Table of Contents

 

 

 

**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,DC 20549**

 

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**FORM 10-Q**

 

**(MarkOne)**

** **

| **x**                                               | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|-----------------------------------------------------|---------------------------------------------------------------------------------------------------------|
| ** **                                          | ** **                                                                                              |
| **For the quarterly period ended May 1, 2010** |
| ** **                                          | ** **                                                                                              |
| **OR**                                              |
| ** **                                          | ** **                                                                                              |
| **o**                                               | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

** **

**For the transition period from           to          **

 

**Commissionfile number 001-09338**

 

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**MICHAELSSTORES, INC.**

(Exact name ofregistrant as specified in its charter)

 

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

 

**8000Bent Branch Drive**

**Irving,Texas 75063**

 (Address of principal executive offices,including zip code)

 

**(972) 409-1300**

(Registrant’stelephone number, including area code)

 

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

 

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

 

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

 

| 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 May 24, 2010, 118,898,939 shares of the Registrant’s Common Stock wereoutstanding.

 

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*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.

 

 

 

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**MICHAELS STORES, INC.**

** **

**FORM 10-Q**

 
| **Part I—FINANCIAL INFORMATION** | ** **                                                                                                      |
|--------------------------------------------|-----------------------------------------------------------------------------------------------------------------|
| **Item 1.**                           | **Financial Statements**                                                                                        | ** ** |
|                                       | Consolidated  Balance Sheets at May 1, 2010, January 30, 2010, and May 2,  2009 (unaudited)      | **3** |
|                                       | Consolidated  Statements of Operations for the quarter ended May 1, 2010 and  May 2, 2009 (unaudited) | **4** |
|                                       | Consolidated  Statements of Cash Flows for the quarter ended May 1, 2010 and  May 2, 2009 (unaudited) | **5** |
|                                       | Notes  to Consolidated Financial Statements (unaudited)                                                         | **6** |
| **Item 2.**                           | **Management’s  Discussion and Analysis of Financial Condition and Results of Operations**                 | **18** |
| **Item 3.**                           | **Quantitative  and Qualitative Disclosures About Market Risk**                                                 | **24** |
| **Item 4.**                           | **Controls and  Procedures**                                                                                    | **24** |
| **Part II—OTHER  INFORMATION**   | ** **                                                                                                      |
| **Item 1.**                           | **Legal Proceedings**                                                                                           | **25** |
| **Item 6.**                           | **Exhibits**                                                                                                    | **25** |
| **Signatures**                             | ** **                                                                                                      | **26** |

 

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** **

**MICHAELS STORES, INC.**

**Part I—FINANCIALINFORMATION**

** **

**Item 1.  Financial Statements.**

** **

**MICHAELSSTORES, INC.**

**CONSOLIDATEDBALANCE SHEETS**

**(In millions, exceptshare data)**

**(Unaudited)**

** **
| ** **                                                                                                                                                                                                                                                         | ** ** | **May 1,** | ** ** | **January 30,** | ** ** | **May 2,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|------------|----------------------|------------|-----------------|------------|
| ** **                                                                                                                                                                                                                                                         | ** ** | **2010**        | ** ** | **2010**             | ** ** | **2009**        | ** ** |
| **ASSETS**                                                                                                                                                                                                                                                         |       |            |       |                 |       |            |       |
| **Current assets:**                                                                                                                                                                                                                                                |       |            |       |                 |       |            |       |
| Cash  and equivalents                                                                                                                                                                                                                                              |       | $               | 79         |                 | $          | 217             |       | $ | 32 |   |
| Merchandise  inventories                                                                                                                                                                                                                                           |       | 866             |       | 873                  |       | 890             |       |
| Prepaid  expenses and other                                                                                                                                                                                                                                        |       | 69              |       | 72                   |       | 71              |       |
| Deferred  income taxes                                                                                                                                                                                                                                             |       | 42              |       | 45                   |       | 41              |       |
| Income  tax receivable                                                                                                                                                                                                                                             |       | 10              |       | —               |       | 12              |       |
| Total  current assets                                                                                                                                                                                                                                              |       | 1,066           |       | 1,207                |       | 1,046           |       |
| **Property and equipment, at cost**                                                                                                                                                                                                                                |       | 1,260           |       | 1,257                |       | 1,222           |       |
| Less  accumulated depreciation                                                                                                                                                                                                                                     |       | (960            | )          | (940                 | )          | (859            | )          |
| Property  and equipment, net                                                                                                                                                                                                                                       |       | 300             |       | 317                  |       | 363             |       |
| **Goodwill**                                                                                                                                                                                                                                                       |       | 94              |       | 94                   |       | 94              |       |
| **Debt issuance costs, net of accumulated amortization of  $61, $56, and $43, respectively**                                                                                                                                                                       |       | 84              |       | 70                   |       | 82              |       |
| **Deferred income taxes**                                                                                                                                                                                                                                          |       | 8               |       | 1                    |       | 13              |       |
| **Other assets**                                                                                                                                                                                                                                                   |       | 11              |       | 21                   |       | 15              |       |
| Total  non-current assets                                                                                                                                                                                                                                          |       | 197             |       | 186                  |       | 204             |       |
| Total  assets                                                                                                                                                                                                                                                      |       | $               | 1,563      |                 | $          | 1,710           |       | $ | 1,613 |   |
|                                                                                                                                                                                                                                                               |       |            |       |                 |       |            |       |
| **LIABILITIES AND STOCKHOLDERS’  DEFICIT**                                                                                                                                                                                                                    |       |            |       |                 |       |            |       |
| **Current liabilities:**                                                                                                                                                                                                                                           |       |            |       |                 |       |            |       |
| Accounts  payable                                                                                                                                                                                                                                                  |       | $               | 196        |                 | $          | 231             |       | $ | 213 |   |
| Accrued  liabilities and other                                                                                                                                                                                                                                     |       | 338             |       | 355                  |       | 249             |       |
| Current  portion of long-term debt                                                                                                                                                                                                                                 |       | —          |       | 119                  |       | 196             |       |
| Income  taxes payable                                                                                                                                                                                                                                              |       | 3               |       | 11                   |       | —          |       |
| Current  liabilities - discontinued operations                                                                                                                                                                                                                     |       | 1               |       | 1                    |       | 1               |       |
| Total  current liabilities                                                                                                                                                                                                                                         |       | 538             |       | 717                  |       | 659             |       |
| **Long-term debt**                                                                                                                                                                                                                                                 |       | 3,695           |       | 3,684                |       | 3,761           |       |
| **Deferred income taxes**                                                                                                                                                                                                                                          |       | 3               |       | —               |       | —          |       |
| **Other long-term liabilities**                                                                                                                                                                                                                                    |       | 83              |       | 80                   |       | 74              |       |
| Total  long-term liabilities                                                                                                                                                                                                                                       |       | 3,781           |       | 3,764                |       | 3,835           |       |
|                                                                                                                                                                                                                                                               |       | 4,319           |       | 4,481                |       | 4,494           |       |
| **Commitments and contingencies**                                                                                                                                                                                                                                  |       |            |       |                 |       |            |       |
| **Stockholders’ deficit:**                                                                                                                                                                                                                                    |       |            |       |                 |       |            |       |
| Common  Stock, $0.10 par value, 220,000,000 shares authorized; 118,389,571 shares  issued and outstanding at May 1, 2010; 118,387,229 shares issued and  outstanding at January 30, 2010; 118,376,402 shares issued and  outstanding at May 2, 2009 |       | 12              |       | 12                   |       | 12              |       |
| Additional  paid-in capital                                                                                                                                                                                                                                        |       | 37              |       | 35                   |       | 30              |       |
| Accumulated  deficit                                                                                                                                                                                                                                               |       | (2,812          | )          | (2,824               | )          | (2,927          | )          |
| Accumulated  other comprehensive income                                                                                                                                                                                                                            |       | 7               |       | 6                    |       | 4               |       |
| Total  stockholders’ deficit                                                                                                                                                                                                                                  |       | (2,756          | )          | (2,771               | )          | (2,881          | )          |
| Total  liabilities and stockholders’ deficit                                                                                                                                                                                                                  |       | $               | 1,563      |                 | $          | 1,710           |       | $ | 1,613 |   |

 

See accompanying notes to consolidated financialstatements.

 

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** **

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

**(In millions)(Unaudited)**

 
| ** **                                    | ** ** | **Quarter Ended** | ** ** |
|-----------------------------------------------|------------|-------------------|------------|
| ** **                                    | ** ** | **May 1,**   | ** ** | **May 2,** | ** ** |
| ** **                                    | ** ** | **2010**          | ** ** | **2009** | ** ** |
| **Net sales**                                 |       | $                 | 901        |   | $ | 852 |   |
| Cost  of sales and occupancy expense          |       | 547               |       | 537 |   |
| **Gross profit**                              |       | 354               |       | 315 |   |
| Selling,  general, and administrative expense |       | 245               |       | 246 |   |
| Related  party expenses                       |       | 3                 |       | 4 |   |
| Store  pre-opening costs                      |       | 1                 |       | 1 |   |
| **Operating income**                          |       | 105               |       | 64 |   |
| Interest  expense                             |       | 68                |       | 63 |   |
| Other  (income) and expense, net              |       | 7                 |       | (6 | ) |
| **Income before income taxes**                |       | 30                |       | 7 |   |
| Provision  for income taxes                   |       | 17                |       | 3 |   |
| **Net income**                                |       | $                 | 13         |   | $ | 4 |   |

 

See accompanying notes to consolidated financial statements.

