Tableof Contents

 

 

 

**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON, DC 20549**

 

----

 

**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 August 2,  2008**                                                                                        |
| ** **                                                                                                                                     | ** ** | ** ** |
| **OR**                                                                                                                                         |
|                                                                                                                                           |   |   |
| **o**                                                                                                                                          | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| ** **                                                                                                                                     | ** ** | ** ** |
| **For the transition period from                     to** |

 

**Commission file number 001-09338**

 

----

 

**MICHAELSSTORES, INC.**

(Exact name of registrant as specified in its charter)

 

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

 

**8000 Bent Branch Drive**

**Irving, Texas 75063**

(Address of principal executive offices, including zip code)

 

**(972) 409-1300**

(Registrant’s telephone number, including area code)

 

----

 

Indicateby check mark whether the Registrant: (1) has filed all reports requiredto be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theRegistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days.   Yes **x****     **No ** ̈**

 

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerated filer, a non-accelerated filer, or a smaller reportingcompany. See the definitions of “large accelerated filer,” “accelerated filer”and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Checkone):

 
| 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 August 30, 2008, 118,503,202 shares of the Registrant’sCommon Stock were outstanding.

 

 

 

----

**Table of Contents**

** **

**MICHAELS STORES, INC.FORM 10-Q**

 
| **Part I—FINANCIAL  INFORMATION** | **3**                                                                                                                                |
|---------------------------------------------|--------------------------------------------------------------------------------------------------------------------------------------|
| **Item 1.**                            | **Financial  Statements**                                                                                                            | **3** |
|                                        | Consolidated Balance Sheets at August 2, 2008,  February 2, 2008, and August 4, 2007 (unaudited)                      | **3** |
|                                        | Consolidated  Statements of Operations for the quarter and six months ended August 2,  2008 and August 4, 2007 (unaudited) | **4** |
|                                        | Consolidated Statements of Cash Flows for the six  months ended August 2, 2008 and August 4, 2007 (unaudited)              | **5** |
|                                        | Notes to Consolidated Financial Statements (unaudited)                                                                               | **6** |
| **Item 2.**                            | **Management’s  Discussion and Analysis of Financial Condition and Results of Operations**                                      | **19** |
| **Item 3.**                            | **Quantitative  and Qualitative Disclosures About Market Risk**                                                                      | **24** |
| **Item 4.**                            | **Controls and  Procedures**                                                                                                         | **25** |
| **Part II—OTHER  INFORMATION**    | **26**                                                                                                                               |
| **Item 1.**                            | **Legal Proceedings**                                                                                                                | **26** |
| **Item 6.**                            | **Exhibits**                                                                                                                         | **26** |
| **Signatures**                              | **27**                                                                                                                               |

 

2

----

**Table of Contents**

** **

**MICHAELS STORES, INC.**

**Part I—FINANCIAL INFORMATION**

 

**Item 1.  Financial Statements.**

 

**MICHAELS STORES, INC.**

**CONSOLIDATED BALANCE SHEETS**

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

**(Unaudited)**

 
| ** **                                                                                                                                             | ** ** | **August 2,** | ** ** | **February 2,** | ** ** | **August 4,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|----------------------|------------|--------------------|------------|
| ** **                                                                                                                                             | ** ** | **2008**           | ** ** | **2008**             | ** ** | **2007**           | ** ** |
| **ASSETS**                                                                                                                                             |       |               |       |                 |       |               |       |
| **Current assets:**                                                                                                                                    |       |               |       |                 |       |               |       |
| Cash and equivalents                                                                                                                                   |       | $                  | 45         |                 | $          | 29                 |       | $ | 45 |   |
| Merchandise inventories                                                                                                                                |       | 938                |       | 845                  |       | 913                |       |
| Prepaid expenses and other                                                                                                                             |       | 71                 |       | 70                   |       | 75                 |       |
| Deferred income taxes                                                                                                                                  |       | 31                 |       | 31                   |       | 35                 |       |
| Income tax receivable                                                                                                                                  |       | 42                 |       | 5                    |       | 61                 |       |
| Current assets - discontinued operations                                                                                                               |       | —             |       | —               |       | 10                 |       |
| Total current assets                                                                                                                                   |       | 1,127              |       | 980                  |       | 1,139              |       |
| **Property and equipment, at cost**                                                                                                                    |       | 1,187              |       | 1,155                |       | 1,159              |       |
| Less accumulated depreciation                                                                                                                          |       | (777               | )          | (722                 | )          | (712               | )          |
|                                                                                                                                                   |       | 410                |       | 433                  |       | 447                |       |
| **Goodwill**                                                                                                                                           |       | 94                 |       | 94                   |       | 116                |       |
| **Debt  issuance costs, net of accumulated amortization of $30 at August 2,  2008; $22 at February 2, 2008; and $13 at August 4, 2007** |       | 95                 |       | 103                  |       | 112                |       |
| **Other assets**                                                                                                                                       |       | 2                  |       | 4                    |       | 6                  |       |
| **Non-current assets - discontinued  operations**                                                                                                      |       | —             |       | —               |       | 6                  |       |
|                                                                                                                                                   |       | 191                |       | 201                  |       | 240                |       |
| Total assets                                                                                                                                           |       | $                  | 1,728      |                 | $          | 1,614              |       | $ | 1,826 |   |
|                                                                                                                                                   |       |               |       |                 |       |               |       |
| **LIABILITIES  AND STOCKHOLDERS’ DEFICIT**                                                                                                        |       |               |       |                 |       |               |       |
| **Current liabilities:**                                                                                                                               |       |               |       |                 |       |               |       |
| Accounts payable                                                                                                                                       |       | $                  | 244        |                 | $          | 221                |       | $ | 207 |   |
| Accrued liabilities and other                                                                                                                          |       | 304                |       | 332                  |       | 354                |       |
| Current portion of long-term debt                                                                                                                      |       | 286                |       | 122                  |       | 364                |       |
| Current liabilities - discontinued  operations                                                                                                         |       | 2                  |       | 4                    |       | 1                  |       |
| Total current liabilities                                                                                                                              |       | 836                |       | 679                  |       | 926                |       |
| **Long-term debt**                                                                                                                                     |       | 3,748              |       | 3,741                |       | 3,734              |       |
| **Deferred income taxes**                                                                                                                              |       | 4                  |       | 4                    |       | 16                 |       |
| **Other long-term liabilities**                                                                                                                        |       | 78                 |       | 80                   |       | 81                 |       |
| **Long-term liabilities - discontinued  operations**                                                                                                   |       | 1                  |       | 2                    |       | 1                  |       |
| Total long-term liabilities                                                                                                                            |       | 3,831              |       | 3,827                |       | 3,832              |       |
|                                                                                                                                                   |       | 4,667              |       | 4,506                |       | 4,758              |       |
| **Commitments and contingencies**                                                                                                                      |       |               |       |                 |       |               |       |
| **Stockholders’ deficit:**                                                                                                                        |       |               |       |                 |       |               |       |
| Common Stock, $0.10 par value, 220,000,000  shares authorized;                                                                                         |       |               |       |                 |       |               |       |
| 118,382,402 shares issued and outstanding  at August 2, 2008;                                                                                     |       |               |       |                 |       |               |       |
| 118,421,069 shares issued and outstanding  at February 2, 2008;                                                                                   |       |               |       |                 |       |               |       |
| 118,213,397 shares issued and outstanding  at August 4, 2007                                                                                      |       | 12                 |       | 12                   |       | 12                 |       |
| Additional paid-in capital                                                                                                                             |       | 15                 |       | 12                   |       | 6                  |       |
| Accumulated deficit                                                                                                                                    |       | (2,976             | )          | (2,926               | )          | (2,961             | )          |
| Accumulated other comprehensive income                                                                                                                 |       | 10                 |       | 10                   |       | 11                 |       |
| Total stockholders’ deficit                                                                                                                       |       | (2,939             | )          | (2,892               | )          | (2,932             | )          |
| Total liabilities and stockholders’ deficit                                                                                                       |       | $                  | 1,728      |                 | $          | 1,614              |       | $ | 1,826 |   |

 

See accompanying notes toconsolidated financial statements.

 

3

----

**Table of Contents**

** **

**MICHAELS STORES, INC.**

**CONSOLIDATED STATEMENTS OFOPERATIONS**

**(In millions)**

**(Unaudited)**

 
| ** **                                                | ** ** | **Quarter Ended** | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------------------------------|------------|------------------------|------------|--------------------------------|------------|
| ** **                                                | ** ** | **August 2,**     | ** ** | **August 4,**             | ** ** | **August 2,** | ** ** | **August 4,** | ** ** |
| ** **                                                | ** ** | **2008**               | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
| **Net sales**                                             |       | $                      | 796        |                           | $          | 788 |   | $ | 1,643 |   | $ | 1,627 |   |
| Cost of sales and occupancy expense                       |       | 518                    |       | 498                            |       | 1,039 |   | 1,011 |   |
| **Gross profit**                                          |       | 278                    |       | 290                            |       | 604 |   | 616 |   |
| Selling, general, and administrative  expense             |       | 246                    |       | 242                            |       | 518 |   | 497 |   |
| Transaction expenses                                      |       | —                 |       | 16                             |       | — |   | 21 |   |
| Related party expenses                                    |       | 4                      |       | 4                              |       | 8 |   | 8 |   |
| Store pre-opening costs                                   |       | 1                      |       | 1                              |       | 3 |   | 3 |   |
| **Operating income**                                      |       | 27                     |       | 27                             |       | 75 |   | 87 |   |
| Interest expense                                          |       | 76                     |       | 95                             |       | 154 |   | 191 |   |
| Other (income) and expense, net                           |       | —                 |       | (2                             | )          | — |   | (5 | ) |
| **Loss before income taxes and discontinued  operations** |       | (49                    | )          | (66                            | )          | (79 | ) | (99 | ) |
| Income tax benefit                                        |       | (19                    | )          | (23                            | )          | (29 | ) | (34 | ) |
| **Loss before discontinued operations**                   |       | (30                    | )          | (43                            | )          | (50 | ) | (65 | ) |
| Discontinued operations loss, net of income  tax          |       | —                 |       | (1                             | )          | — |   | (2 | ) |
| **Net loss**                                              |       | $                      | (30        | )                              | $          | (44 | ) | $ | (50 | ) | $ | (67 | ) |

 

See accompanying notes to consolidated financial statements.

