Table of Contents

 

 

 

**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON,DC 20549**

** **

----

 

**FORM 10-Q**

 

**(MarkOne)**

** **

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

** **

**For thequarterly period ended October 31, 2009**

** **

**OR**

** **

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

 

**For the transition period from           to        **

** **

**Commissionfile number 001-09338**

 

----

 

**MICHAELSSTORES, INC.**

(Exact name ofregistrant as specified in its charter)

 

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

 

**8000Bent Branch Drive**

**Irving,Texas 75063**

 (Address of principal executive offices,including zip code)

 

**(972) 409-1300**

(Registrant’stelephone number, including area code)

 

----

 

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

 

Indicateby check mark whether the registrant has submitted electronically and posted onits corporate Web site, if any, every Interactive Data File required to besubmitted and posted pursuant to Rule 405 of Regulation S-T during thepreceding 12 months (or for such shorter period that the registrant wasrequired to submit and post such files). * Yes o No o

 

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

 

| 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

 

Asof November 28, 2009, 118,898,939 shares of the Registrant’s Common Stockwere outstanding.

 

----

*TheRegistrant has filed all reports required to be filed by Section 13 or 15(d) ofthe Securities Exchange Act of 1934, but is not required to file such reportsunder such sections.

 

 

 

----

 

**Table of Contents**

** **

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

 
| ** **       | **Part I—FINANCIAL INFORMATION**                                                                                                | ** ** | **3**  |
|------------------|-------------------------------------------------------------------------------------------------------------------------------------------|------------|--------|
| **Item 1.** | **Financial Statements**                                                                                                                  |       | **3**  |
|             | Consolidated Balance Sheets at October 31, 2009,  January 31, 2009, and November 1, 2008 (unaudited)                       |       | **3**  |
|             | Consolidated Statements of Operations for  the quarter and nine months ended October 31, 2009 and November 1,  2008 (unaudited) |       | **4**  |
|             | Consolidated Statements of Cash Flows for  the nine months ended October 31, 2009 and November 1, 2008  (unaudited)             |       | **5**  |
|             | Notes to Consolidated Financial Statements  (unaudited)                                                                                   |       | **6**  |
| **Item 2.** | **Management’s Discussion and Analysis of  Financial Condition and Results of Operations**                                           |       | **20** |
| **Item 3.** | **Quantitative and Qualitative Disclosures  About Market Risk**                                                                           |       | **25** |
| **Item 4.** | **Controls and Procedures**                                                                                                               |       | **25** |
| ** **       | **Part II—OTHER INFORMATION**                                                                                                   | ** ** | **26** |
| **Item 1.** | **Legal Proceedings**                                                                                                                     |       | **26** |
| **Item 1A.**     | **Risk Factors**                                                                                                                          | ** ** | **26** |
| **Item 6.** | **Exhibits**                                                                                                                              |       | **26** |
| **Signatures**   | ** **                                                                                                                                | ** ** | **27** |

 

2

----

**Table of Contents**

** **

**MICHAELS STORES, INC.**

**Part I—FINANCIAL INFORMATION**

 

**Item 1.  FinancialStatements.**

 

**MICHAELSSTORES, INC.**

**CONSOLIDATED BALANCE SHEETS**

**(Inmillions, except share data)**

**(Unaudited)**

 
| ** **                                                                                   | ** ** | **October 31,** | ** ** | **January 31,** | ** ** | **November 1,** | ** ** |
|----------------------------------------------------------------------------------------------|------------|-----------------|------------|-----------------|------------|-----------------|------------|
| ** **                                                                                   | ** ** | **2009**        | ** ** | **2009**        | ** ** | **2008**        | ** ** |
| **ASSETS**                                                                                   |       |            |       |            |       |            |       |
| **Current assets:**                                                                          |       |            |       |            |       |            |       |
| Cash  and equivalents                                                                        |       | $               | 49         |            | $          | 33              |       | $ | 92 |   |
| Merchandise  inventories                                                                     |       | 1,039           |       | 900             |       | 1,083           |       |
| Prepaid  expenses and other                                                                  |       | 83              |       | 73              |       | 83              |       |
| Deferred  income taxes                                                                       |       | 41              |       | 41              |       | 30              |       |
| Income  tax receivable                                                                       |       | 12              |       | 2               |       | 38              |       |
| Total  current assets                                                                        |       | 1,224           |       | 1,049           |       | 1,326           |       |
| **Property and equipment, at cost**                                                          |       | 1,236           |       | 1,214           |       | 1,204           |       |
| Less  accumulated depreciation                                                               |       | (911            | )          | (832            | )          | (802            | )          |
|                                                                                         |       | 325             |       | 382             |       | 402             |       |
| **Goodwill**                                                                                 |       | 94              |       | 94              |       | 94              |       |
| **Debt issuance costs, net of accumulated amortization of  $52, $39, and $35, respectively** |       | 73              |       | 86              |       | 90              |       |
| **Deferred income taxes**                                                                    |       | 16              |       | 12              |       | —          |       |
| **Other assets**                                                                             |       | 28              |       | 2               |       | —          |       |
|                                                                                         |       | 211             |       | 194             |       | 184             |       |
| Total  assets                                                                                |       | $               | 1,760      |            | $          | 1,625           |       | $ | 1,912 |   |
|                                                                                         |       |            |       |            |       |            |       |
| **LIABILITIES AND STOCKHOLDERS’  DEFICIT**                                              |       |            |       |            |       |            |       |
| **Current liabilities:**                                                                     |       |            |       |            |       |            |       |
| Accounts  payable                                                                            |       | $               | 274        |            | $          | 230             |       | $ | 274 |   |
| Accrued  liabilities and other                                                               |       | 353             |       | 275             |       | 336             |       |
| Current  portion of long-term debt                                                           |       | 139             |       | 173             |       | 432             |       |
| Income  taxes payable                                                                        |       | 1               |       | 2               |       | —          |       |
| Current  liabilities - discontinued operations                                               |       | 1               |       | 1               |       | 1               |       |
| Total  current liabilities                                                                   |       | 768             |       | 681             |       | 1,043           |       |
| **Long-term debt**                                                                           |       | 3,772           |       | 3,756           |       | 3,751           |       |
| **Deferred income taxes**                                                                    |       | —          |       | —          |       | 5               |       |
| **Other long-term liabilities**                                                              |       | 78              |       | 74              |       | 76              |       |
| **Long-term liabilities - discontinued operations**                                          |       | 1               |       | 1               |       | 1               |       |
| Total  long-term liabilities                                                                 |       | 3,851           |       | 3,831           |       | 3,833           |       |
|                                                                                         |       | 4,619           |       | 4,512           |       | 4,876           |       |
| **Commitments and contingencies**                                                            |       |            |       |            |       |            |       |
| **Stockholders’ deficit:**                                                              |       |            |       |            |       |            |       |
| Common  Stock, $0.10 par value, 220,000,000 shares authorized;                               |       |            |       |            |       |            |       |
| 118,387,229  shares issued and outstanding at October 31, 2009;                         |       |            |       |            |       |            |       |
| 118,376,402  shares issued and outstanding at January 31, 2009;                         |       |            |       |            |       |            |       |
| 118,376,402  shares issued and outstanding at November 1, 2008                          |       | 12              |       | 12              |       | 12              |       |
| Additional  paid-in capital                                                                  |       | 34              |       | 27              |       | 17              |       |
| Accumulated  deficit                                                                         |       | (2,911          | )          | (2,931          | )          | (2,996          | )          |
| Accumulated  other comprehensive income                                                      |       | 6               |       | 5               |       | 3               |       |
| Total  stockholders’ deficit                                                            |       | (2,859          | )          | (2,887          | )          | (2,964          | )          |
| Total  liabilities and stockholders’ deficit                                            |       | $               | 1,760      |            | $          | 1,625           |       | $ | 1,912 |   |

 

See accompanying notes to consolidated financialstatements.

 

3

----

**Table of Contents**

** **

**MICHAELS STORES, INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**(Inmillions)**

**(Unaudited)**

 
| ** **                                    | ** ** | **Quarter Ended**    | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------|------------|----------------------|------------|-----------------------|------------|
| ** **                                    | ** ** | **October 31,** | ** ** | **November 1,**  | ** ** | **October 31,** | ** ** | **November 1,** | ** ** |
| ** **                                    | ** ** | **2009**             | ** ** | **2008**              | ** ** | **2009** | ** ** | **2008** | ** ** |
| **Net sales**                                 |       | $                    | 929        |                  | $          | 906 |   | $ | 2,588 |   | $ | 2,549 |   |
| Cost  of sales and occupancy expense          |       | 582                  |       | 584                   |       | 1,640 |   | 1,623 |   |
| **Gross profit**                              |       | 347                  |       | 322                   |       | 948 |   | 926 |   |
| Selling,  general, and administrative expense |       | 259                  |       | 247                   |       | 737 |   | 765 |   |
| Related  party expenses                       |       | 4                    |       | 4                     |       | 11 |   | 12 |   |
| Store  pre-opening costs                      |       | —               |       | 3                     |       | 2 |   | 6 |   |
| **Operating income**                          |       | 84                   |       | 68                    |       | 198 |   | 143 |   |
| Interest  expense                             |       | 62                   |       | 77                    |       | 187 |   | 231 |   |
| Other  (income) and expense, net              |       | (1                   | )          | 3                     |       | (21 | ) | 3 |   |
| **Income (loss) before income taxes**         |       | 23                   |       | (12                   | )          | 32 |   | (91 | ) |
| Provision  (benefit) for income taxes         |       | 8                    |       | 8                     |       | 11 |   | (21 | ) |
| **Net income (loss)**                         |       | $                    | 15         |                  | $          | (20 | ) | $ | 21 |   | $ | (70 | ) |

 

See accompanyingnotes to consolidated financial statements.

