Table of Contents

 

 

 

**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON,DC 20549**

** **

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** **

**FORM 10-Q**

 

| **(Mark  One)**                                      |
|------------------------------------------------------|
| **x**                                                | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| ** **                                           | ** ** |
| **For the  quarterly period ended May 2, 2009** |
| ** **                                           | ** ** |
| **OR**                                               |
| ** **                                           | ** ** |
| **o**                                                | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| ** **                                           | ** ** |
| ** **                                           | **For the  transition period from             to             ** |

 

**Commissionfile number 001-09338**

 

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**MICHAELSSTORES, INC.**

(Exact name ofregistrant as specified in its charter)

 

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

 

**8000Bent Branch Drive**

**Irving,Texas 75063**

 (Address of principal executive offices,including zip code)

 

**(972) 409-1300**

(Registrant’stelephone number, including area code)

 

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

 

Indicateby check mark whether the registrant has submitted electronically and posted onits corporate Web site, if any, every Interactive Data File required to besubmitted and posted pursuant to Rule 405 of Regulation S-T during thepreceding 12 months (or for such shorter period that the registrant wasrequired to submit and 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” in Rule 12b-2of the Exchange Act. (Check one):

 

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

 

Indicateby check mark whether the Registrant is a shell company (as defined in Rule 12b-2of the Exchange Act).  Yes o  No x

 

As of May 30, 2009,118,442,246 shares of the Registrant’s Common Stock were outstanding.

 

*The Registrant has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934,but is not required to file such reports under such sections.

 

 

 

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**Table of Contents**

** **

**MICHAELS STORES, INC.**

**FORM 10-Q**

 
| **Part I—FINANCIAL INFORMATION** | ** **                                                                                                      |
|--------------------------------------------|-----------------------------------------------------------------------------------------------------------------|
| **Item 1.**                           | **Financial Statements**                                                                                        | ** ** |
|                                       | Consolidated  Balance Sheets at May 2, 2009, January 31, 2009, and May 3,  2008 (unaudited)      | **3** |
|                                       | Consolidated  Statements of Operations for the quarter ended May 2, 2009 and  May 3, 2008 (unaudited) | **4** |
|                                       | Consolidated  Statements of Cash Flows for the quarter ended May 2, 2009 and  May 3, 2008 (unaudited) | **5** |
|                                       | Notes to Consolidated Financial Statements (unaudited)                                                          | **6** |
| **Item 2.**                           | **Management’s  Discussion and Analysis of Financial Condition and Results of Operations**                 | **17** |
| **Item 3.**                           | **Quantitative  and Qualitative Disclosures About Market Risk**                                                 | **22** |
| **Item 4.**                           | **Controls and  Procedures**                                                                                    | **22** |
| **Part II—OTHER  INFORMATION**   | ** **                                                                                                      |
| **Item 1.**                           | **Legal Proceedings**                                                                                           | **22** |
| **Item 4.**                                | **Submission  of Matters to a Vote of Security Holders**                                                        | **22** |
| **Item 5.**                                | **Other Information**                                                                                           | **22** |
| **Item 6.**                           | **Exhibits**                                                                                                    | **23** |
| **Signatures**                             | ** **                                                                                                      | **24** |

** **

**2**

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**Table of Contents**

** **

**MICHAELS STORES, INC.**

**Part I—FINANCIALINFORMATION**

** **

**Item 1.  Financial Statements.**

** **

**MICHAELSSTORES, INC.**

**CONSOLIDATEDBALANCE SHEETS**

**(In millions, exceptshare data)**

**(Unaudited)**

** **
| ** **                                                                                                                                                                                                                                                        | ** ** | **May 2,** | ** ** | **January 31,** | ** ** | **May 3,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|------------|----------------------|------------|-----------------|------------|
| ** **                                                                                                                                                                                                                                                        | ** ** | **2009**        | ** ** | **2009**             | ** ** | **2008**        | ** ** |
| **ASSETS**                                                                                                                                                                                                                                                        |       |            |       |                 |       |            |       |
| **Current assets:**                                                                                                                                                                                                                                               |       |            |       |                 |       |            |       |
| Cash and equivalents                                                                                                                                                                                                                                              |       | $               | 32         |                 | $          | 33              |       | $ | 42 |   |
| Merchandise inventories                                                                                                                                                                                                                                           |       | 890             |       | 900                  |       | 841             |       |
| Prepaid expenses and other                                                                                                                                                                                                                                        |       | 71              |       | 73                   |       | 70              |       |
| Deferred income taxes                                                                                                                                                                                                                                             |       | 41              |       | 41                   |       | 31              |       |
| Income tax receivable                                                                                                                                                                                                                                             |       | 12              |       | 2                    |       | 19              |       |
| Total current assets                                                                                                                                                                                                                                              |       | 1,046           |       | 1,049                |       | 1,003           |       |
| **Property and equipment, at cost**                                                                                                                                                                                                                               |       | 1,222           |       | 1,214                |       | 1,168           |       |
| Less accumulated depreciation                                                                                                                                                                                                                                     |       | (859            | )          | (832                 | )          | (748            | )          |
|                                                                                                                                                                                                                                                              |       | 363             |       | 382                  |       | 420             |       |
| **Goodwill**                                                                                                                                                                                                                                                      |       | 94              |       | 94                   |       | 94              |       |
| **Debt issuance costs, net of accumulated  amortization of $43, $39, and $26, respectively**                                                                                                                                                                      |       | 82              |       | 86                   |       | 99              |       |
| **Deferred income taxes**                                                                                                                                                                                                                                         |       | 13              |       | 12                   |       | —          |       |
| **Other assets**                                                                                                                                                                                                                                                  |       | 15              |       | 2                    |       | 3               |       |
|                                                                                                                                                                                                                                                              |       | 204             |       | 194                  |       | 196             |       |
| Total assets                                                                                                                                                                                                                                                      |       | $               | 1,613      |                 | $          | 1,625           |       | $ | 1,619 |   |
|                                                                                                                                                                                                                                                              |       |            |       |                 |       |            |       |
| **LIABILITIES AND STOCKHOLDERS’  DEFICIT**                                                                                                                                                                                                                   |       |            |       |                 |       |            |       |
| **Current liabilities:**                                                                                                                                                                                                                                          |       |            |       |                 |       |            |       |
| Accounts payable                                                                                                                                                                                                                                                  |       | $               | 213        |                 | $          | 230             |       | $ | 191 |   |
| Accrued liabilities and other                                                                                                                                                                                                                                     |       | 249             |       | 275                  |       | 273             |       |
| Current portion of long-term debt                                                                                                                                                                                                                                 |       | 196             |       | 173                  |       | 235             |       |
| Income taxes payable                                                                                                                                                                                                                                              |       | —          |       | 2                    |       | —          |       |
| Current liabilities - discontinued operations                                                                                                                                                                                                                     |       | 1               |       | 1                    |       | 2               |       |
| Total current liabilities                                                                                                                                                                                                                                         |       | 659             |       | 681                  |       | 701             |       |
| **Long-term debt**                                                                                                                                                                                                                                                |       | 3,761           |       | 3,756                |       | 3,744           |       |
| **Deferred income taxes**                                                                                                                                                                                                                                         |       | —          |       | —               |       | 4               |       |
| **Other long-term liabilities**                                                                                                                                                                                                                                   |       | 74              |       | 74                   |       | 79              |       |
| **Long-term liabilities - discontinued operations**                                                                                                                                                                                                               |       | —          |       | 1                    |       | 1               |       |
| Total long-term liabilities                                                                                                                                                                                                                                       |       | 3,835           |       | 3,831                |       | 3,828           |       |
|                                                                                                                                                                                                                                                              |       | 4,494           |       | 4,512                |       | 4,529           |       |
| **Commitments and contingencies**                                                                                                                                                                                                                                 |       |            |       |                 |       |            |       |
| **Stockholders’ deficit:**                                                                                                                                                                                                                                   |       |            |       |                 |       |            |       |
| Common Stock, $0.10 par value, 220,000,000 shares authorized;  118,376,402 shares issued and outstanding at May 2, 2009;  118,376,402 shares issued and outstanding at January 31, 2009;  118,415,735 shares issued and outstanding at May 3, 2008 |       | 12              |       | 12                   |       | 12              |       |
| Additional paid-in capital                                                                                                                                                                                                                                        |       | 30              |       | 27                   |       | 16              |       |
| Accumulated deficit                                                                                                                                                                                                                                               |       | (2,927          | )          | (2,931               | )          | (2,947          | )          |
| Accumulated other comprehensive income                                                                                                                                                                                                                            |       | 4               |       | 5                    |       | 9               |       |
| Total stockholders’ deficit                                                                                                                                                                                                                                  |       | (2,881          | )          | (2,887               | )          | (2,910          | )          |
| Total liabilities and stockholders’ deficit                                                                                                                                                                                                                  |       | $               | 1,613      |                 | $          | 1,625           |       | $ | 1,619 |   |

** **

See accompanying notes to consolidated financialstatements.

 

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** **

**MICHAELS STORES, INC.CONSOLIDATED STATEMENTS OF OPERATIONS**

**(In millions)(Unaudited)**

 
| ** **                                   | ** ** | **Quarter Ended** | ** ** |
|----------------------------------------------|------------|-------------------|------------|
| ** **                                   | ** ** | **May 2,**   | ** ** | **May 3,** | ** ** |
| ** **                                   | ** ** | **2009**          | ** ** | **2008** | ** ** |
| **Net sales**                                |       | $                 | 852        |   | $ | 847 |   |
| Cost of sales and occupancy expense          |       | 537               |       | 521 |   |
| **Gross profit**                             |       | 315               |       | 326 |   |
| Selling, general, and administrative expense |       | 246               |       | 272 |   |
| Related party expenses                       |       | 4                 |       | 4 |   |
| Store pre-opening costs                      |       | 1                 |       | 2 |   |
| **Operating income**                         |       | 64                |       | 48 |   |
| Interest expense                             |       | 63                |       | 78 |   |
| Other (income) and expense, net              |       | (6                | )          | — |   |
| **Income (loss) before income taxes**        |       | 7                 |       | (30 | ) |
| Provision (benefit) for income taxes         |       | 3                 |       | (10 | ) |
| **Net income (loss)**                        |       | $                 | 4          |   | $ | (20 | ) |

 

See accompanying notes to consolidated financial statements.

