Michaels Companies Inc
Q4 2014 Earnings Call Transcript

Published: 19 Mar 2015

[Operator:]

Good day ladies and gentlemen, my name is Saeed and I will be your conference operator today. At this time, I'd like to welcome everyone to the Michaels Fourth Quarter 2014 Earnings Conference Call. All lines 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, Saeed and good morning, everybody and welcome to our fourth-quarter 2014 conference call. Earlier this morning, we released our fourth-quarter financial results. The copy of the press release is available on our website at www.michaels.com. I need to remind you that certain comments made during this call may constitute forward-looking statements and are made pursuant to and within the meaning of the Safe Harbor Provisions of the Private Securities Litigation Reform Act of 1995 as amended. Such forward-looking statements are subject to both known and unknown risks and uncertainties that could cause actual results to differ materially from such statements. Those risks and uncertainties are described in the press release and Michaels' 2014 10-K filings a copy of this filing will available on our website. The forward-looking statements made today are as of this date of this call and we do not undertake any obligation to update our forward-looking statements. 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 fourth quarter earnings release filed in 8-K with the SEC. On the call with me today is our Chief Executive Officer, Chuck Rubin, our Chief Financial Officer and Chief Administrative Officer, Chuck Sonsteby and our VP of IR, Treasury and Corporate Finance Denise Paulonis. I will now turn the call over to Chuck Rubin. Chuck?

[Chuck Rubin:]

Thanks Elaine and good morning, everyone. On today's call I will first review the highlights of our fourth-quarter performance and then outline our key priorities for fiscal year 2015, Chuck Sonsteby will then 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 for your questions. Today I am excited to share our fourth quarter performance with you. We delivered Q4 total sales of $1.6 billion, an increase of 3.4% versus last year and on a comparable store sales increase of 1.4% or 2.2% on a local currency basis. Our operating income increased 6.5% over last year to reach our Q4 record of $294 million with our best ever, ever operating margin of rate of 18.3%. In delivering these results, the entire Michael scheme executed our plans at a high level throughout the quarter. We are especially pleased with our sales considering they were lapping a strong 4.6 comp from the fourth quarter last year that was largely driven by Rainbow Loom. Product category strength was broad-based led by seasonal products, fine arts and craft paint and floral. This was offset by the expected decline in kids due to the Rainbow Loom trend last year. Additionally, we had solid performance across our geographies. We believe customers are starting to respond the initial phases of our vision 2020 strategy. Additionally, we believe Michaels continues to take market-share in the fragmented arts and crafts industry. Some key callouts that did impact our Q4 financial performance was a virtual lack of cold weather which positively affected our sales in Q4 and the West Coast port slowdown that negatively affected our inventory flow as we did experience delays in some of our core product replenishment needed as a result of our better than expected sales and also delayed some of our new product sets. Given our high penetration of private brand, most of which arise to the West Coast ports, we saw in Q4 and continuing into Q1 a negative impact on our sales and operating profit as additional spend was required to expedite freight. With the recent tentative agreement, we hope the backlog of freight clears quickly and product flow returns to a more normalized timeline by the end of our first quarter. As I mentioned earlier, I am very pleased with how we executed our strategy in delivering our financial results. Let me share with you a couple of details. As you know, Q4 was all about holiday, taking a learning from our remodel stores where seasonal has a more consolidated visually impactful presentation and has performed very well, we expanded holiday space in about 800 of our other stores to also showcase a larger, more cohesive presentation of holiday product. In fact our Christmas assortment was the largest that we have ever offered and we were very pleased with the sell through. The on-seasonal product, the execution of our merchandising strategy translated into a successful quarter for our core business products as well. We saw strength in our exclusives including Isaac Mizrahi Yarn, our Lion Brand Yarn in [indiscernible], as well as continued success with our broad-base of private brand products across a variety of categories. In marketing, we continued our efforts to leverage what we believe to be the industry leading customer database with more email and more direct mails than ever before. By changing the mix of our marketing spend to more targeted personalized messaging, we were able to gain greater reach without incremental marketing spend and to increase the effectiveness of our message to our customers. Underpinning the execution of these specific initiatives was the improved coordination between merchandising, marketing and store operations. Turning to our new business channels, e-commerce, which is only a small part of our total business performed well. We had good customer interaction with our site, we executed our operations very well and we shipped to customers on-time as they expected. As we’ve said before, we do not expect e-commerce to become as large a part of our business as it is for some other retailers because of the unique nature of our industry. As a reminder, some of the unique aspects of this industry are that a majority of our products to low price points, there was a large private grand penetration and the industry