 

4

----

**Table of Contents**

** **

**MICHAELSSTORES, INC.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(Inmillions)**

**(Unaudited)**

** **
| ** **                                           | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------|------------|-----------------------|------------|
| ** **                                           | ** ** | **October 31,**  | ** ** | **November 1,** | ** ** |
| ** **                                           | ** ** | **2009**              | ** ** | **2008** | ** ** |
| **Operating activities:**                            |       |                  |       |   |   |
| Net  income (loss)                                   |       | $                     | 21         |   | $ | (70 | ) |
| Adjustments:                                         |       |                  |       |   |   |
| Depreciation  and amortization                       |       | 86                    |       | 94 |   |
| Share-based  compensation                            |       | 6                     |       | 6 |   |
| Deferred  financing costs amortization               |       | 13                    |       | 13 |   |
| Accretion  of subordinated discount notes            |       | 33                    |       | 29 |   |
| Change  in fair value of interest rate cap           |       | (16                   | )          | — |   |
| Other                                                |       | —                |       | 1 |   |
| Changes  in assets and liabilities:                  |       |                  |       |   |   |
| Merchandise  inventories                             |       | (133                  | )          | (250 | ) |
| Prepaid  expenses and other                          |       | (14                   | )          | (5 | ) |
| Deferred  income taxes and other                     |       | (12                   | )          | 3 |   |
| Accounts  payable                                    |       | 54                    |       | 51 |   |
| Accrued  interest                                    |       | 33                    |       | (9 | ) |
| Accrued  liabilities and other                       |       | 42                    |       | 13 |   |
| Income  taxes receivable                             |       | (11                   | )          | (37 | ) |
| Other  long-term liabilities                         |       | 4                     |       | (5 | ) |
| Net  cash provided by (used in) operating activities |       | 106                   |       | (166 | ) |
|                                                 |       |                  |       |   |   |
| **Investing activities:**                            |       |                  |       |   |   |
| Additions  to property and equipment                 |       | (26                   | )          | (66 | ) |
| Net  cash used in investing activities               |       | (26                   | )          | (66 | ) |
|                                                 |       |                  |       |   |   |
| **Financing activities:**                            |       |                  |       |   |   |
| Borrowings  on asset-based revolving credit facility |       | 621                   |       | 749 |   |
| Payments  on asset-based revolving credit facility   |       | (655                  | )          | (439 | ) |
| Repayments  on senior secured term loan facility     |       | (18                   | )          | (18 | ) |
| Repurchase  of Common Stock                          |       | —                |       | (1 | ) |
| Payments  of capital leases                          |       | —                |       | (4 | ) |
| Change  in cash overdraft                            |       | (12                   | )          | 9 |   |
| Other                                                |       | —                |       | (1 | ) |
| Net  cash (used in) provided by financing activities |       | (64                   | )          | 295 |   |
|                                                 |       |                  |       |   |   |
| **Net increase in cash and equivalents**             |       | 16                    |       | 63 |   |
| **Cash and equivalents at beginning of period**      |       | 33                    |       | 29 |   |
| **Cash and equivalents at end of period**            |       | $                     | 49         |   | $ | 92 |   |
|                                                 |       |                  |       |   |   |
| **Supplemental Cash Flow Information:**              |       |                  |       |   |   |
| Cash  paid for interest.                             |       | $                     | 109        |   | $ | 199 |   |
| Cash  paid for income taxes                          |       | $                     | 22         |   | $ | 17 |   |

** **

See accompanying notes to consolidated financialstatements.

 

5

----

** **

 

 

Table of Contents

 

**MICHAELS STORES, INC.**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**For the Nine Months Ended October 31, 2009**

**(Unaudited)**

 

**Note 1.  Summaryof Significant Accounting Policies**

 

*Basis of Presentation*

 

The consolidatedfinancial statements include the accounts of Michaels Stores, Inc. and ourwholly-owned subsidiaries. All significant intercompany accounts andtransactions have been eliminated. All expressions of 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.

 

The accompanyingunaudited consolidated financial statements have been prepared in accordancewith U.S. generally accepted accounting principles for interim financialinformation and with the instructions to Form 10-Q and Article 10 ofRegulation S-X. Accordingly, they do not include all of the informationand notes required by generally accepted accounting principles for completefinancial statements. Therefore, these financial statements should be read inconjunction with our Annual Report on Form 10-K for the fiscal year ended January 31,2009. In accordance with the recently issued Accounting Standards Codification(“ASC” or “Codification”) 855, *SubsequentEvents*, we have evaluated all subsequent events through the issuanceof the financial statements, which occurred on December 4, 2009.

 

The balance sheet at January 31,2009 has been derived from the audited financial statements at that date butdoes not include all of the information and notes required by generallyaccepted accounting principles for complete financial statements. For further information,refer to the consolidated financial statements and notes thereto included inour Annual Report on Form 10-K for the fiscal year ended January 31,2009.

 

In the opinion ofmanagement, all adjustments (consisting of normal recurring accruals and otheritems, as disclosed) considered necessary for a fair presentation have beenincluded.

 

Because of the seasonalnature of our business, the results of operations for the three and nine monthsended October 31, 2009 are not indicative of the results to be expectedfor the entire year.

 

We report on the basis ofa 52 or 53-week fiscal year, which ends on the Saturday closest to January 31.All references herein to “fiscal 2009” relate to the 52 weeks ending January 30,2010, and all references to “fiscal 2008” relate to the 52 weeks ended January 31,2009. In addition, all references herein to “the third quarter of fiscal 2009”relate to the 13 weeks ended October 31, 2009 and all references to “thethird quarter of fiscal 2008” relate to the 13 weeks ended November 1,2008. Finally, all references to “the nine months ended October 31, 2009”relate to the 39 weeks ended October 31, 2009, and “the nine months ended November 1,2008” relate to the 39 weeks ended November 1, 2008.

 

*Recent Accounting Pronouncements*

 

In June 2009, theFinancial Accounting Standards Board (“FASB”) issued ASC 105, *Generally Accepted Accounting Principles.*ASC 105establishes the Codification as the source of authoritative accountingprinciples recognized by the FASB to be applied by non-governmental entities inthe preparation of financial statements in conformity with generally acceptedaccounting principles. Rules and interpretive releases of the SEC underauthority of federal securities laws are also sources of authoritative guidancefor SEC registrants. All guidance contained in the Codification carries anequal level of authority. The U.S. GAAP hierarchy will be modified to includetwo levels of GAAP: authoritative and nonauthoritative. This statement iseffective for financial statements issued for interim and annual periods endedafter September 15, 2009. We have included references to authoritativeaccounting literature in accordance with the Codification. There are no otherchanges to the content of the Company’s consolidated financial statements as aresult of the adoption.

 

In September 2006,the FASB issued ASC 820, *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.  ASC 820 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 ASC 820 for nonfinancial assets andliabilities; however, ASC 820 became effective for fiscal years beginning afterNovember 15, 2007 for financial assets and liabilities, as well as for anyother assets and liabilities that are carried at fair value on a recurringbasis in financial statements.  On February 3,2008, we adopted the provisions of ASC 820 related to financial assets 

 

6

----

Table of Contents

 

and liabilities and on February 1, 2009, weadopted the provisions related to nonfinancial assets and liabilities that arenot required or permitted to be measured at fair value on a recurring basis.These adoptions had no impact on our consolidated financial statements.   See Note 6 for further information regardingfair value measurements. Additionally, in April 2009, the FASB issued ASC825, *Interim Disclosures About Fair Value of FinancialInstruments,* which provides additional guidance and requiresadditional disclosures regarding determining and reporting fair values forcertain assets and liabilities. We adopted ASC 825 in the second quarter offiscal 2009 as reflected in Note 3.

 

In December 2007,the FASB issued ASC 805, *BusinessCombinations*toestablish principles and requirements for the recognition and measurement ofassets, liabilities and goodwill, including the requirement that mosttransaction costs and restructuring costs be expensed. In addition, this ASCrequires disclosures to enable users to evaluate the nature and financialeffects of the business combination. ASC 805 is effective for businesscombinations for which the acquisition date is on or after the beginning of thefirst annual reporting period beginning on or after December 15, 2008. Wewill apply the provisions of ASC 805 to any business combinations occurring onor after February 1, 2009.

 

In March 2008, theFASB issued ASC 815, *Disclosures aboutDerivative Instruments and Hedging Activities*. ASC 815 requiresqualitative disclosures about objectives and strategies for using derivatives,quantitative data about the fair value of and gains and losses on derivativecontracts, and details of credit-risk-related contingent features in hedgedpositions. The statement also requires enhanced disclosures regarding how andwhy entities use derivative instruments, how derivative instruments and relatedhedged items are accounted for, and how derivative instruments and relatedhedged items affect entity’s financial position, financial performance, andcash flows. ASC 815 is effective for fiscal years and interim periods beginningafter November 15, 2008. We adopted the new disclosure requirements of ASC815 in the first quarter of 2009 as reflected in Note 5.

 

In May 2009, theFASB issued ASC 855, *Subsequent Events*.ASC 855 is intended to establish general standards of accounting for anddisclosure of events that occur after the balance sheet date but before thefinancial statements are issued or available to be issued. The statement setsforth the period after the balance sheet date during which management of areporting entity should evaluate events or transactions that may occur forpotential recognition or disclosure in the financial statements, thecircumstances under which an entity should recognize events or transactionsoccurring after the balance sheet date in its financial statements, and thedisclosures that an entity should make about events or transactions thatoccurred after the balance sheet date. ASC 855 is effective for fiscal yearsand interim periods ending after June 15, 2009. We adopted ASC 855 duringthe second quarter of fiscal 2009, but the impact of the adoption in futureperiods will depend on the nature and the extent of transactions that occursubsequent to our interim and annual reporting periods.

 

**Note 2.  Share-BasedCompensation**

 

The 2006 Equity Incentive Plan (“2006Plan”) provides for the grant of share-based awards exercisable for up to 14.2million shares of Common Stock. On June 3,2009, the Company announced an offer to exchange certain employee stock optionsissued under the 2006 Plan (“Exchange Offer”) for new stock options granted ona one-for-one basis.  On July 2,2009, employees exchanged 8.0 million outstanding stock options under thefollowing terms:

 

(1) outstanding vested or unvestedoptions to purchase shares of Common Stock that had an exercise price per shareof $30.00, $37.50, $45.00 or $52.50 for an equal number of new options topurchase shares of Common Stock with an exercise price equal to $7.50 and a newfive-year vesting schedule that commenced on July 2, 2009 and aneight-year term; and

 

(2) outstanding options that had anexercise price per share of $15.00 and $22.50 were exchanged for an equalnumber of new options with the same exercise price. A portion of the newoptions will be vested based on the period of time that the exchanged optionshad been held in relation to the total term of the option and have identicalterms and conditions to the previously issued options, and the remainingoptions have a new five-year vesting schedule that commenced on July 2,2009 and an eight-year term.

 

Thefair value for options granted under ASC 718 was estimated at the date ofgrant using the Black-Scholes-Merton option valuation model. Prior yearassumptions are not reflected due to all options being cancelled as part of theExchange Offer and new options granted. The following assumptions were used toestimate the fair value of options granted during the quarter ended October 31,2009:

 
| **Assumptions****(1)**                              | ** ** | ** **    | ** ** |
|-----------------------------------------------------|------------|---------------|------------|
| Risk-free  interest rates (2)                       |       | 2.4% - 3.3%   |       |
| Expected  dividend yield                            |       | 0.0%          |       |
| Expected  volatility rates of our Common Stock (3)  |       | 41.2% - 45.9% |       |
| Expected  life of options (in years) (4)            |       | 5.5 - 8.0     |       |
| Weighted  average fair value of options granted (5) |       | $             | 0.93       |   |
|                                                     |            |               |            |  |

 

7

----

Table of Contents

 

----

(1)          Forfeitures were estimated based onhistorical experience and anticipated events.

 

(2)          Based on constant maturity interest ratesfor U.S. Treasury instruments with terms consistent with the expected lives ofthe awards.

 

(3)          We considered both the historical volatilityas well as implied volatilities from the exchange-traded options on the commonstock from a peer group of companies.

 

(4)          Expected lives were based on an analysisof historical exercise and post-vesting employment termination behavior.

 

(5)          In determining the fairvalue of our common stock, the Board of Directors considers factors that itbelieves are material to the valuation process including the Company’s actualand projected financial results, the principal amount of the Company’sindebtedness and formal valuations of the Company. Valuations completed rely onprojections of our future performance, estimates of our weighted average costof capital, and metrics based on the performance of a peer group of similarcompanies, including valuation multiples and stock price volatility. As of thedate of the Exchange Offer, the fair value of our Common Stock was determinedto be $4.27.

