excluding Lamrite?

[Carl Rubin:]

So, as we get – what we've been telling people is we could get leveraged at a two comp. I think, right now, we're seeing the benefits of some investments we made in store technology. We've shift around some labor and where it's been done before. It used to be done in stores. We moved some of that labor up to DCs, which have made us more efficient in stores. And it's really been the culmination of what's been now a two-year long process of what we call Fuel for Growth where we solicit ideas from all of our associates and then pay out cash rewards for ways that we can reduce expenses. And we've just seen an enormous flood of ideas that have been able to be implemented that have really helped our profitability and able to give us that kind of leverage.

[Dan Wewer:]

Yeah. It looks like that expense threshold, that breakeven point is more like 0% or plus 1%, not 2%?

[Carl Rubin:]

Yeah. So, that looks a little better because of the Canadian costs. But on a constant currency basis, if we look at 2%, we think we can get leverage at 2%.

[Dan Wewer:]

Yeah. Okay. Great. Thank you.

[Carl Rubin:]

Sure.

[Operator:]

And our next question comes from the line of David Magee with SunTrust. Your line is open.

[David Magee:]

Yeah. Hi. Good morning.

[Carl Rubin:]

Good morning.

[David Magee:]

Yeah. Sort of building on top of the last question, if you think about the EBIT margin going forward, do you see more opportunity with the Fuel for Growth over the next, say, three years? And I guess, private label, it sounds like it's got an upside, too. Are those the two primary drivers to higher numbers in the future on the margin side?

[Carl Rubin:]

Those are two of the biggest, yes. Again, we think this Lamrite West acquisition gives us that opportunity to get better gross margin for better first cost.

[David Magee:]

Thanks, Chuck. And then, secondly, the e-commerce business so far, I know it's early – I know that over time, it's expected to be a modest contributor. Is it something that's at all meaningful this year or next year, do you think, with regard to being accretive to comps?

[Charles Sonsteby:]

Yeah. I mean, that's slightly accretive to comps. It's not having the impact that you see from other retail, but it is contributing. Clearly, it does more than an average store does, but it is as we expected. It's growing at a rather controlled pace. And I think we have said that over time, and let me underscore over time, we saw this having the potential of growing to be a single digit – mid-single digit contributor to our overall sales. And I think we still feel that same way. It's nowhere near that today. It's probably smaller, but it is helping slightly to our comp trend. But, again, I'd contrast that with what you see from so many other retailers where it is contributing the majority of their comp. It's nowhere near that. We are clearly still, and anticipate, continuing to be a brick and mortar-based retailer. E-commerce just doesn't play given the nature of this business without any big powerful national brands and the tactile nature of the business. It just doesn't play in our industry as it does in others. And in our case, e-commerce is a service to complement the brick and mortar as opposed to a freestanding business model.

[David Magee:]

Great. Thanks and good luck.

[Charles Sonsteby:]

Thank you. [indiscernible].

[Operator:]

Thank you.

[Carl Rubin:]

Okay.

[Operator:]

At this time, I'd like to turn the call back to Chuck Rubin for closing remarks.

[Carl Rubin:]

Well, in closing, I'd like to thank all of our team members throughout Michaels and Aaron Brothers and artistry, who have worked so hard to deliver our record 2015 results. Their focus on our customer and our strategic priorities has enabled our success to-date and will drive our success going forward. Our business continues to be resilient in uncertain economic environments. And with the improvements we are driving, I believe, our long-term future is bright. As we look to 2016, we remain focused on achieving our vision 2020 strategy and delivering value for our customers, our team members and our shareholders. We will continue to make investments to improve the shopping environment in our stores for our a trend, relevant merchandising and strengthen our communications with customers. We will continue to provide team members with career opportunities in an engaging and rewarding work experience. And we will continue to work to deliver consistent returns to shareholders through disciplined capital investments to maintain our leadership position with our channel, combined with our balanced approach to debt pay-downs and returning cash to shareholders. With that, let me again thank you again for joining us today. And we look forward to sharing our first quarter results with you on June.

[Operator:]

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program, and you may all disconnect. Everyone, have a wonderful day.