 

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**MICHAELSSTORES, INC.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(In millions)**

**(Unaudited)**

** **
| ** **                                           | ** ** | **Quarter Ended** | ** ** |
|------------------------------------------------------|------------|-------------------|------------|
| ** **                                           | ** ** | **May 1,**   | ** ** | **May 2,** | ** ** |
| ** **                                           | ** ** | **2010**          | ** ** | **2009** | ** ** |
| **Operating activities:**                            |       |              |       |   |   |
| Net  income                                          |       | $                 | 13         |   | $ | 4 |   |
| Adjustments:                                         |       |              |       |   |   |
| Depreciation  and amortization                       |       | 26                |       | 30 |   |
| Share-based  compensation                            |       | 2                 |       | 2 |   |
| Deferred  financing costs amortization               |       | 5                 |       | 4 |   |
| Accretion  of subordinated discount notes            |       | 12                |       | 11 |   |
| Change  in fair value of interest rate cap           |       | 10                |       | (4 | ) |
| Changes  in assets and liabilities:                  |       |              |       |   |   |
| Merchandise  inventories                             |       | 10                |       | 10 |   |
| Prepaid  expenses and other                          |       | 2                 |       | 1 |   |
| Deferred  income taxes and other                     |       | —            |       | (9 | ) |
| Accounts  payable                                    |       | (24               | )          | (9 | ) |
| Accrued  interest                                    |       | 26                |       | (30 | ) |
| Accrued  liabilities and other                       |       | (39               | )          | 5 |   |
| Income  taxes receivable                             |       | (19               | )          | (13 | ) |
| Other  long-term liabilities                         |       | 3                 |       | — |   |
| Net  cash provided by operating activities           |       | 27                |       | 2 |   |
|                                                 |       |              |       |   |   |
| **Investing activities:**                            |       |              |       |   |   |
| Additions  to property and equipment                 |       | (14               | )          | (11 | ) |
| Net  cash used in investing activities               |       | (14               | )          | (11 | ) |
|                                                 |       |              |       |   |   |
| **Financing activities:**                            |       |              |       |   |   |
| Borrowings  on asset-based revolving credit facility |       | —            |       | 236 |   |
| Payments  on asset-based revolving credit facility   |       | —            |       | (212 | ) |
| Repayments  on senior secured term loan facility     |       | (118              | )          | (6 | ) |
| Payment  of debt issuance costs                      |       | (19               | )          | — |   |
| Change  in cash overdraft                            |       | (13               | )          | (10 | ) |
| Other                                                |       | (1                | )          | — |   |
| Net  cash (used in) provided by financing activities |       | (151              | )          | 8 |   |
|                                                 |       |              |       |   |   |
| **Decrease in cash and equivalents**                 |       | (138              | )          | (1 | ) |
| **Cash and equivalents at beginning of period**      |       | 217               |       | 33 |   |
| **Cash and equivalents at end of period**            |       | $                 | 79         |   | $ | 32 |   |
|                                                 |       |              |       |   |   |
| **Supplemental Cash Flow Information:**              |       |              |       |   |   |
| Cash  paid for interest                              |       | $                 | 24         |   | $ | 78 |   |
| Cash  paid for income taxes                          |       | $                 | 32         |   | $ | 14 |   |

 

See accompanying notes toconsolidated financial statements.

 

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

**For the Quarter Ended May 1, 2010(Unaudited)**

** **

**Note 1.  Summaryof Significant Accounting Policies**

 

*Basis ofPresentation*

 

Theconsolidated financial statements include the accounts of Michaels Stores, Inc.and our wholly-owned subsidiaries. All significant intercompany accounts andtransactions have been eliminated. All expressions of the “Company”, “us,” “we,”“our,” and all similar expressions are references to Michaels Stores, Inc.and our consolidated, wholly-owned subsidiaries, unless otherwise expresslystated or the context otherwise requires.

 

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

 

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

 

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

 

Becauseof the seasonal nature of our business, the results of operations for thequarter ended May 1, 2010 are not indicative of the results to be expectedfor the entire year.

 

Wereport on the basis of a 52 or 53-week fiscal year, which ends on the Saturdayclosest to January 31. All references herein to “fiscal 2010” relate tothe 52 weeks ending January 29, 2011, and all references to “fiscal2009” relate to the 52 weeks ended January 30, 2010. In addition, allreferences herein to “the first quarter of fiscal 2010” relate to the 13 weeksended May 1, 2010, and all references to “the first quarter of fiscal 2009”relate to the 13 weeks ended May 2, 2009.

 

*Recent Accounting Pronouncements*

 

In January 2010, theFinancial Accounting Standards Board (“FASB”) issued Accounting StandardsUpdate (“ASU”) No. 2010-06, “*ImprovingDisclosures About Fair Value Measurements”*an amendment to Accounting Standards Codification (“ASC”) topic 820, *“Fair Value Measurements and Disclosures.”*ASU 2010-06expands disclosure requirements related to fair value measurements including (i) separatelydisclosing the amounts of significant transfers in and out of Level 1 and Level2 fair value measurements and describing the reasons for the transfers and (ii) presentingseparate information for Level 3 activity pertaining to gross purchases, sales,issuances, and settlements. The new disclosures are effective forinterim and annual reporting periods beginning after December 15, 2009,except for the Level 3 activity disclosures, which are effective for fiscalyears beginning after December 15, 2010. We adopted all requirements ofASU 2010-06 related to significant transfers in and out of Level 1 and Level 2fair value measurements on January 31, 2010, with no material impact onour consolidated financial statements. See Note 6 for further informationregarding fair value measurements. We will adopt the new disclosurerequirements related to the Level 3 activity on January 30, 2011, with nomaterial impact expected on our consolidated financial statements.

 

**Note 2.  Share-BasedCompensation**

 

The 2006 Equity IncentivePlan (“2006 Plan”) provides for the grant of share-based awards exercisable forup to 14.2 million shares of Common Stock. As of May 1, 2010, there were9.4 million stock option awards outstanding. In addition, there were a total of 589,204 shares ofrestricted stock outstanding under the 2006 Plan, of which 79,836 are vested. 4.2 millionshares of Common Stock remain available for grant under the 2006 Plan. Thetable below sets forth a summary of stock option activity for the quarter endedMay 1, 2010:

 

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| ** **                          | ** ** | **Quarter Ended**    | ** ** |
|-------------------------------------|------------|----------------------|------------|
| ** **                          | ** ** | **May 1, 2010** | ** ** |
| ** **                          | ** ** | **(in millions)**    | ** ** |
|                                |       |                 |       |
| Outstanding  at beginning of period |       | 9.5                  |       |
| Grants                              |       | —               |       |
| Canceled/Forfeited                  |       | (0.1                 | )          |
| Outstanding  at end of period       |       | 9.4                  |       |

 

Generally,awards granted under the 2006 Plan vest ratably over five years and expireeight years from the grant date. The exercise prices of the options ranged from$7.50 per share to $22.50 per share, as determined by the Board of Directors. Share-based compensation expenseassociated with the stock options and the restricted stock was approximately $2million for the first quarter of each of fiscal 2010 and fiscal 2009.

 

**Note 3.  Debt**

 

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

 
| ** **                             | ** ** | **May 1, 2010** | ** ** | **January 30, 2010** | ** ** | **May 2, 2009** | ** ** |
|----------------------------------------|------------|----------------------|------------|---------------------------|------------|----------------------|------------|
| ** **                             | ** ** | **(in millions)**    | ** ** |
|                                   |       |                 |       |                      |       |                 |       |
| Senior  secured term loan              |       | $                    | 2,156      |                      | $          | 2,274                |       | $ | 2,291 |   |
| Senior  notes                          |       | 750                  |       | 750                       |       | 750                  |       |
| Senior  subordinated notes             |       | 400                  |       | 400                       |       | 400                  |       |
| Subordinated  discount notes           |       | 389                  |       | 377                       |       | 343                  |       |
| Asset-based  revolving credit facility |       | —               |       | —                    |       | 173                  |       |
| Other                                  |       | —               |       | 2                         |       | —               |       |
|                                   |       |                 |       |                      |       |                 |       |
| Total  debt                            |       | 3,695                |       | 3,803                     |       | 3,957                |       |
|                                   |       |                 |       |                      |       |                 |       |
| Less  current portion                  |       | —               |       | 119                       |       | 196                  |       |
|                                   |       |                 |       |                      |       |                 |       |
| Long-term  debt                        |       | $                    | 3,695      |                      | $          | 3,684                |       | $ | 3,761 |   |

 

*Asset-based revolving creditfacility*

 

OnFebruary 18, 2010, we entered into an agreement to amend and restatevarious terms of the then existing asset-based revolving credit facility datedas of October 31, 2006 (the “Amended Asset-based revolving credit facility”).

 

The Amended Asset-basedrevolving credit facility extended an aggregate amount of $850 million of thetranche A commitments and $50 million of the FILO (as defined below)commitments, with respect to certain lenders (the “Extending Lenders”), from October 31,2011 to the earlier of April 15, 2014, or 45 days prior to the maturitydate of any class of term loans in the Company’s senior secured term loanfacility. In addition, $202 million of commitments from the other lenders underthe existing asset-based revolving credit facility (the “Non-Extending Lenders”)shall terminate on October 31, 2011. Simultaneously with enteringinto the Amended Asset-based revolving credit facility, the Company exercisedits ability to increase tranche A commitments in the aggregate amount of $152million.

