Michaels Companies Inc
Q3 2014 Earnings Call Transcript

Published: 20 Nov 2014

[Operator:]

Good morning my name is Kevin and I will be your conference operator today. At this time, we would like to welcome everyone to the Michaels third-quarter 2014 earnings conference call. All line have been placed on mute to prevent any background noise. [Operator Instructions]. Thank you. And now, I would like to turn the call over to your host, Elaine Locke, Director of Treasury and Investor Relations. Miss Locke, you may begin the conference.

[Elaine Locke:]

Thank you, Kevin and good morning, everybody and welcome to our third-quarter 2014 conference call. Earlier this morning, we released our third-quarter financial results and 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' SEC filings. The forward-looking statements made today are as of this date of this call and we do not undertake any obligation to update our forward-looking statements. 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 net income have been presented to reflect our view of our ongoing operation and to make our financials more comparable by adjusting for cost and the timing of our initial public offering that closed on July 2, 2014. A reconciliation of these measures to the corresponding GAAP measures can be found at the end of our third quarter earnings release. On the call with me today is our Chief Executive Officer, Chuck Rubin and our Chief Administrative Officer and Chief Financial Officer, Chuck Sonsteby. I will now turn the call over to Chuck Rubin. Chuck?

[Chuck Rubin:]

Thank you. Elaine and good morning, everyone. To start our call today, I will review the highlights of our third-quarter performance and provide an update on some of our growth initiatives and then Chuck Sonsteby will review our financial performance in more detail and discuss our outlook. I will then have some brief closing comments before we open the call up to questions. We delivered a solid third-quarter, successfully marking the anniversary of the 7.9% Rainbow Loom driven comp from the third quarter last year. Total sales of $1.13 billion were up 1.1% and comparable store sales were negative 0.8% or negative 0.2% in local currency. Our strong performance was across geographies with notable strength in Canada and product category strength was broad-based, led by seasonal, fine arts, frames, yarn and floral, offset by the expected decline in kids due to the anniversary of Rainbow Loom last year. We believe this third-quarter performance illustrates the progress we are making in our strategy of taking share in the fragmented arts and crafts industry. Operating income increased to 5% with our operating margin rate up approximately 50 basis points to 12.6%. Our EPS was $0.31, a 19.2% increase versus Q3 2013's EPS of $0.26. I am particularly proud that we deliver this performance, despite a very tough prior-year comparison and against the backdrop of a promotional environment in which we stayed competitive, while also investing in our future. On our last call, I outlined our multiyear strategy that is focused on five key areas. One, improving our store experience, two, curating our offering with more exclusive products, three, improving the effectiveness and excitement of our marketing, four, building new business channels including e-commerce and finally five, maintaining our strong financial discipline through our fuel for growth program. We believe this strategy, over the long-term, will benefit all of our customers from the novice to the enthusiast. Let me spend a moment updating on the progress we made in the third quarter in just a couple of these areas. First, we continue to elevate our in-store experience with our refresh program. During the third quarter, we added Wi-Fi technology and price checkers in all of our Michaels stores to make the shopping experience better for our customers. Additionally, new handheld technology for our associates was rolled out to make it easier and faster for stores to monitor their stock levels and maintain planogram integrity. These efforts, along with many others, contributed to improved customer service scores. These scores are reported directly by customers and gathered by an independent third party and we are pleased to see that our customers are recognizing our continued improvement. Turning to our product offering. We implemented new department resets that lead to stronger comparable sales for our paper crafting, fine arts, decorative arts and floral accessory area. Each of these leveraged our industry-leading private brand team to design, source and deliver on-trend and exclusive products. We continue to curate our offering, infusing it with newness and reflecting product and ideas that are on trend and relevant to our customers. The exclusive Isaac Mizrahi Yarn launch was well received, as was the new exclusives Lion Brand Yarn product from Lion Brand. Together, they were among our best-selling yarns which drove strong comps in yarn overall. In kids, we continue to see Rainbow Loom sales, however now at a normalized level. New this year for kids and exclusive to Michaels within the national arts and craft retailer space is Kinetic Sand which was one of our top-selling kids' items. And finally in merchandising, capitalizing on our recent trend success with chalk, in Q3 we created an exclusive Raw Bar product assortment. This presentation of unfinished products included chalk, caulk and galvanized metal which we merchandised with project ideas that our customer use to personalize her creation. This offering was on-trend, exclusive and very well received by our customers. On the marketing side, we expanded our events versus last year. We believe by better integrating our merchandising, marketing and promotional efforts, we can create events for reasons to shop for our customers. This came to life in August as we had our first arts and craft hall and in September when we created our fall market celebration. These new events complemented our annual Halloween and lowest price of the season events, both of which was strengthened this year. Turning to our strategy to build new business channels. Our e-commerce offering continues to build however, as expected, it still remains a very small part of our total business. We are learning how our customers will shop arts and crafts in an omnichannel fashion and continue to be excited about the unique experience we can offer our customers. These learnings have resulted in a number of enhancements to our website, including a new homepage launched this past Sunday and click to shop from our online ads. Enhancements will continue to be implemented after the holiday shopping season. Another business channel expansion is our small store test, featuring our custom frame offering. During Q3, we opened five of these roughly 2,000 square-foot test stores in the Dallas-Fort Worth Metroplex under our Aaron Brothers banner. The stores carry an expanded custom frame molding assortment, approximately 900 versus 700 in a typical store and leverage our vertically integrated Artistree custom frame production facility. We hope these small stores will continue to build upon our already number one in North America custom frame business by attracting new customers and presenting new real estate opportunities. This test is brand-new and we expect it to take a full year to evaluate the results of this concept. Now turning to Q4. We feel good about our product, our visual merchandising, the improved store experience, our event-based marketing plans and the enhancements we are making to our e-commerce site to further improve our customers' omnichannel experience. Let me provide you a few specific examples. First, within our marketing outreach, we continue to build upon our CRM efforts to leverage our customer database to better target some of our marketing materials based on customers' previous shopping patterns of Michaels. As part of this, we have expanded our direct mail efforts to support our entire offering, not just our historical focus on custom frame. This expansion includes both wider circulation and more personalized messaging ultimately gain more market share. We have also expanded our email campaign to provide customers with more product and project ideas tailored to their interests. For projects, we have developed ones that appeal more to enthusiasts, while others are more novice-friendly. With the novice customer in particular, we include simple visual instructions on how to complete the project, a difficulty level and an estimated time to complete. We are in the early stages of this customer relationship management initiative, but remain very optimistic about the long-term potential. Second, we are better utilizing event-based marketing with promotional and educational content to not only excite our customers, but also to instruct them. With these events, we are showcasing exclusive product and exciting ideas in-store and online to better distinguish us from the competition. One example was our holiday Pinterest party held at our stores last weekend, where our employees helped customers make one of 10 different Pinterest inspired projects. These projects utilized items already in our stores and the marketing material helped the customer choose projects based on their skill, time needed to complete and cost. Our third fourth-quarter initiative is throughout the holiday season in our stores customers will find a larger and more cohesive presentation of holiday product as we have reset approximately 800 stores to create a more integrated Christmas presentation that makes it easier and more exciting for customers to shop. New to our Christmas presentation are ceramic entertaining products such as platters, cookie jars and other tabletop products. We also have decorative pillows, mesh wreaths and our broadest collection ever of mesh ribbon in Christmas trees. And finally four, we will follow the holiday selling season with the launch of our exclusive Make Market product presentation late in the fourth quarter in January. This presentation will feature more trend products and exciting deals. The Make Market offering is inspired by two key trends of unfinished surfaces in personalization. Some of the different surfaces we will offer will be chalkboard, burlap, caulk, wood, rope and denim. We will include trend-right products to help inspire our customer to complete projects around crafting, entertaining, decorating and gardening utilizing these natural materials. So in summary, I am very pleased with good progress on the implementation of our strategic initiatives that we achieved during the third quarter and believe this is reflected in our financial performance. We also look forward to delivering an exciting experience to all of our Michaels customers this holiday season, while recognizing it likely will be a very competitive retail time. With that, let me introduce Chuck Sonsteby to discuss our financial performance in more detail. Chuck?

