**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSIONWASHINGTON, DC 20549**

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**FORM 10-Q**
| **(Mark One)**                                                                                                                                 |
|------------------------------------------------------------------------------------------------------------------------------------------------|
| **x**                                                                                                                                          | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934** |
|                                                                                                                                           |   |
| **For the quarterly period ended August 4, 2007**                                                                                              |
| ** **                                                                                                                                     | ** ** |
| **OR**                                                                                                                                         |
|                                                                                                                                           |   |
| **o**                                                                                                                                          | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934** |
| ** **                                                                                                                                     | ** ** |
| **For the transition period from                     to** |

 

**Commissionfile number 001-09338**

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**MICHAELSSTORES, INC.**

(Exact name ofregistrant as specified in its charter)

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

 

**8000Bent Branch Drive**

**Irving,Texas 75063**

(Address ofprincipal 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 **x***

Indicate by check markwhether the Registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large acceleratedfiler **o**     Acceleratedfiler **o**     Non-acceleratedfiler **x**

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

Indicate the number ofshares outstanding of each of the Registrant’s classes of Common Stock, as ofthe latest practicable date.
| Title                                   | ** ** | **Shares Outstanding as of  September 7, 2007** | ** ** |
|-----------------------------------------|------------|--------------------------------------------------------------------------|------------|
| Common Stock,  par value $.10 per share |       | 118,465,069                                                              |       |

 

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*Although the Registranthas not been subject to such filing requirements for the past 90 days, it hasfiled all periodic reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months.

 

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**MICHAELS STORES, INC.FORM 10-Q**
|                  | ** ** | **Part I—FINANCIAL  INFORMATION**                                                                               | ** ** | **3**  |
|------------------|------------|---------------------------------------------------------------------------------------------------------------------------|------------|--------|
| **Item 1.** | ** ** | **Financial Statements**                                                                                                  | ** ** | **3**  |
|             |       | Consolidated  Balance Sheets at August 4, 2007, February 3, 2007, and July 29, 2006  (unaudited)                          | ** ** | **3**  |
|             |       | Consolidated Statements of  Operations for the quarter and six months ended August 4, 2007 and July 29,  2006 (unaudited) | ** ** | **4**  |
|             |       | Consolidated  Statements of Cash Flows for the six months ended August 4, 2007 and July 29,  2006 (unaudited)             | ** ** | **5**  |
|             |       | Notes to Consolidated  Financial Statements (unaudited)                                                                   | ** ** | **6**  |
| **Item 2.** | ** ** | **Management’s  Discussion and Analysis of Financial Condition and Results of Operations**                           | ** ** | **17** |
| **Item 3.** | ** ** | **Quantitative  and Qualitative Disclosures About Market Risk**                                                           | ** ** | **25** |
| **Item 4.** | ** ** | **Controls and  Procedures**                                                                                              | ** ** | **25** |
| ** **       | ** ** | **Part II—OTHER  INFORMATION**                                                                                  | ** ** | **26** |
| **Item 1.** | ** ** | **Legal Proceedings**                                                                                                     | ** ** | **26** |
| **Item 1A.**     | ** ** | **Risk Factors**                                                                                                          | ** ** | **26** |
| **Item 2.** | ** ** | **Unregistered  Sale of Equity Securities and Use of Proceeds**                                                           | ** ** | **27** |
| **Item 4.**      | ** ** | **Submission  of Matters to a Vote of Security Holders**                                                                  | ** ** | **27** |
| **Item 6.** | ** ** | **Exhibits**                                                                                                              | ** ** | **28** |
| **Signatures**   | ** ** | **29**                                                                                                                    |

 

2

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**MICHAELS STORES, INC.**

**Part I—FINANCIAL INFORMATION**

**Item 1.  FinancialStatements.**

**MICHAELSSTORES, INC.**

**CONSOLIDATEDBALANCE SHEETS**

**(Inthousands, except share data)**

**(Unaudited)**
| ** **                                                                                                                                                                                                                                                                                                      | ** ** | **August 4,** | ** ** | **February 3,** | ** ** | **July 29,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|----------------------|------------|-------------------|------------|
| ** **                                                                                                                                                                                                                                                                                                      | ** ** | **2007**           | ** ** | **2007**             | ** ** | **2006**          | ** ** |
| **ASSETS**                                                                                                                                                                                                                                                                                                      |       |               |       |                 |       |              |       |
| **Current assets:**                                                                                                                                                                                                                                                                                             |       |               |       |                 |       |              |       |
| Cash and  equivalents                                                                                                                                                                                                                                                                                           |       | $                  | 45,029     |                 | $          | 30,098            |       | $ | 379,320 |   |
| Merchandise  inventories                                                                                                                                                                                                                                                                                        |       | 922,860            |       | 847,529              |       | 875,217           |       |
| Prepaid expenses  and other                                                                                                                                                                                                                                                                                     |       | 74,831             |       | 54,435               |       | 46,594            |       |
| Deferred income  taxes                                                                                                                                                                                                                                                                                          |       | 35,391             |       | 35,216               |       | 56,502            |       |
| Income tax  receivable                                                                                                                                                                                                                                                                                          |       | 60,947             |       | 32,902               |       | —            |       |
| Total current  assets                                                                                                                                                                                                                                                                                           |       | 1,139,058          |       | 1,000,180            |       | 1,357,633         |       |
| **Property and equipment, at cost**                                                                                                                                                                                                                                                                             |       | 1,169,463          |       | 1,122,948            |       | 1,073,595         |       |
| Less accumulated  depreciation                                                                                                                                                                                                                                                                                  |       | (716,644           | )          | (674,275             | )          | (636,349          | )          |
|                                                                                                                                                                                                                                                                                                            |       | 452,819            |       | 448,673              |       | 437,246           |       |
| **Goodwill**                                                                                                                                                                                                                                                                                                    |       | 115,839            |       | 115,839              |       | 115,839           |       |
| **Debt issuance costs, net of  accumulated amortization of $13,083 at August 4, 2007 and $4,537 at February  3, 2007**                                                                                                                                                                                          |       | 110,757            |       | 120,193              |       | —            |       |
| **Other assets**                                                                                                                                                                                                                                                                                                |       | 7,155              |       | 8,117                |       | 22,929            |       |
|                                                                                                                                                                                                                                                                                                            |       | 233,751            |       | 244,149              |       | 138,768           |       |
| Total assets                                                                                                                                                                                                                                                                                                    |       | $                  | 1,825,628  |                 | $          | 1,693,002         |       | $ | 1,933,647 |   |
|                                                                                                                                                                                                                                                                                                            |       |               |       |                 |       |              |       |
| **LIABILITIES  AND STOCKHOLDERS’ (DEFICIT) EQUITY**                                                                                                                                                                                                                                                        |       |               |       |                 |       |              |       |
| **Current liabilities:**                                                                                                                                                                                                                                                                                        |       |               |       |                 |       |              |       |
| Accounts payable                                                                                                                                                                                                                                                                                                |       | $                  | 207,326    |                 | $          | 214,470           |       | $ | 272,886 |   |
| Accrued interest                                                                                                                                                                                                                                                                                                |       | 75,276             |       | 34,551               |       | 89                |       |
| Accrued  liabilities and other                                                                                                                                                                                                                                                                                  |       | 279,534            |       | 255,880              |       | 249,602           |       |
| Income taxes  payable                                                                                                                                                                                                                                                                                           |       | —             |       | 7,331                |       | —            |       |
| Current portion  of long-term debt                                                                                                                                                                                                                                                                              |       | 364,061            |       | 229,765              |       | —            |       |
| Total current  liabilities                                                                                                                                                                                                                                                                                      |       | 926,197            |       | 741,997              |       | 522,577           |       |
| **Long-term debt**                                                                                                                                                                                                                                                                                              |       | 3,733,751          |       | 3,728,745            |       | —            |       |
| **Deferred income taxes**                                                                                                                                                                                                                                                                                       |       | 16,356             |       | 29,139               |       | —            |       |
| **Other long-term liabilities**                                                                                                                                                                                                                                                                                 |       | 81,176             |       | 68,444               |       | 89,173            |       |
| Total long-term  liabilities                                                                                                                                                                                                                                                                                    |       | 3,831,283          |       | 3,826,328            |       | 89,173            |       |
|                                                                                                                                                                                                                                                                                                            |       | 4,757,480          |       | 4,568,325            |       | 611,750           |       |
| **Commitments and contingencies Stockholders’  (deficit) equity:**                                                                                                                                                                                                                                         |       |               |       |                 |       |              |       |
| Common Stock,  $0.10 par value, 220,000,000 shares authorized; 118,213,397 shares issued and  outstanding at August 4, 2007; 117,973,396 shares issued and outstanding at  February 3, 2007; 1,026,666,666 shares authorized and 398,657,963 shares  issued and 390,543,190 shares outstanding at July 29, 2006 |       | 11,821             |       | 11,797               |       | 39,866            |       |
| Additional  paid-in capital                                                                                                                                                                                                                                                                                     |       | 6,309              |       | —               |       | 443,498           |       |
| Retained  (deficit) earnings                                                                                                                                                                                                                                                                                    |       | (2,961,402         | )          | (2,893,918           | )          | 924,749           |       |
| Accumulated  other comprehensive income                                                                                                                                                                                                                                                                         |       | 11,420             |       | 6,798                |       | 7,911             |       |
| Treasury Stock  (none at August 4, 2007 and February 3, 2007; 8,114,773 shares at July 29,  2006)                                                                                                                                                                                                               |       | —             |       | —               |       | (94,127           | )          |
| Total  stockholders’ (deficit) equity                                                                                                                                                                                                                                                                      |       | (2,931,852         | )          | (2,875,323           | )          | 1,321,897         |       |
| Total liabilities and stockholders’ (deficit) equity                                                                                                                                                                                                                                                       |       | $                  | 1,825,628  |                 | $          | 1,693,002         |       | $ | 1,933,647 |   |

 

See accompanyingnotes to consolidated financial statements.

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**MICHAELS STORES, INC.**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

**(Inthousands)**

**(Unaudited)**
| ** **                                    | ** ** | **Quarter Ended** | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------------------|------------|------------------------|------------|--------------------------------|------------|
| ** **                                    | ** ** | **August 4,**     | ** ** | **July 29,**              | ** ** | **August 4,** | ** ** | **July 29,** | ** ** |
| ** **                                    | ** ** | **2007**               | ** ** | **2006**                       | ** ** | **2007** | ** ** | **2006** | ** ** |
| **Net  sales**                                |       | $                      | 792,939    |                           | $          | 768,264 |   | $ | 1,637,072 |   | $ | 1,600,745 |   |
| Cost of sales  and occupancy expense          |       | 501,841                |       | 493,016                        |       | 1,018,262 |   | 1,006,261 |   |
| **Gross  profit**                             |       | 291,098                |       | 275,248                        |       | 618,810 |   | 594,484 |   |
| Selling,  general, and administrative expense |       | 243,005                |       | 233,681                        |       | 498,909 |   | 470,717 |   |
| Transaction  expenses                         |       | 15,688                 |       | 8,499                          |       | 21,252 |   | 13,199 |   |
| Related party  expenses                       |       | 5,403                  |       | —                         |       | 10,665 |   | — |   |
| Store  pre-opening costs                      |       | 1,420                  |       | 1,521                          |       | 2,968 |   | 2,958 |   |
| **Operating  income**                         |       | 25,582                 |       | 31,547                         |       | 85,016 |   | 107,610 |   |
| Interest expense                              |       | 95,208                 |       | 252                            |       | 190,560 |   | 424 |   |
| Other (income)  and expense, net              |       | (2,085                 | )          | (3,329                         | )          | (4,531 | ) | (10,491 | ) |
| **(Loss)  income before income taxes**        |       | (67,541                | )          | 34,624                         |       | (101,013 | ) | 117,677 |   |
| (Benefit)  provision for income taxes         |       | (23,594                | )          | 13,071                         |       | (34,463 | ) | 44,423 |   |
| **Net  (loss) income**                        |       | $                      | (43,947    | )                              | $          | 21,553 |   | $ | (66,550 | ) | $ | 73,254 |   |

 

See accompanyingnotes to consolidated financial statements.

