** **

**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON,DC 20549**

 

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**FORM 10-Q**

** **
| **(Mark One)**                                                                                                                                 |
|------------------------------------------------------------------------------------------------------------------------------------------------|
| **x**                                                                                                                                          | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                           |   |
| **For the quarterly period ended November 3,  2007**                                                                                      |
| ** **                                                                                                                                     | ** ** |
| **OR**                                                                                                                                         |
|                                                                                                                                           |   |
| **o**                                                                                                                                          | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| ** **                                                                                                                                     | ** ** |
| **For the transition period from                     to** |

 

**Commissionfile number 001-09338**

 

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**MICHAELSSTORES, INC.**

(Exact name ofregistrant as specified in its charter)

 

| **Delaware**                     | ** ** | **75-1943604**          |
|----------------------------------|------------|-------------------------|
| (State or other  jurisdiction of |       | (I.R.S. employer        |
| incorporation or  organization)  |       | identification  number) |

 

**8000Bent Branch Drive**

**Irving,Texas 75063**

(Address ofprincipal executive offices, including zip code)

 

**(972) 409-1300**

(Registrant’stelephone number, including area code)

 

----

 

Indicate by check markwhether the Registrant: (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the Registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days.   Yes **x****     **No **o**

 

Indicate by check markwhether the Registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large acceleratedfiler **o**     Acceleratedfiler **o**     Non-acceleratedfiler **x**

 

Indicate by check markwhether the Registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).  Yes **o****     **No **x**

 

Indicate the number ofshares outstanding of each of the Registrant’s classes of Common Stock, as ofthe latest practicable date.

 

| **Title**                               | ** ** | **Shares Outstanding as of   December 14, 2007** |
|-----------------------------------------|------------|--------------------------------------------------------------------------------|
| Common Stock,  par value $.10 per share |       | 118,451,736                                                                    |

 

 

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**MICHAELS STORES, INC.**

**FORM 10-Q**

 
|                  | ** ** | **Part I—FINANCIAL INFORMATION**                                                                                                | **3**  |
|------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------|--------|
| **Item 1.** | ** ** | **Financial  Statements**                                                                                                                 | **3**  |
|             |       | Consolidated Balance Sheets at  November 3, 2007, February 3, 2007, and October 28, 2006  (unaudited)                      | **3**  |
|             |       | Consolidated Statements of  Operations for the quarter and nine months ended November 3, 2007 and October 28,  2006 (unaudited) | **4**  |
|             |       | Consolidated Statements of  Cash Flows for the nine months ended November 3, 2007 and  October 28, 2006 (unaudited)             | **5**  |
|             |       | Notes  to Consolidated Financial Statements (unaudited)                                                                                   | **6**  |
| **Item 2.** | ** ** | **Management’s  Discussion and Analysis of Financial Condition and Results of Operations**                                           | **19** |
| **Item 3.** | ** ** | **Quantitative and  Qualitative Disclosures About Market Risk**                                                                           | **27** |
| **Item 4.** | ** ** | **Controls and  Procedures**                                                                                                              | **27** |
| ** **       | ** ** | **Part II—OTHER  INFORMATION**                                                                                                  | **28** |
| **Item 1.** | ** ** | **Legal Proceedings**                                                                                                                     | **28** |
| **Item 6.** | ** ** | **Exhibits**                                                                                                                              | **29** |
| **Signatures**   | ** ** | ** **                                                                                                                                | **30** |

 

2

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**MICHAELS STORES, INC.**

**Part I—FINANCIAL INFORMATION**

 

**Item 1.  FinancialStatements.**

 

**MICHAELSSTORES, INC.**

**CONSOLIDATED BALANCE SHEETS**

**(Inthousands, except share data)**

**(Unaudited)**

 
| ** **                                                                                                              | ** ** | **November 3,   2007** | ** ** | **February 3,   2007** | ** ** | **October 28,   2006** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| **ASSETS**                                                                                                              | ** ** | ** **                       | ** ** | ** **                       | ** ** | ** **                       | ** ** |
| **Current assets:**                                                                                                     |       |                             |       |                             |       |                             |       |
| Cash and equivalents                                                                                                    |       | $                                | 56,676     |                             | $          | 30,098                           |       | $ | 315,249 |   |
| Merchandise inventories                                                                                                 |       | 1,035,129                        |       | 847,529                          |       | 978,901                          |       |
| Prepaid expenses and other                                                                                              |       | 72,794                           |       | 54,435                           |       | 52,425                           |       |
| Deferred income taxes                                                                                                   |       | 35,594                           |       | 35,216                           |       | 36,946                           |       |
| Income tax receivable                                                                                                   |       | 79,186                           |       | 32,902                           |       | —                           |       |
| Total current assets                                                                                                    |       | 1,279,379                        |       | 1,000,180                        |       | 1,383,521                        |       |
| **Property and equipment, at cost**                                                                                     |       | 1,153,596                        |       | 1,122,948                        |       | 1,108,575                        |       |
| Less accumulated depreciation                                                                                           |       | (708,861                         | )          | (674,275                         | )          | (661,611                         | )          |
|                                                                                                                    |       | 444,735                          |       | 448,673                          |       | 446,964                          |       |
| **Goodwill**                                                                                                            |       | 115,839                          |       | 115,839                          |       | 115,839                          |       |
| **Debt issuance costs, net of accumulated  amortization of $17,257 at November 3, 2007 and $4,537 at February 3, 2007** |       | 106,438                          |       | 120,193                          |       | —                           |       |
| **Other assets**                                                                                                        |       | 7,526                            |       | 8,117                            |       | 24,119                           |       |
|                                                                                                                    |       | 229,803                          |       | 244,149                          |       | 139,958                          |       |
| Total assets                                                                                                            |       | $                                | 1,953,917  |                             | $          | 1,693,002                        |       | $ | 1,970,443 |   |
|                                                                                                                    |       |                             |       |                             |       |                             |       |
| **LIABILITIES AND STOCKHOLDERS’  (DEFICIT) EQUITY**                                                                |       |                             |       |                             |       |                             |       |
| **Current liabilities:**                                                                                                |       |                             |       |                             |       |                             |       |
| Accounts payable                                                                                                        |       | $                                | 281,811    |                             | $          | 214,470                          |       | $ | 244,981 |   |
| Accrued interest                                                                                                        |       | 44,748                           |       | 34,551                           |       | 90                               |       |
| Accrued liabilities and other                                                                                           |       | 290,142                          |       | 255,880                          |       | 277,635                          |       |
| Income taxes payable                                                                                                    |       | —                           |       | 7,331                            |       | —                           |       |
| Current portion of long-term debt                                                                                       |       | 444,693                          |       | 229,765                          |       | —                           |       |
| Total current liabilities                                                                                               |       | 1,061,394                        |       | 741,997                          |       | 522,706                          |       |
| **Long-term debt**                                                                                                      |       | 3,736,460                        |       | 3,728,745                        |       | —                           |       |
| **Deferred income taxes**                                                                                               |       | 16,361                           |       | 29,139                           |       | —                           |       |
| **Other long-term liabilities**                                                                                         |       | 81,307                           |       | 68,444                           |       | 90,586                           |       |
| Total long-term liabilities                                                                                             |       | 3,834,128                        |       | 3,826,328                        |       | 90,586                           |       |
|                                                                                                                    |       | 4,895,522                        |       | 4,568,325                        |       | 613,292                          |       |
| **Commitments and contingencies**                                                                                       |       |                             |       |                             |       |                             |       |
| **Stockholders’ (deficit) equity:**                                                                                |       |                             |       |                             |       |                             |       |
| Common Stock, $0.10 par value, 220,000,000 shares authorized;                                                           |       |                             |       |                             |       |                             |       |
| 118,451,736 shares issued and outstanding at November 3, 2007;                                                          |       |                             |       |                             |       |                             |       |
| 117,973,396 shares issued and outstanding at February 3, 2007;                                                          |       |                             |       |                             |       |                             |       |
| 350,000,000 shares authorized and 136,313,415 shares issued                                                             |       |                             |       |                             |       |                             |       |
| and 133,547,015 shares outstanding at October 28, 2006                                                                  |       | 11,845                           |       | 11,797                           |       | 13,631                           |       |
| Additional paid-in capital                                                                                              |       | 11,233                           |       | —                           |       | 485,727                          |       |
| Retained (deficit) earnings                                                                                             |       | (2,979,550                       | )          | (2,893,918                       | )          | 943,769                          |       |
| Accumulated other comprehensive income                                                                                  |       | 14,867                           |       | 6,798                            |       | 8,151                            |       |
| Treasury Stock (none at November 3, 2007 and February 3, 2007;                                                          |       |                             |       |                             |       |                             |       |
| 2,766,400 shares at October 28, 2006)                                                                                   |       | —                           |       | —                           |       | (94,127                          | )          |
| Total stockholders’ (deficit) equity                                                                               |       | (2,941,605                       | )          | (2,875,323                       | )          | 1,357,151                        |       |
| Total liabilities and stockholders’ (deficit) equity                                                               |       | $                                | 1,953,917  |                             | $          | 1,693,002                        |       | $ | 1,970,443 |   |

 

See accompanying notes to consolidated financialstatements.

 

3

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**MICHAELSSTORES, INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**(Inthousands)**

**(Unaudited)**

 
| ** **                                   | ** ** | **Quarter Ended** | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------------------|------------|------------------------|------------|---------------------------------|------------|
| ** **                                   | ** ** | **November 3,**   | ** ** | **October 28,**            | ** ** | **November 3,** | ** ** | **October 28,** | ** ** |
| ** **                                   | ** ** | **2007**               | ** ** | **2006**                        | ** ** | **2007** | ** ** | **2006** | ** ** |
| **Net sales**                                |       | $                      | 940,222    |                            | $          | 896,080 |   | $ | 2,577,294 |   | $ | 2,496,825 |   |
| Cost of sales and occupancy expense          |       | 594,920                |       | 576,705                         |       | 1,613,182 |   | 1,582,966 |   |
| **Gross profit**                             |       | 345,302                |       | 319,375                         |       | 964,112 |   | 913,859 |   |
| Selling, general, and administrative expense |       | 262,496                |       | 255,352                         |       | 761,405 |   | 726,070 |   |
| Exit costs for concept businesses            |       | 6,983                  |       | —                          |       | 6,983 |   | — |   |
| Transaction expenses                         |       | 7,834                  |       | 8,532                           |       | 29,086 |   | 21,730 |   |
| Related party expenses                       |       | 5,897                  |       | —                          |       | 16,562 |   | — |   |
| Store pre-opening costs                      |       | 2,964                  |       | 1,684                           |       | 5,932 |   | 4,642 |   |
| **Operating income**                         |       | 59,128                 |       | 53,807                          |       | 144,144 |   | 161,417 |   |
| Interest expense                             |       | 94,770                 |       | 225                             |       | 285,330 |   | 649 |   |
| Other (income) and expense, net              |       | (6,112                 | )          | (2,716                          | )          | (10,643 | ) | (13,207 | ) |
| **(Loss) income before income taxes**        |       | (29,530                | )          | 56,298                          |       | (130,543 | ) | 173,975 |   |
| (Benefit) provision for income taxes         |       | (11,434                | )          | 21,253                          |       | (45,898 | ) | 65,676 |   |
| **Net (loss) income**                        |       | $                      | (18,096    | )                               | $          | 35,045 |   | $ | (84,645 | ) | $ | 108,299 |   |

 

See accompanyingnotes to consolidated financial statements.

