Michaels Companies Inc
Q2 2016 Earnings Call Transcript

Published: 25 Aug 2016

[Operator:]

Good morning. My name is William and I will be your conference operator today. At this time, we would like to welcome everyone to the Michaels Company Earnings Conference Call for the Second Quarter of Fiscal 2016. All lines have been placed on mute to prevent any background noise. [Operator Instructions]. Thank you. And now I’d like to turn the call over to your host, Kiley Rawlins, Vice President of Investor Relations and Communications. Ms. Rawlins, you may now begin the conference. Please go ahead.

[Kiley Rawlins:]

Thank you, William. Good morning everyone and thank you for joining us today. Earlier this morning, we released our second quarter financial results. A copy of the press release is available on the Investor Relations section of our website at www.michaels.com. Before we begin our discussion, let me remind you that today’s press release and the presentations made by our executives on this call may constitute forward-looking statements and are made pursuant to and within the meaning of the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995, as amended. While these statements address plans or events which we expect will or may occur in the future, a number of factors as set forth in our SEC filings and press releases could cause actual results to differ materially from our expectations. We refer you to and specifically incorporate the cautionary and risk statements contained in today’s press release and in our SEC filings. You are cautioned not to place undue reliance on these forward-looking statements, which speak only as of today, August 25, 2016. We have no obligation to update or revise our forward-looking statements except as required by law, and you should not expect us to do so. In today’s earnings release, we have presented non-GAAP financial measures such as adjusted EBITDA as defined in our credit agreement, adjusted operating income, adjusted net income, and adjusted earnings per share. Adjusted operating income, adjusted net income, and adjusted earnings per share have been presented to reflect our view of our ongoing operations by adjusting for non-recurring inventory-related purchase accounting adjustments and non-recurring integration costs and benefits associated with the February 2016 acquisition of Lamrite West. A reconciliation of these measures to the corresponding GAAP measures can be found in today’s earnings release. Our call today will begin with some highlights from Chuck Rubin, Chairman and CEO, and then Chuck Sonsteby; Vice Chairman will review our financial results and outlook in more detail. Denise Paulonis, he will become CFO as of Monday, August 29, 2016 is also on the call with us this morning and will be available during the Q&A session. Following our prepared remarks, the call will be open for questions. As a reminder, we would appreciate it if participants could limit themselves to one question and one follow-up. I will now turn the call over to Chuck Rubin. Chuck?

[Carl Rubin:]

