**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 October 28, 2006** |
| ** **     | ** ** | ** ** |
|           | OR |
|           |   |   |
| **o**          | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| ** **     | ** ** | ** ** |
|           | **For the transition period from                    to                 ** |

 

**Commission file number 001-09338**

 

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**MICHAELSSTORES, INC.**

(Exact name of registrant as specified in its charter)

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

 

**8000 Bent Branch Drive**

**Irving, Texas 75063**

**P.O. Box 619566**

**DFW, Texas 75261-9566**

(Address of principal executive offices, including zip code)

 

**(972) 409-1300**

(Registrant’s telephone number, including area code)

 

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Indicate bycheck mark whether the Registrant: (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of 1934during the preceding 12 months (or for such shorter period that theRegistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days.  Yes **x     **No**o**

 

Indicate bycheck mark whether the Registrant is a large accelerated filer, an acceleratedfiler, or a non-accelerated filer. See definition of “accelerated filer andlarge accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

 

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

 

Indicate bycheck mark whether the Registrant is a shell company (as defined inRule 12b-2 of the Exchange Act).  Yes **o     **No **x**

 

Indicate thenumber of shares outstanding of each of the Registrant’s classes of CommonStock, as of the latest practicable date.

 

| **Title**                              | ** ** | **Shares  Outstanding as of****October 31, 2006** |
|----------------------------------------|------------|---------------------------------------------------|
| Common Stock, par value $.10 per share |       | 137,147,914                                       |

 

 

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**MICHAELS STORES, INC.**

**FORM 10-Q**

 

**Part I—FINANCIALINFORMATION**
| **Item 1.** | ** ** | **Financial Statements**                                                                                                    |   |   |
|------------------|------------|-----------------------------------------------------------------------------------------------------------------------------|--------|--------|
|             |       | Consolidated  Balance Sheets at October 28, 2006, January 28, 2006, and October 29,  2005 (unaudited)                  |   |   |
|             |       | Consolidated Statements of Income for the  quarter and nine months ended October 28, 2006 and October 29, 2005  (unaudited) |   |   |
|             |       | Consolidated Statements of Cash Flows for  the nine months ended October 28, 2006 and October 29, 2005 (unaudited)          |   |   |
|             |       | Notes to  Consolidated Financial Statements (unaudited)                                                                     |   |   |
| **Item 2.** | ** ** | **Management’s Discussion and Analysis of  Financial Condition and Results of Operations**                             |   |   |
| **Item 3.** | ** ** | **Quantitative and Qualitative Disclosures  About Market Risk**                                                             |   |   |
| **Item 4.** | ** ** | **Controls and Procedures**                                                                                                 |   |   |

**Part II—OTHER INFORMATION**
| **Item 1.**  | ** ** | **Legal Proceedings** |   |   |
|-------------------|------------|-----------------------|--------|--------|
| **Item 1A.** | ** ** | **Risk Factors**      |   |   |
| **Item 6.**  | ** ** | **Exhibits**          |   |   |
| **Signatures**    |       |                  |   |   |

 

2

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** **

**MICHAELS STORES, INC.**

**Part I—FINANCIAL INFORMATION**

 

**Item 1.  FinancialStatements.**

 

**MICHAELS STORES, INC.**

**CONSOLIDATED BALANCE SHEETS**

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

**(Unaudited)**

 
| ** **                                                                                                                                                                                                                                                                                              | ** ** | **October 28,** | ** ** | **January 28,** | ** ** | **October 29,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------|------------|----------------------|------------|----------------------|------------|
| ** **                                                                                                                                                                                                                                                                                              | ** ** | **2006**             | ** ** | **2006**             | ** ** | **2005**             | ** ** |
|                                                                                                                                                                                                                                                                                                    |       |                 |       |                 |       |                 |       |
| **ASSETS**                                                                                                                                                                                                                                                                                              |       |                 |       |                 |       |                 |       |
| **Current assets:**                                                                                                                                                                                                                                                                                     |       |                 |       |                 |       |                 |       |
| Cash and equivalents                                                                                                                                                                                                                                                                                    |       | $                    | 315,249    |                 | $          | 452,449              |       | $ | 112,517 |   |
| Merchandise inventories                                                                                                                                                                                                                                                                                 |       | 979,600              |       | 784,032              |       | 1,046,990            |       |
| Prepaid expenses and other                                                                                                                                                                                                                                                                              |       | 52,425               |       | 44,042               |       | 49,033               |       |
| Deferred and prepaid income taxes                                                                                                                                                                                                                                                                       |       | 36,692               |       | 34,125               |       | 94,021               |       |
| Total current assets                                                                                                                                                                                                                                                                                    |       | 1,383,966            |       | 1,314,648            |       | 1,302,561            |       |
| **Property and equipment, at cost**                                                                                                                                                                                                                                                                     |       | 1,108,575            |       | 1,011,201            |       | 990,171              |       |
| Less accumulated depreciation                                                                                                                                                                                                                                                                           |       | (661,611             | )          | (586,382             | )          | (571,554             | )          |
|                                                                                                                                                                                                                                                                                                    |       | 446,964              |       | 424,819              |       | 418,617              |       |
| **Goodwill**                                                                                                                                                                                                                                                                                            |       | 115,839              |       | 115,839              |       | 115,839              |       |
| **Other assets**                                                                                                                                                                                                                                                                                        |       | 24,119               |       | 20,249               |       | 18,362               |       |
|                                                                                                                                                                                                                                                                                                    |       | 139,958              |       | 136,088              |       | 134,201              |       |
| Total assets                                                                                                                                                                                                                                                                                            |       | $                    | 1,970,888  |                 | $          | 1,875,555            |       | $ | 1,855,379 |   |
|                                                                                                                                                                                                                                                                                                    |       |                 |       |                 |       |                 |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                                                                                          |       |                 |       |                 |       |                 |       |
| **Current liabilities:**                                                                                                                                                                                                                                                                                |       |                 |       |                 |       |                 |       |
| Accounts payable                                                                                                                                                                                                                                                                                        |       | $                    | 244,981    |                 | $          | 193,595              |       | $ | 253,034 |   |
| Accrued liabilities and other                                                                                                                                                                                                                                                                           |       | 277,725              |       | 282,499              |       | 259,154              |       |
| Income taxes payable                                                                                                                                                                                                                                                                                    |       | —               |       | 20,672               |       | —               |       |
| Total current liabilities                                                                                                                                                                                                                                                                               |       | 522,706              |       | 496,766              |       | 512,188              |       |
| **Deferred income taxes**                                                                                                                                                                                                                                                                               |       | —               |       | 2,803                |       | 17,437               |       |
| **Other long-term liabilities**                                                                                                                                                                                                                                                                         |       | 90,586               |       | 88,637               |       | 85,582               |       |
| Total long-term liabilities                                                                                                                                                                                                                                                                             |       | 90,586               |       | 91,440               |       | 103,019              |       |
|                                                                                                                                                                                                                                                                                                    |       | 613,292              |       | 588,206              |       | 615,207              |       |
| **Commitments and contingencies**                                                                                                                                                                                                                                                                       |       |                 |       |                 |       |                 |       |
| **Stockholders’ equity:**                                                                                                                                                                                                                                                                          |       |                 |       |                 |       |                 |       |
| Preferred Stock, $0.10 par value, 2,000,000  shares authorized; none issued                                                                                                                                                                                                                             |       | —               |       | —               |       | —               |       |
| Common Stock, $0.10 par value, 350,000,000  shares authorized; 136,313,415 shares issued and 133,547,015 shares  outstanding at October 28, 2006, 133,821,417 shares issued and 132,986,517  shares outstanding at January 28, 2006, and 134,800,844 shares issued and outstanding  at October 29, 2005 |       | 13,631               |       | 13,382               |       | 13,480               |       |
| Additional paid-in capital                                                                                                                                                                                                                                                                              |       | 458,630              |       | 386,627              |       | 411,023              |       |
| Retained earnings                                                                                                                                                                                                                                                                                       |       | 971,389              |       | 907,773              |       | 803,889              |       |
| Treasury Stock (2,766,400 shares at October  28, 2006, 834,900 shares at January 28, 2006, and none at October 29, 2005)                                                                                                                                                                                |       | (94,127              | )          | (27,944              | )          | —               |       |
| Accumulated other comprehensive income                                                                                                                                                                                                                                                                  |       | 8,073                |       | 7,511                |       | 11,780               |       |
| Total stockholders’ equity                                                                                                                                                                                                                                                                         |       | 1,357,596            |       | 1,287,349            |       | 1,240,172            |       |
| Total liabilities and stockholders’ equity                                                                                                                                                                                                                                                         |       | $                    | 1,970,888  |                 | $          | 1,875,555            |       | $ | 1,855,379 |   |

 

See accompanying notes to consolidated financial statements.

