**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON,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 May 3, 2008**                                                 |
| ** **                                                                                           | ** ** |
| **OR**                                                                                               |
| ** **                                                                                           | ** ** |
| **o**                                                                                                | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| ** **                                                                                           | ** ** |
| **For the  transition period from             to** |

 

**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**

**P.O. Box 619566**

**DFW,Texas 75261-9566**

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

 

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

 

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

 

Indicate by check mark whether the Registrant is ashell company (as defined in Rule 12b-2 of the ExchangeAct).  Yes **o     **No **x**

 

As of May 31, 2008, 118,477,068 shares of theRegistrant’s Common Stock were outstanding.

 

** **

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**MICHAELS STORES, INC.**

**FORM 10-Q**

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

 

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** **

**MICHAELS STORES, INC.**

**Part I—FINANCIALINFORMATION**

** **

**Item 1.  Financial Statements.**

** **

**MICHAELSSTORES, INC.CONSOLIDATED BALANCE SHEETS**

**(In millions, exceptshare data)(Unaudited)**

** **
| ** **                                                                                                                                                                                                                                                         | ** ** | **May 3,** | ** ** | **February 2,** | ** ** | **May 5,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|------------|----------------------|------------|-----------------|------------|
| ** **                                                                                                                                                                                                                                                         | ** ** | **2008**        | ** ** | **2008**             | ** ** | **2007**        | ** ** |
| **ASSETS**                                                                                                                                                                                                                                                         |       |            |       |                 |       |            |       |
| **Current  assets:**                                                                                                                                                                                                                                               |       |            |       |                 |       |            |       |
| Cash and  equivalents                                                                                                                                                                                                                                              |       | $               | 42         |                 | $          | 29              |       | $ | 45 |   |
| Merchandise  inventories                                                                                                                                                                                                                                           |       | 841             |       | 845                  |       | 871             |       |
| Prepaid expenses  and other                                                                                                                                                                                                                                        |       | 70              |       | 70                   |       | 76              |       |
| Deferred income  taxes                                                                                                                                                                                                                                             |       | 31              |       | 31                   |       | 35              |       |
| Income tax  receivable                                                                                                                                                                                                                                             |       | 19              |       | 5                    |       | 50              |       |
| Current assets -  discontinued operations                                                                                                                                                                                                                          |       | —          |       | —               |       | 8               |       |
| Total current  assets                                                                                                                                                                                                                                              |       | 1,003           |       | 980                  |       | 1,085           |       |
| **Property  and equipment, at cost**                                                                                                                                                                                                                               |       | 1,168           |       | 1,155                |       | 1,129           |       |
| Less accumulated  depreciation                                                                                                                                                                                                                                     |       | (748            | )          | (722                 | )          | (682            | )          |
|                                                                                                                                                                                                                                                               |       | 420             |       | 433                  |       | 447             |       |
| **Goodwill**                                                                                                                                                                                                                                                       |       | 94              |       | 94                   |       | 116             |       |
| **Debt  issuance costs, net of accumulated amortization of $26 at May 3, 2008;  $22 at February 2, 2008; and $9 at May 5, 2007**                                                                                                                    |       | 99              |       | 103                  |       | 116             |       |
| **Other  assets**                                                                                                                                                                                                                                                  |       | 3               |       | 4                    |       | 8               |       |
| **Non-current  assets - discontinued operations**                                                                                                                                                                                                                  |       | —          |       | —               |       | 6               |       |
|                                                                                                                                                                                                                                                               |       | 196             |       | 201                  |       | 246             |       |
| Total assets                                                                                                                                                                                                                                                       |       | $               | 1,619      |                 | $          | 1,614           |       | $ | 1,778 |   |
|                                                                                                                                                                                                                                                               |       |            |       |                 |       |            |       |
| **LIABILITIES AND STOCKHOLDERS’ DEFICIT**                                                                                                                                                                                                                     |       |            |       |                 |       |            |       |
| **Current  liabilities:**                                                                                                                                                                                                                                          |       |            |       |                 |       |            |       |
| Accounts payable                                                                                                                                                                                                                                                   |       | $               | 191        |                 | $          | 221             |       | $ | 238 |   |
| Accrued  liabilities and other                                                                                                                                                                                                                                     |       | 273             |       | 332                  |       | 256             |       |
| Current portion  of long-term debt                                                                                                                                                                                                                                 |       | 235             |       | 122                  |       | 345             |       |
| Current  liabilities - discontinued operations                                                                                                                                                                                                                     |       | 2               |       | 4                    |       | —          |       |
| Total current  liabilities                                                                                                                                                                                                                                         |       | 701             |       | 679                  |       | 839             |       |
| **Long-term  debt**                                                                                                                                                                                                                                                |       | 3,744           |       | 3,741                |       | 3,731           |       |
| **Deferred  income taxes**                                                                                                                                                                                                                                         |       | 4               |       | 4                    |       | 16              |       |
| **Other  long-term liabilities**                                                                                                                                                                                                                                   |       | 79              |       | 80                   |       | 81              |       |
| **Long-term  liabilities - discontinued operations**                                                                                                                                                                                                               |       | 1               |       | 2                    |       | 1               |       |
| Total long-term  liabilities                                                                                                                                                                                                                                       |       | 3,828           |       | 3,827                |       | 3,829           |       |
|                                                                                                                                                                                                                                                               |       | 4,529           |       | 4,506                |       | 4,668           |       |
| **Commitments  and contingencies**                                                                                                                                                                                                                                 |       |            |       |                 |       |            |       |
| **Stockholders’  deficit:**                                                                                                                                                                                                                                   |       |            |       |                 |       |            |       |
| Common Stock, $0.10  par value, 220,000,000 shares authorized;  118,415,735 shares issued and outstanding at May 3, 2008;  118,421,069 shares issued and outstanding at February 2, 2008;  118,262,731 shares issued and outstanding at May 5, 2007 |       | 12              |       | 12                   |       | 12              |       |
| Additional  paid-in capital                                                                                                                                                                                                                                        |       | 16              |       | 12                   |       | 6               |       |
| Accumulated  deficit                                                                                                                                                                                                                                               |       | (2,947          | )          | (2,926               | )          | (2,918          | )          |
| Accumulated  other comprehensive income                                                                                                                                                                                                                            |       | 9               |       | 10                   |       | 10              |       |
| Total  stockholders’ deficit                                                                                                                                                                                                                                  |       | (2,910          | )          | (2,892               | )          | (2,890          | )          |
| Total  liabilities and stockholders’ deficit                                                                                                                                                                                                                  |       | $               | 1,619      |                 | $          | 1,614           |       | $ | 1,778 |   |

 

Seeaccompanying notes to consolidated financial statements.

 

3

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**MICHAELSSTORES, INC.CONSOLIDATED STATEMENTS OF OPERATIONS**

**(Inmillions)(Unaudited)**

 
| ** **                                                | ** ** | **Quarter Ended** | ** ** |
|-----------------------------------------------------------|------------|------------------------|------------|
| ** **                                                | ** ** | **May 3,**        | ** ** | **May 5,** | ** ** |
| ** **                                                | ** ** | **2008**               | ** ** | **2007** | ** ** |
| **Net  sales**                                            |       | $                      | 847        |   | $ | 839 |   |
| Cost of sales  and occupancy expense                      |       | 521                    |       | 513 |   |
| **Gross  profit**                                         |       | 326                    |       | 326 |   |
| Selling,  general, and administrative expense             |       | 272                    |       | 254 |   |
| Transaction  expenses                                     |       | —                 |       | 6 |   |
| Related party  expenses                                   |       | 4                      |       | 4 |   |
| Store pre-opening  costs                                  |       | 2                      |       | 2 |   |
| **Operating  income**                                     |       | 48                     |       | 60 |   |
| Interest expense                                          |       | 78                     |       | 95 |   |
| Other (income)  and expense, net                          |       | —                 |       | (3 | ) |
| **Loss  before income taxes and discontinued operations** |       | (30                    | )          | (32 | ) |
| Income tax  benefit                                       |       | (10                    | )          | (10 | ) |
| **Loss  before discontinued operations**                  |       | (20                    | )          | (22 | ) |
| Discontinued  operations loss, net of income tax          |       | —                 |       | (1 | ) |
| **Net  loss**                                             |       | $                      | (20        | ) | $ | (23 | ) |

 

See accompanyingnotes to consolidated financial statements.