[Chuck Sonsteby:]

Thank you. Similar to last quarter, my discussion of the third quarter results today will focus on adjusted results. The term adjusted operating income reflects our operating income excluding only related party or sponsor fees in the third quarter last year. On a full-year basis, adjusted operating income reflects our operating income excluding the IPO expenses and related party or sponsor fees. The term adjusted net income reflects our net income excluding IPO fees, related party or sponsor fees, all prior quarter debt refinancing costs and the associated tax impact. It also adjusts the interest expense from the second quarter 2014 debt refinancing as if had occurred at the beginning of Q2 2014. And finally adjusted earnings per share divides this adjusted net income by share count that assumes the IPO shares were issued and outstanding for all reported periods. Please reference our press release for all definitions and a reconciliation of GAAP numbers to these adjusted numbers. Our third-quarter net sales increased 1.1% to $1.13 billion from $1.12 billion last year. Comps declined 0.8%, primarily from a 60 basis point negative impact from unfavorable foreign exchange rates. The year-over-year results are impressive, given the difficult comparisons against the strong 7.9% Rainbow Loom driven comp in the third quarter last year. As you will recall, we estimate that the Rainbow Loom and related product drove to third-quarters of our quarterly comp last year. We are very pleased with our third quarter sales performance. Gross profit dollars for the quarter was about flat with third quarter last year at $452 million, which was a good outcome, given the slightly negative comp. Our gross profit rate decreased 50 basis points to 40% versus 40.5% last year. The 50 basis point contraction in our gross profit rate reflects slightly lower product margins, higher occupancy costs and the expenses of e-commerce business, partially offset by favorable shrink and damage costs. Store rent expense reflected our growth, totaling $90.2 million versus $89.1 million last year due to 28 additional Michaels and Aaron brothers stores and that's net of closures. We did lose some gross profit rate leverage, given the slightly negative comp. Selling, general and administrative expense improved 100 basis points to 27.4% of sales from 28.4% of sales last year at $310 million versus $318 million last year. The reduction in SG&A name comes from less incentive-based pay and our fuel for growth expense management activities, partially offset by increased marketing costs to support our events and an increase in payroll from operating an additional 28 stores. We accrue incentive compensation based on our operating income performance. Last year, due to the phenomenon of Rainbow Loom, our bonus accrual was somewhat lumpy, with the third quarter reflecting the highest accrual. In Q3 this year, as part of a more consistent full-year performance in accrual, we recorded $7 million lower bonus and payroll taxes. The timing will reverse in Q4 and the favorable comparison will flip and result in about 90 basis points of deleverage next quarter. Both of these expenses were fully anticipated in our back half guidance provided last quarter and updated in today's press release. Adjusted operating income increased 3% to $142 million or 12.6% of sales compared with $138 million or 12.3% of sales in the third quarter of last year. Interest expense for the quarter was approximately $41.5 million dollars. The effective tax rate was 36% for the third quarter this year compared to 35.6% last year. The 2014 effective tax rate is higher than the prior year primarily due to fewer jobs tax credits. Now the expected adjusted effective tax rate for the third quarter of fiscal 2014 of 37.5% came in lower due to some higher than anticipated tax credits and benefits recognized in the third quarter of fiscal 2014. Adjusted net income increased 16% to $64 million or $0.31 per diluted share from $55 million or $0.27 per diluted share in the third quarter of last year. The adjusted diluted weighted average share count used in both EPS calculations was $207 million. Adjusted EBITDA for the quarter increased t o$181 million from $177 million last year. Our cash balance at the end of the quarter was $194 million versus $73 million last year. Total merchandise inventory was $1.12 billion at quarter end. Our average Michaels inventory on a per store basis, including inventory at distribution centers and inventory for the recently launched e-commerce site, was $923,000 compared to $951,000 per store last year, despite adding a third-party e-commerce fulfillment center in the first quarter of this year. We do not expect to see lower average per store inventory levels as we move through the balance of Q4 and into 2015. The stronger than anticipated Q3 sales and adding basic inventory to support the strategies of event-based marketing will result in a moderate increase to our inventory levels. We ended Q3 will total debt of $3.34 billion and $588 million of revolver availability. Capital expenditures were $38 million, up from $32 million in the