 

3

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**MICHAELS STORES, INC.**

**CONSOLIDATED STATEMENTS OF INCOME**

**(In thousands, except per share data)**

**(Unaudited)**

 
| ** **                                                                  | ** ** | **Quarter Ended** | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------------------------------------|------------|------------------------|------------|---------------------------------|------------|
| ** **                                                                  | ** ** | **October 28,**   | ** ** | **October 29,**            | ** ** | **October 28,** | ** ** | **October 29,** | ** ** |
| ** **                                                                  | ** ** | **2006**               | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Net sales**                                                               |       | $                      | 896,080    |                            | $          | 839,663 |   | $ | 2,496,825 |   | $ | 2,406,172 |   |
| Cost of sales and occupancy expense                                         |       | 575,075                |       | 535,155                         |       | 1,582,126 |   | 1,519,622 |   |
| **Gross profit**                                                            |       | 321,005                |       | 304,508                         |       | 914,699 |   | 886,550 |   |
| ** **                                                                  |       |                   |       |                            |       |   |   |   |   |
| Selling, general, and administrative  expense                               |       | 263,884                |       | 251,235                         |       | 747,800 |   | 702,233 |   |
| Store pre-opening costs                                                     |       | 1,684                  |       | 2,456                           |       | 4,642 |   | 6,650 |   |
| **Operating income**                                                        |       | 55,437                 |       | 50,817                          |       | 162,257 |   | 177,667 |   |
| ** **                                                                  |       |                   |       |                            |       |   |   |   |   |
| Interest expense                                                            |       | 225                    |       | 226                             |       | 649 |   | 20,813 |   |
| Other (income) and expense, net                                             |       | (2,716                 | )          | (3,038                          | )          | (13,207 | ) | (8,088 | ) |
| **Income before income taxes and cumulative  effect of accounting  change** |       | 57,928                 |       | 53,629                          |       | 174,815 |   | 164,942 |   |
| ** **                                                                  |       |                   |       |                            |       |   |   |   |   |
| Provision for income taxes                                                  |       | 21,868                 |       | 20,382                          |       | 65,993 |   | 62,680 |   |
| **Income before cumulative effect of  accounting change**                   |       | 36,060                 |       | 33,247                          |       | 108,822 |   | 102,262 |   |
| Cumulative effect of accounting change, net  of income tax of $54.2 million |       | —                 |       | —                          |       | — |   | 88,488 |   |
| **Net income**                                                              |       | $                      | 36,060     |                            | $          | 33,247 |   | $ | 108,822 |   | $ | 13,774 |   |
|                                                                        |       |                   |       |                            |       |   |   |   |   |
| **Basic earnings per common share:**                                        |       |                   |       |                            |       |   |   |   |   |
| Income before cumulative effect of  accounting change                       |       | $                      | 0.27       |                            | $          | 0.25 |   | $ | 0.82 |   | $ | 0.75 |   |
| Cumulative effect of accounting change, net  of income tax                  |       | —                 |       | —                          |       | — |   | (0.65 | ) |
| Net income                                                                  |       | $                      | 0.27       |                            | $          | 0.25 |   | $ | 0.82 |   | $ | 0.10 |   |
|                                                                        |       |                   |       |                            |       |   |   |   |   |
| **Diluted earnings per common share:**                                      |       |                   |       |                            |       |   |   |   |   |
| Income before cumulative effect of  accounting change                       |       | $                      | 0.27       |                            | $          | 0.24 |   | $ | 0.81 |   | $ | 0.74 |   |
| Cumulative effect of accounting change, net  of income tax                  |       | —                 |       | —                          |       | — |   | (0.64 | ) |
| Net income                                                                  |       | $                      | 0.27       |                            | $          | 0.24 |   | $ | 0.81 |   | $ | 0.10 |   |
|                                                                        |       |                   |       |                            |       |   |   |   |   |
| Dividends declared per common share                                         |       | $                      | 0.12       |                            | $          | 0.10 |   | $ | 0.34 |   | $ | 0.27 |   |

 

See accompanying notes to consolidated financial statements.

 

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** **

**MICHAELS STORES, INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(In thousands)**

**(Unaudited)**

 
| ** **                                                      | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                      | ** ** | **October 28,**            | ** ** | **October 29,** | ** ** |
| ** **                                                      | ** ** | **2006**                        | ** ** | **2005** | ** ** |
| **Operating activities:**                                       |       |                            |       |   |   |
| Net income                                                      |       | $                               | 108,822    |   | $ | 13,774 |   |
| Adjustments:                                                    |       |                            |       |   |   |
| Depreciation                                                    |       | 84,778                          |       | 72,656 |   |
| Amortization                                                    |       | 281                             |       | 292 |   |
| Share-based compensation                                        |       | 15,557                          |       | 23,578 |   |
| Tax benefits from stock options exercised                       |       | (20,740                         | )          | (18,892 | ) |
| Non-cash charge for the cumulative effect  of accounting change |       | —                          |       | 142,723 |   |
| Loss from early extinguishment of debt                          |       | —                          |       | 12,136 |   |
| Other                                                           |       | 226                             |       | 389 |   |
| Changes in assets and liabilities:                              |       |                            |       |   |   |
| Merchandise inventories                                         |       | (195,818                        | )          | (251,848 | ) |
| Prepaid expenses and other                                      |       | (9,166                          | )          | (22,420 | ) |
| Deferred income taxes and other                                 |       | (8,106                          | )          | (14,429 | ) |
| Accounts payable                                                |       | 29,342                          |       | (3,232 | ) |
| Accrued liabilities and other                                   |       | 13,354                          |       | 20,640 |   |
| Income taxes payable                                            |       | (2,471                          | )          | (66,431 | ) |
| Other long-term liabilities                                     |       | 2,984                           |       | 10,265 |   |
| Net cash provided by (used in) operating  activities            |       | 19,043                          |       | (80,799 | ) |
|                                                            |       |                            |       |   |   |
| **Investing activities:**                                       |       |                            |       |   |   |
| Additions to property and equipment                             |       | (107,679                        | )          | (85,785 | ) |
| Purchases of short-term investments                             |       | —                          |       | (226 | ) |
| Sales of short-term investments                                 |       | —                          |       | 50,605 |   |
| Net proceeds from sales of property and  equipment              |       | 14                              |       | — |   |
| Net cash used in investing activities                           |       | (107,665                        | )          | (35,406 | ) |
|                                                            |       |                            |       |   |   |
| **Financing activities:**                                       |       |                            |       |   |   |
| Repayment of Senior Notes                                       |       | —                          |       | (209,250 | ) |
| Cash dividends paid to stockholders                             |       | (42,563                         | )          | (32,670 | ) |
| Repurchase of Common Stock                                      |       | (66,182                         | )          | (119,133 | ) |
| Proceeds from stock options exercised                           |       | 35,608                          |       | 32,285 |   |
| Tax benefits from stock options exercised                       |       | 20,740                          |       | 18,892 |   |
| Proceeds from issuance of Common Stock and  other               |       | 1,804                           |       | 2,746 |   |
| Change in cash overdraft                                        |       | 2,015                           |       | — |   |
| Net cash used in financing activities                           |       | (48,578                         | )          | (307,130 | ) |
|                                                            |       |                            |       |   |   |
| **Net decrease in cash and equivalents**                        |       | (137,200                        | )          | (423,335 | ) |
| **Cash and equivalents at beginning of period**                 |       | 452,449                         |       | 535,852 |   |
| **Cash and equivalents at end of period**                       |       | $                               | 315,249    |   | $ | 112,517 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

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** **

**MICHAELS STORES, INC.**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

**For the Nine Months Ended October28, 2006**

**(Unaudited)**

** **

**Note 1.  Summaryof Significant Accounting Policies**

 

*Basis of Presentation*

 

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

 

The accompanyingunaudited consolidated financial statements have been prepared in accordancewith U.S. generally accepted accounting principles for interim financialinformation and with the instructions to Form 10-Q and Article 10 ofRegulation S-X. Accordingly, they do not include all of the informationand notes required by generally accepted accounting principles for completefinancial statements. In the opinion of management, all adjustments (consistingof normal recurring accruals and other items, as disclosed) considerednecessary for a fair presentation have been included. Because of the seasonalnature of our business, the results of operations for the quarter ended October28, 2006 are not indicative of the results to be expected for the entire year.

 

The balancesheet at January 28, 2006 has been derived from the audited financialstatements at that date but does not include all of the information and notesrequired by generally accepted accounting principles for complete financialstatements. For further information, refer to the consolidated financialstatements and notes thereto included in our Annual Report on Form 10-Kfor the fiscal year ended January 28, 2006.

 

All referencesherein to “fiscal 2006” relate to the 53 weeks ending February 3,2007 and all references to “fiscal 2005” relate to the 52 weeks endedJanuary 28, 2006. In addition, all references herein to “the third quarterof fiscal 2006” and “the first nine months of fiscal 2006” relate to the 13 and39 weeks ended October 28, 2006, respectively, and all references to “thethird quarter of fiscal 2005” and “first nine months of fiscal 2005” relate tothe 13 and 39 weeks ended October 29, 2005, respectively.

 

Amounts as ofand for the three and nine months ended October 29, 2005 were restated toreflect weighted average cost accounting for inventory and the impact ofexpensing stock options under SFAS No. 123(R). The changes to ouraccounting policies are more fully described in Note 2 to these financialstatements.

 

*Consolidation*

 

Our consolidatedfinancial statements include the accounts of Michaels Stores, Inc. and allwholly-owned subsidiaries. All intercompany balances and transactions have beeneliminated.

 

*Estimates*

 

Thepreparation of financial statements in conformity with U.S. generally acceptedaccounting principles requires us to make estimates and assumptions that affectthe amounts reported in the consolidated financial statements and accompanyingnotes. Actual results could differ from those estimates.

 

*Foreign Currency Translation*

 

Translationadjustments result from translating our Canadian subsidiary’s financialstatements into U.S. dollars. Balance sheet accounts are translated at exchangerates in effect at the balance sheet date. Income statement accounts aretranslated at average exchange rates during the year. Resulting translationadjustments are recorded as a component of accumulated other comprehensiveincome/(loss) in our Consolidated Statements of Stockholders’ Equity.

 

*Cash and Equivalents*

 

Cash andequivalents are comprised of highly liquid instruments with original maturitiesof three months or less. Cash equivalents are carried at cost, whichapproximates fair value. We record interest income earned from our cash andequivalents as a component of other income and expense, net, in our financialstatements.

 

6

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*Merchandise Inventories*

 

We value ourmerchandise inventories at Michaels stores at the lower of average cost ormarket, with cost determined using a weighted average inventory method. Weutilize perpetual inventory records to value inventory in our Michaels stores.Physical inventory counts are performed in a significant number of stores atthe end of each fiscal quarter by a third party inventory counting service firm,with substantially all stores open longer than one year subject to at least oneannual count. We adjust our perpetual records based on the results of thephysical counts.

 

Cost iscalculated based upon the actual landed cost of an item at the time it isreceived by us using actual vendor invoices and also includes the cost ofwarehousing, handling, purchasing, and transporting the inventory to thestores. Vendor allowances, which primarily represent volume rebates andcooperative advertising funds, are recorded as a reduction of the cost of themerchandise inventories. The cost of warehousing, handling, purchasing, andtransporting, and the vendor allowances are recognized through cost of salesbased on our estimates of when the inventories are sold.