 

4

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** **

**MICHAELSSTORES, INC.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(Inthousands)**

**(Unaudited)**

** **
| ** **                                           | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------|------------|-----------------------|------------|
| ** **                                           | ** ** | **November 3,**       | ** ** | **October 28,** | ** ** |
| ** **                                           | ** ** | **2007**              | ** ** | **2006** | ** ** |
| **Operating activities:**                            |       |                  |       |   |   |
| Net (loss) income                                    |       | $                     | (84,645    | ) | $ | 108,299 |   |
| Adjustments:                                         |       |                  |       |   |   |
| Depreciation and amortization                        |       | 93,668                |       | 85,059 |   |
| Share-based compensation                             |       | 4,166                 |       | 15,557 |   |
| Tax benefits from stock options exercised            |       | —                |       | (20,740 | ) |
| Exit costs for concept businesses                    |       | 6,983                 |       | — |   |
| Deferred financing costs amortization                |       | 12,720                |       | — |   |
| Other                                                |       | (882                  | )          | 226 |   |
| Changes in assets and liabilities:                   |       |                  |       |   |   |
| Merchandise inventories                              |       | (187,601              | )          | (194,978 | ) |
| Prepaid expenses and other                           |       | 99                    |       | (9,166 | ) |
| Deferred income taxes and other                      |       | (13,905               | )          | (8,423 | ) |
| Accounts payable                                     |       | 55,771                |       | 29,342 |   |
| Accrued interest                                     |       | 10,196                |       | 20 |   |
| Accrued liabilities and other                        |       | 37,916                |       | 13,334 |   |
| Income taxes payable                                 |       | (52,214               | )          | (2,471 | ) |
| Other long-term liabilities                          |       | 37,911                |       | 2,984 |   |
| Net cash (used in) provided by operating activities  |       | (79,817               | )          | 19,043 |   |
|                                                 |       |                  |       |   |   |
| **Investing activities:**                            |       |                  |       |   |   |
| Additions to property and equipment                  |       | (85,913               | )          | (107,665 | ) |
| Net cash used in investing activities                |       | (85,913               | )          | (107,665 | ) |
|                                                 |       |                  |       |   |   |
| **Financing activities:**                            |       |                  |       |   |   |
| Borrowings on asset-based revolving credit facility  |       | 792,786               |       | — |   |
| Payments on asset-based revolving credit facility    |       | (577,860              | )          | — |   |
| Repayments on senior secured term loan facility      |       | (17,625               | )          | — |   |
| Equity investment of Management                      |       | 8,055                 |       | — |   |
| Cash dividends paid to stockholders                  |       | —                |       | (42,563 | ) |
| Repurchase of old Common Stock                       |       | —                |       | (66,182 | ) |
| Repurchase of new Common Stock                       |       | (940                  | )          | — |   |
| Proceeds from stock options exercised                |       | —                |       | 35,608 |   |
| Tax benefits from stock options exercised            |       | —                |       | 20,740 |   |
| Proceeds from issuance of old Common Stock and other |       | —                |       | 1,804 |   |
| Payment of capital leases                            |       | (6,551                | )          | — |   |
| Change in cash overdraft                             |       | (5,557                | )          | 2,015 |   |
| Net cash provided by (used in) financing activities  |       | 192,308               |       | (48,578 | ) |
|                                                 |       |                  |       |   |   |
| **Net increase (decrease) in cash  and equivalents** |       | 26,578                |       | (137,200 | ) |
| **Cash and equivalents at  beginning of period**     |       | 30,098                |       | 452,449 |   |
| **Cash and equivalents at end of  period**           |       | $                     | 56,676     |   | $ | 315,249 |   |

** **

See accompanying notes to consolidated financialstatements.

 

5

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**MICHAELS STORES, INC.**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**For the Quarter and Nine Months Ended November 3,2007**

**(Unaudited)**

 

**Note 1.  Summaryof Significant Accounting Policies**

 

*Basis of Presentation*

 

The consolidatedfinancial statements include the accounts of Michaels Stores, Inc. and ourwholly-owned subsidiaries. All significant intercompany accounts andtransactions have been eliminated. All expressions of “us,” “we,” “our,” andall similar expressions are references to Michaels Stores, Inc. and ourconsolidated, wholly-owned subsidiaries, unless otherwise expressly stated orthe context otherwise requires.

 

The accompanyingunaudited consolidated financial statements have been prepared in accordancewith U.S. generally accepted accounting principles for interim financialinformation and with the instructions to Form 10-Q and Article 10 ofRegulation S-X. Accordingly, they do not include all of the informationand notes required by generally accepted accounting principles for completefinancial statements. In the opinion of management, all adjustments (consistingof normal recurring accruals and other items, as disclosed) considerednecessary for a fair presentation have been included. Because of the seasonalnature of our business, the results of operations for the three and nine monthsended November 3, 2007 are not indicative of the results to be expectedfor the entire year.

 

The balance sheet at February 3,2007 has been derived from the audited financial statements at that date butdoes not include all of the information and notes required by generallyaccepted accounting principles for complete financial statements. For furtherinformation, refer to the consolidated financial statements and notes theretoincluded in our Annual Report on Form 10-K for the fiscal year ended February 3,2007.

 

All references herein to “fiscal2007” relate to the 52 weeks ending February 2, 2008 and allreferences to “fiscal 2006” relate to the 53 weeks ended February 3,2007. In addition, all references herein to “the third quarter of fiscal 2007”relate to the 13 weeks ended November 3, 2007 and all references to “thethird quarter of fiscal 2006” relate to the 13 weeks ended October 28,2006.  Finally, all references to “thenine months ended November 3, 2007” relate to the 39 weeks ended November 3,2007, and “the nine months ended October 28, 2006” relate to the 39 weeksended October 28, 2006.

 

Certain prior year amountswere reclassified to conform to current year presentation.  These reclassifications consist primarily oftransaction expenses on the statements of operations.

 

*Recent Accounting Pronouncements*

 

In July 2006, theFASB issued FASB Interpretation No. 48, *Accountingfor Uncertainty in Income Taxes — an interpretation of FASB StatementNo. 109*, which clarifies the accounting for uncertainty inincome tax positions. FIN 48 requires that a company recognize in itsconsolidated financial statements the impact of a tax position that is morelikely than not to be sustained upon examination based on the technical meritsof the position. We adopted FIN 48 as of the beginning of our first quarter offiscal 2007 with no material impact to our consolidated statement of operations,balance sheet, stockholders’ equity, or statement of cash flows.

 

Upon adoption, we electedto record any interest and penalties associated with audits as a component ofincome tax expense. The Company identified its federal tax return, Canadian taxreturn, and its state tax returns in California, Florida, Illinois, New York,North Carolina, Pennsylvania, and Texas as “major” tax jurisdictions.  The periods subject to examination for ourfederal returns are 2002 to present, 2000 to present for our Canadian returns,and 2003 to present for all “major” state returns except for California, NorthCarolina, and Texas.  These states are subject to examination asfollows:   California from 1999 to present, North Carolina from2001 to present, and Texas from 2002 to present. 

 

6

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In September 2006,the FASB issued Statement of Financial Accounting Standard No. 158, *Employers’ Accounting for Defined Benefit Pensions and OtherPostretirement Plans*, which requires an entity to recognize theoverfunded or underfunded status of a defined benefit postretirement plan as anasset or liability in its balance sheet and to recognize changes in that fundedstatus in the year in which the changes occur through comprehensiveincome.  It also requires an entity tomeasure the funded status of a plan as of the date of its year-end balancesheet.  As we have no publicly tradedequity securities (due to the Merger as described in Note 2 below), FAS 158 iseffective for us at the end of fiscal 2007, with early adoption permitted.  We plan to adopt FAS 158 at the end of fiscal2007, with no material impact expected on our consolidated statement ofoperations, balance sheet, stockholders’ equity, or statement of cash flows.

 

In February 2007,the FASB issued Statement of Financial Accounting Standard No. 159, *The Fair Value Option for Financial Assets and Financial Liabilities*,which permits companies to measure certain financial instruments and otheritems at fair value (at specified measurement dates) that are not currentlyrequired to be measured at fair value. Any unrealized gains or lossesapplicable to those items measured at fair value shall be reported in earnings.The decision to apply fair value shall generally be made on an instrument byinstrument basis, is irrevocable, and is applied only to an entire instrument.The provisions of FAS 159 will be effective for us as of the beginning offiscal 2008, with early adoption permitted.

 

**Note 2.  MergerTransaction**

 

On October 31, 2006,substantially all of the Common Stock of Michaels Stores, Inc. wasacquired through a merger transaction (the “Merger”) by affiliates of twoprivate investment firms, Bain Capital Partners, LLC and The Blackstone Group(collectively, together with their applicable affiliates, the “Sponsors”), withcertain shares retained by affiliates of Highfields Capital Partners (athen-existing shareholder of Michaels Stores, Inc.). As a result of theMerger, Michaels Holdings LLC, an entity controlled by the Sponsors, ownsapproximately 93% of our outstanding Common Stock, which is no longer publiclytraded. We accounted for the Merger as a leveraged recapitalization whereby thehistorical book value of the assets and liabilities of Michaels were maintainedwith no push down accounting required.

 

The Merger considerationpaid to then-existing equity holders was approximately $5.8 billion, with feesand expenses totaling an additional $239.7 million. The purchase price wasfunded by:

 

·Aggregate cash equity contribution by theSponsors of approximately $1.7 billion;

·Retention of certain shares held byaffiliates of Highfields Capital Partners totaling $110.0 million;

·The issuance of the following debt (SeeNote 4 for further information concerning our issuance of debt):

 

·$750.0 million of 10% Senior Notes due2014;

·$400.0 million of 113¤8%Senior Subordinated Notes due 2016;

·$250.0 million of 13% SubordinatedDiscount Notes due 2016 (with an accreted value at maturity of $469.4 million);

·$2.4 billion Senior secured term loanfacility; and

·$400.0 million of borrowings under ourAsset-based revolving credit facility; and

 

·Our available cash as of the date of theMerger.

 

The Merger occurredsimultaneously with the closing of the financing and equity transactionsdescribed above as well as the termination of our previous $300 million seniorunsecured credit facility with Bank of America, N.A.

 

7

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We capitalized $124.7million of costs related to our issuance of various debt instruments.  We amortize the deferred financing costs overthe lives of the respective debt agreements (which range from five to tenyears) and record the amortization to interest expense. Amortization of thedeferred financing costs was $4.2 million and $12.7 million for the three andnine months ended November 3, 2007, respectively.

 

Transaction expenses forthe three and nine months ended November 3, 2007 relate primarily tocompensation arrangements associated with the change in control.

 

**Note 3.  Share-BasedCompensation**

 

OnFebruary 15, 2007, our stockholders and Board of Directors approved the2006 Equity Incentive Plan (“2006 Plan”), which provides for the grant ofshare-based awards exercisable for up to 14.2 million shares of Common Stock.  The table below sets forth a summary of stockoption activity for the three and nine months ended November 3, 2007.  As of November 3, 2007, there are 0.1million shares of restricted stock outstanding and share-based awardsexercisable for up to 2.6 million shares of Common Stock remain available forgrant.

 
| ** **                         | ** ** | **Quarter Ended**  | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------|------------|-------------------------|------------|---------------------------------|------------|
| ** **                         | ** ** | **(in thousands)** | ** ** |
|                               |       |                    |       |                            |       |
| Outstanding at beginning of period |       | 11,355                  |       | —                          |       |
| Grants                             |       | 397                     |       | 13,398                          |       |
| Cancellations                      |       | (284                    | )          | (1,930                          | )          |
| Outstanding at November 3, 2007    |       | 11,468                  |       | 11,468                          |       |

 

Generally, awards grantedunder the 2006 Plan vest ratably over five years and expire eight years fromthe grant date. The exercise prices of the awards issued during the three andnine months ended November 3, 2007 ranged, depending upon the tranche inwhich issued, from $15 per share to $52.50 per share. The fair value of theawards, for purposes of calculating compensation expense, was determined afterconsidering various factors, and using the Black-Scholes-Merton option valuationmodel. Share-based compensation expense for the three and nine months ended November 3,2007 was $1.4 million and $4.2 million, respectively.

