Table of Contents

** **

 

** **

**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON, DC 20549**

 

----

 

**FORM 10-Q**

 

**(MarkOne)**

 

**x****      QUARTERLY REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

** **

**For the quarterly period ended July 31, 2010**

** **

**OR**

** **

**o****         TRANSITION REPORTPURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934**

 

**For the transition period from             to              **

 

**Commission file number 001-09338**

 

----

** **

**MICHAELSSTORES, INC.**

(Exactname of registrant as specified in its charter)

 

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

 

**8000 Bent Branch Drive**

**Irving, Texas 75063**

 (Address of principal 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 bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the Registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.* Yes o No o

 

Indicate by check markwhether the registrant has submitted electronically and posted on its corporateWeb site, if any, every Interactive Data File required to be submitted andposted pursuant to Rule 405 of Regulation S-T during the preceding 12months (or for such shorter period that the registrant was required to submitand post such files).   Yes o No o

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, anon-accelerated filer, or a smaller reporting company. See the definitions of “largeaccelerated filer,” “accelerated filer” and “smaller reporting company” inRule 12b-2 of the Exchange Act.

 

| Large accelerated filer o                     |   | Accelerated filer o         |
|-----------------------------------------------|--------|-----------------------------|
| Non-accelerated filer x                       |   | Smaller reporting company o |
| (Do not check if a smaller reporting company) |   |                        |

 

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

 

As of August 23, 2010,118,898,939 shares of the Registrant’s Common Stock were outstanding.

 

----

*The Registrant has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934, but isnot required to file such reports under such sections.

 

 

 

----

Table of Contents

 

**MICHAELSSTORES, INC.**

**FORM 10-Q**

 
| **Part I—FINANCIAL INFORMATION** |
|--------------------------------------------|
| ** **                                 |
| **Item 1.**                           | **Financial Statements** | ** ** |
|                                       | Consolidated  Balance Sheets at July 31, 2010, January 30, 2010, and  August 1, 2009 (unaudited) | **3** |
|                                       | Consolidated Statements of Operations for the quarter  and six months ended July 31, 2010 and August 1,  2009 (unaudited) | **4** |
|                                       | Consolidated  Statements of Cash Flows for the six months ended July 31, 2010 and  August 1, 2009 (unaudited) | **5** |
|                                       | Notes to Consolidated Financial Statements (unaudited) | **6** |
| **Item 2.**                           | **Management’s  Discussion and Analysis of Financial Condition and Results of Operations** | **20** |
| **Item 3.**                           | **Quantitative  and Qualitative Disclosures About Market Risk** | **27** |
| **Item 4.**                           | **Controls and  Procedures** | **27** |
| ** **                                 | ** ** | ** ** |
| **Part II—OTHER  INFORMATION**   |
| ** **                                 |
| **Item 1.**                           | **Legal Proceedings** | **28** |
| **Item 6.**                           | **Exhibits** | **28** |
| **Signatures**                             | ** ** | **29** |

 

2

----

Tableof Contents

 

**MICHAELS STORES, INC.**

**Part I—FINANCIAL INFORMATION**

 

**Item 1.  FinancialStatements.**

 

**MICHAELS STORES, INC.**

**CONSOLIDATED BALANCE SHEETS**

**(In millions, except share data)**

**(Unaudited)**

 
| ** **                                                                                                                                                                                                                                                             | ** ** | **July 31,** | ** ** | **January 30,** | ** ** | **August 1,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|----------------------|------------|--------------------|------------|
| ** **                                                                                                                                                                                                                                                             | ** ** | **2010**          | ** ** | **2010**             | ** ** | **2009**           | ** ** |
| **ASSETS**                                                                                                                                                                                                                                                             |       |              |       |                 |       |               |       |
| **Current assets:**                                                                                                                                                                                                                                                    |       |              |       |                 |       |               |       |
| Cash and equivalents                                                                                                                                                                                                                                                   |       | $                 | 69         |                 | $          | 217                |       | $ | 36 |   |
| Merchandise inventories                                                                                                                                                                                                                                                |       | 888               |       | 873                  |       | 950                |       |
| Prepaid expenses and other                                                                                                                                                                                                                                             |       | 70                |       | 72                   |       | 75                 |       |
| Deferred income taxes                                                                                                                                                                                                                                                  |       | 42                |       | 45                   |       | 41                 |       |
| Income tax receivable                                                                                                                                                                                                                                                  |       | 31                |       | —               |       | 16                 |       |
| Total current assets                                                                                                                                                                                                                                                   |       | 1,100             |       | 1,207                |       | 1,118              |       |
| **Property and equipment, at cost**                                                                                                                                                                                                                                    |       | 1,276             |       | 1,257                |       | 1,228              |       |
| Less accumulated depreciation                                                                                                                                                                                                                                          |       | (981              | )          | (940                 | )          | (883               | )          |
| Property and equipment, net                                                                                                                                                                                                                                            |       | 295               |       | 317                  |       | 345                |       |
| **Goodwill**                                                                                                                                                                                                                                                           |       | 94                |       | 94                   |       | 94                 |       |
| **Debt issuance costs, net of  accumulated amortization of $65, $56, and $47, respectively**                                                                                                                                                                           |       | 80                |       | 70                   |       | 78                 |       |
| **Deferred income taxes**                                                                                                                                                                                                                                              |       | 8                 |       | 1                    |       | 14                 |       |
| **Other assets**                                                                                                                                                                                                                                                       |       | 7                 |       | 21                   |       | 26                 |       |
| Total non-current assets                                                                                                                                                                                                                                               |       | 189               |       | 186                  |       | 212                |       |
| Total assets                                                                                                                                                                                                                                                           |       | $                 | 1,584      |                 | $          | 1,710              |       | $ | 1,675 |   |
|                                                                                                                                                                                                                                                                   |       |              |       |                 |       |               |       |
| **LIABILITIES  AND STOCKHOLDERS’ DEFICIT**                                                                                                                                                                                                                        |       |              |       |                 |       |               |       |
| **Current liabilities:**                                                                                                                                                                                                                                               |       |              |       |                 |       |               |       |
| Accounts payable                                                                                                                                                                                                                                                       |       | $                 | 222        |                 | $          | 231                |       | $ | 216 |   |
| Accrued liabilities and other                                                                                                                                                                                                                                          |       | 321               |       | 355                  |       | 288                |       |
| Current portion of long-term debt                                                                                                                                                                                                                                      |       | 1                 |       | 119                  |       | 198                |       |
| Income taxes payable                                                                                                                                                                                                                                                   |       | 1                 |       | 11                   |       | —             |       |
| Current liabilities - discontinued operations                                                                                                                                                                                                                          |       | —            |       | 1                    |       | 1                  |       |
| Total current liabilities                                                                                                                                                                                                                                              |       | 545               |       | 717                  |       | 703                |       |
| **Long-term debt**                                                                                                                                                                                                                                                     |       | 3,707             |       | 3,684                |       | 3,766              |       |
| **Deferred income taxes**                                                                                                                                                                                                                                              |       | 2                 |       | —               |       | —             |       |
| **Other long-term liabilities**                                                                                                                                                                                                                                        |       | 84                |       | 80                   |       | 79                 |       |
| **Long-term liabilities -  discontinued operations**                                                                                                                                                                                                                   |       | —            |       | —               |       | 1                  |       |
| Total long-term liabilities                                                                                                                                                                                                                                            |       | 3,793             |       | 3,764                |       | 3,846              |       |
| Total liabilities                                                                                                                                                                                                                                                      |       | 4,338             |       | 4,481                |       | 4,549              |       |
| **Commitments and contingencies**                                                                                                                                                                                                                                      |       |              |       |                 |       |               |       |
| **Stockholders’ deficit:**                                                                                                                                                                                                                                        |       |              |       |                 |       |               |       |
| Common Stock, $0.10 par value, 220,000,000 shares  authorized; 118,389,571 shares issued and outstanding at July 31, 2010; 118,387,229  shares issued and outstanding at January 30, 2010; 118,387,229 shares  issued and outstanding at August 1, 2009 |       | 12                |       | 12                   |       | 12                 |       |
| Additional paid-in capital                                                                                                                                                                                                                                             |       | 39                |       | 35                   |       | 32                 |       |
| Accumulated deficit                                                                                                                                                                                                                                                    |       | (2,812            | )          | (2,824               | )          | (2,925             | )          |
| Accumulated other comprehensive income                                                                                                                                                                                                                                 |       | 7                 |       | 6                    |       | 7                  |       |
| Total stockholders’ deficit                                                                                                                                                                                                                                       |       | (2,754            | )          | (2,771               | )          | (2,874             | )          |
| Total liabilities and stockholders’ deficit                                                                                                                                                                                                                       |       | $                 | 1,584      |                 | $          | 1,710              |       | $ | 1,675 |   |

 

Seeaccompanying notes to consolidated financial statements.

 

3

----

Table of Contents

 

**MICHAELS STORES, INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**(In millions)**

**(Unaudited)**

 
| ** **                                   | ** ** | **Quarter Ended** | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------|------------|-------------------|------------|----------------------|------------|
| ** **                                   | ** ** | **July 31,** | ** ** | **August 1,**   | ** ** | **July 31,** | ** ** | **August 1,** | ** ** |
| ** **                                   | ** ** | **2010**          | ** ** | **2009**             | ** ** | **2010** | ** ** | **2009** | ** ** |
| **Net sales**                                |       | $                 | 831        |                 | $          | 807 |   | $ | 1,732 |   | $ | 1,659 |   |
| Cost of sales and occupancy expense          |       | 520               |       | 521                  |       | 1,067 |   | 1,058 |   |
| **Gross profit**                             |       | 311               |       | 286                  |       | 665 |   | 601 |   |
| Selling, general, and administrative expense |       | 233               |       | 232                  |       | 478 |   | 478 |   |
| Related party expenses                       |       | 4                 |       | 3                    |       | 7 |   | 7 |   |
| Store pre-opening costs                      |       | —            |       | 1                    |       | 1 |   | 2 |   |
| **Operating income**                         |       | 74                |       | 50                   |       | 179 |   | 114 |   |
| Interest expense                             |       | 70                |       | 62                   |       | 138 |   | 125 |   |
| Other (income) and expense, net              |       | 4                 |       | (14                  | )          | 11 |   | (20 | ) |
| **Income before income taxes**               |       | —            |       | 2                    |       | 30 |   | 9 |   |
| Provision for income taxes                   |       | 1                 |       | —               |       | 18 |   | 3 |   |
| **Net (loss) income**                        |       | $                 | (1         | )                    | $          | 2 |   | $ | 12 |   | $ | 6 |   |

 

Seeaccompanying notes to consolidated financial statements.

 

4

----

Table of Contents

** **

**MICHAELS STORES, INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(In millions)**

**(Unaudited)**

 
| ** **                                           | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------|------------|----------------------|------------|
| ** **                                           | ** ** | **July 31,**    | ** ** | **August 1,** | ** ** |
| ** **                                           | ** ** | **2010**             | ** ** | **2009** | ** ** |
| **Operating activities:**                            |       |                 |       |   |   |
| Net income                                           |       | $                    | 12         |   | $ | 6 |   |
| Adjustments:                                         |       |                 |       |   |   |
| Depreciation and amortization                        |       | 52                   |       | 58 |   |
| Share-based compensation                             |       | 4                    |       | 4 |   |
| Debt issuance costs amortization                     |       | 9                    |       | 8 |   |
| Accretion of subordinated discount notes             |       | 24                   |       | 22 |   |
| Change in fair value of interest rate cap            |       | 13                   |       | (15 | ) |
| Changes in assets and liabilities:                   |       |                 |       |   |   |
| Merchandise inventories                              |       | (15                  | )          | (43 | ) |
| Prepaid expenses and other                           |       | 2                    |       | (5 | ) |
| Deferred income taxes and other                      |       | (1                   | )          | (8 | ) |
| Accounts payable                                     |       | (9                   | )          | 7 |   |
| Accrued interest                                     |       | (2                   | )          | 1 |   |
| Accrued liabilities and other                        |       | (29                  | )          | 7 |   |
| Income taxes receivable                              |       | (41                  | )          | (17 | ) |
| Other long-term liabilities                          |       | 4                    |       | 5 |   |
| Net cash provided by operating activities            |       | 23                   |       | 30 |   |
|                                                 |       |                 |       |   |   |
| **Investing activities:**                            |       |                 |       |   |   |
| Additions to property and equipment                  |       | (33                  | )          | (17 | ) |
| Net cash used in investing activities                |       | (33                  | )          | (17 | ) |
|                                                 |       |                 |       |   |   |
| **Financing activities:**                            |       |                 |       |   |   |
| Borrowings on asset-based revolving credit  facility |       | 13                   |       | 441 |   |
| Payments on asset-based revolving credit facility    |       | (13                  | )          | (415 | ) |
| Repayments on senior secured term loan facility      |       | (118                 | )          | (12 | ) |
| Payment of debt issuance costs                       |       | (19                  | )          | — |   |
| Change in cash overdraft                             |       | —               |       | (23 | ) |
| Other                                                |       | (1                   | )          | (1 | ) |
| Net cash used in financing activities                |       | (138                 | )          | (10 | ) |
|                                                 |       |                 |       |   |   |
| **(Decrease) increase in cash and  equivalents**     |       | (148                 | )          | 3 |   |
| **Cash and equivalents at beginning  of period**     |       | 217                  |       | 33 |   |
| **Cash and equivalents at end of  period**           |       | $                    | 69         |   | $ | 36 |   |
|                                                 |       |                 |       |   |   |
| **Supplemental Cash Flow  Information:**             |       |                 |       |   |   |
| Cash paid for interest                               |       | $                    | 105        |   | $ | 93 |   |
| Cash paid for income taxes                           |       | $                    | 58         |   | $ | 19 |   |

 

Seeaccompanying notes to consolidated financial statements.