 

The borrowing base on theAmended Asset-based revolving credit facility equals the sum of (i) 90% ofeligible credit card receivables and debit card receivables; (ii) between85% and 87.5% of the appraised net orderly liquidation value of eligibleinventory and of eligible letters of credit; (iii) a percentage ofeligible in-transit inventory, less certain reserves; and, (iv) the sum ofan additional 5% of the appraised net orderly liquidation value of eligibleinventory and of eligible letters of credit plus an additional 5% of eligiblecredit card receivables and debit card receivables under a last out tranche(collectively, the first in last out tranche “FILO”), up to a maximum amount of$50 million.

 

TheAmended Asset-based revolving credit facility provides us with the right torequest up to $200 million of additional commitments under this facilityafter the maturity of the existing asset-based revolving credit facility on October 31,2011.  The 

 

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lenders under this facilityare not under any obligation to provide any such additional commitments, andany increase in commitments is subject to customary conditions precedent.  If we were to request any such additionalcommitments, and the existing lenders or new lenders were to agree to providesuch commitments, the facility size under the Amended Asset-based revolvingcredit facility could be increased to up to $1.2 billion after the maturity ofthe loans with respect to Non-Extending Lenders. However, our ability to borrowunder this facility would still be limited by the amount of the borrowing base.

 

With respect to theExtending Lenders, borrowings under the Amended Asset-based revolving creditfacility bear interest at a rate per annum equal to, at our option, either (a) abase rate determined by reference to the highest of (1) the prime rate ofBank of America, N.A., (2) the federal funds effective rate plus 0.50% and(3) a LIBOR rate subject to certain adjustments plus 1.00% or (b) aLIBOR rate subject to certain adjustments, in each case plus an applicable margin. With respect to the Non-Extending Lenders, borrowings under the AmendedAsset-based revolving credit facility bear interest at a rate per annum equalto, at our option, either (a) a base rate determined by reference to thehigher of (1) the prime rate of Bank of America, N.A. and (2) thefederal funds effective rate plus 0.50% or (b) a LIBOR rate subject tocertain adjustments, in each case plus an applicable margin.  The initialapplicable margin with respect to Extending Lenders is (a) 2.50% for non-FILObase rate borrowings and 3.50% for non-FILO LIBOR borrowings and (b) 4.50%for FILO base rate borrowings and 5.50% for FILO LIBOR borrowings.  Theinitial applicable margin with respect to Non-Extending Lenders is 0.50% forbase rate borrowings and 1.50% for LIBOR borrowings.  The applicablemargin is subject to adjustment each fiscal quarter based on the excessavailability under the Amended Asset-based revolving credit facility. Same-day borrowings bear interest at a rate per annum equal to a base ratedetermined by reference to the highest of (a) the prime rate of Bank ofAmerica, N.A., (b) the federal funds effective rate plus 0.50% and (c) aLIBOR rate subject to certain adjustments plus 1.00%.

 

We are required to pay acommitment fee of 0.625% per annum on the unutilized commitments with respectto Extending Lenders and 0.25% with respect to Non-Extending Lenders under theAmended Asset-based revolving credit facility. We must also pay customary letter of credit fees and agency fees.

 

If, at any time, theaggregate amount of outstanding loans, unreimbursed letter of credit drawingsand undrawn letters of credit under the Amended Asset-based revolving creditfacility exceeds the lesser of (i) the commitment amount or (ii) theborrowing base, we will be required to repay outstanding loans and cashcollateralize letters of credit in an aggregate amount equal to such excess,with no reduction of the commitment amount. If the amount available under the Amended Asset-based revolving creditfacility is less than $75 million at any time, or for five consecutive businessdays is less than the greater of $100 million and 15% of the lesser of the (i) thenborrowing base and (ii) Revolving Credit Ceiling (as defined below), or ifcertain events of default have occurred, we will be required to repayoutstanding loans and cash collateralize letters of credit with the cash we arerequired to deposit daily in a collection account maintained with the agentunder the Amended Asset-based revolving credit facility. We may voluntarilyreduce the unutilized portion of the commitment amount and repay outstandingloans at any time without premium or penalty other than customary breakagecosts with respect to LIBOR loans.

 

Although the AmendedAsset-based revolving credit facility does not require us to comply with anyfinancial ratio maintenance, it does contain a number of covenants that, amongother things and subject to certain exceptions, restricts the Company’s abilityand the ability of its subsidiaries to:

 

·                  incur additional indebtedness;

·                  pay dividends on the Company’s capitalstock or redeem, repurchase or retire the Company’s capital stock or its otherindebtedness;

·                  make investments, loans, advances andacquisitions;

·                  create restrictions on the payment ofdividends or other amounts to the Company from its restricted subsidiaries;

·                  engage in transactions with affiliates ofthe Company;

·                  sell assets, including capital stock ofthe Company’s subsidiaries;

·                  consolidate or merge; and

·                  create liens.

 

The covenants limitingdividends and other restricted payments; investments, loans, advances andacquisitions; and prepayments or redemptions of indebtedness, each permit therestricted actions in an unlimited amount, subject to the satisfaction ofcertain payment conditions, principally that we must meet certain specifiedexcess availability requirements and minimum consolidated fixed charge coverageratios, to be tested on a pro forma and 12 months projected basis. AdjustedEBITDA is used in the calculation of the consolidated fixed charge coverageratios.

 

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We must not permit excessavailability at any time to be less than the greater of (a) $75 millionand (b) 10% of the lesser of (1) the then borrowing base under theAmended Asset-based revolving credit facility or (2) $1.102 million (asreduced or increased in accordance with the terms of the Amended Asset-basedcredit facility, the “Revolving Credit Ceiling”).  Excess availabilityunder the senior secured asset-based revolving credit facility means the lesserof (a) the Revolving Credit Ceiling minus the outstanding creditextensions and (b) the then borrowing base minus the outstanding creditextensions. The Amended Asset-based revolving credit facility also containscertain customary affirmative covenants and events of default.

 

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

 

Asof May 1, 2010, the borrowing base was $697 million, of which we had nooutstanding borrowings, $46 million of outstanding letters of credit, and $651million of excess 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 (“Deutsche Bank”) and otherlenders, (the “Senior secured term loan facility”) bear interest at a rate perannum equal to, at our option, either (a) a base rate determined byreference to the higher of (1) the prime rate of Deutsche Bank and (2) thefederal funds effective rate plus 0.5% or (b) a LIBOR rate, subjectto certain adjustments, in each case plus an applicable margin as describedbelow.

 

OnNovember 5, 2009, we amended the Senior secured term loan facility toextend $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” and togetherwith the B-2 Term Loans, the “Term Loans”) keeping the originalmaturity date of October 31, 2013. The B-2 Term Loans are subject to (i) a springingmaturity date of July 31, 2014 unless we have either (x) refinancedour Senior Notes by July 30, 2014 with new indebtedness that does notmature or require any principal payments prior to 91 days after the extendedmaturity date of the B-2 Term Loans or (y) met a pro forma securedleverage ratio of 3.25x for the test period ending April 30, 2014; and (ii) aminimum increase in interest rates on the B-2 loans in connection with anyfuture extensions of term loans such that any extension has an increase ineffective yield in excess of 0.25%As of May 1, 2010, theapplicable margin for the B-1 and B-2 Term Loans was 1.25% and 3.50%,respectively, with respect to base rate borrowings and 2.25% and 4.50%,respectively, with respect to LIBOR borrowings.

 

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 30, 2010. Under the facilities, excesscash flow payments serve to reduce future scheduled quarterly principalpayments. The fiscal 2009 excess cash flow payment effectively satisfies allscheduled quarterly principal payments until maturity of the B-1 Term Loans andrequired payments under the B-2 Term Loans until the end of fiscal 2014.

 

**Note4.  Comprehensive Income**

 

Our comprehensive income, net of related tax, is asfollows:

 
| ** **                                         | ** ** | **Quarter Ended**    | ** ** |
|----------------------------------------------------|------------|----------------------|------------|
| ** **                                         | ** ** | **May 1, 2010** | ** ** | **May 2, 2009** | ** ** |
| ** **                                         | ** ** | **(in millions)**    | ** ** |
|                                               |       |                 |       |   |   |
| Net  income                                        |       | $                    | 13         |   | $ | 4 |   |
| Other  comprehensive income (loss):                |       |                 |       |   |   |
| Derivative  loss                                   |       | —               |       | (1 | ) |
| Foreign  currency translation adjustment and other |       | 1                    |       | 1 |   |
| Comprehensive  income                              |       | $                    | 14         |   | $ | 4 |   |

 

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

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

 

**Note 5.  DerivativeInstruments**

 

Weare exposed to fluctuations in interest rates on our Senior secured term loan.During the first quarter of fiscal 2009, we purchased an interest ratederivative with the objective to cap our exposure to interest rate increases onour senior secured term loan that result from fluctuations in the three-monthLIBOR rate. The cap limits our interest exposure on a notional value of $2.0 billionto the lesser of the three-month LIBOR rate or 7.0%.  The term of the cap extends to the firstquarter of fiscal 2015. The interest rate cap does not qualify for hedgeaccounting under ASC 815, *Derivatives and Hedging*.The fair value of the cap as of May 1, 2010 was $8 million and is includedin Other assets on the Consolidated Balance Sheet. The change in fair value ofthe cap for the quarter ended May 1, 2010, resulted in a loss of $10million and is recorded in Other (income) and expense, net in the ConsolidatedStatement of Operations.