 

All share-based awardsoutstanding immediately prior to the Merger were settled on the Merger date.There were no share-based awards outstanding as of February 3, 2007.

 

8

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**Note 4.  Debt**

 

Ouroutstanding debt is detailed in the table below.  We had no debt outstanding as of October 28,2006. We were in compliance with the terms and conditions of all debtagreements for all periods presented.

 
| ** **                            | ** ** | **November 3, 2007** | ** ** | **February 3, 2007** | ** ** | **Interest Rate** | ** ** |
|---------------------------------------|------------|--------------------------------|------------|--------------------------------|------------|------------------------|------------|
| ** **                            | ** ** | **(In thousands)**        | ** ** | ** **                     | ** ** |
|                                  |       |                           |       |                           |       |                   |       |
| Senior notes                          |       | $                              | 750,000    |                           | $          | 750,000                |       | 10.000 | % |
| Senior subordinated notes             |       | 400,000                        |       | 400,000                        |       | 11.375                 | %          |
| Subordinated discount notes.          |       | 283,960                        |       | 258,620                        |       | 13.000                 | %          |
| Senior secured term loan              |       | 2,326,500                      |       | 2,344,125                      |       | Variable               |       |
| Asset-based revolving credit facility |       | 420,693                        |       | 205,765                        |       | Variable               |       |
|                                  |       |                           |       |                           |       |                   |       |
| Total debt                            |       | 4,181,153                      |       | 3,958,510                      |       |                   |       |
|                                  |       |                           |       |                           |       |                   |       |
| Less current portion                  |       | 444,693                        |       | 229,765                        |       |                   |       |
|                                  |       |                           |       |                           |       |                   |       |
| Long-term debt                        |       | $                              | 3,736,460  |                           | $          | 3,728,745              |       |   |   |

 

*Asset-based revolving creditfacility*

 

The Asset-based revolvingcredit facility provides senior secured financing of up to $1.0 billion, subjectto a borrowing base described below. As of November 3, 2007, the borrowingbase was $958.6 million with $509.4 million of unused availability.

 

The borrowing base equalsthe sum of (i) 90% of eligible credit card receivables and debit cardreceivables; (ii) between 85% and 90% of the appraised net orderlyliquidation value of eligible inventory and of eligible letters of credit; (iii) apercentage of eligible in-transit inventory, less certain reserves; and (iv) thesum of an additional 10% of the appraised net orderly liquidation value ofeligible inventory and of eligible letters of credit plus an additional 5% ofeligible credit card receivables and debit card receivables, up to a maximumamount of $100.0 million.

 

*Senior secured term loan facility*

 

Borrowings under theSenior secured term loan facility bear interest at a rate per annum equal to,at our option, either (a) a base rate determined by reference to thehigher of (1) the prime rate of Deutsche Bank and (2) the federalfunds effective rate plus 1⁄2 of 1% or (b) a LIBOR rate, subject tocertain adjustments, in each case plus an applicable margin. The applicablemargin at November 3, 2007 was 1.25% with respect to base rate borrowingsand 2.25% with respect to LIBOR borrowings, subject to downward adjustmentbased on the leverage and ratings thresholds set forth in the Senior securedterm loan facility agreement.

 

On May 10, 2007, weamended the Senior secured term loan facility to reduce the applicable marginto 1.25% with respect to base rate borrowings and 2.25% with respect to LIBORborrowings. The amendment also provides that if there is a repricingtransaction that reduces the interest rate margins prior to May 10, 2008,then each lender will receive a fee equal to 1.00% of the principal amounts ofloans that are repriced. Finally, the amendment eliminated the requirement thatwe maintain a specified consolidated secured debt ratio.

 

9

----

 

**Note 5.  Comprehensive(Loss) Income**

 

Ourcomprehensive (loss) income is as follows:

 
| ** **                                        | ** ** | **Quarter Ended**  | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------|------------|-------------------------|------------|---------------------------------|------------|
| ** **                                        | ** ** | **November 3,**    | ** ** | **October 28,**            | ** ** | **November 3,** | ** ** | **October 28,** | ** ** |
| ** **                                        | ** ** | **2007**                | ** ** | **2006**                        | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                        | ** ** | **(In thousands)** | ** ** |
| Net (loss) income                                 |       | $                       | (18,096    | )                               | $          | 35,045 |   | $ | (84,645 | ) | $ | 108,299 |   |
| Other comprehensive income (loss):                |       |                    |       |                            |       |   |   |   |   |
| Derivative loss                                   |       | (2,241                  | )          | —                          |       | (2,133 | ) | — |   |
| Foreign currency translation adjustment and other |       | 5,688                   |       | 240                             |       | 10,202 |   | 562 |   |
| Comprehensive (loss) income.                      |       | $                       | (14,649    | )                               | $          | 35,285 |   | $ | (76,576 | ) | $ | 108,861 |   |

 

**Note 6.  Derivativeinstruments**

 

We are exposed tofluctuations in exchange rates between the US and Canadian dollars, as thefunctional currency of our Canadian subsidiary is the Canadian dollar.  To mitigate the effects of currencyfluctuations, during the second quarter of fiscal 2007, we executed a foreigncurrency cash flow hedge. To facilitate cash flow hedge accounting, theobjective is to hedge payments for forecasted purchases of intercompanyinventory by our Canadian subsidiary denominated in US dollars.  The term of this cash flow hedge extendsthrough fiscal 2007.

 

To achieve our objectiveand to minimize the risk of ineffectiveness, the notional values represent aportion of our Canadian subsidiary’s forecasted intercompany purchases.  Any hedge ineffectiveness is recorded inOther income. For the three and nine month periods ended November 3, 2007,the ineffective portion of the hedge was recorded as a loss of $1.5 million.

 

For the portion of thehedge that is effective, the change in fair value of that hedge will initiallybe recorded in Other comprehensive income. As the underlying inventory is sold to our customers, amounts will bereclassified from Other comprehensive income to Cost of sales and occupancyexpense in the statement of operations. The change in fair value of the hedge for the three and nine monthperiods ended November 3, 2007, were recorded as losses of $2.2 millionand $2.1 million, respectively.

 

Thetable below provides the remaining quarterly notional values and the averageCAD/USD exchange rate associated with the hedge (dollars in thousands).

 
| **Period**      | ** ** | **CAD Amount** | ** ** | **USD Amount** | ** ** | **Rate**   | ** ** |
|-----------------|------------|---------------------|------------|---------------------|------------|------------|------------|
| ** **      | ** ** | ** **          | ** ** | ** **          | ** ** | ** ** | ** ** |
| Quarter 4, 2007 |       | $                   | 19,940     |                | $          | 19,000     |       | 1.049 |   |
|                 |            |                     |            |                     |            |            |            |  |  |

 

**Note 7.  Commitmentsand Contingencies**

 

Referenceis made to the action described under “Part I. Item 3. Legal Proceedings –Employee Class Action Claims – Clark Claim” in our Annual Report on Form 10-Kfor fiscal 2006.  In that action, on November 14,2007, the court granted final approval of the settlement.  The settlement had no material impact on ourstatement of operations, balance sheet, or statement of cash flows for anyperiod presented.

 

Referenceis made to the description of the potential Section 16 liability issuesunder “Item 3. Legal Proceedings — Governmental Inquiries and Related Matters —Non-U.S. Trust Inquiry” in our Annual Report on Form 10-K for fiscal2006.  The tolling agreement with theWylys expired on October 5, 2007. On October 4, 2007, our Board ofDirectors determined that it was in the best interest of the Company and itsstockholders not to further pursue the potential Section 16 liability.

 

Weare involved in ongoing legal and regulatory proceedings. Other than theupdates described in the preceding paragraphs, there were no material changesto our disclosures of commitments and contingencies from our Annual Report on Form 10-Kfor fiscal 2006 and our Quarterly Reports on Form 10-Q for the quartersended April 5, 2007 and August 4, 2007.

 

10

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**Note 8.  Segments**

 

We consider our Michaels,Aaron Brothers, Recollections stores and our Star Decorators Wholesaleoperations to be our operating segments for purposes of determining reportablesegments based on the criteria of SFAS No. 131, *Disclosures AboutSegments of an Enterprise and Related Information*. We determinedthat our Michaels and Aaron Brothers operating segments have similar economiccharacteristics and meet the aggregation criteria set forth in paragraph 17 ofSFAS No. 131. With regard to our Aaron Brothers operating segment, wedetermined that it did not meet the quantitative thresholds for separatedisclosure set forth in SFAS No. 131. We also determined thatindividually, and in the aggregate, the Recollections stores and Star DecoratorsWholesale operations were immaterial for segment reporting purposes. Therefore,we combine all operating segments into one reporting segment.

 

Subsequent to the Merger,our chief operating decision makers evaluate historical operating performance,plan and forecast future periods’ operating performance and base incentivecompensation targets for certain management personnel on earnings beforeinterest, income taxes, and depreciation and amortization (“EBITDA”). Areconciliation of income before income taxes and cumulative effect ofaccounting change to EBITDA is presented below. Segment income for the threeand nine months ended October 28, 2006 was restated to conform to currentyear presentation.

 
| ** **                        | ** ** | **Quarter Ended**         | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------|------------|--------------------------------|------------|---------------------------------|------------|
| ** **                        | ** ** | **November 3, 2007** | ** ** | **October 28, 2006**  | ** ** | **November 3, 2007** | ** ** | **October 28, 2006** | ** ** |
| ** **                        | ** ** | **(in thousands)**        | ** ** |
|                              |       |                           |       |                            |       |   |   |   |   |
| (Loss) income before income taxes |       | $                              | (29,530    | )                               | $          | 56,298 |   | $ | (130,543 | ) | $ | 173,975 |   |
| Interest expense                  |       | 94,770                         |       | 225                             |       | 285,330 |   | 649 |   |
| Interest income                   |       | (298                           | )          | (2,690                          | )          | (700 | ) | (9,605 | ) |
| Depreciation and amortization     |       | 31,617                         |       | 28,439                          |       | 93,668 |   | 85,059 |   |
| EBITDA                            |       | $                              | 96,559     |                            | $          | 82,272 |   | $ | 247,755 |   | $ | 250,078 |   |

 

Oursales and assets by country are as follows:

 
| ** **                              | ** ** | **Net Sales**      | ** ** | **Total Assets** | ** ** |
|-----------------------------------------|------------|-------------------------|------------|-----------------------|------------|
| ** **                              | ** ** | **(in thousands)** | ** ** |
| **Quarter ended November 3, 2007:**     |       |                    |       |                  |       |
| United States                           |       | $                       | 862,368    |                  | $          | 1,850,036 |   |
| Canada                                  |       | 77,854                  |       | 103,881               |       |
| Consolidated Total                      |       | $                       | 940,222    |                  | $          | 1,953,917 |   |
|                                    |       |                    |       |                  |       |
| **Quarter ended October 28, 2006:**     |       |                    |       |                  |       |
| United States                           |       | $                       | 830,223    |                  | $          | 1,877,051 |   |
| Canada                                  |       | 65,857                  |       | 93,392                |       |
| Consolidated Total                      |       | $                       | 896,080    |                  | $          | 1,970,443 |   |
|                                    |       |                    |       |                  |       |
| **Nine Months Ended November 3, 2007:** |       |                    |       |                  |       |
| United States                           |       | $                       | 2,380,196  |                  | $          | 1,850,036 |   |
| Canada                                  |       | 197,098                 |       | 103,881               |       |
| Consolidated Total                      |       | $                       | 2,577,294  |                  | $          | 1,953,917 |   |
|                                    |       |                    |       |                  |       |
| **Nine Months ended October 28, 2006:** |       |                    |       |                  |       |
| United States                           |       | $                       | 2,326,538  |                  | $          | 1,877,051 |   |
| Canada                                  |       | 170,287                 |       | 93,392                |       |
| Consolidated Total                      |       | $                       | 2,496,825  |                  | $          | 1,970,443 |   |

 

11

----

 

**Note 9.  RelatedParty Transactions**

 

We pay annual managementfees to the Sponsors in the amount of $12.0 million and an annual managementfee to Highfields Capital Management LP in the amount of $1.0 million. Duringthe three and nine months ended November 3, 2007, we recognized $3.5million and $10.3 million, respectively, of expense related to annualmanagement fees and related expenses.