 

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** **

**MICHAELSSTORES, INC.CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(In millions)(Unaudited)**

 
| ** **                                           | ** ** | **Quarter Ended** | ** ** |
|------------------------------------------------------|------------|------------------------|------------|
| ** **                                           | ** ** | **May 3,**        | ** ** | **May 5,** | ** ** |
| ** **                                           | ** ** | **2008**               | ** ** | **2007** | ** ** |
| **Operating  activities:**                           |       |                   |       |   |   |
| Net loss                                             |       | $                      | (20        | ) | $ | (23 | ) |
| Adjustments:                                         |       |                   |       |   |   |
| Depreciation and  amortization                       |       | 31                     |       | 31 |   |
| Share-based  compensation                            |       | 3                      |       | 1 |   |
| Deferred  financing costs amortization               |       | 4                      |       | 4 |   |
| Accretion of  subordinated discount notes            |       | 9                      |       | 8 |   |
| Changes in  assets and liabilities:                  |       |                   |       |   |   |
| Merchandise  inventories                             |       | 4                      |       | (31 | ) |
| Prepaid expenses  and other                          |       | —                 |       | (3 | ) |
| Deferred income  taxes and other                     |       | 1                      |       | (14 | ) |
| Accounts payable                                     |       | (38                    | )          | 13 |   |
| Accrued interest                                     |       | (53                    | )          | (29 | ) |
| Accrued  liabilities and other                       |       | (9                     | )          | 2 |   |
| Income taxes  receivable                             |       | (13                    | )          | (9 | ) |
| Other long-term  liabilities                         |       | (2                     | )          | (1 | ) |
| Net cash used in  operating activities               |       | (83                    | )          | (51 | ) |
|                                                 |       |                   |       |   |   |
| **Investing  activities:**                           |       |                   |       |   |   |
| Additions to  property and equipment                 |       | (21                    | )          | (28 | ) |
| Net cash used in  investing activities               |       | (21                    | )          | (28 | ) |
|                                                 |       |                   |       |   |   |
| **Financing  activities:**                           |       |                   |       |   |   |
| Borrowings on  asset-based revolving credit facility |       | 304                    |       | 448 |   |
| Payments on  asset-based revolving credit facility   |       | (193                   | )          | (333 | ) |
| Repayments on  senior secured term loan facility     |       | (6                     | )          | (6 | ) |
| Equity  investment of Management                     |       | —                 |       | 4 |   |
| Repurchase of  Common Stock                          |       | —                 |       | — |   |
| Payment of  capital leases                           |       | (3                     | )          | (4 | ) |
| Change in cash  overdraft                            |       | 14                     |       | (15 | ) |
| Other                                                |       | 1                      |       | — |   |
| Net cash  provided by financing activities           |       | 117                    |       | 94 |   |
|                                                 |       |                   |       |   |   |
| **Net  increase in cash and equivalents**            |       | 13                     |       | 15 |   |
| **Cash  and equivalents at beginning of period**     |       | 29                     |       | 30 |   |
| **Cash  and equivalents at end of period**           |       | $                      | 42         |   | $ | 45 |   |

 

See accompanying notes toconsolidated financial statements.

 

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

**For theQuarter Ended May 3, 2008(Unaudited)**

 

**Note 1.  Summary ofSignificant Accounting Policies**

 

*Basis of Presentation*

 

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

 

The accompanyingunaudited consolidated financial statements have been prepared in accordancewith U.S. generally accepted accounting principles for interim financialinformation and with the instructions to Form 10-Q and Article 10 ofRegulation S-X. Accordingly, they do not include all of the informationand notes required by generally accepted accounting principles for completefinancial statements. Therefore, these financial statements should be read inconjunction with our Annual Report on Form 10-K for the fiscal year ended February 2,2008.

 

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

 

Because of the seasonalnature of our business, the results of operations for the quarter ended May 3,2008 are not indicative of the results to be expected for the entire year.

 

The balance sheet at February 2,2008 has been derived from the audited financial statements at that date, butdoes not include all of the information and notes required by generallyaccepted accounting principles for complete financial statements. For furtherinformation, refer to the consolidated financial statements and notes theretoincluded in our Annual Report on Form 10-K for the fiscal year ended February 2,2008.

 

We report on the basis ofa 52 or 53-week fiscal year, which ends on the Saturday closest to January 31.All references herein to “fiscal 2008” relate to the 52 weeks ending January 31,2009, and all references to “fiscal 2007” relate to the 52 weeks ended February 2,2008. In addition, all references herein to “the first quarter of fiscal 2008”relate to the 13 weeks ended May 3, 2008, and all references to “the firstquarter of fiscal 2007” relate to the 13 weeks ended May 5, 2007.

 

*Reclassifications*

 

Certain prior yearamounts were reclassified to conform to the current year presentation.  These reclassifications consist primarily ofthe presentation of discontinued operations.

 

*Recent Accounting Pronouncements*

 

In September 2006,the Financial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards (“SFAS”) No. 157, *Fair Value Measurements*,which is intended to increase consistency and comparability in fair valuemeasurements by defining fair value, establishing a framework for measuringfair value and expanding disclosures about fair value measurements.  SFAS 157 was originally effective forfinancial statements issued for fiscal years beginning after November 15,2007, and interim periods within those fiscal years.  In November 2007, the FASB placed a oneyear deferral for the implementation of SFAS 157 for nonfinancial assets andliabilities; however, SFAS 157 is effective for fiscal years beginning after November 15,2007 for financial assets and liabilities, as well as for any other assets andliabilities that are carried at fair value on a recurring basis in financialstatements.  We adopted all requirementsof SFAS 157 as they relate to financial assets and liabilities on February 3,2008, with no impact on our consolidated financial statements.  The requirements related to nonfinancialassets and liabilities will be adopted on February 1, 2009, as allowed bySFAS 157. We have not yet determined the impact, if any, on our consolidatedfinancial statements for these nonfinancial assets and liabilities.

 

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In February 2007,the FASB issued SFAS No. 159, *The Fair Value Option forFinancial Assets and Financial Liabilities*, which permits companiesto measure certain financial instruments and other items at fair value (atspecified measurement dates) that are not currently required to be measured atfair value. Any unrealized gains or losses applicable to those items measuredat fair value shall be reported in earnings. The decision to apply fair valueshall generally be made on an instrument by instrument basis, is irrevocable,and is applied only to an entire instrument. We adopted SFAS 159 on February 3,2008, and there was no impact on our consolidated financial statements as wedid not choose to measure any eligible financial assets or liabilities at fairvalue.

 

In December 2007,the FASB issued SFAS No. 141 (revised 2007), *Business Combinations*(“SFAS 141R”). SFAS 141R replaces SFASNo. 141, *Business Combinations*.The statement retains the purchase method of accounting used in businesscombinations, but replaces SFAS 141 by establishing principles and requirementsfor the recognition and measurement of assets, liabilities and goodwill,including the requirement that most transaction costs and restructuring costsbe expensed. In addition, the statement requires disclosures to enable users toevaluate the nature and financial effects of the business combination. SFAS141R is effective for business combinations for which the acquisition date ison or after the beginning of the first annual reporting period beginning on orafter December 15, 2008. We will adopt SFAS 141R on February 1, 2009for acquisitions on or after this date.

 

In March 2008, theFASB issued SFAS No. 161, *Disclosuresabout Derivative Instruments and Hedging Activities – an amendment of FASBStatement No. 133*. SFAS 161 requires qualitative disclosuresabout objectives and strategies for using derivatives, quantitative data aboutthe fair value of and gains and losses on derivative contracts, and details ofcredit-risk-related contingent features in hedged positions. The statement alsorequires enhanced disclosures regarding how and why entities use derivativeinstruments, how derivative instruments and related hedged items are accountedfor in accordance with SFAS 133 and its related interpretation, and howderivative instruments and related hedged items affect entity’s financialposition, financial performance, and cash flows. SFAS 161 is effective forfiscal years and interim periods beginning after November 15, 2008. Wewill adopt the new disclosure requirements of SFAS 161 in the first quarter of2009.

 

**Note 2.  Discontinued Operations**

 

On October 16, 2007,we announced plans to align resources around our core retail chains, Michaelsand Aaron Brothers.  As a result, wediscontinued our concept businesses, Recollections and Star DecoratorsWholesale.  As of the end of fiscal 2007,we had closed 11 Recollections and three of the four Star locations.  The remaining Star location has beenconverted to a Michaels store.

 

The unaudited consolidatedfinancial statements, accompanying notes and other information provided in thisQuarterly Report on Form 10-Q reflect these concept businesses asdiscontinued operations for all periods presented.

 

Summarized financialinformation with respect to the results of operations of these discontinuedoperations is as follows:

 
| ** **                                             | ** ** | **Quarter Ended**    | ** ** |
|--------------------------------------------------------|------------|---------------------------|------------|
| ** **                                             | ** ** | **May 3, 2008** | ** ** | **May 5, 2007** | ** ** |
| ** **                                             | ** ** | **(in millions)**    | ** ** |
|                                                   |       |                      |       |   |   |
| Net sales                                              |       | $                         | —     |   | $ | 5 |   |
|                                                   |       |                      |       |   |   |
| Loss from  discontinued operations before income taxes |       | $                         | —     |   | $ | (1 | ) |
| Income tax  benefit                                    |       | —                    |       | — |   |
| Net loss from  discontinued operations                 |       | $                         | —     |   | $ | (1 | ) |

 

**Note 3.  Share-BasedCompensation**

 

On February 15,2007, our shareholders 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 quarters ended May 3, 2008 and May 5, 2007.As of May 3, 2008, 

 

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there are 133,333shares of restricted stock outstanding, 10.7 million share-based awardsoutstanding and up to 3.4 million shares of Common Stock remain available forgrant.

 
| ** **                          | ** ** | **Quarter Ended**    | ** ** |
|-------------------------------------|------------|---------------------------|------------|
| ** **                          | ** ** | **May 3, 2008** | ** ** | **May 5, 2007** | ** ** |
| ** **                          | ** ** | **(in millions)**    | ** ** |
|                                |       |                      |       |   |   |
| Outstanding at  beginning of period |       | 11.1                      |       | — |   |
| Grants                              |       | 1.1                       |       | 9.7 |   |
| Cancellations                       |       | (1.4                      | )          | — |   |
| Outstanding at  end of period       |       | 10.8                      |       | 9.7 |   |

 

Generally, awards grantedunder the 2006 Plan vest ratably over five years and expire eight years fromthe grant date. The exercise prices of the awards ranged from $15 per share to$52.50 per share. The fair value of the awards, for the purpose of calculatingcompensation expense, was determined after considering various factors, andusing the Black-Scholes-Merton option valuation model. Share-based compensationexpense associated with these awards was $3 million and $1 million for thefirst quarter of fiscal 2008 and 2007, respectively.