 

4

----

**Table of Contents**

** **

**MICHAELSSTORES, INC.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(Inmillions)**

**(Unaudited)**

 
| ** **                                           | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                           | ** ** | **August 2,**             | ** ** | **August 4,** | ** ** |
| ** **                                           | ** ** | **2008**                       | ** ** | **2007** | ** ** |
| **Operating activities:**                            |       |                           |       |   |   |
| Net loss                                             |       | $                              | (50        | ) | $ | (67 | ) |
| Adjustments:                                         |       |                           |       |   |   |
| Depreciation and amortization                        |       | 63                             |       | 62 |   |
| Share-based compensation                             |       | 4                              |       | 3 |   |
| Deferred financing costs amortization                |       | 8                              |       | 9 |   |
| Accretion of subordinated discount notes             |       | 19                             |       | 17 |   |
| Other                                                |       | —                         |       | (1 | ) |
| Changes in assets and liabilities:                   |       |                           |       |   |   |
| Merchandise inventories                              |       | (94                            | )          | (75 | ) |
| Prepaid expenses and other                           |       | —                         |       | — |   |
| Deferred income taxes and other                      |       | 2                              |       | (13 | ) |
| Accounts payable                                     |       | 18                             |       | (13 | ) |
| Accrued interest                                     |       | (34                            | )          | 70 |   |
| Accrued liabilities and other                        |       | 6                              |       | 1 |   |
| Income taxes receivable                              |       | (37                            | )          | (22 | ) |
| Other long-term liabilities                          |       | (3                             | )          | (1 | ) |
| Net cash used in operating activities                |       | (98                            | )          | (30 | ) |
|                                                 |       |                           |       |   |   |
| **Investing activities:**                            |       |                           |       |   |   |
| Additions to property and equipment                  |       | (39                            | )          | (62 | ) |
| Net cash used in investing activities                |       | (39                            | )          | (62 | ) |
|                                                 |       |                           |       |   |   |
| **Financing activities:**                            |       |                           |       |   |   |
| Borrowings on asset-based revolving credit  facility |       | 506                            |       | 706 |   |
| Payments on asset-based revolving credit  facility   |       | (341                           | )          | (571 | ) |
| Repayments on senior secured term loan  facility     |       | (12                            | )          | (12 | ) |
| Equity investment of Management                      |       | —                         |       | 4 |   |
| Repurchase of new Common Stock                       |       | (1                             | )          | (1 | ) |
| Payments of capital leases                           |       | (4                             | )          | (5 | ) |
| Change in cash overdraft                             |       | 6                              |       | (14 | ) |
| Other                                                |       | (1                             | )          | — |   |
| Net cash provided by financing activities            |       | 153                            |       | 107 |   |
|                                                 |       |                           |       |   |   |
| **Net increase in cash and equivalents**             |       | 16                             |       | 15 |   |
| **Cash and equivalents at beginning of period**      |       | 29                             |       | 30 |   |
| **Cash and equivalents at end of period**            |       | $                              | 45         |   | $ | 45 |   |

** **

See accompanying notes toconsolidated financial statements.

 

5

----

Tableof Contents

 

**MICHAELS STORES, INC.**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

**For the Six Months Ended August 2,2008**

**(Unaudited)**

 

**Note 1.  Summaryof Significant Accounting Policies**

 

*Basisof Presentation*

 

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, thesefinancial statements should be read in conjunction with our Annual Report on Form 10-Kfor the fiscal year ended February 2, 2008.

 

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 the threeand six months ended August 2, 2008 are not indicative of the results tobe expected for the entire year.

 

Thebalance sheet at February 2, 2008 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 February 2, 2008.

 

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 2008” relate tothe 52 weeks ending January 31, 2009, and all references to “fiscal2007” relate to the 52 weeks ended February 2, 2008. In addition, allreferences herein to “the second quarter of fiscal 2008” relate to the 13 weeksended August 2, 2008 and all references to “the second quarter of fiscal2007” relate to the 13 weeks ended August 4, 2007.  Finally, all references to “the six monthsended August 2, 2008” relate to the 26 weeks ended August 2, 2008,and “the six months ended August 4, 2007” relate to the 26 weeks ended August 4,2007.

 

*Reclassifications*

 

Certainprior year amounts were reclassified to conform to current year presentation.These reclassifications consist primarily of the presentation of discontinuedoperations.

 

*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.  We adopted all requirementsof SFAS 157 as they relate to financial assets and liabilities on February 3,2008. See Note 7 for further information on the impact of this standard tofinancial assets and liabilities. The requirements related to nonfinancialassets and liabilities will be adopted on February 1, 2009, as allowed bySFAS 157. We have not yet determined the impact, if any, on our consolidatedfinancial statements for these nonfinancial assets and liabilities.

 

In February 2007, the FASB issued SFAS No. 159, *The Fair Value Option for Financial Assets and Financial*

 

6

----

Tableof Contents

 

*Liabilities*,which permits companies to measure certain financial instruments and otheritems at fair value (at specified measurement dates) that are not currentlyrequired to be measured at fair value. Any unrealized gains or lossesapplicable to those items measured at fair value shall be reported in earnings.The decision to apply fair value shall generally be made on an instrument byinstrument basis, is irrevocable, and is applied only to an entire instrument.We adopted SFAS 159 on February 3, 2008, and there was no impact on ourconsolidated financial statements as we did not choose to measure any eligiblefinancial assets or liabilities at fair value.

 

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 adopt SFAS 141R on February 1, 2009for acquisitions on or after this date.

 

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 detailsof credit-risk-related contingent features in hedged positions. The statementalso requires enhanced disclosures regarding how and why entities usederivative instruments, how derivative instruments and related hedged items areaccounted for in accordance with SFAS 133 and its related interpretation, andhow derivative instruments and related hedged items affect an entity’sfinancial position, financial performance, and cash flows. SFAS 161 iseffective for fiscal years and interim periods beginning after November 15,2008. We will adopt the new disclosure requirements of SFAS 161 in the firstquarter of 2009.

 

**Note 2.  DiscontinuedOperations**

 

On October 16, 2007, we announced plans to align resources aroundour core retail chains, Michaels and Aaron Brothers.  As a result, we discontinued our conceptbusinesses, Recollections and Star Decorators Wholesale.  As of the end of fiscal 2007, we had closed11 Recollections and three of the four Star locations.  The remaining Star location has beenconverted to a Michaels store.

 

The unaudited consolidated financial statements, accompanying notes andother information provided in this Quarterly Report on Form 10-Q reflectthese concept businesses as discontinued operations for all periods presented.

 

Summarized financial information with respect to the results ofoperations of these discontinued operations is as follows:

 
| ** **                                             | ** ** | **Quarter Ended**       | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------------|------------|------------------------------|------------|--------------------------------|------------|
| ** **                                             | ** ** | **August 4, 2007** | ** ** | **August 4, 2007**   | ** ** |
| ** **                                             | ** ** | **(in  millions)**           | ** ** |
| ** **                                             | ** ** | ** **                   | ** ** | ** **                     | ** ** |
| Net sales                                              |       | $                            | 5          |                           | $          | 10 |   |
|                                                   |       |                         |       |                           |       |
| Loss from discontinued operations before  income taxes |       | $                            | (1         | )                              | $          | (2 | ) |
| Income tax benefit                                     |       | —                       |       | —                         |       |
| Net loss from discontinued operations                  |       | $                            | (1         | )                              | $          | (2 | ) |

 

**Note 3.  Share-BasedCompensation**

 

On February 15, 2007, our stockholders and Board of Directorsapproved the 2006 Equity Incentive Plan (“2006 Plan”), which provides for thegrant of share-based awards exercisable for up to 14.2 million shares of CommonStock.  The table below sets forth asummary of stock option activity for the three and six months ended August 2,2008 and August 4, 2007.  As of August 2,2008, there were 187,467 shares of restricted stock outstanding, 10.2 millionshare-based awards outstanding and up to 3.8 million shares of Common Stockremaining available for grant under the 2006 Plan.

 

7

----

Table of Contents

 
| ** **                         | ** ** | **Quarter Ended**       | ** ** | **Six Months Ended** | ** ** |
|------------------------------------|------------|------------------------------|------------|--------------------------------|------------|
| ** **                         | ** ** | **August 2, 2008** | ** ** | **August 4, 2007**   | ** ** | **August 2, 2008** | ** ** | **August 4, 2007** | ** ** |
| ** **                         | ** ** | **(in millions)**       | ** ** |
|                               |       |                         |       |                           |       |   |   |   |   |
| Outstanding at beginning of period |       | 10.8                         |       | 9.7                            |       | 11.1 |   | — |   |
| Grants                             |       | 1.1                          |       | 3.3                            |       | 2.2 |   | 13.0 |   |
| Cancellations                      |       | (1.5                         | )          | (1.6                           | )          | (2.9 | ) | (1.6 | ) |
| Outstanding at end of period       |       | 10.4                         |       | 11.4                           |       | 10.4 |   | 11.4 |   |

 

Generally,awards granted under the 2006 Plan vest ratably over five years and expireeight years from the grant date. The exercise prices of the awards ranged from$15 per share to $52.50 per share, as determined by the Board ofDirectors.  Share-based compensationexpense associated with these awards was $1 million for the second quarter offiscal 2008 and 2007, and $4 million and $3 million for the six months ended August 2,2008 and August 4, 2007, respectively.