 

We maintain aprovision for estimated shrinkage based on the actual historical results of ourphysical inventories. We compare these estimates to the actual results of thephysical inventory counts as they are taken and adjust our shrink estimatesaccordingly. We also record adjustments to the value of inventory equal to thedifference between the carrying value and the estimated market value, based onassumptions about future demand.

 

We value theinventory in our distribution centers, Aaron Brothers stores, Star DecoratorsWholesale stores, and custom framing operations at the lower of average cost ormarket, with cost determined using a weighted average cost method. The cost ofinventory also includes certain costs associated with the warehousing, handling,purchasing, and transporting of the inventory.

 

*Property and Equipment*

 

Property andequipment is recorded at cost. Depreciation is recorded on a straight-linebasis over the estimated useful lives of the assets. We expense repairs andmaintenance costs as incurred. We capitalize and depreciate significantrenewals or betterments that substantially extend the life of the asset. Usefullives are generally estimated as follows (in years):

 
| Buildings              |   | 30 |   |
|------------------------|--------|----|--------|
| Leasehold improvements |   | 10 |   |
| Fixtures and equipment |   | 8  |   |
| Computer equipment     |   | 5  |   |

 

*Goodwill*

 

Under theprovisions of SFAS No. 142, *Goodwill andOther Intangible Assets,* we do not amortize goodwill, but insteadperform annual (or, under certain circumstances, more frequent) impairmenttests. We use discounted cash flow models to determine the fair value of ourreporting units for purposes of our annual impairment tests.

 

*Impairment of Long-Lived Assets*

 

Weperiodically review long-lived assets for impairment by comparing the carryingvalue of the assets with their estimated future undiscounted cash flows. If itis determined that an impairment loss has occurred, the loss would berecognized during that period. The impairment loss is calculated as thedifference between asset carrying values and the present value of estimated netcash flows or comparable market values, giving consideration to recentoperating performance and pricing trends.

 

7

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** **

*Reserve for Closed Facilities*

 

We maintain areserve for future rental obligations, carrying costs, and other closing costsrelated to closed facilities, primarily closed and relocated stores. Inaccordance with the provisions of SFAS No. 146, *Costs Associated With Disposal Activities*,**we recognize exit costs for any store closures at the timethe store is closed.

 

The cost ofclosing a store or facility is calculated based on management’s estimate ofcosts to exit the lease, which generally represents the lesser of the presentvalue of future rental obligations remaining under the lease (less estimatedsublease rental income) or the lease termination fee. Once a store has beenidentified for closure, we accelerate the remaining depreciation so the assetsare fully depreciated at the date of closure.

 

*Insurance Liabilities*

 

We use acombination of insurance and self-insurance for our workers’ compensation,general liability, and employee-related health care plans. We pay premiums forthese coverages, a portion of which are paid by our associates for health carecosts. In addition, under our self-insurance, we pay all claims up to thelimits provided for in our contracts. Liabilities associated with these plansare actuarially estimated, giving consideration to historical claims experienceand industry trends. In the event our insurance carriers are unable to payclaims submitted to them, we would record a liability for such estimatedpayments we expect to incur.

 

*Revenue Recognition*

 

Revenue fromsales of our merchandise is recognized at the time of the merchandise sale,excluding revenue from the sale of custom frames, which is recognized at thetime of delivery. Revenue is presented net of sales taxes collected. We allowfor merchandise to be returned under most circumstances and provide a reservefor estimated returns.

 

We record agift card liability on the date we issue the gift card to the customer. Werecord revenue and reduce the gift card liability as the customer redeems thegift card. We escheat the value of unredeemed gift cards where required by law.Any remaining liabilities not subject to escheatment are evaluated to determinewhether the likelihood of the gift card being redeemed is remote (gift cardbreakage). We recognize gift card breakage as revenue, by applying our estimateof the rate of gift card breakage to the amount we expect will go unused andnot subject to escheatment, over the period of estimated performance. Ourestimates of the gift card breakage rate are based on customers’ historicalredemption rates and patterns, which may not be indicative of future redemptionrates and patterns.

 

*Costs of Sales and Occupancy Expenses*

 

Included inour costs of sales are the following:

 

• purchaseprice or invoiced cost of merchandise, net of vendor allowances and rebates,

• inbound freight, inspection costs, andduties,

•warehousing, handling, transportation, and distribution costs (includinginternal transfer costs such as DC to store freight costs) and purchasing andreceiving costs, and

• share-based compensation costs.

 

These costsare included in merchandise inventories and expensed as the merchandise issold.

 

Included inour occupancy expenses are the following:

 

• storeexpenses such as rent, insurance, taxes, common area maintenance, utilities,repairs and maintenance,

• amortization of store buildings and leaseholdimprovements, and

• store closure costs

 

8

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We record rentexpense ratably over the term of the lease beginning with the date we takepossession of or control the physical access to the premises. We recordleasehold improvement reimbursements as a liability and ratably accrete theliability as a reduction to rent expense over the lease term beginning with thedate we take possession of or control the physical access to the premises.

 

*Selling, General, and Administrative Costs*

 

Included inour selling, general, and administrative costs are store personnel costs(including share-based compensation), store operating expenses, advertisingexpenses, store depreciation expense, and corporate overhead costs.

 

Advertisingcosts are expensed in the period in which the advertising first occurs. Ourcooperative advertising allowances are accounted for as a reduction in thepurchase price of merchandise since an obligation to advertise specific productdoes not exist in our cooperative advertising arrangements.

 

*Store Pre-Opening Costs*

 

We expense allstart-up activity costs as incurred, which primarily include store pre-openingcosts. Rent expense incurred prior to the store opening is recorded in cost ofsales and occupancy expense on our consolidated income statement.

 

*Income Taxes*

 

We recordincome tax expense using the liability method for taxes and are subject toincome tax in many jurisdictions, including the United States, various statesand localities, and Canada. A current tax liability or asset is recognized forthe estimated taxes payable or refundable on the tax returns for the currentyear and a deferred tax liability or asset is recognized for the estimatedfuture tax effects attributable to temporary differences and carryforwards.Deferred tax assets and liabilities are measured using enacted income tax ratesexpected to apply to taxable income in the years in which those temporarydifferences are expected to be recovered or settled. The effect of a change intax rates is recognized as income or expense in the period that includes theenactment date. A valuation allowance is recorded to reduce the carryingamounts of deferred tax assets unless it is more likely than not that suchassets will be realized. If different assumptions had been used, our taxexpense, assets, and liabilities could have varied from recorded amounts. Ifactual results differ from estimated results or if we adjust these assumptionsin the future, we may need to adjust our deferred tax assets or liabilities,which could impact our effective tax rate.

 

*Share-Based Compensation*

 

As more fullydescribed in Note 2 below, we elected to early adopt SFAS No. 123(R), *Share-Based Payment,*in the fourth quarter of fiscal 2005.We recorded compensation expense for unvested awards based on the amountspreviously determined for pro forma disclosure under SFAS No. 123, *Accounting for Stock-Based Compensation*, for the first threequarters of fiscal 2005 and under SFAS No. 123(R) for the fourth quarter offiscal 2005. Beginning in the fourth quarter of fiscal 2005, compensation costis based on the grant date fair value of the award and ratably recognized asexpense over the effective vesting period.

 

*Reclassifications*

 

Certain priorperiod amounts were reclassified to conform to current year presentation.

 

9

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** **

**Note 2.  Changesin Accounting**

 

As more fullydescribed in our fiscal 2005 Annual Report on Form 10-K, we changed ourmethod of accounting for merchandise inventories from a retail inventory methodto the weighted average cost (“WAC”) method in the fourth quarter of fiscal2005, effective as of the beginning of that fiscal year. We also adoptedSFAS No. 123(R), *Share-BasedPayment*, during the fourth quarter of fiscal 2005 using the modifiedretrospective transition method from the beginning of fiscal 2005. As a resultof these accounting changes, certain items on our consolidated balance sheetsand statements of cash flows for the third quarter of fiscal 2005 are notcomparable to previously reported amounts on our Form 10-Q, althoughtotal cash flows did not change as a result of these changes in accounting. Wepresented the effects on the income statement of adopting these policies in ourfiscal 2005 Annual Report on Form 10-K.

 

The followingtable reconciles the line items in our consolidated balance sheets andstatements of cash flows from the previously reported amounts to the adjustedamounts (in thousands):

 
| ** **                                                                                                        | ** ** | **As Previously  Reported** | ** ** | **WAC  Adjustments** | ** ** | **SFAS No.  123(R)  Adjustments** | ** ** | **As Adjusted** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|----------------------|------------|----------------------------------------|------------|----------------------|------------|
| **Quarter Ended October 29, 2005**                                                            |       |                             |       |                 |       |                                   |       |                 |       |
| **Balance Sheet**                                                                                                 |       |                             |       |                 |       |                                   |       |                 |       |
| Merchandise inventories                                                                                           |       | $                                | 1,214,504  |                 | $          | (169,093                               | )          | $                    | 1,579      |   | $ | 1,046,990 |   |
| Deferred and prepaid income taxes                                                                                 |       | 30,405                           |       | 64,276               |       | (660                                   | )          | 94,021               |       |
| Other assets                                                                                                      |       | 18,676                           |       | —               |       | (314                                   | )          | 18,362               |       |
| Deferred income taxes                                                                                             |       | 26,848                           |       | —               |       | (9,411                                 | )          | 17,437               |       |
| Additional paid-in-capital                                                                                        |       | 386,330                          |       | —               |       | 24,693                                 |       | 411,023              |       |
| Retained earnings                                                                                                 |       | 922,907                          |       | (104,398             | )          | (14,620                                | )          | 803,889              |       |
| Accumulated other comprehensive income                                                                            |       | 12,199                           |       | (419                 | )          | —                                 |       | 11,780               |       |
|                                                                                                              |       |                             |       |                 |       |                                   |       |                 |       |
| **Nine  Months Ended October 29, 2005**                                                                           |       |                             |       |                 |       |                                   |       |                 |       |
| **Statement of Cash Flows**                                                                                       |       |                             |       |                 |       |                                   |       |                 |       |
| Net income                                                                                                        |       | 132,790                          |       | (104,396             | )          | (14,620                                | )          | 13,774               |       |
| Share-based compensation expense                                                                                  |       | —                           |       | —               |       | 23,578                                 |       | 23,578               |       |
| Non-cash charge for the cumulative effect of  accounting change                                                   |       | —                           |       | 142,723              |       | —                                 |       | 142,723              |       |
| Merchandise inventories                                                                                           |       | (278,109                         | )          | 25,661               |       | 600                                    |       | (251,848             | )          |
| Deferred income taxes and other                                                                                   |       | (4,871                           | )          | —               |       | (9,558                                 | )          | (14,429              | )          |
| Income taxes payable                                                                                              |       | (2,445                           | )          | (63,986              | )          | —                                 |       | (66,431              | )          |
| Tax benefits from stock options exercised  (a reclassification from operating activities to financing activities) |       | —                           |       | —               |       | (18,892                                | )          | (18,892              | )          |
|                                                                                                                   |            |                                  |            |                      |            |                                        |            |                      |            |  |  |  |  |