Thank you, Kiley, and good morning everyone. Let me begin by discussing the announcement we made this morning regarding our succession planning efforts in the promotion of Denise Paulonis to CFO. Today we are number one in our channel, and through the execution of our Vision 2020 strategy, we are investing to maintain and expand this leadership position. Succession planning and ensuring that we have the best talents to support our growth ambitions are critical to these efforts. On our last call, we announced that we had launched a search for a new CFO early this year. I am pleased that we had many outstanding choices, both external and internal to consider. After this extensive process, we concluded that Denise’s integrity, experience, and leadership skills made her the best choice to succeed Chuck as CFO. Denise joined Michaels in 2014 as Vice President of Corporate Finance, Investor Relations, and Treasury; and last year was promoted as Senior Vice President of Finance expanding her responsibility to include the financial management of all of our operational functions. Since joining Michaels, Denise has built strong relationships across the organisation and has been a critical leader of our finance and strategy teams. I look forward to working with her in this new role. I am also pleased that Chuck Sonsteby will remain with the Company as Vice Chairman and will oversee the growth and continued integration of Lamrite West as well as the operations of our Aaron Brothers chain, while helping facilitate a smooth transition of CFO responsibilities to Denise. Let me now turn to an overview of our second quarter performance and an update on our progress against our fiscal 2016 priorities. Then I will turn the call over to Chuck for additional details on our quarterly results and financial outlook. This morning, we reported sales and earnings growth within our original guidance range. The choppiness we saw in Q1 continued through Q2 and the promotional environment intensified as many of our direct competitors engaged in aggressive discounting to drive their traffic. I am generally pleased that against this backdrop, our teams continued to manage the business well and stayed focussed on our priorities. For the quarter, total sales increased 7.7% or 8.1% on a constant currency basis versus last year. Comparable store sales increased 0.7% or 1% on a constant currency basis, driven by an increase in customer transactions. While our sales this quarter were near the lower end of our expectations, we believe we continue to gain share in the market. During the quarter, we opened five new Michael’s stores and two new Pat Catan's stores and we relocated four Michael stores. We also closed three Aaron Brothers stores during the quarter, so at the end of Q2, our total store count for all brands was 1,356 stores. As we have discussed in the past, we manage a portfolio of businesses, some businesses exceeded our expectations this quarter or others were not as strong as had hoped. From a category perspective, paper crafting, fine art and frames, and home décor delivered strong comp growth, while celebrations, kids, and custom framing including our Aaron Brothers business continued to be soft. In addition, the coloring trend seems to be maturing faster than we initially expected. As we have discussed in the past, the second quarter is historically our lowest sales volume quarter, and as expected earnings for the quarter were challenged by the impact of investments we are making to support our long term growth including the integration of Lamrite West and initiatives to reduce product acquisition costs as well as the timing of distribution expenses. Our focus is to drive sustainable long terms success, and these investments will lead to improved financial performance in the second half of this year and into 2017. In addition to these investments, we incurred an unplanned credit card assessment of $3 million during the quarter which negatively impacted EPS by $0.01. Excluding non-recurring costs associated with the cost – with the acquisition of Lamrite West; but including the unplanned credit card assessment, adjusted diluted EPS was flat with Q2 last year. In the second quarter, we continued to invest to support our Vision 2020 strategy, our strategic framework for growth and investment decisions. As a reminder, our Vision 2020 strategy is built on five key pillars; one, create a customer centric shopping experience; two, curate the product and service offering based on trend, value, and customer demand; three, speak to the customer where, when, and how they want; four, grow new businesses; and finally five, deliver fuel for growth through productivity improvements and strict cost disciplines. I am pleased with the progress we have made so far this year on all these fronts and we intend to build on this progress for the remainder of fiscal 2016. Delivering a more customer centric shopping environment is critical to differentiating the Michaels experience. Our teams are working hard to improve the shopping environment in our stores and our customers continue to notice. We measure customer feedback using an independent third party and I am pleased to report that we continue to see meaningful improvement in these scores this year. To help more customers explore their creativity and learn new skills, we have improved our in-store and online educational programs. This initiative is important for us to make shopping at Michaels more experiential than it is today. We’ve increased the number of free classes for kids and adults; and in the second quarter, overall class participation increased 35%. We’ve also increased our offering of unique in-store events like coloring and planner meet-ups, cookie decorating events, in Shopkins swaps. As we move into the second half, our teams are keenly focussed on providing customers with a great in-store experience. We have improved our in-store presentations in all stores to better reflect how the customer shops and make more compelling merchandising statements. We have increased our focus on key items within our Halloween and Christmas offerings and enhanced drive aisle fixtures to make the product easier to shop. And we’ve simplified our pricing and presentation of key items to reinforce the value that we offer. In addition, as we discussed on our last call, we are creating dedicated space for our seasonal presentations in select stores. Applying learning's from previous store lay-out work, this past January, we’ve refreshed 75 stores creating flexible merchandising space in the front of the store to showcase newness to the customer. Based on the results of these stores, we are making these space changes in an additional 280 stores. So by the end of September, 355 stores or almost 30% of the Michaels chain will be positioned to present stronger, more cohesive seasonal statements to customers as we head into the important peak season. These face changers do not require a large capital investment, but do have some related expenses which will be primarily funded by our ongoing fuel for growth efforts. In addition, based on our experience with the initial 75 stores, we do anticipate some temporary sales disruption as customers get used to the new layout and merchandised changes, all of these factors are included in our fiscal 2016 guidance. From a merchandising perspective, we continue to focus on providing customers with newness, merchandise exclusives and trend right merchandise. We’ve completed a number of planogram resets in key core areas like jewelry and yarn, and customers are responding to the enhanced distortment and strong value