 

**Note 4.  Debt**

 

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

 
| ** **                            | ** ** | **August 2, 2008** | ** ** | **February 2, 2008** | ** ** | **Interest Rate** | ** ** |
|---------------------------------------|------------|------------------------------|------------|--------------------------------|------------|------------------------|------------|
| ** **                            | ** ** | **(in millions)**       | ** ** | ** **                     | ** ** |
|                                  |       |                         |       |                           |       |                   |       |
| Senior notes                          |       | $                            | 750        |                           | $          | 750                    |       | 10.000% |   |
| Senior subordinated notes             |       | 400                          |       | 400                            |       | 11.375%                |       |
| Subordinated discount notes           |       | 312                          |       | 293                            |       | 13.000%                |       |
| Senior secured term loan              |       | 2,309                        |       | 2,321                          |       | Variable               |       |
| Asset-based revolving credit facility |       | 262                          |       | 97                             |       | Variable               |       |
| Other                                 |       | 1                            |       | 2                              |       | Variable               |       |
|                                  |       |                         |       |                           |       |                   |       |
| Total debt                            |       | 4,034                        |       | 3,863                          |       |                   |       |
|                                  |       |                         |       |                           |       |                   |       |
| Less current portion                  |       | 286                          |       | 122                            |       |                   |       |
|                                  |       |                         |       |                           |       |                   |       |
| Long-term debt                        |       | $                            | 3,748      |                           | $          | 3,741                  |       |   |   |

 

*Asset-basedrevolving credit facility*

 

Our senior secured asset-based revolving credit facility, which weentered into on October 31, 2006, with Banc of America, N.A. and otherlenders (the “Asset-based revolving credit facility”) provides senior securedfinancing of up to $1.0 billion, subject to a borrowing base as described inour Annual Report on Form 10-K. As of August 2, 2008, the borrowingbase was $732 million with $440 million of unused availability.

 

*Seniorsecured term loan facility*

 

Borrowings under our senior secured term loan facility, which weentered into on October 31, 2006, with Deutsche Bank A.G. New York Branchand other lenders (the “Senior secured term loan facility”) bore interest at arate per annum equal to, at our option, either (a) a base rate determinedby reference to the higher of (1) the prime rate of Deutsche Bank and (2) thefederal funds effective rate plus 1⁄2 of 1% or (b) a LIBOR rate,subject to certain adjustments, in each case plus an applicable margin. Theapplicable margin at August 2, 2008 was 1.25% with respect to base rateborrowings and 2.25% with respect to LIBOR borrowings, subject to adjustmentsbased on the leverage and ratings thresholds set forth in the Senior securedterm loan facility agreement.

 

8

----

Tableof Contents

 

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

 

Our comprehensive (loss) income is as follows:

 
| ** **                                         | ** ** | **Quarter Ended**       | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------|------------|------------------------------|------------|--------------------------------|------------|
| ** **                                         | ** ** | **August 2, 2008** | ** ** | **August 4, 2007**   | ** ** | **August 2, 2008** | ** ** | **August 4, 2007** | ** ** |
| ** **                                         | ** ** | **(in millions)**       | ** ** | **(in millions)**         | ** ** |
|                                               |       |                         |       |                           |       |   |   |   |   |
| Net loss                                           |       | $                            | (30        | )                              | $          | (44 | ) | $ | (50 | ) | $ | (67 | ) |
| Other comprehensive income (loss):                 |       |                         |       |                           |       |   |   |   |   |
| Foreign currency translation adjustment and  other |       | 1                            |       | 2                              |       | — |   | 5 |   |
| Comprehensive loss                                 |       | $                            | (29        | )                              | $          | (42 | ) | $ | (50 | ) | $ | (62 | ) |

 

**Note 6.  DerivativeInstruments**

 

Weare exposed to fluctuations in exchange rates between the US and Canadiandollars, as the functional currency of our Canadian subsidiary is the Canadiandollar.  During the second quarter offiscal 2008, we executed foreign currency forward contracts to mitigate theeffects of currency fluctuations, which we designated as a cash flow hedge. Theobjective of the forward contracts is to hedge intercompany payments forforecasted purchases of inventory by our Canadian subsidiary, which aredenominated in US dollars.  The term ofthis cash flow hedge extends through the first quarter of fiscal 2009.

 

Toachieve our objective and to minimize the risk of ineffectiveness, the notionalvalues represent a portion of our Canadian subsidiary’s forecasted intercompanypurchases.  Hedge ineffectiveness isrecorded in Other income, as required. For the quarter ended August 2,2008, the ineffective portion of the hedge was immaterial.

 

Forthe portion of the hedge that is effective, as defined, the change in fairvalue of that hedge will initially be recorded in Other comprehensiveincome.  As the underlying inventory issold to our customers, amounts will be reclassified from Other comprehensiveincome to Cost of sales and occupancy expense in the statement ofoperations.  The fair value of the hedgefor the quarter ended August 2, 2008 was $1 million.

 

The table below provides the remaining quarterly notional values andthe average CAD/USD exchange rate associated with the hedge (dollars inmillions).

** **
| **Period**      | ** ** | **CAD Amount** | ** ** | **USD Amount** | ** ** | **Rate** | ** ** |
|-----------------|------------|---------------------|------------|---------------------|------------|----------|------------|
| Quarter 3, 2008 |       | $                   | 16.6       |                | $          | 16.6     |       | 1.000 |   |
| Quarter 4, 2008 |       | 17.4                |       | 17.4                |       | 1.001    |       |
| Quarter 1, 2009 |       | 12.2                |       | 12.2                |       | 1.001    |       |
|            |       | $                   | 46.2       |                | $          | 46.2     |       | 1.001 |   |

 

**Note7.  Fair Value Measurements**

 

As defined in SFAS No. 157, fair value is theprice that would be received to sell an asset or paid to transfer a liabilityin an orderly transaction between market participants at the measurementdate.  SFAS No. 157 establishes a three-level valuationhierarchy for fair value measurements. These valuation techniques are basedupon observable and unobservable inputs. Observable inputs reflect market dataobtained from independent sources, while unobservable inputs reflect our marketassumptions. These two types of inputs create the following fair valuehierarchy:

 

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

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

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

 

9

----

Table of Contents

 

Thefollowing table presents net financial assets (liabilities) accounted for atfair value on a recurring basis as of August 2, 2008 (in millions):

 
| ** **                              | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** | **Total** | ** ** |
|-----------------------------------------|------------|------------------|------------|------------------|------------|------------------|------------|-----------|------------|
| Cash equivalents                        |       | $                | 12         |             | $          | —           |       | $         | —     |   | $ | 12 |   |
| Foreign Currency Derivative Instruments |       | $                | —     |             | $          | 1                |       | $         | —     |   | $ | 1 |   |

 

Cash equivalents consist of highly liquid investments,with a maturity of 90 days or less at the date of purchase, including U.S.Treasury bills, various government obligations, and money market funds.  We carry cash equivalents at cost, whichapproximates fair value.

 

Derivativesin Level 2 are measured based on a variety of pricing factors, which includethe market price of the derivative instrument available in the dealer-market, whichhave been corroborated with market data. See Note 6 for additional informationon our derivative instruments.

 

**Note 8.  Commitmentsand Contingencies**

 

We are 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 February 2, 2008 and our Quarterly Report on Form 10-Q for thequarterly period ended May 3, 2008.

 

*Employee Class Action Claims*

 

*Torgerson Claim*

 

On January 26, 2007, KatherineTorgerson, a former “lead framer” for Aaron Brothers, Inc. (“AaronBrothers”) in San Diego, California, filed a purported class action proceedingin the Superior Court of California, County of San Diego.  Torgerson filedthis action against Aaron Brothers on behalf of herself and all current andformer California-based leads or keyholders.  The Torgerson suit allegesthat Aaron Brothers failed to provide its leads and keyholders with adequatemeal and rest breaks (or compensation in lieu thereof) and accurate wagestatements.  The Torgerson suit additionally alleges that the foregoingconduct was in breach of California’s unfair competition law.   Theplaintiff sought injunctive relief, compensatory damages, meal and rest breakpenalties, waiting time penalties, interest, and attorneys’ fees and costs. The parties participated in voluntary mediation on July 10, 2007 andreached a tentative settlement of the case.  On April 25, 2008, theCourt approved the settlement thereby requiring Aaron Brothers to make thesettlement payments by August 8, 2008. The required settlement paymentswere made by Aaron Brothers in a timely manner. These settlement payments hadno material impact on our statement of operations, balance sheet, or cash flowsfor any period presented.

 

*Consumer Claims*

 

*Palmer Claim*

 

On August 30, 2007, Rebecca Palmer,a consumer, filed a purported class action proceeding in Superior Court ofCalifornia, County of San Diego.  Palmer filed this action againstMichaels Stores, Inc., on behalf of herself and all similarly-situatedCalifornia consumers.  The Palmer suit alleges that Michaels unlawfullyrequested and recorded personally identifiable information (i.e., her zip code)as part of a credit card transaction.  The plaintiff seeks statutorypenalties, interest, and attorneys’ fees.  On March 28, 2008, theplaintiff submitted a brief in support of class certification.  Wecontested class certification by filing responding materials on May 8,2008.  We also filed a motion for summary judgment on May 8,2008.  Plaintiff filed a reply brief in support of class certification on May 23,2008.  On May 30, 2008, the Court issued an order denying plaintiff’smotion for class certification.  On June 30, 2008, the plaintiffagreed to dismiss her individual lawsuit against Michaels in exchange for considerationwhich will have no material impact on our statement of operations, balancesheet, or cash flows for any period presented. On July 9, 2008 the Court dismissed the case.