 

5

----

Table of Contents

 

**MICHAELS STORES, INC.**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

**For the Six Months Ended July 31,2010**

**(Unaudited)**

 

**Note 1.  Summaryof Significant Accounting Policies**

 

*Basisof Presentation*

 

Theconsolidated financial statements include the accounts of MichaelsStores, Inc. and our wholly-owned subsidiaries. All significantintercompany accounts and transactions have been eliminated. All expressions ofthe “Company”, “us,” “we,” “our,” and all similar expressions are references toMichaels Stores, Inc. and our consolidated, wholly-owned subsidiaries,unless otherwise expressly stated or the context otherwise requires.

 

Theaccompanying unaudited consolidated financial statements have been prepared inaccordance with U.S. generally accepted accounting principles for interimfinancial information and with the instructions to Form 10-Q andArticle 10 of Regulation S-X. Accordingly, they do not include all ofthe information and notes required by U.S. generally accepted accountingprinciples for complete financial statements. Therefore, these financial statements should be read in conjunction withour Annual Report on Form 10-K for the fiscal year ended January 30,2010.

 

Thebalance sheet at January 30, 2010 has been derived from the auditedfinancial statements at that date but does not include all of the informationand notes required by U.S. generally accepted accounting principles forcomplete financial statements. For further information, refer to theconsolidated financial statements and notes thereto included in our AnnualReport on Form 10-K for the fiscal year ended January 30, 2010.

 

Inthe opinion of management, all adjustments (consisting of normal recurringaccruals and other items disclosed herein) considered necessary for a fairpresentation have been included.

 

Becauseof the seasonal nature of our business, the results of operations for the threeand six months ended July 31, 2010 are not indicative of the results to beexpected for the entire year.

 

Wereport on the basis of a 52 or 53-week fiscal year, which ends on the Saturdayclosest to January 31. All references herein to “fiscal 2010” relate tothe 52 weeks ending January 29, 2011, and all references to “fiscal2009” relate to the 52 weeks ended January 30, 2010. In addition, allreferences herein to “the second quarter of fiscal 2010” relate to the 13 weeksended July 31, 2010 and all references to “the second quarter of fiscal 2009”relate to the 13 weeks ended August 1, 2009.  Finally, all references to “the six monthsended July 31, 2010” relate to the 26 weeks ended July 31, 2010, and “thesix months ended August 1, 2009” relate to the 26 weeks endedAugust 1, 2009.

 

*RecentAccounting Pronouncements*

 

InJanuary 2010, the Financial Accounting Standards Board (“FASB”) issuedAccounting Standards Update (“ASU”) No. 2010-06, “*Improving Disclosures About Fair Value Measurements”*an amendment to Accounting StandardsCodification (“ASC”) topic 820, *“Fair Value Measurementsand Disclosures.”*ASU 2010-06 requires expanded disclosures relatedto fair value measurements including (i) disclose separately the amounts ofsignificant transfers in and out of Level 1 and Level 2 fair value measurementsand describe the reasons for the transfers and (ii) present separateinformation for Level 3 activity pertaining to gross purchases, sales,issuances, and settlements. The new disclosures are effective forinterim and annual reporting periods beginning after December 15, 2009,except for the Level 3 activity disclosures, which are effective for fiscalyears beginning after December 15, 2010. We adopted all requirements ofASU 2010-06 related to significant transfers in and out of Level 1 and Level 2fair value measurements on January 31, 2010, with no material impact on ourconsolidated financial statements. See Note 6 for further information regardingfair value measurements. We will adopt the new disclosure requirements relatedto the Level 3 activity on January 30, 2011, with no material impact expectedon our consolidated financial statements.

 

**Note 2.  Share-BasedCompensation**

 

The 2006 Equity IncentivePlan (“2006 Plan”) provides for the grant of share-based awards exercisable forup to 14.2 million shares of Common Stock. As of July 31, 2010, there were 10.1million stock option awards outstanding. In addition, there were a total of589,204 shares of restricted stock outstanding under the 2006 Plan, of which79,836 are vested. 3.5 million shares of Common Stock remain available forgrant under the 2006 Plan. The table below sets forth a summary of stock optionactivity:

 

6

----

Table of Contents

 

| ** **                         | ** ** | **Six Months Ended** | ** ** |
|------------------------------------|------------|----------------------|------------|
| ** **                         | ** ** | **July 31, 2010**    | ** ** |
| ** **                         | ** ** | **(in millions)**    | ** ** |
| ** **                         | ** ** | ** **           | ** ** |
| Outstanding at beginning of period |       | 9.5                  |       |
| Grants                             |       | 0.9                  |       |
| Canceled/Forfeited                 |       | (0.3                 | )          |
| Outstanding at end of period       |       | 10.1                 |       |

 

Generally,awards granted under the 2006 Plan vest ratably over five years and expireeight years from the grant date. The exercise prices of the options range from$7.50 per share to $22.50 per share, as determined by the Board of Directors.Share-based compensation expense associated with the stock options and therestricted stock was approximately $2 million for the second quarter of each offiscal 2010 and fiscal 2009, and $4 million during each of the six months endedJuly 31, 2010 and August 1, 2009.

 

**Note 3.  Debt**

 

Ouroutstanding debt is detailed in the table below.  We were in compliance with the terms andconditions of all debt agreements for all periods presented.

 
| ** **                            | ** ** | **July 31, 2010** | ** **                                             | **January 30, 2010** | ** ** | **August 1, 2009**                                     | ** ** |
|---------------------------------------|------------|-------------------|--------------------------------------------------------|----------------------|------------|--------------------------------------------------------|------------|
| ** **                            | ** ** | **(in millions)** | ** **                                             |
| ** **                            | ** ** | ** **        | ** **                                             | ** **           | ** ** | ** **                                             | ** ** |
| Senior secured term loan              |       | $                 |       2,156                   |                 | $          |         2,274       |       | $ |           2,285 |   |
| Senior notes                          |       | 750               |                                                   | 750                  |       | 750                                                    |       |
| Senior subordinated notes             |       | 400               |                                                   | 400                  |       | 400                                                    |       |
| Subordinated discount notes           |       | 401               |                                                   | 377                  |       | 354                                                    |       |
| Asset-based revolving credit facility |       | —            |                                                   | —               |       | 174                                                    |       |
| Other                                 |       | 1                 |                                                   | 2                    |       | 1                                                      |       |
|                                  |       |              |                                                   |                 |       |                                                   |       |
| Total debt                            |       | 3,708             |                                                   | 3,803                |       | 3,964                                                  |       |
|                                  |       |              |                                                   |                 |       |                                                   |       |
| Less current portion                  |       | 1                 |                                                   | 119                  |       | 198                                                    |       |
|                                  |       |              |                                                   |                 |       |                                                   |       |
| Long-term debt                        |       | $                 |          3,707 |                 | $          |          3,684 |       | $ |          3,766 |   |

 

*Asset-basedrevolving credit facility*

 

On February 18, 2010,we entered into an agreement to amend and restate various terms of the thenexisting asset-based revolving credit facility dated as of October 31,2006 (the “Amended Asset-based revolving credit facility”).

 

TheAmended Asset-based revolving credit facility extended an aggregate amount of$850 million of the tranche A commitments and $50 million of the FILO (asdefined below) commitments, with respect to certain lenders (the “ExtendingLenders”), from October 31, 2011 to the earlier of April 15, 2014, or45 days prior to the maturity date of any class of term loans in the Company’ssenior secured term loan facility. In addition, $202 million of commitmentsfrom the other lenders under the existing asset-based revolving credit facility(the “Non-Extending Lenders”) shall terminate on October 31, 2011.Simultaneously with entering into the Amended Asset-based revolving creditfacility, the Company exercised its ability to increase tranche A commitmentsin the aggregate amount of $152 million.

 

Theborrowing base on the Amended Asset-based revolving credit facility equals thesum of (i) 90% of eligible credit card receivables and debit cardreceivables; (ii) between 85% and 87.5% of the appraised net orderlyliquidation value of eligible inventory and of eligible letters of credit;(iii) a percentage of eligible in-transit inventory, less certain reserves;and (iv) the sum of an additional 5% of the appraised net orderlyliquidation value of eligible inventory and of eligible letters of credit plusan additional 5% of eligible credit card receivables and debit card receivablesunder a last out tranche (the first in last out tranche “FILO”).

 

7

----

Table of Contents

 

The Amended Asset-basedrevolving credit facility provides us with the right to request up to$200 million of additional commitments under this facility, of which $48million remains available, prior to the maturity of the existing asset-basedrevolving credit facility on October 31, 2011.  The lenders under this facility are not underany obligation to provide any such additional commitments, and any increase incommitments is subject to customary conditions precedent.  If we were to request any such additionalcommitments, and the existing lenders or new lenders were to agree to providesuch commitments, the facility size under the Amended Asset-based revolvingcredit facility could be increased to up to $1.2 billion after the maturity ofthe loans with respect to Non-Extending Lenders. However, our ability to borrowunder this facility would still be limited by the amount of the borrowing base.

 

Withrespect to the Extending Lenders, borrowings under the Amended Asset-basedrevolving credit facility bear interest at a rate per annum equal to, at ouroption, either (a) a base rate determined by reference to the highest of(1) the prime rate of Bank of America, N.A., (2) the federal fundseffective rate plus 0.50% and (3) a LIBOR rate subject to certainadjustments plus 1.00% or (b) a LIBOR rate subject to certain adjustments,in each case plus an applicable margin.  With respect to the Non-ExtendingLenders, borrowings under the Amended Asset-based revolving credit facilitybear interest at a rate per annum equal to, at our option, either (a) abase rate determined by reference to the higher of (1) the prime rate ofBank of America, N.A. and (2) the federal funds effective rate plus 0.50%or (b) a LIBOR rate subject to certain adjustments, in each case plus anapplicable margin.  The initial applicable margin with respect to ExtendingLenders is (a) 2.50% for non-FILO base rate borrowings and 3.50% fornon-FILO LIBOR borrowings and (b) 4.50% for FILO base rate borrowings and5.50% for FILO LIBOR borrowings.  The initial applicable margin withrespect to Non-Extending Lenders is 0.50% for base rate borrowings and 1.50%for LIBOR borrowings.  The applicable margin is subject to adjustment eachfiscal quarter based on the excess availability under the Amended Asset-basedrevolving credit facility.  Same-day borrowings bear interest at a rateper annum equal to a base rate determined by reference to the highest of(a) the prime rate of Bank of America, N.A., (b) the federal fundseffective rate plus 0.50% and (c) a LIBOR rate subject to certainadjustments plus 1.00%, in each case, plus an applicable margin. The initialapplicable margin with respect to same-day borrowings is 2.50%.

 

Weare required to pay a commitment fee of 0.625% per annum on the unutilizedcommitments with respect to Extending Lenders and 0.25% with respect to Non-ExtendingLenders under the Amended Asset-based revolving credit facility.  We must also pay customary letter of creditfees and agency fees.

 

If,at any time, the aggregate amount of outstanding loans, unreimbursed letter ofcredit drawings and undrawn letters of credit under the Amended Asset-basedrevolving credit facility exceeds the lesser of (i) the commitment amountor (ii) the borrowing base, we will be required to repay outstanding loansand cash collateralize letters of credit in an aggregate amount equal to suchexcess, with no reduction of the commitment amount.  If the amount available under the AmendedAsset-based revolving credit facility is less than $75 million at any time, orfor five consecutive business days is less than the greater of $100 million and15% of the lesser of the (i) then borrowing base and (ii) RevolvingCredit Ceiling (as defined below), or if certain events of default haveoccurred, we will be required to repay outstanding loans and cash collateralizeletters of credit with the cash we are required to deposit daily in acollection account maintained with the agent under the Amended Asset-basedrevolving credit facility. We may voluntarily reduce the unutilized portion ofthe commitment amount and repay outstanding loans at any time without premiumor penalty other than customary breakage costs with respect to LIBOR loans.