 

As previously disclosedin our fiscal 2006 Annual Report on Form 10-K, we amortize over a two-yearperiod Separation Agreements with each of Charles J. Wyly, Jr. and SamWyly, who were executive officers and directors of the Company prior to theMerger. Amortization expense for the three and nine months ended November 3,2007 was $0.7 million and $2.3 million, respectively.

 

During the first quarterof fiscal 2007, The Blackstone Group acquired a majority ownership stake in anexternal vendor we utilize to count our store inventory. Expenses associatedwith this vendor during the three and nine months ended November 3, 2007were approximately $1.7 million and $4.0 million, respectively.

 

During the nine monthsended November 3, 2007, officers of Michaels Stores, Inc. and itssubsidiaries were offered the opportunity to purchase shares of our CommonStock. During the first quarter of fiscal 2007, we sold 289,334 shares, orapproximately $4.3 million, of our Common Stock at a price of $15 per share tocertain officers. During the third quarter of fiscal 2007, we sold 251,672shares, or approximately $3.8 million, of our Common Stock at a price of $15per share to certain officers.  Also,during the three and nine month periods ended November 3, 2007, werepurchased 13,333 shares and 62,666 shares, respectively, of our Common Stockat $15 per share from officers who are no longer with the Company.

 

**Note 10.  Exit Costs for Concept Businesses**

 

On October 16, 2007,we announced plans to align resources around our core retail chains, Michaelsstores and Aaron Brothers. As a result, we will be discontinuing our conceptbusinesses, Recollections and Star Decorators’ Wholesale (“Star”). We anticipateclosing 11 Recollections and three of the four Star locations by the end of thefourth quarter of fiscal 2007.

 

In accordance withStatement of Financial Accounting Standard No. 144, *Accountingfor the Impairment or Disposal of Long-Lived Assets,*we performed impairment analyses for these stores. Based on estimatedfuture cash flows, an impairment loss for property and equipment of $6.1million was recognized during the third quarter of fiscal 2007. Also, $0.9million of related severance and termination costs were recorded during thesame period. All of these exit costs are reflected in a separate line item onthe consolidated statements of operations.

 

At the time the stores are closed, we expect toincur approximately $4.4 million of additional pre-tax charges related toremaining lease obligations. This amount may change if actual resultsmaterially differ from certain estimates inherent in our calculations.

 

**Note 11.   Condensed Consolidating FinancialInformation**

 

All of the Company’sobligations under the Senior notes, Senior subordinated notes, Subordinateddiscount notes, Senior secured term loan, and Asset-based revolving creditfacility are guaranteed by the Company’s subsidiaries. The following condensedconsolidating financial information represents the financial information ofMichaels Stores, Inc. and its wholly-owned subsidiary guarantors, preparedon the equity basis of accounting.  The information is presented inaccordance with the requirements of Rule 3-10 under the SEC’s RegulationS-X.  The financial information may not necessarily be indicative ofresults of operations, cash flows, or financial position had the subsidiaryguarantors operated as independent entities.

 

12

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**Supplemental Condensed Consolidating Balance Sheets**

 
| ** **                                                | ** ** | **November 3, 2007** | ** ** |
|-----------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                | ** ** | **Parent  Company**            | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                | ** ** | **(in thousands)**        | ** ** |
| **ASSETS**                                                | ** ** | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Current assets:**                                       |       |                           |       |   |   |   |   |   |   |
| Cash and equivalents                                      |       | $                              | 39,878     |   | $ | 16,798 |   | $ | — |   | $ | 56,676 |   |
| Merchandise inventories                                   |       | 764,442                        |       | 270,687 |   | — |   | 1,035,129 |   |
| Intercompany receivables                                  |       | —                         |       | 274,735 |   | (274,735 | ) | — |   |
| Other                                                     |       | 167,189                        |       | 20,385 |   | — |   | 187,574 |   |
| Total current assets                                      |       | 971,509                        |       | 582,605 |   | (274,735 | ) | $ | 1,279,379 |   |
| **Property and equipment, net**                           |       | 315,073                        |       | 129,662 |   | — |   | 444,735 |   |
| **Goodwill, net**                                         |       | 94,290                         |       | 21,549 |   | — |   | 115,839 |   |
| **Investment in subsidiaries**                            |       | 319,551                        |       | — |   | (319,551 | ) | — |   |
| **Other assets**                                          |       | 98,091                         |       | 15,873 |   |   |   | 113,964 |   |
| Total assets                                              |       | $                              | 1,798,514  |   | $ | 749,689 |   | $ | (594,286 | ) | $ | 1,953,917 |   |
|                                                      |       |                           |       |   |   |   |   |   |   |
| **LIABILITIES AND STOCKHOLDERS’ (DEFICIT) EQUITY**   |       |                           |       |   |   |   |   |   |   |
| **Current liabilities:**                                  |       |                           |       |   |   |   |   |   |   |
| Accounts payable                                          |       | $                              | 40,251     |   | $ | 241,560 |   | $ | — |   | $ | 281,811 |   |
| Accrued liabilities and other                             |       | 171,616                        |       | 163,274 |   | — |   | 334,890 |   |
| Current portion of long-term debt                         |       | 444,693                        |       | — |   | — |   | 444,693 |   |
| Intercompany payable                                      |       | 274,735                        |       | — |   | (274,735 | ) | — |   |
| Total current liabilities                                 |       | 931,295                        |       | 404,834 |   | (274,735 | ) | 1,061,394 |   |
| **Long-term debt**                                        |       | 3,736,460                      |       | — |   | — |   | 3,736,460 |   |
| **Other long-term liabilities**                           |       | 72,364                         |       | 25,304 |   | — |   | 97,668 |   |
| **Total stockholders’ (deficit) equity**             |       | (2,941,605                     | **)**      | 319,551 | ** ** | (319,551 | **)** | (2,941,605 | ) |
| Total liabilities and stockholders’ (deficit) equity |       | $                              | 1,798,514  |   | $ | 749,689 |   | $ | (594,286 | ) | $ | 1,953,917 |   |

 

14

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| ** **                                              | ** ** | **October 28, 2006** | ** ** |
|---------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                              | ** ** | **Parent  Company**            | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                              | ** ** | **(in thousands)**        | ** ** |
| **ASSETS**                                              | ** ** | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Current assets:**                                     |       |                           |       |   |   |   |   |   |   |
| Cash and equivalents                                    |       | $                              | 285,925    |   | $ | 29,324 |   | $ | — |   | $ | 315,249 |   |
| Merchandise inventories                                 |       | 736,079                        |       | 242,822 |   | — |   | 978,901 |   |
| Intercompany receivables                                |       | —                         |       | 110,045 |   | (110,045 | ) | — |   |
| Other                                                   |       | 49,778                         |       | 39,593 |   | — |   | 89,371 |   |
| Total current assets                                    |       | 1,071,782                      |       | 421,784 |   | (110,045 | ) | 1,383,521 |   |
| **Property and equipment, net**                         |       | 330,015                        |       | 116,949 |   | — |   | 446,964 |   |
| **Goodwill, net**                                       |       | 94,290                         |       | 21,549 |   | — |   | 115,839 |   |
| **Investment in subsidiaries**                          |       | 285,151                        |       | — |   | (285,151 | ) | — |   |
| **Other assets**                                        |       | 5,584                          |       | 18,535 |   |   |   | 24,119 |   |
| Total assets                                            |       | $                              | 1,786,822  |   | $ | 578,817 |   | $ | (395,196 | ) | $ | 1,970,443 |   |
|                                                    |       |                           |       |   |   |   |   |   |   |
| **LIABILITIES AND STOCKHOLDERS’ (DEFICIT) EQUITY** |       |                           |       |   |   |   |   |   |   |
| **Current liabilities:**                                |       |                           |       |   |   |   |   |   |   |
| Accounts payable                                        |       | $                              | 53,181     |   | $ | 191,800 |   | $ | — |   | $ | 244,981 |   |
| Accrued liabilities and other                           |       | 207,890                        |       | 69,835 |   | — |   | 277,725 |   |
| Current portion of long-term debt                       |       | —                         |       | — |   | — |   | — |   |
| Intercompany payable                                    |       | 110,045                        |       | — |   | (110,045 | ) | — |   |
| Total current liabilities                               |       | 371,116                        |       | 261,635 |   | (110,045 | ) | 522,706 |   |
| **Long-term debt**                                      |       | —                         |       | — |   | — |   | — |   |
| **Other long-term liabilities**                         |       | 58,555                         |       | 32,031 |   | — |   | 90,586 |   |
| **Total stockholders’ equity**                     |       | 1,357,151                      | ** ** | 285,151 | ** ** | (285,151 | **)** | 1,357,151 |   |
| Total liabilities and stockholders’ equity         |       | $                              | 1,786,822  |   | $ | 578,817 |   | $ | (395,196 | ) | $ | 1,970,443 |   |
|                                                         |            |                                |            |  |  |  |  |  |  |  |  |  |  |  |

 

**Supplemental Condensed Consolidating Statements of Operations**

 
| ** **                                   | ** ** | **Quarter Ended November 3, 2007** | ** ** |
|----------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                                   | ** ** | **Parent  Company**                                    | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                   | ** ** | **(in thousands)**                                | ** ** |
| ** **                                   |       |                                                   |       |   |   |   |   |   |   |   |   |   |
| **Net sales**                                |       | $                                                      | 823,860    |   | $ | 587,772 |   | $ | (471,410 | ) | $ | 940,222 |   |
| Cost of sales and occupancy expense          |       | 559,244                                                |       | 507,086 |   | (471,410 | ) | 594,920 |   |
| **Gross profit**                             |       | 264,616                                                |       | 80,686 |   | — |   | 345,302 |   |
| Selling, general, and administrative expense |       | 230,129                                                |       | 32,367 |   | — |   | 262,496 |   |
| Exit costs for concept businesses            |       | 6,983                                                  |       | — |   | — |   | 6,983 |   |
| Transaction expenses                         |       | 7,834                                                  |       | — |   | — |   | 7,834 |   |
| Related party expenses                       |       | 5,897                                                  |       | — |   | — |   | 5,897 |   |
| Store pre-opening costs                      |       | 2,697                                                  |       | 267 |   | — |   | 2,964 |   |
| **Operating income**                         |       | 11,076                                                 |       | 48,052 |   | — |   | 59,128 |   |
| Interest expense                             |       | 94,748                                                 |       | 22 |   | — |   | 94,770 |   |
| Other (income) and expense, net              |       | (1,039                                                 | )          | (5,073 | ) | — |   | (6,112 | ) |
| Intercompany charges (income)                |       | 24,379                                                 |       | (24,379 | ) | — |   | — |   |
| Equity in earnings of subsidiaries           |       | 77,482                                                 |       | — |   | (77,482 | ) | — |   |
| **(Loss) income before income taxes**        |       | (29,530                                                | )          | 77,482 |   | (77,482 | ) | (29,530 | ) |
| (Benefit) provision for income taxes         |       | (11,434                                                | )          | 30,001 |   | (30,001 | ) | (11,434 | ) |
| **Net (loss) income**                        |       | $                                                      | (18,096    | ) | $ | 47,481 |   | $ | (47,481 | ) | $ | (18,096 | ) |
|                                              |            |                                                        |            |  |  |  |  |  |  |  |  |  |  |  |

 

