Michaels Companies Inc
Q4 2016 Earnings Call Transcript

Published: 7 Mar 2017

[Operator:]

Good morning. My name is Anita and I will be your conference operator today. At this time, we'd like to welcome everyone to The Michaels Companies Fourth Quarter and FY '16 Earnings Conference Call. [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 begin the conference.

[Kiley Rawlins:]

Thank you, Anita. Good morning, everyone and thank you for joining us today. Earlier this morning, we released our financial results for the fourth quarter and full year of FY '16. 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 statement 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, March 7, 2017. 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 diluted earnings per share. Adjusted operating income, adjusted net income and adjusted diluted earnings per share have been presented to reflect our view of our ongoing operations by adjusting for losses on early extinguishments of debt, nonrecurring inventory-related purchase accounting adjustments and nonrecurring integration costs 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, Denise Paulonis, CFO, will review our financial results and outlook in more detail. Following our prepared remarks, we will open the call for questions. As this is our year-end call, our prepared comments will be longer than usual. To help us accommodate as many questions as possible, we would appreciate it if you could limit yourself to one question and then requeue for any follow-up questions. I'll now turn the call over to Chuck Rubin. Chuck?

[Chuck Rubin:]

Thanks, Kiley and good morning, everyone. I want to start this morning with a review of our Q4 results, share some key accomplishments and learnings from 2016 and then discuss our priorities for 2017. This morning, we reported fourth quarter results which were within the guidance we provided on our last call. Total sales increased 4.1%, comp store sales decreased 1% and adjusted diluted EPS increased to $0.96. As we have discussed on previous calls, we're the only public Company in the arts and crafts space and it is difficult to get a precise sense of real-time market trends. However, aggregating independent third-party data, we believe we continued to increase our market share within the arts and crafts retail industry. While our results were not as strong as we would have liked, we believe our trend-right assortment, combined with our recently launched loyalty program and our investments in marketing delivered industry-leading performance. As we shared on our last call, we saw a nice improvement in sales trends following the election as well as good Black Friday results. However, as the holiday season progressed, we experienced some softness in mid-December, including a larger than normal negative weather impact over two key selling weekends before sales strengthened closer to Christmas. This tendency to shop closer to key events is a trend we've seen more of in 2016 and does not seem to be unique to Michaels. From a category perspective, our seasonal assortment, including an expanded selection of Christmas ornaments, trees and decor, delivered very healthy positive comps and our trend-right merchandise, including planners, Washi Tape and Cricut, sold well. Additionally, e-commerce, while still a very small part of our business, delivered very strong double-digit sales growth. But, Q4 also had challenges. Custom framing, bakeware and ready-made frames were soft and last year's coloring trend was a bigger headwind than we anticipated. In terms of the promotional environment, we saw competitors continue to be very aggressive. At Michaels, we invested in additional promotions to grow market share, as we discussed on our last call. Some of these efforts were successful, but some weren't as effective as desired. Our data analytics around department and customer performance has revealed some key learnings which we will apply in 2017 to be more targeted in our promotional execution. For the year, total net sales increased 5.8%. Comparable sales declined slightly and adjusted diluted EPS grew to $1.88. We did not achieve all of our financial goals. However, I am pleased our team made meaningful progress in pursuit of our Vision 20/20 strategy which is our long term plan to increase market share and deliver shareholder value. In 2016, we improved the shopability of our stores with stronger, more consistent store operating standards and our customers noticed, giving us higher scores across all of our customer service measures. We made our stores more experiential with new free classes and more engaging in-store events for kids and families. More than 1 million customers enjoyed the experience of making something in a Michaels store in 2016. This was a 34% increase compared to 2015 and yet we believe we have only scratched the surface of this opportunity. We expanded and enhanced our merchandise offering, identifying and aggressively chasing new trends, like planners and Washi Tape, expanding the breadth and depth of our seasonal assortment and increasing our selection of quality private brands which grew to $2.8 billion of revenue or 57% of our total sales. We introduced our new loyalty program, Michaels Rewards in the United States and customer response significantly exceeded our initial expectations. The launch has expanded our foundation of customer data and has provided new insights, especially for our cash paying customers which historically have represented a disproportionately high amount of our transactions. I am pleased to report we ended the year with around 14 million Michaels Rewards members, more than double our initial target. We launched a fully integrated brand campaign across both traditional and new media which increased overall brand awareness while also positioning Michaels in a more contemporary light. We acquired and integrated Lamrite West, the owner/operator of Darice, an international wholesale company and Pat Catan's Stores, a retail supplier of arts and crafts in Ohio and surrounding states. And finally, even with lower than planned top-line growth, we increased free cash flow from $380 million in 2015 to $450 million in 2016. And we delivered long term value to shareholders through the refinancing of our debt obligations and the repurchases of almost 22 million of our outstanding shares through the first quarter of 2017 which will drive free cash flow per share even higher in 2017. In addition to these accomplishments, we also had some important learnings. First, we know value has grown in importance for retail customers. Last quarter, we expanded our everyday value program which had previously been launched in Canada, to all U.S. stores. Targeting a select number of items, this program shouts strong whole-dollar price points to showcase the everyday value we offer in crafting basics, like mason jars, glue guns