same time last year. In the third quarter, approximately $28 million was invested in the buildout and maintenance of our stores, including new relocated and existing stores. As Chuck mentioned earlier, we launched functionalities to support our customers and store associates, Wi-Fi and price checkers are now in all stores as part of our continued investment in the store experience. We also spent $4 million on LED lights to improve store lighting and their energy efficiencies to reduce future utility expenses. This quarter we opened 19. Michaels stores, relocated three Michaels stores, opened five Aaron Brothers stores and closed one Aaron Brothers store. At the end of the quarter, we operated 1,287 stores, including 1,166 Michaels and 121 Aaron Brothers. Now, I would like to turn to our outlook. But before I dive into the detail, I think it's worth taking a minute to share some context on our fourth quarter business. Overall Q4 is typically more promotional with a larger seasonal mix than other quarters and while our seasonal business comes with great margins, those margins are slightly lower than our standard business assortment, our SBA products and in turn Q4 has the lowest gross profit flow-through of all of our quarters. Okay, now on to some specifics. For the fourth quarter, we are guiding comparable store sales to be in the range of negative 0.5% to positive 0.5% and total sales to be between 1.3% and 2.3%. As you know, we will still be lapping the tremendous success of the Rainbow Loom and it's reflected in our estimates. This guidance implies total annual sales growth of between 3% and 3.3% for fiscal 2014. Based on our third-quarter outperformance, we are raising our expectation for adjusted operating income for the year to $648 million to $655 million from the prior $636 million to $649 million. This implies fourth-quarter operating income of between $278 million to $285 million. We expect a more promotional environment throughout all retail in Q4 and we are seeing higher transportation costs due to the recent slowdown in the West Coast ports. Our teams have done a tremendous job getting product in stores, but we have had to pay additional costs to ensure the product is there on time. Those additional costs will hurt our gross profit margins in Q4 and they are factored into our guidance. On November 10, we announced the redemption of $180 million in principal of the 7.5% to 8.25% senior PIK toggle notes due in 2018, which we refer to as our PIK notes and that event will occur on December 10. The redemption price requires a 2% premium which we will report in the fourth quarter as $3.6 million in debt extinguishment costs. Additionally, there will be $2.8 million of accelerated amortization expense related to the early redemption of principal. Now there will be interest expense savings in Q4 to offset some of those extinguishment charges. However, we still expect to see a decrease in diluted earnings per share of $0.01 related to the paydown in Q4. This $0.01 in cost has been included in our updated guidance. So despite that 1% headwind in Q4 for the debt redemption, the opportunity to reduce debt leverage and save ongoing interest expense drove earlier than anticipated paydown. We expect to realize about $13.5 million dollars in interest savings in fiscal year 2015 related to this early redemption of the PIK notes. Therefore adjusted interest expense for the year is now forecasted to be $173 million, with interest expense at approximately $40 million for the fourth quarter. Our earnings outlook assumes a tax rate of 38% for the fourth quarter and the effective tax rate for the full year is expected to be about 39%. The effective tax rate to use for the full year adjusted net income calculation is 38%. It also assumes the additional 28 million shares relate to the IPO were outstanding for the full year. So our adjusted EPS guidance assumes diluted weighted average shares of 207 million for the full year, as well as for Q4. This translates to an adjusted EPS in the $1.42 to $1.44 range for the full year of 2014, up from our prior outlook of a $1.38 to $1.42. The new adjusted EPS outlook does include the $0.01 headwind from paying down the PIK notes. Capital expenditures, on a full-year basis, will be in line with original expectations. Turning the balance sheet. We expect slightly higher inventory at the end of the fourth quarter on an average per store basis compared to the prior year period. We have a strong free cash flow business and our capital allocation goal continues to be to deploy excess free cash flow towards debt paydown, such as the recent PIK note payment. Due to the seasonality of our business, we will likely not generate additional excess free cash flow for debt paydown until late next fiscal year. In summary, this was an extremely good quarter as we successfully met the challenge of the significant impact of Rainbow Loom from last year. The team will remain focused on strong fiscal discipline, as we invest in our business and growth initiatives to drive sales and grow earnings per share. And with that, I will now turn it back to Chuck Rubin for closing comments.