is very tact in nature as customers find it difficult to match colors and textures for a project that they are creating on a computer. Turning to our Aaron Brothers custom frame only stores, we are in the early stages of this test with five stores operating since October in the Dallas market. I’d remind you that these are the roughly 2,000 square foot stores that offer an expanded custom frame assortment and leverage our industry leading vertically integrated artistry production facilities, while it is too early to draw conclusions, we remain hopeful about the potential opportunity to further expand our already number one custom frame market-share. As we look to 2015, we will continue to focus on growing our top-line by increasing our market-share expanding our customer base including both enthusiast and novices and developing our new business segments. The strong cash flow generation of our business will allow us to continue to make the necessary investments to further drive our market leadership, which we believe will lead to greater efficiencies and thereby further improve profitability. In the near-term for Q1 however, we have to work through a number of challenges including significant Rainbow Loom sales from last year, the exchange rate impact from a weakened Canadian dollar, the bad weather in February and early March and finally the hangover from the West Coast port issues. The good news however, is that we see these as temporary headwinds and as we continue to implement our vision 2020 strategy, we feel very good about our financial performance for 2015 and believe we will still deliver results for the year that are in line with our long term annual growth targets. Let me share some things that you can expect to see us do this year to make this happen. We will continue to elevate the in store experience for our customers with our refresh program. There are plans in place to improve store signage and graphics in most stores to give them a new look and make it easier for the customer to shop. The in store Wi-Fi will be expanded in selected stores giving them increased bandwidth. We will have more customer facing associate hours and improvements to our visual merchandising will create additional inspiration and excitement around our product offerings. Also try to improving the in store experience is our remodel program. I would remind you that many of the improvements introduced in our previous remodel markets of St. Louis and Boston have now been expanded to most of our stores through our refresh program. As we continue our remodel program however our focus will be on determining the very best space allocation and adjacencies of the product within those stores to not only maximize current store productivity, but also to allow us greater flexibility to expand or contract the different parts of our portfolio businesses across the store. Today, given the snowflake nature of our stores we're challenged in doing this. That said, we plan on remodeling two markets with a total of approximately 30 stores during the second quarter. The focus of our merchandise offering will remain on bringing [trend right] exclusives to both over novice and enthusiastic customers to further differentiate us from our peers. The first quarter began with the introduction of a new private brand label called Make Market. This exclusive to Michaels offering was inspired by two key trends of unfinished surfaces and personalization. There were items that décor and do it yourself projects that are made with on trend surfaces and textures, such as chalk, denim, galvanized metal, cork and burlap all merchandised together in a single presentation. We also included trend right project ideas to how to inspire our customer to complete projects around crafting, entertaining, decorating and gardening, utilizing these natural materials. In other merchandising areas there are a number of exciting new tests planned for 2015 including a new party merchandise set in select stores, new wedding and floral presentations, a new do it yourself home décor offering and a new framing and home décor combined presentation. We believe having exclusive in trend right product is key to differentiating Michaels from our competitors. In marketing we just introduced new online educational classes to augment our already best in class in store education program. Michaels now allows customers regardless of expertise to choose when and how and where they want to take a class. We believe this is an important achievement to improve our omni-channel customer offering. We will also continue to leverage our industry leading customer database to increase the effectiveness of our marketing. New creative with stronger branding will be used in all of our customer touch points and there will be more use of digital marketing mediums as well as additional broadcast tests. Event marketing will continue to be a focus to capture more opportunities to interact with our customers. In March, we kicked off the Spring Time and Paris promotion, encouraging customers to create [a reason] inspired art and submit their photos for a chance to win a trip to Paris. The stores have been converted to support this event and to create a unique in store experience for the customer with products only found at Michaels. Marketing has also been tailored to this event as well as the class offering in stores and online. On the e-commerce front we will continue to make selective enhancements for the site for those customers who do shop online to continue our omni channel effort, we will be relaunching our Michaels app which will include a store way finding functionality to help customers navigate our in store assortment. And lastly, we will continue to monitor and learn from our Aaron Brothers frame store test and look forward to updating you on these learnings as appropriate. Now with that let me turn it over to Chuck Sonsteby for more details on our financial performance. Chuck?