 

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**MICHAELSSTORES, INC.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(In millions)**

**(Unaudited)**

** **
| ** **                                          | ** ** | **Quarter Ended** | ** ** |
|-----------------------------------------------------|------------|-------------------|------------|
| ** **                                          | ** ** | **May 2,**   | ** ** | **May 3,** | ** ** |
| ** **                                          | ** ** | **2009**          | ** ** | **2008** | ** ** |
| **Operating activities:**                           |       |              |       |   |   |
| Net income (loss)                                   |       | $                 | 4          |   | $ | (20 | ) |
| Adjustments:                                        |       |              |       |   |   |
| Depreciation and amortization                       |       | 30                |       | 31 |   |
| Share-based compensation                            |       | 2                 |       | 3 |   |
| Deferred financing costs amortization               |       | 4                 |       | 4 |   |
| Accretion of subordinated discount notes            |       | 11                |       | 9 |   |
| Changes in assets and liabilities:                  |       |              |       |   |   |
| Merchandise inventories                             |       | 10                |       | 4 |   |
| Prepaid expenses and other                          |       | 1                 |       | — |   |
| Deferred income taxes and other                     |       | (13               | )          | 1 |   |
| Accounts payable                                    |       | (9                | )          | (38 | ) |
| Accrued interest                                    |       | (30               | )          | (53 | ) |
| Accrued liabilities and other                       |       | 5                 |       | (9 | ) |
| Income taxes receivable                             |       | (13               | )          | (13 | ) |
| Other long-term liabilities                         |       | —            |       | (2 | ) |
| Net cash provided by (used in) operating activities |       | 2                 |       | (83 | ) |
|                                                |       |              |       |   |   |
| **Investing activities:**                           |       |              |       |   |   |
| Additions to property and equipment                 |       | (11               | )          | (21 | ) |
| Net cash used in investing activities               |       | (11               | )          | (21 | ) |
|                                                |       |              |       |   |   |
| **Financing activities:**                           |       |              |       |   |   |
| Borrowings on asset-based revolving credit facility |       | 236               |       | 304 |   |
| Payments on asset-based revolving credit facility   |       | (212              | )          | (193 | ) |
| Repayments on senior secured term loan facility     |       | (6                | )          | (6 | ) |
| Payment of capital leases                           |       | —            |       | (3 | ) |
| Change in cash overdraft                            |       | (10               | )          | 14 |   |
| Other                                               |       | —            |       | 1 |   |
| Net cash provided by financing activities           |       | 8                 |       | 117 |   |
|                                                |       |              |       |   |   |
| **Net (decrease) increase in cash and equivalents** |       | (1                | )          | 13 |   |
| **Cash and equivalents at beginning of period**     |       | 33                |       | 29 |   |
| **Cash and equivalents at end of period**           |       | $                 | 32         |   | $ | 42 |   |
|                                                |       |              |       |   |   |
| **Supplemental Cash Flow Information:**             |       |              |       |   |   |
| Cash paid for interest                              |       | $                 | 78         |   | $ | 117 |   |
| Cash paid for income taxes                          |       | $                 | 14         |   | $ | 5 |   |

 

See accompanying notes toconsolidated financial statements.

 

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** **

**MICHAELS STORES, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**For theQuarter Ended May 2, 2009(Unaudited)**

** **

**Note 1.  Summaryof Significant Accounting Policies**

 

*Basis ofPresentation*

 

Theconsolidated financial statements include the accounts of Michaels Stores, Inc.and our wholly-owned subsidiaries. All significant intercompany accounts andtransactions have been eliminated. All expressions of the “Company”, “us,” “we,”“our,” and all similar expressions are references to Michaels Stores, Inc.and our consolidated, wholly-owned subsidiaries, unless otherwise expresslystated 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 and Article 10of Regulation S-X. Accordingly, they do not include all of the informationand notes required by generally accepted accounting principles for completefinancial statements. Therefore, these financial statements should be read inconjunction with our Annual Report on Form 10-K for the fiscal year ended January 31,2009.

 

Thebalance sheet at January 31, 2009 has been derived from the auditedfinancial statements at that date, but does not include all of the informationand notes required by generally accepted accounting principles for completefinancial statements. For further information, refer to the consolidatedfinancial statements and notes thereto included in our Annual Report on Form 10-Kfor the fiscal year ended January 31, 2009.

 

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

 

Becauseof the seasonal nature of our business, the results of operations for thequarter ended May 2, 2009 are not indicative of the results to be expectedfor 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 2009” relate tothe 52 weeks ending January 30, 2010, and all references to “fiscal2008” relate to the 52 weeks ended January 31, 2009. In addition, allreferences herein to “the first quarter of fiscal 2009” relate to the 13 weeksended May 2, 2009, and all references to “the first quarter of fiscal 2008”relate to the 13 weeks ended May 3, 2008.

 

*Recent Accounting Pronouncements*

 

In September 2006,the Financial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards (“SFAS”) No. 157, *Fair Value Measurements*,which is intended to increase consistency and comparability in fair valuemeasurements by defining fair value, establishing a framework for measuringfair value and expanding disclosures about fair value measurements.  SFAS 157 was originally effective forfinancial statements issued for fiscal years beginning after November 15,2007, and interim periods within those fiscal years.  In November 2007, the FASB placed a oneyear deferral for the implementation of SFAS 157 for nonfinancial assets andliabilities; however, SFAS 157 is effective for fiscal years beginning after November 15,2007 for financial assets and liabilities, as well as for any other assets andliabilities that are carried at fair value on a recurring basis in financialstatements.  On February 3, 2008, weadopted the provisions of SFAS 157 related to financial assets and liabilitiesand on February 1, 2009, we adopted the provisions related to nonfinancialassets and liabilities that are not required or permitted to be measured atfair value on a recurring basis. These adoptions had no impact on our consolidatedfinancial statements.   See Note 6 forfurther information regarding fair value measurements.

 

In December 2007,the FASB issued SFAS No. 141 (revised 2007), *Business Combinations*(“SFAS 141R”). SFAS 141R replaces SFASNo. 141, *Business Combinations*.The statement retains the purchase method of accounting used in businesscombinations, but replaces SFAS 141 by establishing principles and requirementsfor the recognition and measurement of assets, liabilities and goodwill,including the requirement that most transaction costs and restructuring costsbe expensed. In addition, the statement requires disclosures to enable users toevaluate the nature and financial effects of the business combination. SFAS141R is effective for business combinations for which the acquisition date ison or after the beginning of the first annual reporting period beginning on orafter December 15, 2008. We will apply the provisions of SFAS 141R to anybusiness combinations occurring on or after February 1, 2009.

 

In March 2008, theFASB issued SFAS No. 161, *Disclosuresabout Derivative Instruments and Hedging Activities – an amendment of FASBStatement No. 133*. SFAS 161 requires qualitative disclosuresabout objectives and strategies for using derivatives, quantitative data aboutthe fair value of and gains and losses on derivative contracts, and details ofcredit-risk-related contingent features in hedged positions. The statement alsorequires enhanced disclosures regarding how and why entities use derivativeinstruments, how derivative instruments and related hedged items are accountedfor in accordance with SFAS 133

 

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and its related interpretation, and how derivativeinstruments and related hedged items affect entity’s financial position,financial performance, and cash flows. SFAS 161 is effective for fiscal yearsand interim periods beginning after November 15, 2008. We adopted the newdisclosure requirements of SFAS 161 in the first quarter of 2009 as reflectedin Note 5.

 

**Note 2.  Share-BasedCompensation**

** **

OnFebruary 15, 2007, our shareholders and Board of Directors approved the2006 Equity Incentive Plan (“2006 Plan”), which provides for the grant ofshare-based awards exercisable for up to 14.2 million shares of CommonStock.  The table below sets forth asummary of stock option activity for the quarters ended May 2, 2009 and May 3,2008. As of May 2, 2009, there were 132,511 shares of restricted stockoutstanding, 8.9 million stock options outstanding and up to 5.2 million sharesof Common Stock remained available for grant under the 2006 Plan. On June 3, 2009, the Company announced an offer toexchange certain employee stock options issued under Michaels 2006 EquityIncentive Plan (“Exchange Offer”) for new stock options granted on aone-for-one basis. See note 11 for additional information.

 

| ** **                         | ** ** | **Quarter Ended**    | ** ** |
|------------------------------------|------------|----------------------|------------|
| ** **                         | ** ** | **May 2, 2009** | ** ** | **May 3, 2008** | ** ** |
| ** **                         | ** ** | **(in millions)**    | ** ** |
|                               |       |                 |       |   |   |
| Outstanding at beginning of period |       | 10.1                 |       | 11.1 |   |
| Grants                             |       | 0.5                  |       | 1.1 |   |
| Cancellations                      |       | (1.7                 | )          | (1.4 | ) |
| Outstanding at end of period       |       | 8.9                  |       | 10.8 |   |

 

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 ranged from$15 per share to $52.50 per share, as determined by the Board of Directors.Share-based compensation expense associated with these awards was $2 millionand $3 million for the first quarter of fiscal 2009 and 2008, respectively.