messages. These resets combined with our paper crafting and party planogram changes have added newness to our core assortment. One interesting new trend we are seeing is a move away from electronic calendars to paper based day planners, which provide more opportunity for creativity and personalization. To support this trend, we have expanded our already industry leading assortment of planners introducing new brands, new sizes and new accessories. Customers are excited about this as evidenced by their engagement with Michaels through social media and in-store events. Technology will also play a larger role in paper crafting later this year as we offer the new Cricket Air 2 with new accessories as well as new colors of Fuji cameras to give our customers more options to personalized in memory making projects. For kids, we are expanding our selection of collectibles with new assortments of shopkins in a new miniature collectible called Numb Noms [ph]. I am also pleased that Michaels will carry for the first time "The Elf on the Shelf" program this year with new characters and accessories. As I mentioned on our last call, we introduced a new back-in-class fixture in our drive out in all stores in July. While traditionally we haven’t played in the back to school season, this new fixture in the drive out enables us to maximize our strengths with minimal inventory risk. With a focus on core art supplies, writing instruments in storage we have seen good customer response to this clean, well organized presentation of core products. From a fall of seasonal standpoint we have expanded our Halloween assortment significantly increasing our selection of new floral, home decor and costumes and we have added new craft and Diorama Pumpkins in finishes and colors that are exclusive to Michaels. We’ve also partnered with the food, allergy, research and education group to be the exclusive retail partner for the Teal Pumpkin project which supports Trick-or-Treating for kids with food allergies. From a décor standpoint, we have added fun new trend stores for customers, so whether you prefer a bright colourful and whimsical or graphic, spooky and sophisticated, we can help you celebrate Halloween in style. These strategies of newness, exclusives and trend will continue into holiday. This year we will offer customers our biggest ever selection of holiday décor and accessories with the introduction of new trend collections that support a variety of styles and celebrations from a nostalgic traditional holiday get together to a new modern, sophisticated gathering. Christmas wouldn’t be Christmas without trees and we have expanded again our selection this year, adding new colors and styles to give our customers more ways to decorate the holiday. And we have improved the packaging, presentation and signage this year to make our annual tree forest even easier to shop. As we enhance our in-store presentation of merchandise offering, we are also making investments on how we speak to the customer. We successfully launched our new loyalty program, Michaels Rewards in the U.S. in July and we are very pleased with the initial response from our customers. For customers, Michaels Rewards offers an elevated experience of tailored exclusive offers and events such as sneak peaks for new products and exclusives, early access to key sales and we seek pre returns, all of this without a point or purchase level requirement. For Michaels, the program provides us with rich data to help fuel improved customer segmentation marketing which should translate into more engaged customers, increased Drip frequency and higher sales over the long term. Although it’s only been available approximately six weeks nationwide, Michaels Rewards is resonating well with customers. Our initial enrolment numbers have been stronger than planned and the feedback from customers has been very positive. We’ve already executed several Michaels Rewards campaigns and we have several additional exclusive offers and activities planned for the balance of this year. As the leader in our channel, we see an opportunity to leverage our financial strength to invest in expanding further our market share. As we move into Q4, we will launch a new company wide integrated marketing campaign. This campaign will include both the brand building focus and compelling aggressive promotions. Importantly, it will tap into the growing consumer trends of Do it yourself, and personalization to show Michaels in a more contemporary light. We are excited about this campaign and plan to aggressively support it across all of our media vehicles. We will provide more details as we get closer to its launch. Reflecting our investments to grow new business, our integration of Lamrite West continues to progress well and we remain very excited about the long term benefit potential this acquisition provides. As we have discussed the business to business, or a B2B channel is an important long term growth opportunity and the acquisition of Darice positions us well to capitalize on this potential. And while the industry overall seems to be feeling the impact of the current general retail environment, the Darice team has continued to add new customers while retaining existing relationships. We remain excited about how Darice can add to our long term revenue and profit growth. Since launching Michaels.com two years ago, we have seen steady growth in our online business although today it is still a very small percentage of our overall sales. Our acquisition of Lamrite West gives us another online platform for growth. We don’t expect that e-commerce will grow to be the double digit penetration of sales as it is for many other retail formats but we do believe that longer term our consolidated B2B and B2C e-commerce businesses can grow to be in the mid to upper single digit range of sales, which is still a very attractive growth opportunity. We believe e-commerce can provide us with opportunities to compete in new categories without giving up valuable retail floor space. One example is fabric, which we do not sell in stores today. Our recent opportunistic acquisition of the intellectual property of Hancock fabrics including trademarks, customer lists and domain names will provide us the opportunity to leverage this well respected brand. Finally, we continue to make real progress towards our goals of reducing cost through the expansion of our global sourcing capabilities as well as our efforts to reduce our product acquisition costs. In June, we began to use the China sourcing office that we acquired through the Lamrite West transaction to support purchases from Michaels and Aaron Brothers. And over the next few months we will continue to expand the team and resources to support our growth objectives. While our investment in this effort created some headwinds in Q2, we have identified and captured meaningful savings which have begun to flow through our inventory. We should begin to see the P&L benefit later this year and into 2017. In summary, the first half of fiscal 2016 was more challenging from a topline perspective than we hoped. While we feel very good about our merchandising and marketing plans for the balance of the year we do believe it is prudent to be conservative with our comp store sales expectations. However, we have maintained our earnings growth guidance for the year reflecting the benefits of tax planning associated with the Lamrite West acquisition and the use of our strong cash flow to opportunistically support our stock buyback program. With that let me turn the call over to Chuck Sonsteby for a more detailed discussion of our financial performance. Chuck?