[Chuck Rubin:]

Thanks, Chuck. In conclusion, I want to thank all of our associates and the entire Michaels team for their commitment to our customers and to the initiatives we have put in place to further strengthen our industry-leading position and drive share gains. We continue to improve all aspects of the business from our product and service offering to our increasingly personalized communications to the experience customers have at our stores or online and we will continue to elevate and improve this experience from start to finish while maintaining financial discipline on both the expense and capital allocation side. With that, operator, we can open up for questions.

[Operator:]

[Operator Instructions]. Our first question comes from Christopher Horvers with JPMorgan.

[Christopher Horvers:]

Thanks. Good morning, guys.

[Chuck Rubin:]

Good morning, Chris.

[Chuck Sonsteby:]

Hi, Chris.

[Christopher Horvers:]

So a detailed question and then a bigger picture question. So first on the cost to refi, on a gross basis, the $6.4 million premium and the $2.8 million of the accelerated amortization, that's actually $0.03 on the gross basis and then the interest savings is a $0.02 offset. Is that the math?

[Chuck Sonsteby:]

It's a little less than $0.03 and a little bit more than $0.01 but the net net is $0.01 of cost in Q4.

[Christopher Horvers:]

But from an ongoing cost perspective, you would think that the $6.4 million and the $2.8 million is really more one-time where the interest expense savings persists?

[Chuck Sonsteby:]

That would be correct.

[Christopher Horvers:]

Okay, understood and then on the debt. Can you talk about the decision to paydown the $180 million perhaps earlier than you thought you could, especially really ahead of even seeing Black Friday and the holiday season? What drove that decision? And does that change the potential debt paydown in 2015?

[Chuck Sonsteby:]

Well, we had a good Q3. So we generated more cash than we anticipated. I would say that the opportunity for us to really save cash interest expense by doing the paydown earlier and plus we heard some comments in the marketplace that people felt we were highly leveraged and so some of those were inputs into our decision to go ahead and accelerate the paydown a couple months earlier. I think we had been anticipating and in fact had even told people that we would more likely pay it down in the first quarter of 2015, but given the strong performance in Q3, some of the comments we had heard from people that we were very highly leveraged and the opportunity to save the interest expense all drove us accelerating that.

[Christopher Horvers:]

Understood and then for Chuck Rubin. As you think about what's driving the strong comp performance, do you think it's close rates going up? Is it more people coming to that stores? And can you tell at this point if it's more effective with the core enthusiasts, or with the novice? Thanks.

[Chuck Rubin:]

Yes. Chris, just to add to Chuck's earlier statement, back to the debt paydown. We would anticipate, at this point, that given the flow of our business that we wouldn't be looking at this again until late next year, in all likelihood. To your question, you know, if you exclude Rainbow Loom, we saw positive transactions as well as positive ticket in the third quarter. We think that, you know, all of the customer facing initiatives, the better shopping experience in the store, the exclusive product that we offered, the marketing that was more compelling combined to make it just a better place to shop. As far the novice customer, you know as we have talked before, this is a long-term play. So we would like to think that we are making progress with the novice customer. It's a really hard thing to see in the data thus far. So therefore, we suspect that we are gaining share with the enthusiast more than getting a lot more novices in. Remember that novice customer, she is inspired by a variety of sources, whether it's Pinterest or something else. Her challenge is overcoming the obstacle of figuring out how to convert that into action. So when you have to address a customer's reluctance in that sense, that's going to take a little bit of time and the things we are working on, we are convinced of the right things. It's just going to take a little bit of time for that novice customer to feel comfortable that Michaels is going to be the place to help her consistently.

[Christopher Horvers:]

Understood. Thanks very much.

[Chuck Rubin:]

Thanks, Chris. Operator Ladies and gentlemen, we ask that you limit yourself to one question and a follow-up going forward. Our next question comes from Matthew Fassler of Goldman Sachs.

[Matthew Fassler:]

Good morning.

[Chuck Rubin:]

Hi, Matt.

[Chuck Sonsteby:]

Hi, Matt.

[Matthew Fassler:]

You talked about events, incremental events, that you drove in the third quarter. What's the opportunity for more of the same on the Fanatic side as you move into Q4? And at what point did you, Chuck Rubin, start to introduce more of these as you got to the company so we can think about when we cycle some of those creative stimuli?