 

**Note 9.  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 About Segmentsof an Enterprise and Related Information*. We determined that ourMichaels 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, discontinued operations, goodwill impairment,depreciation and amortization (“EBITDA”). In addition, an element of base incentive compensation targets forcertain

 

10

----

Table of Contents

 

management personnel are based on EBITDA. Areconciliation of EBITDA to loss before income taxes and discontinuedoperations is presented below.

 
| ** **                                            | ** ** | **Quarter Ended**       | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------------------|------------|------------------------------|------------|--------------------------------|------------|
| ** **                                            | ** ** | **August 2, 2008** | ** ** | **August 4, 2007**   | ** ** | **August 2, 2008** | ** ** | **August 4, 2007** | ** ** |
|                                                  |       | **(in millions)**       |       |
|                                                  |       |                         |       |                           |       |   |   |   |   |
| Loss before income taxes and discontinued  operations |       | $                            | (49        | )                              | $          | (66 | ) | $ | (79 | ) | $ | (99 | ) |
| Interest expense                                      |       | 76                           |       | 95                             |       | 154 |   | 191 |   |
| Depreciation and amortization                         |       | 32                           |       | 31                             |       | 63 |   | 61 |   |
| EBITDA                                                |       | $                            | 59         |                           | $          | 60 |   | $ | 138 |   | $ | 153 |   |

 

Our sales and assets by country are as follows:

 
| ** **                                | ** ** | **Net Sales**     | ** ** | **Total Assets** | ** ** |
|-------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                | ** ** | **(in millions)** | ** ** |
| **Quarter ended August 2, 2008:**    |       |                   |       |                  |       |
| United States                             |       | $                      | 731        |                  | $          | 1,616 |   |
| Canada                                    |       | 65                     |       | 112                   |       |
| Consolidated Total                        |       | $                      | 796        |                  | $          | 1,728 |   |
|                                      |       |                   |       |                  |       |
| **Quarter ended August 4, 2007:**    |       |                   |       |                  |       |
| United States                             |       | $                      | 729        |                  | $          | 1,722 |   |
| Canada                                    |       | 59                     |       | 104                   |       |
| Consolidated Total                        |       | $                      | 788        |                  | $          | 1,826 |   |
|                                      |       |                   |       |                  |       |
| **Six Months ended August 2, 2008:** |       |                   |       |                  |       |
| United States                             |       | $                      | 1,509      |                  | $          | 1,616 |   |
| Canada                                    |       | 134                    |       | 112                   |       |
| Consolidated Total                        |       | $                      | 1,643      |                  | $          | 1,728 |   |
|                                      |       |                   |       |                  |       |
| **Six Months ended August 4, 2007:** |       |                   |       |                  |       |
| United States                             |       | $                      | 1,508      |                  | $          | 1,722 |   |
| Canada                                    |       | 119                    |       | 104                   |       |
| Consolidated Total                        |       | $                      | 1,627      |                  | $          | 1,826 |   |

 

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 10.  RelatedParty Transactions**

 

As previously disclosed, on October 31, 2006, substantially all ofthe Common Stock of Michaels Stores, Inc. was acquired through a mergertransaction (the “Merger”) by affiliates of Bain Capital Partners, LLC and TheBlackstone Group. We pay annual management fees to Bain Capital Partners, LLCand The Blackstone Group (collectively, together with their applicableaffiliates, the “Sponsors”) and Highfields Capital Management LP in the amountof $12 million and $1 million, respectively. We recognized $3 million ofexpense related to annual management fees during the second quarter of fiscal2008 and fiscal 2007, and $7 million during the six months ended August 2,2008 and August 4, 2007. These expenses are included in related partyexpenses on the statement of operations.

 

Bain Capital owns a majority ownership stake in an external vendor weutilize to print our circular advertisements. Expenses associated with this vendor during the second quarter of fiscal2008 and fiscal 2007 were $6 million and $8 million, respectively, and $16million and $18 million for the six months ended August 2, 2008 and August 4,2007, respectively.  These expenses areincluded in selling, general and administrative expense on the consolidatedstatements of operations.

 

11

----

Table of Contents

 

During the first quarter of fiscal 2007, The Blackstone Group acquireda majority ownership stake in an external vendor we utilize to count our storeinventory. Expenses associated with this vendor during the second quarter ofeach of fiscal 2008 and 2007 were $1 million. Expenses for the six months endedAugust 2, 2008 and August 4, 2007 were $3 million and $2 million,respectively.  These expenses areincluded in selling, general and administrative expense on the consolidatedstatements of operations.

 

During the third quarter of fiscal 2007, Bain Capital acquired anownership stake in an external vendor we utilize for non-merchandisesupplies.  Expenses associated with thisvendor during the second quarter of fiscal 2008 and the six months ended August 2,2008 were $1 million and $2 million, respectively.  These expenses are included in selling,general and administrative expense on the consolidated statements ofoperations.

 

During fiscal 2007, officers of Michaels Stores, Inc. and itssubsidiaries were offered the opportunity to purchase shares of our CommonStock. There were no shares sold to officers of Michaels Stores, Inc.during the first six months of fiscal 2008. Also, during the second quarter of 2008 and the six months ended August 2,2008, we repurchased 100,000 and 105,334 shares, respectively, from officerswho are no longer with the Company.

 

In connection with the consummation of the Merger, the Company enteredinto a Separation Agreement with each of Charles Wyly and Sam Wyly, executiveofficers and 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 are amortizing theseSeparation Agreements over two years. These expenses are included in relatedparty expenses on the consolidated statements of operations.

 

**Note11.   Condensed Consolidating FinancialInformation**

 

Allof the Company’s obligations under the Senior notes, Senior subordinated notes,Subordinated discount notes, Senior secured term loan, and Asset-basedrevolving credit facility are guaranteed by the Parent and Guarantorsubsidiaries. Currently, Aaron Brothers Card Services, LLC is a non-guarantorsubsidiary that was organized on July 11, 2008. As of August 2, 2008,the financial statements of Aaron Brothers Card Services, LLC were immaterial.

 

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

 

12

----

Table of Contents

 

**Supplemental Condensed Consolidating BalanceSheet**

 
| ** **                                                 | ** ** | **August 2, 2008** | ** ** |
|------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                 | ** ** | **Parent  Company**          | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                 | ** ** | **(in  millions)**           | ** ** |
| **ASSETS**                                                 | ** ** | ** **                   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Current assets:**                                        |       |                         |       |   |   |   |   |   |   |
| Cash and equivalents                                       |       | $                            | 32         |   | $ | 13 |   | $ | — |   | $ | 45 |   |
| Merchandise inventories                                    |       | 665                          |       | 273 |   | — |   | 938 |   |
| Intercompany receivables                                   |       | —                       |       | 374 |   | (374 | ) | — |   |
| Other                                                      |       | 95                           |       | 49 |   | — |   | 144 |   |
| Total current assets                                       |       | 792                          |       | 709 |   | (374 | ) | $ | 1,127 |   |
| **Property and equipment, net**                            |       | 294                          |       | 116 |   | — |   | 410 |   |
| **Goodwill, net**                                          |       | 94                           |       | — |   | — |   | 94 |   |
| **Investment in subsidiaries**                             |       | 474                          |       | — |   | (474 | ) | — |   |
| **Other assets**                                           |       | 82                           |       | 15 |   | — |   | 97 |   |
| Total assets                                               |       | $                            | 1,736      |   | $ | 840 |   | $ | (848 | ) | $ | 1,728 |   |
|                                                       |       |                         |       |   |   |   |   |   |   |
| **LIABILITIES  AND STOCKHOLDERS’ (DEFICIT) EQUITY**   |       |                         |       |   |   |   |   |   |   |
| **Current liabilities:**                                   |       |                         |       |   |   |   |   |   |   |
| Accounts payable                                           |       | $                            | 18         |   | $ | 226 |   | $ | — |   | $ | 244 |   |
| Accrued liabilities and other                              |       | 225                          |       | 79 |   | — |   | 304 |   |
| Current portion of long-term debt                          |       | 286                          |       | — |   | — |   | 286 |   |
| Intercompany payable                                       |       | 374                          |       | — |   | (374 | ) | — |   |
| Other                                                      |       | (38                          | )          | 40 |   | — |   | 2 |   |
| Total current liabilities                                  |       | 865                          |       | 345 |   | (374 | ) | 836 |   |
| **Long-term debt**                                         |       | 3,748                        |       | — |   | — |   | 3,748 |   |
| **Other long-term liabilities**                            |       | 62                           |       | 21 |   | — |   | 83 |   |
| **Total stockholders’ (deficit) equity**              |       | (2,939                       | )          | 474 |   | (474 | ) | (2,939 | ) |
| Total liabilities and stockholders’  (deficit) equity |       | $                            | 1,736      |   | $ | 840 |   | $ | (848 | ) | $ | 1,728 |   |

 

13

----

Table of Contents

 

**Supplemental Condensed Consolidating BalanceSheet**

 
| ** **                                                 | ** ** | **February 2, 2008** | ** ** |
|------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                 | ** ** | **Parent  Company**            | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|                                                       |       | **(in  millions)**             |       |
| **ASSETS**                                                 | ** ** | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Current assets:**                                        |       |                           |       |   |   |   |   |   |   |
| Cash and equivalents                                       |       | $                              | 26         |   | $ | 3 |   | $ | — |   | $ | 29 |   |
| Merchandise inventories                                    |       | 622                            |       | 223 |   | — |   | 845 |   |
| Intercompany receivables                                   |       | —                         |       | 250 |   | (250 | ) | — |   |
| Other                                                      |       | 61                             |       | 45 |   | — |   | 106 |   |
| Total current assets                                       |       | 709                            |       | 521 |   | (250 | ) | $ | 980 |   |
| **Property and equipment, net**                            |       | 308                            |       | 125 |   | — |   | 433 |   |
| **Goodwill, net**                                          |       | 94                             |       | — |   | — |   | 94 |   |
| **Investment in subsidiaries**                             |       | 325                            |       | — |   | (325 | ) | — |   |
| **Other assets**                                           |       | 91                             |       | 16 |   | — |   | 107 |   |
| Total assets                                               |       | $                              | 1,527      |   | $ | 662 |   | $ | (575 | ) | $ | 1,614 |   |
|                                                       |       |                           |       |   |   |   |   |   |   |
| **LIABILITIES  AND STOCKHOLDERS’ (DEFICIT) EQUITY**   |       |                           |       |   |   |   |   |   |   |
| **Current liabilities:**                                   |       |                           |       |   |   |   |   |   |   |
| Accounts payable                                           |       | $                              | 29         |   | $ | 192 |   | $ | — |   | $ | 221 |   |
| Accrued liabilities and other                              |       | 249                            |       | 83 |   | — |   | 332 |   |
| Current portion of long-term debt                          |       | 122                            |       | — |   | — |   | 122 |   |
| Intercompany payable                                       |       | 250                            |       | — |   | (250 | ) | — |   |
| Other                                                      |       | (37                            | )          | 41 |   | — |   | 4 |   |
| Total current liabilities                                  |       | 613                            |       | 316 |   | (250 | ) | 679 |   |
| **Long-term debt**                                         |       | 3,741                          |       | — |   | — |   | 3,741 |   |
| **Other long-term liabilities**                            |       | 65                             |       | 21 |   | — |   | 86 |   |
| **Total stockholders’ (deficit) equity**              |       | (2,892                         | )          | 325 |   | (325 | ) | (2,892 | ) |
| Total liabilities and stockholders’  (deficit) equity |       | $                              | 1,527      |   | $ | 662 |   | $ | (575 | ) | $ | 1,614 |   |