[Chuck Sonsteby:]

Thanks. Today I'll focus on our adjusted results for the fourth quarter. The term adjusted operating reflects our operating income excluding related party/sponsor fees in the fourth quarter of last year. On a full year basis, adjusted operating income reflects our operating income excluding IPO expenses and related party/sponsor fees. The term adjusted net income reflects our net income excluding IPO fees related party/sponsor fees, all prior quarter debt refinancing cost and the associated tax impact. It also adjust interest expense from the second quarter of 2014 debt refinancings as if they had occurred at the beginning Q2 2014. And finally, adjusted earnings per share divides this adjusted net income by a share count that assumes the IPO shares were issued and outstanding for all recorded periods. Please reference our press release for all definitions and a reconciliation of the GAAP numbers to these adjusted numbers. Our fourth quarter net sales increased 3.4% to 1.61 billion from 1.56 billion last year. Comp sales increased 1.4%, despite the persistent headwind from an unfavorable foreign exchange rate of 80 basis points and we're proud the broad-base strengthened our business. As in Q3, we were able to successfully lap the massive contribution of Rainbow Loom last year. Operating income increased 6.5% to $294 million, which was $3 million above our recent development release in January. And that was 18.3% of sales compared with $276 million or 17.8% of sales in the fourth quarter of last year. The 50 basis point expansion in operating income margin was achieved through higher gross profit margin, which more than offset the impact of the expected increase of performance based compensation. Gross profit dollars for the quarter were up 6.4% to $663 million. Our gross profit rate for the quarter grew 110 basis points to 41.2% versus 40.1% last year, reflecting lower promotional activity, primarily on seasonal products as we lap significant weather impacts in Q4 last year with virtually no weather impact in 2014. We also saw favorable shrink experience and leverage from our higher sales. These benefits were partially offset by the impact of e-commerce initiatives and again a reminder this was the first fourth quarter of e-commerce for us and additional supply chain costs related to the West Coast port issue. Store rent expense for the year reflected our unit growth totaling 355 million versus 347 million last year due to 31 net additional Michaels and Aaron Brothers stores. Selling, general and administrative expenses including share-based compensation related party and store reopening cost for the fourth quarter was $369 million versus $347 million last year. As a percent of sales, SG&A increased 60 basis points to 22.9% from 22.3% last year. We discussed in our last call the performance based compensation would be up over last year and it ended up delevering a 110 basis points versus the expected 90 basis points directly correlated to our improved sales and profit performance versus our previous expectations. SG&A also saw dollar increases associated with operating 31 net additional stores and then we had a minor $700,000 of cost associated with the January secondary offering. These costs were partially offset by continued efficiencies generated by our fuel for growth initiatives where we solicit and reward internal ideas to help improve our business effectiveness. For the quarter, interest expense was $39 which is significant lower than the $61 million in Q4 of last year and much of that benefit comes from the debt restructuring and pay-down discussed on our Q2 call. Additionally on December 10th, we redeemed a $180 million in principle of the 7.5% to 8.25% senior PIK toggle notes due in 2018. And in other words our PIK note, they're also known as our PIK notes. The redemption price required a 2% premium, which drove $3.6 million of debt extinguishment costs. And additionally, there were $2.8 million of accelerated amortization expense related to the early redemption of principal also included in debt extinguishment costs. We benefited from interest expense savings from the redemption in Q4, which partially offset the extinguishment charges, but the net effect lowered our fourth quarter diluted EPS by $0.01 and we realized about $13.5 million of interest expense savings in fiscal 2015 related to this early redemption. Other expenses which represent a portion of the impact of foreign exchange rates was a $2.2 million expense this year versus a $1 million expense last year. The effective tax rate was 36.4% for the quarter compared to 35.7% for the fourth quarter of fiscal 2013. This year's tax rate increase was due to higher income year-over-year and the tax benefit of recognized intercompany foreign currency transactions last year and lower tax credits this year. The quarterly rate was lower from the expected 38% effective tax rate as we recognized the benefit from the reinstatement of the work opportunity tax credit extension and a higher domestic manufacturing credit than if originally forecast. Adjusted net income for the quarter increased 10.6% to $57 million or $0.75 per diluted share, despite the additional $0.01 in cost from the PIK note redemption and that was compared to $142 million or $0.69 per diluted share in the fourth quarter of last year. Looking at our results on a full year basis, net sales increased 3.7% to $4.74 billion. Comps for the full fiscal year were 1.7% lapping a Rainbow Loom comp impact of 2.9% in fiscal 2013 all of which occurred in the second half. For the full year adjusted operating income increased 6.4% to $664 million or 14% of sales, reflecting a 35 basis point margin expansion over fiscal year 2013 as we leveraged higher comps for sales and drove efficiencies in our cost structure. Adjusted net income for fiscal 2014 increased 12.2% to $303 million or a $1.46 per diluted share from 270 million or 1.30 or $1.30 per diluted share in fiscal 2013. For the full year we generated free cash flow to find this cash flow from operations plus capital expenditures of $303 million which drove additional debt payments in 2014 returning value to our shareholders as we realized lower ongoing interest expense. And now turning to the balance sheet total merchandize inventory was $958 million at year end with actual in store inventory lower than we would like you due to in trends in inventory which was $65 million higher than last year. Our lower in store inventory position was driven by the combined impact of better than expected sales and the West Coast port slowdown. At Michaels our high level of private brand penetration requires longer replenishment lead times. We effectively managed the