Table of Contents

 

 

 

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, DC 20549**

 

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**FORM 10-Q**

 

**(MarkOne)**

 

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

 

**For the quarterly period ended October 30, 2010**

 

**OR**

 

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

 

**For the transition period from           to           **

 

**Commission file number 001-09338**

 

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**MICHAELS STORES, INC.**

(Exactname of registrant as specified in its charter)

 

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

 

**8000 Bent Branch Drive**

**Irving, Texas 75063**

 (Address of principal executive offices,including zip code)

 

**(972) 409-1300**

(Registrant’stelephone number, including area code)

 

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Indicate by check markwhether the Registrant: (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the Registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.* Yes o No o

 

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

 

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

 

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

 

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

 

As of November 19,2010, 118,929,218 shares of the Registrant’s Common Stock were outstanding.

 

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

 

 

 

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**MICHAELSSTORES, INC.FORM 10-Q**

 
| ** **       | ** ** | **Part I—FINANCIAL  INFORMATION**                                                                                               | ** ** | **3**  |
|------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------|------------|--------|
| **Item 1.** | ** ** | **Financial Statements**                                                                                                                  | ** ** | **3**  |
|             |       | Consolidated  Balance Sheets at October 30, 2010, January 30, 2010, and  October 31, 2009 (unaudited)                      | ** ** | **3**  |
|             |       | Consolidated  Statements of Operations for the quarter and nine months ended  October 30, 2010 and October 31, 2009 (unaudited) | ** ** | **4**  |
|             |       | Consolidated  Statements of Cash Flows for the nine months ended October 30, 2010 and  October 31, 2009 (unaudited)             | ** ** | **5**  |
|             |       | Notes to  Consolidated Financial Statements for the quarter and nine months ended  October 30, 2010 (unaudited)                      | ** ** | **6**  |
| **Item 2.** | ** ** | **Management’s  Discussion and Analysis of Financial Condition and Results of Operations**                                           | ** ** | **23** |
| **Item 3.** | ** ** | **Quantitative  and Qualitative Disclosures About Market Risk**                                                                           | ** ** | **31** |
| **Item 4.** | ** ** | **Controls and  Procedures**                                                                                                              | ** ** | **31** |
| ** **       | ** ** | **Part II—OTHER  INFORMATION**                                                                                                  | ** ** | **33** |
| **Item 1.** | ** ** | **Legal Proceedings**                                                                                                                     | ** ** | **33** |
| **Item 6.** | ** ** | **Exhibits**                                                                                                                              | ** ** | **33** |
| **Signatures**   | ** ** | ** **                                                                                                                                | ** ** | **34** |

 

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**MICHAELS STORES, INC.**

**Part I—FINANCIAL INFORMATION**

 

**Item 1.  FinancialStatements.**

 

**MICHAELS STORES, INC.**

**CONSOLIDATED BALANCE SHEETS**

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

**(Unaudited)**

 
| ** **                                                                                   | ** ** | **October 30,** | ** ** | **January 30,** | ** ** | **October 31,** | ** ** |
|----------------------------------------------------------------------------------------------|------------|----------------------|------------|----------------------|------------|----------------------|------------|
| ** **                                                                                   | ** ** | **2010**             | ** ** | **2010**             | ** ** | **2009**             | ** ** |
| **ASSETS**                                                                                   |       |                 |       |                 |       |                 |       |
| **Current assets:**                                                                          |       |                 |       |                 |       |                 |       |
| Cash and equivalents                                                                         |       | $                    | 115        |                 | $          | 217                  |       | $ | 49 |   |
| Merchandise inventories                                                                      |       | 1,004                |       | 873                  |       | 1,039                |       |
| Prepaid expenses and other                                                                   |       | 78                   |       | 72                   |       | 83                   |       |
| Deferred income taxes                                                                        |       | 41                   |       | 45                   |       | 41                   |       |
| Income tax receivable                                                                        |       | 48                   |       | —               |       | 12                   |       |
| Total current assets                                                                         |       | 1,286                |       | 1,207                |       | 1,224                |       |
| **Property and equipment, at cost**                                                          |       | 1,304                |       | 1,257                |       | 1,236                |       |
| Less accumulated depreciation                                                                |       | (1,002               | )          | (940                 | )          | (911                 | )          |
| Property and equipment, net                                                                  |       | 302                  |       | 317                  |       | 325                  |       |
| **Goodwill**                                                                                 |       | 95                   |       | 94                   |       | 94                   |       |
| **Debt issuance costs, net of  accumulated amortization of $57, $56, and $52, respectively** |       | 78                   |       | 70                   |       | 73                   |       |
| **Deferred income taxes**                                                                    |       | 8                    |       | 1                    |       | 16                   |       |
| **Other assets**                                                                             |       | 7                    |       | 21                   |       | 28                   |       |
| Total non-current assets                                                                     |       | 188                  |       | 186                  |       | 211                  |       |
| Total assets                                                                                 |       | $                    | 1,776      |                 | $          | 1,710                |       | $ | 1,760 |   |
|                                                                                         |       |                 |       |                 |       |                 |       |
| **LIABILITIES  AND STOCKHOLDERS’ DEFICIT**                                              |       |                 |       |                 |       |                 |       |
| **Current liabilities:**                                                                     |       |                 |       |                 |       |                 |       |
| Accounts payable                                                                             |       | $                    | 324        |                 | $          | 231                  |       | $ | 274 |   |
| Accrued liabilities and other                                                                |       | 361                  |       | 355                  |       | 353                  |       |
| Current portion of long-term debt                                                            |       | 1                    |       | 119                  |       | 139                  |       |
| Income taxes payable                                                                         |       | 2                    |       | 11                   |       | 1                    |       |
| Current liabilities - discontinued operations                                                |       | —               |       | 1                    |       | 1                    |       |
| Total current liabilities                                                                    |       | 688                  |       | 717                  |       | 768                  |       |
| **Long-term debt**                                                                           |       | 3,764                |       | 3,684                |       | 3,772                |       |
| **Deferred income taxes**                                                                    |       | 2                    |       | —               |       | —               |       |
| **Other long-term liabilities**                                                              |       | 86                   |       | 80                   |       | 78                   |       |
| **Long-term liabilities -  discontinued operations**                                         |       | —               |       | —               |       | 1                    |       |
| Total long-term liabilities                                                                  |       | 3,852                |       | 3,764                |       | 3,851                |       |
| Total liabilities                                                                            |       | 4,540                |       | 4,481                |       | 4,619                |       |
| **Commitments and contingencies**                                                            |       |                 |       |                 |       |                 |       |
| **Stockholders’ deficit:**                                                              |       |                 |       |                 |       |                 |       |
| Common Stock, $0.10 par value, 220,000,000 shares  authorized;                               |       |                 |       |                 |       |                 |       |
| 118,419,850 shares issued and outstanding at  October 30, 2010;                         |       |                 |       |                 |       |                 |       |
| 118,387,229 shares issued and outstanding at  January 30, 2010;                         |       |                 |       |                 |       |                 |       |
| 118,387,229 shares issued and outstanding at  October 31, 2009                          |       | 12                   |       | 12                   |       | 12                   |       |
| Additional paid-in capital                                                                   |       | 41                   |       | 35                   |       | 34                   |       |
| Accumulated deficit                                                                          |       | (2,824               | )          | (2,824               | )          | (2,911               | )          |
| Accumulated other comprehensive income                                                       |       | 7                    |       | 6                    |       | 6                    |       |
| Total stockholders’ deficit                                                             |       | (2,764               | )          | (2,771               | )          | (2,859               | )          |
| Total liabilities and stockholders’ deficit                                             |       | $                    | 1,776      |                 | $          | 1,710                |       | $ | 1,760 |   |

 

See accompanying notes toconsolidated financial statements.

 

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**MICHAELS STORES, INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**(In millions)**

**(Unaudited)**

 
| ** **                                   | ** ** | **Quarter Ended** | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------------------|------------|------------------------|------------|---------------------------------|------------|
| ** **                                   | ** ** | **October 30,**   | ** ** | **October 31,**            | ** ** | **October 30,** | ** ** | **October 31,** | ** ** |
| ** **                                   | ** ** | **2010**               | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
| **Net sales**                                |       | $                      | 968        |                            | $          | 929 |   | $ | 2,700 |   | $ | 2,588 |   |
| Cost of sales and occupancy expense          |       | 592                    |       | 582                             |       | 1,659 |   | 1,640 |   |
| **Gross profit**                             |       | 376                    |       | 347                             |       | 1,041 |   | 948 |   |
| Selling, general, and administrative expense |       | 269                    |       | 259                             |       | 747 |   | 737 |   |
| Related party expenses                       |       | 3                      |       | 4                               |       | 10 |   | 11 |   |
| Store pre-opening costs                      |       | 2                      |       | —                          |       | 3 |   | 2 |   |
| **Operating income**                         |       | 102                    |       | 84                              |       | 281 |   | 198 |   |
| Interest expense                             |       | 69                     |       | 62                              |       | 207 |   | 187 |   |
| Loss on early extinguishment of debt         |       | 53                     |       | —                          |       | 53 |   | — |   |
| Other (income) and expense, net              |       | 1                      |       | (1                              | )          | 12 |   | (21 | ) |
| **(Loss) income before income taxes**        |       | (21                    | )          | 23                              |       | 9 |   | 32 |   |
| (Benefit) provision for income taxes         |       | (9                     | )          | 8                               |       | 9 |   | 11 |   |
| **Net (loss) income**                        |       | $                      | (12        | )                               | $          | 15 |   | $ | — |   | $ | 21 |   |

 

Seeaccompanying notes to consolidated financial statements.

 

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**MICHAELS STORES, INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(In millions)**

**(Unaudited)**

 
| ** **                                           | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                           | ** ** | **October 30,**            | ** ** | **October 31,** | ** ** |
| ** **                                           | ** ** | **2010**                        | ** ** | **2009** | ** ** |
| **Operating activities:**                            |       |                            |       |   |   |
| Net income                                           |       | $                               | —     |   | $ | 21 |   |
| Adjustments:                                         |       |                            |       |   |   |
| Depreciation and amortization                        |       | 77                              |       | 86 |   |
| Share-based compensation                             |       | 6                               |       | 6 |   |
| Debt issuance costs amortization                     |       | 14                              |       | 13 |   |
| Accretion of subordinated discount notes             |       | 37                              |       | 33 |   |
| Change in fair value of interest rate cap            |       | 15                              |       | (16 | ) |
| Loss on early extinguishment of debt                 |       | 53                              |       | — |   |
| Changes in assets and liabilities:                   |       |                            |       |   |   |
| Merchandise inventories                              |       | (131                            | )          | (133 | ) |
| Prepaid expenses and other                           |       | (6                              | )          | (14 | ) |
| Deferred income taxes and other                      |       | (1                              | )          | (12 | ) |
| Accounts payable                                     |       | 97                              |       | 54 |   |
| Accrued interest                                     |       | (9                              | )          | 33 |   |
| Accrued liabilities and other                        |       | 18                              |       | 42 |   |
| Income taxes receivable, net                         |       | (57                             | )          | (11 | ) |
| Other long-term liabilities                          |       | 2                               |       | 4 |   |
| Net cash provided by operating activities            |       | 115                             |       | 106 |   |
|                                                 |       |                            |       |   |   |
| **Investing activities:**                            |       |                            |       |   |   |
| Business acquisition                                 |       | (2                              | )          | — |   |
| Additions to property and equipment                  |       | (61                             | )          | (26 | ) |
| Net cash used in investing activities                |       | (63                             | )          | (26 | ) |
|                                                 |       |                            |       |   |   |
| **Financing activities:**                            |       |                            |       |   |   |
| Issuance of senior notes due 2018                    |       | 794                             |       | — |   |
| Repayments on senior notes due 2014                  |       | (791                            | )          | — |   |
| Repayments on senior secured term loan facility      |       | (118                            | )          | (18 | ) |
| Borrowings on asset-based revolving credit  facility |       | 13                              |       | 621 |   |
| Payments on asset-based revolving credit facility    |       | (13                             | )          | (655 | ) |
| Payment of debt issuance costs                       |       | (34                             | )          | — |   |
| Change in cash overdraft                             |       | (4                              | )          | (12 | ) |
| Other                                                |       | (1                              | )          | — |   |
| Net cash used in financing activities                |       | (154                            | )          | (64 | ) |
|                                                 |       |                            |       |   |   |
| **(Decrease) increase in cash and  equivalents**     |       | (102                            | )          | 16 |   |
| **Cash and equivalents at beginning  of period**     |       | 217                             |       | 33 |   |
| **Cash and equivalents at end of  period**           |       | $                               | 115        |   | $ | 49 |   |
|                                                 |       |                            |       |   |   |
| **Supplemental Cash Flow  Information:**             |       |                            |       |   |   |
| Cash paid for interest.                              |       | $                               | 164        |   | $ | 109 |   |
| Cash paid for income taxes                           |       | $                               | 64         |   | $ | 22 |   |
| Non-cash investing activity:                         |       |                            |       |   |   |
| Contingent consideration liability                   |       | $                               | 4          |   | $ | — |   |

 

Seeaccompanying notes to consolidated financial statements.