 

**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.

 

| ** **                            | ** ** | **May 2, 2009** | ** ** | **January 31, 2009** | ** ** | **Interest Rate** | ** ** |
|---------------------------------------|------------|----------------------|------------|---------------------------|------------|-------------------|------------|
| ** **                            | ** ** | **(in millions)**    | ** ** | ** **                | ** ** |
|                                  |       |                 |       |                      |       |              |       |
| Senior notes                          |       | $                    | 750        |                      | $          | 750               |       | 10.000% |   |
| Senior subordinated notes             |       | 400                  |       | 400                       |       | 11.375%           |       |
| Subordinated discount notes           |       | 343                  |       | 332                       |       | 13.000%           |       |
| Senior secured term loan              |       | 2,291                |       | 2,297                     |       | Variable          |       |
| Asset-based revolving credit facility |       | 173                  |       | 148                       |       | Variable          |       |
| Other                                 |       | —               |       | 2                         |       | Variable          |       |
|                                  |       |                 |       |                      |       |              |       |
| Total debt                            |       | 3,957                |       | 3,929                     |       |              |       |
|                                  |       |                 |       |                      |       |              |       |
| Less current portion                  |       | 196                  |       | 173                       |       |              |       |
|                                  |       |                 |       |                      |       |              |       |
| Long-term debt                        |       | $                    | 3,761      |                      | $          | 3,756             |       |   |   |

 

*Asset-based revolving creditfacility*

 

Oursenior secured asset-based revolving credit facility, which we entered into on October 31,2006, with Banc of America, N.A. and other lenders (the “Asset-based revolvingcredit facility”) provides senior secured financing of up to $1.0 billion,subject to a borrowing base as described in our Annual Report on Form 10-K.As of May 2, 2009, the borrowing base was $757 million, of which we hadunused standby letters of credit of $45 million and $539 million of unusedavailability.

 

*Senior secured term loan facility*

* *

Borrowingsunder our senior secured term loan facility, which we entered into on October 31,2006, with Deutsche Bank A.G. New York Branch, and other lenders, (the “Seniorsecured term loan facility”) bore interest at a rate per annum equal to, at ouroption, either (a) a base rate determined by reference to the higher of (1) theprime rate of Deutsche Bank and (2) the federal funds

 

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effective rate plus 1⁄2of 1% or (b) a LIBOR rate, subject to certain adjustments, in each caseplus an applicable margin. The applicable margin is subject to downwardadjustment based on the ratings threshold set forth in the Senior secured termloan facility agreement. At May 2, 2009, the margin was 1.25% with respectto base rate borrowings and 2.25% with respect to LIBOR borrowings.

 

**Note4.  Comprehensive Income (Loss)**

** **

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

 

| ** **                                        | ** ** | **Quarter Ended**    | ** ** |
|---------------------------------------------------|------------|----------------------|------------|
| ** **                                        | ** ** | **May 2, 2009** | ** ** | **May 3, 2008** | ** ** |
| ** **                                        | ** ** | **(in millions)**    | ** ** |
|                                              |       |                 |       |   |   |
| Net income (loss)                                 |       | $                    | 4          |   | $ | (20 | ) |
| Other comprehensive income (loss):                |       |                 |       |   |   |
| Foreign currency translation adjustment and other |       | —               |       | (1 | ) |
| Comprehensive income (loss)                       |       | $                    | 4          |   | $ | (21 | ) |

 

**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 rate cap tomitigate the effects of interest rate fluctuations. The objective of the cap isto hedge the variability of cash flows associated with our interest payments onour Senior secured term loan that result from fluctuations in the three-monthLIBOR rate and does not qualify for hedge accounting under SFAS 133. The caplimits our interest exposure on a notional value of $2.0 billion to the lesserof the three-month Libor rate or 7.0%. The term of the cap extends to the first quarter of fiscal 2015. Thefair value of the cap as of May 2, 2009 was $13 million and is included inOther assets on the Consolidated Balance Sheet. The change in fair value of thecap for the quarter ended May 2, 2009, was $4 million and is recorded inOther (income) and expense, net in the Consolidated Statement of Operations.

 

Weare exposed to fluctuations in exchange rates between the US and Canadiandollar, which is the functional currency of our Canadian subsidiary. We hadforeign currency forward contracts in place, beginning during the 2nd quarter of fiscal 2008 and ending during the 1st quarter of fiscal 2009, to mitigate theeffects of currency fluctuations. The objective of these forward contracts wasto hedge intercompany payments for forecasted purchases of inventory by ourCanadian subsidiary, which are denominated in US dollars. For the portion ofthe hedge that was effective, the change in fair value was recorded inAccumulated other comprehensive income. As the underlying inventory is sold toour customers, amounts will be reclassified from Accumulated othercomprehensive income to Cost of sales and occupancy expense. During the firstquarter of fiscal 2009, we reclassified $2 million from other comprehensiveincome into Cost of sales and occupancy expense. An immaterial amount wasrecognized in other comprehensive income during the 1st quarter of fiscal 2009 related to theeffective portion of the hedge. Hedge ineffectiveness was recorded in Other(income) and expense, net. For the quarter ended May 2, 2009, theineffective portion of the hedge was immaterial.

 

**Note 6. Fair Value Measurements**

 

Asdefined in SFAS No. 157, fair value is the price that would be received tosell an asset or paid to transfer a liability in an orderly transaction betweenmarket participants at the measurement date.  SFAS No. 157establishes a three-level valuation hierarchy for fair value measurements.These valuation techniques are based upon observable and unobservable inputs.Observable inputs reflect market data obtained from independent sources, whileunobservable inputs reflect our market assumptions. These two types of inputscreate the following fair value hierarchy:

 

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

·                  Level 2 — Quoted prices for *similar*instruments in active markets; quoted prices for identical orsimilar instruments in markets that are not active; and model-derivedvaluations whose significant inputs are observable; and

·                  Level 3 — Instruments whose significant inputs are *unobservable.*

 

The following tablepresents net financial assets (liabilities) accounted for at fair value on arecurring basis as of May 2, 2009 (in millions):

 

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| ** **        | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** | **Total** | ** ** |
|-------------------|------------|-------------|------------|-------------|------------|-------------|------------|-----------|------------|
| Cash equivalents  |       | $           | 4          |        | $          | —      |       | $         | —     |   | $ | 4 |   |
| Interest Rate Cap |       | —      |       | 13          |       | —      |       | 13        |       |
|                   |            |             |            |             |            |             |            |           |            |  |  |  |  |

 

Cashequivalents consist ofhighly liquid investments, with a maturity of 90 days or less at the date ofpurchase, including U.S. Treasury bills, various government obligations, andmoney market funds.

 

Derivatives in Level 2are measured based on a variety of pricing factors, which include the marketprice of the derivative instrument available in the dealer-market, which havebeen corroborated with market data. See Note 5 for additional information onour derivative instruments.

 

We generally apply fairvalue techniques on a non-recurring basis associated for the establishment ofpotential impairment loss related to goodwill pursuant to SFAS 142 anddetermining the fair value of long-lived assets pursuant to SFAS 144.

 

**Note 7.  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 31, 2009.

 

*EmployeeClaims and Class Actions*

 

*Adams Claim*

 

On December 29, 2006, John DeJoseph,a former Michaels store manager in Valencia, California, commenced a purportedclass action proceeding against Michaels Stores, Inc. on behalf of himselfand current and former salaried store managers employed in California from May 10,2002 to the present.  On June 4,2008, the class was certified as to certain claims.  However, on a motion for de-certificationfiled by the Company, the Court de-certified the class on March 12,2009.  Thereafter, on April 22,2009, counsel for the former class filed a new action, Adams, et. al. v.Michaels Stores, Inc. in the United States District Court for the CentralDistrict of California.  The Adams suit includes approximately 125individual plaintiffs who were members of the former class in the DeJoseph suitand alleges that Michaels failed to pay overtime wages, provide meal and restperiods (or compensation in lieu thereof), accurately record hours worked andprovide itemized employee wage statements.  The Adams suit additionallyalleges that the foregoing conduct was in breach of California’s unfaircompetition law.  The plaintiff seeks injunctive relief, damages forunpaid wages, penalties, restitution, interest, and attorneys’ fees andcosts. We believe we have meritorious defenses and intend to defend thelawsuit vigorously. We are unable to estimate a range of loss, if any, in thiscase.

 

*McLeod Claim*

 

On March 30, 2009,Nicole McLeod, a former Michaels employee, commenced a purported class actionproceeding against Michaels Stores, Inc. on behalf of herself and currentand former hourly retail employees employed in California from March 30,2005 to the present. The McLeod suit was filed in the Superior Court ofCalifornia, County of Los Angeles, and removed by the Company to the UnitedStates District Court for the Central District of California.  The McLeod suit alleges that Michaels failedto pay overtime wages and provide meal and rest periods (or compensation inlieu thereof). The McLeod suit also alleges that this conduct was in breach ofCalifornia’s unfair competition law. The plaintiffs seek injunctive relief,restitution, damages for unpaid wages, waiting time penalties, interest, andattorneys’ fees and costs.  We believe we have meritorious defenses andintend to defend the lawsuit vigorously. We are unable to estimate a range ofloss, if any, in this case.

 

**Note 8.  Segments**

** **

Weconsider our Michaels and Aaron Brothers operations to be our operatingsegments for purposes of determining reportable segments based on the criteriaof SFAS No. 131, *Disclosures AboutSegments of an Enterprise and Related Information.* We determinedthat our Michaels and Aaron Brothers operating segments have similar economiccharacteristics and meet the aggregation criteria set forth in paragraph 17 ofSFAS No. 131. Therefore, we combine both operating segments into onereporting segment.