 

**Note 4.  Debt**

 

Our outstanding debt isdetailed in the table below.  We were incompliance with the terms and conditions of all debt agreements for all periodspresented.

 
| ** **                             | ** ** | **May 3, 2008** | ** ** | **February 2, 2008** | ** ** | **Interest Rate** | ** ** |
|----------------------------------------|------------|---------------------------|------------|--------------------------------|------------|------------------------|------------|
| ** **                             | ** ** | **(In millions)**    | ** ** | ** **                     | ** ** |
|                                   |       |                      |       |                           |       |                   |       |
| Senior notes                           |       | $                         | 750        |                           | $          | 750                    |       | 10.000 | % |
| Senior  subordinated notes             |       | 400                       |       | 400                            |       | 11.375                 | %          |
| Subordinated  discount notes           |       | 303                       |       | 293                            |       | 13.000                 | %          |
| Senior secured  term loan              |       | 2,315                     |       | 2,321                          |       | Variable               |       |
| Asset-based  revolving credit facility |       | 208                       |       | 97                             |       | Variable               |       |
| Other                                  |       | 3                         |       | 2                              |       | Variable               |       |
| Total debt                             |       | 3,979                     |       | 3,863                          |       |                   |       |
| Less current  portion                  |       | 235                       |       | 122                            |       |                   |       |
| Long-term debt                         |       | $                         | 3,744      |                           | $          | 3,741                  |       |   |   |

 

*Asset-based revolving credit facility*

 

Our October 31, 2006senior secured asset-based revolving credit facility with Banc of America, N.A.and other lenders (the “Asset-based revolving credit facility”) provides seniorsecured financing of up to $1.0 billion, subject to a borrowing base asdescribed in our Annual Report on Form 10-K. As of May 3, 2008, the borrowing base was $711 million with $477million of unused availability.

 

*Senior secured term loan facility*

 

Borrowings under our October 31,2006 senior secured term loan facility with Deutsche Bank A.G. New York Branch,and other lenders, (the “Senior secured term loan facility”) bore interest at arate per annum equal to, at our option, either (a) a base rate determinedby reference to the higher of (1) the prime rate of Deutsche Bank and (2) thefederal funds effective rate plus 1⁄2 of 1% or (b) a LIBOR rate,subject to certain adjustments, in each case plus an applicable margin. Theapplicable margin at May 3, 2008 was 1.25% with respect to base rateborrowings and 2.25% with respect to LIBOR borrowings, subject to adjustmentsbased on the leverage and ratings thresholds set forth in the Senior securedterm loan facility agreement.

 

8

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**Note 5.  Comprehensive Income**

 

Ourcomprehensive income is as follows:

 
| ** **                                         | ** ** | **Quarter Ended**    | ** ** |
|----------------------------------------------------|------------|---------------------------|------------|
| ** **                                         | ** ** | **May 3, 2008** | ** ** | **May 5, 2007** | ** ** |
| ** **                                         | ** ** | **(in millions)**    | ** ** |
|                                               |       |                      |       |   |   |
| Net loss                                           |       | $                         | (20        | ) | $ | (23 | ) |
| Other  comprehensive income (loss):                |       |                      |       |   |   |
| Foreign currency  translation adjustment and other |       | (1                        | )          | 3 |   |
| Comprehensive  loss                                |       | $                         | (21        | ) | $ | (20 | ) |

 

**Note 6.  Commitmentsand Contingencies**

 

We are involved inongoing legal and regulatory proceedings. Other than those described in the following paragraphs, there were nomaterial changes to our disclosures of commitments and contingencies from ourAnnual Report on Form 10-K for the fiscal year ended February 2, 2008.

 

*Shareholder Claims*

 

The Company was adefendant in an action filed on September 6, 2006 by a former purportedshareholder, Massachusetts Laborers’ Annuity Fund, which sought to represent aclass of other former shareholders.  Thisaction was consolidated with two other actions filed by other purported formershareholders and was pending in the United States District Court, NorthernDistrict of Texas, Dallas Division.  Byan order dated December 8, 2006, Massachusetts Laborers’ Annuity Fund wasnamed the lead plaintiff in this action. On July 5, 2007 the lead plaintiff filed a first amended consolidatedclass action complaint, which named Michaels and certain of its current andformer officers and directors as defendants. The amended complaint alleged that the defendants misrepresented and/oromitted material facts in Michaels’ annual proxy statements for 2004, 2005 and2006, including, among others, failing to disclose:  (a) Michaels’ and the defendants’alleged option backdating practices; (b) information regardingtransactions and holdings of Michaels Common Stock by certain trusts owned byor for the benefit of two of Michaels’ former officers and directors and theirfamily members; and (c) that Michaels and the defendants had reportedfalse financial statements as a result of those practices.  Further, the amended complaint madeallegations regarding the Company’s financial restatement of periods prior to2006, as well as the Merger (as defined in Note 8 to the Consolidated FinancialStatements).  In the amended complaint,the lead plaintiff asserted claims against all defendants for violations of Section 14(a) ofthe Securities Exchange Act of 1934, Rule 14a-9 promulgated thereunder,and Section 20(a) of the Securities Exchange Act of 1934.  The lead plaintiff sought, among otherrelief, (a) an indeterminate amount of damages, (b) pre-judgment andpost-judgment interest, (c) an award of attorneys’ fees and costs, and (d)equitable or injunctive relief, including the rescission of stock optiongrants.  On April 18, 2008, thecourt dismissed with prejudice all of the claims against all of the defendants.  The time for the lead plaintiff to file anappeal of that dismissal has now elapsed.

 

*Employee Class ActionClaims*

* *

*Cotton Claim*

 

On December 20,2002, James Cotton, a former store manager of Michaels of Canada, ULC (“Michaelsof Canada”), our wholly-owned subsidiary, and Suzette Kennedy, a formerassistant manager of Michaels of Canada, commenced a purported class proceedingagainst Michaels of Canada and Michaels Stores, Inc. on behalf ofthemselves and current and former store managers and assistant store managersemployed in Canada. The Cotton claim was filed in the Ontario Superior Court ofJustice and alleges that the defendants violated employment standardslegislation in Ontario and other provinces and territories of Canada by failingto pay overtime compensation as required by that legislation. The Cotton claimalso alleges that this conduct was in breach of the contracts of employment ofthose individuals. The Cotton claim seeks a declaration that the defendantshave acted in breach of applicable legislation, payment to current and formeremployees for overtime, damages for breach of contract, punitive, aggravatedand exemplary damages, interest, and costs. In May of 2005, the plaintiffsdelivered material in support of their request that this action be certified asa class proceeding. Michaels filed and 

 

9

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served its responding materials opposing classcertification on January 31, 2006. The hearing with respect to classcertification has been set for December 9-10, 2008.  We intend to contest certification of thisclaim as a class action. Further, we believe we have certain defenses on themerits and intend to defend this lawsuit vigorously. We are unable to estimatea range of possible loss, if any, in this claim.

 

*DeJoseph**Claim*

 

On December 29,2006, John DeJoseph, a former Michaels store manager in Valencia, California,commenced a purported class action proceeding against Michaels Stores, Inc.on behalf of himself and current and former salaried store managers employed inCalifornia from May 10, 2002 to the present. The DeJoseph suit was filedin the Superior Court of California, County of Los Angeles.  The DeJoseph suit alleges that Michaelsfailed to pay overtime wages, provide meal periods, accurately record hoursworked, provide itemized employee wage statements, and that Michaels unlawfullymade deductions from employees’ earnings. The DeJoseph suit additionally alleges that the foregoing conduct was inbreach of California’s unfair competition law. The plaintiff seeks injunctive relief, damages for unpaid wages,penalties, restitution, interest, and attorneys’ fees and costs.  In April 2008, the Court certified theclass as to monetary relief for the overtime claim, but denied certification asto the wage statement and meal break claims plus the injunctive relief portionof the overtime claim.  We believe wehave meritorious defenses and intend to defend this lawsuit vigorously. We areunable to estimate a range of loss, if any, in this case.

 

*TorgersonClaim*

 

On January 26, 2007,Katherine Torgerson, a former “lead framer” for Aaron Brothers, Inc. (“AaronBrothers”) in San Diego, California, filed a purported class action proceedingin the Superior Court of California, County of San Diego.  Torgerson filed this action against AaronBrothers on behalf of herself and all current and former California-based leadsor keyholders.  The Torgerson suitalleges that Aaron Brothers failed to provide its leads and keyholders withadequate meal and rest breaks (or compensation in lieu thereof) and accuratewage statements.  The Torgerson suitadditionally alleges that the foregoing conduct was in breach of California’sunfair competition law.   The plaintiffsought injunctive relief, compensatory damages, meal and rest break penalties,waiting time penalties, interest, and attorneys’ fees and costs.  The parties participated in voluntarymediation on July 10, 2007 and had reached a tentative settlement of thecase.  On April 25, 2008, the Courtapproved the settlement thereby requiring Aaron Brothers to make the settlementpayments by August 8, 2008.  Thesesettlement payments will have no material impact on our statement ofoperations, balance sheet, or cash flows for any period presented.