 

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**MICHAELS STORES, INC.**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

**For the Three and Nine MonthsEnded October 30, 2010**

**(Unaudited)**

 

**Note 1.  Summaryof Significant Accounting Policies**

 

*Basisof Presentation*

 

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

 

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

 

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

 

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

 

Becauseof the seasonal nature of our business, the results of operations for the threeand nine months ended October 30, 2010 are not indicative of the resultsto be expected for the entire year.

 

Wereport on the basis of a 52 or 53-week fiscal year, which ends on the Saturdayclosest to January 31. All references herein to “fiscal 2010” relate tothe 52 weeks ending January 29, 2011, and all references to “fiscal2009” relate to the 52 weeks ended January 30, 2010. In addition, allreferences herein to “the third quarter of fiscal 2010” relate to the 13 weeksended October 30, 2010 and all references to “the third quarter of fiscal2009” relate to the 13 weeks ended October 31, 2009. Finally, allreferences to “the nine months ended October 30, 2010” relate to the 39weeks ended October 30, 2010, and “the nine months ended October 31, 2009”relate to the 39 weeks ended October 31, 2009.

 

*RecentAccounting Pronouncements*

 

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

 

**Note 2.  Share-BasedCompensation**

 

The2006 Equity Incentive Plan (“2006 Plan”) provides for the grant of share-basedawards exercisable for up to 14.2 million shares of Common Stock. As of October30, 2010, there were 9.9 million stock option awards outstanding. In addition,there were a total of 619,483 shares of restricted stock outstanding under the2006 Plan, of which 110,115 are vested. 3.7 million shares of Common Stockremain available for grant under the 2006 Plan. The table below sets forth asummary of stock option activity:

 

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| ** **                         | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------|------------|---------------------------------|------------|
| ** **                         | ** ** | **October 30, 2010**  | ** ** |
| ** **                         | ** ** | **(in millions)**          | ** ** |
|                               |       |                            |       |
| Outstanding at beginning of period |       | 9.5                             |       |
| Grants                             |       | 1.3                             |       |
| Canceled/Forfeited                 |       | (0.9                            | )          |
| Outstanding at end of period       |       | 9.9                             |       |

 

Generally,awards granted under the 2006 Plan vest ratably over five years and expireeight years from the grant date. The exercise prices of the options range from$7.50 per share to $22.50 per share, as determined by the Board of Directors.Share-based compensation expense associated with the stock options and therestricted stock was approximately $2 million for the third quarter of each offiscal 2010 and fiscal 2009, and $6 million during each of the nine monthsended October 30, 2010 and October 31, 2009.

 

**Note 3.Debt**

 

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

 
| ** **                            | ** ** | **October 30, 2010** | ** ** | **January 30, 2010** | ** ** | **October 31, 2009** | ** ** |
|---------------------------------------|------------|--------------------------------|------------|--------------------------------|------------|--------------------------------|------------|
| ** **                            | ** ** | **(in millions)**         | ** ** |
|                                  |       |                           |       |                           |       |                           |       |
| Senior secured term loan              |       | $                              | 2,156      |                           | $          | 2,274                          |       | $ | 2,280 |   |
| Senior notes                          |       | 794                            |       | 750                            |       | 750                            |       |
| Senior subordinated notes             |       | 400                            |       | 400                            |       | 400                            |       |
| Subordinated discount notes           |       | 414                            |       | 377                            |       | 365                            |       |
| Asset-based revolving credit facility |       | —                         |       | —                         |       | 114                            |       |
| Other                                 |       | 1                              |       | 2                              |       | 2                              |       |
|                                  |       |                           |       |                           |       |                           |       |
| Total debt                            |       | 3,765                          |       | 3,803                          |       | 3,911                          |       |
|                                  |       |                           |       |                           |       |                           |       |
| Less current portion                  |       | 1                              |       | 119                            |       | 139                            |       |
|                                  |       |                           |       |                           |       |                           |       |
| Long-term debt                        |       | $                              | 3,764      |                           | $          | 3,684                          |       | $ | 3,772 |   |

 

*10%Senior Notes due 2014*

 

OnOctober 6, 2010, we commenced a tender offer and consent solicitation relatedto our 10% Senior Notes due 2014 (“2014 Senior Notes”). Pursuant to the consentsolicitation, we received tenders and consents from the holders of$658,593,000, or approximately 87.81%, of the 2014 Senior Notes before theconsent payment deadline, October 20, 2010, at 5:00 p.m. Eastern time (the “ConsentDate”). The consents received exceeded the number needed to approve theproposed amendments to the indenture governing the 2014 Senior Notes (the “2014Senior Indenture”). The amendments to the 2014 Senior Indenture eliminatedsubstantially all of the affirmative and restrictive covenants contained in the2014 Senior Indenture and the 2014 Senior Notes (other than, among othercovenants, the covenant to pay interest and premium, if any, on, and principalof, the 2014 Senior Notes when due) and certain events of default, and modifiedor eliminated certain other provisions contained in the 2014 Senior Indentureand the 2014 Senior Notes.

 

Pursuantto the terms of the tender offer, we accepted for payment all 2014 Senior Notestendered on or prior to the Consent Date, and holders who tendered such 2014Senior Notes received $1,055.00 per $1,000 in principal amount of the 2014Senior Notes validly tendered. On October 21, 2010, we also (i) instructedthe trustee under the 2014 Senior Indenture (the “2014 Senior Notes Trustee”)to deliver a notice of redemption to the holders of the remaining outstanding2014 Senior Notes and (ii) deposited cash with the 2014 Senior NotesTrustee to satisfy and discharge the 2014 Senior Indenture and to fund theredemption of the remaining outstanding 2014 Senior Notes at a price equal to105% plus the payment of accrued interest through the date of redemption,November 22, 2010. As a result, the 2014 Senior Indenture was discharged.

 

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Inaccordance with ASC 470, *Debt*, werecorded a loss of $53 million related to the early extinguishment of our 2014Senior Notes.  The $53 million loss is comprisedof $41 million tender and call premiums and the write-off of $12 million forthe remaining unamortized debt issuance costs.

 

*7 3⁄4% Senior Notes due 2018*

 

On October 21, 2010, weissued $800.0 million aggregate principal amount of 7 3⁄4% Senior Notes thatmature on November 1, 2018 (the “2018 Senior Notes”) and were sold at adiscounted price of 99.262% of face value. The 2018 Senior Notes areguaranteed, jointly and severally, on an unsecured senior basis, by each of oursubsidiaries that guarantee indebtedness under our amended and restated seniorsecured asset-based revolving facility and senior secured term loan facility(the “Senior Secured Credit Facilities”).

 

The 2018 Senior Notes andthe guarantees thereof are our and the guarantors’ unsecured senior obligationsand rank senior in right of payment to all of our and the guarantors’ existingand future debt and other obligations that are, by their terms, expresslysubordinated in right of payment to the 2018 Senior Notes (including the seniorsubordinated notes due 2016 and the subordinated discount notes due 2016, asdescribed in our Annual Report on Form 10-K for the fiscal year ended January30, 2010); rank equally in right of payment to all of our and the guarantors’existing and future debt and other obligations that are not, by their terms,expressly subordinated in right of payment to the 2018 Senior Notes; and areeffectively subordinated in right of payment to all of our and the guarantors’existing and future secured debt (including obligations under the SeniorSecured Credit Facilities), to the extent of the value of the assets securingsuch debt, and are structurally subordinated to all obligations of oursubsidiaries that are not guarantors of the 2018 Senior Notes.

 

At any time prior toNovember 1, 2014, we may redeem all or a part of the 2018 Senior Notes ata redemption price equal to 100% of the principal amount of the 2018 SeniorNotes redeemed plus the Applicable Premium (as defined in the indenturegoverning the 2018 Senior Notes (the “2018 Senior Indenture”)) and accrued andunpaid interest and Additional Interest (as defined in the 2018 SeniorIndenture), if any, to the date of redemption, subject to the right of holdersof record on the relevant record date to receive interest due on the relevantinterest payment date.

 

On and afterNovember 1, 2014, the Company may redeem the 2018 Senior Notes, in wholeor in part, upon notice, at the redemption prices (expressed as percentages ofprincipal amount of the 2018 Senior Notes to be redeemed) set forth below, plusaccrued and unpaid interest thereon and Additional Interest, if any, to theapplicable date of redemption if redeemed during the twelve-month periodbeginning on November 1 of each of the years indicated below:

 
| **Year**             | ** ** | **Percentage** | ** ** |
|----------------------|------------|----------------|------------|
| 2014                 |       | 103.875        | %          |
| 2015                 |       | 101.938        | %          |
| 2016  and thereafter |       | 100.000        | %          |

 

In addition, untilNovember 1, 2013 we may, at our option, on one or more occasions redeem upto 35% of the aggregate principal amount of the 2018 Senior Notes (includingthe aggregate principal amount of the 2018 Senior Notes issued after the issuedate) at a redemption price equal to 107.750% of the aggregate principal amountthereof, plus accrued and unpaid interest thereon and Additional Interest, ifany, to the applicable date of redemption, subject to the right of holders ofrecord on the relevant record date to receive interest due on the relevantinterest payment date, with the net cash proceeds of one or more EquityOfferings (as defined in the 2018 Senior Indenture); *provided*that at least 50% of the sum of the aggregateprincipal amount of the 2018 Senior Notes originally issued under the 2018Senior Indenture and any 2018 Senior Notes that are issued under the 2018Senior Indenture after the issue date remains outstanding immediately after theoccurrence of each such redemption; *providedfurther*that each such redemption occurs within 90 days of the dateof closing of each such Equity Offering.

 

Upon a change in control weare required to offer to purchase all of the 2018 Senior Notes at a price incash equal to 101% of the aggregate principal amount thereof, plus accrued andunpaid interest.

 

The 2018 Senior NotesIndenture contains covenants limiting, among other things, the Company’s abilityand the ability of the Company’s restricted subsidiaries to:

 

·                  incuradditional debt;

 

·                  pay dividendsor distributions on the Company’s capital stock or repurchase the Company’scapital stock;

 

·                  issue stock ofsubsidiaries;

 

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·                  make certaininvestments;

 

·                  create liens onthe Company’s assets to secure debt;

 

·                  enter intotransactions with affiliates;

 

·                  merge orconsolidate with another company; and

 

·                  sell orotherwise transfer assets.

 

The 2018 Senior Indenturealso provides for events of default, which, if certain of them occur, wouldpermit the trustee under the 2018 Senior Indenture or holders of at least 25%in principal amount of the then outstanding 2018 Senior Notes to declare theprincipal, premium, if any, interest and any other monetary obligations on allthe then outstanding 2018 Senior Notes to be due and payable immediately.

 

Inaccordance with ASC 470, we recorded $15 million in debt issuance costs thatwill be amortized as interest expense over the life of the 2018 Senior Notes.

 

*Asset-basedrevolving credit facility*

 

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

 

TheAmended Asset-based revolving credit facility extended an aggregate amount of$850 million of the tranche A commitments and $50 million of the FILO (asdefined below) commitments, with respect to certain lenders (the “ExtendingLenders”), from October 31, 2011 to the earlier of April 15, 2014, or45 days prior to the maturity date of any class of term loans in the Company’ssenior secured term loan facility (the “Extended Maturity Date”). The remaining$202 million of commitments from the other lenders under the existingasset-based revolving credit facility (the “Non-Extending Lenders”) shallterminate on October 31, 2011. Simultaneously with entering into theAmended Asset-based revolving credit facility, the Company exercised itsability to increase tranche A commitments in the aggregate amount of $152million.