[Charles Sonsteby:]

Well thanks, and good morning. As expected, Q2 was challenged by some timing differences, and the impact of investments we are making to improve longer term profitability. I am pleased we delivered comp sales, operating income and EPS within our original guidance, inclusive of these timing differences, which included an unplanned credit card assessment and a retail environment which has been difficult for many. Our second quarter net sales increased 7.7% to $1.1 billion, up from $984 million last year. On a local currency basis, net sales grew 8.1% as the stronger U.S. dollar continued to have a negative impact year-over-year. The increase in net sales was primarily due to $54 million in sales from the acquisition of Lamrite West, and a $15 million related to the operation of 17 net additional stores during the period. And as Chuck indicated, comparable store sales increased 0.7% or 1% on a constant currency basis, driven by a growth in transactions. Normalizing for FX and Rainbow Loom, our two-year stacked comp was 5.2%. Gross profit dollars for the quarter grew 4.7% to $391 million, and our gross profit rate for the quarter was 36.8% versus 37.9% last year, a decrease of 110 basis points, however, 60 basis points of the decrease resulted from the acquisition of Lamrite West. As we’ve discussed on previous calls the Lamrite West’s wholesale business has a lower gross margin rate than the Michaels business. In addition, the delayed timing of profit recognition of product Michaels purchased through Lamrite West results in a temporary headwind in the first half of the year. This timing difference will moderate in the second half of fiscal 2016 and normalize in fiscal 2017. So in context, the gross profit rate for the business excluding the impact of Lamrite West de-leveraged by about 50 basis points and the gross profit rate would have expanded modestly except for the anticipated headwinds which we talked about last quarter from an additional distribution expense resulting from a more normalized flow of inventory this year as compared to the port [ph] impacted second quarter last year. Benefits from sourcing and pricing efficiencies offset coupon utilization and higher occupancy costs. As we stated on our first quarter call, a more normalized flow of inventory resulted in additional distribution expense in Q2 this year as compared to Q2 of 2015 with its more normalized flow of inventory we expect some timing benefits to gross profit in Q3 and Q4 versus last year. Total rent expense for the quarter was $97 million versus $92 million last year, with the increase due to a net 52 additional stores, including 35 Pat Catan stores. Selling, general and administrative expense in the quarter, including preopening costs was $304 million compared to $277 million in the second quarter last year. The increase was primarily due to the acquisition of Lamrite West, which added about $16 million of expenses to the P&L. In addition, we incurred about $2 million of integration expense during the quarter. As a percent of sales, SG&A expense for the business was 28.6% versus 28.1% last year, an increase of 50 basis points. So excluding the unplanned credit card assessment of $3 million related to the 2014 data breach and the $2 million of integration costs, SG&A expense for the core Michaels business would have been flat as a percent of sales compared with the second quarter last year. Our teams continue to do an excellent job managing expenses, reducing ongoing costs through our fuel for growth program and helping us continue to invest in the brands all while delivering on our earnings target. Advertising expense for the quarter as a percent of sales was lower this year reflecting in-store signage investments made in Q2 last year. As you may recall, last year we invested in new way finding and perimeter signage to make it easier for customers to shop at stores. As Chuck indicated, we are expanding our marketing investments and for the full year we expect advertising expense will be higher than last year and inline as a percent of sales. As we discussed on our last earnings call, we’ve been working in earnest with the help of some outside partners to reduce our product acquisition costs. In addition to focussing on cash earning commodity and currency benefits, we are leveraging bottom up cost modelling to product design and our supplier portfolio to identify opportunities to lower cost across our brands without sacrificing quality for the customer. This effort has been underway for several quarters and while the investment pressure of SG&A expense this quarter we have captured meaningful sourcing and shipping savings which will begin to flow through the P&L in the second half of this year and into 2017. Excluding non-recurring inventory related purchase accounting adjustments and integration expense related to Lamrite West, adjusted operating income was $88 million compared to $97 million in the second quarter of fiscal 2015. As a percent of net sales adjusted operating income was 8.3% compared to 9.8% in the second quarter of fiscal 2015. For the quarter, interest expense was $32 million, down $2 million from $34 million in the second quarter last year. This decrease was due to the voluntary principal payment of $150 million on our term debt in December 2015, and the interest savings from the refinancing of our ABL in May. Associated with the refinancing of our ABL we recognized $400,000 of expense in the quarter. As a reminder, last year in Q2, we've recorded a loss on the early extinguishment of debt of $6 million related to the redemption of the PIK notes in May of 2015. The effective tax rate for Q2 this year was 35.5%, compared to 36.6% for the second quarter last year. While on year-over-year basis that's a large change as a percent of sales, the dollar amount of the change was relatively small and it was a couple immaterial items. We continue to utilize our strong cash flow and balance sheet to return value to shareholders by reducing debt and opportunistically repurchasing shares. In Q2, we purchased 2.4 million shares for about $68 million and given the timing of purchases that was minimal EPS benefit in the second quarter. Excluding non-recurring inventory related purchase accounting adjustments and integration expense related to Lamrite West, adjusted net income for the quarter was $36 million or $0.17 per diluted common share, flat with the second quarter of last year. Now, turning to the balance sheet, total merchandise inventory was $1.1 billion, up $72 million or 6.7% from the end of Q2, 2015. The increase in total inventory included $96 million in additional inventory related to the acquisition of Lamrite West. We ended the quarter in good inventory shape, and believe our inventory position supports our plans for the peak shopping seasons of the year. On a per store basis for the Michaels business, inventory levels were 3.9% lower than at the end of Q2 last year, and again last year we made that strategic decision to pull forward delivery of seasonal and standard assortment products in an effort to mitigate the impact of the West Coast port issues in early 2015. So, we don't necessarily expect this tend to continue and we do expect inventory levels will be about flat at the end of Q3. Our liquidity position remains strong. At the end of the quarter cash on the balance sheet was $150 million, total debt was $2.8 billion and revolver availability was $597 million. Debt to adjusted EBITDA remains at 3.2 times. Cash, capital expenditures for the quarter were $24 million compared to $28 million last year, primarily due to the timing of spend for new and relocated stores. And finally, we have $73 million remaining for additional share repurchases under the current authorization. The full year diluted earnings per share benefit associated with the repurchase activity in the second quarter is about a penny. And as a reminder, the share repurchase program does not have an expiration date and the timing and number of repurchase transactions under the program will depend on market conditions, corporate considerations, debt agreements, and regulatory requirements. Looking to the rest of the year, the event nature of the second half of the year, the favourable impact of an extra shopping day between Thanksgiving and Christmas, our enhanced marketing effort, and the specific actions we're taking to improve the shopping experience give us confident that comps will accelerate in the second half as compared to the first half of fiscal 2016. However, as Chuck indicated we don't necessarily see big external catalyst for the macro operating environment to improve. Consequently, we believe it's prudent to take a more conservative view of sales growth for the rest of the year. Although we continue to have confidence in the initiatives we have in place for the back half. For the full year, we now anticipate net sales will increase between 6.8% and 7.8% and comp store sales will increase between 1% and 1.5%. Operating income for fiscal 2016 will be in the range of $750 million to $770 million including the impact of Lamrite West, but excluding integration costs and non-recurring inventory related purchase accounting adjustments. Since our last call, we've identified more opportunities with the Lamrite West acquisition to drive increased profitability and now expect integration costs and non-recurring inventory related purchase accounting adjustments will be higher between $14 million and $15 million in total for the year. The integration is going well and we're moving faster than initially plan to capture potential savings from the combination. As a result, we'll have additional integration expenses related to tax planning work and restructuring efforts to support the consolidated stores opportunity. The benefits generated from the integration will have an ongoing benefit to our tax rate beginning in the third quarter, so the effective tax rate will be lower approximately 35.4% for the full year, this translates to an adjusted diluted EPS range of $1.92 to a $1.98 for fiscal 2016, on a diluted weighted average share count of 207 million shares for the full year. The work we're doing on the efficiency front including business structuring in combination with the strong free cash flow profile of our business, which allows for opportunistic share repurchases is providing EPS benefits. We continue to expect capital expenditures for 2016 will be between $125 million and $135 million. Now turning to Q3, we're planning comp store sales to increase between 0.5% and 1.5% and planned to open 13 net new stores in the quarter. Operating income for the quarter is expected to be between $160 million and $165 million, excluding non-recurring inventory related purchase accounting adjustments and the integration expenses related to Lamrite West. This translates into Q3 adjusted EPS guidance of $0.42 to $0.44 per diluted share, assuming a diluted weighted average common share count of 206 million shares and no additional benefits are including for excess cash deployment. All-in-all, it was a solid quarter. Our earnings performance was at the high end of our guidance excluding the planned credit card, the unplanned credit card assessment. Once again, the multifaceted strength of the company was demonstrated, using discipline expense management and strong cash flow to fund longer term earnings growth initiatives, which will provide benefits in the second half of the year and more in fiscal 2017 and beyond. Before we take your questions, I want to offer congratulations to Denise, on a well earned promotion. During her tenure she's proven to be a trusted and highly effective leader who will bring Michaels to a new level. I look forward to partnering with her and my role over at Lamrite West and Aaron Brothers with a common goal of increasing stakeholder value. It's been a pleasure working with each of you in my role as, CFO, and I want to thank the team members of Michaels for all their accomplishments over the past almost six years. And with that, I want to open the call up to take your questions. Operator?