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**MICHAELSSTORES, INC.CONSOLIDATED STATEMENTS OF CASH FLOWS**(In thousands)(Unaudited)
| ** **                                           | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                           | ** ** | **August 4,**             | ** ** | **July 29,** | ** ** |
| ** **                                           | ** ** | **2007**                       | ** ** | **2006** | ** ** |
| **Operating  activities:**                           |       |                           |       |   |   |
| Net (loss) income                                    |       | $                              | (66,550    | ) | $ | 73,254 |   |
| Adjustments:                                         |       |                           |       |   |   |
| Depreciation and amortization                        |       | 62,051                         |       | 56,620 |   |
| Share-based compensation                             |       | 2,793                          |       | 10,867 |   |
| Tax benefits from stock options exercised            |       | —                         |       | (16,065 | ) |
| Other                                                |       | 7,673                          |       | 168 |   |
| Changes in assets and liabilities:                   |       |                           |       |   |   |
| Merchandise inventories                              |       | (75,248                        | )          | (90,817 | ) |
| Prepaid expenses and other                           |       | 278                            |       | (2,991 | ) |
| Deferred income taxes and other                      |       | (12,801                        | )          | (5,892 | ) |
| Accounts payable                                     |       | (12,774                        | )          | 50,560 |   |
| Accrued interest                                     |       | 69,759                         |       | 18 |   |
| Accrued liabilities and other                        |       | 1,053                          |       | (8,725 | ) |
| Income taxes payable                                 |       | (21,599                        | )          | (27,329 | ) |
| Other long-term liabilities                          |       | 15,419                         |       | 1,845 |   |
| Net cash (used in) provided by operating activities  |       | (29,946                        | )          | 41,513 |   |
|                                                 |       |                           |       |   |   |
| **Investing  activities:**                           |       |                           |       |   |   |
| Additions to property and equipment                  |       | (61,629                        | )          | (69,541 | ) |
| Net cash used in investing activities                |       | (61,629                        | )          | (69,541 | ) |
|                                                 |       |                           |       |   |   |
| **Financing  activities:**                           |       |                           |       |   |   |
| Borrowings on asset-based revolving credit facility  |       | 705,577                        |       | — |   |
| Payments on asset-based revolving credit facility    |       | (571,281                       | )          | — |   |
| Repayments on senior secured term loan facility      |       | (11,750                        | )          | — |   |
| Equity investment of Management                      |       | 4,280                          |       | — |   |
| Cash dividends paid to stockholders                  |       | —                         |       | (26,625 | ) |
| Repurchase of old Common Stock                       |       | —                         |       | (66,182 | ) |
| Repurchase of new Common Stock                       |       | (740                           | )          | — |   |
| Proceeds from stock options exercised                |       | —                         |       | 27,870 |   |
| Tax benefits from stock options exercised            |       | —                         |       | 16,065 |   |
| Proceeds from issuance of old Common Stock and other |       | —                         |       | 1,791 |   |
| Payment of capital leases                            |       | (5,039                         | )          | — |   |
| Change in cash overdraft                             |       | (14,541                        | )          | 1,980 |   |
| Net cash provided by (used in) financing activities  |       | 106,506                        |       | (45,101 | ) |
|                                                 |       |                           |       |   |   |
| **Net  increase (decrease) in cash and equivalents** |       | 14,931                         |       | (73,129 | ) |
| **Cash  and equivalents at beginning of period**     |       | 30,098                         |       | 452,449 |   |
| **Cash and equivalents at end of  period**           |       | $                              | 45,029     |   | $ | 379,320 |   |

 

See accompanying notes to consolidated financialstatements.

5

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**MICHAELS STORES, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSFor the Six Months Ended August 4, 2007(Unaudited)**

**Note 1.  Summaryof Significant Accounting Policies**

*Basis of Presentation*

The consolidatedfinancial statements include the accounts of Michaels Stores, Inc. and ourwholly-owned subsidiaries. All significant intercompany accounts andtransactions have been eliminated. All expressions of “us,” “we,” “our,” andall similar expressions are references to Michaels Stores, Inc. and ourconsolidated, wholly-owned subsidiaries, unless otherwise expressly stated orthe context otherwise requires.

The accompanyingunaudited consolidated financial statements have been prepared in accordancewith U.S. generally accepted accounting principles for interim financialinformation and with the instructions to Form 10-Q and Article 10 ofRegulation S-X. Accordingly, they do not include all of the informationand notes required by generally accepted accounting principles for completefinancial statements. In the opinion of management, all adjustments (consistingof normal recurring accruals and other items, as disclosed) considerednecessary for a fair presentation have been included. Because of the seasonalnature of our business, the results of operations for the three and six monthsended August 4, 2007 are not indicative of the results to be expected for theentire year.

The balance sheetat February 3, 2007 has been derived from the audited financial statements atthat date but does not include all of the information and notes required bygenerally accepted accounting principles for complete financial statements. Forfurther information, refer to the consolidated financial statements and notesthereto included in our Annual Report on Form 10-K for the fiscal yearended February 3, 2007.

All referencesherein to “fiscal 2007” relate to the 52 weeks ending February 2, 2008 andall references to “fiscal 2006” relate to the 53 weeks endedFebruary 3, 2007. In addition, all references herein to “the secondquarter of fiscal 2007” relate to the 13 weeks ended August 4, 2007 and allreferences to “the second quarter of fiscal 2006” relate to the 13 weeks endedJuly 29, 2006.  Finally, all referencesto “the six months ended August 4, 2007” relate to the 26 weeks ended August 4, 2007, and “the six months endedJuly 29, 2006” relate to the 26 weeks ended July 29, 2006.

Certain prior yearamounts were reclassified to conform to current year presentation.

*Recent Accounting Pronouncements*

In July 2006,the FASB issued FASB Interpretation No. 48, *Accountingfor Uncertainty in Income Taxes — an interpretation of FASB StatementNo. 109*, which clarifies the accounting for uncertainty inincome tax positions. FIN 48 requires that a company recognize in itsconsolidated financial statements the impact of a tax position that is morelikely than not to be sustained upon examination based on the technical meritsof the position. We adopted FIN 48 as of the beginning of our first quarter offiscal 2007 with no material impact to our consolidated statement ofoperations, balance sheet, shareholders’ equity, or statement of cash flows.

Upon adoption, weelected to record any interest and penalties associated with audits as acomponent of income tax expense. The Company identified its federal tax return,Canadian tax return, and its state tax returns in California, Florida,Illinois, New York, North Carolina, Pennsylvania, and Texas as “major” taxjurisdictions.  The periods subject toexamination for our federal returns are 2002 to present, 2000 to present forour Canadian returns, and 2003 to present for all state returns except forNorth Carolina and Texas.  North Carolinais subject to examination from 2001 to present, and Texas is subject to examinationfrom 2002 to present.

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In September 2006,the FASB issued Statement of Financial Accounting Standard No. 158, *Employers’ Accounting for Defined Benefit Pensions and OtherPostretirement Plans*, which requires an entity to recognize theoverfunded or underfunded status of a defined benefit postretirement plan as anasset or liability in its balance sheet and to recognize changes in that fundedstatus in the year in which the changes occur through comprehensiveincome.  It also requires an entity tomeasure the funded status of a plan as of the date of its year-end balancesheet.  As we have no publicly tradedequity securities (due to the Merger as described in Note 2 below), FAS 158 iseffective for us at the end of fiscal 2007, with early adoption permitted.  We plan to adopt FAS 158 at the end of fiscal2007, with no material impact expected on our consolidated statement ofoperations, balance sheet, shareholders’ equity, or statement of cash flows.

In February 2007,the FASB issued Statement of Financial Accounting Standard No. 159, *The Fair Value Option for Financial Assets and Financial Liabilities*,which permits companies to measure certain financial instruments and otheritems at fair value (at specified measurement dates) that are not currentlyrequired to be measured at fair value. Any unrealized gains or lossesapplicable to those items measured at fair value shall be reported in earnings.The decision to apply fair value shall generally be made on an instrument byinstrument basis, is irrevocable, and is applied only to an entire instrument.The provisions of FAS 159 will be effective for us as of the beginning offiscal 2008, with early adoption permitted.

**Note 2.  MergerTransaction**

On October 31,2006, substantially all of the Common Stock of Michaels Stores, Inc. wasacquired through a merger transaction (the “Merger”) by affiliates of twoprivate investment firms, Bain Capital Partners, LLC and The Blackstone Group(collectively, together with their applicable affiliates, the “Sponsors”), withcertain shares retained by affiliates of Highfields Capital Partners (athen-existing shareholder of Michaels Stores, Inc.). As a result of the Merger,Michaels Holdings LLC, an entity controlled by the Sponsors, owns approximately93.3% of our outstanding Common Stock, which is no longer publicly traded. Weaccounted for the Merger as a leveraged recapitalization whereby the historicalbook value of the assets and liabilities of Michaels were maintained with nopush down accounting required.

The Mergerconsideration paid to then-existing equity holders was approximately $5.8billion, with fees and expenses totaling an additional $239.7 million. Thepurchase price was funded by:

·                  Aggregate cashequity contribution by the Sponsors of approximately $1.7 billion;

·                  Retention ofcertain shares held by affiliates of Highfields Capital Partners totaling$110.0 million;

·                  Theissuance of the following debt (See Note 4 for further information concerningour issuance of debt):

·                  $750.0million of 10% Senior Notes due 2014;

·                  $400.0million of 113¤8% Senior Subordinated Notes due 2016;

·                  $250.0million of 13% Subordinated Discount Notes due 2016 (with an accreted value atmaturity of $469.4 million);

·                  $2.4billion Senior secured term loan facility; and

·                  $400.0 millionof borrowings under our Asset-based revolving credit facility; and

·                  Ouravailable cash as of the date of the Merger.

The Mergeroccurred simultaneously with the closing of the financing and equitytransactions described above as well as the termination of our previous $300million senior unsecured credit facility with Bank of America, N.A.

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We capitalized$124.7 million of costs related to our issuance of various debtinstruments.  We amortize the deferredfinancing costs over the lives of the respective debt agreements (which rangefrom five to ten years) and record the amortization to interest expense.Amortization of the deferred financing costs was $4.3 million and $8.5 millionfor the three and six months ended August 4, 2007, respectively.

Transactionexpenses for the three and six months ended August 4, 2007 relate primarily tocompensation arrangements associated with the change in control.

**Note 3.  Share-BasedCompensation**

On February 15,2007, our stockholders and Board of Directors approved the 2006 EquityIncentive Plan (“2006 Plan”), which provides for the grant of share-basedawards exercisable for up to 14.2 million shares of Common Stock.  The table below sets forth a summary of stockoption activity for the three and six months ended August 4, 2007.  As of August 4, 2007, share-based awardsexercisable for up to 2.8 million shares of Common Stock remain available forgrant.
| ** **                          | ** ** | **Quarter Ended**       | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------|------------|------------------------------|------------|--------------------------------|------------|
| ** **                          | ** ** | **August 4, 2007** | ** ** |
| ** **                          | ** ** | **(in thousands)**      | ** ** |
|                                |       |                         |       |                           |       |
| Outstanding at  beginning of period |       | 9,652                        |       | —                         |       |
| Grants                              |       | 3,349                        |       | 13,001                         |       |
| Cancellations                       |       | (1,646                       | )          | (1,646                         | )          |
| Outstanding at August  4, 2007      |       | 11,355                       |       | 11,355                         |       |

 

Generally, awardsgranted under the 2006 Plan vest ratably over five years and expire eight yearsfrom the grant date. The exercise prices of the awards issued during the threeand six months ended August 4, 2007 ranged, depending upon the tranche in whichissued, from $15 per share to $52.50 per share. The fair value of the awardswas determined by the Board of Directors after considering various factors, andusing the Black-Scholes-Merton option valuation model. Share-based compensationexpense for the three and six months ended August 4, 2007 was $1.3 million and$2.8 million, respectively.