and foam brushes. Customers do not have to wait for a sale on these core items and in fact, these products are excluded from our high/low promotions. We're very pleased with the initial customer response and have identified opportunities to make a more impactful statement to the customer in 2017. Second, we've learned our customers need more time to acclimate to major store layout changes. This year, we completed layout changes in 280 stores in addition to the 70 stores we completed in January of 2016, creating what we call flexible merchandising space in the front of the store to present more cohesive seasonal statements to customers. As expected, this new layout delivered strong sales of seasonal product. But we underestimated the rate at which the inventory would sell through and this resulted in sporadic seasonal out-of-stocks and, we believe, missed sales opportunities. Additionally, these layouts were more disruptive to core basic categories than expected. Because we made very few adjustments to our core assortments, the disruption, we believe, was due to customers acclimating to the new location of these core items throughout the store. Going forward, we're allocating and flowing more seasonal inventory to better represent these seasonal stores. We will also selectively add payroll, refresh signage and leverage technology to enhance way finding to improve sales in core basic categories. We continue to believe the creation of this flexible merchandising space is the right decision to drive overall sales productivity, but we want more time to learn and improve before we make additional changes in additional stores. Finally, as our loyalty program has ramped up, we have accumulated more detailed customer and transaction data which is providing new insights. We're expanding our data analytics capabilities and have learned more about the differences between new customer and existing customer behavior. In Q4, we saw good sales growth from our core customers. However, sales from new customers were down, reflecting the strength of 2015's coloring trend which drew new customers into our stores. We believe that much of the volatility we saw in 2016 was related to the challenge of retaining these new customers. We have developed market-leading capabilities to identify and chase trends, but not all trends are created equal. Some trends, like last year's coloring trend, are universal and have broad appeal. Other trends, like planners and Caron Cakes Yarn, are more specific and appeal to a more narrow range of core customers. Hot universal trends can cause some volatility in our year-over-year comp results. However, economically, it makes great sense from both a margin and cash generation standpoint for us to harvest the goodness of these trends, even though as we have seen with coloring this past year, they can be tough to anniversary. Looking forward in 2017, we're investing in a number of key initiatives intended to increase our appeal to new customers, while also expanding our share with existing core customers. We believe these efforts will enhance our competitive positioning while generating higher free cash flow and sales, operating income and EPS growth. We will strengthen our omni-channel offering, expanding our e-commerce platform and connecting it with the in-store experience to drive increased conversion and a larger basket. Since launching e-commerce in 2014, we have learned much about how customers use online search and purchases to support their personalization and making needs. The tactile nature of the product, the general lack of national brands and a low average item price make it unlikely that e-commerce will grow to be the double-digit penetration of sales as it is for most other retail formats. However, we believe online will be an important complement to the brick and mortar experience and could ultimately grow to be in the mid- to upper-single-digit range of our total sales. Given our very small sales penetration today, this is an attractive sales growth opportunity for us. To support the growth of our e-commerce business, we will expand our online assortment in 2017 to include the vast majority of our in-store assortment and we will introduce ship from store which will reduce the cost of shipping and increase product availability. We're also making investments to improve our online search capabilities and provide visibility to in-store product. This visibility will allow us to introduce buy online, pick up in store functionality which will make it easier for customers to get what they want when they need it. And we're investing in new mobile applications for customers and our own team members with new store-specific online product search and in-store way finding which is intended to help address the number one customer complaint in an arts and crafts retailer which is specifically, where do I find the product I'm looking for? The new apps will also integrate product, information including in-stocks, reviews and product specifications as well as online and in-store project support. These enhancements will help new and existing customers complete their projects more easily. We're also making a number of investments this year to improve and differentiate the customer shopping experience in stores. Project and educational opportunities are important enablers to give new customers more confidence to move of from inspiration to action. To that end, we're strengthening our online education efforts and I am pleased to announce a new exclusive partnership with Craftsy, the leader in online craft education with more than 1,300 top quality online courses across multiple categories. Not only will we offer Craftsy courses to our customers, but we will integrate supply lists and project kits with the Craftsy courses, making it easier for customers to purchase everything they need for their project or course directly from Michaels. Our Craftsy partnership will complement our in-store education program. As I mentioned, in 2016, more than 1 million people participated in an in-store event or class at Michaels. This was a significant increase over 2015 and reflects our efforts to engage and connect with customers while also reinforcing the importance of brick and mortar in this industry. Building on our success this past year, we will expand our in-store offering of free, trend-relevant project classes, while also offering paid classes for the more advanced maker who is interested in perfecting their skills. We will also host more in-store events for kids and families to create opportunities for both new and existing customers to share memorable moments of making together. This year we will upgrade our POS system in all U.S. stores which will offer customers a faster checkout experience. This new system will also provide us with the foundation to test new promotional capabilities to allow us to better target our