15

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| ** **                                   | ** ** | **Nine Months Ended November 3, 2007** | ** ** |
|----------------------------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                                   | ** ** | **Parent  Company**                                             | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                   | ** ** | **(in thousands)**                                         | ** ** |
|                                         |       |                                                            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Net sales**                                |       | $                                                               | 2,259,464  |   | $ | 1,401,267 |   | $ | (1,083,437 | ) | $ | 2,577,294 |   |
| Cost of sales and occupancy expense          |       | 1,536,637                                                       |       | 1,159,982 |   | (1,083,437 | ) | 1,613,182 |   |
| **Gross profit**                             |       | 722,827                                                         |       | 241,285 |   | — |   | 964,112 |   |
| Selling, general, and administrative expense |       | 666,714                                                         |       | 94,691 |   | — |   | 761,405 |   |
| Exit costs for concept businesses            |       | 6,983                                                           |       | — |   | — |   | 6,983 |   |
| Transaction expenses                         |       | 29,086                                                          |       | — |   | — |   | 29,086 |   |
| Related party expenses                       |       | 16,562                                                          |       | — |   | — |   | 16,562 |   |
| Store pre-opening costs                      |       | 5,224                                                           |       | 708 |   | — |   | 5,932 |   |
| **Operating (loss) income**                  |       | (1,742                                                          | )          | 145,886 |   | — |   | 144,144 |   |
| Interest expense                             |       | 285,270                                                         |       | 60 |   | — |   | 285,330 |   |
| Other (income) and expense, net              |       | (1,072                                                          | )          | (9,571 | ) | — |   | (10,643 | ) |
| Intercompany charges (income)                |       | 58,086                                                          |       | (58,086 | ) | — |   | — |   |
| Equity in earnings of subsidiaries           |       | 213,483                                                         |       | — |   | (213,483 | ) | — |   |
| **(Loss) income before income taxes**        |       | (130,543                                                        | )          | 213,483 |   | (213,483 | ) | (130,543 | ) |
| (Benefit) provision for income taxes         |       | (45,898                                                         | )          | 75,061 |   | (75,061 | ) | (45,898 | ) |
| **Net (loss) income**                        |       | $                                                               | (84,645    | ) | $ | 138,422 |   | $ | (138,422 | ) | $ | (84,645 | ) |
|                                              |            |                                                                 |            |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                                   | ** ** | **Quarter Ended October 28, 2006** | ** ** |
|----------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                                   | ** ** | **Parent  Company**                                    | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                   | ** ** | **(in thousands)**                                | ** ** |
|                                         |       |                                                   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Net sales**                                |       | $                                                      | 789,983    |   | $ | 514,840 |   | $ | (408,743 | ) | $ | 896,080 |   |
| Cost of sales and occupancy expense          |       | 546,795                                                |       | 438,653 |   | (408,743 | ) | 576,705 |   |
| **Gross profit**                             |       | 243,188                                                |       | 76,187 |   | — |   | 319,375 |   |
| Selling, general, and administrative expense |       | 226,079                                                |       | 29,273 |   | — |   | 255,352 |   |
| Transaction expenses                         |       | 8,532                                                  |       | — |   | — |   | 8,532 |   |
| Store pre-opening costs                      |       | 1,552                                                  |       | 132 |   | — |   | 1,684 |   |
| **Operating income**                         |       | 7,025                                                  |       | 46,782 |   | — |   | 53,807 |   |
| Interest expense                             |       | 215                                                    |       | 10 |   | — |   | 225 |   |
| Other (income) and expense, net              |       | (2,088                                                 | )          | (628 | ) | — |   | (2,716 |   |
| Intercompany charges (income)                |       | 20,279                                                 |       | (20,279 | ) | — |   | — |   |
| Equity in earnings of subsidiaries           |       | 67,679                                                 |       | — |   | (67,679 | ) | — |   |
| **Income before income taxes**               |       | 56,298                                                 |       | 67,679 |   | (67,679 | ) | 56,298 |   |
| Provision for income taxes                   |       | 21,253                                                 |       | 25,549 |   | (25,549 | ) | 21,253 |   |
| **Net income**                               |       | $                                                      | 35,045     |   | $ | 42,130 |   | $ | (42,130 | ) | $ | 35,045 |   |
|                                              |            |                                                        |            |  |  |  |  |  |  |  |  |  |  |  |

 

16

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| ** **                                    | ** ** | **Nine Months Ended October 28, 2006** | ** ** |
|-----------------------------------------------|------------|----------------------------------------|------------|
| ** **                                    | ** ** | **Parent  Company**                    | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                    | ** ** | **(in thousands)**                     | ** ** |
| ** **                                    |       |                                   |       |   |   |   |   |   |   |   |   |   |
| **Net sales**                                 |       | $                                      | 2,199,282  |   | 1,260,642 |   | $ | (963,099 | ) | $ | 2,496,825 |   |
| Cost of sales and  occupancy expense          |       | 1,509,836                              |       | 1,036,229 |   | (963,099 | ) | 1,582,966 |   |
| **Gross  profit**                             |       | 689,446                                |       | 224,413 |   | — |   | 913,859 |   |
| Selling, general, and  administrative expense |       | 642,757                                |       | 83,313 |   | — |   | 726,070 |   |
| Transaction expenses                          |       | 21,730                                 |       | — |   | — |   | 21,730 |   |
| Related party expenses                        |       | —                                 |       | — |   | — |   | — |   |
| Store pre-opening costs                       |       | 4,015                                  |       | 627 |   | — |   | 4,642 |   |
| **Operating  income**                         |       | 20,944                                 |       | 140,473 |   | — |   | 161,417 |   |
| Interest expense                              |       | 623                                    |       | 26 |   | — |   | 649 |   |
| Other (income) and  expense, net              |       | (11,560                                | )          | (1,647 | ) | — |   | (13,207 | ) |
| Intercompany charges  (income)                |       | 59,273                                 |       | (59,273 | ) | — |   | — |   |
| Equity in earnings of  subsidiaries           |       | 201,367                                |       | — |   | (201,367 | ) | — |   |
| **Income (loss) before income  taxes**        |       | 173,975                                |       | 201,367 |   | (201,367 | ) | 173,975 |   |
| Provision (benefit) for  income taxes         |       | 65,676                                 |       | 76,016 |   | (76,016 | ) | 65,676 |   |
| **Net  income (loss)**                        |       | $                                      | 108,299    |   | $ | 125,351 |   | $ | (125,351 | ) | $ | 108,299 |   |
|                                               |            |                                        |            |  |  |  |  |  |  |  |  |  |  |

 

**Supplemental Condensed Consolidating Statements of Cash Flows**

 
| ** **                                           | ** ** | **Nine Months Ended November 3, 2007** | ** ** |
|------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                           | ** ** | **Parent  Company**                    | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                           | ** ** | **(in thousands)**                     | ** ** |
| **Operating activities:**                            | ** ** | ** **                             | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net cash (used in) provided by operating activities  |       | $                                      | (123,352   | ) | $ | 149,785 |   | $ | (106,250 | ) | $ | (79,817 | ) |
|                                                 |       |                                   |       |   |   |   |   |   |   |
| **Investing activities:**                            | ** ** | ** **                             | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net  cash used in investing activities               |       | (55,693                                | )          | (30,220 | ) | — |   | (85,913 | ) |
|                                                 |       |                                   |       |   |   |   |   |   |   |
| **Financing activities:**                            | ** ** | ** **                             | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net borrowings (repayments) of long-term debt        |       | 197,301                                |       | — |   | — |   | 197,301 |   |
| Intercompany dividends                               |       | —                                 |       | (106,250 | ) | 106,250 |   | — |   |
| Other financing activities                           |       | (4,957                                 | )          | (36 | ) | — |   | (4,993 | ) |
| Net  cash provided by (used in) financing activities |       | 192,344                                |       | (106,286 | ) | 106,250 |   | 192,308 |   |
|                                                 |       |                                   |       |   |   |   |   |   |   |
| **Increase in cash and  equivalents**                |       | 13,299                                 |       | 13,279 |   | — |   | 26,578 |   |
| **Beginning cash and cash  equivalents**             |       | 26,579                                 |       | 3,519 |   | — |   | 30,098 |   |
| **Ending cash and cash  equivalents**                |       | $                                      | 39,878     |   | $ | 16,798 |   | $ | — |   | $ | 56,676 |   |

 

17

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| ** **                                | ** ** | **Nine Months Ended October 28, 2006** | ** ** |
|-------------------------------------------|------------|----------------------------------------|------------|
| ** **                                | ** ** | **Parent  Company**                    | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                | ** ** | **(in thousands)**                     | ** ** |
| **Operating activities:**                 | ** ** | ** **                             | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net cash provided by operating activities |       | $                                      | 30,927     |   | $ | 118,082 |   | $ | (129,966 | ) | $ | 19,043 |   |
|                                      |       |                                   |       |   |   |   |   |   |   |
| **Investing activities:**                 | ** ** | ** **                             | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net cash used in investing activities     |       | (83,467                                | )          | (24,198 | ) | — |   | (107,665 | ) |
|                                      |       |                                   |       |   |   |   |   |   |   |
| **Financing activities:**                 | ** ** | ** **                             | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash dividends paid to stockholders       |       | (42,563                                | )          | — |   | — |   | (42,563 | ) |
| Intercompany dividends                    |       | —                                 |       | (129,966 | ) | 129,966 |   | — |   |
| Repurchase of old Common Stock            |       | (66,182                                | )          | — |   | — |   | (66,182 | ) |
| Other financing activities                |       | 39,426                                 |       | 20,741 |   | — |   | 60,167 |   |
| Net cash used in financing activities     |       | (69,319                                | )          | (109,225 | ) | 129,966 |   | (48,578 | ) |
|                                      |       |                                   |       |   |   |   |   |   |   |
| **Decrease in cash and  equivalents**     |       | (121,859                               | )          | (15,341 | ) | — |   | (137,200 | ) |
| **Beginning cash and cash  equivalents**  |       | 407,783                                |       | 44,666 |   | — |   | 452,449 |   |
| **Ending cash and cash  equivalents**     |       | $                                      | 285,924    |   | $ | 29,325 |   | $ | — |   | $ | 315,249 |   |

 

18

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**Item 2.  Management’s Discussion and Analysisof Financial Condition and****Results of Operations.**

 

Allexpressions of “us,” “we,” “our,” and all similar expressions are references toMichaels Stores, Inc. and its consolidated wholly-owned subsidiaries,unless otherwise expressly stated or the context otherwise requires.