 

Asof October 31, 2009, there were 9.8 million stock option awardsoutstanding and up to 3.8 million shares of Common Stock remaining availablefor grant under the 2006 Plan. The table below sets forth a summary of stockoption activity for the nine months ended October 31, 2009.

 
| ** **                                       | ** ** | **Number of  Shares  (in millions)** | ** ** | **Weighted-Average  Exercise Price** | ** ** | **Weighted-Average  Remaining  Contractual Term  (in years)** | ** ** |
|--------------------------------------------------|------------|--------------------------------------|------------|--------------------------------------|------------|---------------------------------------------------------------|------------|
|                                             |       |                                 |       |                                 |       |                                                          |       |
| Outstanding  at January 31, 2009            |       | 10.1                                 |       | $                                    | 26.25      |                                                          |       |   |
| Grants  (1)                                      |       | 11.3                                 |       | 15.55                                |       |                                                          |       |
| Canceled/Forfeited  (1)                          |       | (11.6                                | )          | 25.22                                |       |                                                          |       |
| Outstanding  at October 31, 2009            |       | 9.8                                  |       | $                                    | 15.04      |                                                          | 7.3        |   |
| Vested  and Exercisable at October 31, 2009 |       | 1.7                                  |       | $                                    | 18.75      |                                                          | 5.7        |   |

 

----

(1)          The number of options granted andcanceled/forfeited includes options granted and canceled in connection with theExchange Offer.

 

In addition, as of October 31,2009, there were a total of 589,204 shares of restricted stock outstanding, ofwhich 77,494 are vested.

 

As of October 31,2009, the total fair value of vested options, subsequent to the Exchange Offer,was $1.4 million. As of October 31, 2009, there were 8.1 million nonvestedoptions with a weighted average fair value of $0.96 per share.

 

Share-based compensationexpense was $2 million for the third quarter of each of fiscal 2009 and 2008,and $6 million for each of the nine months ended October 31, 2009 and November 1,2008. As a result of the Exchange Offer, share-based compensation expense isexpected to increase by $2.1 million over the life of the options due to theincremental value ascribed to the new options that were issued at a lowerexercise price. Share-based compensation expense for fiscal 2009 is expected todecrease by $0.5 million as a result of the longer vesting period of the newoptions compared to the vesting period of the original grants. During the thirdquarter of fiscal 2009, share-based compensation expense decreased by $0.2million as a result of the Exchange Offer.

 

As of October 31,2009, compensation cost not yet recognized related to nonvested awards totaled$19.9 million and is expected to be recognized over a weighted average periodof 4.7 years. To the extent the actual forfeiture rate is different from whatwe have anticipated, share-based compensation related to these awards will bedifferent from our expectations.

 

8

----

Table of Contents

 

**Note 3.  Debt**

 

Ouroutstanding debt is detailed in the table below. We were in compliance with theterms and conditions of all debt agreements for all periods presented.

 
| ** **                             | ** ** | **October 31, 2009** | ** ** | **January 31, 2009** | ** ** | **November 1, 2008** | ** ** | **Interest Rate** | ** ** |
|----------------------------------------|------------|---------------------------|------------|---------------------------|------------|---------------------------|------------|-------------------|------------|
| ** **                             | ** ** | **(in millions)**         | ** ** | ** **                | ** ** |
|                                   |       |                      |       |                      |       |                      |       |              |       |
| Senior  secured term loan              |       | $                         | 2,280      |                      | $          | 2,297                     |       | $                 | 2,303      |   | Variable |   |
| Senior  notes                          |       | 750                       |       | 750                       |       | 750                       |       | 10.000%           |       |
| Senior  subordinated notes             |       | 400                       |       | 400                       |       | 400                       |       | 11.375%           |       |
| Subordinated  discount notes           |       | 365                       |       | 332                       |       | 322                       |       | 13.000%           |       |
| Asset-based  revolving credit facility |       | 114                       |       | 148                       |       | 407                       |       | Variable          |       |
| Other                                  |       | 2                         |       | 2                         |       | 1                         |       | Variable          |       |
| Total  debt                            |       | 3,911                     |       | 3,929                     |       | 4,183                     |       |              |       |
| Less  current portion                  |       | 139                       |       | 173                       |       | 432                       |       |              |       |
| Long-term  debt                        |       | $                         | 3,772      |                      | $          | 3,756                     |       | $                 | 3,751      |   |   |   |

 

*Asset-based revolving creditfacility*

 

Oursenior secured asset-based revolving credit facility, which we entered into on October 31,2006, with Banc of America, N.A. and other lenders (the “Asset-based revolvingcredit facility”) provides senior secured financing of up to $1.0 billion,subject to a borrowing base as described in our Annual Report on Form 10-K.As of October 31, 2009, the borrowing base was $963 million with $799million of unused availability.

 

*Senior secured term loan facility*

 

Borrowingsunder our senior secured term loan facility, which we entered into on October 31,2006, with Deutsche Bank A.G. New York Branch and other lenders (the “Seniorsecured term loan facility”) bear interest at a rate per annum equal to, at ouroption, either (a) a base rate determined by reference to the higher of (1) theprime rate of Deutsche Bank and (2) the federal funds effective rateplus 1⁄2 of 1% or (b) a LIBOR rate, subject to certain adjustments, ineach case plus an applicable margin. The applicable margin is subject todownward adjustment based on the ratings threshold set forth in the Seniorsecured term loan facility agreement. At October 31, 2009, the margin was1.25% with respect to base rate borrowings and 2.25% with respect to LIBORborrowings.

 

OnNovember 5, 2009, we entered into an amendment to the credit agreement tothe Senior secured term loan facility. See Note 11 for additional information.

 

Thetable below provides the carrying and fair values of our senior andsubordinated term loan and notes. The fair value of these debt instruments wasdetermined based on quoted market prices.

 
| ** **                   | ** ** | **Carrying Value** | ** ** | **Fair Value** | ** ** |
|------------------------------|------------|--------------------|------------|----------------|------------|
| ** **                   | ** ** | **(in millions)**  | ** ** |
| Senior  secured term loan    |       | $                  | 2,280      |           | $          | 2,045 |   |
| Senior  notes                |       | 750                |       | 751            |       |
| Senior  subordinated notes   |       | 400                |       | 386            |       |
| Subordinated  discount notes |       | 365                |       | 265            |       |
|                              |            |                    |            |                |            |  |  |

 

9

----

Table of Contents

 

**Note 4.  ComprehensiveIncome (Loss)**

 

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

 
| ** **                                         | ** ** | **Quarter Ended**         | ** ** | **Nine Months Ended**     | ** ** |
|----------------------------------------------------|------------|---------------------------|------------|---------------------------|------------|
| ** **                                         | ** ** | **October 31, 2009** | ** ** | **November 1, 2008** | ** ** | **October 31, 2009** | ** ** | **November 1, 2008** | ** ** |
| ** **                                         | ** ** | **(in millions)**         | ** ** |
|                                               |       |                      |       |                      |       |   |   |   |   |
| Net  income (loss)                                 |       | $                         | 15         |                      | $          | (20 | ) | $ | 21 |   | $ | (70 | ) |
| Other  comprehensive income (loss):                |       |                      |       |                      |       |   |   |   |   |
| Derivative  (loss) gain                            |       | (1                        | )          | 5                         |       | (4 | ) | 7 |   |
| Foreign  currency translation adjustment and other |       | —                    |       | (12                       | )          | 5 |   | (14 | ) |
| Comprehensive  income (loss)                       |       | $                         | 14         |                      | $          | (27 | ) | $ | 22 |   | $ | (77 | ) |

 

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

 
| **(in millions)**                                      | ** ** | **Foreign Currency  Translation  and Other** | ** ** | **Derivative  Instruments** | ** ** | **Total** | ** ** |
|--------------------------------------------------------|------------|----------------------------------------------|------------|-----------------------------|------------|-----------|------------|
| Balance  at January 31, 2009                      |       | $                                            | 1          |                        | $          | 4         |       | $ | 5 |   |
| Foreign  currency translation adjustment               |       | 5                                            |       | —                      |       | 5         |       |
| Reclassification  of hedge instruments to earnings (1) |       | —                                       |       | (4                          | )          | (4        | )          |
| Balance  at October 31, 2009                      |       | $                                            | 6          |                        | $          | —    |       | $ | 6 |   |

 

----

(1)          Thereclassification of hedge instruments to earnings is related to our foreigncurrency forward contracts that extended through the first quarter of fiscal2009.

** **

**Note 5.  DerivativeInstruments**

 

Weare exposed to fluctuations in interest rates on our Senior secured term loan.During the first quarter of fiscal 2009, we purchased an interest rate cap tomitigate the effects of interest rate fluctuations. The objective of the cap isto hedge the variability of cash flows associated with our interest payments onour Senior secured term loan that result from fluctuations in the three-monthLIBOR rate and does not qualify for hedge accounting under ASC 815. The caplimits our interest exposure on a notional value of $2.0 billion to the lesserof the three-month LIBOR rate or 7.0%. The term of the cap extends to the first quarter of fiscal 2015. Thefair value of the cap as of October 31, 2009 was $25 million and isincluded in Other assets on the Consolidated Balance Sheet. The change in fairvalue of the cap for the quarter and nine months ended October 31, 2009,resulted in an income of $1 million and $16 million, respectively, and isrecorded in Other (income) and expense, net in the Consolidated Statements ofOperations.

 

**Note 6. Fair Value Measurements**

 

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

 

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

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

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

* *

The following table presents net financial assets (liabilities)accounted for at fair value on a recurring basis as of October 31, 2009(in millions):

 
| ** **         | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** | **Total** | ** ** |
|--------------------|------------|-------------|------------|-------------|------------|-------------|------------|-----------|------------|
| Cash  equivalents  |       | $           | 5          |        | $          | —      |       | $         | —     |   | $ | 5 |   |
| Interest  Rate Cap |       | —      |       | 25          |       | —      |       | 25        |       |
|                    |            |             |            |             |            |             |            |           |            |  |  |  |  |

 

10

----

Tableof Contents

 

Cashequivalents consist ofhighly liquid investments, with a maturity of 90 days or less at the date ofpurchase, including U.S. Treasury bills, various government obligations, andmoney market funds.  We carry cashequivalents at cost, which approximates fair value.

 

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

 

We generally apply fairvalue techniques on a non-recurring basis for the establishment of potentialimpairment loss related to goodwill pursuant to ASC 350 and determining thefair value of long-lived assets pursuant to ASC 360.

 

**Note 7.  Commitmentsand Contingencies**

** **

Weare involved in ongoing legal and regulatory proceedings.  Other than those described in the followingparagraphs, there were no material changes to our disclosures of commitmentsand contingencies from our Annual Report on Form 10-K for the fiscal yearended January 31, 2009 and our Quarterly Reports on Form 10-Q for thequarterly periods ended May 2, 2009 and August 1, 2009.

 

*Employee Class Action Claims*

 

*Cotton Claim*

* *

James Cotton, a formerstore manager of Michaels of Canada, ULC, our wholly-owned subsidiary, andSuzette Kennedy, a former assistant manager of Michaels of Canada, commenced apurported class proceeding, filed in the Ontario Superior Court of Justice,against Michaels of Canada and Michaels Stores, Inc. on behalf ofthemselves and current and former employees employed in Canada, alleging thatthe defendants violated employment standards legislation in Ontario and otherprovinces and territories of Canada by failing to pay overtime compensation asrequired by that legislation and that this conduct was in breach of thecontracts of employment of those individuals. Motions for class certification and responses thereto were filed in 2005and 2006.  The parties subsequentlyagreed that the case should not proceed as a class action and reached atentative settlement of Cotton’s and Kennedy’s individual claims.  In August 2009 the Court entered an orderdismissing the class action subject to notice to purported class members.  The individual cases were settled and suchsettlements did not have a material effect on our business.  A Notice of Discontinuance dismissing thematter was filed on November 18, 2009.