[Chuck Rubin:]

So, Matt, a few parts. We have a bunch of creative people in the company. So there's still a number of things that we can do but you do have to consider the seasonal nature of our business. So specifically in the fourth quarter, you know, the Christmas selling season is already kind of a big event that Michaels has focused on for years. So the opportunity to add incremental events into the fourth quarter calendar is a little bit challenging. Not impossible, but it does present a bit more of a challenge. Then the seasonal calendar also comes in the play. So when you look out at first quarter 2015 as an example, you know, you have an earlier Easter, which for our business, as in a lot of retail businesses, is a bit of a hurdle that we have to overcome. So the short answer to your question. There are certainly more events and excitement that we can bring to the customer. The fourth quarter is arguably the place where there is the least additional upside in that sense, because of the focus on Christmas. Although you know, after Christmas, I mentioned this Make Market event which we plan in January. But these events will tend to focus more on Q1 through Q3, recognizing especially in 2015 that we have a tough Easter shift that we are going to be facing given that it's earlier

[Matthew Fassler:]

And if I could have a very brief follow-up. You talked about Halloween. You talked about some of your events. If you look at the underlying cadence of traffic, is it all event-driven? Or would you say the consumer, or your consumer, is on stronger footing than you might have thought three to six months ago?

[Chuck Rubin:]

Well, we don't want to get into great detail in the flows within the quarter, but you know, we did see -- we saw our best performance generally during some of these events.

[Matthew Fassler:]

Thank you.

[Chuck Rubin:]

Thanks, Matt.

[Operator:]

Our next question comes from Gary Balter of Credit Suisse.

[Chuck Rubin:]

Good morning, Gary.

[Chuck Sonsteby:]

H, Gary.

[Gary Balter:]

Great quarter. I still can't get my Kinetic Sand to stand up at all, work on it. Small store test and that you are pleased with the results. What's the potential for that? Could you go into a bit more detail on it and what's the potential for that?

[Chuck Rubin:]

On the small store test? Was that it, Gary?

[Gary Balter:]

Yes.

[Chuck Rubin:]

I was focused on helping you with your Kinetic Sand problem. So, yes. The small store test is, as I mentioned in the prepared comments, we have five of them that we just opened. It's a new concept. The premise behind it is, well first of all, the construct of the store is small square footage and the heavy, heavy focus in these stores is custom frame. And the premise behind it is, we have an enormous capability, vertical manufacturing capability, with our Artistree division and we can offer great quality, great pricing in this custom frame space. The custom frame industry, as a whole, is over $1 billion. So it's not a massive industry. But it is one still dominated by independent mom-and-pop's. And from the best insight that we have in the United States there is, give or take about 8,000 of those mom-and-pop's. So while we are clearly the biggest shareholder in the custom frame business, there is a lot of independent players out there that we think we compete very nicely against and that's what led us to the small store test.

[Gary Balter:]

So what percent of it is framing?

[Chuck Rubin:]

Well, all of it is framing. Most of it, the overwhelming majority of it is custom frame. The part that is not custom frame are ready-made frames. Frames that you can just pick up off the shelf and buy on the spot. But that again is just a very small complementary part of the offering. It's really a custom frame offering.

[Gary Balter:]

How much better is your pricing versus the local player, the independent?

[Chuck Rubin:]

Well, because this is a custom business, it really depends on what the customer wants, but given our vertical nature, we believe we can beat anybody in the market on exact like-for-like offerings. But it's like anything else that's custom, you really come in and you can design it to be as simple or as luxurious as you really want that custom frame to be.

[Operator:]

Our next question comes from Simeon Gutman with Morgan Stanley

[Simeon Gutman:]

Good morning.

[Chuck Rubin:]

Good morning, Simeon.

[Simeon Gutman:]

Good morning. Two questions on mostly sales related. First, in terms of your communication with customers and your marketing and whether it's email or if there's any print, can you talk about what you are doing there? And if anything has changed in your capabilities?

[Chuck Rubin:]

Sure, Simeon. As I mentioned in the prepared comments, we are balancing our mass media and our personalized media or individualized media better. We are starting to leverage our database where we have millions and millions of customer names with transactional data. We are leveraging that better. So that we are talking to a young customer differently than we are talking to a bakeware customer, as an example. We have brought our marketing events to life in a more uniform way across all different media. The look and the feel of the event is consistent, whether it's in print or online or in direct mail or email. And we also have made great strides, we believe in our creative so that you know the appearance of our marketing continues to improve. It's a bit more creative. It's a bit more fun, given that this ultimately is a fun business. So I think we have made great progress in all of our marketing efforts. I would quickly add that on many of these fronts, especially around this customer segmentation being able to personalize our messaging, that is a very long-term effort because there are many, many, many layers that you can delve into. It is a very hard thing to do, but as I have talked previously about, you know, the first foundational point is having the customer data and we have that. And that's what many retailers are challenge to get. We are very fortunate to have that. We are focused aggressively on being able to segment that data and start to talk to customers in a more meaningful individualized way that we think over time, will allow us to gain more share.