 

14

----

Table of Contents

 

**Supplemental Condensed Consolidating Balance Sheet**

 
| ** **                                                 | ** ** | **August 4, 2007** | ** ** |
|------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                 | ** ** | **Parent  Company**          | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                 | ** ** | **(in millions)**       | ** ** |
| **ASSETS**                                                 |       |                         |       |   |   |   |   |   |   |
| **Current assets:**                                        |       |                         |       |   |   |   |   |   |   |
| Cash and equivalents                                       |       | $                            | 27         |   | $ | 18 |   | $ | — |   | $ | 45 |   |
| Merchandise inventories                                    |       | 664                          |       | 249 |   | — |   | 913 |   |
| Intercompany receivables                                   |       | —                       |       | 197 |   | (197 | ) | — |   |
| Other                                                      |       | 157                          |       | 24 |   | — |   | 181 |   |
| Total current assets                                       |       | 848                          |       | 488 |   | (197 | ) | $ | 1,139 |   |
| **Property and equipment, net**                            |       | 320                          |       | 127 |   | — |   | 447 |   |
| **Goodwill, net**                                          |       | 94                           |       | 22 |   | — |   | 116 |   |
| **Investment in subsidiaries**                             |       | 331                          |       | — |   | (331 | ) | — |   |
| **Other assets**                                           |       | 109                          |       | 15 |   | — |   | 124 |   |
| Total assets                                               |       | $                            | 1,702      |   | $ | 652 |   | $ | (528 | ) | $ | 1,826 |   |
|                                                       |       |                         |       |   |   |   |   |   |   |
| **LIABILITIES AND STOCKHOLDERS’ (DEFICIT)  EQUITY**   |       |                         |       |   |   |   |   |   |   |
| **Current liabilities:**                                   |       |                         |       |   |   |   |   |   |   |
| Accounts payable                                           |       | $                            | 41         |   | $ | 166 |   | $ | — |   | $ | 207 |   |
| Accrued liabilities and other                              |       | 282                          |       | 72 |   | — |   | 354 |   |
| Current portion of long-term debt                          |       | 364                          |       | — |   | — |   | 364 |   |
| Intercompany payable                                       |       | 197                          |       | — |   | (197 | ) | — |   |
| Other                                                      |       | (57                          | )          | 58 |   | — |   | 1 |   |
| Total current liabilities                                  |       | 827                          |       | 296 |   | (197 | ) | 926 |   |
| **Long-term debt**                                         |       | 3,734                        |       | — |   | — |   | 3,734 |   |
| **Other long-term liabilities**                            |       | 73                           |       | 25 |   | — |   | 98 |   |
| **Total stockholders’ (deficit) equity**              |       | (2,932                       | )          | 331 |   | (331 | ) | (2,932 | ) |
| Total liabilities and stockholders’ (deficit)  equity |       | $                            | 1,702      |   | $ | 652 |   | $ | (528 | ) | $ | 1,826 |   |

 

**Supplemental Condensed ConsolidatingStatement of Operations**

 
| ** **                                                         | ** ** | **Quarter Ended August 2, 2008** | ** ** |
|--------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                         | ** ** | **Parent  Company**                                  | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                         | ** ** | **(in millions)**                               | ** ** |
| **Net sales**                                                      |       | $                                                    | 689        |   | 492 |   | $ | (385 | ) | $ | 796 |   |
| Cost of sales and occupancy expense                                |       | 488                                                  |       | 415 |   | (385 | ) | 518 |   |
| **Gross profit**                                                   |       | 201                                                  |       | 77 |   | — |   | 278 |   |
| Selling, general, and administrative  expense                      |       | 211                                                  |       | 35 |   | — |   | 246 |   |
| Transaction expenses                                               |       | —                                               |       | — |   | — |   | — |   |
| Related party expenses                                             |       | 4                                                    |       | — |   | — |   | 4 |   |
| Store pre-opening costs                                            |       | 1                                                    |       | — |   | — |   | 1 |   |
| **Operating (loss) income**                                        |       | (15                                                  | )          | 42 |   | — |   | 27 |   |
| Interest expense                                                   |       | 76                                                   |       | — |   | — |   | 76 |   |
| Other (income) and expense, net                                    |       | —                                               |       | — |   | — |   | — |   |
| Intercompany charges (income)                                      |       | 18                                                   |       | (18 | ) | — |   | — |   |
| Equity in earnings of subsidiaries                                 |       | 60                                                   |       | — |   | (60 | ) | — |   |
| **Income (loss) before income taxes and discontinued  operations** |       | (49                                                  | )          | 60 |   | (60 | ) | (49 | ) |
| Provision (benefit) for income taxes                               |       | (19                                                  | )          | 23 |   | (23 | ) | (19 | ) |
| **Income (loss) before discontinued  operations**                  |       | (30                                                  | )          | 37 |   | (37 | ) | (30 | ) |
| Discontinued operations loss, net of income  tax                   |       | —                                               |       | — |   | — |   | — |   |
| **Net income (loss)**                                              |       | $                                                    | (30        | ) | $ | 37 |   | $ | (37 | ) | $ | (30 | ) |
|                                                                    |            |                                                      |            |  |  |  |  |  |  |  |  |  |  |

 

15

----

Table of Contents

 

**Supplemental Condensed ConsolidatingStatement of Operations**

 
| ** **                                                         | ** ** | **Quarter Ended August 4, 2007** | ** ** |
|--------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                         | ** ** | **Parent  Company**                                  | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                         | ** ** | **(in millions)**                               | ** ** |
| **Net sales**                                                      |       | $                                                    | 684        |   | 405 |   | $ | (301 | ) | $ | 788 |   |
| Cost of sales and occupancy expense                                |       | 473                                                  |       | 326 |   | (301 | ) | 498 |   |
| **Gross profit**                                                   |       | 211                                                  |       | 79 |   | — |   | 290 |   |
| Selling, general, and administrative  expense                      |       | 210                                                  |       | 32 |   | — |   | 242 |   |
| Transaction expenses                                               |       | 16                                                   |       | — |   | — |   | 16 |   |
| Related party expenses                                             |       | 4                                                    |       | — |   | — |   | 4 |   |
| Store pre-opening costs                                            |       | 1                                                    |       | — |   | — |   | 1 |   |
| **Operating income**                                               |       | (20                                                  | )          | 47 |   | — |   | 27 |   |
| Interest expense                                                   |       | 95                                                   |       | — |   | — |   | 95 |   |
| Other (income) and expense, net                                    |       | 1                                                    |       | (3 | ) | — |   | (2 | ) |
| Intercompany charges (income)                                      |       | 14                                                   |       | (14 | ) | — |   | — |   |
| Equity in earnings of subsidiaries                                 |       | 64                                                   |       | — |   | (64 | ) | — |   |
| **Income (loss) before income taxes and discontinued  operations** |       | (66                                                  | )          | 64 |   | (64 | ) | (66 | ) |
| Provision (benefit) for income taxes                               |       | (23                                                  | )          | 22 |   | (22 | ) | (23 | ) |
| **Income (loss) before discontinued  operations**                  |       | (43                                                  | )          | 42 |   | (42 | ) | (43 | ) |
| Discontinued operations loss, net of income  tax                   |       | (1                                                   | )          | — |   | — |   | (1 | ) |
| **Net income (loss)**                                              |       | $                                                    | (44        | ) | $ | 42 |   | $ | (42 | ) | $ | (44 | ) |
|                                                                    |            |                                                      |            |  |  |  |  |  |  |  |  |  |  |

 

**Supplemental Condensed ConsolidatingStatement of Operations**

 
| ** **                                                         | ** ** | **Six Months Ended August 2, 2008** | ** ** |
|--------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                                         | ** ** | **Parent  Company**                                          | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                         | ** ** | **(in millions)**                                       | ** ** |
| **Net sales**                                                      |       | $                                                            | 1,431      |   | 936 |   | $ | (724 | ) | $ | 1,643 |   |
| Cost of sales and occupancy expense                                |       | 992                                                          |       | 771 |   | (724 | ) | 1,039 |   |
| **Gross profit**                                                   |       | 439                                                          |       | 165 |   | — |   | 604 |   |
| Selling, general, and administrative  expense                      |       | 452                                                          |       | 66 |   | — |   | 518 |   |
| Transaction expenses                                               |       | —                                                       |       | — |   | — |   | — |   |
| Related party expenses                                             |       | 8                                                            |       | — |   | — |   | 8 |   |
| Store pre-opening costs                                            |       | 2                                                            |       | 1 |   | — |   | 3 |   |
| **Operating income**                                               |       | (23                                                          | )          | 98 |   | — |   | 75 |   |
| Interest expense                                                   |       | 154                                                          |       | — |   | — |   | 154 |   |
| Other (income) and expense, net                                    |       | —                                                       |       | — |   | — |   | — |   |
| Intercompany charges (income)                                      |       | 35                                                           |       | (35 | ) | — |   | — |   |
| Equity in earnings of subsidiaries                                 |       | 133                                                          |       | — |   | (133 | ) | — |   |
| **Income (loss) before income taxes and discontinued  operations** |       | (79                                                          | )          | 133 |   | (133 | ) | (79 | ) |
| Provision (benefit) for income taxes                               |       | (29                                                          | )          | 49 |   | (49 | ) | (29 | ) |
| **Income (loss) before discontinued  operations**                  |       | (50                                                          | )          | 84 |   | (84 | ) | (50 | ) |
| Discontinued operations loss, net of income  tax                   |       | —                                                       |       | — |   | — |   | — |   |
| **Net income (loss)**                                              |       | $                                                            | (50        | ) | $ | 84 |   | $ | (84 | ) | $ | (50 | ) |
|                                                                    |            |                                                              |            |  |  |  |  |  |  |  |  |  |  |

 

16

----

Table of Contents

 