 

*DeJoseph Claim*

 

John DeJoseph, a formerMichaels store manager in Valencia, California, commenced a purported classaction proceeding against Michaels Stores, Inc. on behalf of himself andcurrent and former salaried store managers employed in California from May 10,2002 to the present, filed in the Superior Court of California, County of LosAngeles, alleging that Michaels failed to pay overtime wages, provide mealperiods, accurately record hours worked, provide itemized employee wagestatements, that Michaels unlawfully made deductions from employees’ earningsand additionally alleging that the foregoing conduct was in breach ofCalifornia’s unfair competition law. After originally certifying a portion ofthe matter as a class action, the Court reconsidered the matter andde-certified the class in March 2009. The case proceeded with the threeindividual plaintiffs and these cases have been settled and such settlementsdid not have a material effect on our business.

 

**Note 8.  Segments**

 

We consider our Michaelsand Aaron Brothers operations to be our operating segments for purposes ofdetermining reportable segments based on the criteria of ASC 280, *Disclosures About Segments of an Enterprise and Related Information*.We determined that our Michaels and Aaron Brothers operating segments havesimilar economic characteristics and meet the aggregation criteria set forth inASC 280. Therefore, we combine both operating segments into one reportingsegment.

 

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

 

11

----

Tableof Contents

 
| ** **                         | ** ** | **Quarter Ended**         | ** ** | **Nine Months Ended**     | ** ** |
|------------------------------------|------------|---------------------------|------------|---------------------------|------------|
| ** **                         | ** ** | **October 31, 2009** | ** ** | **November 1, 2008** | ** ** | **October 31, 2009** | ** ** | **November 1, 2008** | ** ** |
| ** **                         | ** ** | **(in millions)**         | ** ** |
|                               |       |                      |       |                      |       |   |   |   |   |
| Income  (loss) before income taxes |       | $                         | 23         |                      | $          | (12 | ) | $ | 32 |   | $ | (91 | ) |
| Interest  expense                  |       | 62                        |       | 77                        |       | 187 |   | 231 |   |
| Depreciation  and amortization     |       | 28                        |       | 31                        |       | 86 |   | 94 |   |
| EBITDA                             |       | $                         | 113        |                      | $          | 96 |   | $ | 305 |   | $ | 234 |   |

 

Oursales and assets by country are as follows:

 
| ** **                                   | ** ** | **Net Sales**     | ** ** | **Total Assets** | ** ** |
|----------------------------------------------|------------|-------------------|------------|------------------|------------|
| ** **                                   | ** ** | **(in millions)** | ** ** |
| **Quarter ended October 31, 2009:**     |       |              |       |             |       |
| United  States                               |       | $                 | 850        |             | $          | 1,657 |   |
| Canada                                       |       | 79                |       | 103              |       |
| Consolidated  Total                          |       | $                 | 929        |             | $          | 1,760 |   |
|                                         |       |              |       |             |       |
| **Quarter ended November 1, 2008:**     |       |              |       |             |       |
| United  States                               |       | $                 | 833        |             | $          | 1,801 |   |
| Canada                                       |       | 73                |       | 111              |       |
| Consolidated  Total                          |       | $                 | 906        |             | $          | 1,912 |   |
|                                         |       |              |       |             |       |
| **Nine Months ended October 31, 2009:** |       |              |       |             |       |
| United  States                               |       | $                 | 2,387      |             | $          | 1,657 |   |
| Canada                                       |       | 201               |       | 103              |       |
| Consolidated  Total                          |       | $                 | 2,588      |             | $          | 1,760 |   |
|                                         |       |              |       |             |       |
| **Nine Months ended November 1, 2008:** |       |              |       |             |       |
| United  States                               |       | $                 | 2,342      |             | $          | 1,801 |   |
| Canada                                       |       | 207               |       | 111              |       |
| Consolidated  Total                          |       | $                 | 2,549      |             | $          | 1,912 |   |

 

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

 

**Note 9.  RelatedParty Transactions**

 

Aspreviously disclosed, on October 31, 2006, substantially all of the CommonStock of Michaels Stores, Inc. was acquired through a merger transaction(the “Merger”) by affiliates of Bain Capital Partners, LLC and The BlackstoneGroup. We pay annual management fees to Bain Capital Partners, LLC and TheBlackstone Group (collectively, together with their applicable affiliates, the “Sponsors”)and Highfields Capital Management LP in the amount of $12 million and $1million, respectively. We recognized $4 million and $3 million of expenserelated to annual management fees during the third quarter of fiscal 2009 andfiscal 2008, respectively, and $11 million and $10 million during the ninemonths ended October 31, 2009 and November 1, 2008, respectively.These expenses are included in related party expenses on the ConsolidatedStatements of Operations.

 

BainCapital owns a majority equity position in an external vendor we utilize toprint our circular advertisements. Payments associated with this vendor duringthe third quarter of each of fiscal 2009 and fiscal 2008 were $10 million.Payments for the nine months ended October 31, 2009 and November 1,2008 were $24 million and $26 million, respectively. These expenses areincluded in selling, general and administrative expense on the ConsolidatedStatements of Operations.

 

BainCapital owns a majority equity position in an external vendor we have utilizedfor non-merchandise supplies. Payments associated with this vendor during thethird quarter of fiscal 2008 were $1 million. Payments for the nine monthsended October 31, 2009 and November 1, 2008 were $1 million and $2million, respectively. These expenses are included in selling, general andadministrative expense on the Consolidated Statements of Operations.

 

12

----

Tableof Contents

 

TheBlackstone Group owns a majority equity position in an external vendor weutilize to count our store inventory. Payments associated with this vendorduring the third quarter of fiscal 2009 and 2008 were $3 million and $2million, respectively. Payments for the nine months ended October 31, 2009and November 1, 2008 were $7 million and $5 million, respectively. Theseexpenses are included in selling, general and administrative expense on theConsolidated Statements of Operations.

 

Duringfiscal 2008, we began utilizing an external vendor for waste managementservices that is partially owned by The Blackstone Group. Payments associatedwith this vendor during the third quarter of fiscal 2009 and fiscal 2008 were$2 million and $1 million, respectively, and $5 million and $2 million for thenine months ended October 31, 2009 and November 1, 2008,respectively. These expenses are included in selling, general andadministrative expense on the Consolidated Statements of Operations.

 

During the first quarterof fiscal 2008, The Blackstone Group acquired an equity position in an externalvendor we utilize for all of the impulse candy-type items in our stores.  Payments associated with this vendor duringthe third quarter of each of fiscal 2009 and fiscal 2008 were $4 million. Payments forthe nine months ended October 31, 2009 and November 1, 2008 were $13million and $12 million, respectively. These expenses are recognized in cost of sales asthe sales are incurred.

 

The Blackstone Group ownsa partial equity position in an external vendor we utilize for newspaperadvertisements. Payments associated with this vendor were$1 million during each of the nine months ended October 31, 2009 and November 1,2008. These expenses are included in selling, general and administrativeexpense on the Consolidated Statements of Operations.

 

Ourcurrent directors are affiliates of Bain Capital or The Blackstone Group.  As such, some or all of our directors mayhave an indirect material interest in payments with respect to debt securitiesof the Company that have been purchased by affiliates of Bain Capital and TheBlackstone Group.  Such affiliatesbeneficially own approximately $239 million face amount of ourSubordinated Discount Notes due 2016.

 

TheCompany periodically provides officers of Michaels Stores, Inc. and itssubsidiaries the opportunity to purchase shares of our Common Stock. There wereno shares sold to officers during the first nine months of each of fiscal 2009and fiscal 2008. Also, during the third quarter and first nine months of fiscal2008, we repurchased 6,000 and 111,334 shares, respectively, from officers whoare no longer with the Company. There have been no shares repurchased duringthe first nine months of fiscal 2009.

 

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

 

**Note 10. Condensed Consolidating Financial Information**

 

All obligations ofMichaels Stores, Inc. under the Senior notes, Senior subordinated notes,Subordinated discount notes, Senior secured term loan, and Asset-basedrevolving credit facility are guaranteed by each of our subsidiaries other thanAaron Brothers Card Services, LLC and Canada Artistree, Inc. As of October 31,2009, the financial statements of Aaron Brothers Card Services, LLC and CanadaArtistree, Inc. were immaterial. Each subsidiary guarantor is100% owned by the parent and all guarantees are joint and several.

 

The following condensedconsolidating financial information represents the financial information ofMichaels Stores, Inc. and its wholly-owned subsidiary guarantors, preparedon the equity basis of accounting.  The information is presented inaccordance with the requirements of Rule 3-10 under the SEC’s RegulationS-X.  The financial information may not necessarily be indicative ofresults of operations, cash flows, or financial position had the subsidiaryguarantors operated as independent entities.

 

13

----

Tableof Contents

 

**Supplemental Condensed Consolidating Balance Sheet**

 
| ** **                                                 | ** ** | **October 31, 2009** | ** ** |
|------------------------------------------------------------|------------|---------------------------|------------|
| ** **                                                 | ** ** | **Parent  Company**       | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                 | ** ** | **(in millions)**         | ** ** |
| **ASSETS**                                                 |       |                      |       |   |   |   |   |   |   |
| **Current assets:**                                        |       |                      |       |   |   |   |   |   |   |
| Cash  and equivalents                                      |       | $                         | 37         |   | $ | 12 |   | $ | — |   | $ | 49 |   |
| Merchandise  inventories                                   |       | 732                       |       | 307 |   | — |   | 1,039 |   |
| Intercompany  receivables                                  |       | —                    |       | 591 |   | (591 | ) | — |   |
| Other                                                      |       | 85                        |       | 51 |   | — |   | 136 |   |
| Total  current assets                                      |       | 854                       |       | 961 |   | (591 | ) | 1,224 |   |
| **Property and equipment, net**                            |       | 244                       |       | 81 |   | — |   | 325 |   |
| **Goodwill, net**                                          |       | 94                        |       | — |   | — |   | 94 |   |
| **Investment in subsidiaries**                             |       | 663                       |       | — |   | (663 | ) | — |   |
| **Other assets**                                           |       | 96                        |       | 21 |   | — |   | 117 |   |
| Total  assets                                              |       | $                         | 1,951      |   | $ | 1,063 |   | $ | (1,254 | ) | $ | 1,760 |   |
|                                                       |       |                      |       |   |   |   |   |   |   |
| **LIABILITIES AND STOCKHOLDERS’  (DEFICIT) EQUITY**   |       |                      |       |   |   |   |   |   |   |
| **Current liabilities:**                                   |       |                      |       |   |   |   |   |   |   |
| Accounts  payable                                          |       | $                         | 22         |   | $ | 252 |   | $ | — |   | $ | 274 |   |
| Accrued  liabilities and other                             |       | 267                       |       | 86 |   | — |   | 353 |   |
| Current  portion of long-term debt                         |       | 139                       |       | — |   | — |   | 139 |   |
| Intercompany  payable                                      |       | 591                       |       | — |   | (591 | ) | — |   |
| Other                                                      |       | (34                       | )          | 36 |   | — |   | 2 |   |
| Total  current liabilities                                 |       | 985                       |       | 374 |   | (591 | ) | 768 |   |
| **Long-term debt**                                         |       | 3,772                     |       | — |   | — |   | 3,772 |   |
| **Other long-term liabilities**                            |       | 53                        |       | 26 |   | — |   | 79 |   |
| **Total stockholders’ (deficit) equity**              |       | (2,859                    | )          | 663 |   | (663 | ) | (2,859 | ) |
| Total  liabilities and stockholders’ (deficit) equity |       | $                         | 1,951      |   | $ | 1,063 |   | $ | (1,254 | ) | $ | 1,760 |   |