 

*Consumer Claims*

 

*PalmerClaim*

 

On August 30, 2007,Rebecca Palmer, a consumer, filed a purported class action proceeding inSuperior Court of California, County of San Diego.  Palmer filed this action against MichaelsStores, Inc., on behalf of herself and all similarly-situated Californiaconsumers.  The Palmer suit alleges thatMichaels unlawfully requested and recorded personally identifiable information(i.e., her zip code) as part of a credit card transaction.  The plaintiff seeks statutory penalties,interest, and attorneys’ fees.  On March 28,2008, the plaintiff submitted a brief in support of class certification.  We contested class certification by filingresponding materials on May 8, 2008. We also filed a motion for summary judgment on May 8, 2008.  Plaintiff filed a reply brief in support ofclass certification on May 23, 2008. On May 30, 2008, the Court orally denied plaintiff’s motion forclass certification.  We anticipate aformal written opinion in this regard, but the Court retains the ability to reconsiderits oral decision.  If the case proceeds,we believe we have certain defenses on the merits and intend to defend thislawsuit vigorously.  We are unable toestimate a range of possible loss, if any, in this claim.

 

**Note 7.  Segments**

 

We consider our Michaelsand Aaron Brothers operations to be our operating segments for purposes ofdetermining reportable segments based on the criteria of SFAS No. 131, *Disclosures About Segments of an Enterprise andRelated Information.* We determined that our Michaels and AaronBrothers operating segments have similar economic characteristics and meet theaggregation criteria set forth in paragraph 17 of SFAS No. 131. Therefore,we combine both operating segments into one reporting segment.

 

Our chief operating decisionmakers evaluate historical operating performance, plan and forecast futureperiods’ 

 

10

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operatingperformance and an element of base incentive compensation targets for certainmanagement personnel on earnings before interest, income taxes, anddepreciation and amortization (“EBITDA”). A reconciliation of income beforeincome taxes and cumulative effect of accounting change to EBITDA is presentedbelow.

 

| ** **                                            | ** ** | **Quarter Ended**    | ** ** |
|-------------------------------------------------------|------------|---------------------------|------------|
| ** **                                            | ** ** | **May 3, 2008** | ** ** | **May 5, 2007** | ** ** |
| ** **                                            | ** ** | **(in millions)**    | ** ** |
|                                                  |       |                      |       |   |   |
| Loss before  income taxes and discontinued operations |       | $                         | (30        | ) | $ | (32 | ) |
| Interest expense                                      |       | 78                        |       | 95 |   |
| Depreciation and  amortization                        |       | 31                        |       | 30 |   |
| EBITDA                                                |       | $                         | 79         |   | $ | 93 |   |

 

Our sales and assets bycountry are as follows:

 
| ** **                           | ** ** | **Net Sales**     | ** ** | **Total Assets** | ** ** |
|--------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                           | ** ** | **(in millions)** | ** ** |
| ** **                           |       |                   |       |                  |       |
| **Quarter  ended May 3, 2008:** |       |                   |       |                  |       |
| United States                        |       | $                      | 778        |                  | $          | 1,509 |   |
| Canada                               |       | 69                     |       | 110                   |       |
| Consolidated  Total                  |       | $                      | 847        |                  | $          | 1,619 |   |
|                                 |       |                   |       |                  |       |
| **Quarter  ended May 5, 2007:** |       |                   |       |                  |       |
| United States                        |       | $                      | 779        |                  | $          | 1,684 |   |
| Canada                               |       | 60                     |       | 94                    |       |
| Consolidated  Total                  |       | $                      | 839        |                  | $          | 1,778 |   |

 

Wepresent assets based on their physical, geographic location.  Certain assets located in the United Statesare also used to support our Canadian operations, but we do not allocate theseassets to Canada.

 

**Note 8.  Related PartyTransactions**

 

As previously disclosed,on October 31, 2006, substantially all of the Common Stock of MichaelsStores, Inc. was acquired through a merger transaction (the “Merger”) byaffiliates of Bain Capital Partners, LLC and The Blackstone Group. We payannual management fees to Bain Capital Partners, LLC and The Blackstone Group(collectively, together with their applicable affiliates, the “Sponsors”) andHighfields Capital Management LP in the amount of $12 million and $1 million,respectively. We recognized $3 million of expense related to annual managementfees during the first quarter of fiscal 2008 and fiscal 2007. These expensesare included in related party expenses on the statement of operations.

 

Bain Capital owns a majorityownership stake in an external vendor we utilize to print our circularadvertisements.  Expenses associated withthis vendor during the first quarter of fiscal 2008 and fiscal 2007 were $10million for each quarter.  These expensesare included in selling, general and administrative expense on the consolidatedstatements of operations.

 

During the first quarterof fiscal 2007, The Blackstone Group acquired a majority ownership stake in anexternal vendor we utilize to count our store inventory. Expenses associatedwith this vendor during the first quarter of fiscal 2008 and fiscal 2007 were$2 million and $1 million, respectively. These expenses are included in selling, general and administrativeexpense on the consolidated statements of operations.

 

During the third quarterof fiscal 2007, Bain Capital acquired an ownership stake in an external vendorwe utilize for non-merchandise supplies. Expenses associated with this vendor during the first quarter of fiscal2008 were approximately $1 million.  Theseexpenses are included in selling, general and administrative expense on theconsolidated statements of operations.

 

We have a participationagreement with CoreTrust Purchasing Group (“CPG”), which designates CPG as ourexclusive 

 

11

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supplier ofcertain non-merchandise supplies and equipment. In exchange, we are offerednon-merchandise supplies and equipment from a variety of vendors at apre-determined price. We do not pay any fees to participate in this grouparrangement, and we can terminate our participation prior to the expiration ofthe agreement without penalty. The vendors separately pay fees to CPG foraccess to its consortium of customers. The Blackstone Group entered into anagreement with CPG whereby The Blackstone Group receives a portion of the grossfees vendors pay to CPG based on the volume of purchases made by us and otherparticipants.

 

During fiscal 2007,officers of Michaels Stores, Inc. and its subsidiaries were offered theopportunity to purchase shares of our Common Stock. There were no shares soldto officers of Michaels Stores, Inc. during the first quarter of fiscal2008.  Also, during the first quarter of2008, we repurchased 5,334 shares from officers who are no longer with the Company.

 

In connection with theconsummation of the Merger, the Company entered into a Separation Agreementwith each of Charles Wyly and Sam Wyly, executive officers and directors of theCompany prior to the Merger.  Under theSeparation Agreements, each of Charles Wyly and Sam Wyly received a lump sumpayment of $3.0 million in exchange for his agreement to adhere to certainnon-competition, non-solicitation and confidentiality restrictions. We areamortizing these Separation Agreements over two years. These expenses areincluded in related party expenses on the consolidated statements ofoperations.

 

**Note 9.  Condensed Consolidating Financial Information**

 

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 no non-guarantorsubsidiaries.  The following condensedconsolidating financial information represents the financial information ofMichaels Stores, Inc. and its wholly-owned subsidiary guarantors, preparedon the equity basis of accounting.  Theinformation is presented in accordance with the requirements of Rule 3-10under the SEC’s Regulation S-X.  Thefinancial information may not necessarily be indicative of results ofoperations, cash flows, or financial position had the subsidiary guarantorsoperated as independent entities.

 

12

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**SupplementalCondensed Consolidating Balance Sheet**

** **
| ** **                                        | ** ** | **May 3, 2008** | ** ** |
|---------------------------------------------------|------------|---------------------------|------------|
| ** **                                        | ** ** | **Parent  Company**       | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                        | ** ** | **(in  millions)**        | ** ** |
| ** **                                        |       | ** **                |       |   |   |   |   |   |   |
| **ASSETS**                                        |       | ** **                |       |   |   |   |   |   |   |
| **Current  assets:**                              |       |                      |       |   |   |   |   |   |   |
| Cash and  equivalents                             |       | $                         | 26         |   | $ | 16 |   | $ | — |   | $ | 42 |   |
| Merchandise  inventories                          |       | 622                       |       | 219 |   | — |   | 841 |   |
| Intercompany  receivables                         |       | —                    |       | 351 |   | (351 | ) | — |   |
| Other                                             |       | 74                        |       | 46 |   | — |   | 120 |   |
| Total current  assets                             |       | 722                       |       | 632 |   | (351 | ) |   | 1,003 |   |
| **Property  and equipment, net**                  |       | 299                       |       | 121 |   | — |   | 420 |   |
| **Goodwill,  net**                                |       | 94                        |       | — |   | — |   | 94 |   |
| **Investment  in subsidiaries**                   |       | 463                       |       | — |   | (463 | ) | — |   |
| **Other  assets**                                 |       | 87                        |       | 15 |   | — |   | 102 |   |
| Total assets                                      |       | $                         | 1,665      |   | $ | 768 |   | $ | (814 | ) | $ | 1,619 |   |
|                                              |       |                      |       |   |   |   |   |   |   |
| **LIABILITIES AND STOCKHOLDERS’ DEFICIT**    |       |                      |       |   |   |   |   |   |   |
| **Current  liabilities:**                         |       |                      |       |   |   |   |   |   |   |
| Accounts payable                                  |       | $                         | 26         |   | $ | 165 |   | $ | — |   | $ | 191 |   |
| Accrued  liabilities and other                    |       | 195                       |       | 78 |   | — |   | 273 |   |
| Current portion  of long-term debt                |       | 235                       |       | — |   | — |   | 235 |   |
| Intercompany  payable                             |       | 351                       |       | — |   | (351 | ) | — |   |
| Other                                             |       | (39                       | )          | 41 |   | — |   | 2 |   |
| Total current  liabilities                        |       | 768                       |       | 284 |   | (351 | ) | 701 |   |
| **Long-term  debt**                               |       | 3,744                     |       | — |   | — |   | 3,744 |   |
| **Other  long-term liabilities**                  |       | 63                        |       | 21 |   | — |   | 84 |   |
| **Total  stockholders’ deficit**             |       | (2,910                    | )          | 463 |   | (463 | ) | (2,910 | ) |
| Total liabilities  and stockholders’ deficit |       | $                         | 1,665      |   | $ | 768 |   | $ | (814 | ) | $ | 1,619 |   |