 

OnOctober 1, 2010, we elected to permanently terminate the $202 million ofcommitments from the Non-Extending Lenders. The $850 million of the tranche Acommitments and $50 million of the FILO commitments remain unaffected.

 

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

 

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

 

Borrowingsunder the Amended Asset-based revolving credit facility bear interest at a rateper annum equal to, at our option, either (a) a base rate determined byreference to the highest of (1) the prime rate of Bank of America, N.A.,(2) the federal funds effective rate plus 0.50% and (3) a LIBOR ratesubject to certain adjustments plus 1.00% or (b) a LIBOR rate subject tocertain adjustments, in each case plus an applicable margin. The initialapplicable margin is (a) 2.50% for non-FILO base rate borrowings and 3.50%for non-FILO LIBOR borrowings and (b) 4.50% for FILO base rate borrowingsand 5.50% for FILO LIBOR borrowings. The applicable margin is subject toadjustment each fiscal quarter based on the excess availability under theAmended Asset-based revolving credit facility.  Same-day borrowings bearinterest at a rate per annum equal to a base rate determined by reference tothe highest of (a) the prime rate of Bank of America, N.A., (b) thefederal funds effective rate plus 0.50% and (c) a LIBOR rate subject tocertain adjustments plus 1.00%, in each case, plus an applicable margin. Theinitial applicable margin with respect to same-day borrowings is 2.50%.

 

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

 

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

 

Wemust not permit excess availability at any time to be less than the greater of(a) $75 million and (b) 10% of the lesser of (1) the thenborrowing base under the Amended Asset-based revolving credit facility or(2) $900 million (as reduced or increased in accordance with the terms ofthe Amended Asset-based credit facility, the “Revolving Credit Ceiling”). Inaddition, (a) for the period of thirty consecutive days preceding ourtermination of the tranche A commitments of the Non-Extending Lenders and (b)on a projected pro forma basis, giving effect to such termination ofcommitments, for the six-month period following such termination ofcommitments, we must not permit excess availability at any time to be less than$125 million. Excess availability under the Amended Asset-based revolvingcredit facility means the lesser of (a) the Revolving Credit Ceiling minusthe outstanding credit extensions and (b) the then borrowing base minusthe outstanding credit extensions.

 

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

 

·                  incur additionalindebtedness;

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

·                  make investments, loans,advances and acquisitions;

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

·                  engage in transactions withaffiliates of the Company;

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

·                  consolidate or merge; and

·                  create liens.

 

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. The Amended Asset-based revolving credit facility also contains certaincustomary affirmative covenants and events of default.

 

Inthe first quarter of fiscal 2010, we recorded $19 million in debt issuance costsrelated to the amendment to the asset-based revolving credit facility that isbeing amortized as interest expense over the life of the Amended Asset-basedrevolving credit facility in accordance with ASC 470. In addition, we areamortizing $5 million of the unamortized debt issuance costs related to theasset-based revolving credit facility over the revised life.

 

As of October 30, 2010, theborrowing base was $845 million, of which we had no outstanding borrowings, $50million of outstanding letters of credit, and $795 million of excessavailability.

 

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

 

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

 
| ** **                                        | ** ** | **Quarter Ended**         | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------|------------|--------------------------------|------------|---------------------------------|------------|
| ** **                                        | ** ** | **October 30, 2010** | ** ** | **October 31, 2009**  | ** ** | **October 30, 2010** | ** ** | **October 31, 2009** | ** ** |
| ** **                                        | ** ** | **(in millions)**         | ** ** |
|                                              |       |                           |       |                            |       |   |   |   |   |
| Net (loss) income                                 |       | $                              | (12        | )                               | $          | 15 |   | $ | — |   | $ | 21 |   |
| Other comprehensive (loss) income:                |       |                           |       |                            |       |   |   |   |   |
| Derivative loss                                   |       | —                         |       | (1                              | )          | — |   | (4 | ) |
| Foreign currency translation adjustment and other |       | —                         |       | —                          |       | 1 |   | 5 |   |
| Comprehensive (loss) income                       |       | $                              | (12        | )                               | $          | 14 |   | $ | 1 |   | $ | 22 |   |

 

Accumulatedother comprehensive (loss) 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 October 30, 2010             |       | $                                                      | 7          |   |

 

**Note 5.  DerivativeInstruments**

 

Weare exposed to fluctuations in interest rates on our Senior secured term loan.During the first quarter of fiscal 2009, we purchased an interest ratederivative with the objective to cap our exposure to interest rate increases onour Senior secured term loan that result from fluctuations in the three-monthLIBOR rate. The cap limits our interest exposure on a notional value of $2.0billion to the lesser of the three-month LIBOR rate or 7.0%.  The term of the cap extends to the firstquarter of fiscal 2015. The interest rate cap does not qualify for hedgeaccounting under ASC 815, *Derivatives and Hedging*.The fair value of the cap as of October 30, 2010, January 30, 2010 and October31, 2009 was $3 million, $18 million and $25 million, respectively, and isincluded in Other assets on the Consolidated Balance Sheets. The change in fairvalue of the cap for the quarter and nine months ended October 30, 2010,resulted in a loss of $2 million and $15 million, respectively. The change infair value of the cap for the quarter and nine months ended October 31, 2009,resulted in a gain of $1 million and $16 million, respectively. These amountsare recorded in Other (income) and expense, net in the Consolidated Statementsof Operations.

 

**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 or similar instruments in markets that are notactive; and model-derived valuations whose significant inputs are observable;and

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

 

The following table presents net financial assets (liabilities)accounted for at fair value on a recurring basis as of October 30, 2010(in millions):

 

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| ** **               | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** | **Total** | ** ** |
|--------------------------|------------|------------------|------------|------------------|------------|------------------|------------|-----------|------------|
| Interest rate cap        |       | $                | —     |             | $          | 3                |       | $         | —     |   | $ | 3 |   |
| Contingent consideration |       | $                | —     |             | $          | —           |       | $         | (4         | ) | $ | (4 | ) |

 

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

 

Inconnection with the acquisition of ScrapHD (see Note 10), the Company has acontingent obligation, to be paid in cash, to the owners of ScrapHD, LLC basedon future operating performance. The fair value of this contingentconsideration is determined using an expected present value technique. Expectedoperating results are determined using the probability-weighted average ofpossible outcomes that would occur should certain financial metrics be reached.There is no market data available to use in valuing the contingentconsideration; therefore, the Company developed its own assumptions related tothe future financial performance of the business to estimate the fair value ofthe liability which was then discounted to present value using the weighted average cost of capital. Theweighted average cost of capital was derived from comparable companies andmanagement’s estimates. The contingent consideration was established at thetime of acquisition and will be evaluated at each reporting period. There havebeen no changes to the fair value since the acquisition date of September 15,2010. The liability is recorded in other long-term liabilities on the ConsolidatedBalance Sheets.

 

Weapply fair value techniques on a non-recurring basis for the establishment ofpotential impairment loss related to goodwill pursuant to ASC 350, *Intangibles—Goodwill and Other* and determining the fairvalue of long-lived assets pursuant to ASC 360, *Property,Plant, and Equipment.* During the nine months ended October 30, 2010,there were no events or changes in circumstances indicating the carry amountsof our long-lived assets may not be recoverable.

 

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

 
| ** **                  | ** ** | **Carrying Value** | ** ** | **Fair Value** | ** ** |
|-----------------------------|------------|-------------------------|------------|---------------------|------------|
| ** **                  | ** ** | **(in millions)**  | ** ** |
| Senior secured term loan    |       | $                       | 2,156      |                | $          | 2,107 |   |
| Senior notes                |       | 794                     |       | 791                 |       |
| Senior subordinated notes   |       | 400                     |       | 442                 |       |
| Subordinated discount notes |       | 414                     |       | 406                 |       |
|                             |            |                         |            |                     |            |  |  |

 

**Note 7.  IncomeTaxes**

 

During the third quarter offiscal 2010, we recorded a tax benefit of $9 million at an effective rate of41.4%. During the third quarter of fiscal 2009, we recorded a tax provision of$8 million at an effective rate of 33.2%.

 

For the nine months endedOctober 30, 2010, we recorded a tax provision of $9 million primarily due toadditional expense to correct the federal deferred tax liability relating tostate income taxes and other discrete items. We currently estimate ourannualized effective tax rate for fiscal 2010 to be 41%, including a 3.2%unfavorable impact from the deferred tax liability correction recorded duringthe first quarter of fiscal 2010. The effective tax rate was 34.2% for thefirst nine months of fiscal 2009.

 

**Note 8.  Commitmentsand Contingencies**

 

Weare involved in ongoing legal and regulatory proceedings.  Other than those described in the followingparagraphs, there were no material changes to our disclosures of commitmentsand contingencies from our Annual Report on Form 10-K for the fiscal yearended January 30, 2010 and our Quarterly Reports on Form 10-Q for thequarterly periods ended May 1, 2010 and July 31, 2010.

 

***Employee Claims***

 

*Adams Claim*

 

OnApril 22, 2009, 129 individuals commenced an action against the Company styledAdams, et. al. v. Michaels Stores, Inc. in the United States District Court forthe Central District of California. The Adams suit alleges that Michaels failedto pay overtime wages, provide meal and rest periods (or compensation in lieuthereof), accurately record hours worked and provide itemized

 

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employeewage statements. The Adams suit additionally alleges that the foregoing conductwas in breach of California’s unfair competition law. Similar claims weresubsequently filed by an additional eight individuals.  The plaintiffs seek injunctive relief,damages for unpaid wages, penalties, restitution, interest, and attorneys’ feesand costs. A number of the individual plaintiff claims have been settled forimmaterial amounts. We believe we have meritorious defenses and intend todefend the lawsuits vigorously.

 

*JorudClaim*

 

On May 20, 2009, Kara Jorud,a former Michaels’ store manager, commenced a lawsuit against Michaels Stores,Inc., alleging numerous causes of action including interference with her rightsunder the Family and Medical Leave Act (‘‘FMLA’’) and retaliation anddiscrimination in violation of the FMLA and the Americans with Disabilities Actand Florida Civil Rights Act. The plaintiff also alleged that she was subjectedto a hostile work environment. The case was tried to a jury in West Palm Beach,Florida in August, 2010 and the jury awarded damages to the plaintiff ofapproximately $8 million. We subsequently filed a post-trial brief asking thecourt to dismiss certain claims and addressing plaintiff’s request forfront-pay and liquidated damages. In the interim, we have reached a settlementwith the plaintiff for an amount that the Company does not deem to be material.

 

*Tijero andGodfrey Consolidated Claim*

 

On February 12, 2010, theCompany was served with a lawsuit filed on May 7, 2009 by Jose Tijero, a formerassistant manager for Aaron Brothers as a purported class action proceeding onbehalf of himself and all current and former hourly retail employees employedby Aaron Brothers in California. On July 12, 2010,  the Company was served with a lawsuit filedon July 9, 2010 by Amanda Godfrey, a former Aaron Brothers’ hourly employeealleging similar allegations as in the Tijero suit. On October 15, 2010, thecases were consolidated and refiled in the United States DistrictCourt-Northern District of California. These suits allege that Aaron Brothersfailed to pay all wages and overtime, failed to provide its hourly employeeswith adequate meal and rest breaks (or compensation in lieu thereof), failed totimely pay final wages, unlawfully withheld wages and failed to provideaccurate wage statements and further alleges that the foregoing conduct was inbreach of various law including California’s unfair competition law. The plaintiffseeks injunctive relief, compensatory damages, meal and rest break penalties,waiting time penalties, interest, and attorneys’ fees and costs. We believe wehave meritorious defenses and intend to defend the lawsuit vigorously. We areunable to estimate a range of loss, if any, in this case.

 

***Consumer ClassAction Claims***

 

*CarsonClaim*

 

OnAugust 15, 2008, Linda Carson, a consumer, filed a purported class actionproceeding against Michaels Stores, Inc. in the Superior Court of California,County of San Diego, on behalf of herself and all similarly-situated Californiaconsumers. The Carson suit alleges that Michaels unlawfully requested andrecorded personally identifiable information (i.e., her zip code) as part of acredit card transaction. The plaintiff sought statutory penalties, costs,interest, and attorneys’ fees. We contested certification of this claim as aclass action and filed a motion to dismiss the claim. On March 9, 2009, theCourt dismissed the case with prejudice. The plaintiff appealed this decisionto the California Court of Appeal for the Fourth District, San Diego. On July22, 2010, the Court of Appeal upheld the dismissal of the case. The plaintiffappealed this decision to the Supreme Court of California. On September 29,2010, the Supreme Court granted the plaintiff’s petition for review, however,it stayed any further proceedings in the case until another similar zip codecase pending before the court, Pineda v. Williams-Sonoma, is decided.