 

14

----

Tableof Contents

 

**Supplemental Condensed Consolidating Balance Sheet**

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

 

15

----

Table of Contents

** **

**Supplemental Condensed Consolidating Balance Sheet**

** **
| ** **                                                 | ** ** | **November 1, 2008** | ** ** |
|------------------------------------------------------------|------------|---------------------------|------------|
| ** **                                                 | ** ** | **Parent  Company**       | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                 | ** ** | **(in  millions)**        |       |
| **ASSETS**                                                 |       |                      |       |   |   |   |   |   |   |
| **Current assets:**                                        |       |                      |       |   |   |   |   |   |   |
| Cash  and equivalents                                      |       | $                         | 86         |   | $ | 6 |   | $ | — |   | $ | 92 |   |
| Merchandise  inventories                                   |       | 776                       |       | 307 |   | — |   | 1,083 |   |
| Intercompany  receivables                                  |       | —                    |       | 410 |   | (410 | ) | — |   |
| Other                                                      |       | 97                        |       | 54 |   | — |   | 151 |   |
| Total  current assets                                      |       | 959                       |       | 777 |   | (410 | ) | 1,326 |   |
| **Property and equipment, net**                            |       | 294                       |       | 108 |   | — |   | 402 |   |
| **Goodwill, net**                                          |       | 94                        |       | — |   | — |   | 94 |   |
| **Investment in subsidiaries**                             |       | 517                       |       | — |   | (517 | ) | — |   |
| **Other assets**                                           |       | 76                        |       | 14 |   | — |   | 90 |   |
| Total  assets                                              |       | $                         | 1,940      |   | $ | 899 |   | $ | (927 | ) | $ | 1,912 |   |
|                                                       |       |                      |       |   |   |   |   |   |   |
| **LIABILITIES AND STOCKHOLDERS’  (DEFICIT) EQUITY**   |       |                      |       |   |   |   |   |   |   |
| **Current liabilities:**                                   |       |                      |       |   |   |   |   |   |   |
| Accounts  payable                                          |       | $                         | 30         |   | $ | 244 |   | $ | — |   | $ | 274 |   |
| Accrued  liabilities and other                             |       | 258                       |       | 78 |   | — |   | 336 |   |
| Current  portion of long-term debt                         |       | 432                       |       | — |   | — |   | 432 |   |
| Intercompany  payable                                      |       | 410                       |       | — |   | (410 | ) | — |   |
| Other                                                      |       | (39                       | )          | 40 |   | — |   | 1 |   |
| Total  current liabilities                                 |       | 1,091                     |       | 362 |   | (410 | ) | 1,043 |   |
| **Long-term debt**                                         |       | 3,751                     |       | — |   | — |   | 3,751 |   |
| **Other long-term liabilities**                            |       | 62                        |       | 20 |   | — |   | 82 |   |
| **Total stockholders’ (deficit) equity**              |       | (2,964                    | )          | 517 |   | (517 | ) | (2,964 | ) |
| Total  liabilities and stockholders’ (deficit) equity |       | $                         | 1,940      |   | $ | 899 |   | $ | (927 | ) | $ | 1,912 |   |

 

**Supplemental Condensed Consolidating Statement of Operations**

** **
| ** **                                    | ** ** | **Quarter Ended October 31, 2009** | ** ** |
|-----------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                    | ** ** | **Parent  Company**                     | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                    | ** ** | **(in  millions)**                      | ** ** |
| **Net sales**                                 |       | $                                       | 818        |   | $ | 625 |   | $ | (514 | ) | $ | 929 |   |
| Cost  of sales and occupancy expense          |       | 566                                     |       | 530 |   | (514 | ) | 582 |   |
| **Gross profit**                              |       | 252                                     |       | 95 |   | — |   | 347 |   |
| Selling,  general, and administrative expense |       | 226                                     |       | 33 |   | — |   | 259 |   |
| Related  party expenses                       |       | 4                                       |       | — |   | — |   | 4 |   |
| Store  pre-opening costs                      |       | —                                  |       | — |   | — |   | — |   |
| **Operating income**                          |       | 22                                      |       | 62 |   | — |   | 84 |   |
| Interest  expense                             |       | 62                                      |       | — |   | — |   | 62 |   |
| Other  (income) and expense, net              |       | (1                                      | )          | — |   | — |   | (1 | ) |
| Intercompany  charges (income)                |       | 22                                      |       | (22 | ) | — |   | — |   |
| Equity  in earnings of subsidiaries           |       | 84                                      |       | — |   | (84 | ) | — |   |
| **Income before income taxes**                |       | 23                                      |       | 84 |   | (84 | ) | 23 |   |
| Provision  for income taxes                   |       | 8                                       |       | 29 |   | (29 | ) | 8 |   |
| **Net income**                                |       | $                                       | 15         |   | $ | 55 |   | $ | (55 | ) | $ | 15 |   |

 

16

----

Tableof Contents

 

**Supplemental Condensed Consolidating Statement of Operations**

** **
| ** **                                    | ** ** | **Quarter Ended November 1, 2008** | ** ** |
|-----------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                    | ** ** | **Parent  Company**                     | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                    | ** ** | **(in millions)**                       | ** ** |
| **Net sales**                                 |       | $                                       | 796        |   | $ | 618 |   | $ | (508 | ) | $ | 906 |   |
| Cost  of sales and occupancy expense          |       | 554                                     |       | 538 |   | (508 | ) | 584 |   |
| **Gross profit**                              |       | 242                                     |       | 80 |   | — |   | 322 |   |
| Selling,  general, and administrative expense |       | 221                                     |       | 26 |   | — |   | 247 |   |
| Related  party expenses                       |       | 4                                       |       | — |   | — |   | 4 |   |
| Store  pre-opening costs                      |       | 2                                       |       | 1 |   | — |   | 3 |   |
| **Operating income**                          |       | 15                                      |       | 53 |   | — |   | 68 |   |
| Interest  expense                             |       | 77                                      |       | — |   | — |   | 77 |   |
| Other  (income) and expense, net              |       | —                                  |       | 3 |   | — |   | 3 |   |
| Intercompany  charges (income)                |       | 23                                      |       | (23 | ) | — |   | — |   |
| Equity  in earnings of subsidiaries           |       | 73                                      |       | — |   | (73 | ) | — |   |
| **(Loss) income before income taxes**         |       | (12                                     | )          | 73 |   | (73 | ) | (12 | ) |
| Provision  for income taxes                   |       | 8                                       |       | 28 |   | (28 | ) | 8 |   |
| **Net (loss) income**                         |       | $                                       | (20        | ) | $ | 45 |   | $ | (45 | ) | $ | (20 | ) |

** **

**Supplemental CondensedConsolidating Statement of Operations**

** **
| ** **                                    | ** ** | **Nine Months Ended October 31, 2009** | ** ** |
|-----------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                    | ** ** | **Parent  Company**                         | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                    | ** ** | **(in millions)**                           | ** ** |
| **Net sales**                                 |       | $                                           | 2,287      |   | $ | 1,575 |   | $ | (1,274 | ) | $ | 2,588 |   |
| Cost  of sales and occupancy expense          |       | 1,587                                       |       | 1,327 |   | (1,274 | ) | 1,640 |   |
| **Gross profit**                              |       | 700                                         |       | 248 |   | — |   | 948 |   |
| Selling,  general, and administrative expense |       | 645                                         |       | 92 |   | — |   | 737 |   |
| Related  party expenses                       |       | 11                                          |       | — |   | — |   | 11 |   |
| Store  pre-opening costs                      |       | 2                                           |       | — |   | — |   | 2 |   |
| **Operating income**                          |       | 42                                          |       | 156 |   | — |   | 198 |   |
| Interest  expense                             |       | 187                                         |       | — |   | — |   | 187 |   |
| Other  (income) and expense, net              |       | (16                                         | )          | (5 | ) | — |   | (21 | ) |
| Intercompany  charges (income)                |       | 55                                          |       | (55 | ) | — |   | — |   |
| Equity  in earnings of subsidiaries           |       | 216                                         |       | — |   | (216 | ) | — |   |
| **Income before income taxes**                |       | 32                                          |       | 216 |   | (216 | ) | 32 |   |
| Provision  for income taxes                   |       | 11                                          |       | 74 |   | (74 | ) | 11 |   |
| **Net income**                                |       | $                                           | 21         |   | $ | 142 |   | $ | (142 | ) | $ | 21 |   |

 

17

----

Tableof Contents

 

**Supplemental Condensed Consolidating Statement of Operations**

 
|                                          |   | **Nine Months Ended November 1, 2008** |   |
|-----------------------------------------------|--------|---------------------------------------------|--------|
|                                          |   | **Parent  Company**                         |   | **Guarantor  Subsidiaries** |   | **Eliminations** |   | **Consolidated** |   |
|                                          |   | **(in millions)**                           |   |
| **Net sales**                                 |   | $                                           | 2,227  |   | $ | 1,554 |   | $ | (1,232 | ) | $ | 2,549 |   |
| Cost  of sales and occupancy expense          |   | 1,546                                       |   | 1,309 |   | (1,232 | ) | 1,623 |   |
| **Gross profit**                              |   | 681                                         |   | 245 |   | — |   | 926 |   |
| Selling,  general, and administrative expense |   | 673                                         |   | 92 |   | — |   | 765 |   |
| Related  party expenses                       |   | 12                                          |   | — |   | — |   | 12 |   |
| Store  pre-opening costs                      |   | 5                                           |   | 1 |   | — |   | 6 |   |
| **Operating (loss) income**                   |   | (9                                          | )      | 152 |   | — |   | 143 |   |
| Interest  expense                             |   | 231                                         |   | — |   | — |   | 231 |   |
| Other  (income) and expense, net              |   | —                                      |   | 3 |   | — |   | 3 |   |
| Intercompany  charges (income)                |   | 57                                          |   | (57 | ) | — |   | — |   |
| Equity  in earnings of subsidiaries           |   | 206                                         |   | — |   | (206 | ) | — |   |
| **(Loss) income before income taxes**         |   | (91                                         | )      | 206 |   | (206 | ) | (91 | ) |
| (Benefit)  provision for income taxes         |   | (21                                         | )      | 47 |   | (47 | ) | (21 | ) |
| **Net (loss) income**                         |   | $                                           | (70    | ) | $ | 159 |   | $ | (159 | ) | $ | (70 | ) |

 