**Supplemental Condensed ConsolidatingStatement of Operations**

 
| ** **                                                         | ** ** | **Six Months Ended August 4, 2007** | ** ** |
|--------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                                         | ** ** | **Parent  Company**                                          | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                         | ** ** | **(in millions)**                                       | ** ** |
| **Net sales**                                                      |       | $                                                            | 1,426      |   | 813 |   | $ | (612 | ) | $ | 1,627 |   |
| Cost of sales and occupancy expense                                |       | 970                                                          |       | 653 |   | (612 | ) | 1,011 |   |
| **Gross profit**                                                   |       | 456                                                          |       | 160 |   | — |   | 616 |   |
| Selling, general, and administrative  expense                      |       | 435                                                          |       | 62 |   | — |   | 497 |   |
| Transaction expenses                                               |       | 21                                                           |       | — |   | — |   | 21 |   |
| Related party expenses                                             |       | 8                                                            |       | — |   | — |   | 8 |   |
| Store pre-opening costs                                            |       | 2                                                            |       | 1 |   | — |   | 3 |   |
| **Operating income**                                               |       | (10                                                          | )          | 97 |   | — |   | 87 |   |
| Interest expense                                                   |       | 191                                                          |       | — |   | — |   | 191 |   |
| Other (income) and expense, net                                    |       | —                                                       |       | (5 | ) | — |   | (5 | ) |
| Intercompany charges (income)                                      |       | 34                                                           |       | (34 | ) | — |   | — |   |
| Equity in earnings of subsidiaries                                 |       | 136                                                          |       | — |   | (136 | ) | — |   |
| **Income (loss) before income taxes and discontinued  operations** |       | (99                                                          | )          | 136 |   | (136 | ) | (99 | ) |
| Provision (benefit) for income taxes                               |       | (34                                                          | )          | 46 |   | (46 | ) | (34 | ) |
| **Income (loss) before discontinued  operations**                  |       | (65                                                          | )          | 90 |   | (90 | ) | (65 | ) |
| Discontinued operations loss, net of income  tax                   |       | (2                                                           | )          | — |   | — |   | (2 | ) |
| **Net income (loss)**                                              |       | $                                                            | (67        | ) | $ | 90 |   | $ | (90 | ) | $ | (67 | ) |
|                                                                    |            |                                                              |            |  |  |  |  |  |  |  |  |  |  |

 

**Supplemental Condensed Statement of CashFlows**

 
| ** **                                           | ** ** | **Six Months Ended August 2, 2008** | ** ** |
|------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                           | ** ** | **Parent  Company**                                          | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                           | ** ** | **(in millions)**                                       | ** ** |
| **Operating activities:**                            |       |                                                         |       |   |   |   |   |   |   |
| Net cash (used in) provided by operating  activities |       | $                                                            | (114       | ) | $ | 86 |   | $ | (70 | ) | $ | (98 | ) |
|                                                 |       |                                                         |       |   |   |   |   |   |   |
| **Investing activities:**                            |       |                                                         |       |   |   |   |   |   |   |
| Cash paid for property and equipment                 |       | (33                                                          | )          | (6 | ) | — |   | (39 | ) |
| Net cash used in investing activities                |       | (33                                                          | )          | (6 | ) | — |   | (39 | ) |
|                                                 |       |                                                         |       |   |   |   |   |   |   |
| **Financing activities:**                            |       |                                                         |       |   |   |   |   |   |   |
| Net borrowings of long-term debt                     |       | 153                                                          |       | — |   | — |   | 153 |   |
| Intercompany dividends                               |       | —                                                       |       | (70 | ) | 70 |   | — |   |
| Other financing activities                           |       | —                                                       |       | — |   | — |   | — |   |
| Net cash provided by (used in) financing  activities |       | 153                                                          |       | (70 | ) | 70 |   | 153 |   |
|                                                 |       |                                                         |       |   |   |   |   |   |   |
| **Increase in cash and equivalents**                 |       | 6                                                            |       | 10 |   | — |   | 16 |   |
| **Beginning cash and cash equivalents**              |       | 26                                                           |       | 3 |   | — |   | 29 |   |
| **Ending cash and cash equivalents**                 |       | $                                                            | 32         |   | $ | 13 |   | $ | — |   | $ | 45 |   |

 

17

----

Tableof Contents

**Supplemental Condensed Statement of CashFlows**

 
| ** **                                           | ** ** | **Six Months Ended August 4, 2007** | ** ** |
|------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                           | ** ** | **Parent  Company**                                          | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                           | ** ** | **(in millions)**                                       | ** ** |
| **Operating Activities:**                            | ** ** | ** **                                                   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net cash (used in) provided by operating  activities |       | $                                                            | (48        | ) | $ | 85 |   | $ | (67 | ) | $ | (30 | ) |
|                                                 |       |                                                         |       |   |   |   |   |   |   |
| **Investing Activities:**                            |       |                                                         |       |   |   |   |   |   |   |
| Cash paid for property and equipment                 |       | (58                                                          | )          | (4 | ) | — |   | (62 | ) |
| Net cash used in investing activities                |       | (58                                                          | )          | (4 | ) | — |   | (62 | ) |
| **Financing Activities:**                            |       |                                                         |       |   |   |   |   |   |   |
| Net borrowings of long-term debt                     |       | 123                                                          |       | — |   | — |   | 123 |   |
| Intercompany dividends                               |       | —                                                       |       | (67 | ) | 67 |   | — |   |
| Other financing activities                           |       | (16                                                          | )          | — |   | — |   | (16 | ) |
| Net cash provided by (used in) financing  activities |       | 107                                                          |       | (67 | ) | 67 |   | 107 |   |
| **Increase in cash and equivalents**                 |       | 1                                                            |       | 14 |   | — |   | 15 |   |
| **Beginning cash and cash equivalents**              |       | 26                                                           |       | 4 |   | — |   | 30 |   |
| **Ending cash and equivalents**                      |       | $                                                            | 27         |   | $ | 18 |   | $ | — |   | $ | 45 |   |

 

18

----

Table of Contents

 

**Item 2.  Management’sDiscussion and Analysis of Financial Condition and****Results of Operations.**

 

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

 

**DisclosureRegarding Forward-Looking Information**

 

The following discussion should be read in conjunction with ourconsolidated financial statements and related notes included elsewhere in thisQuarterly Report on Form 10-Q. The following discussion, as well as otherportions of this Quarterly Report on Form 10-Q, contains forward-lookingstatements that reflect our plans, estimates, and beliefs. Any statementscontained herein (including, but not limited to, statements to the effect thatMichaels or its management “anticipates,” “plans,” “estimates,” “expects,”“believes,” and other similar expressions) that are not statements of historicalfact should be considered forward-looking statements and should be read inconjunction with our consolidated financial statements and related notes in ourAnnual Report on Form 10-K for the fiscal year ended February 2,2008. Such forward-looking statements are based upon management’s currentknowledge and assumptions about future events and involve risks anduncertainties that could cause actual results, performance or achievements tobe materially different from anticipated results, prospects, performance orachievements expressed or implied by such forward-looking statements. Suchrisks and uncertainties include, but are not limited to:

 

·                  risks related to our substantial indebtedness, asour** substantial leverage could adversely affectour ability to raise additional capital to fund our operations, limit ourability to react to changes in the economy or our industry, expose us tointerest rate risk to the extent of our variable rate debt and prevent us frommeeting our obligations under our notes and credit facilities;

 

·                  restrictions in our debt agreements that limit ourflexibility in operating our business, as oursenior secured credit facilities and the indentures governing our notes containvarious covenants that limit our ability to engage in specified types of transactions;

 

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

 

·                  how well we manage our business;

 

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

 

·                  improvements to our supply chain may not befully successful;

 

·                  changes in customer demands could materially adverselyaffect our sales, operating results, and cash flow;

 

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

 

·                  changes in newspaper subscription ratesmay result in reduced exposure to our circular advertisements;

 

·                  changes in consumer confidence could result in areduction in consumer spending on items perceived to be discretionary;

 

·                  failure to adequately maintain the security of ourelectronic and other confidential information could materially adversely affectour financial condition and operating results;

 

·                  our suppliers may fail us;

 

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

 

·                  product recalls and/or product liabilitymay adversely impact our operations and merchandise offerings;

 

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

 

·                  our information systems may prove inadequate;

 

·                  a weak fourth quarter would materially adverselyaffect our operating results;

 

19

----

Table of Contents

 

·                  competition could negatively impact our operations;and

 

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

 

For more details on factors that 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 February 2, 2008, and other reports from time totime filed with or furnished to the SEC. We disclaim any intention to, andundertake no obligation to, update or revise any forward-looking statement.

 

**General**

 

We report on the basis of a 52 or 53-week fiscal year, which ends onthe Saturday closest to January 31. All references herein to “fiscal 2008”relate to the 52 weeks ending January 31, 2009 and all references to“fiscal 2007” relate to the 52 weeks ended February 2, 2008. Inaddition, all references herein to “the second quarter of fiscal 2008” relateto the 13 weeks ended August 2, 2008 and all references to “the secondquarter of fiscal 2007” relate to the 13 weeks ended August 4, 2007.  Finally, all references to “the six monthsended August 2, 2008” relate to the 26 weeks ended August 2, 2008,and “the six months ended August 4, 2007” relate to the 26 weeks ended August 4,2007, respectively.