discount dollars. We will continue to refresh the fleet through facility upgrades, relocations and new stores. Based on our internal market analysis, we continue to believe the U.S. and Canadian markets can support somewhere between 1,400 and 1,500 Michaels stores. Today, we operate 1,223 Michaels stores and notably, virtually every store is profitable. Given our current penetration and disciplined return requirements, store growth will likely continue to naturally slow. And in FY '17, we plan to open 17 new Michaels stores and relocate 13 existing Michaels stores into better locations. As we invest to improve the customer shopping experience, we will also continue to leverage our size and scale to offer customers newness, exclusivity and trend. Already this year we partnered with Elmer's Glue to make Michaels the ultimate Slime headquarters and we've just launched Morph, the latest trend in fun compounds for kids. Leveraging the capabilities of the Darice product development team, we're also launching a number of exciting exclusive product lines this year. Next month, we will launch Disney Family Crafts, a new crafts program exclusive to Michaels featuring characters like Mickey, Dory, Elsa and Cinderella. I'm also pleased to announce a new exclusive collaboration with Martha Stewart. Today, we're the largest supplier for Martha craft paint and now, through the successful efforts of our Darice team, we have the exclusive development and distribution rights for all Martha Stewart Crafts. With plans to begin introducing the new line in stores this fall, our Darice team is working closely with Martha to bring her brand to life in a number of new categories which we believe her loyal fans will enjoy as well as new fans who have gotten to know her through her more recent projects, such as her TV show with Snoop Dogg. This exclusive partnership will position us to offer new and existing customers a broader assortment, better values and more targeted distribution than before. We will also improve the value we offer with the expansion of our everyday value program, increased use of strong even dollar price points and enhanced in-store branding and presentation. We'll make additional investments in our loyalty program to expand membership, increase our analytical capabilities and drive transaction growth. Although the program has existed for less than a year, we have seen increased productivity from rewards members in terms of units per transaction and total sales. Today, Michaels Reward members account for about 45% of our total sales. Our goal is to increase this penetration during 2017. Although the arts and crafts industry is characterized by low trip frequency, the improved data our Michaels Rewards program contains will enhance our CRM capabilities and help us tailor our promotions and customer communications more effectively over time. As the market leader, we can use our strength to build brand awareness, a competitive advantage that cannot be easily replicated in our segment. The launch of our Integrated Make campaign in Q4 was a big step in this journey. Our investment in television and radio in the fourth quarter resulted in increased ad awareness. Our digital content series that we had in Q4 focused on unexpected celebrity makers and this resulted in more than 1 billion impressions. Finally, our integrations with the television show Good Morning America exceeded expectations in terms of recall, brand lift and purchase consideration. With a stronger focus on urgency and driving trips into the store and online, we will continue to support our Integrated Make campaign with additional television advertising, unique digital content and expanded integrations with Good Morning America. Even as we focus on growing revenues, we're also investing to support operating margins. It is critical that we continuously look for ways to leverage our size and scale to identify cost savings which can be reinvested into growth initiatives or flowed through to our bottom line. With billions of dollars of merchandise purchases each year, sourcing is a significant savings opportunity and we're attacking the opportunity on two fronts. First, in Q4 2015, we launched a strategic sourcing project to reduce our product acquisition costs. In an industry with new recognizable national brands, our private brands are often the highest sales brand within that category. This competitive advantage has been significant in driving higher margins over the past number of years. Taking a total cost of ownership approach, we identified opportunities to lower first costs without sacrificing quality for the customer. Given the long lead times and slow turn nature of this business, it will take time to cycle through the benefit of any cost reductions. But we're beginning to see tangible results from this work. These efforts provided about $12 million in savings in Q4 and we expect to see more P&L benefit in 2017 and 2018. Second, we're investing in our global sourcing capabilities. In FY '16, we directly imported a little more than $1 billion in receipts. Historically, we have leveraged primarily third-party agents to support our global sourcing efforts. The expansion of our Darice global sourcing team will give us an opportunity to increase the percentage of goods which we procure directly from factories, giving us greater control over the purchase cycle and providing us with the opportunity to lower product costs and increase our speed to market, while maintaining or even improving, quality. We do not expect to fully convert to a wholly owned sourcing process and instead plan to utilize a hybrid sourcing model which will include sourcing product directly from factories, using third-party sourcing agents to procure some merchandise and buying other goods from the branded market. Additionally, we will continue our fuel for growth efforts with an increased focus on process simplification in our store operations, merchandising and supply chain groups as we look to eliminate non-value-added work that needlessly burdens our store teams and prevents them from focusing on serving our customers better. Finally, in closing, I want to reiterate my confidence in the long term opportunity for the Michaels Companies. We're the undisputed leader in a stable channel and operate a business model which generates a retail industry-leading operating margins and cash flows. With a more inclusive and experiential shopping experience online and in-stores, with more trend-right and exclusive products and with more targeted and impactful mass marketing, we believe we can continue to leverage our leadership position, buying power and industry leading profitability and free cash flow generation to further increase our market share and drive attractive shareholder returns. Now, let me turn the call over to Denise for a more detailed discussion of our financial performance. Denise?