**Supplemental Condensed Consolidating Statement of Cash Flows**

 
| ** **                                    | ** ** | **Nine Months Ended October 31, 2009** | ** ** |
|-----------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                    | ** ** | **Parent  Company**                         | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                    | ** ** | **(in millions)**                           | ** ** |
| **Operating activities:**                     |       |                                        |       |   |   |   |   |   |   |
| Net  cash provided by operating activities    |       | $                                           | 100        |   | $ | 90 |   | $ | (84 | ) | $ | 106 |   |
|                                          |       |                                        |       |   |   |   |   |   |   |
| **Investing activities:**                     |       |                                        |       |   |   |   |   |   |   |
| Cash  paid for property and equipment         |       | (25                                         | )          | (1 | ) | — |   | (26 | ) |
|                                          | ** ** | ** **                                  | ** ** |   |   |   |   |   |   |
|    Net cash used in investing activities |       | (25                                         | )          | (1 | ) | — |   | (26 | ) |
|                                          |       |                                        |       |   |   |   |   |   |   |
| **Financing activities:**                     |       |                                        |       |   |   |   |   |   |   |
| Net  borrowings of long-term debt             |       | (52                                         | )          | — |   | — |   | (52 | ) |
| Intercompany  dividends                       |       | —                                      |       | (84 | ) | 84 |   | — |   |
| Other  financing activities                   |       | (12                                         | )          | — |   | — |   | (12 | ) |
|    Net cash used in financing activities |       | (64                                         | )          | (84 | ) | 84 |   | (64 | ) |
|                                          |       |                                        |       |   |   |   |   |   |   |
| **Increase in cash and equivalents**          |       | 11                                          |       | 5 |   | — |   | 16 |   |
| **Beginning cash and cash equivalents**       |       | 26                                          |       | 7 |   | — |   | 33 |   |
| **Ending cash and cash equivalents**          |       | $                                           | 37         |   | $ | 12 |   | $ | — |   | $ | 49 |   |

 

18

----

Tableof Contents

 

**Supplemental Condensed Consolidating Statement of Cash Flows**

 
| ** **                                           | ** ** | **Nine Months Ended November 1, 2008** | ** ** |
|------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                           | ** ** | **Parent**                                  | ** ** | **Guarantor** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                           | ** ** | **Company**                                 | ** ** | **Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                           | ** ** | **(in millions)**                           | ** ** |
| **Operating Activities:**                            |       |                                        |       |   |   |   |   |   |   |
| Net  cash (used in) provided by operating activities |       | $                                           | (176       | ) | $ | 113 |   | $ | (103 | ) | $ | (166 | ) |
|                                                 |       |                                        |       |   |   |   |   |   |   |
| **Investing Activities:**                            |       |                                        |       |   |   |   |   |   |   |
| Cash  paid for property and equipment                |       | (59                                         | )          | (7 | ) | — |   | (66 | ) |
|                                                 |       |                                        |       |   |   |   |   |   |   |
| Net  cash used in investing activities               |       | (59                                         | )          | (7 | ) | — |   | (66 | ) |
|                                                 |       |                                        |       |   |   |   |   |   |   |
| **Financing Activities:**                            |       |                                        |       |   |   |   |   |   |   |
| Net  borrowings of long-term debt                    |       | 292                                         |       | — |   | — |   | 292 |   |
| Intercompany  dividends                              |       | —                                      |       | (103 | ) | 103 |   | — |   |
| Other  financing activities                          |       | 3                                           |       | — |   | — |   | 3 |   |
|                                                 |       |                                        |       |   |   |   |   |   |   |
| Net  cash provided by (used in) financing activities |       | 295                                         |       | (103 | ) | 103 |   | 295 |   |
|                                                 |       |                                        |       |   |   |   |   |   |   |
| **Increase in cash and equivalents**                 |       | 60                                          |       | 3 |   | — |   | 63 |   |
| **Beginning cash and cash equivalents**              |       | 26                                          |       | 3 |   | — |   | 29 |   |
| **Ending cash and equivalents**                      |       | $                                           | 86         |   | $ | 6 |   | $ | — |   | $ | 92 |   |

 

**Note 11. Subsequent Event**

** **

On November 5,2009, we entered into a Fourth Amendment to Credit Agreement (the “FourthAmendment”) to our $2.4 billion Senior secured term loan facility. The Fourth Amendment amended the Senior secured term loan facilityto extend $1.0 billion of existing term loans (the “B-2 Term Loans”) to July 31,2016, with the remaining $1.28 billion of existing term loans (the “B-1 TermLoans”) keeping the original maturity date of October 31, 2013.

 

As a result of the FourthAmendment, the applicable margins for the B-2 Term Loans under the Seniorsecured term loan facility will be 3.50% with respect to base rateborrowings and 4.50% with respect to LIBOR borrowings.  Further, theinterest period for the B-2 LIBOR borrowings may be for three or six months. The B-2 Term Loans are subject to (i) aspringing maturity date of July 31, 2014 unless either (x) our SeniorNotes are refinanced 91days prior to the maturity of such Senior Notes or (y) wecan meet a fixed charge coverage ratio of 3.25x; and (ii) a minimumincrease in interest rates on the B-2 loans in connection with any futureextensions of term loans to the extent any such extension has an increase ineffective yield in excess of 0.25%.

 

Borrowings for the B-1Term Loans under the Senior secured term loan facility are subject to anapplicable margin of 1.25% with respect to base rate borrowings and 2.25% withrespect to LIBOR borrowings. In addition, the one- and two-month LIBOR optionshave been eliminated for the B-1 Term Loans.

 

TheSenior secured term loan facility requires us to prepay outstanding loans tothe extent we have excess cash, as fully described in our Annual Report on Form 10-Kfor the fiscal year ended January 31, 2009. As a result of the Fourth Amendment,any required prepayments must be allocated evenly between the B-1 and B-2 TermLoans. The Fourth Amendment had no impact on the affirmative and negativecovenants contained in the Senior secured term loan facility.

 

In the fourth quarter offiscal 2009, we will record an expense of $3 million related to the FourthAmendment in accordance with ASC 470. The Company will also record $1 millionin debt issuance costs that will be amortized as interest expense over the lifeof the B-2 Term Loans. The unamortized debt issuance costs related to theSenior secured term loan facility will be allocated between the B-1 and B-2Term Loans. The costs allocated to the B-2 Term Loans will be amortized overthe revised life through July 31, 2014.

 

19

----

Tableof Contents

 

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

 

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

 

**DisclosureRegarding Forward-Looking Information**

 

Thefollowing discussion should be read in conjunction with our consolidatedfinancial statements and related notes included elsewhere in this QuarterlyReport on Form 10-Q. The following discussion, as well as other portionsof this Quarterly Report on Form 10-Q, contains forward-looking statementsthat reflect our plans, estimates, and beliefs. Any statements contained herein(including, but not limited to, statements to the effect that Michaels or itsmanagement “anticipates,” “plans,” “estimates,” “expects,” “believes,” andother similar expressions) that are not statements of historical fact should beconsidered forward-looking statements and should be read in conjunction withour consolidated financial statements and related notes in our Annual Report onForm 10-K for the fiscal year ended January 31, 2009. Suchforward-looking statements are based upon management’s current knowledge andassumptions about future events and involve risks and uncertainties that couldcause actual results, performance or achievements to be materially differentfrom anticipated results, prospects, performance or achievements expressed orimplied by such forward-looking statements. Such risks and uncertaintiesinclude, but are not limited to:

 

·                  risks related to general economic conditions; ifthe worldwide economic downturn continues or deteriorates further, it couldcontinue to adversely affect consumer confidence and retail spending,decreasing demand for our merchandise and adversely impact our results ofoperations, cash flows and financial condition;

 

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

 

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

 

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

 

·                  howwell we manage our business;

 

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

 

·                  unexpectedor unfavorable consumer responses to our promotional or merchandising programscould materially adversely affect our sales, operating results, and cash flow;

 

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

 

·                  improvementsto our supply chain may not be fully successful;

 

·                  oursuppliers may fail us;

 

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

 

·                  risks associated with the vendors from whom ourproducts are sourced, including our vendors’ ability to finance their ownoperations, could materially adversely affect our revenue and gross profit;

 

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

 

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

 

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

 

·                  ourinformation systems may prove inadequate;

 

20

----

Tableof Contents

 

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

 

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

 

·                  if proposedlabor relations legislation is adopted, allowing third party involvement orinterruptions to our business, our business could be impacted as a result;

 

·                  aweak fourth quarter would materially adversely affect our annual operatingresults;

 

·                  competitioncould negatively impact our operations; and

 

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

 

For more details on factors that maycause actual results to differ materially from such forward-looking statements,please see Item 1A. Risk Factors of our Annual Report on Form 10-Kfor the fiscal year ended January 31, 2009, and other reports from time totime filed with or furnished to the SEC. We do not intend to, and undertake noobligation to, update or revise any forward-looking statement.

 

**General**

 

Giventhe current soft macroeconomic and retail environments, sales declines couldadversely affect operating income due to a deleveraging of operatingexpenses.  As a result, our historicaltrends may not be indicative of future results.

 

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

 

Wereport on the basis of a 52 or 53-week fiscal year, which ends on the Saturdayclosest to January 31. All references herein to “fiscal 2009” relate tothe 52 weeks ending January 30, 2010 and all references to “fiscal2008” relate to the 52 weeks ended January 31, 2009. In addition, allreferences herein to “the third quarter of fiscal 2009” relate to the 13 weeksended October 31, 2009 and all references to “the third quarter of fiscal2008” relate to the 13 weeks ended November 1, 2008.  Finally, all references to “the nine monthsended October 31, 2009” relate to the 39 weeks ended October 31,2009, and “the nine months ended November 1, 2008” relate to the 39 weeksended November 1, 2008, respectively.

 

Thefollowing table sets forth certain of our unaudited operating data:

 
| ** **                                               | ** ** | **Quarter Ended**    | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------------------------------|------------|----------------------|------------|-----------------------|------------|
| ** **                                               | ** ** | **October 31,** | ** ** | **November 1,**  | ** ** | **October 31,** | ** ** | **November 1,** | ** ** |
| ** **                                               | ** ** | **2009**             | ** ** | **2008**              | ** ** | **2009** | ** ** | **2008** | ** ** |
| **Michaels stores:**                                     |       |                 |       |                  |       |   |   |   |   |
| Retail  stores open at beginning of period               |       | 1,023                |       | 991                   |       | 1,009 |   | 963 |   |
| Retail  stores opened during the period                  |       | 4                    |       | 22                    |       | 18 |   | 50 |   |
| Retail  stores opened (relocations) during the period    |       | 1                    |       | 3                     |       | 5 |   | 9 |   |
| Retail  stores closed during the period                  |       | —               |       | —                |       | — |   | — |   |
| Retail  stores closed (relocations) during the period    |       | (1                   | )          | (3                    | )          | (5 | ) | (9 | ) |
| Retail  stores open at end of period                     |       | 1,027                |       | 1,013                 |       | 1,027 |   | 1,013 |   |
|                                                     |       |                 |       |                  |       |   |   |   |   |
| **Aaron Brothers stores:**                               |       |                 |       |                  |       |   |   |   |   |
| Retail  stores open at beginning of period               |       | 155                  |       | 164                   |       | 161 |   | 166 |   |
| Retail  stores opened during the period                  |       | —               |       | —                |       | — |   | — |   |
| Retail  stores opened (relocations) during the period    |       | —               |       | —                |       | — |   | 1 |   |
| Retail  stores closed during the period                  |       | (3                   | )          | (1                    | )          | (9 | ) | (3 | ) |
| Retail  stores closed (relocations) during the period    |       | —               |       | —                |       | — |   | (1 | ) |
| Retail  stores open at end of period                     |       | 152                  |       | 163                   |       | 152 |   | 163 |   |
|                                                     |       |                 |       |                  |       |   |   |   |   |
| Total  store count at end of period                      |       | 1,179                |       | 1,176                 |       | 1,179 |   | 1,176 |   |
|                                                     |       |                 |       |                  |       |   |   |   |   |
| **Other operating data:**                                |       |                 |       |                  |       |   |   |   |   |
| Average  inventory per Michaels store (in thousands) (1) |       | $                    | 971        |                  | $          | 1,022 |   | $ | 971 |   | $ | 1,022 |   |
| Comparable  store sales (2)                              |       | 1.3                  | %          | (6.5                  | )%         | (0.5 | )% | (4.1 | )% |
|                                                          |            |                      |            |                       |            |  |  |  |  |  |  |  |  |