 

We are exposed to fluctuations in exchange ratesbetween the US and Canadian dollar, which is the functional currency of ourCanadian subsidiary. During the second quarter of fiscal 2008, we executedforeign currency forward contracts to mitigate the effects of currencyfluctuations, which we designated as a cash flow hedge. The objective of theforward contracts was to hedge intercompany payments for forecasted purchasesof inventory by our Canadian subsidiary, which are denominated in US dollars.The term of this cash flow hedge extended through the first quarter of fiscal2009.

 

To achieve our objectiveand to minimize the risk of ineffectiveness, the notional values represented aportion of our Canadian subsidiary’s forecasted intercompany purchases. Hedgeineffectiveness was recorded in Other (income) and expense, net in theConsolidated Statement of Operations. For the quarter ended May 2, 2009,the ineffective portion of the hedge was immaterial.

 

For the portion of thehedge that was effective, the change in fair value of the hedge was initiallyrecorded in Accumulated other comprehensive income. As the underlying inventorywas sold to our customers, amounts were reclassified from Accumulated othercomprehensive income to Cost of sales and occupancy expense. During thefirst quarter of fiscal 2009, we reclassified $2 million from Accumulated othercomprehensive income into Cost of sales and occupancy expense. An immaterialamount was recognized in Accumulated other comprehensive income during thefirst quarter of fiscal 2009 related to the effective portion of the hedge.

 

**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 tablepresents net financial assets (liabilities) accounted for at fair value on arecurring basis as of May 1, 2010 (in millions):

 
| ** **         | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** | **Total** | ** ** |
|--------------------|------------|-------------|------------|-------------|------------|-------------|------------|-----------|------------|
| Interest  Rate Cap |       | $           | —     |        | $          | 8           |       | $         | —     |   | $ | 8 |   |
|                    |            |             |            |             |            |             |            |           |            |  |  |  |  |

 

The interest rate cap ismeasured using widely accepted valuation techniques including discounted cashflow analysis on the expected cash flows. This analysis reflects thecontractual terms of the derivatives, including the period to maturity, anduses 

 

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observablemarket-based inputs, including interest rate curves and impliedvolatilities.  The fair value of the interestrate cap is determined using the market standard methodology of nettingthe discounted future fixed cash payments and the discounted expected variablecash receipts.  The variable cash receipts are based on an expectation offuture interest rates (forward curves) derived from observable market interestrate curves. See Note5 for additional information on our derivative instruments.

 

We generally apply fairvalue techniques on a non-recurring basis associated for the establishment of potentialimpairment loss related to goodwill pursuant to ASC 350, *Intangibles—Goodwilland Other* and determining the fair value of long-lived assetspursuant to ASC 360, *Property, Plant, andEquipment.* During the first quarter of fiscal 2010, there were noevents or changes in circumstances indicating the carry amounts of ourlong-lived assets may not be recoverable.

 

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

 
| ** **                   | ** ** | **Carrying Value** | ** ** | **Fair Value** | ** ** |
|------------------------------|------------|--------------------|------------|----------------|------------|
| ** **                   | ** ** | **(in millions)**  | ** ** |
| Senior  secured term loan    |       | $                  | 2,156      |           | $          | 2,090 |   |
| Senior  notes                |       | 750                |       | 795            |       |
| Senior  subordinated notes   |       | 400                |       | 436            |       |
| Subordinated  discount notes |       | 389                |       | 362            |       |
|                              |            |                    |            |                |            |  |  |

 

**Note 7.  IncomeTaxes**

 

Oureffective income tax rate for the first quarter of fiscal 2010 was 57.9%compared to 40.5% for the first quarter of fiscal 2009. During the firstquarter of fiscal 2010, we recorded a correction to our federal deferred taxliability relating to state income taxes which unfavorably impacted our firstquarter effective income tax rate by 16.5%. We currently estimate our annualizedeffective tax rate for fiscal 2010 to be 41%, including a 2.7% unfavorableimpact from the deferred tax liability correction recorded during the firstquarter.

 

**Note 8.  Commitmentsand Contingencies**

 

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

 

*Consumer Class Action Claims*

 

*Rattray Claim*

 

On April 9, 2010, Ross Rattray, a consumer, filed a purportedclass action proceeding against Michaels Stores, Inc. in the SuperiorCourt of California, County of San Diego, on behalf of himself and allsimilarly-situated California consumers.  The Rattray suit allegescauses of action for unlawful and unfair business practices and falseadvertising under the California Business and Professions Code, and a violationof the Consumer Legal Remedies Act, for misrepresentation that Michaels giftcards are not redeemable for cash and for failure to disclose that theplaintiff could redeem the unused cash balance on a gift card when the valuefell below $10.00.  The plaintiff seeksinjunctive relief, restitution, punitive damages, costs, interest, andattorneys’ fees.  We believe we have meritorious defenses and intend todefend the lawsuit vigorously.  We are unable to estimate a range of loss,if any, in this case.

 

**Note 9.  Segmentsand Geographic Information**

** **

Weconsider our Michaels and Aaron Brothers operations to be our operatingsegments for purposes of determining reportable segments based on the criteria ofASC 280, *Segment Reporting.* Wedetermined that our Michaels and Aaron Brothers operating segments have similareconomic characteristics and meet the aggregation criteria set forth in ASC280. Therefore, we combine both operating segments into one reporting segment.

 

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Our chief operating decision makers evaluatehistorical operating performance, plan and forecast future periods’ operatingperformance based on earnings before interest, income taxes, depreciation andamortization (“EBITDA”). We believe EBITDA represents the financial measurethat more closely reflects the operating effectiveness of factors over whichmanagement has control. As such, an element of base incentive compensationtargets for certain management personnel are based on EBITDA. A reconciliationof EBITDA to income before income taxes is presented below.

 
| ** **                     | ** ** | **Quarter Ended**    | ** ** |
|--------------------------------|------------|----------------------|------------|
| ** **                     | ** ** | **May 1, 2010** | ** ** | **May 2, 2009** | ** ** |
| ** **                     | ** ** | **(in millions)**    | ** ** |
|                           |       |                 |       |   |   |
| Income  before income taxes    |       | $                    | 30         |   | $ | 7 |   |
| Interest  expense              |       | 68                   |       | 63 |   |
| Depreciation  and amortization |       | 26                   |       | 30 |   |
| EBITDA                         |       | $                    | 124        |   | $ | 100 |   |

 

Oursales and assets by country areas follows:

 
| ** **          | ** ** | **Quarter Ended**    | ** ** |
|---------------------|------------|----------------------|------------|
| ** **          | ** ** | **May 1, 2010** | ** ** | **May 2, 2009** | ** ** |
| ** **          | ** ** | **(in millions)**    | ** ** |
| **Net Sales:**      |       |                 |       |   |   |
| United  States      |       | $                    | 825        |   | $ | 792 |   |
| Canada              |       | 76                   |       | 60 |   |
| Consolidated  Total |       | $                    | 901        |   | $ | 852 |   |
|                |       |                 |       |   |   |
| **Total Assets:**   |       |                 |       |   |   |
| United  States      |       | $                    | 1,480      |   | $ | 1,522 |   |
| Canada              |       | 83                   |       | 91 |   |
| Consolidated  Total |       | $                    | 1,563      |   | $ | 1,613 |   |

 

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

 

**Note 10.  RelatedParty Transactions**

 

Wepay annual management fees to Bain Capital Partners, LLC and The BlackstoneGroup (collectively, together with their applicable affiliates, the “Sponsors”)and Highfields Capital Management LP in the amount of $12 million and $1million, respectively. We recognized $3 million and $4 million of expenserelated to annual management fees during the first quarter of fiscal 2010 andfiscal 2009, respectively. These expenses are included in related partyexpenses on the Consolidated Statements of Operations.

 

BainCapital owns a majority equity position in an external vendor we utilize toprint our circular advertisements. Payments associated with this vendor during the first quarter of fiscal2010 and fiscal 2009 were $9 million and $8 million, respectively.  These expenses are included in selling,general and administrative expense on the Consolidated Statements ofOperations.

 

BainCapital owns an equity position in an external vendor we utilized fornon-merchandise supplies.  Paymentsassociated with this vendor during the first quarter of fiscal 2009 were $1million.  These expenses are included inselling, general and administrative expense on the Consolidated Statements ofOperations.

 

TheBlackstone Group owns a majority equity position in an external vendor weutilize to count our store inventory. Payments associated with this vendorduring the first quarter of each of fiscal 2010 and fiscal 2009 were $2million.  These expenses are included inselling, general and administrative expense on the Consolidated Statements ofOperations.

 

TheBlackstone Group owns an equity position in an external vendor we utilize forwaste management services. Payments associated with this vendor during thefirst quarter of fiscal 2010 and fiscal 2009 were $1 million and $2 million,respectively. These expenses are included in selling, general andadministrative expense on the Consolidated Statements of Operations.

 

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TheBlackstone Group owns an equity position in an external vendor we utilize forall of the candy-type items in our stores. Payments associated with this vendor during the first quarter of fiscal2010 and fiscal 2009 were $4 million and $3 million, respectively. Theseexpenses are recognized in cost of sales as the sales are recorded.