[Denise Paulonis:]

Thanks, Chuck and good morning, everyone. As Chuck mentioned earlier, from a financial perspective, our fourth quarter results were in line with the guidance we provided in early December. Our fourth quarter total sales increased 4.1% to $1.75 billion, up from $1.68 billion last year. The increase in total sales was due to $60 million in sales from the acquisition of Lamrite West and $25 million in sales related to the operation of 19 net additional stores during the period. For the quarter, comparable store sales decreased 1%. Although average ticket increased, the improvement was more than offset by a decline in customer transaction. Regionally, our Canadian operations continued to outperform U.S. markets and delivered a positive 3% comp in the quarter on a constant dollar basis. Earlier holiday set dates, strong sell-through of seasonal merchandise and the maturation of our everyday value program contributed to our strong performance in Canada. Though we're not satisfied with our comp performance, we're encouraged by the improvement from the third quarter and believe our comp for the quarter would have been positive but for the impact of last year's coloring trend. During the quarter, we opened two new Michaels stores and one Aaron Brothers store and closed four Aaron Brothers stores. At the end of the quarter, our total store count for all brands was 1,367 stores. Gross profit dollars for the quarter increased 2.6% to $706 million. As a percentage of sales, our gross profit rate for the quarter was 40.3% versus 40.9% last year, a decrease of about 60 basis points. As context, the gross profit rate, excluding the impact of Lamrite West, deleveraged by about 15 basis points. As expected, we realized $12 million in savings in the fourth quarter from the sourcing benefits we have discussed on previous calls. And we continue to expect these savings will increase as we move through FY '17. We also saw a benefit this quarter resulting from less clearance activity as well as less pressure on rate from sales mix. This year in Q4, we sold fewer coloring books which have a below-average margin rate than the rest of the store. These benefits were offset by two choices we made in the quarter. First, following two weather challenged weekends in mid-December, we went deeper on seasonal promotions to ensure we would end the year in a clean inventory position. Second, as we shared on the last call, as the leader in the industry, we can invest to take share. In Q4, we chose to invest in additional promotions to see how our customer would respond. We had some wins and some misses and importantly, we learned a lot. As we look ahead, while we might not invest to the same degree as what we did in Q4, we do see benefit in using unique offers to spur our customers to action and we will continue to have this as a tool in our tool kit, with the goal of increasing gross margin dollars. Total store rent expense for the quarter was $98 million versus $93 million last year, with the increase due to a net 54 additional stores, including 35 Pat Catan's stores. SG&A expense, including store pre-opening costs, increased 1.6% to $369 million or 21.1% of sales. This is up from $363 million or 21.6% of sales last year. The increase in SG&A was primarily due to $18 million associated with the acquisition of Lamrite West. Excluding the impact of Lamrite West, SG&A expense, including store pre-opening cost, decreased by $12 million. Reflecting our pay for performance culture, this decrease was due to a $28 million decrease in performance-based incentive compensation which more than offset an increase in personnel and benefits related costs, higher marketing expense and additional expenses associated with the operation of 19 net additional stores. For the quarter, operating income was $337 million or 19.2% of sales, compared to $324 million or 19.3% of sales, in the fourth quarter of FY '15. Excluding about $900,000 in nonrecurring inventory related purchase accounting adjustments and integration expense related to Lamrite West, adjusted operating income as a percent of sales of 9.3%, flat with the fourth quarter of FY '15. Interest expense was $31 million in the fourth quarter, down from $33 million in the fourth quarter last year. This decrease was due to the voluntary principal payment of $150 million on our term debt in December 2015 as well as interest savings from the refinancing of our asset-based lending facility and our term loan credit facility this year. The effective tax rate for Q4 this year was 36.2%, flat with Q4 last year. For the quarter, net income increased 6.3% to $195 million or 11.2% of sales, from $184 million or 10.9% of sales, last year. Excluding nonrecurring inventory-related purchase accounting adjustments and integration expenses associated with the acquisition of Lamrite West, adjusted net income for the quarter was $196 million or 11.2% of sales. For the full year, net sales increased 5.8% to $5.2 billion, including $232 million in sales from the acquisition of Lamrite West. Comp sales for the full year decreased 5.5%. For the full year, operating income was $715 million or 13.8% of sales, compared to $721 million or 14.7% of sales, last year. Excluding nonrecurring inventory-related purchase accounting adjustments and integration expenses associated with the acquisition of Lamrite West, adjusted operating income was $727 million or 14% of net sales. Finally, net income for the year increased 4.2% to $378 million or $1.82 per diluted common share, compared to $363 million or $1.72 per diluted common share, in FY '15. Excluding nonrecurring inventory-related purchase accounting adjustments, integration expenses associated with the acquisition of Lamrite West and losses on early extinguishment of debt and refinancing costs, adjusted net income for FY '16 was $390 million or $1.88 per diluted common share. As expected, the impact of our acquisition of Lamrite West, excluding purchase accounting adjustments and integration expenses, was slightly accretive to dilutive earnings per share in FY '16. Now turning to the balance sheet, total merchandise inventory was $1.1 billion, up $125 million or 12.5%, from the end of 2015. The increase in total inventory included $92 million in additional inventory related to the acquisition of Lamrite West and approximately $15 million in additional inventory related to the operation of 19 net additional stores. Average