 

***GovernmentalInquiries and Related Matters***

 

*Non-U.S.Trust Inquiry*

 

In early 2005, the DistrictAttorney’s office of the County of New York and the SEC opened inquiriesconcerning non-U.S. trusts that directly or indirectly held shares of Michaelscommon stock and common stock options. A federal grand jury requestedinformation with respect to the same facts. We are cooperating in theseinquiries and have provided information in response to the requests.

 

Certain of these trusts andcorporate subsidiaries of the trusts acquired securities of Michaels intransactions directly or indirectly with Charles J. Wyly, Jr. and Sam Wyly, whowere, respectively, Chairman and Vice Chairman of the Board of Directors priorto the consummation of the Merger, or with other Wyly family members. Inaddition, subsidiaries of certain of these trusts acquired securities directlyfrom us in private placement transactions in 1996 and 1997 and upon theexercise of stock options transferred, directly or indirectly, to the trusts ortheir subsidiaries by Charles Wyly, Sam Wyly, or other Wyly family members.

 

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We understand that CharlesWyly and Sam Wyly and/or certain of their family members are beneficiaries ofirrevocable non-U.S. trusts. The 1996 and 1997 private placement sales by us ofMichaels securities to subsidiaries of certain of these trusts were disclosedby us in filings with the SEC. The transfer by Charles Wyly and/or Sam Wyly (orby other Wyly family members or family-related entities) of Michaels securitiesto certain of these trusts and subsidiaries was also disclosed in filings withthe SEC by us and/or by Charles Wyly and Sam Wyly. Based on informationprovided to us, our SEC filings prior to 2005 did not report securities ownedby the non-U.S. trusts or their corporate subsidiaries as beneficially owned byCharles Wyly and Sam Wyly.

 

Charles Wyly and Sam Wylyfiled an amended Schedule 13D with the SEC on April 8, 2005, stating that theymay be deemed the beneficial owners of Michaels securities held directly orindirectly by the non-U.S. trusts. In our 2005 and 2006 proxy statements, weincluded the securities held in the non-U.S. trusts or their separate subsidiaries,as reported by the Wylys, in the beneficial ownership table of our principalstockholders and management, with appropriate footnotes.

 

On July 29, 2010, the SECfiled a civil enforcement action in federal district court for the SouthernDistrict of New York against Charles Wyly, Sam Wyly and others alleging, amongother things, violations of various federal securities laws, including thosegoverning ownership reporting and trading of securities, in connection with thenon-U.S. trusts and their subsidiaries. Additional information may be obtainedat the SEC’s website. Charles Wyly, Sam Wyly and their attorney Michael French,a former director of the Company, have requested indemnification from theCompany with respect to these matters. The Company is currently assessing theWylys’ claim and French’s claim.

 

**Note 9.  Segments**

 

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

 

Ourchief operating decision makers evaluate historical operating performance, planand forecast future periods’ operating performance based on earnings beforeinterest, income taxes, depreciation and amortization (“EBITDA”). We believeEBITDA represents the financial measure that more closely reflects theoperating effectiveness of factors over which management has control. As such,an element of base incentive compensation targets for certain managementpersonnel are based on EBITDA. A reconciliation of EBITDA to (loss) incomebefore income taxes is presented below.

 
| ** **                           | ** ** | **Quarter Ended**         | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------|------------|--------------------------------|------------|---------------------------------|------------|
| ** **                           | ** ** | **October 30, 2010** | ** ** | **October 31, 2009**  | ** ** | **October 30, 2010** | ** ** | **October 31, 2009** | ** ** |
| ** **                           | ** ** | **(in millions)**         | ** ** |
|                                 |       |                           |       |                            |       |   |   |   |   |
| (Loss) income before income taxes    |       | $                              | (21        | )                               | $          | 23 |   | $ | 9 |   | $ | 32 |   |
| Interest expense                     |       | 69                             |       | 62                              |       | 207 |   | 187 |   |
| Loss on early extinguishment of debt |       | 53                             |       | —                          |       | 53 |   | — |   |
| Depreciation and amortization        |       | 25                             |       | 28                              |       | 77 |   | 86 |   |
| EBITDA                               |       | $                              | 126        |                            | $          | 113 |   | $ | 346 |   | $ | 305 |   |

 

Oursales and assets by country are as follows:

 
| ** **         | ** ** | **Quarter Ended**         | ** ** | **Nine Months Ended** | ** ** |
|--------------------|------------|--------------------------------|------------|---------------------------------|------------|
| ** **         | ** ** | **October 30, 2010** | ** ** | **October 31, 2009**  | ** ** | **October 30, 2010** | ** ** | **October 31, 2009** | ** ** |
| ** **         | ** ** | **(in millions)**         | ** ** | **(in millions)**          | ** ** |
| **Net Sales:**     |       |                           |       |                            |       |   |   |   |   |
| United States      |       | $                              | 882        |                            | $          | 850 |   | $ | 2,467 |   | $ | 2,387 |   |
| Canada             |       | 86                             |       | 79                              |       | 233 |   | 201 |   |
| Consolidated Total |       | $                              | 968        |                            | $          | 929 |   | $ | 2,700 |   | $ | 2,588 |   |
|               |       |                           |       |                            |       |   |   |   |   |
| **Total Assets:**  |       |                           |       |                            |       |   |   |   |   |
| United States      |       | $                              | 1,678      |                            | $          | 1,657 |   | $ | 1,678 |   | $ | 1,657 |   |
| Canada             |       | 98                             |       | 103                             |       | 98 |   | 103 |   |
| Consolidated Total |       | $                              | 1,776      |                            | $          | 1,760 |   | $ | 1,776 |   | $ | 1,760 |   |

 

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**Note10.  Business Combination**

 

OnSeptember 15, 2010, the Company acquired certain assets related to the onlinescrapbooking application created by ScrapHD, LLC, an Illinois limited liabilitycompany (“ScrapHD”).  The applicationallows customers to work online to create digital scrapbooks that they canprint at home or have bound into a professional book.  Pursuant to the acquisition, we purchased100% of the proprietary software and intellectual property assets necessary tooperate the online scrapbooking application.

 

Thetotal consideration for the ScrapHD acquisition is currently estimated at $6million, which is comprised of $2 million cash consideration paid at closingand an additional contingent consideration arrangement currently valued at $4million. The potential payment that we could be required to make under thecontingent consideration arrangement ranges from $0 to $10 million. Thecontingent consideration arrangement requires Michaels to pay the owners ofScrapHD an amount equal to (i) the operating performance of ScrapHD for, at theowners’ option, the 52 weeks ended January 28, 2012 (“Fiscal 2011”) or the 53weeks ended February 3, 2013 (“Fiscal 2012”) minus (ii) the cash considerationpaid at closing, up to a maximum amount of $10 million. If the owners ofScrapHD elect to designate Fiscal 2012 as the designated fiscal year, theoperating performance of ScrapHD will be multiplied by a fraction, thenumerator of which is 52 and the denominator of which is 53 due to Fiscal 2012containing a 53rd week. As of October 30, 2010, servicesprovided by the ScrapHD acquisition had not been placed into operation.

 

Thetotal purchase price was allocated to the tangible and identifiable assetsacquired based on their estimated fair value at the acquisition date. TheScrapHD acquisition resulted in $1 million of goodwill, of which none isexpected to be deductible for income tax purposes. The goodwill recognized isprimarily the result of synergies and economies of scale expected to arise fromcombining the operations of the Company and ScrapHD.

 

Thefollowing table summarizes the acquisition date fair value of the assetsacquired (in millions):

 
| Software intangible asset |   | $ | 4      |   |
|---------------------------|--------|---|--------|--------|
| Non-compete agreements    |   | 1 |   |
| Goodwill                  |   | 1 |   |
| Assets acquired           |   | $ | 6      |   |

 

**Note 11.  RelatedParty Transactions**

 

We pay annual managementfees to Bain Capital Partners, LLC and The Blackstone Group (collectively,together with their applicable affiliates, the “Sponsors”) and HighfieldsCapital Management LP (“Highfields”) in the amount of $12 million and $1million, respectively. We recognized $3 million and $4 million of expenserelated to annual management fees and expenses during the third quarter offiscal 2010 and fiscal 2009, respectively, and $10 million and $11 millionduring the nine months ended October 30, 2010 and October 31, 2009,respectively. These expenses are included in related party expenses on theConsolidated Statements of Operations.

 

Bain Capital owns a majorityequity position in an external vendor we utilize to print our circularadvertisements.  Payments associated withthis vendor during the third quarter of fiscal 2010 and fiscal 2009 were $9million and $10 million, respectively, and $24 million for each of the ninemonths ended October 30, 2010 and October 31, 2009.  These expenses are included in selling,general and administrative expense on the Consolidated Statements ofOperations.

 

BainCapital owns an equity position in an external vendor we utilized fornon-merchandise supplies. Payments associated with this vendor for the ninemonths ended October 31, 2009 were $1 million. These expenses are included in selling, general and administrativeexpense on the Consolidated Statements of Operations.

 

TheBlackstone Group owns a majority equity position in an external vendor weutilize to count our store inventory. Payments associated with this vendorduring the third quarter of fiscal 2010 and fiscal 2009 were $2 million and $3million, respectively, and $6 million and $7 million for the nine months endedOctober 30, 2010 and October 31, 2009, respectively. These expenses areincluded in selling, general and administrative expense on the ConsolidatedStatements of Operations.

 

TheBlackstone Group owns an equity position in an external vendor we utilize forwaste management services. Payments associated with this vendor during thethird quarter of fiscal 2010 and fiscal 2009 were $1 million and $2 million,respectively, and $3 million and $5 million for the nine months ended October30, 2010 and October 31, 2009, respectively. These expenses are included in selling, general and administrativeexpense 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 third quarter of fiscal2010 and fiscal 2009 were $5 million and $4 million, respectively, and $14million and $13 million for the nine months ended October 30, 2010 and October31, 2009, respectively. These expenses are recognized in cost of sales as thesales are recorded.

 

Ourcurrent directors are affiliates of Bain Capital or The Blackstone Group.  As such, some or all of our directors mayhave an indirect material interest in payments with respect to debt securitiesof the Company that have been purchased by affiliates of Bain Capital and TheBlackstone Group.  During the first ninemonths of fiscal 2010, such affiliates sold approximately $199 millionface amount of our Subordinated Discount Notes due 2016. As of October 302010, such affiliates did not hold any of our debt securities.

 

**Note12.  Condensed Consolidating FinancialInformation**

 

Allobligations of Michaels Stores, Inc. under the Senior notes, Seniorsubordinated notes, Subordinated discount notes, Senior secured term loan, andAmended asset-based revolving credit facility are guaranteed by each of oursubsidiaries other than Aaron Brothers Card Services, LLC and Artistree ofCanada, ULC. As of October 30, 2010, the financial statements of Aaron BrothersCard Services, LLC and Artistree of Canada, ULC were immaterial. Eachsubsidiary guarantor is 100% owned by the parent and all guarantees are jointand several.

 

Thefollowing condensed consolidating financial information represents thefinancial information of Michaels Stores, Inc. and its wholly-ownedsubsidiary guarantors, prepared on the equity basis of accounting.  Theinformation is presented in accordance with the requirements of Rule 3-10under the SEC’s Regulation S-X.  The financial information may notnecessarily be indicative of results of operations, cash flows, or financialposition had the subsidiary guarantors operated as independent entities.