 

13

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**SupplementalCondensed Consolidating Balance Sheet**

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

 

14

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**SupplementalCondensed Consolidating Balance Sheet**

** **
| ** **                                        | ** ** | **May 5, 2007** | ** ** |
|---------------------------------------------------|------------|---------------------------|------------|
| ** **                                        | ** ** | **Parent  Company**       | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                        | ** ** | **(in millions)**    | ** ** |
| ** **                                        |       |                      |       |   |   |   |   |   |   |
| **ASSETS**                                        |       |                      |       |   |   |   |   |   |   |
| **Current  assets:**                              |       |                      |       |   |   |   |   |   |   |
| Cash and  equivalents                             |       | $                         | 28         |   | $ | 17 |   | $ | — |   | $ | 45 |   |
| Merchandise  inventories                          |       | 671                       |       | 200 |   | — |   | 871 |   |
| Intercompany  receivables                         |       | —                    |       | 200 |   | (200 | ) | — |   |
| Other                                             |       | 149                       |       | 20 |   | — |   | 169 |   |
| Total current  assets                             |       | 848                       |       | 437 |   | (200 | ) |   | 1,085 |   |
| **Property  and equipment, net**                  |       | 320                       |       | 127 |   | — |   | 447 |   |
| **Goodwill,  net**                                |       | 94                        |       | 22 |   | — |   | 116 |   |
| **Investment  in subsidiaries**                   |       | 334                       |       | — |   | (334 | ) | — |   |
| **Other  assets**                                 |       | 116                       |       | 14 |   | — |   | 130 |   |
| Total assets                                      |       | $                         | 1,712      |   | $ | 600 |   | $ | (534 | ) | $ | 1,778 |   |
|                                              |       |                      |       |   |   |   |   |   |   |
| **LIABILITIES AND STOCKHOLDERS’ DEFICIT**    |       |                      |       |   |   |   |   |   |   |
| **Current  liabilities:**                         |       |                      |       |   |   |   |   |   |   |
| Accounts payable                                  |       | $                         | 65         |   | $ | 173 |   | $ | — |   | $ | 238 |   |
| Accrued  liabilities and other                    |       | 191                       |       | 65 |   | — |   | 256 |   |
| Current portion  of long-term debt                |       | 345                       |       | — |   | — |   | 345 |   |
| Intercompany  payable                             |       | 200                       |       | — |   | (200 | ) | — |   |
| Other                                             |       | (3                        | )          | 3 |   | — |   | — |   |
| Total current  liabilities                        |       | 798                       |       | 241 |   | (200 | ) | 839 |   |
| **Long-term  debt**                               |       | 3,731                     |       | — |   | — |   | 3,731 |   |
| **Other  long-term liabilities**                  |       | 73                        |       | 25 |   | — |   | 98 |   |
| **Total  stockholders’ deficit**             |       | (2,890                    | )          | 334 |   | (334 | ) | (2,890 | ) |
| Total liabilities  and stockholders’ deficit |       | $                         | 1,712      |   | $ | 600 |   | $ | (534 | ) | $ | 1,778 |   |

 

15

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**SupplementalCondensed Consolidating Statement of Operations**

** **
| ** **                                                         | ** ** | **Quarter Ended May 3, 2008** | ** ** |
|--------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                         | ** ** | **Parent  Company**                               | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                         |       | **(in  millions)**                                |       |
|                                                               |       |                                              |       |   |   |   |   |   |   |
| **Net  sales**                                                     |       | $                                                 | 743        |   | 442 |   | $ | (338 | ) | $ | 847 |   |
| Cost of sales and  occupancy expense                               |       | 504                                               |       | 355 |   | (338 | ) | 521 |   |
| **Gross  profit**                                                  |       | 239                                               |       | 87 |   | — |   | 326 |   |
| Selling,  general, and administrative expense                      |       | 240                                               |       | 32 |   | — |   | 272 |   |
| Transaction  expenses                                              |       | —                                            |       | — |   | — |   | — |   |
| Related party  expenses                                            |       | 4                                                 |       | — |   | — |   | 4 |   |
| Store  pre-opening costs                                           |       | 2                                                 |       | — |   | — |   | 2 |   |
| **Operating  (loss) income**                                       |       | (7                                                | )          | 55 |   | — |   | 48 |   |
| Interest expense                                                   |       | 78                                                |       | — |   | — |   | 78 |   |
| Other (income)  and expense, net                                   |       | —                                            |       | — |   | — |   | — |   |
| Intercompany  charges (income)                                     |       | 17                                                |       | (17 | ) | — |   | — |   |
| Equity in  earnings of subsidiaries                                |       | 72                                                |       | — |   | (72 | ) | — |   |
| **Income  (loss) before income taxes and discontinued operations** |       | (30                                               | )          | 72 |   | (72 | ) | (30 | ) |
| Provision  (benefit) for income taxes                              |       | (10                                               | )          | 24 |   | (24 | ) | (10 | ) |
| **Income  (loss) before discontinued operations**                  |       | (20                                               | )          | 48 |   | (48 | ) | (20 | ) |
| Discontinued  operations loss, net of income tax                   |       | —                                            |       | — |   | — |   | — |   |
| **Net  income (loss)**                                             |       | $                                                 | (20        | ) | $ | 48 |   | $ | (48 | ) | $ | (20 | ) |
|                                                                    |            |                                                   |            |  |  |  |  |  |  |  |  |  |  |

 

**SupplementalCondensed Consolidating Statement of Operations**

** **
| ** **                                                         | ** ** | **Quarter Ended May 5, 2007** | ** ** |
|--------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                         | ** ** | **Parent  Company**                               | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                         | ** ** | **(in millions)**                                 | ** ** |
|                                                               |       |                                              |       |   |   |   |   |   |   |
| **Net  sales**                                                     |       | $                                                 | 742        |   | 408 |   | $ | (311 | ) | $ | 839 |   |
| Cost of sales  and occupancy expense                               |       | 497                                               |       | 327 |   | (311 | ) | 513 |   |
| **Gross  profit**                                                  |       | 245                                               |       | 81 |   | — |   | 326 |   |
| Selling,  general, and administrative expense                      |       | 223                                               |       | 31 |   | — |   | 254 |   |
| Transaction expenses                                               |       | 6                                                 |       | — |   | — |   | 6 |   |
| Related party  expenses                                            |       | 4                                                 |       | — |   | — |   | 4 |   |
| Store  pre-opening costs                                           |       | 1                                                 |       | 1 |   | — |   | 2 |   |
| **Operating  income**                                              |       | 11                                                |       | 49 |   | — |   | 60 |   |
| Interest expense                                                   |       | 95                                                |       | — |   | — |   | 95 |   |
| Other (income)  and expense, net                                   |       | —                                            |       | (3 | ) | — |   | (3 | ) |
| Intercompany  charges (income)                                     |       | 19                                                |       | (19 | ) | — |   | — |   |
| Equity in  earnings of subsidiaries                                |       | 71                                                |       | — |   | (71 | ) | — |   |
| **Income  (loss) before income taxes and discontinued operations** |       | (32                                               | )          | 71 |   | (71 | ) | (32 | ) |
| Provision  (benefit) for income taxes                              |       | (10                                               | )          | 22 |   | (22 | ) | (10 | ) |
| **Income  (loss) before discontinued operations**                  |       | (22                                               | )          | 49 |   | (49 | ) | (22 | ) |
| Discontinued operations  loss, net of income tax                   |       | (1                                                | )          | — |   | — |   | (1 | ) |
| **Net  income (loss)**                                             |       | $                                                 | (23        | ) | $ | 49 |   | $ | (49 | ) | $ | (23 | ) |
|                                                                    |            |                                                   |            |  |  |  |  |  |  |  |  |  |  |

 