 

Wemust not permit excess availability at any time to be less than the greater of(a) $75 million and (b) 10% of the lesser of (1) the thenborrowing base under the Amended Asset-based revolving credit facility or(2) $1,102 million (as reduced or increased in accordance with the termsof the Amended Asset-based credit facility, the “Revolving Credit Ceiling”). Excess availability under the Amended Asset-based revolving credit facilitymeans the lesser of (a) the Revolving Credit Ceiling minus the outstandingcredit extensions and (b) the then borrowing base minus the outstandingcredit extensions.

 

Althoughthe Amended Asset-based revolving credit facility does not require us to complywith any financial ratio maintenance, it does contain a number of covenantsthat, among other things and subject to certain exceptions, restricts theCompany’s ability and the ability of its subsidiaries to:

 

·                  incur additionalindebtedness;

·                  pay dividends on the Company’scapital stock or redeem, repurchase or retire the Company’s capital stock orits other indebtedness;

·                  make investments, loans,advances and acquisitions;

·                  create restrictions on thepayment of dividends or other amounts to the Company from its restrictedsubsidiaries;

·                  engage in transactions withaffiliates of the Company;

·                  sell assets, includingcapital stock of the Company’s subsidiaries;

·                  consolidate or merge; and

·                  create liens.

 

8

----

Table of Contents

 

Thecovenants limiting dividends and other restricted payments; investments, loans,advances and acquisitions; and prepayments or redemptions of indebtedness, eachpermit the restricted actions in an unlimited amount, subject to thesatisfaction of certain payment conditions, principally that we must meetcertain specified excess availability requirements and minimum consolidatedfixed charge coverage ratios, to be tested on a pro forma and 12 monthsprojected basis. Adjusted EBITDA is used in the calculation of the consolidatedfixed charge coverage ratios.

 

In addition, (a) for theperiod of thirty consecutive days preceding the maturity of the loans of theNon-Extending Lenders and (b) on a projected pro forma basis, giving effect tothe repayment of the loans of the Non-Extending Lenders and termination orreduction, as applicable, of the commitments of such lenders, for the six-monthperiod following the maturity of the loans of the Non-Extending Lenders, wemust not permit excess availability at any time to be less than $125 million.The Amended Asset-based revolving credit facility also contains certaincustomary affirmative covenants and events of default.

 

Inthe first quarter of fiscal 2010, we recorded $19 million in debt issuancecosts related to the amendment to the asset-based revolving credit facilitythat will be amortized as interest expense over the life of the AmendedAsset-based revolving credit facility in accordance with ASC 470, *Debt*. In addition, we will amortize $5 million of theunamortized debt issuance costs related to the asset-based revolving creditfacility over the revised life, with the remaining $1 million being amortizedover the original life.

 

As of July 31, 2010,the borrowing base was $661 million, of which we had no outstanding borrowings,$53 million of outstanding letters of credit, and $608 million of excessavailability.

 

*Seniorsecured term loan facility*

 

Borrowings under our seniorsecured term loan facility, which we entered into on October 31, 2006,with Deutsche Bank A.G. New York Branch (“Deutsche Bank”) and other lenders(the “Senior secured term loan facility”) bear interest at a rate per annumequal to, at our option, either (a) a base rate determined by reference tothe higher of (1) the prime rate of Deutsche Bank and (2) the federalfunds effective rate plus 0.5% or (b) a LIBOR rate, subject to certainadjustments, in each case plus an applicable margin as described below.

 

On November 5, 2009, weamended the Senior secured term loan facility to extend $1.0 billion ofexisting term loans (the “B-2 Term Loans”) to July 31, 2016, with theremaining $1.28 billion of existing term loans (the “B-1 Term Loans” andtogether with the B-2 Term Loans, the “Term Loans”) keeping the originalmaturity date of October 31, 2013. The B-2 Term Loans are subject to(i) a springing maturity date of July 31, 2014, unless we have either(x) refinanced our Senior Notes by July 30, 2014 with newindebtedness that does not mature or require any principal payments prior to 91days after the extended maturity date of the B-2 Term Loans or (y) met apro forma secured leverage ratio of 3.25:1.00 for the test period endingApril 30, 2014; and (ii) a minimum increase in interest rates on theB-2 Term Loans in connection with any future extensions of term loans to theextent that any such future extension has an increase in effective yield in excessof 0.25% above the effective yield of the B-2 Term Loans. As of July 31, 2010,the applicable margin for the B-1 and B-2 Term Loans was 1.25% and 3.50%,respectively, with respect to base rate borrowings and 2.25% and 4.50%,respectively, with respect to LIBOR borrowings.

 

The Senior secured term loanfacility requires us to prepay outstanding loans to the extent we have ExcessCash Flow, as fully described in our Annual Report on Form 10-K for thefiscal year ended January 30, 2010. Under the facilities, excess cash flowpayments serve to reduce future scheduled quarterly principal payments. Thefiscal 2009 excess cash flow payment effectively satisfies all scheduledquarterly principal payments until maturity of the B-1 Term Loans and requiredpayments under the B-2 Term Loans until the end of fiscal 2014. The excess cashflow calculation used to determine the required payment amount, if any, iscalculated at the end of each fiscal year. Due to the nature of thecalculation, we are unable to estimate if there will be a required payment forfiscal 2010.

 

9

----

Table of Contents

 

**Note 4.  Comprehensive(Loss) Income**

 

Ourcomprehensive (loss) income, net of related tax, is as follows:

 
| ** **                                        | ** ** | **Quarter Ended** | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------------------|------------|-------------------|------------|----------------------|------------|
| ** **                                        | ** ** | **July 31, 2010** | ** ** | **August 1, 2009**   | ** ** | **July 31, 2010** | ** ** | **August 1, 2009** | ** ** |
| ** **                                        | ** ** | **(in millions)** | ** ** |
|                                              |       |              |       |                 |       |   |   |   |   |
| Net (loss) income                                 |       | $                 | (1         | )                    | $          | 2 |   | $ | 12 |   | $ | 6 |   |
| Other comprehensive (loss) income:                |       |              |       |                 |       |   |   |   |   |
| Derivative loss                                   |       | —            |       | (1                   | )          | — |   | (3 | ) |
| Foreign currency translation adjustment and other |       | —            |       | 4                    |       | 1 |   | 5 |   |
| Comprehensive (loss) income                       |       | $                 | (1         | )                    | $          | 5 |   | $ | 13 |   | $ | 8 |   |

 

Accumulatedother comprehensive income, net of tax, is reflected in the ConsolidatedBalance Sheets as follows:

 

| **(in millions)**                       | ** ** | **Foreign Currency  Translation  and Other** | ** ** |
|-----------------------------------------|------------|----------------------------------------------|------------|
| Balance at January 30, 2010             |       | $                                            | 6          |   |
| Foreign currency translation adjustment |       | 1                                            |       |
| Balance at July 31, 2010                |       | $                                            | 7          |   |

 

**Note 5.  DerivativeInstruments**

 

Weare exposed to fluctuations in interest rates on our Senior secured term loan.During the first quarter of fiscal 2009, we purchased an interest ratederivative with the objective to cap our exposure to interest rate increases onour Senior secured term loan that result from fluctuations in the three-monthLIBOR rate. The cap limits our interest exposure on a notional value of $2.0billion to the lesser of the three-month LIBOR rate or 7.0%.  The term of the cap extends to the firstquarter of fiscal 2015. The interest rate cap does not qualify for hedgeaccounting under ASC 815, *Derivatives and Hedging*.The fair value of the cap as of July 31, 2010 and August 1, 2009 was $5 millionand $24 million, respectively, and is included in Other assets on theConsolidated Balance Sheets. The change in fair value of the cap for thequarter and six months ended July 31, 2010, resulted in a loss of $3 millionand $13 million, respectively. The change in fair value of the cap for thequarter and six months ended August 1, 2009, resulted in a gain of $11 millionand $15 million, respectively. These amounts are recorded in Other (income) andexpense, net in the Consolidated Statements of Operations.

 

**Note6.  Fair Value Measurements**

 

Asdefined in ASC 820, fair value is the price that would be received to sell anasset or paid to transfer a liability in an orderly transaction between marketparticipants at the measurement date. ASC 820 establishes a three-levelvaluation hierarchy for fair value measurements. These valuation techniques arebased upon observable and unobservable inputs. Observable inputs reflect marketdata obtained from independent sources, while unobservable inputs reflect ourmarket assumptions. These two types of inputs create the following fair valuehierarchy:

 

·                  Level 1 — Quoted prices for *identical*instruments in active markets;

·                  Level 2 — Quoted prices for *similar*instruments in active markets;quoted prices for identical or similar instruments in markets that are notactive; and model-derived valuations whose significant inputs are observable;and

·                  Level 3 — Instruments whosesignificant inputs are *unobservable.*

 

The following table presents net financial assets (liabilities)accounted for at fair value on a recurring basis as of July 31, 2010 (inmillions):

 
| ** **        | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** | **Total** | ** ** |
|-------------------|------------|-------------|------------|-------------|------------|-------------|------------|-----------|------------|
| Interest Rate Cap |       | $           | —     |        | $          | 5           |       | $         | —     |   | $ | 5 |   |
|                   |            |             |            |             |            |             |            |           |            |  |  |  |  |

 

10

----

Table of Contents

 

Theinterest rate cap is measured using widely accepted valuation techniquesincluding discounted cash flow analysis on the expected cash flows. Thisanalysis reflects the contractual terms of the derivatives, including theperiod to maturity, and uses observable market-based inputs, including interestrate curves and implied volatilities. The fair value of the interest rate cap is determined using themarket standard methodology of netting the discounted future fixed cashpayments and the discounted expected variable cash receipts.  The variablecash receipts are based on an expectation of future interest rates (forwardcurves) derived from observable market interest rate curves. See Note 5 foradditional information on our derivative instruments.

 

Weapply fair value techniques on a non-recurring basis associated for theestablishment of potential impairment loss related to goodwill pursuant to ASC350, *Intangibles—Goodwill and Other* anddetermining the fair value of long-lived assets pursuant to ASC 360, *Property, Plant, and Equipment.* During the six months ended July 31,2010, there were no events or changes in circumstances indicating the carryamounts of our long-lived assets may not be recoverable.

 

The table below provides thecarrying and fair values of our loan and notes. The fair value of these debtinstruments were determined based on quoted market prices or recent trades.

 

| ** **                  | ** ** | **Carrying Value** | ** ** | **Fair Value** | ** ** |
|-----------------------------|------------|--------------------|------------|----------------|------------|
| ** **                  | ** ** | **(in millions)**  | ** ** |
| Senior secured term loan    |       | $                  | 2,156      |           | $          | 2,016 |   |
| Senior notes                |       | 750                |       | 789            |       |
| Senior subordinated notes   |       | 400                |       | 432            |       |
| Subordinated discount notes |       | 401                |       | 364            |       |
|                             |            |                    |            |                |            |  |  |

 

**Note 7.  IncomeTaxes**

 

During the second quarter offiscal 2010, we recorded a tax provision of $1 million, primarily due toadditional expense related to discrete items. The effective tax rate was 19.5%for the second quarter of fiscal 2009. As a result of our low income base for the second quarter of each offiscal 2010 and fiscal 2009, our effective rate is highly sensitive to changescaused by discrete items and permanent differences (i.e. differences betweenbook income and tax income that are not expected to reverse in future periods).

 

Our effective income taxrate for the first six months of fiscal 2010 was 59.8% compared to 36.6% forthe first six months of fiscal 2009. During the first quarter of fiscal 2010,we recorded a correction to our federal deferred tax liability relating tostate income taxes which unfavorably impacted our effective income tax rate by16.7%. We currently estimate our annualized effective tax rate for fiscal 2010to be 41%, including a 2.7% unfavorable impact from the deferred tax liabilitycorrection recorded during the first quarter.

 

**Note 8.  Commitmentsand Contingencies**

 

Weare involved in ongoing legal and regulatory proceedings.  Other than those described in the followingparagraphs, there were no material changes to our disclosures of commitmentsand contingencies from our Annual Report on Form 10-K for the fiscal yearended January 30, 2010 and our Quarterly Report on Form 10-Q for thequarterly period ended May 1, 2010.