 

10

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**Note 3.  Earningsper Share**

 

The followingtable sets forth the computation of basic and diluted earnings per commonshare:

 
| ** **                                                                                                    | ** ** | **Quarter Ended**                                             | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                                    | ** ** | **October 28,**                                               | ** ** | **October 29,**            | ** ** | **October 28,** | ** ** | **October 29,** | ** ** |
| ** **                                                                                                    | ** ** | **2006**                                                           | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                                                                    | ** ** | **(In thousands, except per share data)** | ** ** |
| **Numerator:**                                                                                                |       |                                                               |       |                            |       |   |   |   |   |
| Income before cumulative effect of  accounting change                                                         |       | $                                                                  | 36,060     |                            | $          | 33,247 |   | $ | 108,822 |   | $ | 102,262 |   |
| Cumulative effect of accounting change, net  of income tax                                                    |       | —                                                             |       | —                          |       | — |   | 88,488 |   |
| Net income                                                                                                    |       | $                                                                  | 36,060     |                            | $          | 33,247 |   | $ | 108,822 |   | $ | 13,774 |   |
|                                                                                                          |       |                                                               |       |                            |       |   |   |   |   |
| **Denominator:**                                                                                              |       |                                                               |       |                            |       |   |   |   |   |
| Denominator for basic earnings per common share  - weighted average shares                                    |       | 133,361                                                            |       | 135,395                         |       | 132,684 |   | 135,729 |   |
| Effect of dilutive securities: Employee  stock options                                                        |       | 2,382                                                              |       | 1,875                           |       | 2,129 |   | 1,987 |   |
| Denominator for diluted earnings per common  share - weighted average shares adjusted for dilutive securities |       | 135,743                                                            |       | 137,270                         |       | 134,813 |   | 137,716 |   |
|                                                                                                          |       |                                                               |       |                            |       |   |   |   |   |
| **Basic earnings per common share:**                                                                          |       |                                                               |       |                            |       |   |   |   |   |
| Income before cumulative effect of  accounting change                                                         |       | $                                                                  | 0.27       |                            | $          | 0.25 |   | $ | 0.82 |   | $ | 0.75 |   |
| Cumulative effect of accounting change, net  of income tax                                                    |       | —                                                             |       | —                          |       | — |   | (0.65 | ) |
| Net income                                                                                                    |       | $                                                                  | 0.27       |                            | 0.25       |   | 0.82 |   | 0.10 |   |
|                                                                                                          |       |                                                               |       |                            |       |   |   |   |   |
| **Diluted earnings per common share:**                                                                        |       |                                                               |       |                            |       |   |   |   |   |
| Income before cumulative effect of  accounting change                                                         |       | $                                                                  | 0.27       |                            | $          | 0.24 |   | $ | 0.81 |   | $ | 0.74 |   |
| Cumulative effect of accounting change, net  of income tax                                                    |       | —                                                             |       | —                          |       | — |   | (0.64 | ) |
| Net income                                                                                                    |       | $                                                                  | 0.27       |                            | $          | 0.24 |   | $ | 0.81 |   | $ | 0.10 |   |

 

We did notrepurchase any shares of our Common Stock during the third quarter of fiscal2006. Our repurchase of 1.4 million shares of our Common Stock in the thirdquarter of fiscal 2005 reduced the number of weighted average sharesoutstanding by 650,000 for the three months ended October 29, 2005. Ourpurchase of 1.9 million and 3.3 million shares of our Common Stock, duringthe first nine months of fiscal 2006 and 2005, respectively, reduced our numberof weighted average shares outstanding by 1.6 million and 1.4 million for thenine months ended October 28, 2006 and October 29, 2005, respectively.

 

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**Note 4.  Share-BasedCompensation**

 

OurCompensation Committee administered our option and awards plans that were ineffect prior to the Merger as discussed in Note 9 to these consolidatedfinancial statements. On April 21, 2006, our Compensation Committeeapproved amendments to the award agreements under the 1997 Stock Option Planand the 2005 Incentive Compensation Plan to add a provision that accelerated thevesting of awards under those Plans upon a change in control. Options issuedunder our 2001 General Stock Option Plan and 2001 Employee Stock Option Planalready contained an acceleration provision that was triggered as a result ofthe Merger. Under the 2001 Plans, our Board of Directors had the power to deferthe acceleration of vesting until the actual consummation of a change incontrol, thereby conforming the accelerated vesting of options under thoseplans to the accelerated vesting provision in the awards under the 1997 StockOptions Plan and the 2005 Incentive Compensation Plan.

 

Upon theMerger, which occurred subsequent to the third quarter of fiscal 2006, weaccelerated approximately $23.3 million of unrecognized compensation costrelated to the accelerated vesting of awards and also recognized approximately$95.8 million of incremental compensation expense related to the cash payout ofthe awards. Pursuant to SFAS No. 123(R), because the intrinsic value of theawards was settled in cash by Michaels, the total share-based compensationexpense we were required to recognize was equal to the intrinsic value of thesettled awards, less any previously recognized share-based compensation costfor those awards outstanding as of the settlement date.

 

**Note 5.  Debt**

** **

*91⁄4% Senior Notes due 2009*

 

In fiscal2001, we issued $200 million in principal amount of 91⁄4% Senior Notesdue July 1, 2009, which were unsecured and interest thereon was payablesemi-annually on each January 1 and July 1. On July 1, 2005, weredeemed the Senior Notes at a price of $1,046.25 per $1,000 of principalamount. This early redemption resulted in a pre-tax charge of$12.1 million in the second quarter of fiscal 2005, which represents acombination of a $9.3 million call premium and $2.8 million ofunamortized costs associated with the Senior Notes, and was recorded asinterest expense.

 

*Credit Agreement*

 

OnNovember 18, 2005, we entered into a new five-year, $300 millionsenior unsecured credit facility with Bank of America, N.A. and other lenders.The $300 million Credit Agreement replaced our then-existing$200 million revolving credit facility with Fleet National Bank and theother lenders, which we terminated immediately prior to entering into our$300 million Credit Agreement. We were in compliance with all terms andconditions of our $200 million credit agreement through the terminationdate, and we did not incur any early termination penalties in connection withits termination. No borrowings were outstanding under our $200 millioncredit agreement at any time during fiscal 2005.

 

Upon theMerger of the Company, as discussed in Note 9 to these consolidated financialstatements, we terminated our $300 million Credit Agreement. We were incompliance with all terms and conditions of our $300 million creditagreement through the termination date, and we did not incur any earlytermination penalties in connection with its termination. No borrowings wereoutstanding under our $300 million credit agreement at any time duringfiscal 2006.

 

To finance theMerger, we issued 10% Senior Notes due 2014, 11 3/8%Senior Subordinated Notes due 2016, and 13% Subordinated Discount Notes due2016 (collectively, the “Notes”). We also executed an asset-based revolvingcredit facility as well as a senior secured term loan facility (collectively,the “Senior Credit Facilities”).

 

*10% SeniorNotes due 2014*

 

On October 31,2006, we issued $750.0 million in principal amount of 10% Senior Notes dueNovember 1, 2014. Interest is payable semi-annually in arrears on each May 1and November 1, commencing on May 1, 2007. The Senior Notes are guaranteed,jointly and severally, on an unsecured senior basis, by each of oursubsidiaries.

 

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The SeniorNotes and the guarantees thereof are our and the guarantors’ unsecured seniorobligations and (i) rank senior in right of payment to all of our and theguarantors’ existing and future debt and other obligations that are, by theirterms, expressly subordinated in right of payment to the Senior Notes(including the Senior Subordinated Notes and the Subordinated Discount Notesdescribed below); (ii) rank equally in right of payment to all of our and theguarantors’ existing and future debt and other obligations that are not, bytheir terms, expressly subordinated in right of payment to the Senior Notes;and (iii) are effectively subordinated to all of our and the guarantors’existing and future secured debt (including obligations under the Senior CreditFacilities) to the extent of the value of the assets securing such debt.

 

At any timeprior to November 1, 2010, we may redeem all or a part of the Senior Notes at aredemption price equal to the sum of (i) 100% of the principal amount of theSenior Notes redeemed; (ii) the Applicable Premium (as defined in the SeniorIndenture); and (iii) accrued and unpaid interest to the date of redemptionplus Additional Interest (as defined in the Senior Indenture).

 

On and afterNovember 1, 2010, we may redeem all or part of the Senior Notes at the redemptionprices (expressed as percentages of principal amount of the Senior Notes) setforth below, plus accrued and unpaid interest and Additional Interest to theapplicable date of redemption if redeemed during the twelve-month periodbeginning on November 1 of each of the years indicated below:

 
| **Year**            | ** ** | **Percentage** | ** ** |
|---------------------|------------|----------------|------------|
| 2010                |       | 105.000        | %          |
| 2011                |       | 102.500        | %          |
| 2012 and thereafter |       | 100.000        | %          |

 

In addition,until November 1, 2009, we may, at our option, on one or more occasions redeemup to 35% of the aggregate principal amount of Senior Notes at a redemptionprice equal to 110.000% of the aggregate principal amount thereof, plus accruedand unpaid interest and Additional Interest, to the applicable date ofredemption, with the net cash proceeds of one or more Equity Offerings (asdefined in the Senior Indenture); provided**that at least 50% of the aggregateprincipal amount of Senior Notes remains outstanding immediately after theoccurrence of each such redemption, and that each such redemption occurs within90 days of the date of closing of each such Equity Offering.