[Operator:]

Thank you. We will now begin the question and answer session. [Operator Instructions] The first questioner today is Christopher Horvers with JPMorgan. Please go ahead.

[Christopher Horvers:]

Thanks. Good morning, guys.

[Carl Rubin:]

Good morning, Chris.

[Christopher Horvers:]

So, you know, you lowered the comp outlook for the back half, but the operating income dollars really didn't come down that much at all. Can you generally talk about your updated assumptions on margins in the back half, not specifics per say, but are you more optimistic on gross margin and the sourcing benefits than you are initially embedding into the guide or is it coming more from the SG&A control line?

[Charles Sonsteby:]

We are seeing some good things in gross margin, Chris, we've been working hard on shipping and sourcing, and we're starting to see some of those things pay off, maybe a little bit higher than what we've first thought it might be at the beginning of the year. We're seeing some traction in Lamrite West, and we're starting to see a little bit of savings in that SG&A line, some of our fuel for growth programs are delivering at a higher rate than what we'd expected. So, we're seeing really a good combination in both lines of savings versus what we had originally anticipated.

[Christopher Horvers:]

Understood. And then as a follow-up, can you talk about the outlook for share repurchase, as you mentioned excess cash deployment is not in the guide for the back half. Are there any restrictions on the cash that's available for repurchasing? How should we think about the need to fund inventory in 3Q as you go into peak? And then finally, I guess, longer term, should we expect that cash deployment will be dedicated towards share repurchase versus paying down debt? Thank you.

[Denise Paulonis:]

Good morning, Chris. It's Denise. Regarding back half of the year and share repurchases, there is no constraints by any of our debt covenants or anything to that side of the equation that would stop us from repurchasing shares. We make that decision as we go through each of those quarters, but no constraints there so to speak. You know, we are in the light of cash period of the year. So as you look towards Q3 and Q4, that's when we start to build cash back up. So, right now we are primarily buying inventory and using costs -- using our cash to do that.

[Christopher Horvers:]

And then on the debt?

[Denise Paulonis:]

I'm sorry, can you repeat the question?

[Christopher Horvers:]

And then just, as you think longer term, having a prioritizing repurchase versus paying down debt?

[Denise Paulonis:]

So I think we would echo what we've talked about in the last few calls, which is, we generally want to maintain a balanced program going forward. We're very comfortable with our ability to cover interest expense that we have on our debt today, so no new news at this point.

[Christopher Horvers:]

Okay. Thank you.

[Operator:]

Our next questioner is Steven Forbes with Guggenheim Securities. Please go ahead.

[Steven Forbes:]

Good morning.

[Carl Rubin:]

Good morning.

[Steven Forbes:]

You've talked about in the past your ability to comp around events, I guess, with that in mind what is the recent customer behavior, and maybe what you've seen in the first half year? How do you back consumer trends as it relates to conversion around these events, and the overall reaction to promotions across the space given your commentary about aggressive discounting from competitors?