All share-basedawards outstanding immediately prior to the Merger were settled on the Mergerdate. There were no share-based awards outstanding as of February 3, 2007.

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**Note 4.  Debt**

Our outstandingdebt is detailed in the table below.  Wehad no debt outstanding as of July 29, 2006. We were in compliance with theterms and conditions of all debt agreements for all periods presented.
|                                        | ** ** | **Principal**                | ** ** | ** **                     | ** ** |
|----------------------------------------|------------|------------------------------|------------|--------------------------------|------------|
| ** **                             | ** ** | **August 4, 2007** | ** ** | **February 3, 2007** | ** ** | **Interest Rate** | ** ** |
| ** **                             | ** ** | **(In thousands)**      | ** ** | ** **                     | ** ** |
|                                   |       |                         |       |                           |       |   |   |
| Senior notes                           |       | $                            | 750,000    |                           | $          | 750,000 |   | 10.000 | % |
| Senior subordinated  notes             |       | 400,000                      |       | 400,000                        |       | 11.375 | % |
| Subordinated  discount notes           |       | 275,376                      |       | 258,620                        |       | 13.000 | % |
| Senior secured  term loan              |       | 2,332,375                    |       | 2,344,125                      |       | Variable |   |
| Asset-based  revolving credit facility |       | 340,061                      |       | 205,765                        |       | Variable |   |
| Total debt                             |       | 4,097,812                    |       | 3,958,510                      |       |   |   |
| Less current  portion                  |       | 364,061                      |       | 229,765                        |       |   |   |
| Long-term debt                         |       | $                            | 3,733,751  |                           | $          | 3,728,745 |   |   |   |

 

*Asset-based revolving creditfacility*

The Asset-basedrevolving credit facility provides senior secured financing of up to $1.0billion, subject to a borrowing base described below. As of August 4, 2007, theborrowing base was $773.7 million with $403.3 million of unused availability.

The borrowing baseequals the sum of (i) 90% of eligible credit card receivables and debit cardreceivables; (ii) between 85% and 90% of the appraised net orderly liquidationvalue of eligible inventory and of eligible letters of credit; (iii) apercentage of eligible in-transit inventory, less certain reserves; and (iv)the sum of an additional 10% of the appraised net orderly liquidation value ofeligible inventory and of eligible letters of credit plus an additional 5% ofeligible credit card receivables and debit card receivables, up to a maximumamount of $100.0 million.

*Senior secured term loan facility*

Borrowings underthe Senior secured term loan facility bear interest at a rate per annum equalto, at our option, either (a) a base rate determined by reference to thehigher of (1) the prime rate of Deutsche Bank and (2) the federalfunds effective rate plus 1⁄2 of 1% or (b) a LIBOR rate, subject tocertain adjustments, in each case plus an applicable margin. The applicablemargin at August 4, 2007 was 1.25% with respect to base rate borrowings and2.25% with respect to LIBOR borrowings, subject to downward adjustment based onthe leverage and ratings thresholds set forth in the Senior secured term loanfacility agreement.

On May 10, 2007,we amended the Senior secured term loan facility to reduce the applicablemargin to 1.25% with respect to base rate borrowings and 2.25% with respect toLIBOR borrowings. The amendment also provides that if there is a repricingtransaction that reduces the interest rate margins prior to May 10, 2008, theneach lender will receive a fee equal to 1.00% of the principal amounts of loansthat are repriced. Finally, the amendment eliminated the requirement that wemaintain a specified consolidated secured debt ratio.

9

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

Our comprehensive(loss) income is as follows:
|                                                   | ** ** | **Quarter Ended**  | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------------------|------------|-------------------------|------------|--------------------------------|------------|
| ** **                                        | ** ** | **Au**gust 4,      | ** ** | **July 29,**              | ** ** | **Au**gust 4, | ** ** | **July 29,** | ** ** |
| ** **                                        | ** ** | **2007**                | ** ** | **2006**                       | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                        | ** ** | **(In thousands)** | ** ** | **(In thousands)**        | ** ** |
| Net (loss)  income                                |       | $                       | (43,947    | )                              | $          | 21,553 |   | $ | (66,550 | ) | $ | 73,254 |   |
| Other  comprehensive income (loss):               |       |                    |       |                           |       |   |   |   |   |
| Foreign currency translation adjustment and other |       | 1,825                   |       | (289                           | )          | 4,622 |   | 327 |   |
| Comprehensive (loss)  income                      |       | $                       | (42,122    | )                              | $          | 21,264 |   | $ | (61,928 | ) | $ | 73,581 |   |

 

**Note 6.  Derivativeinstruments**

We are exposed tofluctuations in exchange rates between the US and Canadian dollars, as thefunctional currency of our Canadian subsidiary is the Canadian dollar.  To mitigate the effects of currencyfluctuations, during the second quarter of fiscal 2007, we executed a foreigncurrency cash flow hedge. To facilitate cash flow hedge accounting, theobjective is to hedge payments for forecasted purchases of intercompanyinventory by our Canadian subsidiary denominated in US dollars.  The term of this cash flow hedge extendsthrough fiscal 2007.

To achieve ourobjective and to minimize the risk of ineffectiveness, the notional valuesrepresent a portion of our Canadian subsidiary’s forecasted intercompanypurchases.  Any hedge ineffectiveness isrecorded in Other income. For the three months ended August 4, 2007, theineffective portion of the hedge was immaterial.

For the portion ofthe hedge that is effective, the change in fair value of that hedge willinitially be recorded in Other comprehensive income.  As the underlying inventory is sold to ourcustomers, amounts will be reclassified from Other comprehensive income to Costof sales and occupancy expense in the statement of operations.  The change in fair value of the hedge for thethree months ended August 4, 2007, was immaterial.

The table belowprovides the remaining quarterly notional values and the average CAD/USDexchange rate associated with the hedge.
| Period      | ** ** | **CAD Amount**     | ** ** | **USD Amount** | ** ** | **Rate** | ** ** |
|-------------|------------|-------------------------|------------|---------------------|------------|----------|------------|
| ** **  | ** ** | **(in thousands)** | ** ** | ** **          | ** ** |
| Quarter 3   |       | $                       | 12,495     |                | $          | 13,117   |       | 1.050 |   |
| Quarter 4   |       | 14,229                  |       | 14,933              |       | 1.049    |       |
| Fiscal 2007 |       | $                       | 26,724     |                | $          | 28,050   |       | 1.050 |   |

 

**Note 7.  Commitmentsand Contingencies**

Reference is madeto the action described under “Part I. Item 3. Legal Proceedings — ShareholderClaims — State Court Litigation” in our Annual Report on Form 10-K for fiscal2006.  In that action, on July 12, 2007,named plaintiffs and proposed class representatives Feivel Gottlieb and RobertaSchuman voluntarily dismissed their claims. Julie Fathergill continues as the sole remaining named plaintiff andproposed class representative.

10

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Reference is madeto the consolidated action described under “Part I. Item 3. LegalProceedings — Shareholder Claims — Federal Court Litigation”in our Annual Report on Form 10-K for fiscal 2006 and under “Part II. Item1. Legal Proceedings” in our Quarterly Report on Form 10-Q for thequarterly period ended May 5, 2007.  Inthat action, on July 3, 2007, the court granted the motion of the leadplaintiff, Massachusetts Laborers’ Annuity Fund, for leave to file the proposedamended complaint, as described under “Part II. Item 1. Legal Proceedings” inour Quarterly Report on Form 10-Q for the quarterly period ended May 5,2007.  On July 5, 2007, the leadplaintiff filed the amended complaint in the proposed form filed with the courton May 21, 2007, which is described in “Part II. Item 1. Legal Proceedings” inour Quarterly Report on Form 10-Q for the quarterly period ended May 5,2007.

Reference is madeto the action described under “Part I. Item 3. Legal Proceedings – EmployeeClass Action Claims – Morris Claim” in our Annual Report on Form 10-K forfiscal 2006.  In that action, on June 22,2007, the court granted final approval of the settlement.  On July 11, 2007, the Court entered the FinalSettlement Judgment.  The settlement hadno material impact on our statement of operations, balance sheet, or statementof cash flows for any period presented.

Reference is madeto the action described under “Part I. Item 3. Legal Proceedings – EmployeeClass Action Claims – Torgersen Claim” in our Annual Report on Form 10-K forfiscal 2006.  In that action, on July 10,2007, the parties participated in a voluntary mediation and have reached atentative settlement, which is contingent on court approval.  If the settlement is approved in its currentform, it will have no material impact on our statement of operations, balancesheet, or statement of cash flows for any period presented.

Weare involved in ongoing legal and regulatory proceedings. Other than theupdates described in the preceding paragraphs, there were no material changesto our disclosures of commitments and contingencies from our Annual Report onForm 10-K for fiscal 2006 and our Quarterly Report on Form 10-Q for the quarterended April 5, 2007.

**Note 8.  Segments**

We consider ourMichaels, Aaron Brothers, and Recollections stores and our Star DecoratorsWholesale operations to be our operating segments for purposes of determiningreportable segments based on the criteria of SFAS No. 131, *DisclosuresAbout Segments of an Enterprise and Related Information*. Wedetermined that our Michaels and Aaron Brothers operating segments have similareconomic characteristics and meet the aggregation criteria set forth inparagraph 17 of SFAS No. 131. With regard to our Aaron Brothers operatingsegment, we determined that it did not meet the quantitative thresholds forseparate disclosure set forth in SFAS No. 131. We also determined thatindividually, and in the aggregate, the Recollections stores and StarDecorators Wholesale operations were immaterial for segment reporting purposes.Therefore, we combine all operating segments into one reporting segment.

Subsequent to theMerger, our chief operating decision makers evaluate historical operatingperformance, plan and forecast future periods’ operating performance and baseincentive compensation targets for certain management personnel on earningsbefore interest, income taxes, and depreciation and amortization (“EBITDA”). Areconciliation of income before income taxes and cumulative effect ofaccounting change to EBITDA is presented below. Segment income for the threeand six months ended July 29, 2006 was restated to conform to current yearpresentation.

11

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|                                    | ** ** | **Quarter Ended**       | ** ** | **Six Months Ended** | ** ** |
|------------------------------------|------------|------------------------------|------------|--------------------------------|------------|
| ** **                         | ** ** | **August 4, 2007** | ** ** | **July 29, 2006**    | ** ** | **August 4, 2007** | ** ** | **July 29, 2006** | ** ** |
| ** **                         | ** ** | **(in thousands)**      | ** ** | **(in thousands)**        | ** ** |
|                               |       |                         |       |                           |       |   |   |   |   |
| (Loss) Income  before income taxes |       | $                            | (67,541    | )                              | $          | 34,624 |   | $ | (101,013 | ) | $ | 117,677 |   |
| Interest expense                   |       | 95,208                       |       | 252                            |       | 190,560 |   | 424 |   |
| Interest income                    |       | (177                         | )          | (3,515                         | )          | (402 | ) | (6,915 | ) |
| Depreciation and  amortization     |       | 31,320                       |       | 29,164                         |       | 62,051 |   | 56,620 |   |
| EBITDA                             |       | $                            | 58,810     |                           | $          | 60,525 |   | $ | 151,196 |   | $ | 167,806 |   |

 

Our sales andassets by country are as follows:
|                                       | ** ** | **Net Sales**      | ** ** | **Total Assets** | ** ** |
|---------------------------------------|------------|-------------------------|------------|-----------------------|------------|
| ** **                            | ** ** | **(in thousands)** | ** ** |
| **Quarter  ended August 4, 2007:**    |       |                    |       |                  |       |
| United States                         |       | $                       | 733,963    |                  | $          | 1,721,991 |   |
| Canada                                |       | 58,976                  |       | 103,637               |       |
| Consolidated  Total                   |       | $                       | 792,939    |                  | $          | 1,825,628 |   |
|                                  |       |                    |       |                  |       |
| **Quarter  ended July 29, 2006:**     |       |                    |       |                  |       |
| United States                         |       | $                       | 717,959    |                  | $          | 1,853,401 |   |
| Canada                                |       | 50,305                  |       | 80,246                |       |
| Consolidated  Total                   |       | $                       | 768,264    |                  | $          | 1,933,647 |   |
|                                  |       |                    |       |                  |       |
| **Six  Months Ended August 4, 2007:** |       |                    |       |                  |       |
| United States                         |       | $                       | 1,517,829  |                  | $          | 1,721,991 |   |
| Canada                                |       | 119,243                 |       | 103,637               |       |
| Consolidated  Total                   |       | $                       | 1,637,072  |                  | $          | 1,825,628 |   |
|                                  |       |                    |       |                  |       |
| **Six  Months ended July 29, 2006:**  |       |                    |       |                  |       |
| United States                         |       | $                       | 1,496,315  |                  | $          | 1,853,401 |   |
| Canada                                |       | 104,430                 |       | 80,246                |       |
| Consolidated  Total                   |       | $                       | 1,600,745  |                  | $          | 1,933,647 |   |

 

**Note 9.  RelatedParty Transactions**

We pay annualmanagement fees to the Sponsors in the amount of $12.0 million and an annualmanagement fee to Highfields Capital Management LP in the amount of $1.0million. During the three and six months ended August 4, 2007, we recognized$3.3 million and $6.7 million of expense related to annual management fees andrelated expenses, respectively.