 

*Consumer Class Action Claims*

 

*Acevedo Claim*

 

OnMarch 12, 2010, Arthur Acevedo, a consumer, filed a purported class actionproceeding against Aaron Brothers, Inc. in the Superior Court ofCalifornia, Los Angeles County, on behalf of himself and all similarly-situatedmobility impaired/wheelchair bound persons. The suit alleges that certain of Aaron Brothers retail stores inCalifornia are not compliant with disability access non-discrimination statutesof California and the plaintiffs seek injunctive relief, statutory damages,attorneys’ fees and costs.  The partieshave reached an agreement in principle to settle the matter on an individualbasis for an immaterial amount and with certain improvements or repairs to bemade at selected Aaron Brothers stores.

 

*Carson Claim*

 

OnAugust 15, 2008, Linda Carson, a consumer, filed a purported classaction proceeding against Michaels Stores, Inc. in the Superior Court ofCalifornia, County of San Diego, on behalf of herself and allsimilarly-situated California consumers.  The Carson suit allegesthat Michaels unlawfully requested and recorded personally identifiableinformation (i.e., her zip code) as part of a credit card transaction. The plaintiff sought statutory penalties, costs, interest, and attorneys’fees.  We contested certification of this claim as a class action andfiled a motion to dismiss the claim. On March 9, 2009, the Courtdismissed the case with prejudice.  The plaintiff appealed this decisionto the California Court of Appeal for the Fourth District, San Diego. On July 22,2010, the Court of Appeal ruled in favor Michaels and the case was dismissed.

 

11

----

Tableof Contents

* *

*Governmental Inquiries and Related Matters*

 

*Non-U.S. Trust Inquiry*

 

Inearly 2005, the District Attorney’s office of the County of New York and theSEC opened inquiries concerning non-U.S. trusts that directly orindirectly held shares of Michaels Common Stock and Common Stock options. Afederal grand jury requested information with respect to the same facts. We arecooperating in these inquiries and have provided information in response to therequests.

 

Certainof these trusts and corporate subsidiaries of the trusts acquired securities ofMichaels in transactions directly or indirectly with Charles J. Wyly, Jr.and Sam Wyly, who were, respectively, Chairman and Vice Chairman of the Boardof Directors prior to the consummation of the Merger, or with other Wyly familymembers. In addition, subsidiaries of certain of these trusts acquiredsecurities directly from us in private placement transactions in 1996 and 1997and upon the exercise of stock options transferred, directly or indirectly, tothe trusts or their subsidiaries by Charles Wyly, Sam Wyly, or other Wylyfamily members.

 

Weunderstand that Charles Wyly and Sam Wyly and/or certain of their familymembers are beneficiaries of irrevocable non-U.S. trusts. The 1996 and1997 private placement sales by us of Michaels securities to subsidiaries ofcertain of these trusts were disclosed by us in filings with the SEC. Thetransfer by Charles Wyly and/or Sam Wyly (or by other Wyly family members orfamily-related entities) of Michaels securities to certain of these trusts andsubsidiaries was also disclosed in filings with the SEC by us and/or by CharlesWyly and Sam Wyly. Based on information provided to us, our SEC filings priorto 2005 did not report securities owned by the non-U.S. trusts or theircorporate subsidiaries as beneficially owned by Charles Wyly and Sam Wyly.

 

CharlesWyly and Sam Wyly filed an amended Schedule 13D with the SEC onApril 8, 2005, stating that they may be deemed the beneficial owners ofMichaels securities held directly or indirectly by thenon-U.S. trusts.  In our 2005 and 2006 proxy statements, we includedthe securities held in the non-U.S. trusts or their separate subsidiaries,as reported by the Wylys, in the beneficial ownership table of our principalstockholders and management, with appropriate footnotes.

 

OnJuly 29, 2010, the SEC filed a civil enforcement action infederal district court for the Southern District of New York against CharlesWyly, Sam Wyly and others alleging, among other things, violations of variousfederal securities laws, including those governing ownership reporting andtrading of securities, in connection with the non-U.S. trusts and theirsubsidiaries. Additional information may be obtained at the SEC’s website.

 

**Note 9.  Segments**

 

We consider our Michaels andAaron Brothers operations to be our operating segments for purposes ofdetermining reportable segments based on the criteria of ASC 280, *Segment Reporting.* We determined that ourMichaels and Aaron Brothers operating segments have similar economiccharacteristics and meet the aggregation criteria set forth in ASC 280.Therefore, we combine both operating segments into one reporting segment.

 

Our chief operating decisionmakers evaluate historical operating performance, plan and forecast futureperiods’ operating performance based on earnings before interest, income taxes,depreciation and amortization (“EBITDA”). We believe EBITDA represents thefinancial measure that more closely reflects the operating effectiveness offactors over which management has control. As such, an element of baseincentive compensation targets for certain management personnel are based onEBITDA. A reconciliation of EBITDA to income before income taxes is presentedbelow.

 
| ** **                    | ** ** | **Quarter Ended**      | ** ** | **Six Months Ended**    | ** ** |
|-------------------------------|------------|------------------------|------------|-------------------------|------------|
| ** **                    | ** ** | **July 31, 2010** | ** ** | **August 1, 2009** | ** ** | **July 31, 2010** | ** ** | **August 1, 2009** | ** ** |
| ** **                    | ** ** | **(in millions)**      | ** ** |
|                          |       |                   |       |                    |       |   |   |   |   |
| Income before income taxes    |       | $                      | —     |                    | $          | 2 |   | $ | 30 |   | $ | 9 |   |
| Interest expense              |       | 70                     |       | 62                      |       | 138 |   | 125 |   |
| Depreciation and amortization |       | 26                     |       | 28                      |       | 52 |   | 58 |   |
| EBITDA                        |       | $                      | 96         |                    | $          | 92 |   | $ | 220 |   | $ | 192 |   |

 

12

----

Table of Contents

 

Oursales and assets by country are as follows:

 
| ** **         | ** ** | **Quarter Ended**      | ** ** | **Six Months Ended**    | ** ** |
|--------------------|------------|------------------------|------------|-------------------------|------------|
| ** **         | ** ** | **July 31, 2010** | ** ** | **August 1, 2009** | ** ** | **July 31, 2010** | ** ** | **August 1, 2009** | ** ** |
| ** **         | ** ** | **(in millions)**      | ** ** | **(in millions)**       | ** ** |
| **Net Sales:**     |       |                   |       |                    |       |   |   |   |   |
| United States      |       | $                      | 760        |                    | $          | 744 |   | $ | 1,585 |   | $ | 1,536 |   |
| Canada             |       | 71                     |       | 63                      |       | 147 |   | 123 |   |
| Consolidated Total |       | $                      | 831        |                    | $          | 807 |   | $ | 1,732 |   | $ | 1,659 |   |
|               |       |                   |       |                    |       |   |   |   |   |
| **Total Assets:**  |       |                   |       |                    |       |   |   |   |   |
| United States      |       | $                      | 1,506      |                    | $          | 1,578 |   | $ | 1,506 |   | $ | 1,578 |   |
| Canada             |       | 78                     |       | 97                      |       | 78 |   | 97 |   |
| Consolidated Total |       | $                      | 1,584      |                    | $          | 1,675 |   | $ | 1,584 |   | $ | 1,675 |   |

 

Wepresent assets based on their physical, geographic location.  Certain assets located in the United Statesare also used to support our Canadian operations, but we do not allocate theseassets to Canada.

 

**Note10.  Related Party Transactions**

 

We pay annual managementfees to Bain Capital Partners, LLC and The Blackstone Group (collectively,together with their applicable affiliates, the “Sponsors”) and HighfieldsCapital Management LP (“Highfields”) in the amount of $12 million and $1million, respectively. We recognized $4 million and $3 million of expenserelated to annual management fees and expenses during the second quarter offiscal 2010 and fiscal 2009, respectively, and $7 million during each of thesix months ended July 31, 2010 and August 1, 2009. These expenses areincluded in related party expenses on the Consolidated Statements ofOperations.

 

Bain Capital owns a majorityequity position in an external vendor we utilize to print our circularadvertisements.  Payments associated withthis vendor during the second quarter of fiscal 2010 and fiscal 2009 were $5million and $6 million, respectively, and $14 million for each of the sixmonths ended July 31, 2010 and August 1, 2009.  These expenses are included in selling,general and administrative expense on the Consolidated Statements ofOperations.

 

BainCapital owns an equity position in an external vendor we utilized fornon-merchandise supplies. Payments for the six months ended August 1, 2009were $1 million.  These expenses areincluded in selling, general and administrative expense on the ConsolidatedStatements of Operations.

 

TheBlackstone Group owns a majority equity position in an external vendor weutilize to count our store inventory. Payments associated with this vendorduring the second quarter of fiscal 2010 and fiscal 2009 were $1 million and $2million, respectively.  Payments for eachof the six months ended July 31, 2010 and August 1, 2009 were $3million and $4 million, respectively. These expenses are included in selling, general and administrativeexpense on the Consolidated Statements of Operations.

 

TheBlackstone Group owns an equity position in an external vendor we utilize forwaste management services. Payments associated with this vendor during thesecond quarter of both fiscal 2010 and fiscal 2009 were $2 million, andpayments for the six months ended July 31, 2010 and August 1, 2009were $3 million and $4 million, respectively. These expenses are included in selling, general and administrativeexpense on the Consolidated Statements of Operations.

 

TheBlackstone Group owns an equity position in an external vendor we utilize forall of the candy-type items in our stores. Payments associated with this vendor during the second quarter of fiscal2010 and fiscal 2009 were $5 million and $6 million, respectively, and $9million for each of the six months ended July 31, 2010 and August 1,2009. These expenses are recognized in cost of sales as the sales are recorded.

 

Ourcurrent directors are affiliates of Bain Capital or The Blackstone Group.  As such, some or all of our directors mayhave an indirect material interest in payments with respect to debt securitiesof the Company that have been purchased by affiliates of Bain Capital and TheBlackstone Group.  During the first sixmonths of fiscal 2010, such affiliates sold approximately $199 millionface amount of our Subordinated Discount Notes due 2016. As of July 31,2010, such affiliates did not hold any of our debt securities.

 

13

----

Table of Contents

 

**Note11.   Condensed Consolidating FinancialInformation**

 

Allobligations of Michaels Stores, Inc. under the Senior notes, Seniorsubordinated notes, Subordinated discount notes, Senior secured term loan, andAmended asset-based revolving credit facility are guaranteed by each of oursubsidiaries other than Aaron Brothers Card Services, LLC and Artistree ofCanada, ULC. As of July 31, 2010, the financial statements of AaronBrothers Card Services, LLC and Artistree of Canada, ULC were immaterial. Eachsubsidiary guarantor is 100% owned by the parent and all guarantees are jointand several.

 

Thefollowing condensed consolidating financial information represents the financialinformation of Michaels Stores, Inc. and its wholly-owned subsidiaryguarantors, prepared on the equity basis of accounting.  The informationis presented in accordance with the requirements of Rule 3-10 under theSEC’s Regulation S-X.  The financial information may not necessarily beindicative of results of operations, cash flows, or financial position had thesubsidiary guarantors operated as independent entities.

 

Certainprior year balance sheet amounts were reclassified to conform to the currentyear presentation. These reclassifications consist primarily of thepresentation of deferred taxes.