16

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**SupplementalCondensed Consolidating Statement of Cash Flows**

 
| ** **                                 | ** ** | **Quarter Ended May 3, 2008** | ** ** |
|--------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                 | ** ** | **Parent  Company**                               | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                 | ** ** | **(in millions)**                            | ** ** |
| ** **                                 |       |                                              |       |   |   |   |   |   |   |
| **Operating  activities:**                 |       |                                              |       |   |   |   |   |   |   |
| Net cash used in  operating activities     |       | $                                                 | (100       | ) | $ | 53 |   | $ | (36 | ) | $ | (83 | ) |
|                                       |       |                                              |       |   |   |   |   |   |   |
| **Investing  activities:**                 |       |                                              |       |   |   |   |   |   |   |
| Cash paid for  property and equipment      |       | (16                                               | )          | (5 | ) | — |   | (21 | ) |
| Net cash used in  investing activities     |       | (16                                               | )          | (5 | ) | — |   | (21 | ) |
|                                       |       |                                              |       |   |   |   |   |   |   |
| **Financing  activities:**                 |       |                                              |       |   |   |   |   |   |   |
| Net borrowings  of long-term debt          |       | 105                                               |       | — |   | — |   | 105 |   |
| Intercompany  dividends                    |       | —                                            |       | (36 | ) | 36 |   | — |   |
| Other financing  activities                |       | 12                                                |       | — |   | — |   | 12 |   |
| Net cash  provided by financing activities |       | 117                                               |       | (36 | ) | 36 |   | 117 |   |
|                                       |       |                                              |       |   |   |   |   |   |   |
| **Increase  in cash and equivalents**      |       | 1                                                 |       | 12 |   | — |   | 13 |   |
| **Beginning  cash and cash equivalents**   |       | 26                                                |       | 3 |   | — |   | 29 |   |
| **Ending  cash and cash equivalents**      |       | $                                                 | 27         |   | $ | 15 |   | $ | — |   | $ | 42 |   |

 

**SupplementalCondensed Consolidating Statement of Cash Flows**

 
| ** **                                 | ** ** | **Quarter Ended May 5, 2007** | ** ** |
|--------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                 | ** ** | **Parent  Company**                               | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                 | ** ** | **(in millions)**                            | ** ** |
|                                       |       |                                              |       |   |   |   |   |   |   |
| **Operating  Activities:**                 |       |                                              |       |   |   |   |   |   |   |
| Net cash used in  operating activities     |       | $                                                 | (66        | ) | $ | 42 |   | $ | (27 | ) | $ | (51 | ) |
|                                       |       |                                              |       |   |   |   |   |   |   |
| **Investing  Activities:**                 |       |                                              |       |   |   |   |   |   |   |
| Cash paid for  property and equipment      |       | (27                                               | )          | (1 | ) | — |   | (28 | ) |
| Net cash used in  investing activities     |       | (27                                               | )          | (1 | ) | — |   | (28 | ) |
|                                       |       |                                              |       |   |   |   |   |   |   |
| **Financing  Activities:**                 |       |                                              |       |   |   |   |   |   |   |
| Net borrowings  of long-term debt          |       | 109                                               |       | — |   | — |   | 109 |   |
| Equity  investment of the Sponsors         |       | 4                                                 |       | — |   | — |   | 4 |   |
| Intercompany  dividends                    |       | —                                            |       | (27 | ) | 27 |   | — |   |
| Other financing  activities                |       | (19                                               | )          | — |   | — |   | (19 | ) |
| Net cash provided  by financing activities |       | 94                                                |       | (27 | ) | 27 |   | 94 |   |
| ** **                                 |       |                                              |       |   |   |   |   |   |   |
| **Increase  in cash and equivalents**      |       | 1                                                 |       | 14 |   | — |   | 15 |   |
| **Beginning  cash and cash equivalents**   |       | 27                                                |       | 3 |   | — |   | 30 |   |
| **Ending  cash and equivalents**           |       | $                                                 | 28         |   | $ | 17 |   | $ | — |   | $ | 45 |   |

 

17

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**Note10.  Subsequent Event**

 

On May 16, 2008, weexecuted a foreign currency cash flow hedge for a total notional value of $54.5million to mitigate the effects of currency fluctuations, as the functionalcurrency of our Canadian subsidiary is the Canadian dollar.  The term of this hedge begins on June 1,2008 and extends through the end of the first quarter of fiscal 2009. 

 

18

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

 

All expressions of the “Company”,“us,” “we,” “our,” and all similar expressions are references 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 similar expressions)that are not statements of historical fact should be considered forward-lookingstatements and should be read in conjunction with our consolidated financialstatements and related notes in our Annual Report on Form 10-K for thefiscal year ended February 2, 2008. Such forward-looking statements arebased upon management’s current knowledge and assumptions about future eventsand involve risks and uncertainties that could cause actual results,performance or achievements to be materially different from anticipatedresults, prospects, performance or achievements expressed or implied by suchforward-looking statements. Such risks and uncertainties include, but are notlimited to:

 

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

 

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

 

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

 

·                  how well we manage our business;

 

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

 

·                  improvements to our supply chain may not befully successful;

 

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

 

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

 

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

 

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

 

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

 

·                  our suppliers may fail us;

 

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

 

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

 

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

 

·                  our information systems may prove inadequate;

 

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

 

·                  competition could negatively impact our operations;and

 

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

 

For more details on factors that maycause actual results to differ materially from such forward-looking statements,please see Item 1A. Risk Factors of our Annual Report on Form 10-Kfor the fiscal year ended February 2, 2008, and other reports from time totime filed with or furnished to the SEC. We disclaim any intention to, andundertake no obligation to, update or revise any forward-looking statement.

 

**General**

 

We report on the basis ofa 52 or 53-week fiscal year, which ends on the Saturday closest to January 31.  All references herein to “fiscal 2008” relateto the 52 weeks ending January 31, 2009 and all references to “fiscal2007” relate to the 52 weeks ended February 2, 2008. In addition, allreferences herein to “the first quarter of fiscal 2008” relate to the 13 weeksended May 3, 2008 and all references to “the first quarter of fiscal 2007”relate to the 13 weeks ended May 5, 2007.

 

The following table setsforth certain of our unaudited operating data:

 
| ** **                                            | ** ** | **Quarter Ended** | ** ** |
|-------------------------------------------------------|------------|------------------------|------------|
| ** **                                            | ** ** | **May 3,**        | ** ** | **May 5,** | ** ** |
| ** **                                            | ** ** | **2008**               | ** ** | **2007** | ** ** |
| **Michaels  stores:**                                 |       |                   |       |   |   |
| Retail stores  open at beginning of period            |       | 963                    |       | 921 |   |
| Retail stores  opened during the period               |       | 17                     |       | 11 |   |
| Retail stores  opened (relocations) during the period |       | 3                      |       | 5 |   |
| Retail stores  closed during the period               |       | —                 |       | (3 | ) |
| Retail stores  closed (relocations) during the period |       | (3                     | )          | (5 | ) |
| Retail stores  open at end of period                  |       | 980                    |       | 929 |   |
|                                                  |       |                   |       |   |   |
| **Aaron  Brothers stores:**                           |       |                   |       |   |   |
| Retail stores  open at beginning of period            |       | 166                    |       | 166 |   |
| Retail stores  opened during the period               |       | —                 |       | 2 |   |
| Retail stores  closed during the period               |       | (2                     | )          | — |   |
| Retail stores  open at end of period                  |       | 164                    |       | 168 |   |
|                                                  |       |                   |       |   |   |
| Total store  count at end of period                   |       | 1,144                  |       | 1,097 |   |
|                                                  |       |                   |       |   |   |
| **Other  operating data:**                            |       |                   |       |   |   |
| Average  inventory per Michaels store (1)             |       | $                      | 808        |   | $ | 893 |   |
| Comparable store  sales decrease (2)                  |       | (2.9                   | )%         | (0.5 | )% |
|                                                       |            |                        |            |  |  |  |  |

 

----

| (1) | Average inventory per Michaels store calculation  excludes our Aaron Brothers stores. |
|-----|---------------------------------------------------------------------------------------|

 

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

 

**Results 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** | ** ** |
|-----------------------------------------------------------|------------|------------------------|------------|
| ** **                                                | ** ** | **May 3,**        | ** ** | **May 5,** | ** ** |
| ** **                                                | ** ** | **2008**               | ** ** | **2007** | ** ** |
| **Net  sales**                                            |       | 100.0                  | %          | 100.0 | % |
| Cost of sales  and occupancy expense                      |       | 61.5                   |       | 61.1 |   |
| **Gross  profit**                                         |       | 38.5                   |       | 38.9 |   |
| Selling,  general, and administrative expense             |       | 32.1                   |       | 30.3 |   |
| Transaction  expenses                                     |       | —                 |       | 0.7 |   |
| Related party  expenses                                   |       | 0.5                    |       | 0.5 |   |
| Store  pre-opening costs                                  |       | 0.2                    |       | 0.2 |   |
| **Operating  income**                                     |       | 5.7                    |       | 7.2 |   |
| Interest expense                                          |       | 9.2                    |       | 11.3 |   |
| Other (income)  and expense, net                          |       | —                 |       | (0.3 | ) |
| **Loss  before income taxes and discontinued operations** |       | (3.5                   | )          | (3.8 | ) |
| Income tax  benefit                                       |       | (1.1                   | )          | (1.2 | ) |
| **Loss  before discontinued operations**                  |       | (2.4                   | )          | (2.6 | ) |
| Discontinued  operations loss, net of income tax          |       | —                 |       | (0.1 | ) |
| **Net  loss**                                             |       | (2.4                   | )%         | (2.7 | )% |

 

*Quarter Ended May 3, 2008Compared to the Quarter Ended May 5, 2007*

 

*NetSales*—Net sales increased for the first quarter of fiscal2008 by $8 million, or 1.0%, over the first quarter of fiscal 2007. Theresults for the first quarter of fiscal 2008 include sales from 51 Michaelsstores that were opened during the 12-month period ended May 3, 2008.Non-comparable sales increased $32 million, while comparable store salesdecreased $24 million.

 

Comparable store salesdeclined 2.9% in the first quarter of fiscal 2008 compared to the first quarterof fiscal 2007, reflecting a decrease in average ticket of 2.8% and a decreasein customer transactions of 0.1%. The fluctuation in the exchange rates betweenthe United States and Canadian dollars positively impacted the average ticketchange by 100 basis points.  Comparablestore sales were also negatively impacted by the current soft macroeconomic andretail environments, particularly in home décor categories such as floral andgreenery.