 

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

 

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**Supplemental Condensed Consolidating Balance Sheet**

 
| ** **                                                 | ** ** | **October 30, 2010** | ** ** |
|------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                 | ** ** | **Parent  Company**            | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                 |       | **(in millions)**         |       |
| ** **                                                 |       | ** **                     |       |
| **ASSETS**                                                 |       |                           |       |   |   |   |   |   |   |
| **Current assets:**                                        |       |                           |       |   |   |   |   |   |   |
| Cash and equivalents                                       |       | $                              | 96         |   | $ | 19 |   | $ | — |   | $ | 115 |   |
| Merchandise inventories                                    |       | 678                            |       | 326 |   | — |   | 1,004 |   |
| Intercompany receivables                                   |       | —                         |       | 468 |   | (468 | ) | — |   |
| Other                                                      |       | 152                            |       | 15 |   | — |   | 167 |   |
| Total current assets                                       |       | 926                            |       | 828 |   | (468 | ) | 1,286 |   |
| **Property and equipment, net**                            |       | 234                            |       | 68 |   | — |   | 302 |   |
| **Goodwill, net**                                          |       | 95                             |       | — |   | — |   | 95 |   |
| **Investment in subsidiaries**                             |       | 458                            |       | — |   | (458 | ) | — |   |
| **Other assets**                                           |       | 92                             |       | 1 |   | — |   | 93 |   |
| Total assets                                               |       | $                              | 1,805      |   | $ | 897 |   | $ | (926 | ) | $ | 1,776 |   |
|                                                       |       |                           |       |   |   |   |   |   |   |
| **LIABILITIES  AND STOCKHOLDERS’ (DEFICIT) EQUITY**   |       |                           |       |   |   |   |   |   |   |
| **Current liabilities:**                                   |       |                           |       |   |   |   |   |   |   |
| Accounts payable                                           |       | $                              | 1          |   | $ | 323 |   | $ | — |   | $ | 324 |   |
| Accrued liabilities and other                              |       | 257                            |       | 104 |   | — |   | 361 |   |
| Current portion of long-term debt                          |       | 1                              |       | — |   | — |   | 1 |   |
| Intercompany payable                                       |       | 468                            |       | — |   | (468 | ) | — |   |
| Other                                                      |       | 1                              |       | 1 |   | — |   | 2 |   |
| Total current liabilities                                  |       | 728                            |       | 428 |   | (468 | ) | 688 |   |
| **Long-term debt**                                         |       | 3,764                          |       | — |   | — |   | 3,764 |   |
| **Other long-term liabilities**                            |       | 77                             |       | 11 |   | — |   | 88 |   |
| **Total stockholders’ (deficit)  equity**             |       | (2,764                         | )          | 458 |   | (458 | ) | (2,764 | ) |
| Total liabilities and stockholders’ (deficit)  equity |       | $                              | 1,805      |   | $ | 897 |   | $ | (926 | ) | $ | 1,776 |   |

 

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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**

 
| ** **                                                 | ** ** | **October 31, 2009** | ** ** |
|------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                 | ** ** | **Parent  Company**            | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                 | ** ** | **(in millions)**         | ** ** |
| ** **                                                 | ** ** | ** **                     | ** ** |
| **ASSETS**                                                 |       |                           |       |   |   |   |   |   |   |
| **Current assets:**                                        |       |                           |       |   |   |   |   |   |   |
| Cash and equivalents                                       |       | $                              | 37         |   | $ | 12 |   | $ | — |   | $ | 49 |   |
| Merchandise inventories                                    |       | 732                            |       | 307 |   | — |   | 1,039 |   |
| Intercompany receivables                                   |       | —                         |       | 600 |   | (600 | ) | — |   |
| Other                                                      |       | 121                            |       | 15 |   | — |   | 136 |   |
| Total current assets                                       |       | 890                            |       | 934 |   | (600 | ) | 1,224 |   |
| **Property and equipment, net**                            |       | 244                            |       | 81 |   | — |   | 325 |   |
| **Goodwill, net**                                          |       | 94                             |       | — |   | — |   | 94 |   |
| **Investment in subsidiaries**                             |       | 663                            |       | — |   | (663 | ) | — |   |
| **Other assets**                                           |       | 116                            |       | 1 |   | — |   | 117 |   |
| Total assets                                               |       | $                              | 2,007      |   | $ | 1,016 |   | $ | (1,263 | ) | $ | 1,760 |   |
|                                                       |       |                           |       |   |   |   |   |   |   |
| **LIABILITIES  AND STOCKHOLDERS’ (DEFICIT) EQUITY**   |       |                           |       |   |   |   |   |   |   |
| **Current liabilities:**                                   |       |                           |       |   |   |   |   |   |   |
| Accounts payable                                           |       | $                              | 22         |   | $ | 252 |   | $ | — |   | $ | 274 |   |
| Accrued liabilities and other                              |       | 267                            |       | 86 |   | — |   | 353 |   |
| Current portion of long-term debt                          |       | 139                            |       | — |   | — |   | 139 |   |
| Intercompany payable                                       |       | 600                            |       | — |   | (600 | ) | — |   |
| Other                                                      |       | 1                              |       | 1 |   | — |   | 2 |   |
| Total current liabilities                                  |       | 1,029                          |       | 339 |   | (600 | ) | 768 |   |
| **Long-term debt**                                         |       | 3,772                          |       | — |   | — |   | 3,772 |   |
| **Other long-term liabilities**                            |       | 65                             |       | 14 |   | — |   | 79 |   |
| **Total stockholders’ (deficit)  equity**             |       | (2,859                         | )          | 663 |   | (663 | ) | (2,859 | ) |
| Total liabilities and stockholders’ (deficit)  equity |       | $                              | 2,007      |   | $ | 1,016 |   | $ | (1,263 | ) | $ | 1,760 |   |

 

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**Supplemental Condensed Consolidating Statement of Operations**

 
| ** **                                   | ** ** | **Quarter Ended October 30, 2010** | ** ** |
|----------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                                   | ** ** | **Parent  Company**                                    | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                   | ** ** | **(in millions)**                                 | ** ** |
| ** **                                   | ** ** | ** **                                             | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Net sales**                                |       | $                                                      | 849        |   | $ | 628 |   | $ | (509 | ) | $ | 968 |   |
| Cost of sales and occupancy expense          |       | 560                                                    |       | 541 |   | (509 | ) | 592 |   |
| **Gross profit**                             |       | 289                                                    |       | 87 |   | — |   | 376 |   |
| Selling, general, and administrative expense |       | 233                                                    |       | 36 |   | — |   | 269 |   |
| Related party expenses                       |       | 3                                                      |       | — |   | — |   | 3 |   |
| Store pre-opening costs                      |       | 1                                                      |       | 1 |   | — |   | 2 |   |
| **Operating income**                         |       | 52                                                     |       | 50 |   | — |   | 102 |   |
| Interest expense                             |       | 69                                                     |       | — |   | — |   | 69 |   |
| Loss on early extinguishment of debt         |       | 53                                                     |       | — |   | — |   | 53 |   |
| Other (income) and expense, net              |       | 1                                                      |       | — |   | — |   | 1 |   |
| Intercompany charges (income)                |       | 21                                                     |       | (21 | ) | — |   | — |   |
| Equity in earnings of subsidiaries           |       | 71                                                     |       | — |   | (71 | ) | — |   |
| **Loss before income taxes**                 |       | (21                                                    | )          | 71 |   | (71 | ) | (21 | ) |
| Income tax benefit                           |       | (9                                                     | )          | 29 |   | (29 | ) | (9 | ) |
| **Net loss**                                 |       | $                                                      | (12        | ) | $ | 42 |   | $ | (42 | ) | $ | (12 | ) |

 

**Supplemental Condensed Consolidating Statement of Operations**

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

 

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**Supplemental CondensedConsolidating Statement of Operations**

 
| ** **                                   | ** ** | **Nine Months Ended October 30, 2010** | ** ** |
|----------------------------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                                   | ** ** | **Parent  Company**                                             | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                   | ** ** | **(in millions)**                                          | ** ** |
| ** **                                   | ** ** | ** **                                                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Net sales**                                |       | $                                                               | 2,367      |   | $ | 1,594 |   | $ | (1,261 | ) | $ | 2,700 |   |
| Cost of sales and occupancy expense          |       | 1,580                                                           |       | 1,340 |   | (1,261 | ) | 1,659 |   |
| **Gross profit**                             |       | 787                                                             |       | 254 |   | — |   | 1,041 |   |
| Selling, general, and administrative expense |       | 647                                                             |       | 100 |   | — |   | 747 |   |
| Related party expenses                       |       | 10                                                              |       | — |   | — |   | 10 |   |
| Store pre-opening costs                      |       | 2                                                               |       | 1 |   | — |   | 3 |   |
| **Operating income**                         |       | 128                                                             |       | 153 |   | — |   | 281 |   |
| Interest expense                             |       | 207                                                             |       | — |   | — |   | 207 |   |
| Loss on early extinguishment of debt         |       | 53                                                              |       | — |   | — |   | 53 |   |
| Other (income) and expense, net              |       | 14                                                              |       | (2 | ) | — |   | 12 |   |
| Intercompany charges (income)                |       | 53                                                              |       | (53 | ) | — |   | — |   |
| Equity in earnings of subsidiaries           |       | 208                                                             |       | — |   | (208 | ) | — |   |
| **Income before income taxes**               |       | 9                                                               |       | 208 |   | (208 | ) | 9 |   |
| Provision for income taxes                   |       | 9                                                               |       | 85 |   | (85 | ) | 9 |   |
| **Net income**                               |       | $                                                               | —     |   | $ | 123 |   | $ | (123 | ) | $ | — |   |

 

**Supplemental Condensed Consolidating Statement of Operations**

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

 

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**Supplemental Condensed Consolidating Statement of Cash Flows**

 
| ** **                                    | ** ** | **Nine Months Ended October 30, 2010** | ** ** |
|-----------------------------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                                    | ** ** | **Parent  Company**                                             | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                    | ** ** | **(in millions)**                                          | ** ** |
| **Operating activities:**                     |       |                                                            |       |   |   |   |   |   |   |
| Net cash provided by operating activities     |       | $                                                               | 98         |   | $ | 96 |   | $ | (79 | ) | $ | 115 |   |
|                                          |       |                                                            |       |   |   |   |   |   |   |
| **Investing activities:**                     |       |                                                            |       |   |   |   |   |   |   |
| Cost of business acquisition                  |       | (2                                                              | )          | — |   | –– |   | (2 | ) |
| Cash paid for property and equipment          |       | (53                                                             | )          | (8 | ) | — |   | (61 | ) |
| Net cash used in investing activities         |       | (55                                                             | )          | (8 | ) | — |   | (63 | ) |
|                                          |       |                                                            |       |   |   |   |   |   |   |
| **Financing activities:**                     |       |                                                            |       |   |   |   |   |   |   |
| Net borrowings (repayments) of long-term debt |       | (115                                                            | )          | — |   | — |   | (115 | ) |
| Intercompany dividends                        |       | —                                                          |       | (79 | ) | 79 |   | — |   |
| Other financing activities                    |       | (39                                                             | )          | — |   | — |   | (39 | ) |
| Net cash used in financing activities         |       | (154                                                            | )          | (79 | ) | 79 |   | (154 | ) |
|                                          |       |                                                            |       |   |   |   |   |   |   |
| **Decrease in cash and equivalents**          |       | (111                                                            | )          | 9 |   | — |   | (102 | ) |
| **Beginning cash and cash  equivalents**      |       | 207                                                             |       | 10 |   | — |   | 217 |   |
| **Ending cash and cash equivalents**          |       | $                                                               | 96         |   | $ | 19 |   | $ | — |   | $ | 115 |   |

 

**Supplemental Condensed Consolidating Statement of Cash Flows**

 
| ** **                                | ** ** | **Nine Months Ended October 31, 2009** | ** ** |
|-------------------------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                                | ** ** | **Parent  Company**                                             | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                | ** ** | **(in millions)**                                          | ** ** |
| **Operating activities:**                 |       |                                                            |       |   |   |   |   |   |   |
| Net cash provided by operating activities |       | $                                                               | 100        |   | $ | 116 |   | $ | (110 | ) | $ | 106 |   |
|                                      |       |                                                            |       |   |   |   |   |   |   |
| **Investing activities:**                 |       |                                                            |       |   |   |   |   |   |   |
| Cash paid for property and equipment      |       | (25                                                             | )          | (1 | ) | — |   | (26 | ) |
| Net cash used in investing activities     |       | (25                                                             | )          | (1 | ) | — |   | (26 | ) |
|                                      |       |                                                            |       |   |   |   |   |   |   |
| **Financing activities:**                 |       |                                                            |       |   |   |   |   |   |   |
| Net borrowings of long-term debt          |       | (52                                                             | )          | — |   | — |   | (52 | ) |
| Intercompany dividends                    |       | —                                                          |       | (110 | ) | 110 |   | — |   |
| Other financing activities                |       | (12                                                             | )          | — |   | — |   | (12 | ) |
| Net cash used in financing activities     |       | (64                                                             | )          | (110 | ) | 110 |   | (64 | ) |
|                                      |       |                                                            |       |   |   |   |   |   |   |
| **Increase in cash and equivalents**      |       | 11                                                              |       | 5 |   | — |   | 16 |   |
| **Beginning cash and cash equivalents**   |       | 26                                                              |       | 7 |   | — |   | 33 |   |
| **Ending cash and cash equivalents**      |       | $                                                               | 37         |   | $ | 12 |   | $ | — |   | $ | 49 |   |