 

**DisclosureRegarding Forward-Looking Information**

 

Thefollowing discussion should be read in conjunction with our consolidatedfinancial statements and related notes included elsewhere in this QuarterlyReport on Form 10-Q. The following discussion, as well as other portionsof this Quarterly Report on Form 10-Q, contains forward-looking statementsthat reflect our plans, estimates, and beliefs. Any statements contained herein(including, but not limited to, statements to the effect that Michaels or itsmanagement “anticipates,” “plans,” “estimates,” “expects,” “believes,” andother similar expressions) that are not statements of historical fact should beconsidered forward-looking statements and should be read in conjunction withour consolidated financial statements and related notes in our Annual Report onForm 10-K for the fiscal year ended February 3, 2007. Specificexamples of forward-looking statements include, but are not limited to,statements regarding our forecasts of financial performance, capitalexpenditures, and working capital requirements. Our actual results couldmaterially differ from those discussed in these forward-looking statements.Factors that could cause or contribute to such differences include, but are notlimited to:

 

·                  our ability to anticipateand/or react to changes in customer demand and preferences for products andsupplies used in creative activities and the related potential impact tomerchandise inventories in categories that represent a significant portion ofour business;

 

·                  theeffectiveness of, or unexpected consumer responses to, our promotionalprograms;

 

·                  our ability tomitigate any continued declines in newspaper subscription rates, which affectthe frequency in which our customers receive our circular advertisements;

 

·                  changes inconsumer confidence resulting in a reduction in consumer spending on itemsperceived to be discretionary;

 

·                  the executionand management of our store growth, including new concepts, the impact of newcompetitor stores in locations near our existing stores, and the availabilityof acceptable real estate locations for new store openings;

 

·                  our ability toattract and retain qualified personnel, including management and seniorexecutives, to successfully execute our operating plans;

 

·                  financialdifficulties of any of our key vendors or suppliers;

 

·                  possibleproduct recalls and product liability claims;

 

·                  delays in thereceipt of merchandise ordered from suppliers due to delays in connection witheither the manufacture or shipment of such merchandise;

 

·                  transportationdelays (including dock strikes, other work stoppages, and shortages of truckdrivers) and increases in transportation costs due to fuel surcharges andtransportation regulations;

 

·                  restrictiveactions by foreign governments or changes in United States or foreign laws andregulations affecting imports or domestic distribution;

 

·                  significantchanges in tariffs or duties levied on imports which may limit the availabilityof certain merchandise from our foreign suppliers;

 

·                  significantfluctuations in exchange rates;

 

·                  changes inpolitical, economic, and social conditions;

 

19

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·                  the design andimplementation of new management information systems as well as the maintenanceand enhancement of existing systems, particularly in light of our continuedstore growth and the addition of new concepts;

 

·                  theidentification and implementation of enhancements to our supply chain to enableus to distribute additional SKUs through our distribution centers;

 

·                  the effectiveoptimization and maintenance of our perpetual inventory and automatedreplenishment systems and related impacts to inventory levels;

 

·                  our ability tomaintain the security of electronic and other confidential information;

 

·                  the seasonalityof the retail business;

 

·                  unusual weatherconditions;

 

·                  significantincreases in inflation or commodity prices, such as petroleum, natural gas,electricity, steel, and paper, which may adversely affect our costs, includingcost of merchandise;

 

·                  our ability toremain competitive in the areas of merchandise quality, price, breadth ofselection, customer service, and convenience;

 

·                  our substantialleverage, which could adversely affect our ability to raise additional capitalto fund our operations, limit our ability to react to changes in the economy orour industry, and expose us to interest rate risk to the extent of our variablerate debt;

 

·                  our ability toservice the interest and principal payments of our debt (including our SeniorNotes, Senior Subordinated Notes, and Subordinated Discount Notes (the “Notes”))or to repurchase the Notes upon a change in control;

 

·                  restrictionscontained in our various debt agreements that limit our flexibility inoperating our business, including compliance with the covenants containedtherein;

 

·                  significantfluctuations in interest rates;

 

·                  our ability toaddress any conflict between the interests of our controlling stockholders andour creditors; and

 

·                  other factorsas set forth in our Annual Report on Form 10-K for the fiscal year ended February 3,2007 (particularly in “Part I. Item 1A. Risk Factors” and “Part II.Item 7. Management’s Discussion and Analysis of Financial Condition and Resultsof Operations – Critical Accounting Policies and Estimates”).

 

Weintend these forward-looking statements to speak only as of the time of filingthis Quarterly Report on Form 10-Q and do not undertake to update orrevise them as more information becomes available.

 

20

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**General**

 

Allreferences herein to “fiscal 2007” relate to the 52 weeks ending February 2,2008 and all references to “fiscal 2006” relate to the 53 weeks ended February 3,2007. In addition, all references herein to “the third quarter of fiscal 2007” relateto the 13 weeks ended November 3, 2007 and all references to “the thirdquarter of fiscal 2006” relate to the 13 weeks ended October 28,2006.  Finally, all references to “thenine months ended November 3, 2007” relate to the 39 weeks ended November 3,2007, and “the nine months ended October 28, 2006” relate to the 39 weeksended October 28, 2006, respectively.

 

Thefollowing table sets forth certain of our unaudited operating data (dollars inthousands):

 
| ** **                                            | ** ** | **Quarter Ended** | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                            | ** ** | **November 3,**   | ** ** | **October 28,**       | ** ** | **November 3,** | ** ** | **October 28,** | ** ** |
| ** **                                            | ** ** | **2007**          | ** ** | **2006**              | ** ** | **2007** | ** ** | **2006** | ** ** |
| **Michaels stores:**                                  | ** ** | ** **        | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Retail  stores open at beginning of period            |       | 937               |       | 905                   |       | 920 |   | 885 |   |
| Retail  stores opened during the period               |       | 23                |       | 15                    |       | 43 |   | 39 |   |
| Retail  stores opened (relocations) during the period |       | 4                 |       | 2                     |       | 11 |   | 7 |   |
| Retail  stores closed during the period               |       | —            |       | (1                    | )          | (3 | ) | (5 | ) |
| Retail  stores closed (relocations) during the period |       | (4                | )          | (2                    | )          | (11 | ) | (7 | ) |
| Retail  stores open at end of period                  |       | 960               |       | 919                   |       | 960 |   | 919 |   |
|                                                  |       |              |       |                  |       |   |   |   |   |
| **Aaron Brothers stores:**                            | ** ** | ** **        | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Retail  stores open at beginning of period            |       | 167               |       | 165                   |       | 166 |   | 166 |   |
| Retail  stores opened during the period               |       | —            |       | —                |       | 2 |   | — |   |
| Retail  stores closed during the period               |       | —            |       | —                |       | (1 | ) | (1 | ) |
| Retail  stores open at end of period                  |       | 167               |       | 165                   |       | 167 |   | 165 |   |
|                                                  |       |              |       |                  |       |   |   |   |   |
| **Recollections stores:**                             | ** ** | ** **        | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Retail  stores open at beginning of period            |       | 11                |       | 11                    |       | 11 |   | 11 |   |
| Retail  stores opened during the period               |       | —            |       | —                |       | — |   | — |   |
| Retail  stores open at end of period                  |       | 11                |       | 11                    |       | 11 |   | 11 |   |
|                                                  |       |              |       |                  |       |   |   |   |   |
| **Star Decorators Wholesale  stores:**                | ** ** | ** **        | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Wholesale  stores open at beginning of period         |       | 4                 |       | 4                     |       | 4 |   | 4 |   |
| Wholesale  stores opened during the period            |       | —            |       | —                |       | — |   | — |   |
| Wholesale  stores open at end of period               |       | 4                 |       | 4                     |       | 4 |   | 4 |   |
|                                                  |       |              |       |                  |       |   |   |   |   |
| Total store count at end  of period                   |       | 1,142             |       | 1,099                 |       | 1,142 |   | 1,099 |   |
|                                                  |       |              |       |                  |       |   |   |   |   |
| **Other operating data:**                             | ** ** | ** **        | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Average  inventory per Michaels store (1)             |       | $1,020            |       | $1,005                |       | $1,020 |   | $1,005 |   |
| Comparable  store sales increase (decrease) (2)       |       | 1.9               | %          | 3.3                   | %          | 0.8 | % | 0.1 | % |

 

----

(1)                 Averageinventory per Michaels store calculation excludes our Aaron Brothers,Recollections, and Star Decorators Wholesale stores.

 

(2)                 Comparablestore sales increase represents the increase in net sales for stores open thesame number of months in the indicated period and the comparable period of theprevious year, including stores that were relocated or expanded during eitherperiod. A store is deemed to become comparable in its 14th month ofoperation in order to eliminate grand opening sales distortions. A storetemporarily closed more than 2 weeks due to a catastrophic event is notconsidered comparable during the month it closed. If a store is closed longerthan 2 weeks but less than 2 months, it becomes comparable in themonth in which it reopens, subject to a mid-month convention. A store closedlonger than 2 months becomes comparable in its 14th month ofoperation after its reopening.

 

21

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**Results ofOperations**

 

Thefollowing table sets forth the percentage relationship to net sales of eachline item of our unaudited consolidated statements of operations. This tableshould be read in conjunction with the following discussion and with our consolidatedfinancial statements, including the related notes, contained herein.

 
| ** **                                   | ** ** | **Quarter Ended** | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------------------|------------|------------------------|------------|---------------------------------|------------|
| ** **                                   | ** ** | **November 3,**   | ** ** | **October 28,**            | ** ** | **November 3,** | ** ** | **October 28,** | ** ** |
| ** **                                   | ** ** | **2007**               | ** ** | **2006**                        | ** ** | **2007** | ** ** | **2006** | ** ** |
| **Net sales**                                |       | 100.0                  | %          | 100.0                           | %          | 100.0 | % | 100.0 | % |
| Cost of sales and occupancy expense          |       | 63.3                   |       | 64.4                            |       | 62.6 |   | 63.4 |   |
| **Gross profit**                             |       | 36.7                   |       | 35.6                            |       | 37.4 |   | 36.6 |   |
| Selling, general, and administrative expense |       | 27.9                   |       | 28.5                            |       | 29.5 |   | 29.1 |   |
| Exit costs for concept businesses            |       | 0.7                    |       | —                          |       | 0.3 |   | — |   |
| Transaction expenses                         |       | 0.8                    |       | 0.9                             |       | 1.1 |   | 0.8 |   |
| Related party expenses                       |       | 0.6                    |       | —                          |       | 0.6 |   | — |   |
| Store pre-opening costs                      |       | 0.3                    |       | 0.2                             |       | 0.2 |   | 0.2 |   |
| **Operating income**                         |       | 6.4                    |       | 6.0                             |       | 5.7 |   | 6.5 |   |
| Interest expense                             |       | 10.1                   |       | —                          |       | 11.1 |   | — |   |
| Other (income) and expense, net              |       | (0.7                   | )          | (0.3                            | )          | (0.4 | ) | (0.5 | ) |
| **(Loss) Income before income taxes**        |       | (3.0                   | )          | 6.3                             |       | (5.0 | ) | 7.0 |   |
| (Benefit) provision for income taxes         |       | (1.2                   | )          | 2.4                             |       | (1.8 | ) | 2.7 |   |
| **Net (loss) income**                        |       | (1.8                   | )%         | 3.9                             | %          | (3.2 | )% | 4.3 | % |

 

*QuarterEnded November 3, 2007 Compared to the Quarter Ended October 28, 2006*

 

*Net Sales*—Net sales increased for thethird quarter of fiscal 2007 by $44.1 million, or 4.9%, over the thirdquarter of fiscal 2006. At the end of the third quarter of fiscal 2007, weoperated 960 Michaels, 167 Aaron Brothers, 11 Recollections, and four StarDecorators Wholesale stores. Results for the third quarter of fiscal 2007include sales from 47 Michaels and three Aaron Brothers stores that were openedduring the 12-month period ended November 3, 2007. Non-comparable salesincreased $27.2 million and comparable store sales increased 1.9%, or $16.9million.

 

Comparablestore sales increased 1.9% in the third quarter of fiscal 2007 compared to thethird quarter of fiscal 2006, reflecting increases in the average ticket andcustom framing deliveries of 2.5% and 0.3%, respectively, partially offset by adecrease in customer transactions of 0.9%. A favorable currency translation,due to the stronger Canadian dollar, contributed approximately 0.8% to theaverage ticket increase for the quarter.

 

Wecontinue to develop a fully integrated pricing and promotion strategy and mayrefine our existing strategy in future periods. A significant component of ourpricing and promotion strategy involves changes in the breadth and depth of ourpromotional programs. As a result, our historical trends may not be indicativeof future results.

 

*Cost of Sales and Occupancy Expense*—Cost of salesand occupancy expense increased $18.2 million primarily due to increasesin the store base. Cost of sales and occupancy expense, as a percentage of netsales, decreased approximately 110 basis points in the third quarter of fiscal2007 compared to the third quarter of fiscal 2006.  Merchandise margins improved 50 basis pointsfrom a reduction in breadth and depth of promotional programs in addition tocontinued benefits from ongoing product sourcing initiatives. As previouslynoted, we may make changes to our pricing and promotion strategy that mayaffect our merchandise margins in future periods. As a result, historicaltrends may not be indicative of future results. Occupancy costs, as apercentage of sales, decreased approximately 60 basis points due to lowerremodel expenses and a decrease in utility costs.