As previouslydisclosed in our fiscal 2006 Annual Report on Form 10-K, we amortize over a twoyear period Separation Agreements with each of Charles J. Wyly, Jr. and SamWyly, who were executive officers and directors of the Company prior to theMerger. Amortization expense for the three and six months ended August 4, 2007was $0.7 million and $1.5 million, respectively.

12

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During the firstquarter of fiscal 2007, The Blackstone Group acquired a majority ownershipstake in an external vendor we utilize to count our store inventory. Expensesassociated with this vendor during the three and six months ended August 4,2007 were approximately $1.3 million and $2.3 million, respectively.

During the  six months ended August 4, 2007, officers ofMichaels Stores, Inc. and its subsidiaries were offered the opportunity topurchase shares of our Common Stock. During the first quarter of fiscal 2007,we sold 289,334 shares, or approximately $4.3 million of our Common Stock at aprice of $15 per share to certain officers. No shares were sold during thethree months ended August 4, 2007. During the first week of the third quarter of fiscal 2007, we sold251,672 shares, or approximately $3.8 million, of our Common Stock at a priceof $15 per share to certain officers. Also, during the three months ended August 4, 2007, we repurchased  49,333 shares of our Common Stock at $15 pershare from officers who are no longer with the Company.

**Note 10.  Recent Events**

*Appointment of CEO*

On June 4, 2007,the Board of Directors appointed Brian C. Cornell as ChiefExecutive Officer of the Company.   Mr. Cornellrecently served as Executive Vice President and Chief Marketing Officer ofSafeway, Inc., where he was responsible for the merchandising, marketing,manufacturing and supply chain operations, as well as its online business. Mr.Cornell is also a director of OfficeMax Inc.

Pursuant to hisemployment agreement, in addition to his base salary, Mr. Cornell receiveda sign-on bonus, and is eligible to receive an annual incentive bonus based onperformance criteria established by the Board. In addition, on June 4, 2007, Mr. Cornell received a restricted stockaward of 133,333 shares of Common Stock that will vest 50% on each of the firstand second anniversaries of the date of grant, and was granted an option topurchase approximately 2.3 million shares of Common Stock.  The option is divided into six tranches withexercise prices ranging from $15 to $52.50 per share, each tranche vesting 20%on each of the first five anniversaries of February 16, 2007.

*Registration Statement*

We filed aRegistration Statement on Form S-4 (which became effective on August 14, 2007) foran exchange offer relating to our 10% Senior Notes due 2014, 11 3/8% SeniorSubordinated Notes due 2016, and 13% Subordinated Discount Notes due 2016.  As a result, we are required to file reportsunder Section 15(d) of the Securities Exchange Act of 1934, as amended.

**Note 11.   Condensed Consolidating FinancialInformation**

All of the Company’sobligations under the Senior notes, Senior subordinated notes, Subordinated discountnotes, Senior secured term loan, and Asset-based revolving credit facility areguaranteed by the Parent and Guarantor subsidiaries. Currently, there are nonon-guarantor subsidiaries. The following condensed consolidating financialinformation represents the financial information of Michaels Stores, Inc. andits wholly-owned subsidiary guarantors, prepared on the equity basis ofaccounting.  The information is presented in accordance with therequirements of Rule 3-10 under the SEC’s Regulation S-X.  The financialinformation may not necessarily be indicative of results of operations, cashflows, or financial position had the subsidiary guarantors operated asindependent entities.

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**SupplementalCondensed Consolidating Balance Sheet**
| ** **                                                | ** ** | **August 4, 2007** | ** ** |
|-----------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                | ** ** | **Parent  Company**          | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| **ASSETS**                                                |       |                         |       |   |   |   |   |   |   |
| **Current assets:**                                       |       |                         |       |   |   |   |   |   |   |
| Cash and  equivalents                                     |       | $                            | 27,118     |   | $ | 17,911 |   | $ | — |   | $ | 45,029 |   |
| Merchandise inventories                                   |       | 673,739                      |       | 249,121 |   | — |   | 922,860 |   |
| Intercompany  receivables                                 |       | —                       |       | 196,951 |   | (196,951 | ) | — |   |
| Other                                                     |       | 146,906                      |       | 24,263 |   | — |   | 171,169 |   |
| Total current  assets                                     |       | 847,763                      |       | 488,246 |   | (196,951 | ) | $ | 1,139,058 |   |
| **Property and equipment, net**                           |       | 325,948                      |       | 126,871 |   | — |   | 452,819 |   |
| **Goodwill, net**                                         |       | 94,290                       |       | 21,549 |   | — |   | 115,839 |   |
| **Investment in subsidiaries**                            |       | 330,938                      |       | — |   | (330,938 | ) | — |   |
| **Other assets**                                          |       | 103,217                      |       | 14,695 |   |   |   | 117,912 |   |
| Total assets                                              |       | $                            | 1,702,156  |   | $ | 651,361 |   | $ | (527,889 | ) | $ | 1,825,628 |   |
|                                                      |       |                         |       |   |   |   |   |   |   |
| **LIABILITIES  AND STOCKHOLDERS’ (DEFICIT) EQUITY**  |       |                         |       |   |   |   |   |   |   |
| **Current liabilities:**                                  |       |                         |       |   |   |   |   |   |   |
| Accounts payable                                          |       | $                            | 41,363     |   | $ | 165,963 |   | $ | — |   | $ | 207,326 |   |
| Accrued  liabilities and other                            |       | 224,893                      |       | 129,917 |   | — |   | 354,810 |   |
| Current portion  of long-term debt                        |       | 364,061                      |       | — |   | — |   | 364,061 |   |
| Intercompany  payable                                     |       | 196,951                      |       | — |   | (196,951 | ) | — |   |
| Total current  liabilities                                |       | 827,268                      |       | 295,880 |   | (196,951 | ) | 926,197 |   |
| **Long-term debt**                                        |       | 3,733,751                    |       | — |   | — |   | 3,733,751 |   |
| **Other long-term liabilities**                           |       | 72,989                       |       | 24,543 |   | — |   | 97,532 |   |
| **Total stockholders’ (deficit)  equity**            |       | (2,931,852                   | )          | 330,938 |   | (330,938 | ) | (2,931,852 | ) |
| Total liabilities and stockholders’ (deficit) equity |       | $                            | 1,702,156  |   | $ | 651,361 |   | $ | (527,889 | ) | $ | 1,825,628 |   |

 

 
| ** **                                 | ** ** | **July 29, 2006** | ** ** |
|--------------------------------------------|------------|-----------------------------|------------|
| ** **                                 | ** ** | **Parent  Company**         | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| **ASSETS**                                 |       |                        |       |   |   |   |   |   |   |
| **Current assets:**                        |       |                        |       |   |   |   |   |   |   |
| Cash and  equivalents                      |       | $                           | 351,380    |   | $ | 27,940 |   | $ | — |   | $ | 379,320 |   |
| Merchandise  inventories                   |       | 643,388                     |       | 231,829 |   | — |   | 875,217 |   |
| Intercompany  receivables                  |       | —                      |       | 115,204 |   | (115,204 | ) | — |   |
| Other                                      |       | 67,795                      |       | 35,301 |   | — |   | 103,096 |   |
| Total current  assets                      |       | 1,062,563                   |       | 410,274 |   | (115,204 | ) | $ | 1,357,633 |   |
| **Property and equipment, net**            |       | 324,732                     |       | 112,514 |   | — |   | 437,246 |   |
| **Goodwill,  net**                         |       | 94,290                      |       | 21,549 |   | — |   | 115,839 |   |
| **Investment in subsidiaries**             |       | 294,877                     |       | — |   | (294,877 | ) | — |   |
| **Other  assets**                          |       | 4,483                       |       | 18,446 |   |   |   | 22,929 |   |
| Total assets                               |       | $                           | 1,780,945  |   | $ | 562,783 |   | $ | (410,081 | ) | $ | 1,933,647 |   |
|                                       |       |                        |       |   |   |   |   |   |   |
| **LIABILITIES  AND STOCKHOLDERS' EQUITY**  |       |                        |       |   |   |   |   |   |   |
| **Current liabilities:**                   |       |                        |       |   |   |   |   |   |   |
| Accounts payable                           |       | $                           | 95,108     |   | $ | 177,778 |   | $ | — |   | $ | 272,886 |   |
| Accrued  liabilities and other             |       | 191,546                     |       | 58,145 |   | — |   | 249,691 |   |
| Current portion  of long-term debt         |       | —                      |       | — |   | — |   | — |   |
| Intercompany  payable                      |       | 115,204                     |       | — |   | (115,204 | ) | — |   |
| Total current  liabilities                 |       | 401,858                     |       | 235,923 |   | (115,204 | ) | 522,577 |   |
| **Long-term  debt**                        |       | —                      |       | — |   | — |   | — |   |
| **Other long-term liabilities**            |       | 57,190                      |       | 31,983 |   | — |   | 89,173 |   |
| **Total stockholders' equity**             |       | 1,321,897                   |       | 294,877 |   | (294,877 | ) | 1,321,897 |   |
| Total liabilities and stockholders' equity |       | $                           | 1,780,945  |   | $ | 562,783 |   | $ | (410,081 | ) | $ | 1,933,647 |   |