 

Ourcurrent directors are affiliates of Bain Capital or The Blackstone Group.  As such, some or all of our directors may havean indirect material interest in payments with respect to debt securities ofthe Company that have been purchased by affiliates of Bain Capital and TheBlackstone Group.  During the firstquarter of fiscal 2010, such affiliates sold approximately $199 millionface amount of our Subordinated Discount Notes due 2016. As of May 1,2010, such affiliates did not hold any of our debt securities.

 

**Note11.  Condensed Consolidating FinancialInformation**

** **

All obligations ofMichaels Stores, Inc. under the Senior notes, Senior subordinated notes,Subordinated discount notes, Senior secured term loan, and Amended asset-basedrevolving credit facility are guaranteed by each of our subsidiaries other thanAaron Brothers Card Services, LLC and Artistree of Canada, ULC. As of May 1,2010, the financial statements of Aaron Brothers Card Services, LLC andArtistree of Canada, ULC 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.

 

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

 

**SupplementalCondensed Consolidating Balance Sheet**

 
| ** **                                                 | ** ** | **May 1, 2010** | ** ** |
|------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                 | ** ** | **Parent   Company** | ** ** | **Guarantor   Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                 | ** ** | **(in millions)**    | ** ** |
| **ASSETS**                                                 |       |                 |       |   |   |   |   |   |   |
| **Current assets:**                                        |       |                 |       |   |   |   |   |   |   |
| Cash  and equivalents                                      |       | $                    | 66         |   | $ | 13 |   | $ | — |   | $ | 79 |   |
| Merchandise  inventories                                   |       | 584                  |       | 282 |   | — |   | 866 |   |
| Intercompany  receivables                                  |       | —               |       | 314 |   | (314 | ) | — |   |
| Other                                                      |       | 103                  |       | 18 |   | — |   | 121 |   |
| Total  current assets                                      |       | 753                  |       | 627 |   | (314 | ) | 1,066 |   |
| **Property and equipment, net**                            |       | 227                  |       | 73 |   | — |   | 300 |   |
| **Goodwill, net**                                          |       | 94                   |       | — |   | — |   | 94 |   |
| **Investment in subsidiaries**                             |       | 417                  |       | — |   | (417 | ) | — |   |
| **Other assets**                                           |       | 102                  |       | 1 |   | — |   | 103 |   |
| Total  assets                                              |       | $                    | 1,593      |   | $ | 701 |   | $ | (731 | ) | $ | 1,563 |   |
|                                                       |       |                 |       |   |   |   |   |   |   |
| **LIABILITIES AND STOCKHOLDERS’  (DEFICIT) EQUITY**   |       |                 |       |   |   |   |   |   |   |
| **Current liabilities:**                                   |       |                 |       |   |   |   |   |   |   |
| Accounts  payable                                          |       | $                    | 13         |   | $ | 183 |   | $ | — |   | $ | 196 |   |
| Accrued  liabilities and other                             |       | 249                  |       | 89 |   | — |   | 338 |   |
| Current  portion of long-term debt                         |       | —               |       | — |   | — |   | — |   |
| Intercompany  payable                                      |       | 314                  |       | — |   | (314 | ) | — |   |
| Other                                                      |       | 4                    |       | — |   | — |   | 4 |   |
| Total  current liabilities                                 |       | 580                  |       | 272 |   | (314 | ) | 538 |   |
| **Long-term debt**                                         |       | 3,695                |       | — |   | — |   | 3,695 |   |
| **Other long-term liabilities**                            |       | 74                   |       | 12 |   | — |   | 86 |   |
| **Total stockholders’ (deficit) equity**              |       | (2,756               | )          | 417 |   | (417 | ) | (2,756 | ) |
| Total  liabilities and stockholders’ (deficit) equity |       | $                    | 1,593      |   | $ | 701 |   | $ | (731 | ) | $ | 1,563 |   |

 

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**Supplemental Condensed Consolidating Balance Sheet**

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

 

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**Supplemental Condensed Consolidating Balance Sheet**

 
| ** **                                                 | ** ** | **May 2, 2009** | ** ** |
|------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                 | ** ** | **Parent   Company** | ** ** | **Guarantor   Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                 | ** ** | **(in millions)**    | ** ** |
| **ASSETS**                                                 |       |                 |       |   |   |   |   |   |   |
| **Current assets:**                                        |       |                 |       |   |   |   |   |   |   |
| Cash  and equivalents                                      |       | $                    | 25         |   | $ | 7 |   | $ | — |   | $ | 32 |   |
| Merchandise  inventories                                   |       | 628                  |       | 262 |   | — |   | 890 |   |
| Intercompany  receivables                                  |       | —               |       | 535 |   | (535 | ) | — |   |
| Other                                                      |       | 107                  |       | 17 |   | — |   | 124 |   |
| Total  current assets                                      |       | 760                  |       | 821 |   | (535 | ) | 1,046 |   |
| **Property and equipment, net**                            |       | 271                  |       | 92 |   | — |   | 363 |   |
| **Goodwill, net**                                          |       | 94                   |       | — |   | — |   | 94 |   |
| **Investment in subsidiaries**                             |       | 628                  |       | — |   | (628 | ) | — |   |
| **Other assets**                                           |       | 109                  |       | 1 |   | — |   | 110 |   |
| Total  assets                                              |       | $                    | 1,862      |   | $ | 914 |   | $ | (1,163 | ) | $ | 1,613 |   |
|                                                       |       |                 |       |   |   |   |   |   |   |
| **LIABILITIES AND STOCKHOLDERS’  (DEFICIT) EQUITY**   |       |                 |       |   |   |   |   |   |   |
| **Current liabilities:**                                   |       |                 |       |   |   |   |   |   |   |
| Accounts  payable                                          |       | $                    | 15         |   | $ | 198 |   | $ | — |   | $ | 213 |   |
| Accrued  liabilities and other                             |       | 173                  |       | 76 |   | — |   | 249 |   |
| Current  portion of long-term debt                         |       | 196                  |       | — |   | — |   | 196 |   |
| Intercompany  payable                                      |       | 535                  |       | — |   | (535 | ) | — |   |
| Other                                                      |       | 1                    |       | — |   | — |   | 1 |   |
| Total  current liabilities                                 |       | 920                  |       | 274 |   | (535 | ) | 659 |   |
| **Long-term debt**                                         |       | 3,761                |       | — |   | — |   | 3,761 |   |
| **Other long-term liabilities**                            |       | 62                   |       | 12 |   | — |   | 74 |   |
| **Total stockholders’ (deficit) equity**              |       | (2,881               | )          | 628 |   | (628 | ) | (2,881 | ) |
| Total  liabilities and stockholders’ (deficit) equity |       | $                    | 1,862      |   | $ | 914 |   | $ | (1,163 | ) | $ | 1,613 |   |

 

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**Supplemental Condensed Consolidating Statement of Operations**

 
| ** **                                    | ** ** | **Quarter Ended May 1, 2010** | ** ** |
|-----------------------------------------------|------------|------------------------------------|------------|
| ** **                                    | ** ** | **Parent   Company**               | ** ** | **Guarantor   Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                    | ** ** | **(in millions)**                  | ** ** |
|                                          | ** ** | ** **                         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Net sales**                                 |       | $                                  | 794        |   | $ | 485 |   | $ | (378 | ) | $ | 901 |   |
| Cost  of sales and occupancy expense          |       | 528                                |       | 397 |   | (378 | ) | 547 |   |
| **Gross profit**                              |       | 266                                |       | 88 |   | — |   | 354 |   |
| Selling,  general, and administrative expense |       | 212                                |       | 33 |   | — |   | 245 |   |
| Related  party expenses                       |       | 3                                  |       | — |   | — |   | 3 |   |
| Store  pre-opening costs                      |       | 1                                  |       | — |   | — |   | 1 |   |
| **Operating income**                          |       | 50                                 |       | 55 |   | — |   | 105 |   |
| Interest  expense                             |       | 68                                 |       | — |   | — |   | 68 |   |
| Other  (income) and expense, net              |       | 11                                 |       | (4 | ) | — |   | 7 |   |
| Intercompany  charges (income)                |       | 15                                 |       | (15 | ) | — |   | — |   |
| Equity  in earnings of subsidiaries           |       | 74                                 |       | — |   | (74 | ) | — |   |
| **Income before income taxes**                |       | 30                                 |       | 74 |   | (74 | ) | 30 |   |
| Provision  for income taxes                   |       | 17                                 |       | 30 |   | (30 | ) | 17 |   |
| **Net income**                                |       | $                                  | 13         |   | $ | 44 |   | $ | (44 | ) | $ | 13 |   |

 

**Supplemental Condensed Consolidating Statement of Operations**

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

 