delays through the fourth quarter adding additional costs [indiscernible] product. But as we entered January the backlog was so great we were unable to get product out of the ports and into stores. And it did impact available inventory. However the math of our average Michael's inventory on a per store basis, including inventory in transit and at distribution centers, and inventory for the recently launched e-commerce side was up 790,000 compared to 764,000 per store. We expect to see inventory increases on a year over year basis at the end of Q1 and Q2 as we accelerate receives to replenish store and continue to add basic inventory to support the strategies of our event base marketing. We ended the year with total debt of $3.2 billion and 588 million of revolver availability. During fiscal 2014 we reduced our outstanding debt by 545 million. Cash capital expenditures for the year were 138 million up from 112 million last year. In the fourth quarter approximately $18 million was invested in the billed out and maintenance of our stores. We updated stores with Wi-Fi to help our customers and associates reach our web platform added more efficient LED lighting to a number of stores and rolled out end to end credit card encryption to many markets. This quarter we opened two Michael stores and closed one Aaron Brother store and at the end of the year we operated 1,288 stores including 1,168 Michaels and 120 Aaron Brothers. Before we discuss 2015 guidance I'd like to outline our long term expectations. And they are 4% to 5% total sales growth 8% to 9% EBITA growth which implies a 9% to 10% operating income growth and mid to upper teens net income growth. The 2015 outline provided in our press release this morning is for growth in line with those long term expectations. Specifically for the full year 2015 we're projecting comparable store sales to be in the range of 1.5% to 2% or 2.7% to 3.2% on a constant currency basis and total sales to be between 3.2% and 3.7% or approximately 4.4% to 4.9% on a constant currency basis. We expect operating income for the year to be 700 million to $720 million up 11.6% to 14.8% from the GAAP operating income of 627 million in the prior year period. Our outlook reflects operating approximately 30 net new and or relocated stores and our operating profit will benefit from increased private brand penetration, enhanced pricing and promotion capabilities, reaping benefits and supply chain real estate and store operations from our fuel for growth initiatives plus leverage from higher sales. These benefits will be partially offset by three items that will primarily impact the first half of the year and they're all included in our guidance. First we still have two quarter of Rainbow Loom to lap. In the first quarter of last year we had Rainbow Loom sales of approximately $30 million and 14 million in Q2. Second the continued strength of the U.S dollar impacts the value of our Canadian sales. The currency exchange rates remained where they started this fiscal year. This will cause a negative impact to fiscal 2015 net sales growth of approximately $57 million decreasing the year over year increased value of our Canadian operating income by $17 million which is approximately $0.05 per share. Finally, we expect to recognize $3 million in higher supply chain costs for a penny a share from expediting product to mitigate the impact from the slowdown in the West Coast ports. And about half of those costs from the West Coast port slowdown will be reflected in Q1 with a remainder in Q2. Our Canadian storage then approximately 10% of our stores in 2014, but we have higher volumes in Canada than the average Michael store. So, while transact sales and pay many expenses in Canadian dollars, we buy our inventory in U.S. dollars. As such for the movement in the exchange rate in 2014, our gross margin on the sales in Canada will experience continued pressure in 2015. Our guidance assumes are relatively stable exchange rate from the beginning of our fiscal year. Any further move up or down will have additional impact on our performance. Our outlook assumes yearly interest expense of $141 million, after better than expected Q4, we’re looking to accelerate the final payment of the $181 million on the PIK Notes sometime in Q2. If we call the debt there will be a 2% early payment premium of 3.6 million which will be recorded as debt extinguishment costs in addition to an accelerated amortization expense and as of January 31, there was $2.6 million left unamortized related to the PIK Notes. Over the course of the year, these additional expenses would be offset by about $10 million in interest savings and will provide a $0.01 of the EPS benefit for the full year. In part, we’re able to repay the remaining balance because our restricted payments basket was increased with Q4 net income. The restricted payments basket increases at the end of each quarter by 50% of consolidated net income as defined in the credit agreement. A Q2 2015 pay-off would virtually exhaust to the available basket as of that time. Our earnings outlook assumes an effective tax rate for the full year of approximately 37.5% and this translates to a fully diluted EPS range of $1.65 to $1.71 for fiscal 2015, assuming a higher diluted weighted average share count of 209 million shares for the full year. We expect cash capital expenditures for 2015 of approximately $120 million to $130 million. Now turning to Q1, we anticipate comp store sales to be flat to up 0.9% and total sales to be up 2% to 3%. The impact of exchange rates will hurt Q1 by approximately $13 million which will decrease comps by about 1.2%. We project operating income for the quarter to be between 142 million and 147 million, up 2.2% to 5.8% versus GAAP operating income and Q1 of 2014. Included in this will be a $4 million operating profit impact of approximately $0.01 of EPS impact from exchange rates. The guidance for fully diluted earnings per share in Q1 will be $0.31 to $0.33 with a diluted weighted average share count of 208 shares. So while Q1 may have some unusual issues, we remain excited about how the businesses performing and expect another good year. Our business is generating strong free cash flow and our priority remains to deploy excess cash flow towards debt pay down. In summary, this was another very good quarter and a strong fiscal 2014 from Michaels. As we entered fiscal 2015, we remain focused on maintaining our strong financial and capital allocation discipline, investing in our business and growth initiatives to drive sales, improving profitability, continuing to deleverage the balance sheet and grow earnings per share. And with that, I’ll turn it back to Chuck Rubin for closing comments.