 

Upon a changein control, we are required to offer to purchase all of the Senior Notes at aprice in cash equal to 101% of the aggregate principal amount thereof, plusaccrued and unpaid interest and Additional Interest.

 

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

 

•      incur additional debt;

•      pay dividends or distributions on theCompany’s capital stock or repurchase the Company’s capital stock;

•      issue stock of subsidiaries;

•      make certain investments;

•      create liens on the Company’s assets tosecure debt;

•      enter into transactions with affiliates;

•      merge or consolidate with another company;and

•      sell or otherwise transfer assets.

 

*11**3/**8% SeniorSubordinated Notes due 2016*

 

On October 31,2006, we issued $400.0 million in principal amount of 11 3/8% Senior Subordinated Notes due November1, 2016. Interest is payable semi-annually in arrears on each May 1 andNovember 1, commencing on May 1, 2007. The Senior Subordinated Notes areguaranteed, jointly and severally, on an unsecured senior subordinated basis,by each of our subsidiaries.

 

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The Senior SubordinatedNotes and the guarantees thereof are our and the guarantors’ unsecured seniorsubordinated obligations and (i) are subordinated in right of payment to all ofour and the guarantors’ existing and future senior debt, including the SeniorCredit Facilities and the Senior Notes; (ii) rank equally in right of paymentto all of our and the guarantors’ future senior subordinated debt; (iii) areeffectively subordinated to all of our and the guarantors’ existing and futuresecured debt (including the Senior Credit Facilities) to the extent of thevalue of the assets securing such debt; and (iv) rank senior in right ofpayment to all of our and the guarantors’ existing and future debt and otherobligations that are, by their terms, expressly subordinated in right ofpayment to the Senior Subordinated Notes, including the Subordinated DiscountNotes.

 

At any timeprior to November 1, 2011, we may redeem all or a part of the SeniorSubordinated Notes, at a redemption price equal to the sum of (i) 100% of the principalamount of Senior Subordinated Notes redeemed; (ii) the Applicable Premium (asdefined in the Senior Subordinated Indenture); and (iii) accrued and unpaidinterest to the date of redemption plus Additional Interest (as defined in theSenior Subordinated Indenture).

 

On and afterNovember 1, 2011, we may redeem all or part of the Senior Subordinated Notes atthe redemption prices (expressed as percentages of principal amount of theSenior Subordinated Notes) set forth below, plus accrued and unpaid interestand Additional Interest to the applicable date of redemption if redeemed duringthe twelve-month period beginning on November 1 of each of the years indicatedbelow:

 
| **Year**            | ** ** | **Percentage** | ** ** |
|---------------------|------------|----------------|------------|
| 2011                |       | 105.688        | %          |
| 2012                |       | 103.792        | %          |
| 2013                |       | 101.896        | %          |
| 2014 and thereafter |       | 100.000        | %          |

 

In addition,until November 1, 2009, we may, at our option, on one or more occasions redeemup to 35% of the aggregate principal amount of Senior Subordinated Notes at aredemption price equal to 111.375% of the aggregate principal amount thereof,plus accrued and unpaid interest and Additional Interest, to the applicabledate of redemption, with the net cash proceeds of one or more Equity Offerings(as defined in the Senior Subordinated Indenture); provided**that atleast 50% of the aggregate principal amount of Senior Subordinated Notesremains outstanding immediately after the occurrence of each such redemption,and that each such redemption occurs within 90 days of the date of closing ofeach such Equity Offering.

 

Upon a changein control, we are required to offer to purchase all of the Senior SubordinatedNotes at a price in cash equal to 101% of the aggregate principal amountthereof, plus accrued and unpaid interest and Additional Interest. The SeniorSubordinated notes Indenture contains restrictive covenants substantiallysimilar to those of the Senior Notes described above.

 

*13%Subordinated Discount Notes due 2016*

 

On October 31,2006, we issued $469.4 million in principal amount at maturity of 13%Subordinated Discount Notes due on November 1, 2016. No cash interest ispayable on the Subordinated Discount Notes prior to November 1, 2011. Beginningon November 1, 2011, cash interest will accrue and is payable semi-annually inarrears on each May 1 and November 1 (the first cash interest payment date isMay 1, 2012). The Subordinated Discount Notes are guaranteed, jointly andseverally, on an unsecured subordinated basis, by each of our subsidiaries.

 

TheSubordinated Discount Notes and the guarantees thereof are our and the guarantors’unsecured subordinated obligations and (i) are subordinated in right of paymentto all of our and the guarantors’ existing and future senior debt (includingthe Senior Credit Facilities, the Senior Notes and the Senior SubordinatedNotes), and (ii) are effectively subordinated to all of our and the guarantors’secured debt (including the Senior Credit Facilities to the extent of the valueof the assets securing such debt).

 

At any timeprior to November 1, 2011, we may redeem all or part of the SubordinatedDiscount Notes at a redemption price equal to the sum of 100% of the AccretedValue (as defined in the Subordinated Discount Indenture) of the SubordinatedDiscount Notes 

 

14

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redeemed plusthe Applicable Premium (as defined in the Subordinated Discount Indenture) asof the date of redemption.

 

On and afterNovember 1, 2011, we may redeem all or part of the Subordinated Discount Notesat the redemption prices (expressed as percentages of Accreted Value of theSubordinated Discount Notes to be redeemed) set forth below, plus accrued andunpaid interest and Additional Interest (to the extent not already included inAccreted Value) as of the applicable date of redemption if redeemed during thetwelve-month period beginning on November 1 of each of the years indicatedbelow:

 
| **Year**            | ** ** | **Percentage** | ** ** |
|---------------------|------------|----------------|------------|
| 2011                |       | 106.500        | %          |
| 2012                |       | 104.333        | %          |
| 2013                |       | 102.167        | %          |
| 2014 and thereafter |       | 100.000        | %          |

 

In addition,until November 1, 2009, we may, at our option, on one or more occasions redeemup to 35% of the aggregate principal amount of Subordinated Discount Notes at aredemption price equal to 113.000% of the Accreted Value thereof, with the netcash proceeds of one or more Equity Offerings (as defined in the SubordinatedDiscount Indenture); provided**that at least 50% of the sum ofthe aggregate principal amount at maturity of Subordinated Discount Notesoriginally remains outstanding immediately after the occurrence of each suchredemption, and that each such redemption occurs within 90 days of the date ofclosing of each such Equity Offering.

 

On May 1,2012, and, if necessary, any interest payment date thereafter prior to thematurity date, we are required to redeem a portion of each SubordinatedDiscount Note outstanding on such date equal to an amount sufficient, but notin excess of the amount necessary, to ensure that a Subordinated Discount Notewill not be an “applicable high yield discount obligation” within the meaningof Section 163(i)(1) of the Internal Revenue Code of 1986. These redemptionsare to be at a price equal to 100% of the Accreted Value as of the date ofredemption.

 

Upon a changein control, we are required to offer to purchase all of the SubordinatedDiscount Notes at a price in cash equal to 101% of the Accreted Value, plusaccrued and unpaid interest and Additional Interest. The Subordinated Discountindenture contains restrictive covenants substantially similar to those of theSenior Notes described above.

 

*Asset-basedrevolving credit facility*

 

On October 31,2006, we executed a senior secured asset-based revolving credit facility withBank of America, N.A. and other lenders (“Asset-based revolving creditfacility”). The Asset-based revolving credit facility provides senior securedfinancing of up to $1.0 billion, subject to a borrowing base as describedbelow. Upon consummation of the Merger, the borrowing base was $930.3 million,of which we borrowed $400.0 million. Borrowing capacity is available forletters of credit and borrowings on same-day notice (“Swingline Loans”).

 

The borrowingbase equals the sum of (i) 90% of eligible credit card receivables and debitcard receivables; (ii) between 85% and 90% of the appraised net orderlyliquidation value of eligible inventory and of eligible letters of credit;(iii) a percentage of eligible in-transit inventory, less certain reserves;and, (iv) the sum of an additional 10% of the appraised net orderly liquidationvalue of eligible inventory and of eligible letters of credit plus anadditional 5% of eligible credit card receivables and debit card receivables(collectively, the “last out tranche”), up to a maximum amount of$100.0 million.

 

TheAsset-based revolving credit facility provides us with the right to request upto $200.0 million of additional commitments under this facility aftersuccessful syndication of the facility. The facility was since successfullysyndicated. The lenders under this facility are not under any obligation toprovide any such additional commitments, and any increase in commitments issubject to customary conditions precedent. If we were to request any suchadditional commitments, and the existing lenders or new lenders were to agreeto provide such commitments, the facility size could be increased to up to $1.2billion, but our ability to borrow under this facility would still be limitedby the amount of the borrowing base.

 

15

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Borrowingsunder the Asset-based revolving credit facility bear interest at a rate perannum equal to, at our option, either (a) a base rate determined byreference to the higher of (1) the prime rate of Bank of America, N.A. and(2) the federal funds effective rate plus 1⁄2 of 1% or (b) a LIBORrate subject to certain adjustments, in each case plus an applicable margin.The initial applicable margin for borrowings is 0.50% for base rate borrowingsand 1.50% for LIBOR borrowings. With respect to any last out trancheborrowings, the initial applicable margin is 1.50% for base rate borrowings and2.50% for LIBOR borrowings. The applicable margin is subject to adjustment eachfiscal quarter based on the excess availability under the Asset-based revolvingcredit facility. Swingline Loans bear interest at a rate per annum equal to thebase rate plus the applicable margin.

 

We arerequired to pay a commitment fee of 0.25% per annum on the unutilizedcommitments under the Asset-based revolving credit facility. We must also paycustomary letter of credit fees and agency fees.