 

Ourchief operating decision makers evaluate historical operating performance, planand forecast future periods’ operating performance based on earnings beforeinterest, income taxes, and depreciation and amortization (“EBITDA”). Inaddition, an element of base incentive compensation targets for certainmanagement personnel are based on EBITDA. A reconciliation of EBITDA to income(loss) before income taxes is presented below.

 

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| ** **                        | ** ** | **Quarter Ended**    | ** ** |
|-----------------------------------|------------|----------------------|------------|
| ** **                        | ** ** | **May 2, 2009** | ** ** | **May 3, 2008** | ** ** |
| ** **                        | ** ** | **(in millions)**    | ** ** |
|                              |       |                 |       |   |   |
| Income (loss) before income taxes |       | $                    | 7          |   | $ | (30 | ) |
| Interest expense                  |       | 63                   |       | 78 |   |
| Depreciation and amortization     |       | 30                   |       | 31 |   |
| EBITDA                            |       | $                    | 100        |   | $ | 79 |   |

 

Oursales and assets by country areas follows:

 

| ** **                          | ** ** | **Net Sales**     | ** ** | **Total Assets** | ** ** |
|-------------------------------------|------------|-------------------|------------|------------------|------------|
| ** **                          | ** ** | **(in millions)** | ** ** |
| **Quarter ended May 2, 2009:** |       |              |       |             |       |
| United States                       |       | $                 | 792        |             | $          | 1,522 |   |
| Canada                              |       | 60                |       | 91               |       |
| Consolidated Total                  |       | $                 | 852        |             | $          | 1,613 |   |
|                                |       |              |       |             |       |
| **Quarter ended May 3, 2008:** |       |              |       |             |       |
| United States                       |       | $                 | 778        |             | $          | 1,509 |   |
| Canada                              |       | 69                |       | 110              |       |
| Consolidated Total                  |       | $                 | 847        |             | $          | 1,619 |   |

 

We present assets based on their physical,geographic location.  Certain assetslocated in the United States are also used to support our Canadian operations,but we do not allocate these assets to Canada.

 

**Note 9.  RelatedParty Transactions**

 

Aspreviously disclosed, on October 31, 2006, substantially all of the CommonStock of Michaels Stores, Inc. was acquired through a merger transaction(the “Merger”) by affiliates of Bain Capital Partners, LLC and The BlackstoneGroup. We pay annual management fees to Bain Capital Partners, LLC and TheBlackstone Group (collectively, together with their applicable affiliates, the “Sponsors”)and Highfields Capital Management LP in the amount of $12 million and $1million, respectively. We recognized $4 million and $3 million of expenserelated to annual management fees during the first quarter of fiscal 2009 andfiscal 2008, respectively. These expenses are included in related partyexpenses on the Consolidated Statements of Operations.

 

BainCapital owns a majority ownership stake in an external vendor we utilize toprint our circular advertisements. Payments associated with this vendor during the first quarter of fiscal2009 and fiscal 2008 were $8 million and $10 million, respectively.  These expenses are included in selling,general and administrative expense on the Consolidated Statements ofOperations.

 

BainCapital owns an ownership stake in an external vendor we utilize fornon-merchandise supplies.  Paymentsassociated with this vendor during the first quarter of each of fiscal 2009 andfiscal 2008 were $1 million.  Theseexpenses are included in selling, general and administrative expense on theConsolidated Statements of Operations.

 

TheBlackstone Group owns a majority ownership stake in an external vendor weutilize to count our store inventory. Payments associated with this vendorduring the first quarter of each of fiscal 2009 and fiscal 2008 were $2million.  These expenses are included in selling,general and administrative expense on the Consolidated Statements ofOperations.

 

Duringfiscal 2008, we began utilizing an external vendor for waste managementservices that is partially owned by The Blackstone Group. Payments associatedwith this vendor during the first quarter of fiscal 2009 were $2 million. Wedid not have any payments to this vendor during the first quarter of fiscal2008. These expenses are included in selling, general and administrativeexpense on the Consolidated Statements of Operations.

 

During the first quarterof fiscal 2008, The Blackstone Group acquired an ownership stake in an externalvendor we utilize for all of the candy-type items in our stores.  Payments associated with this vendor duringthe first quarter of fiscal 2009 and fiscal 2008 were $3 million and $4million, respectively. These expenses are recognized in cost of sales as thesales are incurred.

 

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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.  Such affiliatesbeneficially own approximately $233.3 million face amount of ourSubordinated Discount Notes due 2016.

 

TheCompany periodically provides officers of Michaels Stores, Inc. and itssubsidiaries the opportunity to purchase shares of our Common Stock. There wereno shares sold to officers during the first quarter of each of fiscal 2009 and2008. Also, during the first quarter of fiscal 2008, we repurchased 5,334shares from officers who are no longer with the Company. There were no sharesrepurchased during the first quarter of fiscal 2009.

 

Inconnection with the consummation of the Merger, the Company entered into aSeparation Agreement with each of Charles Wyly and Sam Wyly, executive officersand directors of the Company prior to the Merger.  Under the Separation Agreements, each ofCharles Wyly and Sam Wyly received a lump sum payment of $3.0 million inexchange for his agreement to adhere to certain non-competition,non-solicitation and confidentiality restrictions. We amortized theseSeparation Agreements over the two year period ended October 31, 2008.These expenses are included in related party expenses on the ConsolidatedStatements of Operations.

 

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**Note10.  Condensed Consolidating FinancialInformation**

** **

All of the Company’sobligations under the Senior Notes, Senior Subordinated Notes, SubordinatedDiscount Notes, Senior secured term loan, and Asset-based revolving creditfacility are guaranteed by the Parent and each of our subsidiaries other thanAaron Brothers Card Services, LLC. As of May 2, 2009, the financialstatements of Aaron Brothers Card Services, LLC were immaterial.

 

The following condensedconsolidating financial information represents the financial information ofMichaels Stores, Inc. (“Parent”) 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.

 

**Supplemental Condensed Consolidating Balance Sheet**

** **
| ** **                                                     | ** ** | **May 2, 2009** | ** ** |
|----------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                     | ** ** | **Parent  Company**  | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                     | ** ** | **(in millions)**    | ** ** |
| **ASSETS**                                                     | ** ** | ** **           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Current assets:**                                            |       |                 |       |   |   |   |   |   |   |
| Cash and equivalents                                           |       | $                    | 25         |   | $ | 7 |   | $ | — |   | $ | 32 |   |
| Merchandise inventories                                        |       | 628                  |       | 262 |   | — |   | 890 |   |
| Intercompany receivables                                       |       | —               |       | 526 |   | (526 | ) | — |   |
| Other                                                          |       | 71                   |       | 53 |   | — |   | 124 |   |
| Total current assets                                           |       | 724                  |       | 848 |   | (526 | ) | 1,046 |   |
| **Property and equipment, net**                                |       | 271                  |       | 92 |   | — |   | 363 |   |
| **Goodwill, net**                                              |       | 94                   |       | — |   | — |   | 94 |   |
| **Investment in subsidiaries**                                 |       | 628                  |       | — |   | (628 | ) | — |   |
| **Other assets**                                               |       | 89                   |       | 21 |   | — |   | 110 |   |
| **Total assets**                                               |       | $                    | 1,806      |   | $ | 961 |   | $ | (1,154 | ) | $ | 1,613 |   |
|                                                           |       |                 |       |   |   |   |   |   |   |
| **LIABILITIES AND STOCKHOLDERS’  (DEFICIT) EQUITY**       |       |                 |       |   |   |   |   |   |   |
| **Current liabilities:**                                       |       |                 |       |   |   |   |   |   |   |
| Accounts payable                                               |       | $                    | 15         |   | $ | 198 |   | $ | — |   | $ | 213 |   |
| Accrued liabilities and other                                  |       | 173                  |       | 76 |   | — |   | 249 |   |
| Current portion of long-term debt                              |       | 196                  |       | — |   | — |   | 196 |   |
| Intercompany payable                                           |       | 526                  |       | — |   | (526 | ) | — |   |
| Other                                                          |       | (34                  | )          | 35 |   | — |   | 1 |   |
| Total current liabilities                                      |       | 876                  |       | 309 |   | (526 | ) | 659 |   |
| **Long-term debt**                                             |       | 3,761                |       | — |   | — |   | 3,761 |   |
| **Other long-term liabilities**                                |       | 50                   |       | 24 |   | — |   | 74 |   |
| **Total stockholders’ (deficit) equity**                  |       | (2,881               | )          | 628 |   | (628 | ) | (2,881 | ) |
| **Total liabilities and stockholders’ (deficit)  equity** |       | $                    | 1,806      |   | $ | 961 |   | $ | (1,154 | ) | $ | 1,613 |   |

 