 

*Selling, General, and Administrative Expense*—Selling,general, and administrative expense was $262.5 million, or 27.9% of net sales,in the third quarter of fiscal 2007 compared to $255.4 million, or 28.5% of netsales, in the third quarter of fiscal 2006. The $7.1 million expense increasewas primarily due to an increase in the store base.

 

22

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Asa percentage of net sales, selling, general, and administrative expensedecreased approximately 60 basis points, primarily due to a reduction incertain professional fees.

 

*Exit Costs for Concept Businesses—*The exit costs of $7.0 million in the third quarter of fiscal 2007represent costs incurred as a result of the decision to exit the Star andRecollections concept businesses. Based on impairment analyses performed inaccordance with SFAS No. 144, *Accountingfor the Impairment or Disposal of Long-Lived Assets*, the propertyand equipment for both of these businesses were impaired, resulting in an assetimpairment charge of $6.1 million. Severance and termination costs of $0.9 million were also recognized inthe third quarter of fiscal 2007.

 

*Transaction Expenses*—Transaction expensesincurred during the third quarter of fiscal 2007 relate primarily to bonusarrangements associated with the change in control that are ratably recognizedfor a period of one year following the Merger date, as well as othercompensation expenses arising from change in control agreements.  Transaction expenses incurred during thethird quarter of fiscal 2006 primarily relate to legal and investment advisoryexpenses associated with our strategic alternatives process and the Mergerannounced on October 31, 2006.

 

*Related Party Expenses*—Related party expenses were$5.9 million in the third quarter of fiscal 2007 and consisted primarily of$3.5 million of management fees and associated expenses paid to our Sponsorsand Highfields. Also included in related party expenses are $1.7 million offees related to an inventory-count service vendor we utilize, in which TheBlackstone Group acquired a majority ownership stake during the first quarterof fiscal 2007, as well as $0.7 million of amortization expense related to theSeparation Agreements as more fully described in Note 9 to the consolidatedfinancial statements.

 

*Operating Income*—Operating income increasedfrom $53.8 million, or 6.0% of sales, in the third quarter of fiscal 2006 to$59.1 million, or 6.4% of sales, in the third quarter of fiscal 2007.

 

*Interest Expense*—Interest expense increasedfrom $0.2 million in the third quarter of fiscal 2006 to $94.8 million in thethird quarter of fiscal 2007 as a result of debt issued during the fourthquarter of fiscal 2006 to finance the Merger. We expect to incur a substantialamount of interest expense in future quarters as a result of our outstandingdebt.

 

*Other Income*—Other income increased from$2.7 million in the third quarter of fiscal 2006 to $6.1 millionduring the third quarter of fiscal 2007 primarily as a result of a favorablecomparison of foreign currency gains.

 

*(Benefit) Provision for Income Taxes*—The effectivetax rate was 38.7% and 37.8% for the third quarter of fiscal 2007 and 2006,respectively. As a result of our low income base, our effective rate is highlysensitive to changes caused by permanent differences (i.e. differences betweenbook income and tax income that will not be reversed in future periods);therefore, we are unable to predict our effective tax rate for fiscal 2007.

 

*Net (Loss) Income*—As a result of the above,we reported a net loss of $18.1 million for the third quarter of fiscal 2007 ascompared to net income of $35.0 million for the third quarter of fiscal 2006.

 

*NineMonths Ended November 3, 2007 Compared to the Nine Months Ended October 28,2006*

 

*Net Sales*—Net salesincreased in the first nine months of fiscal 2007 by $80.5 million, or 3.2%,over the first nine months of fiscal 2006. Sales at our new stores (net of closures) opened since the third quarterof fiscal 2005 provided incremental revenue of $61.4 million. For the sameperiod, comparable store sales increased 0.8% in fiscal 2007 compared to fiscal2006, reflecting an increase in the average ticket of 3.3%, partially offset bydeclines in customer transactions of 2.3% and custom framing deliveries of0.2%.  The fluctuation in the exchange ratesbetween the US and Canadian dollars contributed 30 basis points to the averageticket increase.

 

*Cost of Sales and Occupancy Expense*—Cost of salesand occupancy expense increased by $30.2 million, or 1.9%, due toincreased occupancy expenses and the number of stores we operate, partially offsetby a decrease in costs related to store remodels and the merchandise marginexpansion as described below.

 

Costof sales and occupancy expense, as a percentage of net sales, decreasedapproximately 80 basis points through the first nine months of fiscal 2007compared to the first nine months of fiscal 2006. This decrease was driven byexpansion of merchandise margin, resulting from a reduction in breadth anddepth of promotional programs as well as continued benefits from ongoingsourcing initiatives.  Partiallyoffsetting the merchandise margin expansion was a 30 basis point increase instore occupancy costs primarily due to inflationary cost increases and adeleveraging of expenses on the 0.8% comparable sales increase.

 

23

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*Selling, General, and Administrative Expense*—Selling,general, and administrative expense was $761.4 million, or 29.5% of netsales, for the first nine months of fiscal 2007 compared to$726.1 million, or 29.1% of net sales, in the first nine months of fiscal2006. The $35.3 million expense increase was primarily due to an increase inthe number of stores we operate compared to last year, and expenses resultingfrom our strategic initiatives. These strategic initiatives include our pricingand promotion strategy, consumer insight research, and product sourcing, whichare more fully described in our Fiscal 2006 Annual Report on Form 10-K.

 

Asa percentage of net sales, selling, general, and administrative expenseincreased approximately 40 basis points, comprised primarily of anincrease in costs related to our strategic initiatives.

 

*Exit Costs for Concept Businesses -*The exit costs of $7.0 million in fiscal 2007 represent costs incurredas a result of the decision to exit the Star and Recollections conceptbusinesses. Based on impairment analyses performed in accordance with SFAS No. 144,*Accounting for the Impairment or Disposal ofLong-Lived Assets*, the property and equipment for both of thesebusinesses were impaired, resulting in an asset impairment charge of $6.1million.  Severance and termination costsof $0.9 million were also recognized in fiscal 2007.

 

*Transaction Expenses —*Transactionexpenses incurred during the first nine months of fiscal 2007 relate primarilyto bonus arrangements associated with the change in control that are ratablyrecognized for a period of one year following the Merger date, as well asother compensation expenses arising from change in control agreements. Transaction expenses incurred during the first nine months of fiscal2006 primarily relate to legal and investment advisory expensesassociated with our strategic alternatives process.

 

*Related Party Expenses*—Related party expenses were$16.6 million for the first nine months of fiscal 2007 and consisted primarilyof $10.3 million of management fees and associated expenses paid to ourSponsors and Highfields. Also included in related party expenses are $4.0million of fees related to an inventory-count service vendor we utilize, inwhich The Blackstone Group acquired a majority ownership stake during the firstquarter of fiscal 2007, as well as $2.3 million of amortization expense relatedto the Separation Agreements as more fully described in Note 9 to theconsolidated financial statements.

 

*Operating Income*—Operating income decreasedfrom $161.4 million, or 6.5% of sales, in the first nine months of fiscal2006 to $144.1 million, or 5.7% of sales, in the first nine months offiscal 2007.

 

*Interest Expense*—Interest expense increased$284.7 million in the nine months ended November 3, 2007 compared tothe nine months ended October 28, 2006. This increase was due to the debtissued associated with the Merger.

 

*Other Income*—Other income of $10.6million was $2.6 million lower than last year primarily due to an $8.9 milliondecline in interest income offset by an increase in foreign currency gains of$9.9 million higher than last year.  Inaddition, we recorded a favorable legal settlement of $3.0 million during thefirst nine months of fiscal 2006.

 

*(Benefit) Provision for Income Taxes*—The effectivetax rate was 35.2% for the first nine months of fiscal 2007 and 37.8% for thefirst nine months of fiscal 2006. As a result of our low income base, oureffective rate is highly sensitive to changes caused by permanent differences;therefore, we are unable to predict our effective tax rate for fiscal 2007.

 

*Net (Loss) Income*—As a result of the above,our net loss for the first nine months of fiscal 2007 was $84.6 million ascompared to net income of $108.3 million for the first nine months of fiscal2006.

 

**Liquidityand Capital Resources**

 

Werequire cash principally for day-to-day operations and to finance capitalinvestments, supply initial inventory for new stores, replenish inventory forexisting stores, service our outstanding debt, and seasonal working capitalneeds. In recent years prior to the Merger, we financed our operations, newstore openings, old Common Stock repurchases, dividend payments, and othercapital investments with cash from operations and proceeds from stock optionexercises. We expect that our available cash, cash flow generated fromoperating activities, and funds available under our Asset-based revolvingcredit facility will be sufficient to fund planned capital expenditures,working capital requirements, debt repayments, debt service requirements, andfuture growth throughout fiscal 2007.

 

Ourcash and equivalents increased $26.6 million, or 88.4%, from$30.1 million at the end of fiscal 2006 to $56.7 million at the endof the third quarter of fiscal 2007. Compared to the end of the third quarterof fiscal 2006, cash and equivalents decreased $258.6 million, or 82.0%,as existing cash at the Merger date was used to help finance the Merger.

 

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*Cash Flowfrom Operating Activities*

 

Cashflow used in operating activities during the first nine months of fiscal 2007was $79.8 million compared to cash provided by operating activities of$19.0 million during the first nine months of fiscal 2006. The $98.8million change was primarily due to lower net income and a higher income taxreceivable balance, partially offset by increased leverage on our inventory andaccounts payable balances.

 

Inventoriesper Michaels store (including supporting distribution centers) increased 1.5%from October 28, 2006 to November 3, 2007. We expect inventories perMichaels store at the end of fiscal 2007 to be flat to higher by approximately2% as compared to the end of fiscal 2006.

 

*Cash Flowused in Investing Activities*

 

Cashflow used in investing activities was primarily the result of the followingcapital expenditure activities:

 
| ** **                                         | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------------------------|------------|---------------------------------|------------|
| ** **                                         | ** ** | **November 3,**            | ** ** | **October 28,** | ** ** |
| ** **                                         | ** ** | **2007 (1)**               | ** ** | **2006 (2)** | ** ** |
|                                               |       | (In thousands )                 |       |
| New and relocated stores and stores not yet opened |       | $                               | 22,628     |   | $ | 25,800 |   |
| Existing stores                                    |       | 25,889                          |       | 42,440 |   |
| Distribution system expansion                      |       | 14,377                          |       | 12,371 |   |
| Information systems                                |       | 21,552                          |       | 23,726 |   |
| Corporate and other                                |       | 1,467                           |       | 3,328 |   |
|                                               |       | $                               | 85,913     |   | $ | 107,665 |   |

 

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| (1)    | In the first nine months of fiscal 2007, we incurred  capital expenditures related to the opening of 43 Michaels and 2 Aaron  Brothers stores in addition to the relocation of 11 Michaels stores. |
|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                               |
| (2)    | In the first nine months of fiscal 2006, we incurred  capital expenditures related to the opening of 39 Michaels stores and the  relocation of 7 Michaels stores.                                  |

 

*Cash Flowprovided by Financing Activities*

 

Duringthe first nine months of fiscal 2007, cash provided by financing activities wasa result of incremental borrowings against our asset-based revolving creditfacility. Prior to the Merger, proceeds from the exercise of outstanding stockoptions served as a source of cash for us. Proceeds from the exercise of stockoptions were $35.6 million for the nine-month period ended October 28,2006. During the first nine months of fiscal 2006, we repurchased $66.2 millionof old Common Stock and paid dividends of $42.6 million. As a result of theMerger, we do not expect any material repurchases of our Common Stock and we donot expect that stock option exercise proceeds will serve as a material futuresource of cash, so long as our equity is not listed on a public exchange.