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**Supplemental Condensed Consolidating Statement of Cash Flows**

 
| ** **                                      | ** ** | **Quarter Ended May 1, 2010** | ** ** |
|-------------------------------------------------|------------|------------------------------------|------------|
| ** **                                      | ** ** | **Parent   Company**               | ** ** | **Guarantor   Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                      | ** ** | **(in millions)**                  | ** ** |
| **Operating activities:**                       |       |                               |       |   |   |   |   |   |   |
| Net  cash provided by operating activities      |       | $                                  | 24         |   | $ | 30 |   | $ | (27 | ) | $ | 27 |   |
|                                            |       |                               |       |   |   |   |   |   |   |
| **Investing activities:**                       |       |                               |       |   |   |   |   |   |   |
| Cash  paid for property and equipment           |       | (14                                | )          | — |   | — |   | (14 | ) |
| Net  cash used in investing activities          |       | (14                                | )          | — |   | — |   | (14 | ) |
|                                            |       |                               |       |   |   |   |   |   |   |
| **Financing activities:**                       |       |                               |       |   |   |   |   |   |   |
| Net  repayments of long-term debt               |       | (118                               | )          | — |   | — |   | (118 | ) |
| Intercompany  dividends                         |       | —                             |       | (27 | ) | 27 |   | — |   |
| Other  financing activities                     |       | (33                                | )          | — |   | — |   | (33 | ) |
| Net  cash used in financing activities          |       | (151                               | )          | (27 | ) | 27 |   | (151 | ) |
|                                            |       |                               |       |   |   |   |   |   |   |
| **(Decrease) increase in cash and equivalents** |       | (141                               | )          | 3 |   | — |   | (138 | ) |
| **Beginning cash and equivalents**              |       | 207                                |       | 10 |   | — |   | 217 |   |
| **Ending cash and equivalents**                 |       | $                                  | 66         |   | $ | 13 |   | $ | — |   | $ | 79 |   |

 

**Supplemental Condensed Consolidating Statement of Cash Flows**

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

 

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

 

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

 

**DisclosureRegarding Forward-Looking Information**

** **

Thefollowing discussion should be read in conjunction with our consolidatedfinancial statements and related notes included elsewhere in this QuarterlyReport on Form 10-Q. The following discussion, as well as other portionsof this Quarterly Report on Form 10-Q, contains forward-looking statementsthat reflect our plans, estimates, and beliefs. Any statements contained herein(including, but not limited to, statements to the effect that Michaels or 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 30, 2010. 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 or impliedby such forward-looking statements. Such risks and uncertainties include, butare not limited to:

 

·                  risks related togeneral economic conditions and the current financial crisis; if worldwide economic conditionsdeteriorate further, or if recovery remains slow or prolonged, it couldcontinue to adversely affect consumer confidence and retail spending, decreasingdemand for our merchandise and adversely impact our results of operations, cashflows and financial condition;

 

·                  risks related to our substantialindebtedness, as our**leveragecould adversely affect our ability to raise additional capital to fund ouroperations, limit our ability to react to changes in the economy or ourindustry, expose us to interest rate risk to the extent of our variable ratedebt and prevent us from meeting our obligations under our notes and creditfacilities;

 

·                  restrictions in our debt agreements thatlimit our flexibility in operating our business, as our senior secured creditfacilities and the indentures governing our notes contain various covenantsthat limit our ability to engage in specified types of transactions and requirethat we maintain specified financial ratios upon the occurrence of certainevents;

 

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

 

·                  how well we manage our business;

 

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

 

·                  unexpected or unfavorable consumerresponses to our promotional or merchandising programs could materiallyadversely affect our sales, operating results, and cash flow;

 

·                  changes innewspaper subscription rates may result in reduced exposure to ourcircular advertisements and adversely affect our sales, operating results andcash flow;

 

·                  improvements to our supply chainmay not be fully successful;

 

·                  our suppliers may fail us;

 

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

 

·                  risks associatedwith the vendors from whom our products are sourced could materially adverselyaffect our revenue and gross profit;

 

·                  product recalls and/or product liability,as well as changes in product safetyand other consumer protection laws, may adversely impact our operations,merchandise offerings, reputation and financial position;

 

·                  significant increases in inflation orcommodity prices such as petroleum, natural gas, electricity, steel and papermay adversely affect our costs, including cost of merchandise;

 

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·                  we haveco-sourced certain of our information technology, accounts payable, payroll,accounting and human resources functions, and may co-source otheradministrative functions, making us more dependent upon third parties;

 

·                  our information systems may proveinadequate;

 

·                  we may fail to optimize or adequatelymaintain our perpetual inventory and automated replenishment systems;

 

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

 

·                  changes in regulations or enforcement mayadversely impact our business;

 

·                  a weak fourth quarter would materiallyadversely affect our operating results;

 

·                  competition could negatively impact ouroperations; and

 

·                  the interests of our controllingstockholders may conflict with the interests of our creditors.

 

For more details on factors that may cause actual results to differmaterially from such forward-looking statements, please see Item 1A. RiskFactors of our Annual Report on Form 10-K for the fiscal year ended January 30,2010, and other reports from time to time filed with or furnished to the SEC.We disclaim any intention to, and undertake no obligation to, update or reviseany forward-looking statement.

 

**General**

** **

Wereport on the basis of a 52 or 53-week fiscal year, which ends on the Saturdayclosest to January 31.  Allreferences herein to “fiscal 2010” relate to the 52 weeks ending January 29,2011 and all references to “fiscal 2009” relate to the 52 weeks ended January 30,2010. In addition, all references herein to “the first quarter of fiscal 2010”relate to the 13 weeks ended May 1, 2010 and all references to “the firstquarter of fiscal 2009” relate to the 13 weeks ended May 2, 2009.

 

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The following table setsforth certain of our unaudited operating data:

 
| ** **                                               | ** ** | **Quarter Ended** | ** ** |
|----------------------------------------------------------|------------|-------------------|------------|
| ** **                                               | ** ** | **May 1,**   | ** ** | **May 2,** | ** ** |
| ** **                                               | ** ** | **2010**          | ** ** | **2009** | ** ** |
| **Michaels stores:**                                     |       |              |       |   |   |
| Retail  stores open at beginning of period               |       | 1,023             |       | 1,009 |   |
| Retail  stores opened during the period                  |       | 5                 |       | 11 |   |
| Retail  stores opened (relocations) during the period    |       | 7                 |       | 4 |   |
| Retail  stores closed during the period                  |       | —            |       | — |   |
| Retail  stores closed (relocations) during the period    |       | (7                | )          | (4 | ) |
| Retail  stores open at end of period                     |       | 1,028             |       | 1,020 |   |
|                                                     |       |              |       |   |   |
| **Aaron Brothers stores:**                               |       |              |       |   |   |
| Retail  stores open at beginning of period               |       | 152               |       | 161 |   |
| Retail  stores opened during the period                  |       | —            |       | — |   |
| Retail  stores opened (relocations) during the period    |       | —            |       | — |   |
| Retail  stores closed during the period                  |       | (6                | )          | (5 | ) |
| Retail  stores closed (relocations) during the period    |       | —            |       | — |   |
| Retail  stores open at end of period                     |       | 146               |       | 156 |   |
|                                                     |       |              |       |   |   |
| Total  store count at end of period                      |       | 1,174             |       | 1,176 |   |
|                                                     |       |              |       |   |   |
| **Other operating data:**                                |       |              |       |   |   |
| Average  inventory per Michaels store (in thousands) (1) |       | $                 | 803        |   | $ | 833 |   |
| Comparable  store sales increase (decrease) (2)          |       | 4.9               | %          | (2.0 | )% |
|                                                          |            |                   |            |  |  |  |  |

 

----

(1)                       The calculationof average inventory per Michaels store excludes our Aaron Brothers stores.

 

(2)                       Comparablestore sales increase (decrease) represents the increase (decrease) in net salesfor Michaels and Aaron Brothers stores open the same number of months in theindicated period and the comparable period of the previous year, includingstores that were relocated or expanded during either period. A store is deemedto become comparable in its 14th month of operation in order to eliminategrand opening sales distortions. A store temporarily closed more than2 weeks due to a catastrophic event is not considered comparable duringthe month it closed. If a store is closed longer than 2 weeks but lessthan 2 months, it becomes comparable in the month in which it reopens,subject to a mid-month convention. A store closed longer than 2 monthsbecomes 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.

 

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| ** **                                    | ** ** | **Quarter Ended** | ** ** |
|-----------------------------------------------|------------|-------------------|------------|
| ** **                                    | ** ** | **May 1,**   | ** ** | **May 2,** | ** ** |
| ** **                                    | ** ** | **2010**          | ** ** | **2009** | ** ** |
| **Net sales**                                 |       | 100.0             | %          | 100.0 | % |
| Cost  of sales and occupancy expense          |       | 60.7              |       | 63.0 |   |
| **Gross profit**                              |       | 39.3              |       | 37.0 |   |
| Selling,  general, and administrative expense |       | 27.2              |       | 28.9 |   |
| Related  party expenses                       |       | 0.3               |       | 0.5 |   |
| Store  pre-opening costs                      |       | 0.1               |       | 0.1 |   |
| **Operating income**                          |       | 11.7              |       | 7.5 |   |
| Interest  expense                             |       | 7.6               |       | 7.4 |   |
| Other  (income) and expense, net              |       | 0.8               |       | (0.7 | ) |
| **Income before income taxes**                |       | 3.3               |       | 0.8 |   |
| Provision  for income taxes                   |       | 1.9               |       | 0.3 |   |
| **Net income**                                |       | 1.4               | %          | 0.5 | % |

* *

*Quarter Ended May 1, 2010 Compared to theQuarter Ended May 2, 2009*

* *

*Net Sales*—Net salesincreased for the first quarter of fiscal 2010 by $49 million, or 5.7%,over the first quarter of fiscal 2009 due primarily to a $41 million increasein comparable store sales. Comparable store sales increased 4.9% primarily dueto an increase in the average ticket of 3.7% and an increase in customer traffic of 1.2%.  The fluctuation in the exchange rates betweenthe United States and Canadian dollars positively impacted the average ticketby 160 basis points.  In addition, salesfrom our non-comparable new stores provided incremental revenue of $8 million.