inventory for Michaels Store, including e-commerce and distribution centers, at the end of 2016 was 1.6% higher than at year end last year. This modest increase reflects additional inventory to support our core business, including improving in-stock presentation and supporting key paper crafting programs, including planners, Washi Tape and Cricut. Our liquidity position remains strong and our 2016 work has removed any short term refinancing risk. At the end of the year, cash on the balance sheet was $299 million, total debt was $2.8 billion and our revolver availability was $736 million. Total debt to adjusted EBITDA remained flat with 2015 at 3.2 times, a very manageable level. Historically, we have consistently generated strong free cash flow, defined as cash flow from operations less capital expenditures and FY '16 was no different. For the full year, we generated free cash flow of $450 million compared to $380 million in FY '15. Cash capital expenditures for FY '16 were $114 million. We continued to utilize our strong cash flow and balance sheet to return value to shareholders by managing our debt obligations and opportunistically repurchasing shares. In 2016, we successfully refinanced our asset-based lending facility and amended our term loan credit facility. As a result of these initiatives and the voluntary prepayment of $150 million on our term loan facility in Q4 of 2015, we saw about $13 million of interest expense savings for the year. In addition, we purchased about 17 million shares of our common stock last year for approximately $401 million. At the end of the year, we had approximately $99 million left under the current repurchase authorization. As we called out in our earnings release, since the year ended, we have repurchased an additional 4.8 million shares for about $99 million, fully utilizing the remaining availability under our share repurchase program. As we look forward to FY '17, we believe uncertainty in the retail climate will likely continue. In addition, we expect we will continue to face headwinds in the first half of the year from coloring. We believe trends will improve as we move into the second half as we anniversary the distraction of the 2016 election and the sales disruption caused by the implementation of flexible merchandising space in 280 stores in the third quarter. For FY '17 which is a 53-week year, we're planning for total sales to increase between 2.5% and 4% and for comp store sales to be flat to up 1.5%. The impact of the 53rd week, a non-comp week, is planned to be approximately $80 million in sales. Additionally, this guidance reflects opening 19 new Michaels stores and one new Pat Catan's store, the relocation of 13 Michaels stores and closing up to 10 Aaron Brothers stores. Operating income for the year is the expected to be $725 million and $760 million. Our guidance for operating income includes approximately $40 million to $50 million in sourcing benefits that will enable incremental investments in marketing and the other initiatives Chuck shared a few minutes ago and the impact of anniversarying the $46 million decrease in performance-based compensation in 2016. Of note, the mid-point of our guidance implies an operating margin rate that is approximately flat to last year inclusive of the performance-based compensation lap and the incremental investments. We expect interest expense to be approximately $131 million, reflecting ongoing benefit from the refinancing of our ABL in May of this year and the successful amendment of our term loan credit facility in September. This expectation assumes two rate increases in the year and that LIBOR crossing over our floor rate of 1% will cost us around $3 million in 2017. Also remember, we have to pay for a 53rd week of interest expense this year. Our earnings outlook assumes an effective tax rate for the full year between 34% and 35%. These assumptions translate to a fully diluted EPS range of $2.05 to $2.17 for FY '17 on approximately 189 million diluted weighted average common shares for the full year. Our outlook includes repurchases already completed in Q1 2017. Finally, we expect capital expenditures for 2017 will be between $125 million and $135 million reflecting our planned POS upgrade and other technology investments. Turning to Q1, we anticipate comp store sales will be flat to down 1%. This guidance includes the impact of weather disruption we saw in early February, lapping the coloring trend from Q1 last year and an expectation that a majority of our sales growth will come later in the quarter due to a later Easter. We plan to open three new Michaels stores, relocate eight Michaels stores and close up to six Aaron Brothers stores in the quarter. We expect operating income for the quarter to be between $141 million and $147 million. This expectation reflects that the positive impact of sourcing benefits will be more than offset by modest occupancy deleverage resulting from tough comps and the impact of anniversarying a $4 million benefit in the first quarter of 2016 from insurance reimbursements related to our 2014 data breach. Additionally, as Chuck mentioned, we plan to invest in incremental marketing efforts this quarter. The Q1 guidance for fully diluted earnings per common share is $0.38 to $0.40, assuming a diluted weighted average common share count of 189 million shares. One housekeeping note. New accounting requirements related to the tax impact of share-based compensation, specifically ASU2016-09 will be effective for us beginning in the first quarter. Under the old accounting methodology, the tax impact from the gains employees have on equity awards was recognized on the balance sheet in shareholders' equity. Going forward, this tax impact will be recognized in the income tax expense on the income statement. Given we can't precisely forecast the future stock price, this accounting requirement could result in some volatility in our income tax expense. Our intent going forward is to specifically call out this impact as we report results. As we enter 2017, we remain committed to delivering shareholder value through net income growth, strong cash flow generation and disciplined capital deployment. Before we take your questions, I want to announce that we plan to host an analyst day in Boston on June 15. We will share more detail with you as we get closer to the date. Now, I would like to open up the call to take your questions. Operator?