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**Supplemental Condensed Consolidating Balance Sheet**

 
| ** **                                                     | ** ** | **January 31, 2009** | ** ** |
|----------------------------------------------------------------|------------|---------------------------|------------|
| ** **                                                     | ** ** | **Parent  Company**       | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                     | ** ** | **(in millions)**         | ** ** |
| **ASSETS**                                                     | ** ** | ** **                | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Current assets:**                                            |       |                      |       |   |   |   |   |   |   |
| Cash and equivalents                                           |       | $                         | 26         |   | $ | 7 |   | $ | — |   | $ | 33 |   |
| Merchandise inventories                                        |       | 627                       |       | 273 |   | — |   | 900 |   |
| Intercompany receivables                                       |       | —                    |       | 387 |   | (387 | ) | — |   |
| Other                                                          |       | 62                        |       | 54 |   | — |   | 116 |   |
| Total current assets                                           |       | 715                       |       | 721 |   | (387 | ) | 1,049 |   |
| **Property and equipment, net**                                |       | 284                       |       | 98 |   | — |   | 382 |   |
| **Goodwill, net**                                              |       | 94                        |       | — |   | — |   | 94 |   |
| **Investment in subsidiaries**                                 |       | 488                       |       | — |   | (488 | ) | — |   |
| **Other assets**                                               |       | 80                        |       | 20 |   | — |   | 100 |   |
| **Total assets**                                               |       | $                         | 1,661      |   | $ | 839 |   | $ | (875 | ) | $ | 1,625 |   |
|                                                           |       |                      |       |   |   |   |   |   |   |
| **LIABILITIES AND STOCKHOLDERS’  (DEFICIT) EQUITY**       |       |                      |       |   |   |   |   |   |   |
| **Current liabilities:**                                       |       |                      |       |   |   |   |   |   |   |
| Accounts payable                                               |       | $                         | 15         |   | $ | 215 |   | $ | — |   | $ | 230 |   |
| Accrued liabilities and other                                  |       | 200                       |       | 75 |   | — |   | 275 |   |
| Current portion of long-term debt                              |       | 173                       |       | — |   | — |   | 173 |   |
| Intercompany payable                                           |       | 387                       |       | — |   | (387 | ) | — |   |
| Other                                                          |       | (32                       | )          | 35 |   | — |   | 3 |   |
| Total current liabilities                                      |       | 743                       |       | 325 |   | (387 | ) | 681 |   |
| **Long-term debt**                                             |       | 3,756                     |       | — |   | — |   | 3,756 |   |
| **Other long-term liabilities**                                |       | 49                        |       | 26 |   | — |   | 75 |   |
| **Total stockholders’ (deficit) equity**                  |       | (2,887                    | )          | 488 |   | (488 | ) | (2,887 | ) |
| **Total liabilities and stockholders’ (deficit)  equity** |       | $                         | 1,661      |   | $ | 839 |   | $ | (875 | ) | $ | 1,625 |   |

 

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**Supplemental Condensed Consolidating Balance Sheet**

 
| ** **                                                     | ** ** | **May 3, 2008** | ** ** |
|----------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                     | ** ** | **Parent  Company**  | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                     | ** ** | **(in millions)**    | ** ** |
| **ASSETS**                                                     | ** ** | ** **           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Current assets:**                                            |       |                 |       |   |   |   |   |   |   |
| Cash and equivalents                                           |       | $                    | 26         |   | $ | 16 |   | $ | — |   | $ | 42 |   |
| Merchandise inventories                                        |       | 622                  |       | 219 |   | — |   | 841 |   |
| Intercompany receivables                                       |       | —               |       | 351 |   | (351 | ) | — |   |
| Other                                                          |       | 74                   |       | 46 |   | — |   | 120 |   |
| Total current assets                                           |       | 722                  |       | 632 |   | (351 | ) | 1,003 |   |
| **Property and equipment, net**                                |       | 299                  |       | 121 |   | — |   | 420 |   |
| **Goodwill, net**                                              |       | 94                   |       | — |   | — |   | 94 |   |
| **Investment in subsidiaries**                                 |       | 463                  |       | — |   | (463 | ) | — |   |
| **Other assets**                                               |       | 87                   |       | 15 |   | — |   | 102 |   |
| **Total assets**                                               |       | $                    | 1,665      |   | $ | 768 |   | $ | (814 | ) | $ | 1,619 |   |
|                                                           |       |                 |       |   |   |   |   |   |   |
| **LIABILITIES AND STOCKHOLDERS’  (DEFICIT) EQUITY**       |       |                 |       |   |   |   |   |   |   |
| **Current liabilities:**                                       |       |                 |       |   |   |   |   |   |   |
| Accounts payable                                               |       | $                    | 26         |   | $ | 165 |   | $ | — |   | $ | 191 |   |
| Accrued liabilities and other                                  |       | 195                  |       | 78 |   | — |   | 273 |   |
| Current portion of long-term debt                              |       | 235                  |       | — |   | — |   | 235 |   |
| Intercompany payable                                           |       | 351                  |       | — |   | (351 | ) | — |   |
| Other                                                          |       | (39                  | )          | 41 |   | — |   | 2 |   |
| Total current liabilities                                      |       | 768                  |       | 284 |   | (351 | ) | 701 |   |
| **Long-term debt**                                             |       | 3,744                |       | — |   | — |   | 3,744 |   |
| **Other long-term liabilities**                                |       | 63                   |       | 21 |   | — |   | 84 |   |
| **Total stockholders’ (deficit) equity**                  |       | (2,910               | )          | 463 |   | (463 | ) | (2,910 | ) |
| **Total liabilities and stockholders’ (deficit)  equity** |       | $                    | 1,665      |   | $ | 768 |   | $ | (814 | ) | $ | 1,619 |   |

 

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**Supplemental Condensed Consolidating Statement of Operations**

 
| ** **                                   | ** ** | **Quarter Ended May 2, 2009** | ** ** |
|----------------------------------------------|------------|------------------------------------|------------|
| ** **                                   | ** ** | **Parent  Company**                | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                   | ** ** | **(in millions)**                  | ** ** |
| **Net sales**                                |       | $                                  | 761        |   | $ | 479 |   | $ | (388 | ) | $ | 852 |   |
| Cost of sales and occupancy expense          |       | 523                                |       | 402 |   | (388 | ) | 537 |   |
| **Gross profit**                             |       | 238                                |       | 77 |   | — |   | 315 |   |
| Selling, general, and administrative expense |       | 216                                |       | 30 |   | — |   | 246 |   |
| Related party expenses                       |       | 4                                  |       | — |   | — |   | 4 |   |
| Store pre-opening costs                      |       | 1                                  |       | — |   | — |   | 1 |   |
| **Operating income**                         |       | 17                                 |       | 47 |   | — |   | 64 |   |
| Interest expense                             |       | 63                                 |       | — |   | — |   | 63 |   |
| Other (income) and expense, net              |       | (5                                 | )          | (1 | ) | — |   | (6 | ) |
| Intercompany charges (income)                |       | 17                                 |       | (17 | ) | — |   | — |   |
| Equity in earnings of subsidiaries           |       | 65                                 |       | — |   | (65 | ) | — |   |
| **Income before income taxes**               |       | 7                                  |       | 65 |   | (65 | ) | 7 |   |
| Provision for income taxes                   |       | 3                                  |       | 28 |   | (28 | ) | 3 |   |
| **Net income**                               |       | $                                  | 4          |   | $ | 37 |   | $ | (37 | ) | $ | 4 |   |

 

**Supplemental Condensed Consolidating Statement of Operations**

 
| ** **                                   | ** ** | **Quarter Ended May 3, 2008** | ** ** |
|----------------------------------------------|------------|------------------------------------|------------|
| ** **                                   | ** ** | **Parent  Company**                | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                   | ** ** | **(in millions)**                  | ** ** |
| **Net sales**                                |       | $                                  | 743        |   | $ | 442 |   | $ | (338 | ) | $ | 847 |   |
| Cost of sales and occupancy expense          |       | 504                                |       | 355 |   | (338 | ) | 521 |   |
| **Gross profit**                             |       | 239                                |       | 87 |   | — |   | 326 |   |
| Selling, general, and administrative expense |       | 240                                |       | 32 |   | — |   | 272 |   |
| Related party expenses                       |       | 4                                  |       | — |   | — |   | 4 |   |
| Store pre-opening costs                      |       | 2                                  |       | — |   | — |   | 2 |   |
| **Operating (loss) income**                  |       | (7                                 | )          | 55 |   | — |   | 48 |   |
| Interest expense                             |       | 78                                 |       | — |   | — |   | 78 |   |
| Other (income) and expense, net              |       | —                             |       | — |   | — |   | — |   |
| Intercompany charges (income)                |       | 17                                 |       | (17 | ) | — |   | — |   |
| Equity in earnings of subsidiaries           |       | 72                                 |       | — |   | (72 | ) | — |   |
| **(Loss) income before income taxes**        |       | (30                                | )          | 72 |   | (72 | ) | (30 | ) |
| (Benefit) provision for income taxes         |       | (10                                | )          | 24 |   | (24 | ) | (10 | ) |
| **Net (loss) income**                        |       | $                                  | (20        | ) | $ | 48 |   | $ | (48 | ) | $ | (20 | ) |

 

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**Supplemental Condensed Consolidating Statement of Cash Flows**

 
| ** **                                          | ** ** | **Quarter Ended May 2, 2009** | ** ** |
|-----------------------------------------------------|------------|------------------------------------|------------|
| ** **                                          | ** ** | **Parent  Company**                | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                          | ** ** | **(in millions)**                  | ** ** |
| **Operating activities:**                           |       |                               |       |   |   |   |   |   |   |
| Net cash provided by operating activities           |       | $                                  | —     |   | $ | 31 |   | $ | (29 | ) | $ | 2 |   |
|                                                |       |                               |       |   |   |   |   |   |   |
| **Investing activities:**                           |       |                               |       |   |   |   |   |   |   |
| Cash paid for property and equipment                |       | (9                                 | )          | (2 | ) | — |   | (11 | ) |
| Net cash used in investing activities               |       | (9                                 | )          | (2 | ) | — |   | (11 | ) |
|                                                |       |                               |       |   |   |   |   |   |   |
| **Financing activities:**                           |       |                               |       |   |   |   |   |   |   |
| Net borrowings of long-term debt                    |       | 18                                 |       | — |   | — |   | 18 |   |
| Intercompany dividends                              |       | —                             |       | (29 | ) | 29 |   | — |   |
| Other financing activities                          |       | (10                                | )          | — |   | — |   | (10 | ) |
| Net cash provided by (used in) financing activities |       | 8                                  |       | (29 | ) | 29 |   | 8 |   |
|                                                |       |                               |       |   |   |   |   |   |   |
| **Decrease in cash and equivalents**                |       | (1                                 | )          | — |   | — |   | (1 | ) |
| **Beginning cash and cash equivalents**             |       | 26                                 |       | 7 |   | — |   | 33 |   |
| **Ending cash and cash equivalents**                |       | $                                  | 25         |   | $ | 7 |   | $ | — |   | $ | 32 |   |