 

If, at anytime, the aggregate amount of outstanding loans, unreimbursed letter of creditdrawings and undrawn letters of credit under the Asset-based revolving creditfacility exceeds the lesser of (i) the commitment amount or (ii) theborrowing base, we will be required to repay outstanding loans and cashcollateralize letters of credit in an aggregate amount equal to such excess,with no reduction of the commitment amount. If the amount available under theAsset-based revolving credit facility is less than $100.0 million for fiveconsecutive business days, or a payment or bankruptcy event of default hasoccurred, we will be required to repay outstanding loans and cash collateralizeletters of credit with the cash we are required to deposit daily in acollection account maintained with the agent under the Asset-based revolvingcredit facility. We may voluntarily reduce the unutilized portion of thecommitment amount and repay outstanding loans at any time without premium orpenalty other than customary breakage costs with respect to LIBOR loans. Thereis no scheduled amortization under the Asset-based revolving credit facility;the principal amount of the loans outstanding is due and payable in full onOctober 31, 2011.

 

Allobligations under the Asset-based revolving credit facility are unconditionallyguaranteed by all of the our existing subsidiaries and are required to beguaranteed by certain of our future domestic wholly-owned subsidiaries. Allobligations under the Asset-based revolving credit facility, and the guaranteesof those obligations, are secured, subject to certain exceptions, bysubstantially all of our assets and the assets of our subsidiaries (the“Subsidiary Guarantors”), including:

 

•      a first-priority security interest inpersonal property consisting of inventory and related accounts, cash, depositaccounts, all payments received by us or the Subsidiary Guarantors from creditcard clearinghouses and processors or otherwise in respect of all credit cardcharges and debit card charges for sales of inventory by us and the SubsidiaryGuarantors, and certain related assets and proceeds of the foregoing;

•      a second-priority pledge of all of thecapital stock held by us (excluding the stock of Michaels of Canada, ULC) andour Subsidiary Guarantors (which pledge, in the case of the capital stock ofany foreign subsidiary, is limited to 65% of the voting stock of such foreignsubsidiary and 100% of the non-voting stock of such subsidiary); and

•      a second-priority security interest in,and mortgages on, substantially all other tangible and intangible assets of usand each Subsidiary Guarantor, including substantially all of our owned realproperty and equipment.

 

TheAsset-based revolving credit facility contains a number of covenants that,among other things and subject to certain exceptions, restricts the Company’sability and the ability of its subsidiaries to:

 

•      incur additional indebtedness;

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

•      make investments, loans, advances andacquisitions;

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

•      engage in transactions with affiliates ofthe Company;

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

•      consolidate or merge; and

•      create liens.

 

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The covenantslimiting dividends and other restricted payments, investments, loans, advancesand acquisitions, and prepayments or redemptions of indebtedness, each permitthe restricted actions in an unlimited amount, subject to the satisfaction ofcertain payment conditions, principally that we must have at least$125.0 million of pro forma excess availability under the Asset-based revolvingcredit facility and that we must be in pro forma compliance with the fixedcharge coverage ratio described in the next paragraph.

 

Although theAsset-based revolving credit facility does not require us to comply with anyfinancial ratio maintenance covenants, if we have less than $75.0 millionof excess availability under the Asset-based revolving credit facility at anytime, we are not permitted to borrow any additional amounts unless our proforma Consolidated Fixed Charge Coverage Ratio (as defined in the Asset-basedrevolving credit facility) is at least 1.1 to 1.0. The Asset-based revolvingcredit facility also contains certain customary affirmative covenants andevents of default.

 

*Seniorsecured term loan facility*

 

On October 31,2006, we executed a $2.4 billion senior secured term loan facility withDeutsche Bank A.G. New York Branch, and other lenders. The full amount wasborrowed on October 31, 2006. We are required to make scheduled quarterlypayments, each equal to 0.25% of the original principal amount of the termloans, for the first six years and three quarters, with the balance payable onOctober 31, 2013.

 

Borrowingsunder the Senior secured term loan facility bear interest at a rate per annumequal to, at our option, either (a) a base rate determined by reference tothe higher of (1) the prime rate of Deutsche Bank and (2) the federalfunds effective rate plus 1⁄2 of 1% or (b) a LIBOR rate, subject tocertain adjustments, in each case plus an applicable margin. The applicablemargin is 2.00% with respect to base rate borrowings and 3.00% with respect toLIBOR borrowings, subject to downward adjustment based on the leverage andratings thresholds set forth in the Senior secured term loan facilityagreement.

 

The Seniorsecured term loan facility requires us to prepay outstanding term loans with(a) 100% of the net proceeds of any debt issued by us or our subsidiaries(with exceptions for certain debt permitted to be incurred under the Seniorsecured term loan facility) and (b) commencing with the fiscal year endingFebruary 2, 2008, 50% (which percentage will be reduced to 25% if ourtotal leverage ratio is less than 6.00:1.00 and will be reduced to 0% if ourtotal leverage ratio is less than 5.00:1.00) of our annual Excess Cash Flow (asdefined in the Senior secured term loan facility). We must also offer to prepayoutstanding term loans at 100% of the principal amount to be prepaid, plusaccrued and unpaid interest, with the proceeds of certain asset sales orcasualty events under certain circumstances. We may voluntarily prepayoutstanding loans under the Senior secured term loan facility at any timewithout premium or penalty other than customary breakage costs with respect toLIBOR loans.

 

Allobligations under the Senior secured term loan facility are unconditionallyguaranteed by each direct and indirect wholly-owned subsidiary that guaranteesthe obligations of the Company under the Asset-based revolving credit facility.All obligations under the Senior secured term loan facility, and the guaranteesof those obligations, are secured, subject to certain exceptions, bysubstantially all of our assets and the assets of the Subsidiary Guarantors,including:

 

•      a first-priority pledge of all of thecapital stock held by us (excluding the stock of Michaels of Canada, ULC) andthe Subsidiary Guarantors (which pledge, in the case of any foreign subsidiary,is limited to 65% of the voting stock of such foreign subsidiary and 100% ofthe non-voting stock of such subsidiary);

•      a first-priority security interest in, andmortgages on, substantially all other tangible and intangible assets of us andeach Subsidiary Guarantor, including substantially all of our owned realproperty and equipment, but excluding, among other things, the collateraldescribed in the following bullet point; and

•      a second-priority security interest inpersonal property consisting of inventory and related accounts, cash, depositaccounts, all payments received by us or the Subsidiary Guarantors from creditcard clearinghouses and processors or otherwise in respect of all credit cardcharges and debit card charges for sales of inventory by us and the SubsidiaryGuarantors, certain related assets and proceeds of the foregoing.

 

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The Seniorsecured term loan facility requires us to satisfy and maintain a consolidatedsecured debt ratio that is no less than 4.0 to 1.0, with our first compliancedate beginning with the twelve months ended February 2, 2008. In addition, theSenior secured term loan facility contains a number of negative covenants thatare substantially similar (but more restrictive in certain respects) to thosegoverning the Senior Notes as well as certain other customary affirmative andnegative covenants and events of default.

 

**Note 6.  ComprehensiveIncome**

 

Ourcomprehensive income is as follows:

 
| ** **                                         | ** ** | **Quarter Ended**  | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------------------------|------------|-------------------------|------------|---------------------------------|------------|
| ** **                                         | ** ** | **October 28,**    | ** ** | **October 29,**            | ** ** | **October 28,** | ** ** | **October 29,** | ** ** |
| ** **                                         | ** ** | **2006**                | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                         | ** ** | **(In thousands)** | ** ** |
| Net income                                         |       | $                       | 36,060     |                            | $          | 33,247 |   | $ | 108,822 |   | $ | 13,774 |   |
| Other comprehensive income:                        |       |                    |       |                            |       |   |   |   |   |
| Foreign currency translation adjustment and  other |       | 240                     |       | 2,468                           |       | 562 |   | 6,458 |   |
| Comprehensive income                               |       | $                       | 36,300     |                            | $          | 35,715 |   | $ | 109,384 |   | $ | 20,232 |   |

 

**Note 7.  Commitmentsand Contingencies**

 

*Shareholder Claims*

 

*FathergillClaim*

 

OnMarch 21, 2003, Julie Fathergill filed a purported stockholder derivativeaction, which is pending in the 192nd District Court for Dallas County,Texas. The lawsuit named certain former and then-current officers anddirectors, including all of Michaels’ then-current directors, as individualdefendants and Michaels as a nominal defendant. The derivative action relatedto actions prior to our announcement on November 7, 2002, that we hadrevised our outlook for the fourth fiscal quarter of 2002, adjusting downwardguidance for annual earnings per diluted share. The plaintiff alleged that,prior to that announcement, certain of the defendants made misrepresentationsand failed to disclose negative information about the financial condition ofMichaels while the individual defendants were selling shares of Michaels CommonStock. The plaintiff asserted claims against the individual defendants forbreach of fiduciary duties, abuse of control, gross mismanagement, waste ofcorporate assets, and unjust enrichment. All of these claims were assertedderivatively on behalf of Michaels. On November 7, 2005, the Court entereda written order granting the defendants’ special exceptions and ordering thatthe case would be dismissed with prejudice unless the plaintiff amended herpetition to state an actionable claim against the defendants.

 

OnDecember 8, 2005, the plaintiff filed an amended petition in which shereasserted many of the same factual allegations, but also added new allegationsquestioning, among other things, issues relating to Michaels’ inventory systemsand infrastructure, as well as transactions and holdings of Michaels CommonStock by certain trusts established by or for the benefit of two of Michaels’now former directors and/or their families. In her amended petition, theplaintiff continued to assert all her claims derivatively on behalf of Michaelsagainst the individual defendants for breach of fiduciary duties, abuse ofcontrol, gross mismanagement, waste of corporate assets, and unjust enrichment.