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**SupplementalCondensed Consolidating Statement of Operations**
| ** **                                   | ** ** | **Quarter Ended August 4, 2007** | ** ** |
|----------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                   | ** ** | **Parent  Company**                                  | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                   | ** ** | **(in thousands)**                              | ** ** |
| **Net sales**                                |       | $                                                    | 688,695    |   | $ | 405,365 |   | $ | (301,121 | ) | $ | 792,939 |   |
| Cost of sales and occupancy expense          |       | 476,434                                              |       | 326,528 |   | (301,121 | ) | 501,841 |   |
| **Gross profit**                             |       | 212,261                                              |       | 78,837 |   | — |   | 291,098 |   |
| Selling, general, and administrative expense |       | 211,678                                              |       | 31,327 |   | — |   | 243,005 |   |
| Transaction expenses                         |       | 15,688                                               |       | — |   | — |   | 15,688 |   |
| Related party expenses                       |       | 5,403                                                |       | — |   | — |   | 5,403 |   |
| Store pre-opening costs                      |       | 1,244                                                |       | 176 |   | — |   | 1,420 |   |
| **Operating (loss) income**                  |       | (21,752                                              | )          | 47,334 |   | — |   | 25,582 |   |
| Interest expense                             |       | 95,187                                               |       | 21 |   | — |   | 95,208 |   |
| Other (income) and expense, net              |       | 104                                                  |       | (2,189 | ) | — |   | (2,085 | ) |
| Intercompany charges (income)                |       | 14,488                                               |       | (14,488 | ) | — |   | — |   |
| Equity in earnings of subsidiaries           |       | 63,990                                               |       | — |   | (63,990 | ) | — |   |
| **(Loss) Income before income taxes**        |       | (67,541                                              | )          | 63,990 |   | (63,990 | ) | (67,541 | ) |
| Provision for income taxes                   |       | (23,594                                              | )          | 22,332 |   | (22,332 | ) | (23,594 | ) |
| **Net (loss)  income**                       |       | $                                                    | (43,947    | ) | $ | 41,658 |   | $ | (41,658 | ) | $ | (43,947 | ) |

 
| ** **                                    | ** ** | **Six Months Ended August 4, 2007** | ** ** |
|-----------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                    | ** ** | **Parent  Company**                                          | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                    | ** ** | **(in thousands)**                                      | ** ** |
| **Net sales**                                 |       | $                                                            | 1,435,605  |   | $ | 813,493 |   | $ | (612,026 | ) | $ | 1,637,072 |   |
| Cost of sales and occupancy  expense          |       | 977,393                                                      |       | 652,895 |   | (612,026 | ) | 1,018,262 |   |
| **Gross profit**                              |       | 458,212                                                      |       | 160,598 |   | — |   | 618,810 |   |
| Selling, general, and  administrative expense |       | 436,585                                                      |       | 62,324 |   | — |   | 498,909 |   |
| Transaction expenses                          |       | 21,252                                                       |       | — |   | — |   | 21,252 |   |
| Related party expenses                        |       | 10,665                                                       |       | — |   | — |   | 10,665 |   |
| Store pre-opening costs                       |       | 2,526                                                        |       | 442 |   | — |   | 2,968 |   |
| **Operating (loss) income**                   |       | (12,816                                                      | )          | 97,832 |   | — |   | 85,016 |   |
| Interest expense                              |       | 190,522                                                      |       | 38 |   | — |   | 190,560 |   |
| Other (income) and  expense, net              |       | (34                                                          | )          | (4,497 | ) | — |   | (4,531 | ) |
| Intercompany charges  (income)                |       | 33,708                                                       |       | (33,708 | ) | — |   | — |   |
| Equity in earnings of  subsidiaries           |       | 135,999                                                      |       | — |   | (135,999 | ) | — |   |
| **(Loss) Income before income  taxes**        |       | (101,013                                                     | )          | 135,999 |   | (135,999 | ) | (101,013 | ) |
| Provision for income  taxes                   |       | (34,463                                                      | )          | 46,376 |   | (46,376 | ) | (34,463 | ) |
| **Net (loss) income**                         |       | $                                                            | (66,550    | ) | $ | 89,623 |   | $ | (89,623 | ) | $ | (66,550 | ) |

 
| ** **                                    | ** ** | **Quarter Ended July 29, 2006** | ** ** |
|-----------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                    | ** ** | **Parent  Company**                                 | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                    | ** ** | **(in thousands)**                             | ** ** |
| **Net  sales**                                |       | $                                                   | 672,717    |   | 378,351 |   | $ | (282,804 | ) | $ | 768,264 |   |
| Cost of sales and occupancy  expense          |       | 469,893                                             |       | 305,927 |   | (282,804 | ) | 493,016 |   |
| **Gross  profit**                             |       | 202,824                                             |       | 72,424 |   | — |   | 275,248 |   |
| Selling, general, and  administrative expense |       | 205,902                                             |       | 27,779 |   | — |   | 233,681 |   |
| Transaction expenses                          |       | 8,499                                               |       | — |   | — |   | 8,499 |   |
| Related party expenses                        |       | —                                              |       | — |   | — |   | — |   |
| Store pre-opening costs                       |       | 1,106                                               |       | 415 |   | — |   | 1,521 |   |
| **Operating  (loss) income**                  |       | (12,683                                             | )          | 44,230 |   | — |   | 31,547 |   |
| Interest expense                              |       | 243                                                 |       | 9 |   | — |   | 252 |   |
| Other (income) and  expense, net              |       | (3,119                                              | )          | (210 | ) | — |   | (3,329 | ) |
| Intercompany charges  (income)                |       | 14,545                                              |       | (14,545 | ) | — |   | — |   |
| Equity in earnings of  subsidiaries           |       | 58,976                                              |       | — |   | (58,976 | ) | — |   |
| **Income before income taxes**                |       | 34,624                                              |       | 58,976 |   | (58,976 | ) | 34,624 |   |
| Provision for income  taxes                   |       | 13,071                                              |       | 22,263 |   | (22,263 | ) | 13,071 |   |
| **Net income**                                |       | $                                                   | 21,553     |   | $ | 36,712 |   | $ | (36,712 | ) | $ | 21,553 |   |
|                                               |            |                                                     |            |  |  |  |  |  |  |  |  |  |  |

 
| ** **                                    | ** ** | **Six Months Ended July 29, 2006** | ** ** |
|-----------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                                    | ** ** | **Parent  Company**                                         | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                    | ** ** | **(in thousands)**                                     | ** ** |
| **Net  sales**                                |       | $                                                           | 1,409,299  |   | 745,801 |   | $ | (554,355 | ) | $ | 1,600,745 |   |
| Cost of sales and  occupancy expense          |       | 963,040                                                     |       | 597,576 |   | (554,355 | ) | 1,006,261 |   |
| **Gross  profit**                             |       | 446,259                                                     |       | 148,225 |   | — |   | 594,484 |   |
| Selling, general, and  administrative expense |       | 416,677                                                     |       | 54,040 |   | — |   | 470,717 |   |
| Transaction expenses                          |       | 13,199                                                      |       | — |   | — |   | 13,199 |   |
| Related party expenses                        |       | —                                                      |       | — |   | — |   | — |   |
| Store pre-opening costs                       |       | 2,463                                                       |       | 495 |   | — |   | 2,958 |   |
| **Operating  income**                         |       | 13,920                                                      |       | 93,690 |   | — |   | 107,610 |   |
| Interest expense                              |       | 409                                                         |       | 15 |   | — |   | 424 |   |
| Other (income) and  expense, net              |       | (6,194                                                      | )          | (4,297 | ) | — |   | (10,491 | ) |
| Intercompany charges  (income)                |       | 35,714                                                      |       | (35,714 | ) | — |   | — |   |
| Equity in earnings of  subsidiaries           |       | 133,686                                                     |       | — |   | (133,686 | ) | — |   |
| **Income before income taxes**                |       | 117,677                                                     |       | 133,686 |   | (133,686 | ) | 117,677 |   |
| Provision for income  taxes                   |       | 44,423                                                      |       | 50,466 |   | (50,466 | ) | 44,423 |   |
| **Net income**                                |       | $                                                           | 73,254     |   | $ | 83,219 |   | $ | (83,219 | ) | $ | 73,254 |   |
|                                               |            |                                                             |            |  |  |  |  |  |  |  |  |  |  |

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**SupplementalCondensed Consolidating Statement of Cash Flows**
| ** **                                          | ** ** | **Six Months Ended Au**gust 4, 2007 | ** ** |
|-----------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                          | ** ** | **Parent  Company**                                          | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                          | ** ** | **(in thousands)**                                      | ** ** |
| **Operating  activities:**                          |       |                                                         |       |   |   |   |   |   |   |
| Net cash (used in) provided by operating activities |       | $                                                            | (48,457    | ) | $ | 85,316 |   | $ | (66,805 | ) | $ | (29,946 | ) |
|                                                |       |                                                         |       |   |   |   |   |   |   |
| **Investing  activities:**                          |       |                                                         |       |   |   |   |   |   |   |
| Net cash used in investing activities               |       | (57,510                                                      | )          | (4,119 | ) | — |   | (61,629 | ) |
|                                                |       |                                                         |       |   |   |   |   |   |   |
| **Financing  activities:**                          |       |                                                         |       |   |   |   |   |   |   |
| Net borrowings (repayments) of long-term debt       |       | 122,546                                                      |       | — |   | — |   | 122,546 |   |
| Intercompany dividends                              |       | —                                                       |       | (66,805 | ) | 66,805 |   | — |   |
| Other financing activities                          |       | (16,040                                                      | )          | — |   | — |   | (16,040 | ) |
| Net cash provided by (used in) financing activities |       | 106,506                                                      |       | (66,805 | ) | 66,805 |   | 106,506 |   |
|                                                |       |                                                         |       |   |   |   |   |   |   |
| **Increase  in cash and equivalents**               |       | 539                                                          |       | 14,392 |   | — |   | 14,931 |   |
| **Beginning  cash and cash equivalents**            |       | 26,579                                                       |       | 3,519 |   | — |   | 30,098 |   |
| **Ending cash and cash  equivalents**               |       | $                                                            | 27,118     |   | $ | 17,911 |   | $ | — |   | $ | 45,029 |   |

 
| ** **                                | ** ** | **Six Months Ended July 29, 2006** | ** ** |
|-------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                                | ** ** | **Parent  Company**                                         | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                | ** ** | **(in thousands)**                                     | ** ** |
| **Operating  activities:**                |       |                                                        |       |   |   |   |   |   |   |
| Net cash provided by operating activities |       | $                                                           | 54,865     |   | $ | 64,519 |   | $ | (77,871 | ) | $ | 41,513 |   |
|                                      |       |                                                        |       |   |   |   |   |   |   |
| **Investing  activities:**                |       |                                                        |       |   |   |   |   |   |   |
| Net cash used in investing activities     |       | (66,167                                                     | )          | (3,374 | ) | — |   | (69,541 | ) |
|                                      |       |                                                        |       |   |   |   |   |   |   |
| **Financing  activities:**                |       |                                                        |       |   |   |   |   |   |   |
| Cash dividends paid to stockholders       |       | (26,625                                                     | )          | — |   | — |   | (26,625 | ) |
| Intercompany dividends                    |       | —                                                      |       | (77,871 | ) | 77,871 |   | — |   |
| Repurchase of Old Common Stock            |       | (66,182                                                     | )          | — |   | — |   | (66,182 | ) |
| Other financing activities                |       | 47,706                                                      |       | — |   | — |   | 47,706 |   |
| Net cash used in financing activities     |       | (45,101                                                     | )          | (77,871 | ) | 77,871 |   | (45,101 | ) |
|                                      |       |                                                        |       |   |   |   |   |   |   |
| **Decrease  in cash and equivalents**     |       | (56,403                                                     | )          | (16,726 | ) | — |   | (73,129 | ) |
| **Beginning  cash and cash equivalents**  |       | 407,783                                                     |       | 44,666 |   | — |   | 452,449 |   |
| **Ending cash and equivalents**           |       | $                                                           | 351,380    |   | $ | 27,940 |   | $ | — |   | $ | 379,320 |   |

 

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

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

**Disclosure Regarding Forward-LookingInformation**

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 similarexpressions) that are not statements of historical fact should be consideredforward-looking statements and should be read in conjunction with ourconsolidated financial statements and related notes in our Annual Report onForm 10-K for the fiscal year ended February 3, 2007. Specific examples offorward-looking statements include, but are not limited to, statementsregarding our forecasts of financial performance, capital expenditures, andworking capital requirements. Our actual results could materially differ fromthose discussed in these forward-looking statements. Factors that could causeor contribute to such differences include, but are not limited to:

·                  our ability toanticipate and/or react to changes in customer demand and preferences forproducts and supplies used in creative activities and the related potentialimpact to merchandise inventories in categories that represent a significantportion of our business;

·                  theeffectiveness of, or unexpected consumer responses to, our promotionalprograms;

·                  our ability tomitigate any continued declines in newspaper subscription rates, which affectthe frequency in which our customers receive our circular advertisements;

·                  changes inconsumer confidence resulting in a reduction in consumer spending on itemsperceived to be discretionary;

·                  the executionand management of our store growth, including new concepts, the impact of newcompetitor stores in locations near our existing stores, and the availabilityof acceptable real estate locations for new store openings;

·                  our ability toattract and retain qualified personnel, including management and seniorexecutives, to successfully execute our operating plans;

·                  financialdifficulties of any of our key vendors, suppliers, or insurance providers;

·                  delays in thereceipt of merchandise ordered from suppliers due to delays in connection witheither the manufacture or shipment of such merchandise;

·                  transportationdelays (including dock strikes, other work stoppages, and shortages of truckdrivers) and increases in transportation costs due to fuel surcharges andtransportation regulations;