** **

**Supplemental Condensed Consolidating Statement of Cash Flows**

 
| ** **                                          | ** ** | **Quarter Ended May 3, 2008** | ** ** |
|-----------------------------------------------------|------------|------------------------------------|------------|
| ** **                                          | ** ** | **Parent  Company**                | ** ** | **Guarantor Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                          | ** ** | **(in millions)**                  | ** ** |
| **Operating activities:**                           |       |                               |       |   |   |   |   |   |   |
| Net cash (used in) provided by operating activities |       | $                                  | (100       | ) | $ | 53 |   | $ | (36 | ) | $ | (83 | ) |
|                                                |       |                               |       |   |   |   |   |   |   |
| **Investing activities:**                           |       |                               |       |   |   |   |   |   |   |
| Cash paid for property and equipment                |       | (16                                | )          | (5 | ) | — |   | (21 | ) |
| Net cash used in investing activities               |       | (16                                | )          | (5 | ) | — |   | (21 | ) |
|                                                |       |                               |       |   |   |   |   |   |   |
| **Financing activities:**                           |       |                               |       |   |   |   |   |   |   |
| Net borrowings of long-term debt                    |       | 105                                |       | — |   | — |   | 105 |   |
| Intercompany dividends                              |       | —                             |       | (36 | ) | 36 |   | — |   |
| Other financing activities                          |       | 12                                 |       | — |   | — |   | 12 |   |
| Net cash provided by (used in) financing activities |       | 117                                |       | (36 | ) | 36 |   | 117 |   |
|                                                |       |                               |       |   |   |   |   |   |   |
| **Increase in cash and equivalents**                |       | 1                                  |       | 12 |   | — |   | 13 |   |
| **Beginning cash and cash equivalents**             |       | 26                                 |       | 3 |   | — |   | 29 |   |
| **Ending cash and cash equivalents**                |       | $                                  | 27         |   | $ | 15 |   | $ | — |   | $ | 42 |   |

 

**Note11.  Subsequent Event**

 

On June 3, 2009, theCompany announced  an offer to exchangecertain employee stock options issued under the 2006 Plan (“Exchange Offer”)for new stock options granted on a one-for-one basis.  Employees who hold eligibleoptions and are employed by the Company as of June 3, 2009 have theopportunity to exchange:

 

(1) outstanding vested or unvestedoptions to purchase shares of Common Stock that have an exercise price pershare of $30.00, $37.50, $45.00 or $52.50 for an equal number of new options topurchase shares of Common Stock with an exercise price equal to $7.50 and a newfive-year vesting schedule that commences at the conclusion of the ExchangeOffer and an 8 year term; and

 

(2) outstanding options that have anexercise price per share of $15.00 and $22.50 will be exchanged for an equalnumber of new options with the same exercise price. A portion of the newoptions will be vested based on the period of time that the exchanged options hadbeen held in relation to the total term of the option and will have identicalterms and conditions to the previously issued options, and the remainingoptions will have a new five-year vesting schedule that commences at theconclusion of the Exchange Offer and an 8 year term.

 

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Those employees electing toexchange their eligible options must exchange all eligible options inconnection with the Exchange Offer.

 

Stock options for an aggregateof approximately 8.0 million shares of Common Stock are eligible to beexchanged.   If all eligible optionsoutstanding as of June 3, 2009 are exchanged, share-based compensationexpense related to these options would result in an estimated $1 million declinein share-based compensation expense for fiscal 2009 and an estimated increaseof $5 million over the life of the options.

 

The Exchange Offerterminates on July 2, 2009.

 

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

** **

Allexpressions of the “Company”, “us,” “we,” “our,” and all similar expressionsare references to Michaels Stores, Inc. and its consolidated wholly-ownedsubsidiaries, unless otherwise expressly stated or the context otherwiserequires.

 

**DisclosureRegarding Forward-Looking Information**

** **

Thefollowing discussion should be read in conjunction with our consolidatedfinancial statements and related notes included elsewhere in this QuarterlyReport on Form 10-Q. The following discussion, as well as other portionsof this Quarterly Report on Form 10-Q, contains forward-looking statementsthat reflect our plans, estimates, and beliefs. Any statements contained herein(including, but not limited to, statements to the effect that Michaels or its management“anticipates,” “plans,” “estimates,” “expects,” “believes,” and other similarexpressions) that are not statements of historical fact should be consideredforward-looking statements and should be read in conjunction with ourconsolidated financial statements and related notes in our Annual Report on Form 10-Kfor the fiscal year ended January 31, 2009. Such forward-lookingstatements are based upon management’s current knowledge and assumptions aboutfuture events and involve risks and uncertainties that could cause actualresults, performance or achievements to be materially different fromanticipated results, prospects, performance or achievements expressed orimplied by such forward-looking statements. Such risks and uncertaintiesinclude, but are not limited to:

 

·                  risks related to general economic conditions andthe current financial crisis; if the worldwide economicdownturn continues or deteriorates further, it could continue to adverselyaffect consumer confidence and retail spending, decreasing demand for our merchandiseand adversely impact our results of operations, cash flows and financialcondition;

 

·                  risksrelated to our substantial indebtedness, as our**leverage could adversely affect our ability to raise additionalcapital to fund our operations, limit our ability to react to changes in theeconomy or our industry, expose us to interest rate risk to the extent of ourvariable rate debt and prevent us from meeting our obligations under our notesand credit facilities;

 

·                  restrictionsin our debt agreements that limit our flexibility in operating our business, asour senior secured credit facilities and the indentures governing our notescontain various covenants that limit our ability to engage in specified typesof transactions and require that we maintain specified financial ratios uponthe occurrence of certain events;

 

·                  ourability to open new stores, as our growth depends on our strategy of increasingour number of stores and if we are unable to continue this strategy, ourability to increase our sales, profitability, and cash flow could be impaired;

 

·                  howwell we manage our business;

 

·                  changesin customer demand could materially adversely affect our sales, operatingresults, and cash flow;

 

·                  unexpectedor unfavorable consumer responses to our promotional or merchandising programscould materially adversely affect our sales, 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;

 

·                  improvementsto our supply chain may not be fully successful;

 

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·                  oursuppliers may fail us;

 

·                  ourreliance on foreign suppliers increases our risk 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;

 

·                  productrecalls and/or product liability, as well as changes in product safety and other consumer protection laws, may adverselyimpact our operations, merchandise offerings, reputation and financial position;

 

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

 

·                  we are co-sourcing certain of our informationtechnology and accounts payable functions, and may co-source otheradministrative functions, making us more dependent upon third parties;

 

·                  ourinformation systems may prove inadequate;

 

·                  wemay fail to optimize or adequately maintain our perpetual inventory andautomated replenishment systems;

 

·                  failureto adequately maintain the security of our electronic and other confidentialinformation could materially adversely affect our financial condition andoperating results;

 

·                  if the Employee Free Choice Act isadopted, it would be easier for our associates to obtain union representationand our businesses could be impacted as a result;

 

·                  aweak fourth quarter would materially adversely affect our operating results;

 

·                  competitioncould negatively impact our operations; and

 

·                  theinterests of our controlling stockholders may conflict with the interestsof our creditors.

 

For more details on factors that maycause actual 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 31, 2009, 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**

** **

Wecontinue to develop a fully integrated pricing and promotion strategy and mayrefine our existing strategy in future periods. A significant component of our pricing and promotion strategy involveschanges in the breadth and depth of our promotional programs.  Given the current soft macroeconomic andretail environments, sales declines could adversely affect operations due to adeleveraging of operating expenses.  As aresult, our historical trends may not be indicative of future results.

 

Wereport on the basis of a 52 or 53-week fiscal year, which ends on the Saturdayclosest to January 31.  Allreferences herein to “fiscal 2009” relate to the 52 weeks ending January 30,2010 and all references to “fiscal 2008” relate to the 52 weeks ended January 31,2009. In addition, all references herein to “the first quarter of fiscal 2009”relate to the 13 weeks ended May 2, 2009 and all references to “the firstquarter of fiscal 2008” relate to the 13 weeks ended May 3, 2008.