 

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

 

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

 

**DisclosureRegarding Forward-Looking Information**

 

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

 

·                  risksrelated to general economic conditions; if worldwide economic conditionsdeteriorate, or if recovery remains slow or prolonged, it could continue toadversely affect consumer confidence and retail spending, decreasing demand forour merchandise and adversely impact our results of operations, cash flows andfinancial 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 agreementsthat limit our flexibility in operating our business, as our senior securedcredit facilities and the indentures governing our notes contain variouscovenants that limit our ability to engage in specified types of transactionsand require that we maintain specified financial ratios upon the occurrence ofcertain events;

 

·                  our ability to open new stores, asour growth depends on our strategy of increasing our number of stores and if weare unable 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 couldmaterially adversely 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;

 

·                  changesin newspaper 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 suppliersincreases our risk of obtaining adequate, timely, and cost-effective productsupplies;

 

·                  risksassociated with the vendors from whom our products are sourced could materiallyadversely affect our revenue and gross profit;

 

·                  product recalls and/or product liability, as well as changes in product safety and otherconsumer protection laws, may adversely impact our operations, merchandiseofferings, reputation and financial position;

 

·                  significant increases in inflationor commodity prices such as petroleum, natural gas, electricity, steel andpaper may 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 oradequately maintain our perpetual inventory and automated replenishmentsystems;

 

·                  unauthorized access to ourelectronic and other confidential information could materially adversely affectour financial condition and operating results;

 

·                  changes in regulations or enforcement mayadversely impact our business;

 

·                  a weak fourth quarter wouldmaterially adversely affect our operating results;

 

·                  competition could negatively impactour operations; and

 

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

 

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

 

**General**

 

We report on the basis of a52 or 53-week fiscal year, which ends on the Saturday closest toJanuary 31.  All references hereinto “fiscal 2010” relate to the 52 weeks ending January 29, 2011 andall references to “fiscal 2009” relate to the 52 weeks ended January 30,2010. In addition, all references herein to “the third quarter of fiscal 2010”relate to the 13 weeks ended October 30, 2010 and all references to “the thirdquarter of fiscal 2009” relate to the 13 weeks ended October 31, 2009. Finally,all references to “the nine months ended October 30, 2010” or “the first ninemonths of fiscal 2010” relate to the 39 weeks ended October 30, 2010, and “thenine months ended October 31, 2009” or “the first nine months of fiscal 2009”relate to the 39 weeks ended October 31, 2009.

 

The following table setsforth certain of our unaudited operating data:

 
| ** **                                               | ** ** | **Quarter Ended**     | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------------------------------|------------|----------------------------|------------|---------------------------------|------------|
| ** **                                               | ** ** | **October 30, ** | ** ** | **October 31,**            | ** ** | **October 30, ** | ** ** | **October 31,** | ** ** |
| ** **                                               | ** ** | **2010**                   | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
| **Michaels stores:**                                     |       |                       |       |                            |       |   |   |   |   |
| Retail stores open at beginning of period                |       | 1,033                      |       | 1,023                           |       | 1,023 |   | 1,009 |   |
| Retail stores opened during the period                   |       | 13                         |       | 4                               |       | 23 |   | 18 |   |
| Retail stores opened (relocations) during the  period    |       | 3                          |       | 1                               |       | 10 |   | 5 |   |
| Retail stores closed during the period                   |       | —                     |       | —                          |       | — |   | — |   |
| Retail stores closed (relocations) during the  period    |       | (3                         | )          | (1                              | )          | (10 | ) | (5 | ) |
| Retail stores open at end of period                      |       | 1,046                      |       | 1,027                           |       | 1,046 |   | 1,027 |   |
|                                                     |       |                       |       |                            |       |   |   |   |   |
| **Aaron Brothers stores:**                               |       |                       |       |                            |       |   |   |   |   |
| Retail stores open at beginning of period                |       | 145                        |       | 155                             |       | 152 |   | 161 |   |
| Retail stores opened during the period                   |       | —                     |       | —                          |       | — |   | — |   |
| Retail stores opened (relocations) during the  period    |       | —                     |       | —                          |       | — |   | — |   |
| Retail stores closed during the period                   |       | (4                         | )          | (3                              | )          | (11 | ) | (9 | ) |
| Retail stores closed (relocations) during the  period    |       | —                     |       | —                          |       | — |   | — |   |
| Retail stores open at end of period                      |       | 141                        |       | 152                             |       | 141 |   | 152 |   |
|                                                     |       |                       |       |                            |       |   |   |   |   |
| Total store count at end of period                       |       | 1,187                      |       | 1,179                           |       | 1,187 |   | 1,179 |   |
|                                                     |       |                       |       |                            |       |   |   |   |   |
| **Other operating data:**                                |       |                       |       |                            |       |   |   |   |   |
| Average inventory per Michaels store (in  thousands) (1) |       | $                          | 923        |                            | $          | 971 |   | $ | 923 |   | $ | 971 |   |
| Comparable store sales (2)                               |       | 2.9                        | %          | 1.3                             | %          | 3.4 | % | (0.5 | )% |
|                                                          |            |                            |            |                                 |            |  |  |  |  |  |  |  |  |

 

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

 

**Results ofOperations**

 

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

 
| ** **                                   | ** ** | **Quarter Ended** | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------------------|------------|------------------------|------------|---------------------------------|------------|
| ** **                                   | ** ** | **October 30,**   | ** ** | **October 31,**            | ** ** | **October 30,** | ** ** | **October 31,** | ** ** |
| ** **                                   | ** ** | **2010**               | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
| **Net sales**                                |       | 100.0                  | %          | 100.0                           | %          | 100.0 | % | 100.0 | % |
| Cost of sales and occupancy expense          |       | 61.2                   |       | 62.7                            |       | 61.5 |   | 63.4 |   |
| **Gross profit**                             |       | 38.8                   |       | 37.3                            |       | 38.5 |   | 36.6 |   |
| Selling, general, and administrative expense |       | 27.8                   |       | 27.9                            |       | 27.7 |   | 28.5 |   |
| Related party expenses                       |       | 0.3                    |       | 0.4                             |       | 0.3 |   | 0.4 |   |
| Store pre-opening costs                      |       | 0.2                    |       | —                          |       | 0.1 |   | 0.1 |   |
| **Operating income**                         |       | 10.5                   |       | 9.0                             |       | 10.4 |   | 7.6 |   |
| Interest expense                             |       | 7.1                    |       | 6.7                             |       | 7.7 |   | 7.2 |   |
| Debt extinguishment loss                     |       | 5.5                    |       | —                          |       | 2.0 |   | — |   |
| Other (income) and expense, net              |       | 0.1                    |       | (0.2                            | )          | 0.4 |   | (0.8 | ) |
| **Income before income taxes**               |       | (2.2                   | )          | 2.5                             |       | 0.3 |   | 1.2 |   |
| (Benefit) provision for income taxes         |       | (0.9                   | )          | 0.9                             |       | 0.3 |   | 0.4 |   |
| **Net (loss) income**                        |       | (1.3                   | )%         | 1.6                             | %          | — | % | 0.8 | % |

 

*QuarterEnded October 30, 2010 Compared to the Quarter Ended October 31, 2009*

 

*Net Sales*—Net salesincreased for the third quarter of fiscal 2010 by $39 million, or 4.2%,over the third quarter of fiscal 2009 due primarily to a $27 million increasein comparable store sales. Comparable store sales increased 2.9% due to anincrease in customer transactions of 2.4% and an increase in the average ticketof 0.7%, partially offset by an adverse impact of 0.2% related to deferredcustom framing revenue. The fluctuation in the exchange rates between theUnited States and Canadian dollars positively impacted the average ticket by 40basis points. In addition, sales from our non-comparable new stores providedincremental revenue of $12 million.

 

*Cost ofSales and Occupancy Expense*—Cost of sales and occupancyexpense increased $10 million to $592 million for the third quarter of fiscal2010 from $582 million for the third quarter of fiscal 2009.  This increase was primarily due to the changein sales, partially offset by the benefit of lower merchandise cost andimproved inventory management. As a percentage of sales, cost of sales and occupancyexpense decreased 150 basis points. Merchandise costs, as a percentage ofsales, improved approximately 90 basis points as a result of our direct importinitiative and improved pricing and promotion management. In addition,occupancy costs decreased by approximately 60 basis points due to leveraging offixed costs on the increase in comparable store sales as well as improved costmanagement.

 

*Selling,General, and Administrative Expense*—Selling, general, andadministrative expense was $269 million or 27.8% of net sales, in the thirdquarter of fiscal 2010 compared to $259 million, or 27.9% of net sales, in thethird quarter of fiscal 2009. Selling, general, and administrative expenseincreased $10 million primarily driven by increases in store costs related tooperating 19 additional Michaels stores during the third quarter of fiscal2010, increased performance-based bonus expense due to higher anticipatedprofitability for fiscal 2010, and an increase in advertising expense,partially offset by lower group insurance costs.  As a

 

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percentage of net sales,selling, general, and administrative expenses decreased 10 basis points due tolower group insurance expense through careful cost management, partially offsetby increased performance based bonus expense as indicated above.

 

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

 

*InterestExpense*—Interest expense for the quarter increased $7 million to $69 millionas a result of increased interest rates associated with our amended creditfacilities.

 

*Loss on Early Extinguishment ofDebt*—**We**recorded aloss of $53 million related to the early extinguishment of our 2014 SeniorNotes during the third quarter of fiscal 2010. The $53 million loss iscomprised of the $41 million tender and call premiums and $12 million to writeoff the remaining unamortized debt issuance costs. Refer to Note 3 for furtherdiscussion.

 

*Other (Income) and Expense, net*—Other expensein the third quarter of fiscal 2010 related to a $2 million unfavorable changein the fair value of our interest rate cap as more fully described in Note 5 tothe consolidated financial statements, partially offset by $1 million relatedto foreign exchange gain. Other income in the third quarter of fiscal 2009related primarily to a $1 million favorable change in the fair value of theinterest rate cap.

 

*(Benefit)Provision for Income Taxes*— During the third quarterof fiscal 2010, we recorded a tax benefit of $9 million at an effective rate of41.4%. During the third quarter of fiscal 2009, we recorded a tax provision of$8 million at an effective rate of 33.2%.

 

*NineMonths Ended October 30, 2010 Compared to the Nine Months Ended October31, 2009*

 

*Net Sales*—Net salesincreased for the first nine months of fiscal 2010 by $112 million, or4.3%, over the first nine months of fiscal 2009 primarily due to an $86 millionincrease in comparable store sales. Comparable store sales increased 3.4% dueto an increase in the average ticket of 1.7% and an increase in customertransactions of 1.7%. The fluctuation in the exchange rates between the UnitedStates and Canadian dollars positively impacted the average ticket by 90 basispoints. In addition, sales from our non-comparable new stores providedincremental revenue of $26 million.

 

*Cost ofSales and Occupancy Expense*— Cost of sales andoccupancy expense increased $19 million to $1,659 million for the first ninemonths of fiscal 2010 from $1,640 million for the first nine months of fiscal2009.The increase was primarily due to the change in sales, partially offset bythe benefit of lower merchandise costs and improved inventory management. Costof sales and occupancy expense decreased 190 basis points as a percentage ofnet sales. Merchandise costs, as a percentage of sales, improved approximately120 basis points as a result of our direct import initiatives and improvedpricing and promotion management. In addition, occupancy costs decreased byapproximately 70 basis points due to leveraging of fixed costs on the increasein comparable store sales, improved cost management, and lower occupancyamortization due to reduced capital expenditures in recent years.