 

The following table sets forth certain of our unaudited operating data:

 
| ** **                                               | ** ** | **Quarter Ended**  | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------------|------------|--------------------|------------|--------------------------------|------------|
| ** **                                               | ** ** | **August 2,** | ** ** | **August 4,**             | ** ** | **August 2,** | ** ** | **August 4,** | ** ** |
| ** **                                               | ** ** | **2008**           | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
| **Michaels stores:**                                     |       |               |       |                           |       |   |   |   |   |
| Retail stores open at beginning of period                |       | 980                |       | 929                            |       | 963 |   | 921 |   |
| Retail stores opened during the period                   |       | 11                 |       | 9                              |       | 28 |   | 20 |   |
| Retail stores opened (relocations) during  the period    |       | 3                  |       | 2                              |       | 6 |   | 7 |   |
| Retail stores closed during the period                   |       | —             |       | —                         |       | — |   | (3 | ) |
| Retail stores closed (relocations) during  the period    |       | (3                 | )          | (2                             | )          | (6 | ) | (7 | ) |
| Retail stores open at end of period                      |       | 991                |       | 938                            |       | 991 |   | 938 |   |
|                                                     |       |               |       |                           |       |   |   |   |   |
| **Aaron Brothers stores:**                               |       |               |       |                           |       |   |   |   |   |
| Retail stores open at beginning of period                |       | 164                |       | 168                            |       | 166 |   | 166 |   |
| Retail stores opened during the period                   |       | —             |       | —                         |       | — |   | 2 |   |
| Retail stores opened (relocations) during  the period    |       | 1                  |       | —                         |       | 1 |   | — |   |
| Retail stores closed during the period                   |       | —             |       | (1                             | )          | (2 | ) | (1 | ) |
| Retail stores closed (relocations) during  the period    |       | (1                 | )          | —                         |       | (1 | ) | — |   |
| Retail stores open at end of period                      |       | 164                |       | 167                            |       | 164 |   | 167 |   |
|                                                     |       |               |       |                           |       |   |   |   |   |
| Total store count at end of period                       |       | 1,155              |       | 1,105                          |       | 1,155 |   | 1,105 |   |
|                                                     |       |               |       |                           |       |   |   |   |   |
| **Other operating data:**                                |       |               |       |                           |       |   |   |   |   |
| Average inventory per Michaels store (in  thousands) (1) |       | $                  | 899        |                           | $          | 930 |   | $ | 899 |   | $ | 930 |   |
| Comparable store sales (decrease) increase  (2)          |       | (2.6               | )%         | 0.8                            | %          | (2.8 | )% | 0.1 | % |
|                                                          |            |                    |            |                                |            |  |  |  |  |  |  |  |  |

 

----

(1)   Average inventory perMichaels store calculation excludes our Aaron Brothers stores.

          

(2)   Comparable store salesincrease (decrease) represents the increase (decrease) in net sales for storesopen the same number of months in the indicated period and the comparableperiod of the previous year, including stores that were relocated or expandedduring either period. A store is deemed to become comparable in its14th month of operation in order to eliminate grand opening salesdistortions. A store temporarily closed more than 2 weeks due to acatastrophic event is not considered comparable during the month it closed. Ifa store is closed longer than 2 weeks but less than 2 months, itbecomes comparable in the month in which it reopens, subject to a mid-monthconvention. A store closed longer than 2 months becomes comparable in its14th month of operation after its reopening.

 

20

----

Table of Contents

 

**Resultsof Operations**

 

The following table sets forth the percentage relationship to net salesof each line item of our unaudited consolidated statements of operations. Thistable should be read in conjunction with the following discussion and with ourconsolidated financial statements, including the related notes, containedherein.

 
| ** **                                                | ** ** | **Quarter Ended** | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------------------------------|------------|------------------------|------------|--------------------------------|------------|
| ** **                                                | ** ** | **August 2,**     | ** ** | **August 4,**             | ** ** | **August 2,** | ** ** | **August 4,** | ** ** |
| ** **                                                | ** ** | **2008**               | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
| **Net sales**                                             |       | 100.0                  | %          | 100.0                          | %          | 100.0 | % | 100.0 | % |
| Cost of sales and occupancy expense                       |       | 65.1                   |       | 63.2                           |       | 63.2 |   | 62.1 |   |
| **Gross profit**                                          |       | 34.9                   |       | 36.8                           |       | 36.8 |   | 37.9 |   |
| Selling, general, and administrative  expense             |       | 30.9                   |       | 30.7                           |       | 31.5 |   | 30.6 |   |
| Transaction expenses                                      |       | —                 |       | 2.1                            |       | — |   | 1.3 |   |
| Related party expenses                                    |       | 0.5                    |       | 0.5                            |       | 0.5 |   | 0.5 |   |
| Store pre-opening costs                                   |       | 0.1                    |       | 0.1                            |       | 0.2 |   | 0.2 |   |
| **Operating income**                                      |       | 3.4                    |       | 3.4                            |       | 4.6 |   | 5.3 |   |
| Interest expense                                          |       | 9.5                    |       | 12.1                           |       | 9.4 |   | 11.7 |   |
| Other (income) and expense, net                           |       | —                 |       | (0.3                           | )          | — |   | (0.3 | ) |
| **Loss before income taxes and discontinued  operations** |       | (6.1                   | )          | (8.4                           | )          | (4.8 | ) | (6.1 | ) |
| Income tax benefit                                        |       | (2.3                   | )          | (2.9                           | )          | (1.8 | ) | (2.1 | ) |
| **Loss before discontinued operations**                   |       | (3.8                   | )          | (5.5                           | )          | (3.0 | ) | (4.0 | ) |
| Discontinued operations loss, net of income  tax          |       | —                 |       | (0.1                           | )          | — |   | (0.1 | ) |
| **Net loss**                                              |       | (3.8                   | )%         | (5.6                           | )%         | (3.0 | )% | (4.1 | )% |

 

*Quarter Ended August 2, 2008 Compared to the Quarter Ended August 4,2007*

 

*Net Sales*—Net salesincreased for the second quarter of fiscal 2008 by $8 million, or 1.0%, overthe second quarter of fiscal 2007. The results for the second quarter of fiscal2008 include sales from 59 Michaels stores that were opened during the 13-monthperiod ended August 2, 2008. Non-comparable sales increased $29 million,while comparable store sales decreased $21 million.

 

Comparable store sales declined 2.6% in the second quarter of fiscal2008 compared to the second quarter of fiscal 2007, reflecting a decrease incustomer transactions of 1.6% and a decrease in the average ticket of 1.0%. Thefluctuation in the exchange rate between the United States and Canadian dollarspositively impacted the average ticket change by 50 basis points. Comparablestore sales were negatively impacted by the current soft macroeconomic andretail environments, particularly in the home décor categories, such as floraland greenery.

 

We continue to develop a fully integrated pricing and promotionstrategy and may refine our existing strategy in future periods.  A significant component of our pricing andpromotion strategy involves changes in the breadth and depth of our promotionalprograms.  Given the current softmacroeconomic and retail environments, sales declines could adversely affectoperations due to a deleveraging of operating expenses.  As a result, our historical trends may not beindicative of future results.

 

We continue to evaluate all options available to us for our AaronBrothers concept, 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*—Costof sales and occupancy expense increased $20 million primarily due to a 4.5%increase in the number of stores. As a percentage of net sales, cost of salesand occupancy expense increased approximately 190 basis points in the secondquarter of fiscal 2008 compared to the second quarter of fiscal 2007.Merchandise margin decreased approximately 100 basis points due to increasedtesting of new promotional programs, elimination of certain in-store programs,and deleveraging of our distribution costs. Occupancy costs increased by 90basis points due to a deleveraging of fixed occupancy costs on a decline incomparable store sales.

 

*Selling, General, and Administrative Expense*—Selling,general, and administrative expense increased $4 million from 

 

21

----

Table of Contents

 

$242 millionin the second quarter of fiscal 2007 to $246 million in the second quarter offiscal 2008. As a percentage of net sales, selling, general and administrativeexpense increased from 30.7% of net sales in the second quarter of fiscal 2007to 30.9% of net sales in the second quarter of fiscal 2008 primarily due toexpenses from our strategic initiatives and employee severance expense,partially offset by a decrease in advertising expense.

 

*Transaction Expenses*—Transactionexpenses incurred during the second quarter of fiscal 2007 related primarily tobonus arrangements associated with the change in control that were ratablyrecognized for a period of one year following the Merger date, as well as othercompensation expenses arising from change in control agreements.

 

*Related Party Expenses*—Related party expenses were $4 million in the second quarter of fiscal 2008 andfiscal 2007.  These costs consistprimarily of approximately $3 million of management fees and associatedexpenses paid to our Sponsors and Highfields Capital Management L.P.(“Highfields”).  Also included in therelated party expenses are approximately $1 million of amortization expenserelated to the Separation Agreements as more fully described in Note 10 to theconsolidated financial statements.

 

*Interest Expense*—Interestexpense for the quarter decreased $19 million to $76 million as a result of alower average interest rate related to our variable-rate debt, and a $64million reduction in our total debt outstanding.

 

*Benefit for Income Taxes*—Theeffective tax rate was 38.6% for the second quarter of fiscal 2008 and 34.9%for the second quarter of fiscal 2007. As a result of our projected low incomebase, our effective rate is highly sensitive to changes caused by permanentdifferences (i.e. differences between book income and tax income that will notbe reversed in future periods).

 

*Six Months Ended August 2, 2008 Compared to the Six Months Ended August 4,2007*

 

*Net Sales*—Net salesincreased in the first six months of fiscal 2008 by $16 million, or 1.0%,over the first six months of fiscal 2007. Sales at our new stores opened since the second quarter of fiscal 2007provided incremental revenue of $61 million, while comparable store salesdecreased $45 million.

 

Comparable store sales decreased 2.8% infiscal 2008 compared to fiscal 2007, reflecting declines in customertransactions of 2.2%, average ticket of 0.4% and custom framing deliveries of0.2%. The fluctuation in the exchange rate between the United States and Canadiandollars positively impacted the average ticket change by 80 basis points.

 

*Cost of Sales and Occupancy Expense*—Costof sales and occupancy expense increased $28 million due primarily to a4.5% increase in the number of stores. As a percentage of sales, cost of sales and occupancy expense increased110 basis points. Merchandise margin decreased approximately 70 basis pointsprimarily related to a deleveraging of our distribution costs. Also, occupancycosts increased by 40 basis points, as a percentage of sales, due to adeleveraging of fixed occupancy costs on a decline in comparable store sales.

 

*Selling, General, and Administrative Expense*—Selling,general, and administrative expense increased $21 million to $518 millionfor the first six months of fiscal 2008 compared to $497 million in thefirst six months of fiscal 2007. As a percentage of net sales, selling,general, and administrative expense increased from 30.6% in the first sixmonths of fiscal 2007 to 31.5% in the first six months of fiscal 2008 primarilydue to planned in-store investments, decreased leverage associated with thedecline in comparable store sales and an increase in severance expense,partially offset by a reduction in advertising expense.

 

*Transaction Expenses –*Transaction expenses incurred during thefirst six months of fiscal 2007 related primarily to bonus arrangementsassociated with the change in control that were ratably recognized for a periodof one year following the Merger date, as well as other compensationexpenses arising from change in control agreements.