 

*Debt*

 

Tofinance the completion of the Merger, we issued 10% Senior Notes due 2014, 11 3/8% Senior Subordinated Notes due 2016, and 13%Subordinated Discount Notes due 2016. We also executed an asset-based revolvingcredit facility as well as a senior secured term loan facility. Borrowingsunder our Asset-based revolving credit facility are influenced by a number offactors as more fully described below.

 

*Asset-based revolving creditfacility*

 

TheAsset-based revolving credit facility provides senior secured financing of upto $1.0 billion, subject to a borrowing base. Asof November 3, 2007, the borrowing base was $958.6 million with $509.4million of unused availability.

 

Theborrowing base equals the sum of (i) 90% of eligible credit cardreceivables and debit card receivables; (ii) between 85% and 90% of theappraised net orderly liquidation value of eligible inventory and of eligibleletters of credit; (iii) a percentage of eligible in-transit inventory,less certain reserves; and (iv) the sum of an additional 10% of theappraised net orderly liquidation value of eligible inventory and of eligibleletters of credit plus an additional 5% of eligible credit card receivables anddebit card receivables, up to a maximum amount of $100.0 million.

 

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*Senior secured term loan facility*

 

Duringthe first nine months of fiscal 2007, borrowings under the Senior secured termloan facility bore interest at a rate per annum equal to, at our option, either(a) a base rate determined by reference to the higher of (1) theprime rate of Deutsche Bank and (2) the federal funds effective rateplus 1⁄2 of 1% or (b) a LIBOR rate, subject to certain adjustments, ineach case plus an applicable margin. During the first quarter of 2007, theapplicable margin was 1.75% with respect to base rate borrowings and 2.75% withrespect to LIBOR borrowings. During most of the second quarter of 2007 and allof the third quarter of 2007, the applicable margin was 1.25% with respect tobase rate borrowings and 2.25% with respect to LIBOR borrowings, subject todownward adjustment based on the leverage and ratings thresholds set forth inthe Senior secured term loan facility agreement.

 

OnMay 10, 2007, we amended the Senior secured term loan facility to reducethe applicable margin to 1.25% with respect to base rate borrowings and 2.25%with respect to LIBOR borrowings. The amendment also provides that if there isa repricing transaction that reduces the interest rate margins prior to May 10,2008, then each lender will receive a fee equal to 1.00% of the principalamounts of loans that are repriced. Finally, the amendment eliminated therequirement that we maintain a specified consolidated secured debt ratio.

 

**RecentAccounting Pronouncements**

 

InJuly 2006, the FASB issued FASB Interpretation No. 48, *Accounting for Uncertainty in IncomeTaxes — an interpretation of FASB Statement No. 109*,which clarifies the accounting for uncertainty in income tax positions. FIN 48requires that a company recognize in its consolidated financial statements theimpact of a tax position that is more likely than not to be sustained uponexamination based on the technical merits of the position. We adopted FIN 48 asof the beginning of our first quarter of fiscal 2007 with no material impact toour consolidated operations statement, balance sheet, stockholders’ equity, orstatement of cash flows.

 

Upon adoption, we elected to record any interest and penaltiesassociated with audits as a component of income tax expense. The Companyidentified its federal tax return, Canadian tax return, and its state taxreturns in California, Florida, Illinois, New York, North Carolina,Pennsylvania, and Texas as “major” tax jurisdictions.  The periods subject to examination for ourfederal return are 2002 to present, 2000 to present for our Canadian return,and 2003 to present for all major state returns except for California, North Carolina, andTexas.  These states are subject to examination as follows:   California from1999 to present, North Carolina from 2001 to present, and Texas from 2002 topresent.

 

InSeptember 2006, the FASB issued Statement of Financial Accounting StandardNo. 158, *Employers’ Accounting for Defined BenefitPensions and Other Postretirement Plans*, which requires an entity torecognize the overfunded or underfunded status of a defined benefitpostretirement plan as an asset or liability in its balance sheet and torecognize changes in that funded status in the year in which the changes occurthrough comprehensive income.  It alsorequires an entity to measure the funded status of a plan as of the date of itsyear-end balance sheet.  As we have nopublicly traded equity securities, FAS 158 is effective for us at the end offiscal 2007, with early adoption permitted. We plan to adopt FAS 158 at the end of fiscal 2007, with no materialimpact expected on our consolidated statement of operations, balance sheet, stockholders’equity, or statement of cash flows.

 

InFebruary 2007, the FASB issued Statement of Financial Accounting Standard No. 159,*The Fair Value Option for Financial Assets andFinancial Liabilities*, which permits companies to measure certainfinancial instruments and other items at fair value (at specified measurementdates) that are not currently required to be measured at fair value. Anyunrealized gains or losses applicable to those items measured at fair valueshall be reported in earnings. The decision to apply fair value shall generallybe made on an instrument by instrument basis, is irrevocable, and is appliedonly to an entire instrument. The provisions of FAS 159 will be effective forus as of the beginning for fiscal 2008, with early adoption permitted.

 

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**Item 3.  Quantitative and QualitativeDisclosures About Market Risk.**

 

Weare exposed to fluctuations in exchange rates between the US and Canadiandollars, as the functional currency of our Canadian subsidiary is the Canadiandollar.  To mitigate the effects ofcurrency fluctuations, during the second quarter of fiscal 2007, we executed aforeign currency cash flow hedge. To facilitate cash flow hedge accounting, theobjective is to hedge payments for forecasted purchases of intercompanyinventory by our Canadian subsidiary denominated in US dollars.  The term of this cash flow hedge extendsthrough fiscal 2007.

 

Toachieve our objective and to minimize the risk of ineffectiveness, the notionalvalues represent a portion of our Canadian subsidiary’s forecasted intercompanypurchases.  Any hedge ineffectiveness isrecorded in Other income. For the three and nine month periods ended November 3,2007, the ineffective portion of the hedge was recorded as a loss of $1.5million.

 

Forthe portion of the hedge that is effective, the change in fair value of thathedge will initially be recorded in Other comprehensive income.  As the underlying inventory is sold to ourcustomers, amounts will be reclassified from Other comprehensive income to Costof sales and occupancy expense in the statement of operations.  The change in fair value of the hedge for thethree and nine month periods ended November 3, 2007, were recorded aslosses of $2.2 million and $2.1 million, respectively.

 

Thetable below provides the remaining quarterly notional values and the averageCAD/USD exchange rate associated with the hedge (dollars in thousands).

 
| **Period**      | ** ** | **CAD Amount** | ** ** | **USD Amount** | ** ** | **Rate**   | ** ** |
|-----------------|------------|---------------------|------------|---------------------|------------|------------|------------|
| ** **      | ** ** | ** **          | ** ** | ** **          | ** ** | ** ** | ** ** |
| Quarter 4, 2007 |       | $                   | 19,940     |                | $          | 19,000     |       | 1.049 |   |
|                 |            |                     |            |                     |            |            |            |  |  |

 

**Item 4.  Controls and Procedures.**

 

*Evaluationof Disclosure Controls and Procedures*

 

Wemaintain a set of disclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) promulgated by the SEC under the Securities Exchange Act of1934). An evaluation was carried out under the supervision and with theparticipation of our management, including our Chief Executive Officer and ourPresident and Chief Financial Officer, of the effectiveness of our disclosurecontrols and procedures as of the end of the period covered by this QuarterlyReport on Form 10-Q. Based on that evaluation, our Chief Executive Officerand our President and Chief Financial Officer concluded that our disclosurecontrols and procedures are effective to provide reasonable assurance thatinformation required to be disclosed in the reports that we file or submitunder the Securities Exchange Act of 1934 is recorded, processed, summarized,and reported within the time periods specified in SEC rules and forms.Such controls and procedures are designed to ensure that information we arerequired to disclose in our reports is accumulated and communicated to ourmanagement, including our principal executive officers and principal financialofficer, to allow timely disclosure decisions. We note that the design of anysystem of controls is based, in part, upon certain assumptions about thelikelihood of future events, and there can be no assurance that any design willsucceed in achieving its stated goals under all potential future conditions.

 

*Change inInternal Control Over Financial Reporting*

 

Therehas not been any change in our internal control over financial reporting (asdefined in Rules 13a-15(f) and 15d-15(f) as promulgated by theSEC under the Securities Exchange Act of 1934) during our most recentlycompleted fiscal quarter that materially affected, or is reasonably likely tomaterially affect, our internal control over financial reporting.

 

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**MICHAELSSTORES, INC.**

**Part II—OTHERINFORMATION**

 

**Item 1.  LegalProceedings.**

 

Referenceis made to the action described under “Part I. Item 3. Legal Proceedings –Employee Class Action Claims – Clark Claim” in our Annual Report on Form 10-Kfor fiscal 2006.  In that action, on November 14,2007, the court granted final approval of the settlement.  The settlement had no material impact on ourstatement of operations, balance sheet, or statement of cash flows for anyperiod presented.

 

Referenceis made to the description of the potential Section 16 liability issuesunder “Item 3. Legal Proceedings — Governmental Inquiries and Related Matters —Non-U.S. Trust Inquiry” in our Annual Report on Form 10-K for fiscal2006.  The tolling agreement with theWylys expired on October 5, 2007. On October 4, 2007, our Board ofDirectors determined that it was in the best interest of the Company and itsstockholders not to further pursue the potential Section 16 liability.

 

Weare involved in ongoing legal and regulatory proceedings. Other than theupdates described in the preceding paragraphs, there were no material changesto our disclosures of commitments and contingencies from our Annual Report on Form 10-Kfor fiscal 2006 and our Quarterly Reports on Form 10-Q for the quartersended April 5, 2007 and August 4, 2007.

 

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**Item 6.  Exhibits.**

 

(a) Exhibits:

 
| Exhibit   Number | ** ** | **Description of Exhibit**                                                                                                                 |
|------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------|
| 31.1             |       | Certifications of Brian C. Cornell pursuant to §302  of the Sarbanes-Oxley Act of 2002 (filed herewith).                              |
|             |       |                                                                                                                                       |
| 31.2             |       | Certifications of Jeffrey N. Boyer pursuant to §302  of the Sarbanes-Oxley Act of 2002 (filed herewith).                              |
|             |       |                                                                                                                                       |
| 32.1             |       | Certification pursuant to 18 U.S.C. §1350, as  adopted pursuant to §906 of the Sarbanes-Oxley Act of 2002 (filed herewith). |

 

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**MICHAELSSTORES, INC.**

**SIGNATURES**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the Registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 
|                                         | MICHAELS STORES, INC. |
|-----------------------------------------|-----------------------|
|                                    |                  |   |
|                                    | By:                   | /s/ Jeffrey N. Boyer |   |
|                                    |                  | Jeffrey N. Boyer |
|                                    |                  | President and Chief Financial Officer |
| ** **                              | ** **            | **(Principal  Financial Officer)** |
| ** **                              | ** **            | ** ** |
| **Dated: December 18,  2007** | ** **            | ** ** |

 

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**INDEX TO EXHIBITS**

 
| Exhibit   Number | ** ** | **Description of Exhibit**                                                                                                                 |
|-----------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------|
|                  |       |                                                                                                                                       |
| 31.1                  |       | Certifications of Brian C. Cornell pursuant to §302  of the Sarbanes-Oxley Act of 2002 (filed herewith).                              |
|                  |       |                                                                                                                                       |
| 31.2                  |       | Certifications of Jeffrey N. Boyer pursuant to §302  of the Sarbanes-Oxley Act of 2002 (filed herewith).                              |
|                  |       |                                                                                                                                       |
| 32.1                  |       | Certification pursuant to 18 U.S.C. §1350, as  adopted pursuant to §906 of the Sarbanes-Oxley Act of 2002 (filed herewith). |

 

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