 

*Selling,General, and Administrative Expense*—Selling, general, andadministrative expense was $747 million or 27.7% of net sales, for the firstnine months of fiscal 2010 compared to $737 million, or 28.5% of net sales, forthe first nine months of fiscal 2009. Selling, general, and administrativeexpense increased $10 million primarily driven by increases in store costsrelated to operating 19 additional Michaels stores during the first nine monthsof fiscal 2010 and increased performance-based bonus expense due to higheranticipated profitability for fiscal 2010. These amounts are partially offsetby lower group insurance expense due to careful cost management. As apercentage of net sales, selling, general, and administrative expense decreased80 basis points due to increased payroll leverage on higher comparable storesales as well as lower group insurance expense as indicated above.

 

*RelatedParty Expenses*—Related party expenses were $10 million and $11million for the first nine months of fiscal 2010 and fiscal 2009, respectively.These costs consist of management fees and associated expenses paid to ourSponsors and Highfields.

 

*InterestExpense*—Interest expense increased $20 million for the nine months endedOctober 30, 2010 compared to the nine months ended October 31, 2009, as aresult of increased interest rates associated with our amended creditfacilities.

 

*Loss on Early Extinguishment ofDebt*—**We**recorded aloss of $53 million related to the early extinguishment of our 2014 SeniorNotes during the first nine months of fiscal 2010. The $53 million loss iscomprised of the $41 million tender and call premiums and $12 million to writeoff the remaining unamortized debt issuance costs. Refer to Note 3 for furtherdiscussion.

 

*Other (Income) and Expense, net*—Other expensefor the first nine months of fiscal 2010 is primarily due to a $15 millionunfavorable change in the fair value of our interest rate cap, partially offsetby $3 million of foreign exchange gains. Other income for

 

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the first nine months offiscal 2009 related to a $16 million favorable change in the fair value of theinterest rate cap and $5 million related to foreign exchange gains.

 

*Provisionfor Income Taxes*— For the nine months ended October 30, 2010, werecorded a tax provision of $9 million primarily due to additional expense tocorrect the federal deferred tax liability relating to state income taxes andother discrete items. We currently estimate our annualized effective tax ratefor fiscal 2010 to be 41%, including a 3.2% unfavorable impact from thedeferred tax liability correction recorded during the first quarter of fiscal2010. The effective tax rate was 34.2% for the first nine months of fiscal2009.

 

**Liquidity andCapital Resources**

 

We require cash principallyfor day-to-day operations, to finance capital investments, inventory for newstores and inventory replenishment for existing stores, to service ouroutstanding debt, and for seasonal working capital needs. We expect that ouravailable cash, cash flow generated from operating activities, and fundsavailable under our Amended asset-based revolving credit facility will besufficient to fund planned capital expenditures, working capital requirements,debt repayments, debt service requirements and anticipated growth for theforeseeable future. Our Amended asset-based revolving credit facility providessenior secured financing of up to $900 million, subject to a borrowing base. Asof October 30, 2010, the borrowing base was $845 million, which supported $50million of outstanding letters of credit and provided $795 million of excessavailability. Our cash and equivalents decreased $102 million from $217 millionat January 30, 2010 to $115 million at October 30, 2010.

 

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

 

*Cash Flowfrom Operating Activities*

 

Cash flow provided byoperating activities during the first nine months of fiscal 2010 was $115million compared to $106 million during the first nine months of fiscal2009. The $9 million increase was due to improved net income beforeconsideration of the loss on the early extinguishment of the 2014 Senior Notesand improved accounts payable leveraging. The improvement was partially offsetby an increase in taxes receivable due to higher estimated payments, loweraccrued interest due to the early payment of interest on the 2014 Senior Notesand slower growth in accrued expenses due to the bonus payments made in thefirst quarter.

 

Average inventory perMichaels store (including supporting distribution centers) decreased 4.9% from$971,000 at October 31, 2009 to $923,000 at October 30, 2010 primarily dueto a planned reduction of store inventory levels, partially offset by higherfreight costs. We anticipate average inventory per Michaels store at the end offiscal 2010 to be down compared to the end of fiscal 2009.

 

*Cash Flowused in Investing Activities*

 

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

 
| ** **                                              | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                              | ** ** | **October 30,**            | ** ** | **October 31,** | ** ** |
| ** **                                              | ** ** | **2010**                        | ** ** | **2009** | ** ** |
| ** **                                              | ** ** | **(in millions)**          | ** ** |
| New and relocated stores and stores not yet opened  (1) |       | $                               | 20         |   | $ | 10 |   |
| Existing stores                                         |       | 18                              |       | 8 |   |
| Information systems                                     |       | 17                              |       | 6 |   |
| Corporate and other                                     |       | 6                               |       | 2 |   |
|                                                    |       | $                               | 61         |   | $ | 26 |   |

 

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| (1) |   | In  the first nine months of fiscal 2010, we incurred capital expenditures  related to the opening of 23 Michaels stores in addition to the relocation of  ten Michaels stores. In the first nine months of fiscal 2009, we incurred  capital expenditures related to the opening of 18 Michaels stores in addition  to the relocation of five Michaels stores. In fiscal 2009, we opened the  majority of our stores in locations where the landlord paid to build the  stores to our specifications. During fiscal 2010, we have opened a greater  number of stores in locations where we paid to build the stores to our  specifications. As a result, our capital expenditures for new and relocated  stores have increased in the first nine months of fiscal 2010 compared to the  first nine months of fiscal 2009. This trend may continue in future years. |
|-----|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

During the third quarter offiscal 2010, we purchased certain assets of ScrapHD, LLC.  See Note 10 to the consolidated financialstatements for further information.

 

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*Cash Flowfrom Financing Activities*

 

Cash flow used in financingactivities during the first nine months of fiscal 2010 was $154 millioncompared to $64 million during the first nine months of fiscal 2009. The $90million change was primarily due to the fiscal 2009 excess cash flow payment onour Senior secured term loan facility of $118 million and $19 million in debtissuance costs related to the amendment to the asset-based revolving creditfacility, both of which were paid during the first quarter of fiscal 2010. Inaddition, we retired our 10% Senior Notes due 2014 (the “2014 Senior Notes”)during the third quarter of fiscal 2010 and issued 7 3⁄4%**SeniorNotes due 2018 (the “2018 Senior Notes”). In connection with the earlyretirement of our 2014 Senior Notes, we paid a $41 million tender and callpremiums.  Additionally, we paid $15million in debt issuance costs related to the 2018 Senior Notes.

 

*Debt*

 

*10%Senior Notes due 2014*

 

OnOctober 6, 2010, we commenced a tender offer and consent solicitation relatedto our 2014 Senior Notes. Pursuant to the consent solicitation, we receivedtenders and consents from the holders of $658,593,000, or approximately 87.81%,of the 2014 Senior Notes before the consent payment deadline, October 20, 2010,at 5:00 p.m. Eastern time (the “Consent Date”). The consents received exceededthe number needed to approve the proposed amendments to the indenture governingthe 2014 Senior Notes (the “2014 Senior Indenture”). The amendments to the 2014Senior Indenture eliminated substantially all of the affirmative andrestrictive covenants contained in the 2014 Senior Indenture and the 2014Senior Notes (other than, among other covenants, the covenant to pay interestand premium, if any, on, and principal of, the 2014 Senior Notes when due) andcertain events of default, and modified or eliminated certain other provisionscontained in the 2014 Senior Indenture and the 2014 Senior Notes.

 

Pursuantto the terms of the tender offer, we accepted for payment all 2014 Senior Notestendered on or prior to the Consent Date, and holders who tendered such 2014Senior Notes received $1,055.00 per $1,000 in principal amount of the 2014Senior Notes validly tendered. On October 21, 2010, we also (i) instructedthe trustee under the 2014 Senior Indenture (the “2014 Senior Notes Trustee”)to deliver a notice of redemption to the holders of the remaining outstanding2014 Senior Notes and (ii) deposited cash with the 2014 Senior NotesTrustee to satisfy and discharge the 2014 Senior Indenture and to fund theredemption of the remaining outstanding 2014 Senior Notes at a price equal to105% plus the payment of accrued interest through the date of redemption,November 22, 2010. As a result, the 2014 Senior Indenture was discharged.

 

Inaccordance with ASC 470, *Debt*, werecorded a loss of $53 million related to the early extinguishment of our 2014Senior Notes.  The $53 million loss iscomprised of the $41 million tender and call premiums and $12 million to writeoff the remaining unamortized debt issuance costs.

 

*7 3⁄4% Senior Notes due 2018*

 

On October 21, 2010, weissued $800.0 million aggregate principal amount of 7 3⁄4% Senior Notes thatmature on November 1, 2018 (the “2018 Senior Notes”) and were sold at adiscounted price of 99.262% of face value. The 2018 Senior Notes areguaranteed, jointly and severally, on an unsecured senior basis, by each of oursubsidiaries that guarantee indebtedness under our amended and restated seniorsecured asset-based revolving facility and senior secured term loan facility(the “Senior Secured Credit Facilities”).

 

The 2018 Senior Notes andthe guarantees thereof are our and the guarantors’ unsecured senior obligationsand rank senior in right of payment to all of our and the guarantors’ existingand future debt and other obligations that are, by their terms, expresslysubordinated in right of payment to the 2018 Senior Notes (including the seniorsubordinated notes due 2016 and the subordinated discount notes due 2016, asdescribed in our Annual Report on Form 10-K for the fiscal year ended January30, 2010); rank equally in right of payment to all of our and the guarantors’existing and future debt and other obligations that are not, by their terms,expressly subordinated in right of payment to the 2018 Senior Notes; and areeffectively subordinated in right of payment to all of our and the guarantors’existing and future secured debt (including obligations under the SeniorSecured Credit Facilities), to the extent of the value of the assets securingsuch debt, and are structurally subordinated to all obligations of oursubsidiaries that are not guarantors of the 2018 Senior Notes.

 

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At any time prior toNovember 1, 2014, we may redeem all or a part of the 2018 Senior Notes ata redemption price equal to 100% of the principal amount of the 2018 SeniorNotes redeemed plus the Applicable Premium (as defined in the indenturegoverning the 2018 Senior Notes (the “2018 Senior Indenture”)) and accrued andunpaid interest and Additional Interest (as defined in the 2018 SeniorIndenture), if any, to the date of redemption, subject to the right of holdersof record on the relevant record date to receive interest due on the relevantinterest payment date.

 

On and afterNovember 1, 2014, the Company may redeem the 2018 Senior Notes, in wholeor in part, upon notice, at the redemption prices (expressed as percentages ofprincipal amount of the 2018 Senior Notes to be redeemed) set forth below, plusaccrued and unpaid interest thereon and Additional Interest, if any, to theapplicable date of redemption if redeemed during the twelve-month periodbeginning on November 1 of each of the years indicated below:

 
| **Year**             | ** ** | **Percentage** | ** ** |
|----------------------|------------|----------------|------------|
| 2014                 |       | 103.875        | %          |
| 2015                 |       | 101.938        | %          |
| 2016  and thereafter |       | 100.000        | %          |

 

In addition, untilNovember 1, 2013 we may, at our option, on one or more occasions redeem upto 35% of the aggregate principal amount of the 2018 Senior Notes (includingthe aggregate principal amount of the 2018 Senior Notes issued after the issuedate) at a redemption price equal to 107.750% of the aggregate principal amountthereof, plus accrued and unpaid interest thereon and Additional Interest, ifany, to the applicable date of redemption, subject to the right of holders ofrecord on the relevant record date to receive interest due on the relevantinterest payment date, with the net cash proceeds of one or more EquityOfferings (as defined in the 2018 Senior Indenture); *provided*that at least 50% of the sum of the aggregateprincipal amount of the 2018 Senior Notes originally issued under the 2018Senior Indenture and any 2018 Senior Notes that are issued under the 2018Senior Indenture after the issue date remains outstanding immediately after theoccurrence of each such redemption; *providedfurther*that each such redemption occurs within 90 days of the dateof closing of each such Equity Offering.

 

Upon a change in control weare required to offer to purchase all of the 2018 Senior Notes at a price incash equal to 101% of the aggregate principal amount thereof, plus accrued andunpaid interest.