[Carl Rubin:]

Steven, I think that, what we're seeing is when there is that natural driver, we have done better, outside of those natural drivers is when we have been more challenged, so when we ran our lowest price of the season event earlier this year, when we had Easter, they were better. Outside of it, it's tough. So, we are managing our inventory well. We're trying to manage our inventory closer to the time of need as best as we can, but we are heavily private brand, so that presents a bit of a challenge, but we're making good progress on that. The competitive nature in this industry, this has always been a promotional industry, and we're seeing some stepped up promotion from some of our competitors. To this point, we have – we believe we have a bigger, better assortment, and we are relying on that as well, but some of this discounting has been more aggressive than we anticipated. We don't think it's necessarily working that well on an overall arching basis, but it is setting a bit of a concern in my mind about what the customer ultimately will come to expect with all this discounting. But we are going into the event rich second half of the year. As Chuck and I both said in our prepared comments, we feel good about our strategies. We think we offer something unique to a customer, and we have a lot customers who shop with us for decorating their home for the season -- for the holiday seasons, and they don't see us all that many times at the beginning of the year, but they do come multiple times at the end of the year, and we think we're in a good position for them.

[Steven Forbes:]

And then, I guess as a follow-up, can you just discuss your progress with Revionics especially as it relates to the promotional suite and how -- kind of what we've just talked about here with customer trends around events. How does that impact or what are your learnings from that as it relates to your promotional strategy heading into the back half of the year?

[Carl Rubin:]

It's hard to say. We haven't actually got it in place and working yet. So, it's something that we'll be put in place here very soon, and then we'll be testing it, working with that as we go through the back half of the year.

[Steven Forbes:]

Thank you.

[Operator:]

Our next question comes from Michael Baker with Deutsche Bank Securities. Please go ahead.

[Michael Baker:]

Thanks. Two questions if I could, one on the framing business, so custom framing still weak yet, you had framing as a strength, so it was just the off the shelf framing. Can you sort of help us what's going on there? Is that just a shift in consumer preferences, and is that economically related or what you think is going on with those two businesses?

[Carl Rubin:]

Yes. There are two different price points off the shelf, but first of all, you assessed it properly, so it's off the shelf frames, which is a significantly less costly purchase for the customer than custom frame. Custom frame continues to be soft, as we've talked before on these calls, our best assessment is, it is our version of the luxury business and there's been some ups and downs in that luxury business. We're starting to cycle it. We're starting to cycle some of the tough business in custom frame from last year and we do have hopes that our comps become a bit easier in the second half of this year. We're still committed very much for that business. It still very attractive business. It's high margin. We're the biggest in the world at custom frame, but we see now multiple points, custom frame at Michaels, custom frame at Aaron Brothers, Pat Catan is a small player in custom frame, but we see these multiple distribution points that it is just a challenged to top line industry right now, but we are – as I said we're going to be committed to it and we believe it does get better if for no other reasons just some easier comps to go against.

[Michael Baker:]

Well, I guess then, I'll use my follow-up to follow up on that. Do you have specific data either historically or different markets or anything like that to really prove out the idea that it a cyclical/macro issue or maybe it just a structural issue where people have decided that off the shelf framing is good enough and don't need the higher priced custom, is it?

[Carl Rubin:]

Well, we're the only public retailer in the space. It's hard to get really great data, but we have multiple data points. When you're the biggest in the world, you sell through now three different name plates at retail. Obviously, we talked to – we're vertical on a lot of what we sell, but we still do buy some product through other sources, so we have insights from them. There were something broad base going on in this. I personally don't believe there is this big secular change that people suddenly don't want a custom frame and instead they just want to buy off the shelf. This is like any other custom business. The quality, the uniqueness that you get by custom framing of product is really something special, and I do think that at a time when you're seeing luxury retail have some challenge this, when you look at a $160, $170, $180 average price point in custom frame which is what its, I think that challenge for upper price product is what we're experiencing. So, we're working that through and we're trying to add levels of value to it, but the reality is it is still a custom product and inherently will be more expensive than other things.

[Michael Baker:]

Okay. Thanks for the color. I'll turn it over to someone else now.

[Carl Rubin:]

Thanks Mike.

[Charles Sonsteby:]

Thanks Mike.

[Operator:]

Our next questioner is Simeon Gutman with Morgan Stanley. Please go ahead.

[Simeon Gutman:]

Thanks. I'm going to ask two upfront -- noisy spot, but first big picture, where can gross margins go over time thinking about Lamrite and some of the sourcing progress? And then second, just clarifying on this quarter, operating income looks like it was down about $9 million and that's pre-integration expenses, though the credit card piece and the purchase accounting kind of washed themselves out. Have you mentioned this distribution headwind? I think it was $3 million year-over-year. So that leaves us operating income down about $6 million. Is that math right? What explains the gap? I guess to know the comp was little light, but was currency or investments that played here? Thanks.

[Carl Rubin:]

So, Simeon, a little bit on the math. As we've had indicated last quarter the distribution expenses were much more substantial than that. The distribution expenses, if you exclude that and the credit card accounting or the credit card charge and the integration expense, it would have been about flat on operating income.

[Simeon Gutman:]

Got it. Okay. And then the first part on, I guess back on gross margin, big picture what's the benefit from Lamrite that’s [Indiscernible]?

[Denise Paulonis:]

So, Simeon, we haven't quantified the benefit of the sourcing opportunity. We do continue to believe that the work that we're doing now will have benefit hence we go through 2017 and then we will continue work beyond that to continue to refine. You can think about, its being a nice help in the mix, but the piece to consider is that within that margin of the Lamrite West businesses are inherently lower margin than the core Michaels business. So when you think about going forward, you should have to factor that in for both portions of the business that would be the case.