[Operator:]

[Operator Instructions]. Our first question comes from Steven Forbes with Guggenheim Securities. Please go ahead.

[Steven Forbes:]

Maybe just to start, you spoke about the fact that you gained market share from the data that you have despite the negative comp here. Can you just expand on what you're seeing in the marketplace today and how you view the competitive landscape across your various peer groups, e-commerce players, mass merchants, specialty guys. The last part of that question and maybe most importantly, as we think about next year, you called out custom framing as a headwind and I think it's been a headwind for a little while here. What's built into the assumption, the top-line assumption for next year as it relates to custom framing?

[Chuck Rubin:]

So a few points. Remember, our total sales grew. Our comps were slightly down. What we have seen from credit card data is that the industry - that we gained share. That the numbers that we put out look much better actually than all of our big box competitors. As you know, there's no - we're the only public Company. There's no great industry data that's real-time in its reporting so the best that we have is this credit card information and triangulating some other data. We're highly confident that we gained good share in the industry. As far as the e-com players that are out there, we remain pretty consistent that e-commerce is a nice add-on to this business, but it's not a game changer like it is in so many other businesses, given the nature of what there is. We're excited about the growth that we're seeing in our e-commerce business, it's still very small and, even at its peak, we still think it's, as a percentage of our overall revenue, lower than other industries would be finding in e-commerce sales, but it's still over the long term, hundreds of millions of dollars of opportunity for us. Today, there's a lot of interesting things going on from a marketing standpoint. We don't see great revenue going through any of these other e-commerce-only channels. As far as the custom frame question, we have planned custom frame this year to perform worse than the overall box, but better than our performance in 2016. I will tell you that so far, we're seeing some encouragement that we have hit the bottom. But it's still early in the New Year on that.

[Operator:]

Our next question comes from Seth Sigman with Credit Suisse. Please go ahead.

[Seth Sigman:]

My question is really around pricing. You've discussed industry promotional activity for a few quarters now. You've also discussed, in this quarter, how some of your own efforts were maybe not as effective as you hoped. What do you think has changed that's made the consumer more price sensitive in this relatively low ticket category? And then as you think about 2017, where do you think your pricing and value proposition needs to go? And does it mean that gross margin will be down again in 2017 or do you think that you can fully offset that with that $40 million to $50 million sourcing benefit?

[Chuck Rubin:]

Let me start with the second part. We're really pleased with the sourcing effort that we have and we talked some about it today and we'll talk more about it in June at the investor day. We think that gives us an asset that our competitors don't have. It's a big bucket of money that we can invest in our business or take to the bottom line. So we think that value is paramount to our customer. This industry always has had value as a key orientation. We're pleased with this everyday value program that we've introduced where customers don't want to wait for a sale, they just want a good, sharp price on core items like glue guns and tape and such. As far as the price sensitivity on customers, we found that customers are surprisingly sensitive on pricing, in a low ticket item, you would think that sometimes that they would be less so, we have not found that to be the case. I'm not sure that we're seeing a lot of change in the customer interest. What we saw in 2016 is a lot of big box competitors stepping up their promotions to a level that we believe was irrational. So what we said in our prepared comments is some of what we did in the fourth quarter, we were pleased with and some of it we weren't. And that's all baked into the consideration in 2017 and we'll be more targeted and more focused in what we do. When we said during the third quarter call that we were going to step up our promotion, at that time, we said we're not going to blindly follow this, that we would be smart about what we're running and analyze the results and have that affect what we do going forward and that's what we just talked about this morning. That's the intent.

[Operator:]

Our next question comes from Simeon Gutman with Morgan Stanley. Please go ahead.

[Simeon Gutman:]

I guess I want to follow on a similar topic because in 2016, the business slowed. You did have tough compares and we all know that the competitive environment got more difficult. It looks like next year, you're sort of holding the line on margin. You're investing, but you're also putting some of the savings you're getting back into the business. Along the lines of what's changing, how do you know it's - like if it was more competitive environment versus some of those tough compares that you were seeing, do you feel like the flow-through rate of the business in a normalized competitive environment is the same? Any color on that.

[Denise Paulonis:]

So, Simeon, let me jump in just with a bit of color on the shape of the P&L. When you think about what we talked about for 2017, a key benefit that we have that we're able to use to our advantage is the expectation of $40 million to $50 million in benefit from the sourcing savings. When we got to a flat operating margin at kind of the midpoint of our guidance, that was including covering lapping our performance-based compensation of $46 million of give-back in 2016. It also is going to cover and be part of what will cover some of the incremental investment that Chuck discussed. Net, if you took out that lapping of performance-based compensation, we'd say we would still have a nice flow-through in the business. That will be managed as we go through quarter-by quarter as we watch what happens with our competition, how they are acting promotionally and what we believe we need to do to continue to take share. So, while we do have a sense of understanding and in a better way than we had before about what might be going on in the marketplace, we always have to be a bit dynamic in adjusting our strategy as we go forward as well.