 

**Supplemental Condensed Consolidating Balance Sheet**

 
| ** **                                                 | ** ** | **July 31, 2010** | ** ** |
|------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                 | ** ** | **Parent  Company**    | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                 | ** ** | **(in millions)**      | ** ** |
| **ASSETS**                                                 | ** ** | ** **             | ** ** | ** ** |   |   |   |   |   |
| **Current assets:**                                        |       |                   |       |   |   |   |   |   |   |
| Cash and equivalents                                       |       | $                      | 60         |   | $ | 9 |   | $ | — |   | $ | 69 |   |
| Merchandise inventories                                    |       | 588                    |       | 300 |   | — |   | 888 |   |
| Intercompany receivables                                   |       | —                 |       | 364 |   | (364 | ) | — |   |
| Other                                                      |       | 127                    |       | 16 |   | — |   | 143 |   |
| Total current assets                                       |       | 775                    |       | 689 |   | (364 | ) | 1,100 |   |
| **Property and equipment, net**                            |       | 226                    |       | 69 |   | — |   | 295 |   |
| **Goodwill, net**                                          |       | 94                     |       | — |   | — |   | 94 |   |
| **Investment in subsidiaries**                             |       | 434                    |       | — |   | (434 | ) | — |   |
| **Other assets**                                           |       | 94                     |       | 1 |   | — |   | 95 |   |
| Total assets                                               |       | $                      | 1,623      |   | $ | 759 |   | $ | (798 | ) | $ | 1,584 |   |
|                                                       |       |                   |       |   |   |   |   |   |   |
| **LIABILITIES  AND STOCKHOLDERS’ (DEFICIT) EQUITY**   |       |                   |       |   |   |   |   |   |   |
| **Current liabilities:**                                   |       |                   |       |   |   |   |   |   |   |
| Accounts payable                                           |       | $                      | (2         | ) | $ | 224 |   | $ | — |   | $ | 222 |   |
| Accrued liabilities and other                              |       | 231                    |       | 90 |   | — |   | 321 |   |
| Current portion of long-term debt                          |       | 1                      |       | — |   | — |   | 1 |   |
| Intercompany payable                                       |       | 364                    |       | — |   | (364 | ) | — |   |
| Other                                                      |       | 1                      |       | — |   | — |   | 1 |   |
| Total current liabilities                                  |       | 595                    |       | 314 |   | (364 | ) | 545 |   |
| **Long-term debt**                                         |       | 3,707                  |       | — |   | — |   | 3,707 |   |
| **Other long-term liabilities**                            |       | 75                     |       | 11 |   | — |   | 86 |   |
| **Total stockholders’ (deficit)  equity**             |       | (2,754                 | )          | 434 |   | (434 | ) | (2,754 | ) |
| Total liabilities and stockholders’ (deficit)  equity |       | $                      | 1,623      |   | $ | 759 |   | $ | (798 | ) | $ | 1,584 |   |

 

14

----

Table of Contents

 

**Supplemental Condensed Consolidating Balance Sheet**

 
| ** **                                                 | ** ** | **January 30, 2010** | ** ** |
|------------------------------------------------------------|------------|---------------------------|------------|
| ** **                                                 | ** ** | **Parent  Company**       | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                 | ** ** | **(in millions)**         | ** ** |
| **ASSETS**                                                 | ** ** | ** **                | ** ** | ** ** |   |   |   |   |   |
| **Current assets:**                                        |       |                      |       |   |   |   |   |   |   |
| Cash and equivalents                                       |       | $                         | 207        |   | $ | 10 |   | $ | — |   | $ | 217 |   |
| Merchandise inventories                                    |       | 599                       |       | 274 |   | — |   | 873 |   |
| Intercompany receivables                                   |       | —                    |       | 243 |   | (243 | ) | — |   |
| Other                                                      |       | 103                       |       | 14 |   | — |   | 117 |   |
| Total current assets                                       |       | 909                       |       | 541 |   | (243 | ) | 1,207 |   |
| **Property and equipment, net**                            |       | 238                       |       | 79 |   | — |   | 317 |   |
| **Goodwill, net**                                          |       | 94                        |       | — |   | — |   | 94 |   |
| **Investment in subsidiaries**                             |       | 288                       |       | — |   | (288 | ) | — |   |
| **Other assets**                                           |       | 90                        |       | 2 |   | — |   | 92 |   |
| Total assets                                               |       | $                         | 1,619      |   | $ | 622 |   | $ | (531 | ) | $ | 1,710 |   |
|                                                       |       |                      |       |   |   |   |   |   |   |
| **LIABILITIES  AND STOCKHOLDERS’ (DEFICIT) EQUITY**   |       |                      |       |   |   |   |   |   |   |
| **Current liabilities:**                                   |       |                      |       |   |   |   |   |   |   |
| Accounts payable                                           |       | $                         | 10         |   | $ | 221 |   | $ | — |   | $ | 231 |   |
| Accrued liabilities and other                              |       | 256                       |       | 99 |   | — |   | 355 |   |
| Current portion of long-term debt                          |       | 119                       |       | — |   | — |   | 119 |   |
| Intercompany payable                                       |       | 243                       |       | — |   | (243 | ) | — |   |
| Other                                                      |       | 11                        |       | 1 |   | — |   | 12 |   |
| Total current liabilities                                  |       | 639                       |       | 321 |   | (243 | ) | 717 |   |
| **Long-term debt**                                         |       | 3,684                     |       | — |   | — |   | 3,684 |   |
| **Other long-term liabilities**                            |       | 67                        |       | 13 |   | — |   | 80 |   |
| **Total stockholders’ (deficit)  equity**             |       | (2,771                    | )          | 288 |   | (288 | ) | (2,771 | ) |
| Total liabilities and stockholders’ (deficit)  equity |       | $                         | 1,619      |   | $ | 622 |   | $ | (531 | ) | $ | 1,710 |   |

 

15

----

Table of Contents

 

**Supplemental Condensed Consolidating Balance Sheet**

 
| ** **                                                 | ** ** | **August 1, 2009** | ** ** |
|------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                 | ** ** | **Parent  Company**     | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                 | ** ** | **(in millions)**       | ** ** |
| **ASSETS**                                                 | ** ** | ** **              | ** ** | ** ** |   |   |   |   |   |
| **Current assets:**                                        |       |                    |       |   |   |   |   |   |   |
| Cash and equivalents                                       |       | $                       | 29         |   | $ | 7 |   | $ | — |   | $ | 36 |   |
| Merchandise inventories                                    |       | 633                     |       | 317 |   | — |   | 950 |   |
| Intercompany receivables                                   |       | —                  |       | 524 |   | (524 | ) | — |   |
| Other                                                      |       | 117                     |       | 15 |   | — |   | 132 |   |
| Total current assets                                       |       | 779                     |       | 863 |   | (524 | ) | 1,118 |   |
| **Property and equipment, net**                            |       | 257                     |       | 88 |   | — |   | 345 |   |
| **Goodwill, net**                                          |       | 94                      |       | — |   | — |   | 94 |   |
| **Investment in subsidiaries**                             |       | 655                     |       | — |   | (655 | ) | — |   |
| **Other assets**                                           |       | 116                     |       | 2 |   | — |   | 118 |   |
| Total assets                                               |       | $                       | 1,901      |   | $ | 953 |   | $ | (1,179 | ) | $ | 1,675 |   |
|                                                       |       |                    |       |   |   |   |   |   |   |
| **LIABILITIES  AND STOCKHOLDERS’ (DEFICIT) EQUITY**   |       |                    |       |   |   |   |   |   |   |
| **Current liabilities:**                                   |       |                    |       |   |   |   |   |   |   |
| Accounts payable                                           |       | $                       | 13         |   | $ | 203 |   | $ | — |   | $ | 216 |   |
| Accrued liabilities and other                              |       | 207                     |       | 81 |   | — |   | 288 |   |
| Current portion of long-term debt                          |       | 198                     |       | — |   | — |   | 198 |   |
| Intercompany payable                                       |       | 524                     |       | — |   | (524 | ) | — |   |
| Other                                                      |       | 1                       |       | — |   | — |   | 1 |   |
| Total current liabilities                                  |       | 943                     |       | 284 |   | (524 | ) | 703 |   |
| **Long-term debt**                                         |       | 3,766                   |       | — |   | — |   | 3,766 |   |
| **Other long-term liabilities**                            |       | 66                      |       | 14 |   | — |   | 80 |   |
| **Total stockholders’ (deficit)  equity**             |       | (2,874                  | )          | 655 |   | (655 | ) | (2,874 | ) |
| Total liabilities and stockholders’ (deficit)  equity |       | $                       | 1,901      |   | $ | 953 |   | $ | (1,179 | ) | $ | 1,675 |   |

 

16

----

Tableof Contents

 

**Supplemental Condensed Consolidating Statement of Operations**

 
| ** **                                   | ** ** | **Quarter Ended July 31, 2010** | ** ** |
|----------------------------------------------|------------|--------------------------------------|------------|
| ** **                                   | ** ** | **Parent  Company**                  | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                   | ** ** | **(in millions)**                    | ** ** |
| ** **                                   | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Net sales**                                |       | $                                    | 724        |   | $ | 481 |   | $ | (374 | ) | $ | 831 |   |
| Cost of sales and occupancy expense          |       | 493                                  |       | 401 |   | (374 | ) | 520 |   |
| **Gross profit**                             |       | 231                                  |       | 80 |   | — |   | 311 |   |
| Selling, general, and administrative expense |       | 202                                  |       | 31 |   | — |   | 233 |   |
| Related party expenses                       |       | 4                                    |       | — |   | — |   | 4 |   |
| Store pre-opening costs                      |       | —                               |       | — |   | — |   | — |   |
| **Operating income**                         |       | 25                                   |       | 49 |   | — |   | 74 |   |
| Interest expense                             |       | 70                                   |       | — |   | — |   | 70 |   |
| Other (income) and expense, net              |       | 4                                    |       | — |   | — |   | 4 |   |
| Intercompany charges (income)                |       | 15                                   |       | (15 | ) | — |   | — |   |
| Equity in earnings of subsidiaries           |       | 64                                   |       | — |   | (64 | ) | — |   |
| **Income before income taxes**               |       | —                               |       | 64 |   | (64 | ) | — |   |
| Provision for income taxes                   |       | 1                                    |       | 26 |   | (26 | ) | 1 |   |
| **Net loss**                                 |       | $                                    | (1         | ) | $ | 38 |   | $ | (38 | ) | $ | (1 | ) |

 

**Supplemental Condensed Consolidating Statement of Operations**

 
| ** **                                   | ** ** | **Quarter Ended August 1, 2009** | ** ** |
|----------------------------------------------|------------|---------------------------------------|------------|
| ** **                                   | ** ** | **Parent  Company**                   | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                   | ** ** | **(in millions)**                     | ** ** |
| ** **                                   | ** ** | ** **                            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Net sales**                                |       | $                                     | 707        |   | $ | 471 |   | $ | (371 | ) | $ | 807 |   |
| Cost of sales and occupancy expense          |       | 498                                   |       | 394 |   | (371 | ) | 521 |   |
| **Gross profit**                             |       | 209                                   |       | 77 |   | — |   | 286 |   |
| Selling, general, and administrative expense |       | 202                                   |       | 30 |   | — |   | 232 |   |
| Related party expenses                       |       | 3                                     |       | — |   | — |   | 3 |   |
| Store pre-opening costs                      |       | 1                                     |       | — |   | — |   | 1 |   |
| **Operating income**                         |       | 3                                     |       | 47 |   | — |   | 50 |   |
| Interest expense                             |       | 62                                    |       | — |   | — |   | 62 |   |
| Other (income) and expense, net              |       | (11                                   | )          | (3 | ) | — |   | (14 | ) |
| Intercompany charges (income)                |       | 16                                    |       | (16 | ) | — |   | — |   |
| Equity in earnings of subsidiaries           |       | 66                                    |       | — |   | (66 | ) | — |   |
| **Income before income taxes**               |       | 2                                     |       | 66 |   | (66 | ) | 2 |   |
| Provision for income taxes                   |       | —                                |       | 13 |   | (13 | ) | — |   |
| **Net income**                               |       | $                                     | 2          |   | $ | 53 |   | $ | (53 | ) | $ | 2 |   |

 

17

----

Table of Contents

 

**Supplemental Condensed Consolidating Statement of Operations**

 
| ** **                                   | ** ** | **Six Months Ended July 31, 2010** | ** ** |
|----------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                   | ** ** | **Parent  Company**                     | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                   | ** ** | **(in millions)**                       | ** ** |
| ** **                                   | ** ** | ** **                              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Net sales**                                |       | $                                       | 1,518      |   | $ | 965 |   | $ | (751 | ) | $ | 1,732 |   |
| Cost of sales and occupancy expense          |       | 1,021                                   |       | 797 |   | (751 | ) | 1,067 |   |
| **Gross profit**                             |       | 497                                     |       | 168 |   | — |   | 665 |   |
| Selling, general, and administrative expense |       | 414                                     |       | 64 |   | — |   | 478 |   |
| Related party expenses                       |       | 7                                       |       | — |   | — |   | 7 |   |
| Store pre-opening costs                      |       | 1                                       |       | — |   | — |   | 1 |   |
| **Operating income**                         |       | 75                                      |       | 104 |   | — |   | 179 |   |
| Interest expense                             |       | 138                                     |       | — |   | — |   | 138 |   |
| Other (income) and expense, net              |       | 14                                      |       | (3 | ) | — |   | 11 |   |
| Intercompany charges (income)                |       | 31                                      |       | (31 | ) | — |   | — |   |
| Equity in earnings of subsidiaries           |       | 138                                     |       | — |   | (138 | ) | — |   |
| **Income before income taxes**               |       | 30                                      |       | 138 |   | (138 | ) | 30 |   |
| Provision for income taxes                   |       | 18                                      |       | 57 |   | (57 | ) | 18 |   |
| **Net income**                               |       | $                                       | 12         |   | $ | 81 |   | $ | (81 | ) | $ | 12 |   |

 