 

*Cost of Sales and Occupancy Expense*—Cost of salesand occupancy expense increased $10 million to $547 million in the firstquarter of 2010 from $537 million in the first quarter of 2009 due primarily toincreased net sales, partially offset by lower costs as a percentage of netsales. Cost of sales and occupancy expense decreased 230 basis points, asa percentage of net sales, as we realized a 130 basis point decrease in cost ofgoods sold primarily due to lower costs associated with an increase in importedmerchandise and improved management of promotional and clearance markdowns. Inaddition occupancy costs for the first quarter of fiscal 2010 were relativelyflat compared to prior year and as a percentage of net sales, decreased 100basis points primarily due to leveraging of fixed costs on an increase incomparable store sales.

 

*Selling, General, and Administrative Expense*—Selling,general, and administrative expense was $245 million, or 27.2% of net sales, inthe first quarter of fiscal 2010 compared to $246 million, or 28.9% of netsales, in the first quarter of fiscal 2009. Selling, general and administrativeexpense decreased $1 million primarily driven by lower severance costs asfiscal 2009 included expenses related to the transition of certain corporatefunctions to a third party. In addition, depreciation expense decreased due tolower capital expenditures in recent years, and advertising expense decreasedprimarily as a result of negotiating lower costs related to our newspaperinserts. These amounts are partially offset by increases in store personnelcosts related to operating eight additional Michaels stores during the firstquarter of fiscal 2010 and increased performance based bonus expense due tohigher profitability levels during the first quarter of fiscal 2010. As apercentage of net sales, selling, general, and administrative expense decreased170 basis points primarily due to increased payroll leverage on highercomparable store sales as well as lower severance, advertising, and depreciationexpense as indicated above.

 

*Related Party Expenses*—Related party expenses were$3 million in the first quarter of fiscal 2010 compared to $4 million in thefirst quarter of fiscal 2009.  Thesecosts consist primarily of $3 million and $4 million of management fees andassociated expenses paid to our Sponsors and Highfields, respectively.

 

*Interest Expense*—Interest expense for thequarter increased $5 million to $68 million as a result of increased interestrates associated with our amended credit facilities.

 

*Other(Income)and Expense, net*—Other expense in the first quarter of fiscal 2010related primarily to a $10 million unfavorable change in the fair value of theinterest rate cap as more fully described in Note 5 to the consolidatedfinancial statements, partially offset by $3 million related to foreignexchange rate gains.  Other income in thefirst quarter of fiscal 2009 related primarily to a $4 million favorable changein the fair value of the interest rate cap and $1 million in foreign exchange rategains.

* *

*Provision for Income Taxes*—Theeffective tax rate was 57.9 % for the first quarter of fiscal 2010. The ratewas higher than the federal tax rate due primarily to additional expenserecorded to correct the federal deferred tax liability relating to state incometaxes. The effective tax rate was 40.5% for the first quarter of fiscal 2009. We currentlyestimate our annualized effective tax rate for fiscal 2010 to be 41%, includinga 2.7% unfavorable impact from the deferred tax liability correction recordedduring the first quarter.

 

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**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 for seasonal working capitalneeds. We expect that our available cash, cash flow generated from operatingactivities, and funds available under our Amended asset-based revolving creditfacility will be sufficient to fund planned capital expenditures, workingcapital requirements, debt repayments, debt service requirements and futuregrowth for the foreseeable future. Our Amended asset-based revolving creditfacility provides senior secured financing of up to $1.1 billion, subject to aborrowing base. As of May 1, 2010, the borrowing base was $697 million,which supported $46 million of outstanding letters of credited and provided$651 million of excess availability. Our cash and equivalents decreased $138million from $217 million at January 30, 2010, to $79 million at May 1,2010.

 

Weand our subsidiaries, affiliates, and significant shareholders may from time totime seek to retire or purchase our outstanding debt (including publicly issueddebt) through cash purchases and/or exchanges, in open market purchases,privately negotiated transactions, by tender offer or otherwise.  Such repurchases or exchanges, if any, willdepend on prevailing market conditions, liquidity requirements, contractualrestrictions and other factors.

 

*Cash Flowfrom Operating Activities*

 

Cashflow provided by operating activities during the first quarter of fiscal 2010was $27 million compared to $2 million during the first quarter of fiscal2009. The $25 million change was primarily due to an increase in netincome and a favorable impact from our accrued interest, partially offset by anunfavorable impact in accrued liabilities compared to the first quarter offiscal 2009.  The change in accruedinterest is attributable to the timing of payments while the change in accruedliabilities was due primarily to higher bonus payments made during the firstquarter of fiscal 2010.

 

Averageinventory per Michaels store (including supporting distribution centers)decreased 3.6% from $833,000 at May 2, 2009 to $803,000 at May 1,2010 primarily due to a planned reduction of store inventory levels. Weanticipate average inventory per Michaels store at the end of fiscal 2010 to bedown compared to the end of fiscal 2009.

 

*Cash Flowused in Investing Activities*

 

Cashflow used in investing activities represents the following capital expenditureactivities:

 
| ** **                                              | ** ** | **Quarter Ended** | ** ** |
|---------------------------------------------------------|------------|-------------------|------------|
| ** **                                              | ** ** | **May 1,**   | ** ** | **May 2,** | ** ** |
| ** **                                              | ** ** | **2010**          | ** ** | **2009** | ** ** |
| ** **                                              | ** ** | **(in millions)** | ** ** |
| New  and relocated stores and stores not yet opened (1) |       | $                 | 5          |   | $ | 4 |   |
| Existing  stores                                        |       | 5                 |       | 3 |   |
| Distribution  system expansion                          |       | —            |       | 1 |   |
| Information  systems                                    |       | 3                 |       | 3 |   |
| Corporate  and other                                    |       | 1                 |       | — |   |
|                                                    |       | $                 | 14         |   | $ | 11 |   |

 

----

(1)                                  In the firstquarter of fiscal 2010, we incurred capital expenditures related to the openingof five Michaels stores and the relocation of seven Michaels stores. In thefirst quarter of fiscal 2009, we incurred capital expenditures related to theopening of 11 Michaels stores and the relocation of four Michaels stores.

 

*Cash Flowprovided by Financing Activities*

 

Cashflow used in financing activities during the first quarter of fiscal 2010was $151 million compared to cash provided by financing activities of $8million during the first quarter of fiscal 2009.  The $159 million change was primarily due tothe fiscal 2009 excess cash flow payment on our Senior secured term loanfacility of $118 million and $19 million in debt issuance costs related to theamendment to the asset-based revolving credit facility that was paid during thefirst quarter of fiscal 2010. In addition, we did not have any borrowings orrepayments under our asset-based revolving credit facility during first quarterof fiscal 2010, while in the first quarter of fiscal 2009, our borrowings werein excess of our repayments by $24 million.

 

**Non-GAAPMeasures**

** **

Thefollowing table sets forth the Company’s Earnings before Interest, Taxes,Depreciation and Amortization (“EBITDA”). The Company defines EBITDA as netincome before interest, income taxes, discontinued operations, depreciation andamortization. 

 

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Additionally,the table presents Adjusted Earnings before Interest, Taxes, Depreciation andAmortization (“Adjusted EBITDA”).  TheCompany defines Adjusted EBITDA as EBITDA adjusted for certain defined amountsthat are added to, or subtracted from, EBITDA (collectively, the “Adjustments”)in accordance with the Company’s $2.4 billion Senior secured term loan and $1.1billion asset-based revolving credit facilities. The Adjustments are describedin further detail in the table, and the footnotes to the table below.

 

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

 

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

 

Thetable below shows a reconciliation of EBITDA and Adjusted EBITDA to net incomeand net cash provided by operating activities.

 
| ** **                                 | ** ** | **Quarter Ended** | ** ** |
|--------------------------------------------|------------|-------------------|------------|
| ** **                                 | ** ** | **May 1,**   | ** ** | **May 2,** | ** ** |
| ** **                                 | ** ** | **2010**          | ** ** | **2009** | ** ** |
|                                       |       |              |       |   |   |
| Net  cash provided by operating activities |       | $                 | 27         |   | $ | 2 |   |
| Depreciation  and amortization             |       | (26               | )          | (30 | ) |
| Share-based  compensation                  |       | (2                | )          | (2 | ) |
| Deferred  financing cost amortization      |       | (5                | )          | (4 | ) |
| Accretion  of subordinated discount notes  |       | (12               | )          | (11 | ) |
| Change  in fair value of interest rate cap |       | (10               | )          | 4 |   |
| Changes  in assets and liabilities         |       | 41                |       | 45 |   |
| Net  income                                |       | 13                |       | 4 |   |
| Interest  expense                          |       | 68                |       | 63 |   |
| Income  tax provision                      |       | 17                |       | 3 |   |
| Depreciation  and amortization             |       | 26                |       | 30 |   |
| EBITDA                                     |       | 124               |       | 100 |   |
| Adjustments:                               |       |              |       |   |   |
| Share-based  compensation                  |       | 2                 |       | 2 |   |
| Sponsor  Fees                              |       | 3                 |       | 4 |   |
| Termination  expense                       |       | —            |       | 3 |   |
| Pre-opening  costs                         |       | 1                 |       | 1 |   |
| Foreign  currency translation gains        |       | (3                | )          | (1 | ) |
| Store  closing costs                       |       | 1                 |       | 1 |   |
| Loss  (gain) on interest rate cap          |       | 10                |       | (4 | ) |
| Other  (1)                                 |       | —            |       | 1 |   |
| Adjusted  EBITDA                           |       | $                 | 138        |   | $ | 107 |   |

 

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(1)          Otheradjustments relate to items such as moving & relocation expenses,franchise taxes, and foreign currency hedge.