[Simeon Gutman:]

Okay. And just finally, you mentioned disruption in the comps from seasonal resets and then I think in Chuck's remarks you talked about the advertising and then you have some aggressive promos. Is the potential list from advertising factored into the back half comp guidance as well?

[Charles Sonsteby:]

All of our initiatives are factored into the second half guidance.

[Simeon Gutman:]

Okay. Thanks Chuck.

[Charles Sonsteby:]

Thank you.

[Operator:]

The next questioner is Matt Fassler with Goldman Sachs. Please go ahead.

[Matt Fassler:]

Thanks so much and good morning.

[Carl Rubin:]

Good morning, Matt.

[Matt Fassler:]

My first question relates to the color you gave on traffic or transaction counts still being up. I know you haven't quantified traffic and ticket for sometime. To the extent that traffic was still up and presumably ticket was under pressure, was the traffic, and given that much of what we've heard from retailers about changes in the environment has related to traffic, is traffic as strong as it had been? Was the de-sale [ph] evident in both line items traffic and ticket during the quarter?

[Carl Rubin:]

Traffic was relatively consistent with what we've seen in the past and it accounted for almost all of the comps, so ticket was about flat in Q2.

[Matt Fassler:]

And I take it that was a change in trajectory for ticket?

[Carl Rubin:]

Yes. On past quarters ticket had been up a little bit, so just in general your comment highlighted that we're pleased that we're seeing more transaction, so we think – we're seeing goodness that were bringing customers into the store. We just can't and clearly in Q2 we struggled and getting her to spend more money on each visit.

[Charles Sonsteby:]

And I think too, one thing to think about too, Matt, is custom frame has been little soft, that's going to drive that ticket down. And it's really hard for us to drive any real core – any core thoughts around Q2. It’s a low volume quarter. So just a couple of million dollars one way or another can really have an outsized impact on the percent, and so as we get into the third and fourth quarter we have a much different shopping customer, a much different customer comes through the front door, one that's more seasonally based in terms of their purchase initiatives. And so I wouldn't want to take what happened in Q2 and necessarily extrapolate that as exactly the proxy for what we'll see in Q3 and Q4.

[Carl Rubin:]

But just to add one more comment, Matt, its part of the reason we do feel more confident, consciously more confident about comps accelerate in the back half. We do speak to a broader set of customers. We are going to step up our marketing as Chuck commented on and we feel really good about the offering that we have being better and bigger and more unique event than we have last year. So, that gives us the greater confidence in the acceleration.

[Matt Fassler:]

And guys, just segue to a quick follow up. You talked about promotional activity increasing. Can you indicate whether that was from your speciality competitors, your broad lines competitors, your online competitors, if it was focused in a given pocket of the competitive set?

[Carl Rubin:]

More so in our big box competitors, our industry-specific competitors.

[Matt Fassler:]

So, when you say big box you don't mean Wal-Mart, Target you might mean without naming names like a Hobby Lobby or something like that?

[Carl Rubin:]

Well, I think you just name names Matt, but I'm not referencing Wal-Mart or Target and we did not see it online.

[Matt Fassler:]

So the craft competitors. Understood. Thank you so much.

[Carl Rubin:]

Thanks, Matt.

[Operator:]

Next questioner is Seth Sigman with Credit Suisse. Please go ahead.

[Seth Sigman:]

Thanks and good morning.

[Carl Rubin:]

Good morning, Seth.

[Seth Sigman:]

I just want to follow up on that last comment about the industry promotional activity. I'm wondering are you seeing any difference in terms of the types of tactics these competitors are using or the magnitude of discounting relative to the past? And then I guess the second piece of that is how are you responding? I think you talked about simplifying the pricing structure to reinforce value. Does that actually mean lowering price selectively across the store?

[Carl Rubin:]

On the first part, we have seen both the depth and frequency of discounting stepped up. And the second point, you know our average price point is $3 for an item, so there are opportunities for us to make it clearer on the value of what we sell everyday, which doesn’t indicate incremental discounting it just means highlighting those price points somewhat clear. So it’s just a minor example. You know $1.99 item sometimes is registered differently to a customer than $2. Examples like that highlighting price points I mentioned in my prepared comments highlighting some value price points in our holiday assortments being a bit deeper on some key items for Christmas and Halloween and calling those out at a price point. Those are things that I am referencing in terms of trying to generate a greater value in presence for the consumer.

[Seth Sigman:]

Okay. Thanks, that’s helpful. And then just anymore color on the fabric opportunity through Hancock and the assets that you have acquired there, in general like what have been the trends in that business? Thanks.

[Carl Rubin:]

You know we are not prepared to get into our plans for that. We just acquired or we just took procession of it literally in the past week or two. You know the fabric business, there’s a lot of movement in that business. You had Hancock fabric which was still a couple of hundred million dollar plus business go out, so that business is shifting somewhere. I don’t think it was aggressively growing business but from what we understand it’s been a relatively stable business that had a lot of ups and downs in terms of competitive sheer play with over the past number of years you have seen Wal-Mart in and Wal-Mart out, we just thought that the Hancock fabric name and the opportunity that potentially expand into the fabric business would be something interesting for us overtime. So we’ll update you more on that as we finalize our plans.