[Chuck Rubin:]

Thanks, Chuck. So again in summary, we are very pleased with our performance in the fourth quarter. This capped the year with a solid execution of our focus strategies achieved strong financial results. Fiscal ’14 overall has been a dynamic and exciting year for us here at Michaels as we have implemented improvements across all areas of our business and our customer has started to respond. I’d like to thank our entire team and in particular our many associates in the stores and our distribution network and in our Artistree production facilities. Their commitment has enable the successful implementation of our strategies as an industry leader providing our customers with a comprehensive on trend offering of merchandise coupled with a much improve store experience and compelling inspiration both in-store and online, we believe we are well positioned to capitalize on the growing style trends towards personalization and self-expression. Our team is energized and ready to build on this 2014 performance and believe we will make further progress in fiscal 2015. With that, we’ll invite to open it up for questions. So operator if you could open up the calls.

[Operator:]

Thank you. [Operator Instructions]. Our first question comes from Chris Horvers from JPMorgan. Your line is open. Please go ahead.

[Chris Horvers:]

If you look at the first quarter, I think prior we're looking at comps of two sticks, FX looks like 60 basis points worse than -- I think everyone was originally thinking about. So can you bridge us down for remaining 150 basis points to the mid pointed guidance between the impact of the ports compared to the slow start to weather?

[Chuck Sonsteby:]

I think the biggest thing Chris is we had $30 million of Rainbow Loom last year, which effectively is about 3% impact on the comp. So, I'm not sure how much people were using or expecting that Rainbow Loom headwind to be, but, again we still see some benefit in the first quarter from Rainbow Loom last year and then we see about $40 million in the second quarter. So I think that’s probably the biggest unknown. And then also, while we don't want to talk too much about weather, it's had some impact on everyone out there.

[Chuck Rubin:]

Chris, just to add, we quantified for the first quarter Rainbow Loom of last year that we're going against, as well as second quarter. Once we get them to Q3, Rainbow Loom continues to be a nice selling item but not nearly the material impact. The bottom line is when you look at Rainbow Loom, when you look at FX, when you look at weather, on the operating side of our business we feel really good about it. And in fact we believe that the underlying performance of this business is certainly at [indiscernible] on the comp that we said if not even above. So, we feel good that our strategy and our execution is where we want it to be.

[Chris Horvers:]

That's very helpful. And then I guess is there a way to quantify, I know you talked about some higher inventory in trends? Is there a way to say hey we've seen close rates go down in the stores at this sort of pace and to try to gauge perhaps how much business is being lost at this point?

[Chuck Sonsteby:]

I think, it's been just want to quantify exactly what the west coast port slowdown, what impact that had on our business. I do know for instance we talked about making market which we think is really exciting presentation in our stores. We were delayed setting that by couple of weeks because we couldn’t get product in the store and even after we did, finally said it, we didn't have a complete for a while. So our inventory has not been as good as we'd like. Thus far we're doing everything we can get more inventory up in shells but we don't think that customer available inventory has been where we'd like it to be. And if you walk the stores or if you have walked the stores over the past couple of weeks, it's getting better incrementally day by day, you will see literally empty tags where product was slotted to go. So tough to quantify the sales impact but we do know it's had a heard on us. But the teams are working hard to try to bring this in.

[Operator:]

Our next question comes from John Heinbockel from Guggenheim Securities. Your line is open. Please go ahead.

[John Heinbockel:]

So the first thing I want to drill down on was make market and your thought on -- it would look like that would primarily impact average transaction but your report on that versus ticket, what the experiences has been to date? I know it's early but can you judge the early customer reaction? And then I noticed on the website that you can't get all of the make market products for a project. Is that by design or is that by product of the inventory availability from the ports?

[Unidentified Company Representative:]

Let's answer the second one first. It's more by design. We're still running on e-commerce, we're very focused on having e-commerce to be contributor to our profit not as attractor and we're still learning in low price point, what we can sell and make money on [FDA] factor in the shipping cost. So, it was by design that not everything was available. As far as the other part of questions on ticket and transaction, it's too soon to tell. What we can tell you was that reaction is really good and our selling on it has been really encouraging. So, it looks great on the store, when the product arrives and the customer responded really well. So, we're excited about this introduction, it's literally weeks old but we think it as a nice long runway to it.

[John Heinbockel:]

All right, then transition one that is not even there yet. You thought process on party, right which looks to be a big opportunity? What's the [indiscernible], how much space? How much you are increasing assortment by? Where does the space come from and -- I forgot my last part -- but just thought process on where we go with party here in the next few months.

[Chuck Rubin:]

Yeah. So, this answer maybe a bit late for you. Firstly we're really excited about the prospect of party and this is not party as you would typically see it in some other retailers. This is -- in some parts it actually is crafting, imitations and table decorations, just like some of it already being pre made, but it looks terrific. The biggest problem we have is what I commented on in the script is that we have snowflakes for stores. And if you boil it down to its simplest form, our stores are not laid out consistently. So, what that means is space allocation by department and adjacencies between departments are not consistent throughout our fleet of stores and in fact they're the opposite of consistent, they're incredibly inconsistent. So to create additional space to expand businesses becomes very complex for us because it becomes a domino effect if I have to move this in this store, but in a different store I have to something else. That's why the seasonal expansion that we did in the fourth quarter, we're incredibly pleased with it because we had to move mountains to make it happen but it worked very well. In my prepared comments we talked about our two markets that we're going to remodel. There's going to be more work around simplifying the adjacencies and making more consistent the space allocation than any other visual component. So this is a long winded way of saying we're excited about party. We're going to be challenged in getting it rolled out into a lot of stores in the very near term and that's what we're working hard on. That is one of the unlocked or still locked that we're working to unlock pieces of really unleashing our portfolio management, the ability to expand and contract businesses quickly is not something that we've been able to do historically.

[Operator:]

Thank you. Our next question comes from Matthew Fassler from Goldman Sachs. Your line is open, please go ahead.

[Matthew Fassler:]

My questions are focused on online. And first of all, obviously we know it's early and as you said e-commerce is small, but I'm curious, how you're seeing customers you saw as interaction with online different over the holiday season when presumably gifting for others is more prominent?