**Supplemental Condensed Consolidating Statement of Operations**

 
| ** **                                   | ** ** | **Six Months Ended August 1, 2009** | ** ** |
|----------------------------------------------|------------|------------------------------------------|------------|
| ** **                                   | ** ** | **Parent  Company**                      | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                   | ** ** | **(in millions)**                        | ** ** |
| ** **                                   | ** ** | ** **                               | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Net sales**                                |       | $                                        | 1,468      |   | $ | 950 |   | $ | (759 | ) | $ | 1,659 |   |
| Cost of sales and occupancy expense          |       | 1,021                                    |       | 796 |   | (759 | ) | 1,058 |   |
| **Gross profit**                             |       | 447                                      |       | 154 |   | — |   | 601 |   |
| Selling, general, and administrative expense |       | 418                                      |       | 60 |   | — |   | 478 |   |
| Related party expenses                       |       | 7                                        |       | — |   | — |   | 7 |   |
| Store pre-opening costs                      |       | 2                                        |       | — |   | — |   | 2 |   |
| **Operating income**                         |       | 20                                       |       | 94 |   | — |   | 114 |   |
| Interest expense                             |       | 125                                      |       | — |   | — |   | 125 |   |
| Other (income) and expense, net              |       | (15                                      | )          | (5 | ) | — |   | (20 | ) |
| Intercompany charges (income)                |       | 33                                       |       | (33 | ) | — |   | — |   |
| Equity in earnings of subsidiaries           |       | 132                                      |       | — |   | (132 | ) | — |   |
| **Income before income taxes**               |       | 9                                        |       | 132 |   | (132 | ) | 9 |   |
| Provision for income taxes                   |       | 3                                        |       | 48 |   | (48 | ) | 3 |   |
| **Net income**                               |       | $                                        | 6          |   | $ | 84 |   | $ | (84 | ) | $ | 6 |   |

 

18

----

Table of Contents

 

**Supplemental Condensed Statement of Cash Flows**

 
| ** **                                | ** ** | **Six Months Ended July 31, 2010** | ** **                                                                              |
|-------------------------------------------|------------|-----------------------------------------|-----------------------------------------------------------------------------------------|
| ** **                                | ** ** | **Parent  Company**                     | ** **                                                                              | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                | ** ** | **(in millions)**                       | ** **                                                                              |
| **Operating activities:**                 |       |                                    |                                                                                    |   |   |   |   |   |   |
| Net cash provided by operating activities |       | $                                       |                21 |   | $ |                55 |   | $ |              (53 | ) | $ |                23 |   |
|                                      |       |                                    |                                                                                    |   |   |   |   |   |   |
| **Investing activities:**                 |       |                                    |                                                                                    |   |   |   |   |   |   |
| Cash paid for property and equipment      |       | (31                                     | )                                                                                       | (2 | ) | — |   | (33 | ) |
| Net cash used in investing activities     |       | (31                                     | )                                                                                       | (2 | ) | — |   | (33 | ) |
|                                      |       |                                    |                                                                                    |   |   |   |   |   |   |
| **Financing activities:**                 |       |                                    |                                                                                    |   |   |   |   |   |   |
| Net repayments of long-term debt          |       | (118                                    | )                                                                                       | — |   | — |   | (118 | ) |
| Intercompany dividends                    |       | —                                  |                                                                                    | (53 | ) | 53 |   | — |   |
| Other financing activities                |       | (20                                     | )                                                                                       | — |   | — |   | (20 | ) |
| Net cash used in financing activities     |       | (138                                    | )                                                                                       | (53 | ) | 53 |   | (138 | ) |
|                                      |       |                                    |                                                                                    |   |   |   |   |   |   |
| **Decrease in cash and equivalents**      |       | (148                                    | )                                                                                       | — |   | — |   | (148 | ) |
| **Beginning cash and equivalents**        |       | 207                                     |                                                                                    | 10 |   | — |   | 217 |   |
| **Ending cash and equivalents**           |       | $                                       |                59 |   | $ |                10 |   | $ |             — |   | $ |                69 |   |

 

**Supplemental Condensed Statement of Cash Flows**

** **
| ** **                                | ** ** | **Six Months Ended August 1, 2009** | ** ** |
|-------------------------------------------|------------|------------------------------------------|------------|
| ** **                                | ** ** | **Parent  Company**                      | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                | ** ** | **(in millions)**                        | ** ** |
| **Operating activities:**                 |       |                                     |       |   |   |   |   |   |   |
| Net cash provided by operating activities |       | $                                        | 29         |   | $ | 58 |   | $ | (57 | ) | $ | 30 |   |
|                                      |       |                                     |       |   |   |   |   |   |   |
| **Investing activities:**                 |       |                                     |       |   |   |   |   |   |   |
| Cash paid for property and equipment      |       | (16                                      | )          | (1 | ) | — |   | (17 | ) |
| Net cash used in investing activities     |       | (16                                      | )          | (1 | ) | — |   | (17 | ) |
|                                      |       |                                     |       |   |   |   |   |   |   |
| **Financing activities:**                 |       |                                     |       |   |   |   |   |   |   |
| Net borrowings of long-term debt          |       | 14                                       |       | — |   | — |   | 14 |   |
| Intercompany dividends                    |       | —                                   |       | (57 | ) | 57 |   | — |   |
| Other financing activities                |       | (24                                      | )          | — |   | — |   | (24 | ) |
| Net cash used in financing activities     |       | (10                                      | )          | (57 | ) | 57 |   | (10 | ) |
|                                      |       |                                     |       |   |   |   |   |   |   |
| **Increase in cash and equivalents**      |       | 3                                        |       | — |   | — |   | 3 |   |
| **Beginning cash and cash  equivalents**  |       | 26                                       |       | 7 |   | — |   | 33 |   |
| **Ending cash and cash equivalents**      |       | $                                        | 29         |   | $ | 7 |   | $ | — |   | $ | 36 |   |

 

19

----

Tableof Contents

 

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

 

All expressions of the “Company,”“us,” “we,” “our,” and all similar expressions are references to MichaelsStores, Inc. and its consolidated wholly-owned subsidiaries, unlessotherwise expressly stated or the context otherwise requires.

 

**DisclosureRegarding Forward-Looking Information**

 

The following discussion shouldbe read in conjunction with our consolidated financial statements and relatednotes included elsewhere in this Quarterly Report on Form 10-Q. Thefollowing discussion, as well as other portions of this Quarterly Report onForm 10-Q, contains forward-looking statements that reflect our plans,estimates, and beliefs. Any statements contained herein (including, but notlimited to, statements to the effect that Michaels or its management “anticipates,”“plans,” “estimates,” “expects,” “believes,” and other similar expressions)that are not statements of historical fact should be considered forward-lookingstatements and should be read in conjunction with our consolidated financialstatements and related notes in our Annual Report on Form 10-K for thefiscal year ended January 30, 2010. Such forward-looking statements arebased upon management’s current knowledge and assumptions about future eventsand involve risks and uncertainties that could cause actual results,performance or achievements to be materially different from anticipatedresults, prospects, performance or achievements expressed or implied by suchforward-looking statements. Such risks and uncertainties include, but are notlimited to:

 

·              risks related to general economic conditions andthe current financial crisis; if worldwide economic conditions deteriorate, orif recovery remains slow or prolonged, it could continue to adversely affectconsumer confidence and retail spending, decreasing demand for our merchandiseand adversely impact our results of operations, cash flows and financialcondition;

 

·              risks related to our substantial indebtedness, asour leverage could adversely affect our ability to raise additional capital tofund our operations, limit our ability to react to changes in the economy orour industry, expose us to interest rate risk to the extent of our variablerate debt and prevent us from meeting our obligations under our notes andcredit facilities;

 

·              restrictions in our debt agreements that limit ourflexibility in operating our business, as our senior secured credit facilitiesand the indentures governing our notes contain various covenants that limit ourability to engage in specified types of transactions and require that wemaintain specified financial ratios upon the occurrence of certain events;

 

·              our ability to open new stores, as our growthdepends on our strategy of increasing our number of stores and if we are unableto continue this strategy, our ability to increase our sales, profitability,and cash flow could be impaired;

 

·              how well we manage our business;

 

·              changes in customer demand could materiallyadversely affect our sales, operating results, and cash flow;

 

·              unexpected or unfavorable consumer responses to ourpromotional or merchandising programs could materially adversely affect oursales, operating results, and cash flow;

 

·              changes in newspaper subscription ratesmay result in reduced exposure to our circular advertisements andadversely affect our sales, operating results and cash flow;

 

·              improvements to our supply chain may not befully successful;

 

·              our suppliers may fail us;

 

·              our reliance on foreign suppliers increases ourrisk of obtaining adequate, timely, and cost-effective product supplies;

 

·              risks associated with the vendors from whom ourproducts are sourced could materially adversely affect our revenue and grossprofit;

 

·              product recalls and/or product liability, as wellas changes in product safety and other consumer protection laws, may adverselyimpact our operations, merchandise offerings, reputation and financialposition;

 

·              significant increases in inflation or commodityprices such as petroleum, natural gas, electricity, steel and paper mayadversely affect our costs, includingcost of merchandise;

 

20

----

Table of Contents

 

·              we have co-sourced certain of our informationtechnology, accounts payable, payroll, accounting and human resourcesfunctions, and may co-source other administrative functions, making usmore dependent upon third parties;

 

·              our information systems may prove inadequate;

 

·              we may fail to optimize or adequately maintainour perpetual inventory and automated replenishment systems;

 

·              unauthorized access to our electronic and otherconfidential information could materially adversely affect our financialcondition and operating results;

 

·              changes in regulations orenforcement may adversely impact our business;

 

·              a weak fourth quarter would materially adversely affectour operating results;

 

·              competition could negatively impact our operations;and

 

·              the interests of our controlling stockholdersmay conflict with the interests of our creditors.

 

For more details on factors that may causeactual results to differ materially from such forward-looking statements,please see Item 1A. Risk Factors of our Annual Report on Form 10-Kfor the fiscal year ended January 30, 2010, and other reports from time totime filed with or furnished to the SEC. We disclaim any intention to, andundertake no obligation to, update or revise any forward-looking statement.

 

**General**

 

We report on the basis of a52 or 53-week fiscal year, which ends on the Saturday closest toJanuary 31.  All references hereinto “fiscal 2010” relate to the 52 weeks ending January 29, 2011 andall references to “fiscal 2009” relate to the 52 weeks endedJanuary 30, 2010. In addition, all references herein to “the secondquarter of fiscal 2010” relate to the 13 weeks ended July 31, 2010 and allreferences to “the second quarter of fiscal 2009” relate to the 13 weeks ended August 1,2009. Finally, all references to “the six months ended July 31, 2010”relate to the 26 weeks ended July 31, 2010, and “the six months endedAugust 1, 2009” relate to the 26 weeks ended August 1, 2009.

 

21

----

Table of Contents

 

The following table setsforth certain of our unaudited operating data:

 
| ** **                                               | ** ** | **Quarter Ended** | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------------|------------|-------------------|------------|----------------------|------------|
| ** **                                               | ** ** | **July 31,** | ** ** | **August 1,**   | ** ** | **July 31,** | ** ** | **August 1,** | ** ** |
| ** **                                               | ** ** | **2010**          | ** ** | **2009**             | ** ** | **2010** | ** ** | **2009** | ** ** |
| **Michaels stores:**                                     |       |              |       |                 |       |   |   |   |   |
| Retail stores open at beginning of period                |       | 1,028             |       | 1,020                |       | 1,023 |   | 1,009 |   |
| Retail stores opened during the period                   |       | 5                 |       | 3                    |       | 10 |   | 14 |   |
| Retail stores opened (relocations) during the  period    |       | —            |       | —               |       | 7 |   | 4 |   |
| Retail stores closed during the period                   |       | —            |       | —               |       | — |   | — |   |
| Retail stores closed (relocations) during the  period    |       | —            |       | —               |       | (7 | ) | (4 | ) |
| Retail stores open at end of period                      |       | 1,033             |       | 1,023                |       | 1,033 |   | 1,023 |   |
|                                                     |       |              |       |                 |       |   |   |   |   |
| **Aaron Brothers stores:**                               |       |              |       |                 |       |   |   |   |   |
| Retail stores open at beginning of period                |       | 146               |       | 156                  |       | 152 |   | 161 |   |
| Retail stores opened during the period                   |       | —            |       | —               |       | — |   | — |   |
| Retail stores opened (relocations) during the  period    |       | —            |       | —               |       | — |   | — |   |
| Retail stores closed during the period                   |       | (1                | )          | (1                   | )          | (7 | ) | (6 | ) |
| Retail stores closed (relocations) during the  period    |       | —            |       | —               |       | — |   | — |   |
| Retail stores open at end of period                      |       | 145               |       | 155                  |       | 145 |   | 155 |   |
|                                                     |       |              |       |                 |       |   |   |   |   |
| Total store count at end of period                       |       | 1,178             |       | 1,178                |       | 1,178 |   | 1,178 |   |
|                                                     |       |              |       |                 |       |   |   |   |   |
| **Other operating data:**                                |       |              |       |                 |       |   |   |   |   |
| Average inventory per Michaels store (in  thousands) (1) |       | $                 | 823        |                 | $          | 889 |   | $ | 823 |   | $ | 889 |   |
| Comparable store sales (2)                               |       | 2.3               | %          | (0.8                 | )%         | 3.6 | % | (1.4 | )% |
|                                                          |            |                   |            |                      |            |  |  |  |  |  |  |  |  |