 

21

----

Tableof Contents

 

----

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

 

**Results ofOperations**

 

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

 
| ** **                                    | ** ** | **Quarter Ended**    | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------|------------|----------------------|------------|-----------------------|------------|
| ** **                                    | ** ** | **October 31,** | ** ** | **November 1,**  | ** ** | **October 31,** | ** ** | **November 1,** | ** ** |
| ** **                                    | ** ** | **2009**             | ** ** | **2008**              | ** ** | **2009** | ** ** | **2008** | ** ** |
| **Net sales**                                 |       | 100.0                | %          | 100.0                 | %          | 100.0 | % | 100.0 | % |
| Cost  of sales and occupancy expense          |       | 62.7                 |       | 64.5                  |       | 63.4 |   | 63.7 |   |
| **Gross profit**                              |       | 37.3                 |       | 35.5                  |       | 36.6 |   | 36.3 |   |
| Selling,  general, and administrative expense |       | 27.9                 |       | 27.3                  |       | 28.5 |   | 30.0 |   |
| Related  party expenses                       |       | 0.4                  |       | 0.4                   |       | 0.4 |   | 0.5 |   |
| Store  pre-opening costs                      |       | —               |       | 0.3                   |       | 0.1 |   | 0.2 |   |
| **Operating income**                          |       | 9.0                  |       | 7.5                   |       | 7.6 |   | 5.6 |   |
| Interest  expense                             |       | 6.7                  |       | 8.5                   |       | 7.2 |   | 9.0 |   |
| Other  (income) and expense, net              |       | (0.2                 | )          | 0.3                   |       | (0.8 | ) | 0.1 |   |
| **Income (loss) before income taxes**         |       | 2.5                  |       | (1.3                  | )          | 1.2 |   | (3.5 | ) |
| Income  tax provision (benefit)               |       | 0.9                  |       | 0.9                   |       | 0.4 |   | (0.8 | ) |
| **Net income (loss)**                         |       | 1.6                  | %          | (2.2                  | )%         | 0.8 | % | (2.7 | )% |

 

*QuarterEnded October 31, 2009 Compared to the Quarter Ended November 1, 2008*

* *

*Net Sales*—Net sales increased for thethird quarter of fiscal 2009 by $23 million, or 2.6%, over the thirdquarter of fiscal 2008. Comparable store sales increased 1.3% primarily due toan increase in customer transactions of 4.7% and a positive impact of 0.1%related to the change in deferred custom framing revenue, partially offset by adecrease in the average ticket of 3.5%. The fluctuation in the exchange rates betweenthe United States and Canadian dollars positively impacted the average ticketby 20 basis points. Sales at 26 Michaels stores that were opened during the13-month period ended October 31, 2009, provided incremental revenue of$12 million.

 

*Cost of Sales and Occupancy Expense*— Cost of salesand occupancy expense decreased $2 million or 0.3% to $582 million in the thirdquarter of fiscal 2009 from $584 million in the third quarter of fiscal 2008primarily due to lower distribution and freight costs. This improvement waspartially offset by an increase in occupancy costs due in part to an increasein the average number of stores open in the period. As a percentage of netsales, cost of sales and occupancy expense decreased approximately 180 basispoints driven by a 170 basis point reduction in cost of sales related primarilyto improved management of clearance markdowns and lower fuel and distributioncosts.

 

*Selling, General, and Administrative Expense*—Selling,general, and administrative expense was $259 or 27.9% of net sales, in thethird quarter of fiscal 2009 compared to $247 million, or 27.3% of net sales,in the third quarter of fiscal 2008. Selling, general, and administrativeexpense increased $12 million, or 60 basis points, primarily due to a $20million increase in performance based bonus expense, which was partially offsetby lower payroll and advertising expense. In the third quarter of fiscal 2008,we reversed bonus expense accruals of approximately $15 million as a result ofchanges in expected company performance in fiscal 2008.

 

*Related Party Expenses*— Related party expenseswere $4 million in each of the third quarters of fiscal 2009 and fiscal2008.  These costs consist primarily ofapproximately $3 million of management fees and associated expenses paid to ourSponsors and Highfields Capital Management L.P. (“Highfields”).  Also included in the related party expensesin fiscal 2008 is approximately $1 million of amortization expense related tothe Separation Agreements as more fully described in Note 9 to the consolidatedfinancial statements.

 

22

----

Tableof Contents

 

*Interest Expense*— Interest expense for thequarter decreased $15 million to $62 million as a result of a lower averageinterest rate related to our variable-rate debt and lower average debt levels.

 

*Other(Income) and Expense, net*—Other income in the third quarter of fiscal2009 related primarily to a $1 million favorable change in the fair value ofthe interest rate cap as more fully described in Note 5 to the consolidatedfinancial statements. For fiscal 2008, other expense included $3 millionrelated to foreign exchange losses.

 

*Provision for Income Taxes*—During the third quarter offiscal 2009, we recorded a tax provision of $8 million at an effective tax rateof 33.2%.  During the third quarter offiscal 2008, we recorded a tax provision of $8 million, despite a loss beforetaxes. The tax provision recorded in fiscal 2008 was primarily related to aprojected annual tax rate decrease due to changes in our results of operationsand our limited ability to recognize foreign tax credits related to ourprofitable Canadian operations.

 

*NineMonths Ended October 31, 2009 Compared to the Nine Months Ended November 1,2008*

 

*Net Sales*—Net salesincreased for the first nine months of fiscal 2009 by $39 million, or1.6%, over the first nine months of fiscal 2008. Comparable store salesdecreased 0.5% primarily due to a decrease in the average ticket of 5.1% and anadverse impact of 0.1% related to the change in deferred custom framingrevenue, partially offset by an increase in customer transactions of 4.7%. Thefluctuation in the exchange rates between the United States and Canadiandollars adversely impacted the average ticket by 80 basis points. The decreasein comparable store sales was more than offset by sales from non-comparable newstores.  Sales at our new stores thatwere opened during the 13-month period ended October 31, 2009, providedincremental revenue of $52 million.

 

*Cost of Sales and Occupancy Expense*—Cost of salesand occupancy expense increased $17 million or 1.1% to $1,640 million for thefirst nine months of fiscal 2009 from $1,623 million for the first nine monthsof fiscal 2008 primarily due to sales from new stores. As a percentage of netsales, cost of sales decreased approximately 30 basis points largely driven bylower fuel and distribution costs, while occupancy costs were flat as apercentage of sales.

 

*Selling, General, and Administrative Expense*—Selling,general, and administrative expense was $737 million, or 28.5% of net sales,for the first nine months of fiscal 2009 compared to $765 million, or30.0% of net sales, for the first nine months of fiscal 2008. Selling, generaland administrative expense decreased $28 million, or 150 basis points,primarily due to lowerpayroll, severance, depreciation advertising and supplies expense.Additionally, prior year amounts include consulting expenses for studiesrelated to consumer insights and other strategic initiatives. Thesereductions were partially offset by an increase in performance based bonusexpense.

 

*Related Party Expenses*—Related party expenses were$11 million and $12 million for the first nine months of fiscal 2009 and fiscal2008, respectively, consisting primarily of $10 million of management fees andassociated expenses paid to our Sponsors and Highfields.  Also included in the related party expensesin fiscal 2008 was approximately $2 million of amortization expense related tothe Separation Agreements as more fully described in Note 9 to the consolidatedfinancial statements.

 

*Interest Expense*—Interest expense decreased$44 million in the nine months ended October 31, 2009 compared to the ninemonths ended November 1, 2008, primarily due to a lower average interestrate on our variable-rate debt and lower average debt levels.

 

*Other(Income) and Expense, net*—Other income for the first nine months offiscal 2009 related primarily to a $16 million favorable change in the fairvalue of the interest rate cap as more fully described in Note 5 to theconsolidated financial statements and $5 million related to foreign exchangegains. In 2008, other expense related primarily to foreign exchange losses.

 

*Provision (Benefit) for Income Taxes*—For the ninemonths ended October 31, 2009, we recorded an income tax provision of $11million at an effective tax rate of 34.2%. The rate is lower than the federaltax rate due to the expected reversal of prior year’s limitations on ourability to recognize foreign tax credits related to its profitable Canadianoperations. For the nine months ended November 1, 2008, we recorded a taxbenefit of $21 million at an effective tax rate of 23.0%. For the first nine monthsof fiscal 2008, the lower effective tax rate was a result of our limitedability to recognize foreign tax credits related to our profitable Canadianoperations.

 

**Liquidityand Capital Resources**

 

Werequire cash principally for day-to-day operations, to finance capitalinvestments, inventory for new stores, and inventory replenishment for existingstores, to service our outstanding debt, and seasonal working capitalneeds.  We and our subsidiaries,affiliates, and significant shareholders may from time to time seek to retireor purchase our outstanding debt (including publicly issued debt) through cashpurchases and/or exchanges, in open market purchases, privately negotiatedtransactions, by tender offer or otherwise. Such repurchases or exchanges, if any, will depend on prevailing marketconditions, liquidity requirements, contractual restrictions and otherfactors.  We expect that our availablecash, cash flow generated from operating activities, and funds available underour Asset-based revolving credit facility will be sufficient to fund plannedcapital expenditures, working capital requirements, debt repayments, debtservice requirements and future growth for the foreseeable future.

 

23

----

Tableof Contents

 

OnNovember 5, 2009, we entered into an amendment to the credit agreement tothe Senior secured term loan facility. See Note 11 for additional information.

 

*Cash Flowfrom Operating Activities*

 

Cashflow provided by operating activities during the first nine months of fiscal2009 was $106 million compared to cash used in operating activities of$166 million during the first nine months of fiscal 2008. The $272 millionchange was primarily due to an increase in net income, a smaller increase inmerchandise inventories, and a favorable impact from accrued interest.  The change in accrued interest was primarilyattributable to the timing of payments and a lower average interest rate.

 

Averageinventory per Michaels store (including supporting distribution centers)decreased 5.0% from $1,022,000 at November 1, 2008 to $971,000 at October 31,2009 primarily due to a planned reduction of store inventory levels. Weanticipate average inventory per Michaels store at the end of fiscal 2009 to bedown compared to the end of fiscal 2008.

 

*Cash Flowused in Investing Activities*

 

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

 
| ** **                                              | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------------|------------|-----------------------|------------|
| ** **                                              | ** ** | **October 31,**  | ** ** | **November 1,** | ** ** |
| ** **                                              | ** ** | **2009**              | ** ** | **2008** | ** ** |
| ** **                                              | ** ** | **(in millions)**     | ** ** |
| New  and relocated stores and stores not yet opened (1) |       | $                     | 10         |   | $ | 23 |   |
| Existing  stores                                        |       | 8                     |       | 17 |   |
| Distribution  system expansion                          |       | 1                     |       | 3 |   |
| Information  systems                                    |       | 6                     |       | 21 |   |
| Corporate  and other                                    |       | 1                     |       | 2 |   |
|                                                    |       | $                     | 26         |   | $ | 66 |   |

 

----

| (1) | In the first nine months  of fiscal 2009, we incurred capital expenditures related to the opening of 18  Michaels and the relocation of five Michaels stores. In the first nine months  of fiscal 2008, we incurred capital expenditures related to the opening of 50  Michaels stores and the relocation of nine Michaels stores and one Aaron  Brothers store. |
|-----|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

Given the currentsoft macroeconomic environment, we have taken a more conservative view oncapital expenditures and postponed or cancelled non-essential spending duringfiscal 2009.