 

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** **

OnJuly 10, 2006, the plaintiff filed a Second Amended Shareholder Derivativeand Class Action Petition in which she reasserted many of the same factualallegations described above, added new derivative allegations regarding thegranting of stock options to certain officers and directors from 1994 through2000, and class action allegations regarding the then-proposed merger ofMichaels and entities sponsored by Bain Capital Partners, LLC (“Bain”) and TheBlackstone Group (“Blackstone”) (see Note 9 to these consolidatedfinancial statements and “Managements Discussion and Analysis of FinancialCondition and Results of Operations—Recent Events” for additional informationregarding the merger, which has now been consummated) and added certainadditional former officers and directors as individual defendants. Among otherthings, the plaintiff sought (a) a declaration that the agreement and planof merger among Michaels and the entities sponsored by Bain and Blackstoneviolated the individual defendants’ fiduciary duties and therefore is unlawfuland unenforceable, (b) an injunction to prevent the consummation of theMerger, (c) an indeterminate amount of damages from the individual defendants,(d) certain corporate governance changes, (e) formation of aconstructive trust to hold the proceeds of defendants’ alleged tradingactivities and (f) restitution from, and disgorgement of proceeds derivedby, the named officers with respect to the alleged acts.

 

By court orderdated August 18, 2006, the Gottlieb and Schuman actions (discussed below) wereconsolidated with the Fathergill action. On October 4, 2006, Fathergill,Gottlieb and Schuman filed a consolidated shareholder derivative class actionpetition that included the claims that had been asserted in any of the threeactions and named as defendants each of the defendants that had been named inany of the three actions. We believe we have certain meritorious defenses andintend to defend this lawsuit vigorously. We are unable to estimate a range of possible loss, if any, in thisclaim.

* *

*Gottlieband Schuman Claim*

 

OnJune 9, 2006, Feivel Gottlieb and on June 12, 2006, Roberta Schumaneach filed purported stockholder derivative actions in the 191st and the14th District Courts for Dallas County, Texas, respectively. The lawsuitsnamed our former Chairman of the Board and Vice Chairman of the Board, both intheir capacities at the time as officers of Michaels and as directors, and allof Michaels’ other then-current directors as individual defendants and Michaelsas a nominal defendant. The plaintiffs asserted claims against the individualdefendants for breach of fiduciary duty, abuse of control, gross mismanagement,waste of corporate assets and unjust enrichment in connection with the grantingof stock options by Michaels between 1990 and October 2001 and sought, amongother relief, an indeterminate amount of damages from the individual defendantsand injunctive relief against Michaels with regard to various corporategovernance matters. All of these claims were asserted derivatively on behalf ofMichaels.

 

OnJuly 5, 2006, each of Feivel Gottlieb and Roberta Schuman filed a FirstAmended Shareholder Derivative and Class Action Petition against theindividual defendants, Michaels as a nominal defendant, and against Bain andBlackstone. In addition to the derivative allegations described above, theseamended petitions added class action allegations against our then-currentdirectors for breach of fiduciary duty related to the then-proposed merger ofMichaels with entities sponsored by Bain and Blackstone, and a claim againstBain and Blackstone for aiding and abetting the directors’ alleged breach offiduciary duty. In addition to the relief previously sought by the plaintiffs,as a result of these new claims, the plaintiffs sought (a) to enjoin thethen-proposed merger (or declare it void, if consummated), (b) to requirethe defendants to disgorge the property they received as a result of their allegedlywrongful conduct and (c) an indeterminate amount of damages from thedefendants, jointly and severally. As discussed above, by court order datedOctober 4, 2006, the Gottlieb and Schuman actions were consolidated with theFathergill action described above.

 

*Dutil Claim*

 

On September11, 2003, Leo J. Dutil filed a purported stockholder derivative action in theUnited States District Court for the Northern District of Texas, DallasDivision. The lawsuit named certain former and then-current officers anddirectors as individual defendants and Michaels as a nominal defendant. In thisderivative action, the plaintiff made allegations of fact similar to those madein the March 21, 2003 Fathergill petition described above. The plaintiffasserted claims against the individual defendants for breach of fiduciary duty,misappropriation of confidential information, and contribution andindemnification. All of these claims were asserted derivatively on behalf ofMichaels. On August 31, 2006, the plaintiff filed a notice of voluntarydismissal. The Court issued an order on September 7, 2006, dismissing the casein its entirety without prejudice.

 

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*HulliungClaim*

 

OnJune 19, 2006, Albert Hulliung filed a purported stockholder derivativeaction, which is pending in the United States District Court, Northern Districtof Texas, Dallas Division. The lawsuit named our former Chairman of the Boardand Vice Chairman of the Board, all of Michaels’ other then-current directors,one additional then-current officer and certain of our former officers asindividual defendants and Michaels as a nominal defendant. In connection withthe granting and repricing of certain stock options between 1993 and 2001, theplaintiff asserted claims of (a) breaches of fiduciary duty and violationsof Section 10(b) of the Securities Exchange Act of 1934 andRule 10b-5 promulgated thereunder against all the individual defendantsand (b) unjust enrichment against our then-Chairman of the Board, then-ViceChairman of the Board, one other then-director and the other then-currentofficer and former officers named in the lawsuit. The plaintiff sought, amongother relief, an indeterminate amount of damages from the individual defendantsand disgorgement of certain options and any proceeds derived therefrom from thedefendants against whom the unjust enrichment claim was asserted. All of theseclaims were asserted derivatively on behalf of Michaels.

 

OnJuly 27, 2006, the plaintiff amended his complaint adding certain otherformer and then-current officers and one former director of Michaels asindividual defendants and including allegations similar to those set forth inthe second amended (July 10, 2006) Fathergill Petition, describedabove. The plaintiff asserted claims derivatively on behalf of Michaels for(a) breach of fiduciary

 

duty andviolations of Section 10(b) of the Securities Exchange Act of 1934 andRule 10b-5 promulgated thereunder by each of the individual defendants,(b) unjust enrichment against certain of the individual defendants whoreceived stock options during the relevant period and (c) insider sellingagainst certain of the individual defendants who sold Michaels Common Stockduring the time period. Additionally, the plaintiff purported to represent aclass of Michaels’ shareholders. The plaintiff sought, among other relief,(i) an indeterminate amount of damages from the individual defendants,(ii) restitution from, and disgorgement of proceeds derived by, theindividual defendants who received stock options, (iii) the imposition ofa constructive trust against the individuals who were alleged to have engagedin insider sales and (iv) other unspecified equitable relief.

 

On November 7,2006, the Ziolkowski action (discussed below) was consolidated with theHulliung action. On November 27, 2006, the plaintiffs in Hulliung andZiolkowski filed a Consolidated Class Action Complaint (“ConsolidatedComplaint”) against Michaels and certain of its former officers and directors.The Consolidated Complaint alleges that the defendants misrepresented and/oromitted material facts in Michaels’ annual proxy statements for 1993 through2006, including, among other things, failing to disclose Michaels’ and thedefendants’ alleged option backdating practices and the fact that Michaels andthe defendants had reported false financial statements as a result of thosepractices. The Consolidated Complaint also alleges that the proxy statementsfailed to disclose: (a) that Michaels had problems with its internal controlsthat prevented it from issuing accurate financial reports and projections; (b)that because of improperly recorded stock-based compensation expenses,Michaels’ reported financial results violated GAAP; (c) that Michaels’ publicdisclosures presented an inflated view of Michaels’ earnings by understatingthe Company’s past compensation expenses; (d) that Michaels faced substantialliability for its past and ongoing backdating practices; and (e) that Michaels’directors had received and acquiesced in the granting of backdated stockoptions. The plaintiff asserts claims against all defendants for violations ofSection 14(a) of the Securities Exchange Act of 1934 and Rule 14a-9 promulgatedthereunder, and seeks, among other relief, an indeterminate amount of damagesfrom the defendants, as well as an award of attorneys fees and costs. Webelieve we have certain meritorious defenses and intend to defend this lawsuitvigorously.  We are unable to estimate arange of possible loss, if any, in this claim.

 

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*ZiolkowskiClaim*

 

OnJuly 7, 2006, James and Christine Ziolkowski filed a purported stockholderderivative action, which is pending in the United States District Court,Northern District of Texas, Dallas Division. The lawsuit named certain formerand then-current officers and directors of Michaels as individual defendants,and Michaels as a nominal defendant. In connection with the granting of stockoptions to the named officers, the plaintiffs asserted claims of(a) breaches of fiduciary duty and violations of Section 10(b) of theSecurities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder byeach of the individual defendants, (b) aiding and abetting of the namedofficers’ breach of their fiduciary duties by the director defendants and(c) unjust enrichment and rescission against the named officers. Theplaintiffs sought, among other relief, (i) an indeterminate amount ofdamages from the individual defendants, (ii) restitution from, anddisgorgement of proceeds derived by, the named officers with respect to thealleged acts, (iii) rescission of all option contracts granted to thenamed officers, and cancellation of any current or future obligations ofMichaels under any executory contracts obtained by the named officers as aresult of the alleged acts, (iv) formation of a constructive trust to holdall executory option contracts issued to the named officers and(v) punitive damages against the named officers. All of these claims wereasserted derivatively on behalf of Michaels.

 

As discussedabove, by court order dated November 7, 2006, the Ziolkowski action wasconsolidated with the Hulliung action described above, and on November 27,2006, the plaintiffs in Hulliung and Ziolkowski filed a Consolidated Complaint.

 

*MassachusettsLaborers’ Annuity Claim*

 

OnSeptember 6, 2006, the Massachusetts Laborers’ Annuity Fund filed aputative class action on behalf of itself and all holders of Michaels CommonStock during the period of May 4, 2004 through the present. The lawsuit ispending in the United States District Court, Northern District of Texas, DallasDivision, and named Michaels and all of its then-current directors asdefendants. The plaintiff alleged that the defendants misrepresented and/oromitted material facts in Michaels’ annual proxy statements for 2004, 2005 and2006, including, among other things, that Michaels’ reported financial resultsinflated its reported earnings by not properly recording stock-basedcompensation expense relating to the granting of stock options, that problemswith Michaels’ internal controls prevented it from issuing accurate financialreports and projections, and that Michaels’ directors had received andacquiesced in the granting of backdated stock options. The plaintiff assertedclaims against all of the defendants of (a) violations ofSection 14(a) of the Securities Exchange Act of 1934 and Rule 14a-9promulgated thereunder and (b) violations of Section 20(a) of theSecurities Exchange Act of 1934. The plaintiff sought, among other relief, anindeterminate amount of damages from the defendants and equitable or injunctiverelief, including the rescission of stock option grants. We believe we havecertain meritorious defenses and intend to defend this lawsuitvigorously.  We are unable to estimate a range of possible loss, if any,in this claim.