·                  restrictiveactions by foreign governments or changes in United States or foreign laws andregulations affecting imports or domestic distribution;

·                  significantchanges in tariffs or duties levied on imports which may limit the availabilityof certain merchandise from our foreign suppliers;

·                  significantfluctuations in exchange rates;

·                  changes inpolitical, economic, and social conditions;

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·                  the design andimplementation of new management information systems as well as the maintenanceand enhancement of existing systems, particularly in light of our continuedstore growth and the addition of new concepts;

·                  theidentification and implementation of enhancements to our supply chain to enableus to distribute additional SKUs through our distribution centers;

·                  the effectiveoptimization and maintenance of our perpetual inventory and automatedreplenishment systems and related impacts to inventory levels;

·                  our ability tomaintain the security of electronic and other confidential information;

·                  the seasonalityof the retail business;

·                  unusual weatherconditions;

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

·                  our ability toremain competitive in the areas of merchandise quality, price, breadth ofselection, customer service, and convenience;

·                  our substantialleverage, which could adversely affect our ability to raise additional capitalto fund our operations, limit our ability to react to changes in the economy orour industry, and expose us to interest rate risk to the extent of our variablerate debt;

·                  our ability toservice the interest and principal payments of our debt (including our SeniorNotes, Senior Subordinated Notes, and Subordinated Discount Notes (the“Notes”)) or to repurchase the Notes upon a change in control;

·                  restrictionscontained in our various debt agreements that limit our flexibility inoperating our business, including compliance with the covenants containedtherein;

·                  significantfluctuations in interest rates;

·                  our ability toaddress any conflict between the interests of our controlling stockholders andour creditors; and

·                  other factors asset forth in our Annual Report on Form 10-K for the fiscal year endedFebruary 3, 2007 (particularly in “Part I. Item 1A Risk Factors” and “Part II.Item 7. Management’s Discussion and Analysis of Financial Condition and Resultsof Operations – Critical Accounting Policies and Estimates”).

We intend these forward-lookingstatements to speak only as of the time of filing this Quarterly Report onForm 10-Q and do not undertake to update or revise them as moreinformation becomes available.

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**General**

All references herein to“fiscal 2007” relate to the 52 weeks ending February 2, 2008 and allreferences to “fiscal 2006” relate to the 53 weeks ended February 3,2007. In addition, all references herein to “the second quarter of fiscal 2007”relate to the 13 weeks ended August 4, 2007 and all references to “the secondquarter of fiscal 2006” relate to the 13 weeks ended July 29, 2006.  Finally, all references to “the six monthsended August 4, 2007” relate to the 26 weeks ended August 4, 2007, and “the sixmonths ended July 29, 2006” relate to the 26 weeks ended July 29, 2006,respectively.

The following table setsforth certain of our unaudited operating data (dollars in thousands):
| ** **                                           | ** ** | **Quarter Ended**   | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------|------------|--------------------------|------------|---------------------------|------------|
| ** **                                           | ** ** | **August 4,  2007** | ** ** | **July 29,  2006**        | ** ** | **August 4,  2007** | ** ** | **July 29,  2006** | ** ** |
| **Michaels  stores:**                                |       |                     |       |                      |       |   |   |   |   |
| Retail stores open at beginning of period            |       | 928                      |       | 899                       |       | 920 |   | 885 |   |
| Retail stores opened during the period               |       | 9                        |       | 7                         |       | 20 |   | 24 |   |
| Retail stores opened (relocations) during the period |       | 2                        |       | 2                         |       | 7 |   | 5 |   |
| Retail stores closed during the period               |       | —                   |       | (1                        | )          | (3 | ) | (4 | ) |
| Retail stores closed (relocations) during the period |       | (2                       | )          | (2                        | )          | (7 | ) | (5 | ) |
| Retail stores open at end of period                  |       | 937                      |       | 905                       |       | 937 |   | 905 |   |
|                                                 |       |                     |       |                      |       |   |   |   |   |
| **Aaron Brothers  stores:**                          |       |                     |       |                      |       |   |   |   |   |
| Retail stores open at beginning of period            |       | 168                      |       | 165                       |       | 166 |   | 166 |   |
| Retail stores opened during the period               |       | —                   |       | —                    |       | 2 |   | — |   |
| Retail stores closed during the period               |       | (1                       | )          | —                    |       | (1 | ) | (1 | ) |
| Retail stores open at end of period                  |       | 167                      |       | 165                       |       | 167 |   | 165 |   |
|                                                 |       |                     |       |                      |       |   |   |   |   |
| **Recollections  stores:**                           |       |                     |       |                      |       |   |   |   |   |
| Retail stores open at beginning of period            |       | 11                       |       | 11                        |       | 11 |   | 11 |   |
| Retail stores opened during the period               |       | —                   |       | —                    |       | — |   | — |   |
| Retail stores open at end of period                  |       | 11                       |       | 11                        |       | 11 |   | 11 |   |
|                                                 |       |                     |       |                      |       |   |   |   |   |
| **Star  Decorators Wholesale stores:**               |       |                     |       |                      |       |   |   |   |   |
| Wholesale stores open at beginning of period         |       | 4                        |       | 4                         |       | 4 |   | 4 |   |
| Wholesale stores opened during the period            |       | —                   |       | —                    |       | — |   | — |   |
| Wholesale stores open at end of period               |       | 4                        |       | 4                         |       | 4 |   | 4 |   |
|                                                 |       |                     |       |                      |       |   |   |   |   |
| Total store  count at end of period                  |       | 1,119                    |       | 1,085                     |       | 1,119 |   | 1,085 |   |
|                                                 |       |                     |       |                      |       |   |   |   |   |
| **Other  operating data:**                           |       |                     |       |                      |       |   |   |   |   |
| Average inventory per Michaels store (1)             |       | $                        | 929        |                      | $          | 902 |   | $ | 929 |   | $ | 902 |   |
| Comparable store  sales increase (decrease) (2)      |       | 0.8                      | %          | (0.3                      | )%         | 0.1 | % | (1.7 | )% |
|                                                      |            |                          |            |                           |            |  |  |  |  |  |  |  |  |

 

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| (1)    | Average inventory per Michaels store calculation  excludes our Aaron Brothers, Recollections, and Star Decorators Wholesale  stores.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| (2)    | Comparable store sales increase represents the  increase 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. |

 

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**Results of Operations**

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**   | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------------------|------------|--------------------------|------------|--------------------------------|------------|
| ** **                                    | ** ** | **August 4,  2007** | ** ** | **July 29,  2006**        | ** ** | **August 4,  2007** | ** ** | **July 29,  2006** | ** ** |
| **Net  sales**                                |       | 100.0                    | %          | 100.0                          | %          | 100.0 | % | 100.0 | % |
| Cost of sales  and occupancy expense          |       | 63.3                     |       | 64.2                           |       | 62.2 |   | 62.9 |   |
| **Gross  profit**                             |       | 36.7                     |       | 35.8                           |       | 37.8 |   | 37.1 |   |
| Selling,  general, and administrative expense |       | 30.6                     |       | 30.4                           |       | 30.5 |   | 29.4 |   |
| Transaction  expenses                         |       | 2.0                      |       | 1.0                            |       | 1.3 |   | 0.7 |   |
| Related party  expenses                       |       | 0.7                      |       | —                         |       | 0.7 |   | — |   |
| Store  pre-opening costs                      |       | 0.2                      |       | 0.2                            |       | 0.2 |   | 0.2 |   |
| **Operating  income**                         |       | 3.2                      |       | 4.1                            |       | 5.2 |   | 6.7 |   |
| Interest expense                              |       | 12.0                     |       | —                         |       | 11.6 |   | — |   |
| Other (income)  and expense, net              |       | (0.3                     | )          | (0.4                           | )          | (0.3 | ) | (0.7 | ) |
| **(Loss) income  before income taxes**        |       | (8.5                     | )          | 4.5                            |       | (6.2 | ) | 7.4 |   |
| (Benefit) provision  for income taxes         |       | (3.0                     | )          | 1.7                            |       | (2.1 | ) | 2.8 |   |
| **Net (loss) income**                         |       | (5.5                     | )%         | 2.8                            | %          | (4.1 | )% | 4.6 | % |

 

*Quarter Ended August 4, 2007Compared to the Quarter Ended July 29, 2006*

*NetSales*—Net sales increased for the second quarter of fiscal2007 by $24.7 million, or 3.2%, over the second quarter of fiscal 2006. Atthe end of the second quarter of fiscal 2007, we operated 937 Michaels, 167Aaron Brothers, 11 Recollections, and four Star Decorators Wholesale stores.Results for the second quarter of fiscal 2007 include sales from 46 Michaels,and three Aaron Brothers stores that were opened during the 12-month periodended August 4, 2007, more than offsetting lost sales from the closure of oneAaron Brothers and eight Michaels stores during the same period. Non-comparablesales increased $18.8 million and comparable store sales increased 0.8%, or$5.9 million.

Comparable store salesincreased 0.8% in the second quarter of fiscal 2007 compared to the secondquarter of fiscal 2006, reflecting an increase in the average ticket of 3.9%,partially offset by decreases in customer transactions and custom framingdeliveries of 2.1%, and 1.0%, respectively. A favorable currency translation,due to the stronger Canadian dollar, contributed approximately 0.3% to theaverage ticket increase for the quarter.

We continue to develop afully integrated pricing and promotion strategy and may refine our existingstrategy in future periods. A significant component of our pricing andpromotion strategy involves changes in the breadth and depth of our promotionalprograms. As a result, our historical trends may not be indicative of futureresults.

*Cost ofSales and Occupancy Expense*—Cost of sales and occupancyexpense increased $8.8 million primarily due to increases in the storebase. Cost of sales and occupancy expense, as a percentage of net sales,decreased approximately 90 basis points in the second quarter of fiscal 2007compared to the second quarter of fiscal 2006. Merchandise margins improved significantly from a reduction in breadthand depth of promotional programs in addition to continued benefits fromongoing product sourcing initiatives. As previously noted, we may make changesto our pricing and promotion strategy and such changes may affect ourmerchandise margins in future periods. As a result, historical trends may notbe indicative of future results. Occupancy costs, as a percentage of sales,increased approximately 70 basis points due to a deleveraging from normaloccupancy cost increases in combination with a low comparable store salesincrease.

*Selling,General, and Administrative Expense*—Selling, general, andadministrative expense was $243.0 million, or 30.6% of net sales, in the secondquarter of fiscal 2007 compared to $233.7 million, or 30.4% of net sales, inthe second quarter of fiscal 2006. The expense increase was primarily due tohigher advertising expenses and expenses associated with the appointment of ournew CEO.

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As a percentage of netsales, selling, general, and administrative expense increased approximately20 basis points. The 20 basis point increase was primarily due toincreases in advertising costs associated with our strategic initiatives andexecutive based compensation costs, partially offset by leverage in store-levelexpenses due to cost containment efforts.

*TransactionExpenses*—Transaction expenses incurred during the secondquarter of fiscal 2007 relate primarily to bonus arrangements associated withthe change in control that are ratably recognized for a period of one yearfollowing the Merger date, as well as other compensation expenses arising fromchange in control agreements. Transaction expenses incurred during the second quarter of fiscal 2006primarily relate to legal expenses associated with our exploration of strategicalternatives.

*RelatedParty Expenses*—Related party expenses were $5.4 million inthe second quarter of fiscal 2007 and consisted primarily of $3.3 million ofmanagement fees and associated expenses paid to our Sponsors and Highfields.Also included in related party expenses are $1.3 million of fees related to anexternal vendor we utilize to count store inventory in which The BlackstoneGroup acquired a majority ownership stake during the first quarter of fiscal2007, as well as $0.8 million of amortization expense related to the SeparationAgreements as more fully described in Note 9 to the consolidated financialstatements.

*OperatingIncome*—Operating income decreased from $31.5 million, or 4.1%of sales, in the second quarter of fiscal 2006 to $25.6 million, or 3.2% ofsales, in the second quarter of fiscal 2007.