 

----

| (1)    | Average  inventory per Michaels store calculation excludes our Aaron Brothers stores.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| (2)    | Comparable  store sales increase (decrease) represents the increase (decrease) in net  sales for stores open the same number of months in the indicated period and  the comparable period of the previous year, including stores that were  relocated or expanded during either period. A store is deemed to become  comparable in its 14th month of operation in order to eliminate grand  opening sales distortions. A store temporarily closed more than 2 weeks  due to a catastrophic event is not considered comparable during the month it  closed. If a store is closed longer than 2 weeks but less than  2 months, it becomes comparable in the month in which it reopens,  subject to a mid-month convention. A store closed longer than 2 months  becomes comparable in its 14th month of operation after its reopening. |

 

22

----

Table of Contents

 

**Results of Operations**

 

The following table setsforth the percentage relationship to net sales of each line item of ourunaudited consolidated statements of operations. This table should be read inconjunction with the following discussion and with our consolidated financialstatements, including the related notes, contained herein.

 
| ** **                                   | ** ** | **Quarter Ended** | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------|------------|-------------------|------------|----------------------|------------|
| ** **                                   | ** ** | **July 31,** | ** ** | **August 1,**   | ** ** | **July 31,** | ** ** | **August 1,** | ** ** |
| ** **                                   | ** ** | **2010**          | ** ** | **2009**             | ** ** | **2010** | ** ** | **2009** | ** ** |
| **Net sales**                                |       | 100.0             | %          | 100.0                | %          | 100.0 | % | 100.0 | % |
| Cost of sales and occupancy expense          |       | 62.5              |       | 64.6                 |       | 61.6 |   | 63.8 |   |
| **Gross profit**                             |       | 37.5              |       | 35.4                 |       | 38.4 |   | 36.2 |   |
| Selling, general, and administrative expense |       | 28.0              |       | 28.7                 |       | 27.6 |   | 28.8 |   |
| Related party expenses                       |       | 0.5               |       | 0.4                  |       | 0.4 |   | 0.4 |   |
| Store pre-opening costs                      |       | 0.1               |       | 0.1                  |       | 0.1 |   | 0.1 |   |
| **Operating income**                         |       | 8.9               |       | 6.2                  |       | 10.3 |   | 6.9 |   |
| Interest expense                             |       | 8.4               |       | 7.8                  |       | 8.0 |   | 7.5 |   |
| Other (income) and expense, net              |       | 0.5               |       | (1.8                 | )          | 0.6 |   | (1.2 | ) |
| **Income before income taxes**               |       | —            |       | 0.2                  |       | 1.7 |   | 0.6 |   |
| Income tax provision                         |       | 0.1               |       | —               |       | 1.0 |   | 0.2 |   |
| **Net (loss) income**                        |       | (0.1              | )%         | 0.2                  | %          | 0.7 | % | 0.4 | % |

 

*QuarterEnded July 31, 2010 Compared to the Quarter Ended August 1, 2009*

 

*Net Sales*—Net salesincreased for the second quarter of fiscal 2010 by $24 million, or 3.0%,over the second quarter of fiscal 2009 due primarily to an $18 million increasein comparable store sales. Comparable store sales increased 2.3% due to anincrease in customer transactions of 1.4%, an increase in the average ticket of0.8%, and a positive impact of 0.1% related to deferred custom framing revenue.The fluctuation in the exchange rates between the United States and Canadiandollars positively impacted the average ticket by 70 basis points. In addition,sales from our non-comparable new stores provided incremental revenue of $6million.

 

*Cost ofSales and Occupancy Expense*—Cost of sales and occupancyexpense was $520 million, or 62.5% of net sales, for the second quarter offiscal 2010 compared to $521 million, or 64.6% of net sales, for the secondquarter of fiscal 2009. Cost of sales decreased $1 million, or 160 basispoints, due to increases in direct imports and improved management ofpromotional and clearance markdowns. In addition, occupancy costs for thesecond quarter of fiscal 2010 were relatively flat compared to prior year andas a percentage of net sales, decreased 50 basis points primarily due toleveraging of fixed costs on an increase in comparable store sales.

 

*Selling,General, and Administrative Expense*—Selling, general, andadministrative expense was $233 million or 28.0% of net sales, in the secondquarter of fiscal 2010 compared to $232 million, or 28.7% of net sales, in thesecond quarter of fiscal 2009. Selling, general, and administrative expensedecreased 70 basis points, as a percentage of net sales, due to increasedpayroll leverage on higher comparable store sales as well as lower groupinsurance expense as a result of initiatives to reduce the cost of medicalinsurance.

 

*RelatedParty Expenses*— Related party expenses were $4 million and $3million in the second quarter of fiscal 2010 and fiscal 2009,respectively.  These costs consist ofmanagement fees and associated expenses paid to our Sponsors and Highfields.

 

*InterestExpense*—Interest expense for the quarter increased $8 million to $70 millionas a result of increased interest rates associated with our amended creditfacilities.

 

*Other (Income) and Expense, net*—Other expensein the second quarter of fiscal 2010 related to a $3 million unfavorable changein the fair value of our interest rate cap as more fully described in Note 5 tothe consolidated financial statements and $1 million related to foreignexchange losses. Other income in the second quarter of fiscal 2009 relatedprimarily to an $11 million favorable change in the fair value of the interestrate cap and $4 million related to foreign exchange gains.

 

*Provision forIncome Taxes*— During the second quarter of fiscal 2010, werecorded a tax provision of $1 million, primarily due to additional expenserelated to discrete items. The effective tax rate was 19.5% for the secondquarter of fiscal 2009.  As a result ofour low income base for the second quarter of each of fiscal 2010 and fiscal2009, our effective rate is highly sensitive to changes caused by discreteitems and permanent differences (i.e. differences between book income and taxincome that are not expected to reverse in future periods).

 

23

----

Table of Contents

 

*Six MonthsEnded July 31, 2010 Compared to the Six Months Ended August 1, 2009*

 

*Net Sales*—Net salesincreased for the first six months of fiscal 2010 by $73 million, or 4.4%,over the first six months of fiscal 2009 primarily due to a $59 millionincrease in comparable store sales. Comparable store sales increased 3.6% dueto an increase in the average ticket of 2.2%, an increase in customer transactionsof 1.3%, and a positive impact of 0.1% related to deferred custom framingrevenue. The fluctuation in the exchange rates between the United States andCanadian dollars positively impacted the average ticket by 110 basis points. Inaddition, sales from our non-comparable new stores provided incremental revenueof $14 million.

 

*Cost ofSales and Occupancy Expense*— Cost of sales andoccupancy expense increased $9 million to $1,067 million for the first sixmonths of fiscal 2010 from $1,058 million for the first six months of fiscal2009 as a result of the 3.6% increase in comparable store sales and an increasein sales from non-comparable new stores. Cost of sales and occupancy expensedecreased 220 basis points as a percentage of net sales. We realized a 150basis point decrease in cost of goods sold primarily due to increases in directimports and improved management of promotional and clearance markdowns. Inaddition, occupancy costs for the first six months of fiscal 2010 wererelatively flat compared to prior year and as a percentage of net sales,decreased 70 basis points primarily due to leveraging of fixed costs on theincrease in comparable store sales.

 

*Selling,General, and Administrative Expense*—Selling, general, andadministrative expense was flat compared to prior year at $478 million anddecreased to 27.6% of net sales for the first six months of fiscal 2010compared to 28.8% of net sales for the first six months of fiscal 2009.Selling, general, and administrative expense was consistent with the prior yearas increases in costs related to operating ten additional Michaels storesduring the first six months of fiscal 2010 and increased performance basedbonus expense driven by higher anticipated profitability for fiscal 2010 wereoffset by a decrease in depreciation expense caused by lower capitalexpenditures over the last several years and lower group insurance expense dueto initiatives to reduce the cost of medical insurance. As a percentage of netsales, selling, general, and administrative expense decreased 120 basis pointsdue to increased advertising and payroll leverage on higher comparable storesales as well as lower group insurance and depreciation expense as indicatedabove.

 

*RelatedParty Expenses*—Related party expenses were $7 million for thefirst six months of each of fiscal 2010 and fiscal 2009, consisting ofmanagement fees and associated expenses paid to our Sponsors and Highfields.

 

*InterestExpense*—Interest expense increased $13 million for the six months ended July 31,2010 compared to the six months ended August 1, 2009, as a result ofincreased interest rates associated with our amended credit facilities.

 

*Other (Income) and Expense, net*—Other expensefor the first six months of fiscal 2010 related to a $13 million unfavorablechange in the fair value of our interest rate cap, partially offset by $2million related to foreign exchange gains. Other income for the first sixmonths of fiscal 2009 related to a $15 million favorable change in the fairvalue of the interest rate cap and $5 million related to foreign exchangegains.

 

*Provision forIncome Taxes*—The effective tax rate was 59.8% for the first sixmonths of fiscal 2010. The rate was higher than the federal tax rate dueprimarily to additional expense to correct the federal deferred tax liabilityrelating to state income taxes.  Theeffective tax rate was 36.6% for the first six months of fiscal 2009. Wecurrently estimate our annualized effective tax rate for fiscal 2010 to be 41%,including a 2.7% unfavorable impact from the deferred tax liability correctionrecorded during the first quarter of fiscal 2010.

 

**Liquidityand Capital Resources**

 

We require cash principallyfor day-to-day operations, to finance capital investments, inventory for newstores, and inventory replenishment for existing stores, to service ouroutstanding debt, and for seasonal working capital needs. We expect that ouravailable cash, cash flow generated from operating activities, and fundsavailable under our Amended asset-based revolving credit facility will besufficient to fund planned capital expenditures, working capital requirements,debt repayments, debt service requirements and future growth for theforeseeable future. Our Amended asset-based revolving credit facility providessenior secured financing of up to $1.1 billion, subject to a borrowing base. Asof July 31, 2010, the borrowing base was $661 million, which supported $53million of outstanding letters of credit and provided $608 million of excessavailability. Our cash and equivalents decreased $148 million from $217 millionat January 30, 2010 to $69 million at July 31, 2010.

 

We and our subsidiaries,affiliates, and significant shareholders may from time to time seek to retireor purchase our outstanding debt (including publicly issued debt) through cashpurchases and/or exchanges, in open market purchases, privately negotiatedtransactions, by tender offer or otherwise. Such repurchases or exchanges, if any, will depend on prevailing marketconditions, liquidity requirements, contractual restrictions and other factors.

 

24

----

Table of Contents

 

*Cash Flowfrom Operating Activities*

 

Cash flow provided byoperating activities during the first six months of fiscal 2010 was $23 millioncompared to $30 million during the first six months of fiscal 2009. The $7million change was primarily due to an unfavorable impact in accruedliabilities, due to higher bonus payments made during the first quarter offiscal 2010, partially offset by the change in merchandise inventories comparedto last year.

 

Average inventory perMichaels store (including supporting distribution centers) decreased 7.4% from$889,000 at August 1, 2009 to $823,000 at July 31, 2010 primarily dueto a planned reduction of store inventory levels. We anticipate averageinventory per Michaels store at the end of fiscal 2010 to be down compared tothe end of fiscal 2009.

 

*Cash Flowused in Investing Activities*

 

Cash flow used in investingactivities was primarily the result of the following capital expenditureactivities:

 
| ** **                                              | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------------------------|------------|----------------------|------------|
| ** **                                              | ** ** | **July 31,**    | ** ** | **August 1,** | ** ** |
| ** **                                              | ** ** | **2010**             | ** ** | **2009** | ** ** |
| ** **                                              | ** ** | **(in millions)**    | ** ** |
| New and relocated stores and stores not yet opened  (1) |       | $                    | 11         |   | $ | 7 |   |
| Existing stores                                         |       | 10                   |       | 5 |   |
| Information systems                                     |       | 9                    |       | 4 |   |
| Corporate and other                                     |       | 3                    |       | 1 |   |
|                                                    |       | $                    | 33         |   | $ | 17 |   |

 

----

(1)          In the first six months offiscal 2010, we incurred capital expenditures related to the opening of tenMichaels stores in addition to the relocation of seven Michaels stores. In thefirst six months of fiscal 2009, we incurred capital expenditures related tothe opening of 14 Michaels stores in addition to the relocation of fourMichaels stores.  In fiscal 2009, we openedthe majority of our stores in locations where the landlord paid to build thestores to our specifications. During fiscal 2010, we have opened a greaternumber of stores in locations where we paid to build the stores to ourspecifications. As a result, our capital expenditures for new and relocatedstores have increased in the first six months of fiscal 2010 compared to thefirst six months of fiscal 2009. This trend may continue in future years.