[Seth Sigman:]

Okay. Thanks.

[Operator:]

The next questioner is Peter Keith with Piper Jaffray. Please go ahead.

[Unidentified Analyst:]

Great, thanks. This is actually John [ph] on for Peter. For our first question, just I think last quarter you mentioned there was a $1 billion sourcing opportunity through Lamrite, just say a couple of months in now with that sourcing relationship with China, what’s your visibility on that billion now and do you think there is any risk around that or do you feel more confident about that number?

[Charles Sonsteby:]

So what really said was you know what we source is a $1 billion. So some of that will go through Lamrite West, some of it will still remain with agents. I think we’ve talked a little bit about we’ll always have a hybrid approach where we will be going through our office as well as still utilizing agents as we go forward. So that $1 billion is the total pie [ph] that’s available out there. As we worked into it, we still feel very comfortable that it’s there, in fact you know we’ve been working in earnest standing up the office in China. We’ve begun to put product through there for the starting in really in June or starting to get the Michael’s business ramped up pretty quickly and it’s going very well.

[Unidentified Analyst:]

Okay, great. And then just my follow up. On the 75 stores that you have reset so far you know obviously you feel good enough to move forward to I think you said get to about a 30 odd stores in time for holiday, so I guess are those flexible sections I mean or mostly feature seasonal product, I’m guessing and then you know is there any numbers you can give us as far as what you’ve seen from a sale or [Indiscernible] comp lift in the stores that you have reset?

[Carl Rubin:]

Yes, John. I guess I’ll answer them backwards. So no, we are not going to go into detail on what we saw in terms of numbers, obviously we felt confident enough to push this further into the chain. Now secondly, just to clarify with the additional stores that we are putting in place right now will end at just under 30% of our chain of our Michaels store chain with this set. And to the first comment that you made, yes it’s generally seasonal product but the point of it is and again this is not a new concept this is very common across retail. It’s showing the customers what’s new. So at Christmas it is seasonal, Halloween it is seasonal, but we have some plans as we move into the first part of next year that it’s just highlighting something new to that customer and giving her a reason to traffic the store. So we are quite hopeful about the impact of it. The other side benefit of it that we have talked about multiple times in the past is a challenge for us is the snow flake nature of our stores with all these different lay outs and all these different versions across our 1,200 stores, this does not erase those snowflakes, but it does help reduce them. So that’s another side benefit that operationally we believe is attractive. So we have high hopes, obviously when we talk to you again in December you know we’ll be able to provide more light on it.

[Unidentified Analyst:]

Great, thanks a lot. Good luck in the second half.

[Carl Rubin:]

Thanks, John.

[Kiley Rawlins:]

William, I think we have time for one more question please.

[Operator:]

Perfect. Our final question will come from David Magee with SunTrust. Please go ahead sir.

[David Magee:]

Hi everybody, good morning.

[Carl Rubin:]

Good morning.

[David Magee:]

Carl, you mentioned that the coloring for adults trend has matured. I’m curious what might be stepping up in its place and how important is that, is there something to step up in the second half?

[Charles Sonsteby:]

Yes, you know trend business is ebb and flow, and every turn business has it. So coloring is still -- and Q2 was still a very good business for us it just, it slowed a little bit more than we had hoped it would and we start to anniversary it in now the second half of the year. There were lots of other things that you know have the potential of contributing upside to us, you know yarn we are seeing some nice traction in yarn right now that’s happening. You know some of the things that we mentioned in our prepared comments, you know planners the old fashioned planner that people would walk around and write all their appointments on we are seeing a very nice resurgence in that because now it’s almost a cross section of operational need of planning your life and the creativity of scrap booking because people personalize these planners. So we are quite excited about that as a prospect and you know we have the biggest and the best assortment in the industry in that space. So you know this type of business is one that you always have to be very eyes open and watching what’s happening out there and you know coloring is just as we said it’s maturing a bit faster but there are some other things we are excited about in the second half and we are in good position right now and we stand poised to try to maximize it if they can grow to be what we hope them to be. But all of that again, when you look at our guidance for the rest of the year you know our best assumptions around both coloring as well as some of these other trends are factored in.

[David Magee:]

Well thank you Chuck and just a quick follow up like -- I’ve heard the B2B opportunity is that something that could be accretive as soon as 2017?

[Charles Sonsteby:]

We are excited about B2B. I’m not sure that we have broken out the timing by year but on our next call obviously we are going to give you some more detailed guidance on 2017 were included in that.

[David Magee:]

Great. Thanks and good luck.

[Charles Sonsteby:]

Thank you.

[Carl Rubin:]

All right. With that, let me thank everyone for participating in our call today. I would remind you that we are the market leader in our industry and our teams are working hard to strengthen that leadership position and further drive market share with all of our customer focussed initiatives. We do feel very good about our plans for the rest of 2016 and we remain confident that our strategy, our Vision 2020 strategy which guides our operational and financial decisions will allow us to address consumer demand, take advantage of the strength of our balance sheet and strong cash flows and create additional share holder value. Again, thanks everyone for joining us today and we look forward to sharing our third quarter results with you in early December.

[Operator:]

The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect your lines.