 

We continue to develop afully integrated pricing and promotion strategy and may refine our existingstrategy in future periods.  Asignificant component of our pricing and promotion strategy involves changes inthe breadth and depth of our promotional programs.  Given the current soft macroeconomic andretail environments, sales declines could adversely affect operations due to adeleveraging of operating expenses.  As aresult, our historical trends may not be indicative of future results.

 

We continue to evaluateall options available to us for our Aaron Brothers concept; which range fromrefining the concept to possible store rationalization.  Certain of these options, if enacted, mayresult in material charges to our consolidated statement of operations infuture periods.

 

21

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*Cost ofSales and Occupancy Expense*—Cost of sales and occupancyexpense, as a percentage of net sales, increased approximately 40 basispoints in the first quarter of fiscal 2008 compared to the first quarter offiscal 2007. Merchandise margins decreased approximately 40 basis pointsprimarily due to a deleveraging of our distribution costs.

 

*Selling,General, and Administrative Expense*—Selling, general, andadministrative expense was $272 million, or 32.1% of net sales, in the firstquarter of fiscal 2008 compared to $254 million, or 30.3% of net sales, in thefirst quarter of fiscal 2007. As a percentage of net sales, selling, generaland administrative expense increased approximately 180 basis points primarilydue to planned in-store investments, decreased leverage associated with thedecline in comparable store sales and an increase in severance expense,partially offset by a reduction in consulting costs.

 

*TransactionExpenses*—Transaction expenses incurred during the firstquarter of fiscal 2007 related primarily to bonus arrangements associated withthe change in control that were ratably recognized for a period of one yearfollowing the Merger date.

 

*RelatedParty Expenses*—Related party expenses were $4 million in thefirst quarter of fiscal 2008 and fiscal 2007. These costs consist primarily of approximately $3 million of managementfees and associated expenses paid to our Sponsors and Highfields.  Also included in the related party expensesare approximately $1 million of amortization expense related to the SeparationAgreements as more fully described in Note 7 to the consolidated financialstatements.

 

*InterestExpense*—Interest expense for the quarter decreased $17million to $78 million as a result of significant decreases in our interestrates related our variable-rate debt, and a $97 million reduction in our totaldebt outstanding.

 

*Provisionfor Income Taxes*—The effective tax rate was 34.1% for thefirst quarter of fiscal 2008 and 32.3% for the first quarter of fiscal 2007. Weexpect the effective tax rate for fiscal 2008 to range from 40% - 45%.  The effective tax rate for the first quarterof fiscal 2008 was lower than our expected effective tax rate for the fiscalyear due to non-deductible severance costs recorded during the quarter.

 

**Liquidity and Capital Resources**

 

We require cashprincipally for day-to-day operations and to finance capital investments,inventory for new stores, inventory replenishment for existing stores, serviceour outstanding debt and seasonal working capital needs. We expect that ouravailable cash, cash flow generated from operating activities and fundsavailable under our Asset-based revolving credit facility will be sufficient tofund planned capital expenditures, working capital requirements, debtrepayments, debt service requirements and future growth throughout fiscal 2008.

 

*Cash Flow from Operating Activities*

 

Cash flow used inoperating activities during the first quarter of fiscal 2008 was $83 millioncompared to cash used in operating activities of $51 million during thefirst quarter of fiscal 2007. The $32 million change was primarily due togreater reductions in our accounts payable and accrued interest accounts in thefirst quarter of 2008.  The reduction inaccounts payable is primarily attributable to the timing of merchandise resetsand inventory purchases.

 

Average inventory perMichaels store (including supporting distribution centers) decreased 9.5% from May 5,2007 to May 3, 2008 primarily due to appropriate management of inventoryin light of the challenging sales environment, benefits from our Hybriddistribution method, and a favorable comparison against the timing of last year’smerchandise resets.  We expect average inventory perMichaels store at the end of fiscal 2008 to be flat to higher by approximately2% as compared to the end of fiscal 2007.

 

*Cash Flow used in InvestingActivities*

 

Cash flow used ininvesting activities was primarily the result of the following capitalexpenditure activities:

 

22

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| ** **                                          | ** ** | **Quarter Ended** | ** ** |
|-----------------------------------------------------|------------|------------------------|------------|
| ** **                                          | ** ** | **May 3,**        | ** ** | **May 5,** | ** ** |
| ** **                                          | ** ** | **2008 (1)**      | ** ** | **2007 (2)** | ** ** |
| ** **                                          | ** ** | **(in millions)** | ** ** |
| New and  relocated stores and stores not yet opened |       | $                      | 7          |   | $ | 6 |   |
| Existing stores                                     |       | 4                      |       | 7 |   |
| Distribution  system expansion                      |       | 1                      |       | 8 |   |
| Information  systems                                |       | 8                      |       | 6 |   |
| Corporate and  other                                |       | 1                      |       | 1 |   |
|                                                |       | $                      | 21         |   | $ | 28 |   |

 

----

| (1)    |   | In the first quarter of fiscal 2008, we incurred  capital expenditures related to the opening of 17 Michaels stores and the  relocation of three Michaels stores.                                  |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                               |
| (2)    |   | In the first quarter of fiscal 2007, we incurred  capital expenditures related to the opening of 11 Michaels and two Aaron  Brothers stores in addition to the relocation of five Michaels stores. |

 

*Cash Flow provided by FinancingActivities*

 

Cash flows from financingactivities are related primarily to borrowings and repayments under ourrevolving credit facility.  The borrowedamounts were primarily used to finance interest payments, accounts payable andcapital expenditures.  The Asset-basedrevolving credit facility provides senior secured financing of up to $1.0billion, subject to a borrowing base. As of May 3, 2008, the borrowingbase was $711 million with $477 million of unused availability.

** **

**Recent Accounting Pronouncements**

 

In September 2006,the Financial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards (“SFAS”) No. 157, *Fair Value Measurements*,which is intended to increase consistency and comparability in fair valuemeasurements by defining fair value, establishing a framework for measuringfair value and expanding disclosures about fair value measurements.  SFAS 157 was originally effective forfinancial statements issued for fiscal years beginning after November 15,2007, and interim periods within those fiscal years.  In November 2007, the FASB placed a oneyear deferral for the implementation of SFAS 157 for nonfinancial assets andliabilities; however, SFAS 157 is effective for fiscal years beginning after November 15,2007 for financial assets and liabilities, as well as for any other assets andliabilities that are carried at fair value on a recurring basis in financialstatements.  We adopted all requirementsof SFAS 157 as they relate to financial assets and liabilities on February 3,2008, with no impact on our consolidated financial statements.  The requirements related to nonfinancialassets and liabilities will be adopted on February 1, 2009, as allowed bySFAS 157. We have not yet determined the impact, if any, on our consolidatedfinancial statements for these nonfinancial assets and liabilities.

 

In February 2007,the FASB issued SFAS No. 159, *The Fair Value Option forFinancial Assets and Financial Liabilities*, which permits companiesto measure certain financial instruments and other items at fair value (atspecified measurement dates) that are not currently required to be measured atfair value. Any unrealized gains or losses applicable to those items measuredat fair value shall be reported in earnings. The decision to apply fair valueshall generally be made on an instrument by instrument basis, is irrevocable,and is applied only to an entire instrument. We adopted SFAS 159 on February 3,2008, and there was no impact on our consolidated financial statements as wedid not choose to measure any eligible financial assets or liabilities at fairvalue.

 

In December 2007,the FASB issued SFAS No. 141 (revised 2007), *Business Combinations*(“SFAS 141R”). SFAS 141R replaces SFASNo. 141, *Business Combinations*.The statement retains the purchase method of accounting used in businesscombinations but replaces SFAS 141 by establishing principles and requirementsfor the recognition and measurement of assets, liabilities and goodwill,including the requirement that most transaction costs and restructuring costsbe expensed. In addition, the statement requires disclosures to enable users toevaluate the nature and financial effects of the business combination. SFAS141R is effective for business combinations for which the acquisition date ison or after the 

 

23

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beginning of the first annual reporting periodbeginning on or after December 15, 2008. We will adopt SFAS 141R on February 1,2009 for acquisitions on or after this date.

 

In March 2008, theFASB issued SFAS No. 161, *Disclosuresabout Derivative Instruments and Hedging Activities – an amendment of FASBStatement No. 133*. SFAS 161 requires qualitative disclosuresabout objectives and strategies for using derivatives, quantitative data aboutthe fair value of and gains and losses on derivative contracts, and details ofcredit-risk-related contingent features in hedged positions. The statement alsorequires enhanced disclosures regarding how and why entities use derivativeinstruments, how derivative instruments and related hedged items are accountedfor in accordance with  SFAS 133 and itsrelated interpretation, and how derivative instruments and related hedged itemsaffect entity’s financial position, financial performance, and cash flows. SFAS161 is effective for fiscal years and interim periods beginning after November 15,2008. We will adopt the new disclosure requirements of SFAS 161 in the firstquarter of 2009.

 

**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, on May 16, 2008, we executed a foreign currency cash flowhedge for a total notional value of $54.5 million.  The term of this hedge begins on June 1,2008 and extends through the end of the first quarter of fiscal 2009.