 

*Cash Flowfrom Financing Activities*

 

Cashflows used in financing activities are related primarily to repayments inexcess of borrowings under our Asset-based revolving credit facility. TheAsset-based revolving credit facility provides senior secured financing of upto $1.0 billion, subject to a borrowing base. As of October 31, 2009, theborrowing base was $963 million with $799 million of unused availability.

 

**RecentAccounting Pronouncements**

** **

In June 2009, theFASB issued ASC 105, *Generally AcceptedAccounting Principles.*ASC 105 establishes the Codification as thesource of authoritative accounting principles recognized by the FASB to beapplied by non-governmental entities in the preparation of financial statementsin conformity with generally accepted accounting principles. Rules andinterpretive releases of the SEC under authority of federal securities laws arealso sources of authoritative guidance for SEC registrants. All guidancecontained in the Codification carries an equal level of authority. The U.S.GAAP hierarchy will be modified to include two levels of GAAP: authoritativeand nonauthoritative. This statement is effective for financial statementsissued for interim and annual periods ended after September 15, 2009. Wehave included references to authoritative accounting literature in accordancewith the Codification. There are no other changes to the content of the Company’sconsolidated financial statements as a result of the adoption.

 

In September 2006,the FASB issued ASC 820, *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.  ASC 820 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 ASC 820 for nonfinancial assets andliabilities; however, ASC 820 became effective for fiscal years beginning afterNovember 15, 2007 for financial assets and liabilities, as well as for anyother assets and liabilities that are carried at fair value on a recurringbasis in financial statements.  On February 3,2008, we adopted the provisions of ASC 820 related to financial assets 

 

24

----

Tableof Contents

 

and liabilities and on February 1, 2009, weadopted the provisions related to nonfinancial assets and liabilities that arenot required or permitted to be measured at fair value on a recurring basis.These adoptions had no impact on our consolidated financial statements.   See Note 6 for further information regardingfair value measurements. Additionally, in April 2009, the FASB issued ASC825, *Interim Disclosures About Fair Value of FinancialInstruments,* which provides additional guidance and requiresadditional disclosures regarding determining and reporting fair values forcertain assets and liabilities. We adopted ASC 825 in the second quarter offiscal 2009 as reflected in Note 3.

 

In December 2007,the FASB issued ASC 805, *BusinessCombinations*toestablish principles and requirements for the recognition and measurement ofassets, liabilities and goodwill, including the requirement that mosttransaction costs and restructuring costs be expensed. In addition, this ASCrequires disclosures to enable users to evaluate the nature and financialeffects of the business combination. ASC 805 is effective for businesscombinations for which the acquisition date is on or after the beginning of thefirst annual reporting period beginning on or after December 15, 2008. Wewill apply the provisions of ASC 805 to any business combinations occurring onor after February 1, 2009.

 

In March 2008, theFASB issued ASC 815, *Disclosures aboutDerivative Instruments and Hedging Activities*. ASC 815 requiresqualitative disclosures about objectives and strategies for using derivatives,quantitative data about the fair value of and gains and losses on derivativecontracts, and details of credit-risk-related contingent features in hedgedpositions. The statement also requires enhanced disclosures regarding how andwhy entities use derivative instruments, how derivative instruments and relatedhedged items are accounted for, and how derivative instruments and relatedhedged items affect entity’s financial position, financial performance, andcash flows. ASC 815 is effective for fiscal years and interim periods beginningafter November 15, 2008. We adopted the new disclosure requirements of ASC815 in the first quarter of 2009 as reflected in Note 5.

 

In May 2009, theFASB issued ASC 855, *Subsequent Events*.ASC 855 is intended to establish general standards of accounting for anddisclosure of events that occur after the balance sheet date but before thefinancial statements are issued or available to be issued. The statement setsforth the period after the balance sheet date during which management of areporting entity should evaluate events or transactions that may occur forpotential recognition or disclosure in the financial statements, thecircumstances under which an entity should recognize events or transactionsoccurring after the balance sheet date in its financial statements, and thedisclosures that an entity should make about events or transactions thatoccurred after the balance sheet date. ASC 855 is effective for fiscal yearsand interim periods ending after June 15, 2009. We adopted ASC 855 duringthe second quarter of fiscal 2009, but the impact of the adoption in futureperiods will depend on the nature and the extent of transactions that occursubsequent to our interim and annual reporting periods.

 

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

 

Duringthe first quarter of fiscal 2009, we purchased an interest rate cap to hedgethe variability of cash flows associated with our interest payments on ourSenior secured term loan that result from fluctuations in the three-month LIBORrate. The cap limits our interest exposure on a notional value of $2.0 billionto the lesser of the three-month LIBOR rate or 7.0%.  The term of the cap is from April 15,2009 through April 15, 2015. The fair value of the cap as of October 31,2009 was $25 million and is included in Other assets on the ConsolidatedBalance Sheet. The change in fair value of the cap for the quarter and ninemonths ended October 31, 2009resulted in an income of $1 million and $16million, respectively, and is recorded in Other (income) and expense, net inthe Consolidated Statements of Operations.

 

Wehave market risk exposure arising from changes in interest rates on ourSenior secured term loan facility. The interest rates on our SeniorCredit Facilities will reprice periodically, which will impact our earnings andcash flow. The interest rates on our Notes issued in connection with the Mergerare fixed.  Based on our overall interest rate exposure tovariable rate debt outstanding as of October 31, 2009, a 1% increaseor decrease in interest rates would increase or decrease pre-tax earnings by$24 million. A 1% increase in interest rates would decrease the fair value ofour long-term fixed rate debt by approximately $52 million. A 1% decrease ininterest rates would increase the fair value of our long-term fixed rate debtby approximately $55 million.  A changein interest rates would not materially affect the fair value of our Seniorsecured term loan facility as the debt reprices periodically.

 

**Item 4.  Controls and Procedures.**

 

*Evaluationof Disclosure Controls and Procedures*

 

Wemaintain a set of disclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) promulgated by the SEC under the Securities Exchange Act of1934) that are designed to provide reasonable assurance that information, whichis required to be timely disclosed, is accumulated and communicated tomanagement in a timely fashion.  We notethat the design of any system of controls is based in part upon certainassumptions about the likelihood of future events, and there can be noassurance that any design will succeed in achieving its stated goals under allpotential future conditions.

 

25

----

Tableof Contents

 

Anevaluation was carried out under the supervision and with the participation ofour management, including our Chief Executive Officer and our Chief FinancialOfficer, of the effectiveness of our disclosure controls and procedures as ofthe end of the period covered by this report. Based on that evaluation, ourChief Executive Officer and our Chief Financial Officer concluded that ourdisclosure controls are effective to provide reasonable assurance thatinformation required to be disclosed in the reports that we file or submitunder the Securities and Exchange Act of 1934 is accumulated and communicatedto management, including our Chief Executive Officer and our Chief FinancialOfficer, to allow timely decisions regarding required disclosure and areeffective to provide reasonable assurance that such information is recorded,processed, summarized and reported within the time periods specified by the SEC’srules and forms.

 

*Change inInternal Control Over Financial Reporting*

 

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

 

**MICHAELSSTORES, INC.**

**Part II—OTHERINFORMATION**

 

**Item 1.  LegalProceedings.**

 

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

 

**Item 1A.  Risk Factors**

** **

Informationregarding our risk factors appear in Item 1A. Risk Factors disclosed in ourAnnual Report on Form 10-K for the fiscal year ended January 31, 2009

 

Therehave been no material changes to the risk factors previously disclosed in ourAnnual Report on Form 10-K for the fiscal year ended January 31, 2009other than the risk factor set forth below:

 

*Healthcarereform legislation could adversely impact us.*

* *

The U.S. Congress, supportedby President Obama, is debating health care reform that could have asignificant impact on our employment benefits and related costs.  Thediscussion centers around universal coverage, revenue sources to keep itdeficit neutral and changes to Medicare that could significantly impact ourassociates and the benefits and costs of our benefit plans.  Untillegislation is final, the impact is impossible to predict.

 

**Item 6.  Exhibits.**

 

(a) Exhibits:

 
| **Exhibit   Number** | ** ** | **Description of Exhibit**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
|---------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1                      |       | Fourth Amendment to  Credit Agreement, dated as of November 5, 2009, to the Credit Agreement,  dated as of October 31, 2006, among Michaels Stores, Inc., Deutsche  Bank AG New York Branch, as administrative agent, the other lenders named  therein, JPMorgan Chase Bank, N.A., as syndication agent, and Bank of  America, N.A. and Credit Suisse, as co-documentation agents, and Deutsche  Bank Securities Inc., J.P. Morgan Securities Inc. and Banc of America  Securities LLC as co-lead arrangers and joint bookrunners (previously filed  as Exhibit 10.1 to Registrant’s Current Report on Form 8-K filed  November 5, 2009). |
|                      |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 31.1                      |       | Certifications  of John B. Menzer pursuant to §302 of the Sarbanes-Oxley Act of 2002 (filed  herewith).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
|                      |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 31.2                      |       | Certifications  of Elaine D. Crowley pursuant to §302 of the Sarbanes-Oxley Act of 2002  (filed herewith).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
|                      |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 32.1                      |       | Certification  pursuant to 18 U.S.C. §1350, as adopted pursuant to §906 of the  Sarbanes-Oxley Act of 2002 (filed herewith).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |

 

26

----

Tableof Contents

 

**MICHAELSSTORES, INC.**

**SIGNATURES**

 

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

 
|                               | MICHAELS  STORES, INC. |
|------------------------------------|------------------------|
|                               |                   |   |
|                               | By:                    | /s/ Elaine  D. Crowley |
|                               |                   | Elaine  D. Crowley |
|                               |                   | Executive  Vice President - Chief Financial Officer |
|                               |                   | (Principal  Financial Officer) |
| ** **                         | ** **             | ** ** |
| Dated: December 4,  2009 | ** **             | ** ** |

 

27

----

Tableof Contents

 

**INDEX TO EXHIBITS**

 
| **Exhibit  Number** | ** ** | **Description of Exhibit**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
|---------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1                |       | Fourth Amendment to  Credit Agreement, dated as of November 5, 2009, to the Credit Agreement,  dated as of October 31, 2006, among Michaels Stores, Inc., Deutsche  Bank AG New York Branch, as administrative agent, the other lenders named  therein, JPMorgan Chase Bank, N.A., as syndication agent, and Bank of  America, N.A. and Credit Suisse, as co-documentation agents, and Deutsche  Bank Securities Inc., J.P. Morgan Securities Inc. and Banc of America  Securities LLC as co-lead arrangers and joint bookrunners (previously filed  as Exhibit 10.1 to Registrant’s Current Report on Form 8-K filed  November 5, 2009). |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 31.1                |       | Certifications  of John B. Menzer pursuant to §302 of the Sarbanes-Oxley Act of 2002 (filed  herewith).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 31.2                |       | Certifications  of Elaine D. Crowley pursuant to §302 of the Sarbanes-Oxley Act of 2002  (filed herewith).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 32.1                |       | Certification  pursuant to 18 U.S.C. §1350, as adopted pursuant to §906 of the  Sarbanes-Oxley Act of 2002 (filed herewith).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |

 

28

----