 

Thefollowing table sets forth certain of our unaudited operating data:

 

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| ** **                                           | ** ** | **Quarter Ended** | ** ** |
|------------------------------------------------------|------------|-------------------|------------|
| ** **                                           | ** ** | **May 2,**   | ** ** | **May 3,** | ** ** |
| ** **                                           | ** ** | **2009**          | ** ** | **2008** | ** ** |
| **Michaels stores:**                                 |       |              |       |   |   |
| Retail stores open at beginning of period            |       | 1,009             |       | 963 |   |
| Retail stores opened during the period               |       | 11                |       | 17 |   |
| Retail stores opened (relocations) during the period |       | 4                 |       | 3 |   |
| Retail stores closed during the period               |       | —            |       | — |   |
| Retail stores closed (relocations) during the period |       | (4                | )          | (3 | ) |
| Retail stores open at end of period                  |       | 1,020             |       | 980 |   |
|                                                 |       |              |       |   |   |
| **Aaron Brothers stores:**                           |       |              |       |   |   |
| Retail stores open at beginning of period            |       | 161               |       | 166 |   |
| Retail stores opened during the period               |       | —            |       | — |   |
| Retail stores closed during the period               |       | (5                | )          | (2 | ) |
| Retail stores open at end of period                  |       | 156               |       | 164 |   |
|                                                 |       |              |       |   |   |
| Total store count at end of period                   |       | 1,176             |       | 1,144 |   |
|                                                 |       |              |       |   |   |
| **Other operating data:**                            |       |              |       |   |   |
| Average inventory per Michaels store (1)             |       | $                 | 833        |   | $ | 808 |   |
| Comparable store sales decrease (2)                  |       | (2.0              | )%         | (2.9 | )% |
|                                                      |            |                   |            |  |  |  |  |

 

----

| (1) | The  calculation of average inventory per Michaels store excludes our Aaron  Brothers stores. |
|-----|-----------------------------------------------------------------------------------------------|

 
| (2) | Comparable  store sales decrease represents the decrease in net sales for Michaels and  Aaron Brothers 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. |
|-----|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

**Results ofOperations**

** **

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

 
| ** **                                   | ** ** | **Quarter Ended** | ** ** |
|----------------------------------------------|------------|-------------------|------------|
| ** **                                   | ** ** | **May 2,**   | ** ** | **May 3,** | ** ** |
| ** **                                   | ** ** | **2009**          | ** ** | **2008** | ** ** |
| **Net sales**                                |       | 100.0             | %          | 100.0 | % |
| Cost of sales and occupancy expense          |       | 63.0              |       | 61.5 |   |
| **Gross profit**                             |       | 37.0              |       | 38.5 |   |
| Selling, general, and administrative expense |       | 28.9              |       | 32.1 |   |
| Related party expenses                       |       | 0.5               |       | 0.5 |   |
| Store pre-opening costs                      |       | 0.1               |       | 0.2 |   |
| **Operating income**                         |       | 7.5               |       | 5.7 |   |
| Interest expense                             |       | 7.4               |       | 9.2 |   |
| Other (income) and expense, net              |       | (0.7              | )          | — |   |
| **Income (loss) before income taxes**        |       | 0.8               |       | (3.5 | ) |
| Provision (benefit) for income taxes         |       | 0.3               |       | (1.1 | ) |
| **Net income (loss)**                        |       | 0.5               | %          | (2.4 | )% |

* *

*QuarterEnded May 2, 2009 Compared to the Quarter Ended May 3, 2008*

* *

*Net Sales*—Net sales increased for thefirst quarter of fiscal 2009 by $5 million, or 0.6%, over the firstquarter of fiscal 2008. Comparable store sales decreased 2.0% primarily due toa decrease in the average ticket of 5.2% and an adverse impact

 

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of 0.4% related to deferred custom framing revenue, partially offset byan increase in customer transactions of 3.6%. The fluctuation in the exchange rates between the United States andCanadian dollars adversely impacted the average ticket by 170 basis points. Thedecrease in comparable store sales was offset by non-comparable newstores.  Sales at 50 Michaels stores thatopened during the 13 month period ended May 2, 2009, provided incrementalrevenue of $22 million.

 

Wecontinue to evaluate all options available to us for our Aaron Brothersconcept; which range from refining the concept to possible storerationalization.  Certain of theseoptions, if enacted, may result in material charges to our consolidatedstatement of operations in future periods.

 

*Cost of Sales and Occupancy Expense*—Cost of salesand occupancy expense increased $16 million to $537 million in the firstquarter of 2009 from $521 million in the first quarter of 2008. As a percentageof net sales, cost of sales and occupancy expense increased 150 basispoints as we realized a decline in merchandise margin of 100 basis pointsprimarily due to increased promotional activity, including two additional newspaperinserts, and clearance activity related to planogram resets scheduled for thefirst half of fiscal 2009. Occupancy costs increased 50 basis points, as apercentage of net sales, primarily due to a deleveraging of fixed occupancycosts on a decline in comparable store sales.

 

*Selling, General, and Administrative Expense*—Selling,general, and administrative expense was $246 million, or 28.9% of net sales, inthe first quarter of fiscal 2009 compared to $272 million, or 32.1% of netsales, in the first quarter of fiscal 2008. Selling, general and administrativeexpense decreased $26 million and 320 basis points, as a percentage of netsales primarily due to a reduction in salaries and benefits, bonus expense andseverance expense. Advertising expense remained flat despite the two additionalnewspaper inserts due to favorable rate renegotiations.

 

*Related Party Expenses*—Related party expenses were$4 million in the first quarter of fiscal 2009 and fiscal 2008.  These costs consist primarily of $4 million and$3 million of management fees and associated expenses paid to our Sponsors andHighfields in fiscal 2009 and fiscal 2008, respectively.  Also included in the related party expensesin fiscal 2008 are approximately $1 million of amortization expense related tothe Separation Agreements as more fully described in Note 9 to the consolidatedfinancial statements.

 

*Interest Expense*—Interest expense for thequarter decreased $15 million to $63 million as a result of a lower averageinterest rate related to our variable-rate debt and lower average debt levels.

 

*Other(Income)and Expense, net*—Other income in the first quarter of fiscal 2009related primarily to a $4 million favorable change in fair value of theinterest rate cap as more fully described in Note 5 to the consolidatedfinancial statements.

* *

*Provision for Income Taxes*—Theeffective tax expense rate is 40.5% for the first quarter of fiscal 2009compared to the 34.1% effective tax benefit rate for the first quarter offiscal 2008. During the first quarter of fiscal 2008, we recordednon-deductible severance costs that were not incurred during the first quarterof 2009, which resulted in an unfavorable adjustment to the 2008 effectiverate.We expect theeffective tax rate for fiscal 2009 to range from 40% - 45%.

 

**Liquidityand Capital Resources**

 

Werequire cash principally for day-to-day operations, to finance capitalinvestments, inventory for new stores, and inventory replenishment for existingstores, to service our outstanding debt, and seasonal working capitalneeds.  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.  We expect that our available cash, cash flowgenerated from operating activities, and funds available under our Asset-basedrevolving credit facility will be sufficient to fund planned capitalexpenditures, working capital requirements, debt repayments, debt servicerequirements and future growth for the foreseeable future.

 

*Cash Flowfrom Operating Activities*

 

Cashflow provided by operating activities during the first quarter of fiscal 2009was $2 million compared to cash used in operating activities of$83 million during the first quarter of fiscal 2008. The $85 millionchange was primarily due to an increase in net income and smaller decreases inour accounts payable and accrued interest accounts as compared to the firstquarter of fiscal 2008.  The change inaccounts payable and accrued interest is primarily attributable to the timingof payments and a lower average interest rate.

 

Averageinventory per Michaels store (including supporting distribution centers)increased 3.1% from May 3, 2008 to May 2, 2009 primarily due to theincrease in new product to be introduced through our planogram resets duringthe first half of the year relative to last year and also due to increasedlevels of certain higher-priced inventory, for which we expect to reduce futureorders of those items over time.

 

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Weanticipate average inventory per Michaels store at the end of fiscal 2009 to beflat compared to the end of fiscal 2008.

 

*Cash Flowused in Investing Activities*

 

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

 
| ** **                                             | ** ** | **Quarter Ended** | ** ** |
|--------------------------------------------------------|------------|-------------------|------------|
| ** **                                             | ** ** | **May 2,**   | ** ** | **May 3,** | ** ** |
| ** **                                             | ** ** | **2009**          | ** ** | **2008** | ** ** |
| ** **                                             | ** ** | **(in millions)** | ** ** |
| New and relocated stores and stores not yet opened (1) |       | $                 | 4          |   | $ | 7 |   |
| Existing stores                                        |       | 3                 |       | 4 |   |
| Distribution system expansion                          |       | 1                 |       | 1 |   |
| Information systems                                    |       | 3                 |       | 8 |   |
| Corporate and other                                    |       | —            |       | 1 |   |
|                                                   |       | $                 | 11         |   | $ | 21 |   |
|                                                        |            |                   |            |  |  |  |  |  |

 

----

| (1) |   | In  the first quarter of fiscal 2009, we incurred capital expenditures related to  the opening of 11 Michaels stores and the relocation of four Michaels stores.  In the first quarter of fiscal 2008, we incurred capital expenditures related  to the opening of 17 Michaels stores and the relocation of three Michaels  stores. |
|-----|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

*Cash Flowprovided by Financing Activities*

 

Cashflows from financing activities are related primarily to borrowings andrepayments under our Asset-based revolving credit facility.  The borrowed amounts were primarily used tofinance interest payments, accounts payable and capital expenditures.  The Asset-based revolving credit facilityprovides senior secured financing of up to $1.0 billion, subject to a borrowingbase. As of May 2, 2009, the borrowing base was $757 million with $539million of unused availability.

 

**RecentAccounting Pronouncements**

 

In September 2006,the Financial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards (“SFAS”) No. 157, *Fair Value Measurements*,which is intended to increase consistency and comparability in fair valuemeasurements by defining fair value, establishing a framework for measuringfair value and expanding disclosures about fair value measurements.  SFAS 157 was originally effective forfinancial statements issued for fiscal years beginning after November 15,2007, and interim periods within those fiscal years.  In November 2007, the FASB placed a oneyear deferral for the implementation of SFAS 157 for nonfinancial assets andliabilities; however, SFAS 157 is effective for fiscal years beginning after November 15,2007 for financial assets and liabilities, as well as for any other assets andliabilities that are carried at fair value on a recurring basis in financialstatements.  On February 3, 2008, weadopted the provisions of SFAS 157 related to financial assets and liabilitiesand on February 1, 2009, we adopted the provisions related to nonfinancialassets and liabilities that are not required or permitted to be measured atfair value on a recurring basis. These adoptions had no impact on ourconsolidated financial statements.   SeeNote 6 for further information regarding fair value measurements.