 

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**RecentAccounting Pronouncements**

 

In January 2010, theFinancial Accounting Standards Board (“FASB”) issued Accounting StandardsUpdate (“ASU”) No. 2010-06, “*ImprovingDisclosures About Fair Value Measurements”*an amendment to Accounting Standards Codification (“ASC”) topic 820, *“Fair Value Measurements and Disclosures.”*ASU 2010-06expands disclosure requirements related to fair value measurements including (i) separatelydisclosing the amounts of significant transfers in and out of Level 1 and Level2 fair value measurements and describing the reasons for the transfers and (ii) presentingseparate information for Level 3 activity pertaining to gross purchases, sales,issuances, and settlements. The new disclosures are effective forinterim and annual reporting periods beginning after December 15, 2009,except for the Level 3 activity disclosures, which are effective for fiscalyears beginning after December 15, 2010. We adopted all requirements ofASU 2010-06 related to significant transfers in and out of Level 1 and Level 2fair value measurements on January 31, 2010, with no material impact onour consolidated financial statements. See Note 6 for further information regardingfair value measurements. We will adopt the new disclosure requirements relatedto the Level 3 activity on January 30, 2011, with no material impactexpected on our consolidated financial statements.

 

**Item 3.  Quantitative and Qualitative DisclosuresAbout Market Risk.**

 

Weare exposed to fluctuations in exchange rates between the US and Canadiandollar, which is the functional currency of our Canadian subsidiaries. Oursales, costs and expenses of our Canadian subsidiaries, when translated into USdollars, can fluctuate due to exchange rate movement. As of May 1, 2010, a10% increase or decrease in the exchange rate of the US and Canadian dollarwould not materially affect net income.

 

Wehave market risk exposure arising from changes in interest rates on our Seniorsecured term loan facility. The interest rates on our Senior Credit Facilitieswill reprice periodically, which will impact our earnings and cash flow. Theinterest rates on our notes are fixed. Based on our overall interest rate exposure to variable rate debtoutstanding as of May 1, 2010, a 1% increase or decrease in interest rateswould increase or decrease income before income taxes by approximately $22million. A 1% increase in interest rates would decrease the fair value of ourlong-term fixed rate debt by approximately $54 million. A 1% decrease ininterest rates would increase the fair value of our long-term fixed rate debtby approximately $56 million.  A changein interest rates would not materially affect the fair value of our variablerate debt as the debt reprices periodically.

 

Duringthe first quarter of fiscal 2009, we purchased an interest rate cap to limitthe variability of cash flows associated with our interest payments on ourSenior secured term loan that result from fluctuations in the three-month LIBORrate. The cap limits our interest exposure on a notional value of $2.0 billionto the lesser of the three-month LIBOR rate or 7.0%.  The term of the cap is from April 15,2009 through April 15, 2015. The fair value of the cap as of May 1,2010 was $8 million and is included in Other assets on the Consolidated BalanceSheet. The change in fair value of the cap for the quarter ended May 1,2010, resulted in a loss of $10 million and is recorded in Other (income) andexpense, net in the Consolidated Statement of Operations. A 1% increase in theinterest rates would increase income before income taxes by approximately $14million. A 1% decrease in the interest rates would decrease income beforeincome taxes by approximately $7 million.

 

**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.

 

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.

 

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*Change inInternal Control Over Financial Reporting*

 

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

 

**MICHAELS STORES, INC.**

**Part II—OTHERINFORMATION**

 

**Item 1.  LegalProceedings.**

 

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

 

**Item 6.  Exhibits.**

** **

(a) Exhibits:

 
| **Exhibit  Number** | ** ** | **Description of Exhibit**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
|---------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1                |       | Amended and Restated  Credit Agreement, dated as of February 18, 2010, among Michaels  Stores, Inc., as lead borrower, the borrowers named therein, the  facility guarantors named therein, Bank of America, N.A., as administrative  agent and collateral agent, the lenders party thereto (collectively, the  “Lenders”), Wells Fargo Retail Finance, LLC, as syndication agent, Deutsche  Bank Securities Inc., JPMorgan Chase Bank, N.A. and Credit Suisse, as  co-documentation agents, General Electric Capital Corporation, UBS Securities  LLC and RBS Business Capital, as senior managing agents, Banc of America  Securities LLC, Wells Fargo Retail Finance, LLC and Deutsche Bank Securities  Inc., as joint lead arrangers, and Banc of America Securities LLC, Wells  Fargo Retail Finance, LLC, Deutsche Bank Securities Inc., J.P. Morgan Securities  Inc. and Credit Suisse, as joint book runners (previously filed as  Exhibit 99.1 to Form 8-K filed by Company on February  19,  2010, SEC File No. 001-09338). |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.2                |       | Exhibits and Schedules  to Amended and Restated Credit Agreement, dated as of February 18, 2010,  among Michaels Stores, Inc., as lead borrower, the borrowers named  therein, the facility guarantors named therein, Bank of America, N.A., as  administrative agent and collateral agent, the lenders party thereto  (collectively, the “Lenders”), Wells Fargo Retail Finance, LLC, as  syndication agent, Deutsche Bank Securities Inc., JPMorgan Chase Bank, N.A.  and Credit Suisse, as co-documentation agents, General Electric Capital  Corporation, UBS Securities LLC and RBS Business Capital, as senior managing  agents, Banc of America Securities LLC, Wells Fargo Retail Finance, LLC and  Deutsche Bank Securities Inc., as joint lead arrangers, and Banc of America  Securities LLC, Wells Fargo Retail Finance, LLC, Deutsche Bank Securities  Inc., J.P. Morgan Securities Inc. and Credit Suisse, as joint book runners  (filed herewith).                                                                                         |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 31.1                |       | Certifications  of John B. Menzer pursuant to §302 of the Sarbanes-Oxley Act of 2002 (filed  herewith).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 31.2                |       | Certifications  of Elaine D. Crowley pursuant to §302 of the Sarbanes-Oxley Act of 2002  (filed herewith).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 32.1                |       | Certification  pursuant to 18 U.S.C. §1350, as adopted pursuant to §906 of the  Sarbanes-Oxley Act of 2002 (filed herewith).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |

 

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**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 |
|   |                  | Senior  Vice President — Chief Financial Officer and Controller |
|   |                  | (Principal  Financial Officer) |

 

Dated: May 28,2010

 

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** **

**INDEX TO EXHIBITS**

 
| **Exhibit  Number** | ** ** | **Description of Exhibit**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
|---------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1                |       | Amended and Restated  Credit Agreement, dated as of February 18, 2010, among Michaels  Stores, Inc., as lead borrower, the borrowers named therein, the  facility guarantors named therein, Bank of America, N.A., as administrative  agent and collateral agent, the lenders party thereto (collectively, the  “Lenders”), Wells Fargo Retail Finance, LLC, as syndication agent, Deutsche  Bank Securities Inc., JPMorgan Chase Bank, N.A. and Credit Suisse, as  co-documentation agents, General Electric Capital Corporation, UBS Securities  LLC and RBS Business Capital, as senior managing agents, Banc of America  Securities LLC, Wells Fargo Retail Finance, LLC and Deutsche Bank Securities  Inc., as joint lead arrangers, and Banc of America Securities LLC, Wells  Fargo Retail Finance, LLC, Deutsche Bank Securities Inc., J.P. Morgan  Securities Inc. and Credit Suisse, as joint book runners (previously filed as  Exhibit 99.1 to Form 8-K filed by Company on February  19,  2010, SEC File No. 001-09338). |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 10.2                |       | Exhibits and Schedules  to Amended and Restated Credit Agreement, dated as of February 18, 2010,  among Michaels Stores, Inc., as lead borrower, the borrowers named  therein, the facility guarantors named therein, Bank of America, N.A., as  administrative agent and collateral agent, the lenders party thereto  (collectively, the “Lenders”), Wells Fargo Retail Finance, LLC, as  syndication agent, Deutsche Bank Securities Inc., JPMorgan Chase Bank, N.A.  and Credit Suisse, as co-documentation agents, General Electric Capital Corporation,  UBS Securities LLC and RBS Business Capital, as senior managing agents, Banc  of America Securities LLC, Wells Fargo Retail Finance, LLC and Deutsche Bank  Securities Inc., as joint lead arrangers, and Banc of America Securities LLC,  Wells Fargo Retail Finance, LLC, Deutsche Bank Securities Inc., J.P. Morgan  Securities Inc. and Credit Suisse, as joint book runners (filed herewith).                                                                                          |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 31.1                |       | Certifications  of John B. Menzer pursuant to §302 of the Sarbanes-Oxley Act of 2002 (filed  herewith).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 31.2                |       | Certifications  of Elaine D. Crowley pursuant to §302 of the Sarbanes-Oxley Act of 2002  (filed herewith).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 32.1                |       | Certification  pursuant to 18 U.S.C. §1350, as adopted pursuant to §906 of the  Sarbanes-Oxley Act of 2002 (filed herewith).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |

 

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