 

The 2018 Senior NotesIndenture contains covenants limiting, among other things, the Company’sability and the ability of the Company’s restricted subsidiaries to:

 

·                  incuradditional debt;

 

·                  pay dividendsor distributions on the Company’s capital stock or repurchase the Company’scapital stock;

 

·                  issue stock ofsubsidiaries;

 

·                  make certain investments;

 

·                  create liens onthe Company’s assets to secure debt;

 

·                  enter intotransactions with affiliates;

 

·                  merge orconsolidate with another company; and

 

·                  sell orotherwise transfer assets.

 

The 2018 Senior Indenturealso provides for events of default, which, if certain of them occur, wouldpermit the trustee under the 2018 Senior Indenture or holders of at least 25%in principal amount of the then outstanding 2018 Senior Notes to declare theprincipal, premium, if any, interest and any other monetary obligations on allthe then outstanding 2018 Senior Notes to be due and payable immediately.

 

Inaccordance with ASC 470, we recorded $15 million in debt issuance costs thatwill be amortized as interest expense over the life of the 2018 Senior Notes.

 

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**Non-GAAPMeasures**

 

Thefollowing table sets forth the Company’s Earnings before Interest, Taxes,Depreciation and Amortization (“EBITDA”). The Company defines EBITDA as netincome before interest, income taxes, discontinued operations, depreciation andamortization. Additionally, the table presents Adjusted Earnings beforeInterest, Taxes, Depreciation and Amortization (“Adjusted EBITDA”).  The Company defines Adjusted EBITDA as EBITDAadjusted for certain defined amounts that are added to, or subtracted from,EBITDA (collectively, the “Adjustments”) in accordance with the Company’s $2.4billion Senior secured term loan and $900 million asset-based revolving creditfacilities. The Adjustments are described in further detail in the table, andthe footnotes to the table below.

 

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

 

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

 

The table below shows areconciliation of EBITDA and Adjusted EBITDA to net income and net cashprovided by operating activities.

 
| ** **                                | ** ** | **Quarter Ended** | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------------|------------|------------------------|------------|---------------------------------|------------|
| ** **                                | ** ** | **October 30,**   | ** ** | **October 31,**            | ** ** | **October 30,** | ** ** | **October 31,** | ** ** |
| ** **                                | ** ** | **2010**               | ** ** | **2009**                        | ** ** | **2010** | ** ** | **2009** | ** ** |
|                                      |       |                   |       |                            |       |   |   |   |   |
| Cash flows from operating activities      |       | $                      | 92         |                            | $          | 76 |   | $ | 115 |   | $ | 106 |   |
| Depreciation and amortization             |       | (25                    | )          | (28                             | )          | (77 | ) | (86 | ) |
| Share-based compensation                  |       | (2                     | )          | (2                              | )          | (6 | ) | (6 | ) |
| Deferred financing cost amortization      |       | (5                     | )          | (5                              | )          | (14 | ) | (13 | ) |
| Accretion of subordinated discount notes  |       | (13                    | )          | (11                             | )          | (37 | ) | (33 | ) |
| Change in fair value of interest rate cap |       | (2                     | )          | 1                               |       | (15 | ) | 16 |   |
| Loss on early extinguishment of debt      |       | (53                    | )          | —                          |       | (53 | ) | — |   |
| Changes in assets and liabilities         |       | (4                     | )          | (16                             | )          | 87 |   | 37 |   |
| Net income                                |       | (12                    | )          | 15                              |       | — |   | 21 |   |
| Interest expense                          |       | 69                     |       | 62                              |       | 207 |   | 187 |   |
| Loss on early extinguishment of debt      |       | 53                     |       | —                          |       | 53 |   | — |   |
| Income tax (benefit) provision            |       | (9                     | )          | 8                               |       | 9 |   | 11 |   |
| Depreciation and amortization             |       | 25                     |       | 28                              |       | 77 |   | 86 |   |
| EBITDA                                    |       | 126                    |       | 113                             |       | 346 |   | 305 |   |
| Adjustments:                              |       |                   |       |                            |       |   |   |   |   |
| Share-based compensation                  |       | 2                      |       | 2                               |       | 6 |   | 6 |   |
| Sponsor Fees                              |       | 3                      |       | 4                               |       | 10 |   | 11 |   |
| Termination expense                       |       | —                 |       | 1                               |       | — |   | 4 |   |
| Pre-opening costs                         |       | 2                      |       | 1                               |       | 3 |   | 2 |   |
| Foreign currency translation gains/losses |       | (1                     | )          | —                          |       | (3 | ) | (5 | ) |
| Store closing costs                       |       | 1                      |       | 1                               |       | 2 |   | 4 |   |
| Loss (gain) on interest rate cap          |       | 2                      |       | (1                              | )          | 15 |   | (16 | ) |
| Other (1)                                 |       | 2                      |       | (3                              | )          | 2 |   | (4 | ) |
| Adjusted EBITDA                           |       | $                      | 137        |                            | $          | 118 |   | $ | 381 |   | $ | 307 |   |

 

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

 

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**RecentAccounting Pronouncements**

 

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

 

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

 

Weare exposed to fluctuations in exchange rates between the US and Canadiandollar, which is the functional currency of our Canadian subsidiaries. Oursales, costs and expenses of our Canadian subsidiaries, when translated into USdollars, can fluctuate due to exchange rate movement. As of October 30,2010, a 10% increase or decrease in the exchange rate of the US and Canadiandollar would 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 October 30, 2010, a 1% increase or decrease in interestrates would increase or decrease income before income taxes by approximately$22 million. A 1% increase in interest rates would decrease the fair value ofour long-term fixed rate debt by approximately $47 million. A 1% decrease ininterest rates would increase the fair value of our long-term fixed rate debtby approximately $101 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 October 30,2010 was $3 million and is included in Other assets on the Consolidated BalanceSheets. The change in fair value of the cap for the quarter and nine monthsended October 30, 2010, resulted in a loss of $2 million and $15 million,respectively, and is recorded in Other (income) and expense, net in theConsolidated Statements of Operations. A 1% increase in the interest rateswould increase income before income taxes by approximately $12 million. A 1%decrease in the interest rates would decrease income before income taxes byapproximately $3 million.

 

**Item 4.  Controlsand Procedures.**

 

*Evaluationof Disclosure Controls and Procedures*

 

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

 

An evaluation was carriedout under the supervision and with the participation of our management,including our Chief Executive Officer and our Chief Financial Officer, of theeffectiveness of our disclosure controls and procedures as of the end of theperiod covered by this report. Based on that evaluation, our Chief ExecutiveOfficer and our Chief Financial Officer concluded that our disclosure controlsare effective to provide reasonable assurance that information required to bedisclosed in the reports that we file or submit under the Securities andExchange Act of 1934 is accumulated and communicated to management, includingour Chief Executive Officer and our Chief Financial Officer, to allow timelydecisions regarding required disclosure and are effective to provide reasonableassurance that such information is recorded, processed, summarized and reportedwithin the time periods specified by the SEC’s rules and forms.

 

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*Change inInternal Control Over Financial Reporting*

 

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

 

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**MICHAELSSTORES, INC.**

**Part II—OTHERINFORMATION**

 

**Item 1.  Legal Proceedings.**

 

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

 

**Item 6.  Exhibits.**

 

(a) Exhibits:

 
| **Exhibit  Number** | ** ** | **Description of Exhibit**                                                                                                                                                                                                                                                                                 |
|---------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 4.1                 |       | Supplemental  Indenture, dated as of October 20, 2010, by and among Michaels  Stores, Inc. and Law Debenture Trust Company of New York, as trustee  (previously filed as Exhibit 4.1 to Form 8-K filed by Company on  October 26, 2010, SEC File No. 001-09338).                       |
|                |       |                                                                                                                                                                                                                                                                                                                 |
| 4.2                 |       | Indenture,  dated as of October 21, 2010, by and among Michaels Stores, Inc.,  the guarantors named therein and Law Debenture Trust Company of New York, as  trustee (previously filed as Exhibit 4.1 to Form 8-K filed by  Company on October 26, 2010, SEC File No. 001-09338).      |
|                |       |                                                                                                                                                                                                                                                                                                                 |
| 4.3                 |       | Registration  Rights Agreement, dated as of October 21, 2010, by and among Michaels  Stores, Inc., the guarantors named therein and the Initial Purchasers  named therein (previously filed as Exhibit 4.1 to Form 8-K filed by  Company on October 26, 2010, SEC File No. 001-09338). |
|                |       |                                                                                                                                                                                                                                                                                                                 |
| 10.1                |       | Letter  Agreement, dated September 15, 2010, between Michaels Stores, Inc.  and Charles M. Sonsteby (previously filed as Exhibit 99.2 to  Form 8-K filed by Company on September 17, 2010, SEC File  No. 001-09338).                                                                   |
|                |       |                                                                                                                                                                                                                                                                                                                 |
| 10.2                |       | Purchase  Agreement, dated October 7, 2010, by and among Michaels  Stores, Inc., the Guarantors named therein and the Initial Purchasers  named therein (previously filed as Exhibit 10.1 to Form 8-K filed  by Company on October 14, 2010, SEC File No. 001-09338).                  |
|                |       |                                                                                                                                                                                                                                                                                                                 |
| 31.1                |       | Certifications  of John B. Menzer pursuant to §302 of the Sarbanes-Oxley Act of 2002 (filed  herewith).                                                                                                                                                                                                         |
|                |       |                                                                                                                                                                                                                                                                                                                 |
| 31.2                |       | Certifications  of Charles M. Sonsteby 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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**MICHAELS STORES, INC.**

**SIGNATURES**

 

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

 
|                                | MICHAELS  STORES, INC. |
|-------------------------------------|-----------------------------|
|                                |                        |
|                                | By:                         | /s/ Charles  M. Sonsteby |
|                                |                        | Charles  M. Sonsteby |
|                                |                        | Chief  Administrative Officer & Chief Financial Officer |
|                                |                        | (Principal  Financial Officer) |
| ** **                          | ** **                  | ** ** |
| Dated: November 23,  2010 | ** **                  | ** ** |

 

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**INDEX TO EXHIBITS**

 
| **Exhibit  Number** | ** ** | **Description of Exhibit**                                                                                                                                                                                                                                                                                 |
|---------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 4.1                 |       | Supplemental  Indenture, dated as of October 20, 2010, by and among Michaels  Stores, Inc. and Law Debenture Trust Company of New York, as trustee  (previously filed as Exhibit 4.1 to Form 8-K filed by Company on  October 26, 2010, SEC File No. 001-09338).                       |
|                |       |                                                                                                                                                                                                                                                                                                                 |
| 4.2                 |       | Indenture,  dated as of October 21, 2010, by and among Michaels Stores, Inc.,  the guarantors named therein and Law Debenture Trust Company of New York, as  trustee (previously filed as Exhibit 4.1 to Form 8-K filed by  Company on October 26, 2010, SEC File No. 001-09338).      |
|                |       |                                                                                                                                                                                                                                                                                                                 |
| 4.3                 |       | Registration  Rights Agreement, dated as of October 21, 2010, by and among Michaels  Stores, Inc., the guarantors named therein and the Initial Purchasers  named therein (previously filed as Exhibit 4.1 to Form 8-K filed by  Company on October 26, 2010, SEC File No. 001-09338). |
|                |       |                                                                                                                                                                                                                                                                                                                 |
| 10.1                |       | Letter  Agreement, dated September 15, 2010, between Michaels Stores, Inc.  and Charles M. Sonsteby (previously filed as Exhibit 99.2 to Form 8-K  filed by Company on September 17, 2010, SEC File No. 001-09338).                                                                    |
|                |       |                                                                                                                                                                                                                                                                                                                 |
| 10.2                |       | Purchase  Agreement, dated October 7, 2010, by and among Michaels  Stores, Inc., the Guarantors named therein and the Initial Purchasers  named therein (previously filed as Exhibit 10.1 to Form 8-K filed  by Company on October 14, 2010, SEC File No. 001-09338).                  |
|                |       |                                                                                                                                                                                                                                                                                                                 |
| 31.1                |       | Certifications  of John B. Menzer pursuant to §302 of the Sarbanes-Oxley Act of 2002 (filed  herewith).                                                                                                                                                                                                         |
|                |       |                                                                                                                                                                                                                                                                                                                 |
| 31.2                |       | Certifications  of Charles M. Sonsteby 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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