[Simeon Gutman:]

And I take it that you are seeing a good response from it and then I will just put my follow-up in, in case I get cut off. You mentioned, I think, paper crafting, fine arts, floral, just some examples of departments that you are enhancing. You look across the store, there is just a lot of departments and I think you have used the word components in the past and there just seems to be so many areas that probably continually can get better and evolve, et cetera. I guess, would you agree with that? And is there still low hanging fruit across the store from either from doing minor things or doing the things you are doing to those categories as you suggested?

[Chuck Rubin:]

Well you know, there's a whole lot of opportunity that we have and you are correct. We don't really have any dominant business in our portfolio, which we think is good news. Because it is a portfolio of offering. So we, even in the third quarter, beyond Rainbow Loom, we had some pockets of our business that didn't perform quite as well, but we didn't expect them to perform quite as well, but they were obviously dramatically offset by most of our businesses that did do quite well. So is there a low hanging fruit. There are many, many things that we continue to believe that we can do, but I would be quick to remind you that, you know, the arts and crafts industry, over the past few years has not been a fast growth industry. So we generally believe, at this stage, that our success is a market share gain. There is not great data on this, given that all of our big-box competitors are private, but that is from our internal research that is what we believe is happening. So low hanging fruit in terms of initiatives, yes. Low hanging fruit in terms of gaining a lot more share, I wouldn't describe them as low hanging, but we have very focused plans to do it. And hence the reason we are very pleased with third quarter. We think we were successful in what we believe is still a very slow growth industry. We are really pleased with our performance and the share that we believe we gained.

[Simeon Gutman:]

Thank you.

[Chuck Rubin:]

Thanks, Simeon.

[Operator:]

Our next question comes from John Heinbockel with Guggenheim Securities.

[Chuck Rubin:]

Good morning, John.

[John Heinbockel:]

Hi, morning. So how would you characterize, I am talking about the promotional environment, how does it compare to a year ago, because you would think with the longer calendar, maybe it would be a little bit less? And then, how long have you been into the price match program? And are people actually using that? Or is it more just to reinforce people's confidence in your overall pricing structure?

[Chuck Rubin:]

Well, let's take the latter first. We have had a price match offering for quite a period of time. We are talking about it more than we had before. It is not excessively used, especially given the exclusive nature of so much of our product and the private brand nature of our product. But it is something that we believe is important to reassure customer that as the leader in the industry, they can feel very comfortable that they will not find better prices than any competitor than at Michaels. As far as the promotional environment, our comments project, both Chuck and I mentioned it in our prepared comments, the promotional environment, both in this part of retail, but in retail in general, we believe certainly we saw some high inactivity in the third quarter and we believe that fourth-quarter will be very competitive, both again within the arts and crafts space but outside of arts and crafts. We are competing with other types of retail whether that's consumer electronics, sporting goods, apparel, whatever you would like to choose for that consumer dollar. And we have it, without calling out names now, but many of you have seen it. We have seen lots of retailers stepping up their activity and at this point we do not see that slowing down for the fourth quarter. One of the benefits we have in our business, as was evidenced in the third quarter is, we do have due to the margin structure of our business, the ability to be quite competitive and still deliver good earnings at the end of the day. So while we did sacrifice some slight level of product margin rate in the third quarter, it allowed us to be competitive and you can see in the numbers that we just put out that the overall picture was good. So I hope we are wrong, but we don't think that we will be. We do envision this to be a pretty competitive fourth-quarter.

[John Heinbockel:]

All right and then secondly, I know you want to get through holiday, but from where we were versus the last call, you did get through a little bit of back-to-school and fall harvest. What's your read now on the remodels versus three months ago in terms of where they sit and what you like about them and don't like?

[Chuck Rubin:]

Yes, you know John, I think it's still early to talk about the remodels, specifically in St. Louis and Boston. Same thing we in talked about before. We did some enhancements in Boston from learnings in St. Louis. There are some goods things to that. We will talk more about that after the first of the year. We said we want to get through holiday and we still do want to do that. The refresh part of our program, which has really stayed wide, those are the kind of the all-in efforts that we have put out, whether it was associate dress code or whether it was putting Wi-Fi in the stores or price scanners or better cleanliness in the stores. We are very pleased with the progress we are making there and we really do believe that that is contributing to both our third-quarter financials, but also to our strong customer survey scores.

[John Heinbockel:]

Okay. Thank you.

[Chuck Rubin:]

Thanks.

[Operator:]

Our next question comes from Alan Rifkin with Barclays Capital.

[Chuck Rubin:]

Good morning, Alan.

[Alan Rifkin:]

Good morning, how are you?

[Chuck Rubin:]

Good. Thank you.

[Alan Rifkin:]

So you mentioned that one of your fourth-quarter initiatives would be a larger presentation of holiday product. I was wondering if you could maybe quantify either from a SKU perspective or a contribution of revenues where your plan is for that category this year compared to last year's holiday season?

[Chuck Rubin:]

Yes. Alan, I don't think we want to do that. That's, for a variety of reasons, not the least of which, we talked about this in the last call, we are very sensitive that we are the only public company in the arts and crafts, pure play retail space. So we did, in certain areas, step up how much we bought but also what we are quite pleased about is that we re-merchandise to our stores so the presentation compared to a year ago is more cohesive. So a year ago, you would have found Christmas product spread out with some different parts of the store. This year, that's much more limited. It's much better organized and focused. And hence we think that the customer once they get in, again remember, this is a generally a low ticket product category. Once they get into our Christmas shop, we think that they will be really pleased with what they see and unlike last year where they may have had to navigate all over the store. It's a lot easier because it's on all-in-one, essentially one shop area.