 

In December 2007,the FASB issued SFAS No. 141 (revised 2007), *Business Combinations*(“SFAS 141R”). SFAS 141R replaces SFASNo. 141, *Business Combinations*.The statement retains the purchase method of accounting used in businesscombinations, but replaces SFAS 141 by establishing principles and requirementsfor the recognition and measurement of assets, liabilities and goodwill,including the requirement that most transaction costs and restructuring costsbe expensed. In addition, the statement requires disclosures to enable users toevaluate the nature and financial effects of the business combination. SFAS141R is effective for business combinations for which the acquisition date ison or after the beginning of the first annual reporting period beginning on orafter December 15, 2008. We will apply the provisions of SFAS 141R to anybusiness combinations occurring on or after February 1, 2009.

 

In March 2008, theFASB issued SFAS No. 161, *Disclosuresabout Derivative Instruments and Hedging Activities — an amendment of FASBStatement No. 133*. SFAS 161 requires qualitative disclosuresabout objectives and strategies for using derivatives, quantitative data aboutthe fair value of and gains and losses on derivative contracts, and details ofcredit-risk-related contingent features in hedged positions. The statement alsorequires enhanced disclosures regarding how and why entities use derivative instruments,how derivative instruments and related hedged items are accounted for inaccordance with SFAS 133 and its related interpretation, and how derivativeinstruments and related hedged items affect entity’s financial position,financial performance, and cash flows. SFAS 161 is effective for fiscal yearsand interim periods beginning after November 15, 2008. We adopted the newdisclosure requirements of SFAS 161 in the first quarter of 2009 as reflectedin Note 5.

 

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

 

Duringthe first quarter of fiscal 2009, we purchased an interest rate cap to hedgethe 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 May 2,2009 was $13 million and is included in Other assets on the ConsolidatedBalance Sheet. The change in fair value of the cap for the quarter ended May 2,2009, was $4 million and is recorded in Other (income) and expense, net in theConsolidated Statement of Operations.

 

**Item 4.  Controls and Procedures.**

 

*Evaluationof Disclosure Controls and Procedures*

 

Wemaintain a set of disclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) promulgated by the SEC under the Securities Exchange Act of1934). An evaluation was carried out under the supervision and with theparticipation of our management, including our Chief Executive Officer and ourChief Financial Officer, of the effectiveness of our disclosure controls andprocedures as of the end of the period covered by this Quarterly Report on Form 10-Q.Based on that evaluation, our Chief Executive Officer and our Chief FinancialOfficer concluded that our disclosure controls and procedures are effective toprovide reasonable assurance that information required to be disclosed in thereports that we file or submit under the Securities Exchange Act of 1934 isrecorded, processed, summarized, and reported within the time periods specifiedin SEC rules and forms. Such controls and procedures are designed toensure that information we are required to disclose in our reports isaccumulated and communicated to our management, including our principalexecutive officers and principal financial officer, to allow timely disclosuredecisions. We note that the design of any system of controls is based, in part,upon certain assumptions about the likelihood of future events, and there canbe no assurance that any design will succeed in achieving its stated goalsunder all potential future conditions.

 

*Change inInternal Control Over Financial Reporting*

 

Therehas not been any change in our internal control over financial reporting (asdefined in Rules 13a-15(f) and 15d-15(f) as promulgated by theSEC under the Securities Exchange Act of 1934) during the quarter covered bythis Quarterly Report on Form 10-Q that materially affected, or arereasonably likely to materially affect, our internal control over financialreporting.

 

**MICHAELS STORES, INC.**

**Part II—OTHERINFORMATION**

 

**Item 1.  LegalProceedings.**

 

Informationregarding legal proceedings is incorporated herein by reference from Note 7 toour Consolidated Financial Statements.

 

**Item 4.  Submission of Matters to a Vote of SecurityHolders.**

** **

By a written consent dated March 11, 2009,holders of 93.14% of the common stock of the Company voted their shares toelect Peter Wallace to the Board to fill the vacancy created by the priorresignation of Matthew Kabaker. The affirmative vote of more than 50% of thestockholders was required to take such action.

 

**Item 5. Other Information**

** **

OnMarch 9, 2009, the Company announced that it had appointed Mr. JohnB. Menzer as the new Chief Executive Officer of the Company and, among otherthings, pursuant to the terms of his employment agreement dated as of the6th day of March, 2009, Mr. Menzer would receive a grant of 1,000,000restricted shares of Company common stock and an option to purchase 2,000,000shares of Company common stock.   On April 6,2009, Mr. Menzer commenced employment with the Company.

 

On June 2, 2009, theBoard of Directors of the Company amended Mr. Menzer’s employmentagreement to provide for the following in lieu of the above describedrestricted stock and option grants: (i) a grant of 500,000 restrictedshares of Company common stock which will vest pro rata on the second throughfifth anniversaries of the date of the commencement of Mr. Menzer’semployment (the vesting of 133,000 shares would accelerate in the event of Mr. Menzer’sdeath or upon certain events of Mr. Menzer’s termination in the first twoyears following the commencement of his employment); and (ii) an option topurchase 2,500,000 shares of Company common stock with exercise prices equal toor greater than fair market value on the date of grant, with the option sharesvesting pro rata on each of the first five anniversaries of the date of thecommencement of Mr. Menzer’s employment.

 

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**Item 6.  Exhibits.**

** **

(a) Exhibits:

 
| **Exhibit  Number** | ** ** | **Description of Exhibit**                                                                                                                  |
|---------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1                |       | Employment  Agreement, dated March 6, 2009, between Michaels Stores, Inc. and  John B. Menzer (filed herewith).*                  |
|                |       |                                                                                                                                        |
| 10.2                |       | Amendment  to Employment Agreement, dated June 2, 2009, between Michaels  Stores, Inc. and John B. Menzer (filed herewith).*      |
|                |       |                                                                                                                                        |
| 10.3                |       | Restricted  Stock Award Agreement, dated June 2, 2009, between Michaels  Stores, Inc. and John B. Menzer (filed herewith).*       |
|                |       |                                                                                                                                        |
| 10.4                |       | Stock  Option Agreement, dated June 2, 2009, between Michaels Stores Inc. and  John B. Menzer (filed herewith).*                       |
|                |       |                                                                                                                                        |
| 10.5                |       | Letter  Agreement, dated February 10, 2009, between Michaels Stores Inc. and  Philo T. Pappas (filed herewith).*                       |
|                |       |                                                                                                                                        |
| 10.6                |       | Compensation  Policy Regarding Company Car (filed herewith).*                                                                               |
|                |       |                                                                                                                                        |
| 31.1                |       | Certifications  of John B. Menzer pursuant to §302 of the Sarbanes-Oxley Act of 2002 (filed  herewith).                                |
|                |       |                                                                                                                                        |
| 31.2                |       | Certifications  of Elaine D. Crowley pursuant to §302 of the Sarbanes-Oxley Act of 2002  (filed herewith).                             |
|                |       |                                                                                                                                        |
| 32.1                |       | Certification  pursuant to 18 U.S.C. §1350, as adopted pursuant to §906 of the  Sarbanes-Oxley Act of 2002 (filed herewith). |

 

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*Managementcontract or compensatory plan or arrangement required to be filed as an exhibitto this Quarterly Report on form 10-Q.

 

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**MICHAELSSTORES, INC.**

**SIGNATURES**

 

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

 
|   | MICHAELS  STORES, INC. |
|--------|------------------------|
|   |                   |   |
|   | By:                    | /s/ Elaine  D. Crowley |
|   |                   | Elaine  D. Crowley |
|   |                   | Executive  Vice President – Chief Financial Officer |
|   |                   | (Principal  Financial Officer) |

 

Dated: June 5,2009

 

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**INDEX TO EXHIBITS**

 
| **Exhibit  Number** | ** ** | **Description of Exhibit**                                                                                                                  |
|---------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1                |       | Employment  Agreement, dated March 6, 2009, between Michaels Stores, Inc. and  John B. Menzer (filed herewith).*                  |
|                |       |                                                                                                                                        |
| 10.2                |       | Amendment  to Employment Agreement, dated June 2, 2009, between Michaels  Stores, Inc. and John B. Menzer (filed herewith).*      |
|                |       |                                                                                                                                        |
| 10.3                |       | Restricted  Stock Award Agreement, dated June 2, 2009, between Michaels  Stores, Inc. and John B. Menzer (filed herewith).*       |
|                |       |                                                                                                                                        |
| 10.4                |       | Stock  Option Agreement, dated June 2, 2009, between Michaels Stores Inc. and  John B. Menzer (filed herewith).*                       |
|                |       |                                                                                                                                        |
| 10.5                |       | Letter  Agreement, dated February 10, 2009, between Michaels Stores Inc. and  Philo T. Pappas (filed herewith).*                       |
|                |       |                                                                                                                                        |
| 10.6                |       | Compensation  Policy Regarding Company Car (filed herewith).*                                                                               |
|                |       |                                                                                                                                        |
| 31.1                |       | Certifications  of John B. Menzer pursuant to §302 of the Sarbanes-Oxley Act of 2002 (filed  herewith).                                |
|                |       |                                                                                                                                        |
| 31.2                |       | Certifications  of Elaine D. Crowley pursuant to §302 of the Sarbanes-Oxley Act of 2002  (filed herewith).                             |
|                |       |                                                                                                                                        |
| 32.1                |       | Certification  pursuant to 18 U.S.C. §1350, as adopted pursuant to §906 of the  Sarbanes-Oxley Act of 2002 (filed herewith). |

 

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*Managementcontract or compensatory plan or arrangement required to be filed as an exhibitto this Quarterly Report on form 10-Q.

 

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