 

*Related Party Expenses*—Relatedparty expenses were $8 million for the first six months of fiscal 2008 andfiscal 2007 consisting primarily of $7 million of management fees andassociated expenses paid to our Sponsors and Highfields.

 

*Interest Expense*—Interestexpense decreased $37 million in the six months ended August 2, 2008compared to the six months ended August 4, 2007 primarily due to a loweraverage interest rate on our variable-rate debt and lower average debt levels.

 

*Benefit for Income Taxes*—Theeffective tax rate was 36.9% for the first six months of fiscal 2008 and 34.0%for the first six months of fiscal 2007. As a result of our projected lowincome tax base, our effective rate is highly sensitive to changes caused bypermanent differences (i.e. differences between book income and tax income thatwill not be reversed in future periods).

 

22

----

Table of Contents

 

**Liquidityand Capital Resources**

 

We require cash principally for day-to-day operations, to financecapital investments, inventory for new stores, and inventory replenishment forexisting stores, to service our outstanding debt and seasonal working capitalneeds. We expect that our available cash, cash flow generated from operatingactivities and funds available under our Asset-based revolving credit facilitywill be sufficient to fund planned capital expenditures, working capitalrequirements, debt repayments, debt service requirements and future growththroughout fiscal 2008.

 

*Cash Flow from Operating Activities*

 

Cash flow used in operating activities during the first six months offiscal 2008 was $98 million compared to $30 million during the first sixmonths of fiscal 2007. The $68 million change was primarily due to decreases inaccrued interest on our outstanding debt and increases in our income taxesreceivable.

 

Average inventory per Michaels store (including supporting distributioncenters) decreased 3.3% from August 4, 2007 to August 2, 2008primarily due to reduced Yarn inventories, ongoing benefits from enhancementsto our distribution network (referred to as our Hybrid distribution network),and lower inventory values associated with our direct sourcing efforts. Weexpect average inventory per Michaels store at the end of fiscal 2008 to beflat to higher by approximately 2% as compared to the end of fiscal 2007.

 

*Cash Flow used in Investing Activities*

 

Cash flow used in investing activities was primarily the result of thefollowing capital expenditure activities:

 
| ** **                                          | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------------------------|------------|--------------------------------|------------|
| ** **                                          | ** ** | **August 2,**             | ** ** | **August 4,** | ** ** |
| ** **                                          | ** ** | **2008 (1)**              | ** ** | **2007 (2)** | ** ** |
| ** **                                          | ** ** | **(in millions)**         | ** ** |
| New and relocated stores and stores not yet  opened |       | $                              | 15         |   | $ | 18 |   |
| Existing stores                                     |       | 7                              |       | 11 |   |
| Distribution system expansion (3)                   |       | 2                              |       | 13 |   |
| Information systems                                 |       | 14                             |       | 19 |   |
| Corporate and other                                 |       | 1                              |       | 1 |   |
|                                                |       | $                              | 39         |   | $ | 62 |   |

 

----

(1)          In thefirst six months of fiscal 2008, we incurred capital expenditures related tothe opening of 28 Michaels stores in addition to the relocation of six Michaelsstores and one Aaron Brothers store.

 

(2)          In thefirst six months of fiscal 2007, we incurred capital expenditures related tothe opening of 20 Michaels and two Aaron Brothers stores in addition to therelocation of seven Michaels stores.

 

(3)          The changein capital expenditures related to the distribution system expansion isprimarily related to 2007 expenditures associated with our Hybrid distributionnetwork.

 

 

*Cash Flow provided by Financing Activities*

 

Cash flows from financing activities are related primarily toborrowings and repayments 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 August 2, 2008, the borrowing base was $732 million with $440million 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 

 

23

----

Table of Contents

 

are carried at fair value on a recurring basis infinancial statements.  We adopted allrequirements of SFAS 157 as they relate to financial assets and liabilities on February 3,2008. See Note 7 to our consolidated financial statements for furtherinformation on the impact of this standard to financial assets and liabilities.The requirements related to nonfinancial assets and liabilities will be adoptedon February 1, 2009, as allowed by SFAS 157. We have not yet determinedthe impact, if any, on our consolidated financial statements for thesenonfinancial assets and liabilities.

 

In February 2007, the FASB issued SFAS No. 159, *The Fair Value Option for Financial Assets and Financial Liabilities*,which permits companies to measure certain financial instruments and otheritems at fair value (at specified measurement dates) that are not currentlyrequired to be measured at fair value. Any unrealized gains or lossesapplicable to those items measured at fair value shall be reported in earnings.The decision to apply fair value shall generally be made on an instrument byinstrument basis, is irrevocable, and is applied only to an entire instrument.We adopted SFAS 159 on February 3, 2008, and there was no impact on ourconsolidated financial statements as we did not choose to measure any eligiblefinancial assets or liabilities at fair value.

 

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 adopt SFAS 141R on February 1, 2009for acquisitions on or after this date.

 

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 detailsof credit-risk-related contingent features in hedged positions. The statementalso requires enhanced disclosures regarding how and why entities usederivative instruments, how derivative instruments and related hedged items areaccounted for in accordance with SFAS 133 and its related interpretation, andhow derivative instruments and related hedged items affect entity’s financialposition, financial performance, and cash flows. SFAS 161 is effective forfiscal years and interim periods beginning after November 15, 2008. Wewill adopt the new disclosure requirements of SFAS 161 in the first quarter of2009.

 

**Item 3.  Quantitative andQualitative Disclosures About Market Risk.**

 

Weare exposed to fluctuations in exchange rates between the US and Canadiandollars, as the functional currency of our Canadian subsidiary is the Canadiandollar.  During the second quarter offiscal 2008, we executed foreign currency forward contracts to mitigate theeffects of currency fluctuations, which we designated as a cash flow hedge. Theobjective of the forward contracts is to hedge intercompany payments forforecasted purchases of inventory by our Canadian subsidiary, which aredenominated in US dollars.  The term ofthis cash flow hedge extends through the first quarter of fiscal 2009.

 

Toachieve our objective and to minimize the risk of ineffectiveness, the notionalvalues represent a portion of our Canadian subsidiary’s forecasted intercompanypurchases.  Hedge ineffectiveness isrecorded in Other income, as required. For the quarter ended August 2,2008, the ineffective portion of the hedge was immaterial.

 

Forthe portion of the hedge that is effective, as defined, the change in fairvalue of that hedge will initially be recorded in Other comprehensiveincome.  As the underlying inventory issold to our customers, amounts will be reclassified from Other comprehensiveincome to Cost of sales and occupancy expense in the statement of operations.  The change in fair value of the hedge for thequarter ended August 2, 2008 was $1 million.

 

The table below provides the remaining quarterly notional values andthe average CAD/USD exchange rate associated with the hedge (dollars inmillions).

 
| **Period**      | ** ** | **CAD Amount** | ** ** | **USD Amount** | ** ** | **Rate** | ** ** |
|-----------------|------------|---------------------|------------|---------------------|------------|----------|------------|
| Quarter 3, 2008 |       | $                   | 16.6       |                | $          | 16.6     |       | 1.000 |   |
| Quarter 4, 2008 |       | 17.4                |       | 17.4                |       | 1.001    |       |
| Quarter 1, 2009 |       | 12.2                |       | 12.2                |       | 1.001    |       |
|            |       | $                   | 46.2       |                | $          | 46.2     |       | 1.001 |   |

 

24

----

Table of Contents

 

**Item 4.  Controls andProcedures.**

 

*Evaluation of Disclosure Controls and Procedures*

 

We maintain 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 officer 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 in Internal Control Over Financial Reporting*

 

There has not been any change in our internal control over financialreporting (as defined in Rules 13a-15(f) and 15d-15(f) aspromulgated by the SEC under the Securities Exchange Act of 1934) duringthe quarter covered by this Quarterly Report on Form 10-Q that materially affected, or is reasonably likely to materiallyaffect, our internal control over financial reporting.

 

25

----

Table of Contents

 

**MICHAELSSTORES, INC.**

**Part II—OTHERINFORMATION**

 

**Item 1.  LegalProceedings.**

 

Information regarding legal proceedings is incorporated herein byreference from Note 8 to our Consolidated Financial Statements.

 

**Item 6.  Exhibits.**

 

(a) Exhibits:

 
| **Exhibit  Number** | ** ** | **Description of Exhibit**                                                                                                                                                                                                                       |
|---------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1                |       | Separation  and Release Agreement, dated July 2, 2008, between Michaels  Stores, Inc. and Thomas M. Bazzone (previously filed as  Exhibit 10.1 to Registrant’s current report on Form 8-K filed on  July 9, 2008). |
|                |       |                                                                                                                                                                                                                                             |
| 10.2                |       | Letter  Agreement, dated July 17, 2008, between Michaels Stores, Inc. and  Elaine D. Crowley (previously filed as Exhibit 99.2 to Registrant’s  current report on Form 8-K filed July 24, 2008).                   |
|                |       |                                                                                                                                                                                                                                             |
| 31.1                |       | Certifications  of Brian C. Cornell 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).                                                                                                      |

 

26

----

Table of Contents

 

**MICHAELSSTORES, INC.**

**SIGNATURES**

 

Pursuant to the requirements of theSecurities Exchange Act of 1934, the Registrant has duly caused this report tobe signed on 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: September 9,  2008 | ** **             | ** ** |

 

27

----

Table of Contents

 

**INDEX TO EXHIBITS**

 
| **Exhibit  Number** | ** ** | **Description of Exhibit**                                                                                                                                                                                                                       |
|---------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1                |       | Separation  and Release Agreement, dated July 2, 2008, between Michaels  Stores, Inc. and Thomas M. Bazzone (previously filed as  Exhibit 10.1 to Registrant’s current report on Form 8-K filed on  July 9, 2008). |
|                |       |                                                                                                                                                                                                                                             |
| 10.2                |       | Letter  Agreement, dated July 17, 2008, between Michaels Stores, Inc. and  Elaine D. Crowley (previously filed as Exhibit 99.2 to Registrant’s  current report on Form 8-K filed July 24, 2008).                   |
|                |       |                                                                                                                                                                                                                                             |
| 31.1                |       | Certifications  of Brian C. Cornell 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).                                                                                                      |

 

28

----