*InterestExpense*—Interest expense increased from $0.3 million in thesecond quarter of fiscal 2006 to $95.2 million in the second quarter of fiscal2007 as a result of debt issued during the fourth quarter of fiscal 2006 tofinance the Merger. We expect to incur a substantial amount of interest expensein future quarters as a result of our outstanding debt.

*OtherIncome*—Other income declined from $3.3 million in thesecond quarter of fiscal 2006 to $2.1 million during the second quarter offiscal 2007 primarily as a result of lower interest income on lower investedcash balances, partially offset by a favorable comparison of foreign currencygain/loss.

*(Benefit)Provision for Income Taxes*—The effective tax rate was 34.9%for the second quarter of fiscal 2007 and 37.8% for the second quarter offiscal 2006. We expect the effective tax rate for fiscal 2007 to range from 45%- 50%. As a result of our low income base, our effective rate is highlysensitive to changes caused by permanent differences (i.e. differences betweenbook income and tax income that will not be reversed in future periods).

*Net(Loss) Income*—As a result of the above, we reported a netloss of $43.9 million for the second quarter of fiscal 2007 as compared to netincome of $21.6 million for the second quarter of fiscal 2006.

*Six Months Ended August 4, 2007Compared to the Six Months Ended July 29, 2006*

*Net Sales*—Net sales increased in the firstsix months of fiscal 2007 by $36.3 million, or 2.3%, over the first sixmonths of fiscal 2006.  Sales at our newstores (net of closures) opened since the second quarter of fiscal 2005provided incremental revenue of $34.2 million. For the same period,comparable store sales increased 0.1% in fiscal 2007 compared to fiscal 2006,reflecting an increase in the average ticket of 3.7%, partially offset bydeclines in customer transactions of 3.2% and custom framing deliveries of0.4%.  We estimate that consolidatedcomparable store sales were negatively impacted 50 basis points by a 16%decline in comparable domestic sales of Yarn, all of which occurred in thefirst three months of fiscal 2007.

*Cost ofSales and Occupancy Expense*—Cost of sales and occupancyexpense increased by $12.0 million, or 1.2%, due to increased occupancyexpenses and the number of stores we operate, partially offset by themerchandise margin expansion as described below.

Cost of sales andoccupancy expense, as a percentage of net sales, decreased approximately 70basis points through the first six months of fiscal 2007 compared to the firstsix months of fiscal 2006. This decrease was driven by significant expansion ofmerchandise margin, resulting from a reduction in breadth and depth ofpromotional programs as well as continued benefits from ongoing sourcinginitiatives.  Partially offsetting themerchandise margin expansion was an 80 basis point increase in store occupancycosts primarily due to inflationary cost increases and a deleveraging ofexpenses on the 0.1% comparable sales increase.

*Selling,General, and Administrative Expense*—Selling, general, andadministrative expense was $498.9 million, or 30.5% of net sales, for thefirst six months of fiscal 2007 compared to $470.7 million, or 29.4% ofnet sales, in the first six months

21

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of fiscal 2006. The expense increase was primarily dueto an increase in the number of stores we operate compared to last year,incremental costs associated with the appointment of our new CEO,  and costs resulting from our strategicinitiatives. These strategic initiatives include our pricing and promotionstrategy, consumer insight research, and product sourcing, which are more fullydescribed in our Fiscal 2006 Annual Report on Form 10-K.

As a percentage of netsales, selling, general, and administrative expense increased approximately110 basis points, comprised primarily of an increase in strategicinitiatives of about 40 basis points, advertising costs of about 30 basispoints, and 20 basis points associated with the appointment of our new CEO.Total store operating expenses, as a percent of sales, were flat compared tolast year.

*TransactionExpenses –*Transactionexpenses incurred during the first six months of fiscal 2007 relate primarilyto bonus arrangements associated with the change in control that are ratablyrecognized for a period of one year following the Merger date, as wellas other compensation expenses arising from change in control agreements. Transaction expenses incurred during the first six months of fiscal 2006primarily relate to legal and investment advisory expenses associatedwith our strategic alternatives process.

*RelatedParty Expenses*—Related party expenses were $10.7 million forthe first six months of fiscal 2007 and consisted primarily of $6.8 million ofmanagement fees and associated expenses paid to our Sponsors and Highfields.Also included in related party expenses are $2.3 million of fees related to anexternal vendor we utilize to count store inventory in which The BlackstoneGroup acquired a majority ownership stake during the first quarter of fiscal2007, as well as $1.6 million of amortization expense related to the SeparationAgreements as more fully described in Note 9 to the consolidated financialstatements.

*OperatingIncome*—Operating income decreased from $107.6 million,or 6.7% of sales, in the first six months of fiscal 2006 to $85.0 million,or 5.2% of sales, in the first six months of fiscal 2007.

*InterestExpense*—Interest expense increased $190.1 million in thesix months ending August 4, 2007 compared to the six months ending July 29,2006. This increase was due to the debt issued associated with the Merger.

*OtherIncome*—Other income of $4.5 million was $6.0 million lowerthan last year on a $6.5 million decline in interest income. Also, our foreigncurrency gains were $3.8 million higher than last year.  In addition, we recorded a favorable legalsettlement of $3.0 million during the first six months of fiscal 2006.

*(Benefit)Provision for Income Taxes*—The effective tax rate was 34.1%for the first six months of fiscal 2007 and 37.8% for the first six months offiscal 2006. The decrease in the effective rate was due to permanentdifferences related to the current year, which increased our income tax expensedespite our pre-tax net loss.

*Net(Loss) Income*—As a result of the above, our net loss for thefirst six months of fiscal 2007 was $66.6 million as compared to net income of$73.3 million for the first six months of fiscal 2006.

**Liquidity and Capital Resources**

We require cashprincipally for day-to-day operations and to finance capital investments,supply initial inventory for new stores, replenish inventory for existingstores, service our outstanding debt, and seasonal working capital needs. Inrecent years prior to the Merger, we financed our operations, new storeopenings, old Common Stock repurchases, dividend payments, and other capitalinvestments with cash from operations and proceeds from stock option exercises.We expect that our available cash, cash flow generated from operatingactivities, and funds available under our Asset-based revolving credit facilitywill be sufficient to fund planned capital expenditures, working capitalrequirements, debt repayments, debt service requirements, and future growththroughout fiscal 2007.

Our cash and equivalentsincreased $14.9 million, or 49.5%, from $30.1 million at the end offiscal 2006 to $45.0 million at the end of the second quarter of fiscal2007. Compared to the end of the second quarter of fiscal 2006, cash andequivalents decreased $334.3 million, or 88.1%, as existing cash at theMerger date was used to help finance the Merger.

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*Cash Flow from Operating Activities*

Cash flow used inoperating activities during the first six months of fiscal 2007 was $29.9million compared to cash provided by operating activities of $41.5 millionduring the first six months of fiscal 2006. The $71.5 million change wasprimarily due to lower net income and decreased leverage on our inventory andaccounts payable balances, partially offset by increases in accrued interest onour outstanding debt.

Inventories per Michaelsstore (including supporting distribution centers) increased 3.0% from July 29,2006 to August 4, 2007 primarily from higher levels of in-stock positionsassociated with certain merchandise resets. We expect inventories per Michaelsstore at the end of fiscal 2007 to be flat to higher by approximately 2% ascompared to the end of fiscal 2006.

*Cash Flow used in InvestingActivities*

Cash flow used ininvesting activities was primarily the result of the following capitalexpenditure activities:
| ** **                                          | ** ** | **Six Months Ended**    | ** ** |
|-----------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                          | ** ** | **August 4,  2007 (1)** | ** ** | **July 29,  2006 (2)** | ** ** |
| ** **                                          | ** ** | **(In thousands)**           | ** ** |
| New and  relocated stores and stores not yet opened |       | $                                 | 18,172     |   | $ | 16,621 |   |
| Existing stores                                     |       | 10,781                            |       | 30,205 |   |
| Distribution  system expansion                      |       | 12,520                            |       | 7,197 |   |
| Information  systems                                |       | 18,958                            |       | 13,582 |   |
| Corporate and  other                                |       | 1,198                             |       | 1,936 |   |
|                                                |       | $                                 | 61,629     |   | $ | 69,541 |   |

 

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| (1)    | In the first six months of fiscal 2007, we incurred  capital expenditures related to the opening of 20 Michaels and two Aaron  Brothers stores in addition to the relocation of seven Michaels stores. |
|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                   |
| (2)    | In the first six months of fiscal 2006, we incurred  capital expenditures related to the opening of 24 Michaels stores and the  relocation of five Michaels stores.                                    |

 

*Cash Flow provided by FinancingActivities*

During the first sixmonths of fiscal 2007, cash provided by financing activities was a result ofincremental borrowings against our asset-based revolving credit facility. Priorto the Merger, proceeds from the exercise of outstanding stock options servedas a source of cash for us. Proceeds from the exercise of stock options were$27.9 million for the six-month period ending July 29, 2006. During thefirst six months of fiscal 2006, we repurchased $66.2 million of old CommonStock and paid dividends of $26.6 million. As a result of the Merger, we do notexpect any material repurchases of our Common Stock and we do not expect thatstock option exercise proceeds will serve as a material future source of cashso long as our equity is not listed on a public exchange.

*Debt*

To finance the completionof the Merger, we issued 10% Senior Notes due 2014, 11 3/8% Senior Subordinated Notes due 2016,and 13% Subordinated Discount Notes due 2016. We also executed an asset-basedrevolving credit facility as well as a senior secured term loan facility.Borrowings under our Asset-based revolving credit facility are influenced by anumber of factors as more fully described below.

*Asset-based revolving credit facility*

The Asset-based revolvingcredit facility provides senior secured financing of up to $1.0 billion,subject to a borrowing base. As of August 4,2007, the borrowing base was $773.7 million with $403.3 million of unusedavailability.

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The borrowing base equalsthe sum of (i) 90% of eligible credit card receivables and debit cardreceivables; (ii) between 85% and 90% of the appraised net orderly liquidationvalue of eligible inventory and of eligible letters of credit; (iii) apercentage of eligible in-transit inventory, less certain reserves; and (iv)the sum of an additional 10% of the appraised net orderly liquidation value ofeligible inventory and of eligible letters of credit plus an additional 5% ofeligible credit card receivables and debit card receivables, up to a maximum amountof $100.0 million.

*Senior secured term loan facility*

During the first sixmonths of fiscal 2007, borrowings under the Senior secured term loan facilitybore interest at a rate per annum equal to, at our option, either (a) abase rate determined by reference to the higher of (1) the prime rate ofDeutsche Bank and (2) the federal funds effective rate plus 1⁄2 of 1%or (b) a LIBOR rate, subject to certain adjustments, in each case plus anapplicable margin. During the first quarter of 2007, the applicable margin was1.75% with respect to base rate borrowings and 2.75% with respect to LIBORborrowings, and during most of the second quarter of 2007, the applicablemargin was 1.75% with respect to base rate borrowings and 2.25% with respect toLIBOR borrowings, subject to downward adjustment based on the leverage andratings thresholds set forth in the Senior secured term loan facilityagreement.

On May 10, 2007, weamended the Senior secured term loan facility to reduce the applicable marginto 1.25% with respect to base rate borrowings and 2.25% with respect to LIBORborrowings. The amendment also provides that if there is a repricingtransaction that reduces the interest rate margins prior to May 10, 2008, theneach lender will receive a fee equal to 1.00% of the principal amounts of loansthat are repriced. Finally, the amendment eliminated the requirement that wemaintain a specified consolidated secured debt ratio.

**Recent Accounting Pronouncements**

In July 2006, theFASB issued FASB Interpretation No. 48, *Accountingfor Uncertainty in Income Taxes — an interpretation of FASB StatementNo. 109*, which clarifies the accounting for uncertainty inincome tax positions. FIN 48 requires that a company recognize in itsconsolidated financial statements the impact of a tax position that is morelikely than not to be sustained upon examination based on the technical meritsof the position. We adopted FIN 48 as of the beginning of our first quarter offiscal 2007 with no material impact to our consolidated operations statement,balance sheet, shareholders’ equity, or statement of cash flows.