[Chuck Rubin:]

Matt it wasn’t a whole lot different for us. We did not sell very much seasonal product online, so most of what we sell was core product and there's certain parts of our businesses like frames that sell well online that we do believe we're gift oriented that someone may have been purchasing, but fourth quarter to some degree at an incrementally higher volume looked as a very similar mix of product sold as the other quarters in the year.

[Matthew Fassler:]

And then my follow up question related to e-commerce, obviously there are remaining third party sites Pinterest and others that we've spoken about as sources of [aviation]. And the way retailers are interacting with those ecosystems continues to revolve, we're starting to hear a little more about it from some of the companies related to [spaces] but not with that much detail yet. Can you give us any sense as to what the high level thinking is about the role that retailers will play with some of those sites? Will they end up being commercial for you in a meaningful way? Is it [coopetition]? Is there a clear business relationship with discipline?

[Chuck Rubin:]

Well I think we'll be talking about that more. We are -- I think we've talked about this in the past, we're very big on Pinterest. We think Pinterest is a great thing for us because it inspires customers and our opportunity is to then enable those customers, so they see something online through Pinterest. They love it. They want it, but they're not quite sure how to make it and that's where we can come into play. So we do think that over time we hope that our relationship with Pinterest continues to get better and tighter and we'll talk more about that as the year unfolds. There are other things out there. [Indiscernible] is clearly a commercial venue where makers are selling their products. We're excited about that as well.

[Matthew Fassler:]

[Indiscernible].

[Chuck Rubin:]

Right exactly, they have to make it -- they have to get it from somewhere and they have to be instructed to some degree for a certain segment of customer and again that's where we come into play. So these are really interesting things for us, but our view on omni-channel we're as excited about these things as we are about online education, about something as unsexy as a way finding app that is going to be a way finding functionality that'll be part of our new mobile app that launches a little bit later this Spring to help customers navigate our store. These are all incremental pieces to our omni-channel approach.

[Operator:]

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

[Seth Sigman:]

I was wondering if you can breakdown the gross margin a little bit more this quarter the improvement that you saw and specifically on the promotional activity and I know you expected that will be a little bit more aggressive coming into the quarter. How did that play out? How did you guys navigate that a little bit better? Was there a change in the industry or there's specific tactics that you feel are working specifically? Thanks.

[Chuck Sonsteby:]

I think the biggest benefit for us is we really saw great weather in Q4 this year versus last year. Going into the year, we weren’t sure and when you're selling Christmas items there is a shelf life to those. In other words, there is certain weekends where we get a lot of business and if you happen to get bad weather as we did in 2013, that certainly impacts your promotional cadence. In 2014, we didn’t see that, so, not only do we have I think a fantastic presentation in store, we had better merchandise which allowed us to have better follow through. We did have some impact of better weather too.

[Chuck Rubin:]

And just to add to that, the fourth quarter was very promotional. We expected it to be this industry is inherently promotional, but to Chuck's point, the seasonal part of our business for the Christmas product that we would -- that we liquidate at the end of the season because it was such a strong season our margins were enhanced because we had less to clear, but the rest of our high low multiple day kinds of sales that was pretty aggressive in the marketplace in the fourth quarter, but we knew it would be. We had planned for it.

[Seth Sigman:]

And then as you look at the store growth plans to open 30 net new stores, pretty similar to past years. Can you put that in perspective of the industry and what you're seeing out there from some of your competitors in terms of their growth?

[Chuck Rubin:]

There is lot of competitors out there. So we compete with everyone from Wal-Mart to Target to Hobby Lobby to Jilance to [niche] players there Hancock Fabrics to some degree. There are others Hobby Lobby is opening a fair number of stores. But there is no one player that is a local like to Michaels. We have the benefit of being by far number one in our industry and that gives us great muscle to leverage and that’s where we between our numbers position our strong private brand, capability, our vertical custom frame capability. We feel really good about our foundation competing with all the different players that we compete with.

[Seth Sigman:]

Alright thanks for that and good luck ahead.

[Operator:]

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

[Simeon Gutman:]

I am [indiscernible] with Simeon today. First question on sales I think Chuck Rubin you mentioned that the underlying rate is pretty solid in a degree. And I think even with some of the headwinds whatever you have from the port. The sales trends are pretty good. How do you measure yourself for internally what the industry is doing versus what the internal drivers are doing? And then connected to that and lighted to Mats question you have other underlying drivers on the craft side social media type thing helping. How did that factor into it and do you think that that creates some under current for you going forward?

[Chuck Rubin:]

I'm not sure if I follow the first part of your question. The second part of your question though is that yes, when we went public and we met on the road we talked about this broader societal trend that people want to personalize things they want to customize things and people who are very knowledgeable about how to do that are doing it. But people who are less knowledgeable about how to do it are still desiring to that and that plays right to our sweet spot. Now this isn’t an overnight issue but that's the strategy that we have focused especially on these novice customers. So when you look at things like Pinterest just use that one because it's such a prime example, we see it all the time that people are -- and you probably see it in your own life. Your neighbor a [leaf] hanging of their front door and you look at it that’s something that you kind of like and you'd like to try it yourself. That’s where Michaels can come into play we have all the pieces and parts that your need to make it and between our in store classes and now we've launched digital online classes where they are to show you how to do that. So that’s societal trend is going to be here for a long time to come. We believe we're excited about our opportunity that taps into it. But we also acknowledge that we're in the early stages of kind of evolving from Arch and crafts retailers to a retailer that they'd had to help customers understand how to personalize, how to create.