 

**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 of1934). An evaluation was carried out under the supervision and with theparticipation of our management, including our Chief Executive Officer and ourChief Financial Officer, of the effectiveness of our disclosure controls andprocedures as of the end of the period covered by this Quarterly Report on Form 10-Q.Based on that evaluation, our Chief Executive Officer and our Chief FinancialOfficer concluded that our disclosure controls and procedures are effective toprovide reasonable assurance that information required to be disclosed in thereports that we file or submit under the Securities Exchange Act of 1934 isrecorded, processed, summarized, and reported within the time periods specifiedin SEC rules and forms. Such controls and procedures are designed toensure that information we are required to disclose in our reports isaccumulated and communicated to our management, including our principal executiveofficers and principal financial officer, to allow timely disclosure decisions.We note that the design of any system of controls is based, in part, uponcertain assumptions about the likelihood of future events, and there can be noassurance that any design will succeed in achieving its stated goals under allpotential future conditions.

 

*Change in Internal Control OverFinancial Reporting*

 

There has not been anychange in our internal control over financial reporting (as defined in Rules 13a-15(f)and 15d-15(f) as promulgated by the SEC under the Securities Exchange Act of1934) during the quarter covered by this Quarterly Report on Form 10-Q thatmaterially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

 

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**MICHAELSSTORES, INC.**

**Part II—OTHER INFORMATION**

 

**Item 1.  Legal Proceedings.**

 

Information regardinglegal proceedings is incorporated herein by reference from Note 6 to ourConsolidated Financial Statements.

 

**Item 1A. Risk Factors.**

 

Information regarding the Company’s risk factorsappears in Item 1A. Risk Factors disclosed in our Annual Report on Form 10-Kfor the fiscal year ended February 2, 2008.

 

There have been no material changes from the riskfactors previously disclosed in our Annual Report on Form 10-K for thefiscal year ended February 2, 2008 other than to the risk factor entitled “*Our Success Will Depend on How Well We Manage OurBusiness*.*” *Theamended risk factor is set forth below:

 

*Our Success Will Depend on How Well WeManage Our Business*

 

Even if we are able to substantially continueour strategy of expanding our store base, or additionally, to expand ourbusiness through acquisitions or vertical integration opportunities, we mayexperience problems, which may prevent any significant increase inprofitability or negatively impact our cash flow. For example:

 

·                  thecosts of opening and operating new stores may offset the increased salesgenerated by the additional stores;

 

·                  theclosure of unsuccessful stores may result in the retention of liability forexpensive leases;

 

·                  asignificant portion of our management’s time and energy may be consumed withissues unrelated to advancing our core business strategy, which could possiblyresult in a deterioration of our operating results;

 

·                  ourexpansion may outpace our planned technological advances and current systemswith the possible consequences of breakdowns in our supply chain management andreduced effectiveness of our operational systems and controls;

 

·                  theimplementation of future operational efficiency******initiatives, which may include theconsolidation of certain operations and/or the possible outsourcing of selectedfunctions, may not produce the desired reduction in costs and may result indisruptions arising from such actions;

 

·                  wemay be unable to hire, train, and retain qualified employees, includingmanagement and senior executives;

 

·                  failureto maintain stable relations with our labor force could possibly result in adeterioration of our operating results;

 

·                  oursuppliers may be unable to meet the increased demand of additional stores in atimely manner; and

 

·                  wemay be unable to expand our existing distribution centers or use third-partydistribution centers on a cost-effective basis to provide merchandise for saleby our new stores.

 

**Item 5.  OtherInformation**

 

On June 6, 2008, Michaels announced that ShelleyG. Broader is joining the Company as its President & Chief OperatingOfficer effective June 23, 2008. Since March 2006, Ms. Broader, 44, has served as President andChief Executive Officer of SweetbaySupermarkets, Inc., formerly doing business as Kash n’ Karry FoodStores, Inc., part of the U.S. division of Brussels basedDelhaize Group.  Ms. Broaderpreviously served as President and Chief Operating Officer of SweetbaySupermarkets from June 2003 to March 2006. Prior to joining SweetbaySupermarkets, Ms Broader served in various management positions at Hannaford Bros. Co. fromApril 1991 to June 2003, most recently as Senior Vice President, 

 

25

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BusinessStrategy, Marketing and Communications.  She currently serves on the Board ofDirectors, and is a member of the Audit Committee, of Raymond James Financial, Inc., listed on the New York StockExchange.  Ms. Broader holds a B.A.from Washington State University.

 

On May 19, 2008, Michaels entered into an offerletter agreement (the “Letter Agreement”) with Ms. Broader which providesfor compensation and related benefits to Ms. Broader during her employmentwith the Company.  Ms. Broader willreceive an annualized basesalary of $625,000, subject to increase, and will be eligible for a fiscal year2008 bonus with a target equal to 70% and a maximum payout of 140% of her prorated base salary.  Ms. Broader’sbonus for fiscal year 2008 is guaranteed at the target level of $255,208. Ms. Broaderwill also receive a one-time (net) sign-on bonus of $500,000, and a restrictedstock award of 54,134 shares of common stock with 20% vesting on each of thefirst five anniversaries from the date of grant (vesting would accelerate inthe event of Ms. Broader’s death or disability). Under the LetterAgreement, Ms. Broader’s employment with the Company is at-will.

 

Ms. Broader will also receive an option topurchase 567,648 shares of common stock which will be divided into six trancheswith exercise prices to be determined on the date of grant, each tranchevesting 20% on each of the first five anniversaries from the commencement dateof her employment with Michaels.

 

The foregoing description of the Letter Agreement isqualified in its entirety by the terms of such Letter Agreement, which is filedas Exhibit 10.4 hereto and is incorporated by reference to this QuarterlyReport on Form 10-Q.

 

No arrangement or understanding existsbetween Ms. Broader and any other person pursuant to which Ms. Broaderwas selected as an officer of the Company.

 

There is no family relationship betweenany director, executive officer, or person nominated or chosen by the Companyto become a director or executive officer of the Company and Ms. Broader. ** **In addition, except for execution ofLetter Agreement, since the beginning of the Company’s last fiscal year, therehas been no transaction (or series of transactions), and there is no currentlyproposed transaction (or series of transactions), to which the Company was oris to be a party, in which the amount involved exceeds $120,000 and in which Ms. Broaderor any member of her immediate family had or will have a direct or indirectmaterial interest.

 

**Item 6.  Exhibits.**

 

(a) Exhibits:

 
| **Exhibit  Number** | ** ** | **Description of Exhibit**                                                                                                                 |
|---------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1                |       | Form of Fiscal Year 2008 Bonus Plan (filed  herewith).                                                                                |
|                |       |                                                                                                                                       |
| 10.2                |       | Michaels Stores, Inc. Officer Severance Pay  Plan (filed herewith).                                                                   |
|                |       |                                                                                                                                       |
| 10.3                |       | Form of Restricted Stock Award Agreement under the  Michaels Stores, Inc. 2006 Equity Incentive Plan (filed herewith).                     |
|                |       |                                                                                                                                       |
| 10.4                |       | Letter Agreement, dated May 19, 2008, between  Michaels Stores, Inc. and Shelley G. Broader (filed herewith).                         |
|                |       |                                                                                                                                       |
| 10.5                |       | Separation and Release Agreement, dated May 27,  2008, between Michaels Stores, Inc. and Harvey S. Kanter (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 Lisa K. Klinger pursuant to §302  of the Sarbanes-Oxley Act of 2002 (filed herewith).                               |
|                |       |                                                                                                                                       |
| 32.1                |       | Certification pursuant to 18 U.S.C. §1350, as  adopted pursuant to §906 of the Sarbanes-Oxley Act of 2002 (filed herewith). |

 

26

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**MICHAELS STORES, INC.**

**SIGNATURES**

 

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

 
|   | MICHAELS STORES, INC. |
|--------|-----------------------|
|   |                  |   |
|   | By:                   | /s/ Lisa K. Klinger |
|   |                  | Lisa K. Klinger |
|   |                  | Senior Vice President – Finance and Treasurer,

Acting Chief Financial Officer |
|   |                  | (Principal Financial Officer) |

 

Dated: June 6,2008

 

27

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**INDEX TO EXHIBITS**

 
| **Exhibit  Number** | ** ** | **Description of Exhibit**                                                                                                                 |
|---------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1                |       | Form of Fiscal Year 2008 Bonus Plan (filed  herewith).                                                                                |
|                |       |                                                                                                                                       |
| 10.2                |       | Michaels Stores, Inc. Officer Severance Pay  Plan (filed herewith).                                                                   |
|                |       |                                                                                                                                       |
| 10.3                |       | Form of Restricted Stock Award Agreement under the  Michaels Stores, Inc. 2006 Equity Incentive Plan (filed herewith).                     |
|                |       |                                                                                                                                       |
| 10.4                |       | Letter Agreement, dated May 19, 2008, between  Michaels Stores, Inc. and Shelley G. Broader (filed herewith).                         |
|                |       |                                                                                                                                       |
| 10.5                |       | Separation and Release Agreement, dated May 27,  2008, between Michaels Stores, Inc. and Harvey S. Kanter (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 Lisa K. Klinger pursuant to §302  of the Sarbanes-Oxley Act of 2002 (filed herewith).                               |
|                |       |                                                                                                                                       |
| 32.1                |       | Certification pursuant to 18 U.S.C. §1350, as  adopted pursuant to §906 of the Sarbanes-Oxley Act of 2002 (filed herewith). |

 

28

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