Upon adoption, we electedto record any interest and penalties associated with audits as a component ofincome tax expense. The Company identified its federal tax return, Canadian taxreturn, and its state tax returns in California, Florida, Illinois, New York,North Carolina, Pennsylvania, and Texas as “major” tax jurisdictions.  The periods subject to examination for ourfederal return are 2002 to present, 2000 to present for our Canadian return,and 2003 to present for all state returns except for North Carolina andTexas.  North Carolina is subject toexamination from 2001 to present, and Texas is subject to examination from 2002to present.

In September 2006, theFASB issued Statement of Financial Accounting Standard No. 158, *Employers’ Accounting for Defined Benefit Pensions and OtherPostretirement Plans*, which requires an entity to recognize theoverfunded or underfunded status of a defined benefit postretirement plan as anasset or liability in its balance sheet and to recognize changes in that fundedstatus in the year in which the changes occur through comprehensiveincome.  It also requires an entity tomeasure the funded status of a plan as of the date of its year-end balancesheet.  As we have no publicly tradedequity securities, FAS 158 is effective for us at the end of fiscal 2007, withearly adoption permitted.  We plan toadopt FAS 158 at the end of fiscal 2007, with no material impact expected onour consolidated statement of operations, balance sheet, shareholders’ equity,or statement of cash flows.

In February 2007, theFASB issued Statement of Financial Accounting Standard No. 159, *The Fair Value Option for Financial Assets and Financial Liabilities*,which permits companies to measure certain financial instruments and otheritems at fair value (at specified measurement dates) that are not currentlyrequired to be measured at fair value. Any unrealized gains or losses applicableto those items measured at fair value shall be reported in earnings. Thedecision to apply fair value shall generally be made on an instrument byinstrument basis, is irrevocable, and is applied only to an entire instrument.The provisions of FAS 159 will be effective for us as of the beginning forfiscal 2008, with early adoption permitted.

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**Item 3.  Quantitativeand Qualitative Disclosures About Market Risk.**

We are exposed tofluctuations in exchange rates between the US and Canadian dollars, as thefunctional currency of our Canadian subsidiary is the Canadian dollar.  To mitigate the effects of currencyfluctuations, during the second quarter of fiscal 2007, we executed a foreigncurrency cash flow hedge. To facilitate cash flow hedge accounting, theobjective is to hedge payments for forecasted purchases of intercompanyinventory by our Canadian subsidiary denominated in US dollars.  The term of this cash flow hedge extendsthrough fiscal 2007.

To achieve our objectiveand to minimize the risk of ineffectiveness, the notional values represent aportion of our Canadian subsidiary’s forecasted intercompany purchases.  Any hedge ineffectiveness is recorded inOther income. For the three months ended August 4, 2007, the ineffectiveportion of the hedge was immaterial.

For the portion of thehedge that is effective, the change in fair value of that hedge will initiallybe recorded in Other comprehensive income. As the underlying inventory is sold to our customers, amounts will be reclassifiedfrom Other comprehensive income to Cost of sales and occupancy expense in thestatement of operations.  The change infair value of the hedge for the three months ended August 4, 2007, wasimmaterial.

The table below providesthe remaining quarterly notional values and the average CAD/USD exchange rateassociated with the hedge.
| **Period**  | ** ** | **CAD Amount**     | ** ** | **USD Amount** | ** ** | **Rate** | ** ** |
|-------------|------------|-------------------------|------------|---------------------|------------|----------|------------|
| ** **  | ** ** | **(in thousands)** | ** ** | ** **          | ** ** |
| Quarter 3   |       | $                       | 12,495     |                | $          | 13,117   |       | 1.050 |   |
| Quarter 4   |       | 14,229                  |       | 14,933              |       | 1.049    |       |
| Fiscal 2007 |       | $                       | 26,724     |                | $          | 28,050   |       | 1.050 |   |

 

**Item 4.  Controlsand Procedures.**

*Evaluation of Disclosure Controlsand Procedures*

We maintain a set ofdisclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) promulgated by the SEC under the Securities Exchange Act of 1934). Anevaluation was carried out under the supervision and with the participation ofour management, including our Chief Executive Officer and our President andChief Financial Officer, of the effectiveness of our disclosure controls andprocedures as of the end of the period covered by this Quarterly Report onForm 10-Q. Based on that evaluation, our Chief Executive Officer and ourPresident and Chief Financial Officer concluded that our disclosure controlsand procedures are effective to provide reasonable assurance that informationrequired to be disclosed in the reports that we file or submit under theSecurities Exchange Act of 1934 is recorded, processed, summarized, andreported within the time periods specified in SEC rules and forms. Suchcontrols and procedures are designed to ensure that information we are requiredto disclose in our reports is accumulated and communicated to our management,including our principal executive officers and principal financial officer, toallow timely disclosure decisions. 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.

*Change in Internal Control OverFinancial 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 under theSecurities Exchange Act of 1934) during our most recently completed fiscalquarter that materially affected, or is reasonably likely to materially affect,our internal control over financial reporting.

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**MICHAELSSTORES, INC.**

**Part II—OTHER INFORMATION**

**Item 1.  Legal Proceedings.**

Reference is made to theaction described under “Part I. Item 3. Legal Proceedings — Shareholder Claims— State Court Litigation” in our Annual Report on Form 10-K for fiscal2006.  In that action, on July 12, 2007, namedplaintiffs and proposed class representatives Feivel Gottlieb and RobertaSchuman voluntarily dismissed their claims. Julie Fathergill continues as the sole remaining named plaintiff andproposed class representative.

Reference is made to theconsolidated action described under “Part I. Item 3. LegalProceedings — Shareholder Claims — Federal CourtLitigation” in our Annual Report on Form 10-K for fiscal 2006 and under“Part II. Item 1. Legal Proceedings” in our Quarterly Report on Form 10-Qfor the quarterly period ended May 5, 2007. In that action, on July 3, 2007, the court granted the motion of thelead plaintiff, Massachusetts Laborers’ Annuity Fund, for leave to file theproposed amended complaint, as described under “Part II. Item 1. LegalProceedings” in our Quarterly Report on Form 10-Q for the quarterly periodended May 5, 2007.  On July 5, 2007, thelead plaintiff filed the amended complaint in the proposed form filed with thecourt on May 21, 2007, which is described in “Part II. Item 1. Legal Proceedings”in our Quarterly Report on Form 10-Q for the quarterly period ended May 5,2007.

Reference is made to theaction described under “Part I. Item 3. Legal Proceedings – Employee ClassAction Claims – Morris Claim” in our Annual Report on Form 10-K for fiscal2006.  In that action, on June 22, 2007,the court granted final approval of the settlement.  On July 11, 2007, the Court entered the FinalSettlement Judgment.  The settlement hadno material impact on our statement of operations, balance sheet, or statementof cash flows for any period presented.

Reference is made to theaction described under “Part I. Item 3. Legal Proceedings – Employee ClassAction Claims – Torgersen Claim” in our Annual Report on Form 10-K for fiscal2006.  In that action, on July 10, 2007,the parties participated in a voluntary mediation and have reached a tentativesettlement which is contingent on court approval.  If the settlement is approved in its currentform, it will have no material impact on our statement of operations, balancesheet, or statement of cash flows for any period presented.

We are involved inongoing legal and regulatory proceedings. Other than the updates described inthe preceding paragraph, there were no material changes to our disclosures ofcommitments and contingencies from our Annual Report on Form 10-K for fiscal2006 and our Quarterly Report on Form 10-Q for the quarter ended April 5, 2007.

**Item 1A.  Risk Factors**

*Product recalls and/or productliability may adversely impact our operations and merchandise offerings*

We are subject toregulations by a variety of state and international regulatory authorities,including the Consumer Product Safety Commission. In fiscal 2006, we purchasedmerchandise from approximately 1,200 vendors. A majority of our merchandise is manufactured in foreign countries.  One or more of our vendors might not adhereto product safety requirements or our quality control standards, and we mightnot identify the deficiency before merchandise ships to our stores. Any issuesof product safety, including but not limited to those manufactured in foreigncountries, could cause us to recall some of those products. The failure of ourvendors to manufacture or import merchandise that does not adhere to ourquality control standards could damage our reputation and brands and could leadto increases in customer litigation against us. Furthermore, to the extent we are unable to replace any recalledproducts, we may have to reduce our merchandise offerings, resulting in adecrease in sales, especially if a recall occurs near or during a seasonalperiod.  If our vendors are unable orunwilling to recall products failing to meet our quality standards, we may berequired to recall those products at a substantial cost to us. We may be unableto recover costs related to product recalls from our vendors.

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**Item 2.  UnregisteredSale of Equity Securities and Use of Proceeds**

Duringthe second quarter of fiscal 2007, certain officers of Michaels Stores, Inc.and its subsidiaries were offered the opportunity to purchase shares of ourCommon Stock at a price of $15 per share. The offering closed in the first weekof the third quarter of fiscal 2007.  Wesold 251,672 shares of our Common Stock to certain officers for approximately$3.8 million, and such shares represent approximately 0.21% of the totaloutstanding shares of Michaels Stores, Inc. Set forth in the table below is information regarding purchases ofshares of our Common Stock in that transaction by the named executives whoparticipated.
| **Named Executive** | ** ** | **Number of Shares** | ** ** | **Amount** | ** ** |
|--------------------------|------------|--------------------------------|------------|------------|------------|
| Brian C. Cornell         |       | 133,334                        |       | $          | 2,000,010  |   |
| Jeffrey N. Boyer         |       | 22,667                         |       | 340,000    |       |
| Thomas C. DeCaro         |       | 6,667                          |       | 100,005    |       |
| Harvey S. Kanter         |       | 20,000                         |       | 300,000    |       |
|                          |            |                                |            |            |            |  |

 

**Item 4.  Submission of Matters to a Vote ofSecurity Holders.**

OnJuly 10, 2007, approximately 93% of our shareholders, by written consent,approved an increase in the aggregate number of shares of Michaels common stockavailable for sale and issuance to certain members of management from 500,000to 600,000 shares of Michaels Common Stock. The increase was made in anticipation of the second offering tomanagement completed on August 17, 2007.

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**Item 6.  Exhibits.**

(a) Exhibits:
| Exhibit  Number | ** ** | **Description of Exhibit**                                                                                                                 |
|-----------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1            |       | Compensation Policy Regarding Company Cars for Chief  Executive Officer and President and Chief Financial Officer (filed herewith).        |
|            |       |                                                                                                                                       |
| 31.1            |       | Certifications of Brian C. Cornell pursuant to §302  of the Sarbanes-Oxley Act of 2002 (filed herewith).                              |
|            |       |                                                                                                                                       |
| 31.2            |       | Certifications of Jeffrey N. Boyer pursuant to §302  of the Sarbanes-Oxley Act of 2002 (filed herewith).                              |
|            |       |                                                                                                                                       |
| 32.1            |       | Certification pursuant to 18 U.S.C. §1350, as  adopted pursuant to §906 of the Sarbanes-Oxley Act of 2002 (filed herewith). |

 

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**MICHAELSSTORES, INC.**

**SIGNATURES**

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/ Jeffrey N. Boyer |   |
|                            |                  | Jeffrey N. Boyer |   |
|                            |                  | President and Chief Financial Officer |   |
|                            |                  | **(Principal Financial Officer)** | ** ** |
|                            |                  | ** ** | ** ** |
| Dated: September  13, 2007 |                  | ** ** | ** ** |

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**INDEX TOEXHIBITS**
| Exhibit Number | ** ** | **Description of Exhibit**                                                                                                                 |
|----------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1           |       | Compensation Policy Regarding Company Cars for Chief  Executive Officer and President and Chief Financial Officer (filed herewith).        |
|           |       |                                                                                                                                       |
| 31.1           |       | Certifications of Brian C. Cornell pursuant to §302  of the Sarbanes-Oxley Act of 2002 (filed herewith).                              |
|           |       |                                                                                                                                       |
| 31.2           |       | Certifications of Jeffrey N. Boyer 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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