[Chuck Sonsteby:]

And Simeon on the first part of your question it's really hard for us to get industry data. It is a very fragmented industry. The other people who are relatively big box that might play in these categories some are there mostly privates. So we have hard time getting information. We have to go back and try and look at vendors and trying to go back to our vendor sources to find out, how we're doing sort of versus the categories. And we feel like we are taking share in total. But try and identify how much the category itself is growing. We have a very difficult time finding that out.

[Simeon Gutman:]

Okay and my follow up is for you Chuck sounds best. Question on the debt pay down if we pay down the pick notes like second quarter I think our model get pretty close to that interest expense next year you had for the year give or take a little bit more pay down. So are you factoring in additional debt pay down beyond that PIK note in the second quarter?

[Chuck Sonsteby:]

No we are not again I talked a little bit about our RP basket and I think it's a good time to refresh a little bit more about that. So we're allowed to make certain payments and paying down sort of lower tiered debt is something that goes against our RP basket. With our good fourth quarter we have just about enough in that to replenish that basket and it will allow us to pay down the 118 million of PIK notes as we start Q2. But that will just about the deplete everything we have in there. Now as we fall our Q1, 10-Q will replenish that by half to consolidated net income as we continue to file each quarter we get to rebuild that basket by half of the consolidated net income each quarter. So that puts a little bit of handcuffs on us for now as to additional debt pay down we go through the year. But I think some folks might want to take that into account and say look at their models. But I do think that again we think that it's the right thing to do that pay down it's going to increase interest expense substantially and increase income and EPS by about a penny net, net for the year.

[Operator:]

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

[Mike Baker:]

Couple of issues one just on the inventory that’s tied up on the West Coast, what -- can you discuss the complexion of that inventory in terms of seasonal parts or maybe even Easter parts and what kind of markdown risk do you anticipated if some of these products come in to close to when the seasonal time period is?

[Chuck Rubin:]

It has very limited markdown risk because we prioritize things like Easter and Valentine’s Day. So obviously Valentine’s Day is behind us, virtually everything for Easter is in. So most of the product that we’re focused on is part of our new product steps on go forward product in core replenishment. So not great markdown liability to go with the product, just the hindering on our top-line and now to say in our operating margin given that where we’re having to pay more to move this rate, then we would like to be doing, but very limited markdown risk.

[Mike Baker:]

Second question remodel store, so good you are doing couple of more markets, I guess my questions are can you discuss what the lift was in Boston and St. Louis when you did remodels and if that those numbers would be applicable to the new markets that you're doing? And I guess, why [indiscernible] what are the two new markets, I don’t think you said what they are I suppose we can find them with some point, but might be easier to just start of?

[Chuck Sonsteby:]

It would be easier for you to tell, but we be telling everyone out to so, we will proudly and we’ll make that out on the next quarter call. Couple of things that happen Mike, we did see a lift in those stores, but we’re also using those stores as a bit of test environment for us. For instance in those St. Louis and Boston, one of the big things, the big ideas was allocate more space to seasonal to be able to pull it altogether and make a more powerful statement about merchandise in season. And that we saw benefits of that in those -- both those markets. So what we did in Q4 is on about 800 stores we actually took some of our stems out of the front selling space and used that increased space to offer more seasonal. And it really made the stores look tremendous. There was a much more powerful statement around Michaels is in seasonal merchandise and seasonal product and that really did help us get a lift in sales, but our sell through as we saw, as we said. So we were able to take some of those learnings of those two remodel markets and implement them at 800 stores as we went through Q4. So again trying to say, okay, what did we do pre and post, we don’t have a pre and post as we go into these new markets now, because they have already benefitted from some of the things that we did in those "remodel markets". So, we don’t want to get everybody all tied up because the effect that we saw, the lift that we saw in those stores won’t be comparable as we move forward because we’re taking the great ideas that we put in those remodel stores and putting them in every store, so that we can get a lift at a much lower cost than we were spending on the remodel. So again, I know that wasn’t really a question, but I really wanted to make that statement to make sure people understand we’re going to take those markets and continue to learn things and then roll it out to everything under our refresh program and get the benefits at a lower cost.

[Operator:]

Thank you. Our next question comes from Jessica Mace from Nomura Securities. Your line is open. Please go ahead.

[Jessica Mace:]

The first question I had was follow-up on the space allocation and then if there is any numbers you could give us around the holiday presentation weather time or disruption maybe or even cost, I am just thinking about that maybe any comments another opportunities whether it would be seasonal or categories where you think doing something to work as well as it did for holiday in 4Q?