[Operator:]

Our next question comes from Matt Fassler with Goldman Sachs. Please go ahead.

[Matt Fassler:]

My question relates to capital allocation. Really in the past several months, you've gunned the buyback including what you've done year-to-date. Can you talk about whether the Board would consider another authorization? I know you've exhausted the outstanding one. Your general thoughts on capital allocation from here and just update us your thinking on leverage targets, please.

[Chuck Rubin:]

Well, a few points. Denise mentioned we're just over three times on our leverage and we're generally comfortable with that point at this stage. Capital allocation, as we've had this discussion on numerous calls, is a frequent discussion amongst the Board. At the stock price that we've been trading at for the past number of months, we believe that was an incredibly attractive value and that's why we were aggressive on purchasing our own stock. We know we have terrific cash flow, even in a year where our sales disappointed our internal plan, we still generated, give or take, $80 million of additional cash flow year-over-year. So, we know we have a lot of opportunities to use that cash, whether it's investing in the business, buying back shares, paying down debt or at some point instituting a dividend. I will tell you that we have a Board meeting coming up in April. Again, this will be a significant topic on that and I know we will be talking about this in June at our investor day.

[Operator:]

Our next question comes from Peter Keith with Piper Jaffray. Please go ahead.

[Peter Keith:]

So with the Canadian business was comping up 3%, it looks like the gap is widening between your Canadian and U.S. business. And I was curious if you think it's just the direct reflection of the competitive environment or if there's some of the coloring book trend that maybe wasn't as meaningful up there.

[Chuck Rubin:]

Well, a couple of things. The competitive environment up there is more rational than it has been in the U.S. and the Canadians didn't have an election that was a major distraction. Coloring was a factor up in Canada. I think we said in our prepared comments, minus coloring, we had a positive comp in the fourth quarter. So Canada, no election, a more rational marketplace competitively, they've been in this everyday value program longer than the U.S. has been, so that also gives us confidence in the potential for some of those programs or the EDV program in particular, in the U.S..

[Operator:]

Our next question comes from David Magee with SunTrust. Please go ahead.

[David Magee:]

My question has to do with the marketing, just asking about the level of expenditures for the year versus last year. And maybe as a quick follow-on, just how do you feel like the effectiveness is now with regard to younger consumers as to how you go to market now? Thank you.

[Chuck Rubin:]

Well, I'll take the second one. On the younger consumer, we're really happy with some of the progress that we're making. A lot of these things have long lead times to realizing the benefit, but when you look at just what we did in the fourth quarter with this Make campaign, we had, we created a bunch of digital videos with these unexpected celebrities, Snoop Dogg is one of our favorites where we have these make-off competitions that had just tremendous viewership online. We were pleased with the integration that we did with Good Morning America and, in fact, we're continuing that. I think our first one for the season is this week, it's occurring. Our digital outreach, whether it's social media or digital marketing, continue to expand extensively. Some of these free classes and now with the Craftsy partnership that we have just announced, we think that those welcome in a whole range of customers that maybe have previously thought of arts and crafts or Michaels as a bit of an old fogey kind of store. All of these are contributing to changing the perception of the Company. We wish that some of these things would kick in a little bit faster, but we know that, like any other business, some of these brand building efforts are going to take some time. But we're confident that, we continue to make some tweaks, but we're confident that the long term investments we're making are the right ones.

[David Magee:]

And just the level of cost this year?

[Denise Paulonis:]

Right now, we're expecting to be up modestly. That increase is going to happen primarily earlier in the year. As we had mentioned already, we had shifted some of our spend and increased our spend in the fourth quarter of last year, so we don't expect the fourth quarter of this year to be materially changed from 2016.

[Chuck Rubin:]

Just adding a little bit of color to that. Historically, the second quarter for our Company is a low-volume quarter and, at this point, we're not looking at stepping up a lot of marketing spend because it's proven to be a, just based on the seasonality of the second quarter, it's just proven to be a tough quarter to get a lot of payback on any incremental investments.

[Operator:]

[Operator Instructions]. Our next question comes from Denise Chai with Bank of America Merrill Lynch. Please go ahead.

[Denise Chai:]

I had a question about your in-store classes. You said that you saw great growth there in terms of the number of people who participated in those. What are you seeing in terms of the mix of core as opposed to new customers? And in relation to that, what do you see in terms of conversion and perhaps traffic? You did mention that you're just scratching the surface with this, so if you could elaborate there a little bit more too, please.