[Alan Rifkin:]

Okay and one follow-up, if I may. You also mentioned that one of the reasons for the decline in gross margin was higher occupancy. Yet in dollars, it was just barely up about 1% or so. Was the deleverage more a function of the 28 new stores that you have added? And maybe if you can also just provide a little bit more color as to what you are seeing in average rent expenses for existing stores as you renegotiate leases?

[Chuck Rubin:]

So the real impact was on triple nets. We have seen higher property taxes than a year ago. We have had a number of developers fixing up their shopping centers and packaging them up for sale, which has had some higher expenses that they flowed through to us. As we look at average rents, we haven't seen anything that's been outsized or unusual compared to the prior periods and prior experiences in rent renewals.

[Alan Rifkin:]

Okay. Thank you.

[Operator:]

Our next question comes from Mike Baker with Deutsche Bank.

[Chuck Rubin:]

Hi, Mike.

[Chuck Sonsteby:]

Good morning, Mike.

[Mike Baker:]

Hi, guys. A follow-up on a previous question regarding some of the resets that you have done. Is there any way to quantify, you have touched X number of four foot bays and you have X number to go? Or how does that work? Again, it sounds like it's been successful. So we are just trying to get a sense of how much more there is to go there.

[Chuck Rubin:]

Mike, it's an ongoing process. We are resetting product for a good part of the year because we have all these different categories. We work to bring in freshness and reset departments throughout the year. When you look in our business, the amount of new SKUs in our business -- I am trying to walk a fine line. I would rather not go into extreme detail, but we have a good portion of new SKUs that we bring in annually into our assortment. It is less than half of what we carry, which again gives us a nice stable non-cyclical assortment of product, but that rotates in throughout the year as we move through and we sequence those in based on the opportunity that we see in upgrading that assortment. So it is the minority of our assortment at any given time. But over a years time, it's a constant flow of SKUs, which is not quite but the little less than half of, at the end of the day, half of what we offer to the customer.

[Mike Baker:]

Okay and so maybe I will ask it this way and then another follow-up. I think you have been with the company, correct me if I am wrong, about a year-and-half? Are there parts of the store categories that haven't been touched at all since you have been there? Or do you generally hit every category once a year? And then as a follow-up, the Make Market that you are describing for January, did you do something similar last year, kind of a post-Christmas event? Or is that brand new this year?

[Chuck Rubin:]

We did not do this Make Market event this past Christmas. So the event itself is new and the offering is new. To the first part of your question, there are still parts of the store that we have not touched. The answer is yes, but even those areas that we have touched continue to evolve. So Michaels is a company that has great merchandising ability and we can't stand still. We will continually make our merchandising offering better.

[Chuck Sonsteby:]

So, Mike. One thing I want to point out is, we are very excited by the Make Market event, but it will be a late January timeframe and also given just the high dollars of sales in the fourth quarter, we would not anticipate that being a meaningful impact to comps in Q4.

[Mike Baker:]

Okay. Understood. Thanks.

[Chuck Rubin:]

We love the product. We think it's got great presentation. We think it's going to be a different look for our stores, but for those of you might be looking for things that might be impactful, that wouldn't necessarily move the needle.

[Chuck Sonsteby:]

Yes. That's a good point, Chuck. Just add to it. Remember because we have this diverse portfolio of offering, some of the new things that we do, in fact most of the new things we do are affecting a portion of our offering. So it gives newness to a customer to come, shop, a reason to shop. That's why we are calling these things events, but it's unlike other types of retailers, like an apparel retailer that the whole store would be talking to one statement. Make Market is an interesting statement that were excited about the very end of the fourth quarter, but it is only part of the offering at that time.

[Mike Baker:]

Right. That makes sense. Thank you.

[Chuck Rubin:]

Thanks, Mike.

[Operator:]

Our next question comes from Matt Nemer with Wells Fargo.

[Chuck Rubin:]

Good morning, Matt.

[Omair Asif:]

Good morning. This is Omair, on for Matt. Just a couple of questions on the gross margin. You called out a shrinking damage of some of these offset to gross margin. Just wondering what changes you made to help drive that? And then just a follow-up, although it's small, did e-commerce have any sort of impact to gross margin? Thank you.

[Chuck Rubin:]

E-commerce did have an impact to gross margin. It was slightly negative. We carry all of the costs, except for some of the people costs related to fulfilling e-commerce in our gross profit line. You asked about shrinking damages. We have done a number of things. I think the biggest thing has been the fact that we rebalanced the little bit of our labor to where we are focused a lot more on down stocking and feeling the pegs in stores and also by putting associates in red dress uniform. That's been a good deterrent. It's been the fact that people are visible in the aisles and in the store. We think that that's helped with shrink. We have also done a number of things regarding some closed circuit TVs, et cetera in some of the high shrink areas that have helped us prevent loss in that way as well.

[Omair Asif:]

Got it. Thank you.

[Chuck Rubin:]

Thank you.