[Chuck Sonsteby:]

Yes, Jessica we’re not going to break out how much we spend in fourth quarter to get this seasonal presentation done. It's obviously included in our performance and you saw that we had performance that we’re pretty proud of, so it took a great coordinated effort between the merchants and the operators to get that done. As we go forward, we have a lot of desire, a lot of places that we would like to be able to do it, again the snowflake nature of our store portfolio and I hope people can appreciate what I am describing with this makes them very challenging. So the -- what we’re really focused on, on these two new markets we’re going to do in the second quarter is a little bit less on visual upgrade, because as Chuck just talked about a minute ago, we’ve done a lot of that, we’re going to continue to do that throughout the chain, the first part of this year as well. What we’re really focused on these two markets is try to refine space allocation and adjacencies in a very cost effective way so that we can then hopefully as we learned from this roll that a bit faster across the chain. So there will be selected places we do it this year. But what we’re really focused on is trying to get this formula built out so that we can expand it very quickly more on the mid-term than the near-term.

[Jessica Mace:]

Makes sense and then just another question on the gross margin performance in the quarter and I am not sure if you mentioned, but the private brand penetration move in a direction that that contributed to the strong gross margin expansion?

[Chuck Sonsteby:]

It did most of our seasonal product is private brand and again good sell through on seasonal which really helped us and better on private brand penetration too.

[Operator:]

Thank you. Our next question comes from Dan Wewer from Raymond James, your line is open. Please go ahead.

[Dan Wewer:]

Thanks. Two longer term questions. First on operating margin rate, in your script you talked about margin expansion continuing, you gave a number of initiatives pleading to that. But also looking over the last three years, operating margin rates at a life time high, it's increased about 10 basis points over the last two years. What changes for the EBIT rate to increase at a faster rate than it has?

[Chuck Sonsteby:]

To increase at -- for EBIT to increase at a faster rate than it has?

[Dan Wewer:]

If you look at EBIT rate, it's going about 10 basis points or so over the last 24 months. And it sounds like during the guidance you think it might increase at a faster rate?

[Chuck Sonsteby:]

Yes, I think for us just getting the very efficient model, where we can get comp growth at about 2%, we can see expanded margins. So I think, again as we look out into this year, that will help us. One other thing that will help too is we can finally get exchange rates to bottom out. That's been an impact on gross margin, it's been fairly consistent headwind in both 2013-'14 and we expect it in '15 as well. And we still will see margin expansion despite of that. So if we can get back to where we see a little bit of an FX rate to flatten out, that will give us some benefit back in gross margin beyond just leverage and increase in private brand and the other initiatives that I outlined on the call.

[Dan Wewer:]

The other question I have, with the 200 additional store opportunities in the U.S. and Canada we're not that far away. At what point does Michaels have to start thinking about the next federation at growth and perhaps we're looking at that with test of the small [year and] by the stores in Dallas. But, to a certain perspective what point, we have to be thinking about another growth comps to continue that -- say 2% to 3% square footage growth.

[Chuck Rubin:]

Well Dan, I think that we're focused on our long term growth, it's not simply 2% to 3% square footage growth that'll get us there. So when we went public we talked about, one of our strategies is to look at new business channels, certainly this Aaron Brothers test is one of those, e-commerce although we believe it's going to be relatively small, we've said that we think overtime it can grow to the mid-single digit penetrations. So that's a piece of business. And when you look at some other parts of our business, there were some interesting things out there. We believe there is B2B play, there are wedding planners and photographers who shop with us today that we think we can do a better job of servicing. We have this enormous private brand capability that we've talked about before. In fact our private brands are in almost every category, the highest volumes sales brand in that category. This is the opportunity for us to wholesale all those brands potentially to other retailers, either domestically or internationally. So, we're doing some real work on this now. But clearly most of these are things that have a rather long development process to them, but we've very conscious that we're a mature retailer and that x number of years down the road there will be other opportunities for growth for us to be focused on.

[Operator:]

Thank you. Our next question comes from Peter Keith from Piper Jaffray. Your line is open. Please go ahead.

[Peter Keith:]

To follow up on some of the comments on private brand, could you give us what the penetration increase for 2014 was? And then how should we think about that penetration accelerating actually in 2015, now with some of the mid-market merchandise?

[Unidentified Company Representative:]

Sure, when we think about what happened between 2013 and 2014 we increased private brand head penetration by about 1%. And looking forward to 2015, as Chuck Sonsteby had referenced on my call we are expecting additional give or take percent increase in private brand penetration as well. Private brand stretches across those are seasonal product as well as our [FDA] product in category, so it's really a comprehensive effort across the store. And we'll continue to look for the right opportunities to take advantage of that as it comes overtime.

[Chuck Sonsteby:]

So one of the other thing too is, while we do go ahead and talk about that number. For us it's all about gaining margin and gaining gross margin and however we can do that, we will. So I know [indiscernible] and his team go back to existing vendors all the time and try and get benefits in gross margin. And we have the very real threat that we can move the private brand. And so sometimes, those vendors [might act react] and give us a rate decrease which will cause us not to move to private brand, yet still be able to improve our gross margin. And that’s really what we want to make sure that we continue to get. So, while we want to talk about private brand penetration and the increase, that's not really the full impact of what we'll see in gross margin improvement, it has many other aspects. So, Chuck we'll wrap it up.

[Chuck Rubin:]

I think, we'll wrap it up, we're running couple of minutes over. Let me thank everybody on behalf of Michaels for joining the call today and to tell you we appreciate your time and that we look forward to speaking with you on our Q1 update. Thanks everybody.

[Operator:]

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