 

*Cash Flowused in Financing Activities*

 

Cash flow used in financingactivities during the first six months of fiscal 2010 was $138 million comparedto $10 million during the first six months of fiscal 2009. The $128 millionchange was primarily due to the fiscal 2009 excess cash flow payment on ourSenior secured term loan facility of $118 million and $19 million in debtissuance costs related to the amendment to the asset-based revolving creditfacility, both of which were paid during the first quarter of fiscal 2010.

 

**Non-GAAPMeasures**

 

Thefollowing table sets forth the Company’s Earnings before Interest, Taxes,Depreciation and Amortization (“EBITDA”). The Company defines EBITDA as netincome before interest, income taxes, discontinued operations, depreciation andamortization. Additionally, the table presents Adjusted Earnings beforeInterest, Taxes, Depreciation and Amortization (“Adjusted EBITDA”).  The Company defines Adjusted EBITDA as EBITDAadjusted for certain defined amounts that are added to, or subtracted from,EBITDA (collectively, the “Adjustments”) in accordance with the Company’s $2.4billion Senior secured term loan and $1.1 billion asset-based revolving creditfacilities. The Adjustments are described in further detail in the table, andthe footnotes to the table below.

 

TheCompany has presented EBITDA and Adjusted EBITDA to provide investors withadditional information to evaluate our operating performance and our ability toservice our debt.  The Company usesEBITDA, among other metrics, to evaluate operating performance, to plan andforecast future periods’ operating performance and as an element of itsincentive compensation targets. Adjusted EBITDA is a required calculation underthe Company’s Senior secured term loan and its asset-based revolving creditfacilities. As it relates to the Senior secured term loan, Adjusted EBITDA isused in the calculations of fixed charge coverage and leverage ratios, which,under certain circumstances may result in limitations on the Company’s abilityto make restricted payments as well as the determination of mandatoryrepayments of the loans. Under the asset-based revolving facility, AdjustedEBITDA is used in the calculation of fixed charge coverage ratios, which undercertain circumstances, may restrict the Company’s ability to make certainpayments (characterized as restricted payments), investments (includingacquisitions) and debt repayments.

 

25

----

Table of Contents

 

AsEBITDA and Adjusted EBITDA are not measures of operating performance orliquidity calculated in accordance with U.S. generally accepted accountingprinciples (“GAAP”), these measures should not be considered in isolation of,or as a substitute for, net income, as an indicator of operating performance,or net cash provided by operating activities as an indicator of liquidity.  Our computation of EBITDA and Adjusted EBITDAmay differ from similarly titled measures used by other companies. As EBITDAand Adjusted EBITDA exclude certain financial information compared with netincome and net cash provided by operating activities, the most directlycomparable GAAP financial measures, users of this financial information shouldconsider the types of events and transactions which are excluded.

 

The table below shows a reconciliationof EBITDA and Adjusted EBITDA to net income and net cash provided by operatingactivities.

 
| ** **                                           | ** ** | **Quarter Ended** | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------|------------|-------------------|------------|----------------------|------------|
| ** **                                           | ** ** | **July 31,** | ** ** | **August 1,**   | ** ** | **July 31,** | ** ** | **August 1,** | ** ** |
| ** **                                           | ** ** | **2010**          | ** ** | **2009**             | ** ** | **2010** | ** ** | **2009** | ** ** |
|                                                 |       |              |       |                 |       |   |   |   |   |
| Net cash (used in) provided by operating  activities |       | $                 | (4         | )                    | $          | 28 |   | $ | 23 |   | $ | 30 |   |
| Depreciation and amortization                        |       | (26               | )          | (28                  | )          | (52 | ) | (58 | ) |
| Share-based compensation                             |       | (2                | )          | (2                   | )          | (4 | ) | (4 | ) |
| Debt issuance costs amortization                     |       | (4                | )          | (4                   | )          | (9 | ) | (8 | ) |
| Accretion of subordinated discount notes             |       | (12               | )          | (11                  | )          | (24 | ) | (22 | ) |
| Change in fair value of interest rate cap            |       | (3                | )          | 11                   |       | (13 | ) | 15 |   |
| Changes in assets and liabilities                    |       | 50                |       | 8                    |       | 91 |   | 53 |   |
| Net (loss) income                                    |       | (1                | )          | 2                    |       | 12 |   | 6 |   |
| Interest expense                                     |       | 70                |       | 62                   |       | 138 |   | 125 |   |
| Income tax provision                                 |       | 1                 |       | —               |       | 18 |   | 3 |   |
| Depreciation and amortization                        |       | 26                |       | 28                   |       | 52 |   | 58 |   |
| EBITDA                                               |       | 96                |       | 92                   |       | 220 |   | 192 |   |
| Adjustments:                                         |       |              |       |                 |       |   |   |   |   |
| Share-based compensation                             |       | 2                 |       | 2                    |       | 4 |   | 4 |   |
| Sponsor Fees                                         |       | 4                 |       | 3                    |       | 7 |   | 7 |   |
| Termination expense                                  |       | —            |       | —               |       | — |   | 3 |   |
| Pre-opening costs                                    |       | —            |       | —               |       | 1 |   | 1 |   |
| Foreign currency translation loss (gain)             |       | 1                 |       | (4                   | )          | (2 | ) | (5 | ) |
| Store closing costs                                  |       | —            |       | 2                    |       | 1 |   | 3 |   |
| Loss (gain) on interest rate cap                     |       | 3                 |       | (11                  | )          | 13 |   | (15 | ) |
| Other (1)                                            |       | —            |       | 1                    |       | — |   | 2 |   |
| Adjusted EBITDA                                      |       | $                 | 106        |                 | $          | 85 |   | $ | 244 |   | $ | 192 |   |

 

----

(1)          Other adjustments relate toitems such as moving & relocation expenses, franchise taxes, andforeign currency hedge.

 

**RecentAccounting Pronouncements**

 

InJanuary 2010, the Financial Accounting Standards Board (“FASB”) issuedAccounting Standards Update (“ASU”) No. 2010-06, “*Improving Disclosures About Fair Value Measurements”*an amendment to Accounting StandardsCodification (“ASC”) topic 820, *“Fair Value Measurementsand Disclosures.”*ASU 2010-06 expands disclosure requirementsrelated to fair value measurements including (i) separately disclosing theamounts of significant transfers in and out of Level 1 and Level 2 fair valuemeasurements and describing the reasons for the transfers and(ii) presenting separate information for Level 3 activity pertaining togross purchases, sales, issuances, and settlements. The new disclosuresare effective for interim and annual reporting periods beginning afterDecember 15, 2009, except for the Level 3 activity disclosures, which areeffective for fiscal years beginning after December 15, 2010. We adoptedall requirements of ASU 2010-06 related to significant transfers in and out ofLevel 1 and Level 2 fair value measurements on January 31, 2010, with nomaterial impact on our consolidated financial statements. See Note 6 forfurther information regarding fair value measurements. We will adopt the newdisclosure requirements related to the Level 3 activity on January 30,2011, with no material impact expected on our consolidated financialstatements.

 

26

----

Table of Contents

 

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

 

Weare exposed to fluctuations in exchange rates between the US and Canadiandollar, which is the functional currency of our Canadian subsidiaries. Oursales, costs and expenses of our Canadian subsidiaries, when translated into USdollars, can fluctuate due to exchange rate movement. As of July 31, 2010,a 10% increase or decrease in the exchange rate of the US and Canadian dollarwould not materially affect net income.

 

Wehave market risk exposure arising from changes in interest rates on our Seniorsecured term loan facility. The interest rates on our Senior Credit Facilitieswill reprice periodically, which will impact our earnings and cash flow. Theinterest rates on our notes are fixed. Based on our overall interest rate exposure to variable rate debtoutstanding as of July 31, 2010, a 1% increase or decrease in interestrates would increase or decrease income before income taxes by approximately$22 million. A 1% increase in interest rates would decrease the fair value ofour long-term fixed rate debt by approximately $51 million. A 1% decrease ininterest rates would increase the fair value of our long-term fixed rate debtby approximately $53 million.  A changein interest rates would not materially affect the fair value of our variablerate debt as the debt reprices periodically.

 

Duringthe first quarter of fiscal 2009, we purchased an interest rate cap to limitthe variability of cash flows associated with our interest payments on ourSenior secured term loan that result from fluctuations in the three-month LIBORrate. The cap limits our interest exposure on a notional value of $2.0 billionto the lesser of the three-month LIBOR rate or 7.0%.  The term of the cap is from April 15,2009 through April 15, 2015. The fair value of the cap as of July 31,2010 was $5 million and is included in Other assets on the Consolidated BalanceSheets. The change in fair value of the cap for the quarter and six monthsended July 31, 2010, resulted in a loss of $3 million and $13 million,respectively, and is recorded in Other (income) and expense, net in theConsolidated Statements of Operations. A 1% increase in the interest rateswould increase income before income taxes by approximately $12 million. A 1%decrease in the interest rates would decrease income before income taxes byapproximately $4 million.

 

**Item 4.  Controlsand Procedures.**

 

*Evaluationof Disclosure Controls and Procedures*

 

Wemaintain a set of disclosure controls and procedures (as defined inRules 13a-15(e) and 15d-15(e) promulgated by the SEC under theSecurities Exchange Act of 1934) that are designed to provide reasonableassurance that information, which is required to be timely disclosed, isaccumulated and communicated to management in a timely fashion.  We note that the design of any system ofcontrols is based in part upon certain assumptions about the likelihood offuture events, and there can be no assurance that any design will succeed inachieving its stated goals under all potential future conditions.

 

An evaluation was carriedout under the supervision and with the participation of our management,including our Chief Executive Officer and our Principal Financial Officer, ofthe effectiveness of our disclosure controls and procedures as of the end ofthe period covered by this report. Based on that evaluation, our ChiefExecutive Officer and our Principal Financial Officer concluded that ourdisclosure controls are effective to provide reasonable assurance thatinformation required to be disclosed in the reports that we file or submitunder the Securities and Exchange Act of 1934 is accumulated and communicatedto management, including our Chief Executive Officer and our PrincipalFinancial Officer, to allow timely decisions regarding required disclosure andare effective to provide reasonable assurance that such information isrecorded, processed, summarized and reported within the time periods specifiedby the SEC’s rules and forms.

 

*Change inInternal Control Over Financial Reporting*

 

There has not been anychange in our internal control over financial reporting (as defined inRules 13a-15(f) and 15d-15(f) as promulgated by the SEC underthe Securities Exchange Act of 1934) during the quarter covered by thisQuarterly Report on Form 10-Q that materially affected, or is reasonablylikely to materially affect, our internal control over financial reporting.

 

27

----

Table of Contents

 

**MICHAELSSTORES, INC.**

**Part II—OTHERINFORMATION**

 

**Item 1.  Legal Proceedings.**

 

Informationregarding legal proceedings is incorporated herein by reference from Note 8 toour Consolidated Financial Statements.

 

**Item 6.  Exhibits.**

 

(a) Exhibits:

 
| **Exhibit  Number** | ** ** | **Description of Exhibit**                                                                                                                  |
|---------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------|
| 31.1                |       | Certifications  of John B. Menzer pursuant to §302 of the Sarbanes-Oxley Act of 2002 (filed  herewith).                                |
|                |       |                                                                                                                                        |
| 31.2                |       | Certifications  of Richard S. Jablonski 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). |

 

28

----

Table of Contents

 

**MICHAELS STORES, INC.**

**SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 
|                              | MICHAELS  STORES, INC. |
|-----------------------------------|-----------------------------|
|                              |                        |   |
|                              | By:                         | /s/ Richard  S. Jablonski |
|                              |                        | Richard  S. Jablonski |
|                              |                        | Vice  President — Financial Planning and Analysis and Interim Controller |
|                              |                        | (Principal  Accounting Officer) |
| ** **                        | ** **                  | ** ** |
| Dated: August 27,  2010 | ** **                  | ** ** |

 

29

----

Table of Contents

 

**INDEX TO EXHIBITS**

 
| **Exhibit  Number** | ** ** | **Description of Exhibit**                                                                                                                  |
|---------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------|
| 31.1                |       | Certifications  of John B. Menzer pursuant to §302 of the Sarbanes-Oxley Act of 2002 (filed  herewith).                                |
|                |       |                                                                                                                                        |
| 31.2                |       | Certifications  of Richard S. Jablonski 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). |

 

30

----