[Operator:]

Our next question comes from Peter Keith of Parker Jeffrey.

[Peter Keith:]

Good morning. Excuse me. Nice comp for Q3.

[Chuck Rubin:]

Thanks, Peter.

[Peter Keith:]

I was hoping you could update us on the refresh program. I know you plan on touching all stores in 2014, 2015. It sounds like some are being touched all at once. Could you help us understand where you are with some of the initiatives and what benefits you might be seeing?

[Chuck Rubin:]

Well, again, as I mentioned before, the refresh program is kind of our foundational program to upgrade all stores. The environment in all stores. The activities that we are doing this refresh program are higher cleanliness standards, putting associates into a consistent dress code, adding Wi-Fi, adding price scanners, a new sign package that, everything I have mentioned just thus far is already complete. A new sign package that is in a handful of stores today, but will out to all stores at the beginning of 2015. Lower drive aisle, main drive out fixtures. So sightlines are improved. That has been put in place in most areas. So these are all things that we have done. There are still more things that will go into effect in 2015. We did not hold control stores out in this because we believe that these were fundamental foundational things that all stores needed to benefit from. In terms of the results, we have not measured the incrementality of each of those activities, again because we believe that they were basic ante in today's retail, but we do believe collectively they contributed to our performance financially as well as from a customer impression of Michaels during the third quarter.

[Peter Keith:]

Okay. Thank you for that summary. And I had a separate question pivoting over to e-commerce. I was wondering, this will be your first holiday with e-commerce and while it certainly is a strategic step that's necessary. It does maybe expose your pricing to your competitors in better fashion. Is that a potential gross margin risk for this holiday season that you didn't have last year?

[Chuck Rubin:]

I think a couple things. Number one, while we do carry a very broad assortment of our product, we don't carry seasonal product in our e-commerce facility. So it would mostly be our standard business assortment and then the promotions that we have would be the same in-store and online or at least the vast majority of promotions will be through both channels. So I think what you see in store is what you would see on e-commerce. So I am not sure that that's necessarily giving additional visibility to our competition.

[Peter Keith:]

Okay. Well, thank you very much. Good luck this holiday.

[Chuck Rubin:]

Thanks.

[Chuck Sonsteby:]

Thanks.

[Operator:]

Our next question comes from Rick Nelson with Stephens.

[Nick Zangler:]

Hi, guys. This is Nick Zangler, in for Rick. It looks like you have a $0.03 worth of expenses shifting from the third quarter to the fourth quarter with a performance comp of $7 million and lower taxes in 3Q versus higher taxes in 4Q. Just qualitatively, have your 4Q expectations changed as you progressed through 3Q for the time of your prior guidance outside the impact of the principal paydown and offsetting interest savings?

[Chuck Sonsteby:]

So the answer is yes. I think we have had some puts and takes. We felt a little bit better about same-store sales, but then we have also seen some higher costs related to freight and the dock stoppages. I don't know that we have talked about that very much but you know there was a big slowdown in the West Coast ports. That did cause us more transportation to get product, both in stores and in our distribution centers, as we went through the end of Q3 and you will see those costs come through cost of sales as we sell that inventory in Q4 and into Q1. So the higher sales, the higher stock costs, you mentioned some of the other things, the change in timing of bonus between Q3 and Q4, as well as the PIK notes, all those things were puts and takes to the guidance that we updated today.

[Nick Zangler:]

Great thanks for the detail and then just on e-commerce. While it still might be early, are their products that you offer online going forward that you might not offer in the store? Or said another way, are there any product categories that in e-commerce offering opens you up to that a store might not be able to accommodate in the future?

[Chuck Rubin:]

Short answer is yes. We would hope as we continue to move down this path that there will be things that we can offer online that we don't offer at all in a store or in other cases an expanded assortment online compared to what we offer in the store.

[Nick Zangler:]

Great. Thanks for taking the questions.

[Chuck Rubin:]

Yes, operator. We probably have time for one more question.

[Operator:]

Okay. Our last question comes from David McGee was SunTrust.

[David McGee:]

Hi. Good morning and good quarter.

[Chuck Rubin:]

Thank you.

[David McGee:]

I just want to clarify on the promotional environment. Would it be fair to assume that, that will ease after the holiday season? And I guess as a second part to that, to the degree you see promotions out there, are you seeing it coming more from specialists like yourselves? Or do you see it more from discounters at this point?

[Chuck Rubin:]

We see both. It will vary day by day, week by week. But we are seeing both online and we are not a big player online, as we have talked about, but we are seeing online promotions, but in-store promotions as well. We are seeing them on products. We are seeing them on storewide. So there is a pretty diverse promotional offering from pretty much everyone that we pay any attention to. As far as what happens post-Christmas, we hope that that things would come down, but you know, our crystal ball probably isn't quite as good as maybe some of yours. But between now and Christmas, we are ready for what we anticipate to be a promotional time.

[David McGee:]

Okay. Thank you.

[Chuck Rubin:]

Thank you. Well, this does include our Q3 2014 call. We appreciate everybody joining us and we hope that that we will see you shopping at our stores and online between now and Christmas. Thanks so much everybody.

[Operator:]

Ladies and gentlemen, this concludes today's presentation. You may now disconnect and have a wonderful day.