[Chuck Rubin:]

A lot there. So, in terms of new and core, I think it's sometimes tough to read that. What we're seeing is that we've had great progress across most of our categories of classes that we've offered. But probably the - maybe partly because some of the most fun ones, but the ones that address kids, we've seen tremendous improvement. You're getting a younger shopper. You're getting, quite often, a younger kid with a younger parent that comes in. We're really pleased with that. The conversion is really good because the class is free and, quite often, we provide some of the core supplies. But there's still products that the customer has to buy to participate in the class. And it's a way for kids to get their nose out of digital, their phones and their iPads, et cetera and actually engage in something that's a lot of fun. So when you look at the content of the classes, again, as I said, a lot of them are catered around kids and whether it was coloring or now Slime and this new product that we have called Morph, versus the stereotypical classes that historically we've offered around bakeware and knitting. Those are still part of the mix. But we're seeing a lot more energy on some of these more trend-based, younger targeted kinds of products. And I mentioned that we've scratched the surface because, like anything, there's been a learning curve and customers are starting to get to know this and we're starting to see customers come back more frequently for follow-on classes and we think there were opportunities to expand the frequency of the offering that we have out there. And again, with the Craftsy partnership, we're pleased to be able to offer that online component in a much stronger way than we've been able to do thus far.

[Denise Paulonis:]

Denise, I'd build on that with one other part that, in addition to the classes, we're also emphasizing in-store events which are a little less formal. You don't have to sign up in quite the same way that you would sign up for a class. They are very relevant to what is going on now. They are things that could tie in with some of the work that we're doing with Good Morning America, but also are just ways to get people to have that experience in-store with other people, understand what making is all about, that complements the way we think about classes as well.

[Denise Chai:]

And then my follow-on was actually about the Craftsy partnership. Craftsy offers online classes and they sell materials themselves online. I'm just wondering how you partner with them without competing. If you could elaborate there a little bit, please.

[Chuck Rubin:]

Well, when you really look at the core of what they do and what we do, they're an online educator and we're a retailer. We provide online education as well and they sell some product, but I wouldn't consider those two things each of our respective strengths. I think this is an acknowledgement that, while they sell some product, most of it is very limited in its scope of category. We offer them a whole breadth of range that's much better and much bigger and I think the Craftsy team is excited about that. When you look at their 1,300 course offering and what they can do going forward as well with our backing, we're excited. So I think it's a very good play of their strength complementing our strength and vice versa.

[Denise Chai:]

And is that exclusive?

[Chuck Rubin:]

It is.

[Denise Chai:]

Okay.

[Chuck Rubin:]

Within the retail channel, they have some relationships with a couple of vendors, but within the retail channel, it is exclusive between us and Craftsy.

[Operator:]

Our next question comes from Christina Fernandez with Telsey Advisory Group. Please go ahead.

[Cristina Fernandez:]

I wanted to talk about e-commerce. Today, you talked about online penetration ultimately being mid-single digit to high-single digit. I believe in the past it was just mid-single digit, so it's slightly higher. Can you talk about what you're seeing on your app or online that is leading to this slightly higher forecast?

[Chuck Rubin:]

The view that we have of it is pretty consistent with what we've thought for the past you few years. Couple of points. The Darice acquisition which wasn't part of our viewpoint going forward when we went public a few years ago, that gives us some opportunities to sell B2B which we think is on top of what we had seen for just Michaels, the Michaels stores itself. So that's some of the upside there. When you look at what we do today, our michaels.com, just the michaels.com website, we have a few, but the michaels.com website, has just under 300 million visits a year to that site. Most of it is looking for product information or project ideas, but the idea of being able to convert that and create that omni-channel shopping approach was attractive to us a few years ago and remains just as attractive. So quite honestly, what we're seeing today, minus the Darice change which came a year ago with that acquisition, is pretty consistent with what we had seen before. And we're kind of on the same time line that we thought we would be when we launched it in 2014. And again, I would just stress, in the world of e-commerce, where lots of retailers are facing significant issues against e-commerce and Amazon in particular, this business, we still believe, has a very strong defense given the nature of the business and more than most other retailers, this we believe is truly an omni-channel shopping experience, where brick and mortar has a fundamental role to play. We look at e-commerce as a good augmentation, but not a replacement of our core brick and mortar business.

[Operator:]

This concludes our question-and-answer session. I would like to turn the conference back over to Chuck Rubin, Chairman and CEO, for any closing remarks.

[Chuck Rubin:]

Let me thank you all for joining us today. In closing, I do want to thank all of our team members who worked very hard to support our progress that was made in 2016. While our sales results were not as strong as we would have liked, we did generate earnings growth, strong cash flows and made meaningful progress in pursuit of our long term strategy. As we look to 2017, we do remain focused on expanding our market share and delivering greater value for our customers with a more inclusive and experiential shopping experience, both online and in stores, with more trend-right and exclusive products and more targeted and impactful marketing. As we continue to pursue our Vision 20/20 strategy, we believe we will continue to leverage our size and leadership position to increase our market share and deliver returns to shareholders. Again, thanks to everyone for joining us today and we look forward to talking about our first quarter results with you in June. Thank you.

[Operator:]

This conference has now concluded. Thank you for attending today's presentation. You may now disconnect.