 

*Employee Class Action Claims*

 

*CottonClaim*

 

OnDecember 20, 2002, James Cotton, a former store manager of Michaels ofCanada, ULC, our wholly-owned subsidiary, and Suzette Kennedy, a formerassistant manager of Michaels of Canada, commenced a proposed class proceedingagainst Michaels of Canada and Michaels Stores, Inc. on behalf of themselvesand current and former employees employed in Canada. The Cotton claim was filedin the Ontario Superior Court of Justice and alleges that the defendantsviolated employment standards legislation in Ontario and other provinces andterritories of Canada by failing to pay overtime compensation as required bythat legislation. The Cotton claim also alleges that this conduct was in breachof the contracts of employment of those individuals. The Cotton claim seeks adeclaration that the defendants have acted in breach of applicable legislation,payment to current and former employees for overtime, damages for breach ofcontract, punitive, aggravated and exemplary damages, interest, and costs. InMay of 2005, the plaintiffs delivered material in support of their request thatthis action be certified as a class proceeding. Michaels filed and served itsresponding materials opposing class certification on January 31, 2006. Adate has not yet been set for the hearing with respect to certification. Weintend to contest certification of this claim as a class action. Further, webelieve we have certain defenses on the merits and intend to defend this lawsuitvigorously. We are unable to estimate a range of possible loss, if any, in thisclaim.

 

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*Clark Claim*

 

OnJuly 13, 2005, Michael Clark, a former Michaels store assistant manager,and Lucinda Prouty, a former Michaels store department manager, commenced aproposed class action proceeding against Michaels Stores, Inc. on behalf ofthemselves and current and former hourly retail employees employed inCalifornia from July 13, 2001 to the present. The Clark suit was filed inthe Superior Court of California, County of San Diego, and alleges thatMichaels failed to pay overtime wages, provide meal and rest periods (orcompensation in lieu thereof), and provide itemized employee wage statements.The Clark suit also alleges that this conduct was in breach of California’sunfair competition law. The plaintiffs seek injunctive relief, damages forunpaid overtime pay, meal break penalties, waiting time penalties, interest,and attorneys’ fees and costs. Under the Class Action Fairness Act, weremoved the case to federal court on August 5, 2005. The partiesparticipated in a voluntary mediation on October 16, 2006 and have reached atentative settlement of the case. Contingent on court approval, the partieshave agreed to a claims made process, with no material impact on our statementof operations, balance sheet, or cash flows for any period presented.

 

*MorrisClaim*

 

OnNovember 16, 2005, Geoffrey Morris, a former Aaron Brothers employee inSan Diego, California, commenced a proposed class action proceedingagainst Aaron Brothers, Inc. on behalf of himself and current and former AaronBrothers employees in California from November 16, 2001 to the present.The Morris suit was filed in the Superior Court of California, County ofSan Diego, and alleges that Aaron Brothers failed to pay overtime wages,reimburse the plaintiff for necessary expenses (including the cost of gas usedin driving his car for business purposes), and provide adequate meal and restbreaks (or compensation in lieu thereof). The Morris suit also alleges thatthis conduct was in breach of California’s unfair competition law. Theplaintiff seeks injunctive relief, damages for unpaid overtime pay, meal breakpenalties, waiting time penalties, interest, and attorneys’ fees and costs.Morris filed an Amended Complaint on June 8, 2006 and now seeks torepresent a class of current and former assistant managers only. We believethat the Morris claim lacks merit, and we intend to vigorously defend ourinterests. We are unable to estimate a range of possible loss, if any, in thisclaim.

 

*Governmental Inquiries and Related Matters*

 

*Non-U.S.Trust Inquiry*

 

In early 2005,the District Attorney’s office of the County of New York and the SEC openedinquiries concerning non-U.S. trusts that directly or indirectly heldshares of Michaels Common Stock and Common Stock options. The staff of aU.S. Senate subcommittee and a federal grand jury requested informationwith respect to the same facts. We are cooperating in these inquiries and haveprovided information in response to the requests.

 

Certain ofthese trusts and corporate subsidiaries of the trusts acquired securities ofMichaels in transactions directly or indirectly with Charles J. Wyly, Jr.and Sam Wyly, who were, respectively, Chairman and Vice Chairman of the Boardof Directors prior to the consummation of the merger of Michaels and entitiessponsored by Bain and Blackstone, or with other Wyly family members. Inaddition, subsidiaries of certain of these trusts acquired securities directlyfrom us in private placement transactions in 1996 and 1997 and upon theexercise of stock options transferred, directly or indirectly, to the trusts ortheir subsidiaries by Charles Wyly, Sam Wyly, or other Wyly family members.

 

We understandthat Charles Wyly and Sam Wyly and/or certain of their family members arebeneficiaries of irrevocable non-U.S. trusts. The 1996 and 1997 privateplacement sales by us of Michaels securities to subsidiaries of certain ofthese trusts were disclosed by us in filings with the SEC. The transfer byCharles Wyly and/or Sam Wyly (or by other Wyly family members or family-relatedentities) of Michaels securities to certain of these trusts and subsidiarieswas also disclosed in filings with the SEC by us and/or by Charles Wyly and SamWyly. Based on information provided to us, our SEC filings did not reportsecurities owned by the non-U.S. trusts or their corporate subsidiaries asbeneficially owned by Charles Wyly and Sam Wyly prior to 2005.

 

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Following thefiling by Charles Wyly and Sam Wyly of an amended Schedule 13D with theSEC on April 8, 2005, stating that they may be deemed the beneficialowners of Michaels securities held directly or indirectly by thenon-U.S. trusts, we disclosed in a press release that, as ofMarch 31, 2005, under SEC Rule 13d-3, Charles Wyly may be deemed theowner of 6,045,818 shares, or 4.4% of our then outstanding Common Stock,and Sam Wyly may be deemed the beneficial owner of 4,822,534 shares, or3.5% of our then outstanding Common Stock. In our 2005 and 2006 proxystatements, we included the securities held in the non-U.S. trusts ortheir separate subsidiaries, as reported by the Wylys, in the beneficial ownershiptable of our principal stockholders and management, with appropriate footnotes.

 

Charles Wylyand Sam Wyly had not historically reported purchases and sales of Michaelssecurities by the non-U.S. trusts and their subsidiaries in reports filedby them with the SEC under Section 16 of the Securities Exchange Act of1934. In an April 2005 letter from their counsel, Charles Wyly and Sam Wylyundertook to file any additional required Section 16 reports and to pay usthe amount of any Section 16 liability. Charles Wyly and Sam Wyly have notfiled additional or amended Section 16 reports with respect to thetransactions in question. They have, however, since June 2005, reported on Form4 filings the ownership of Michaels securities by the non-U.S. trusts and theirsubsidiaries and the sales of such securities in connection with the mergerinvolving Michaels and entities sponsored by Bain and Blackstone. In thosefilings, Charles Wyly and Sam Wyly have disclaimed beneficial ownership of thesecurities except to the extent of a pecuniary interest in the securities.

 

Charles Wylyand Sam Wyly made a proposal to settle the issue, without admitting or denyingthat they have or had, for Section 16 purposes, beneficial ownership ofMichaels securities that are or were held by the non-U.S. trusts or theirsubsidiaries. Following that proposal, on March 15, 2006, the Board ofDirectors appointed a special committee of the Board to investigate and makedecisions on behalf of Michaels with respect to the potential Section 16liability issue. The special committee was also given authority to makedecisions for Michaels relating to the allegations in the Fathergill derivativesuit related to the transactions and holdings of Michaels Common Stock bycertain of the non-U.S. trusts, and authority to investigate and respondto the governmental inquiries, described above. The special committee hadretained independent counsel to advise it in these matters.

 

In connectionwith the consummation of the merger of Michaels with entities sponsored by Bainand Blackstone, all the members of the Board of Directors, including themembers of the special committee, resigned. As a result, the committee nolonger exists, and authority concerning those matters has now reverted to thenew Board of Directors. The independent counsel retained by the special committeeis now advising the Company. The Company and Charles Wyly, Sam Wyly and EvanWyly entered into a tolling agreement, effective November 6, 2006, suspendingthe running of applicable statutes of limitations periods and similar defensesto the potential Section 16 claims from November 6, 2006 through February 1,2007.

 

*StockOptions Inquiry*

 

OnJune 15, 2006, following Michaels’ announcement that its Audit Committeehad initiated an internal review, described below, into the Company’shistorical stock option practices, Michaels received a letter from the Divisionof Enforcement of the SEC requesting that the Company preserve all documentsconcerning its granting of stock options from 1990 through the present andstating that the SEC intended to request production of such documents in thefuture. In a letter dated November 15, 2006, the Division requested thedocuments. A June 16, 2006 grand jury subpoena issued by the U.S. DistrictCourt for the Southern District of New York requesting documents relating tothe granting of stock options during the period 1996 to the present waswithdrawn in connection with a July 27, 2006 grand jury subpoena issued by theU.S. District Court for the Northern District of Texas on behalf of theFraud section of the Department of Justice requesting documents relating to thegranting of stock options during the same period. We are cooperating in theseinquiries and have provided information in response to the requests.

 

On August 28,2006, the Board of Directors appointed a special committee of the Board toinvestigate and make decisions on behalf of Michaels with respect to thesesubpoenas and any stock option grant issue raised by the SEC. The Board alsodesignated the special committee to investigate and make decisions on behalf ofMichaels with respect to allegations regarding Michaels’ historical stockoption practices asserted in each of the Fathergill, Gottlieb and Schuman,Hulliung and Ziokowski claims, described above under “Shareholder Claims.” Thiscommittee no longer exists as a result of the resignation of the members of theBoard of Directors, including the members of this committee, in connection withthe consummation of the merger of Michaels with entities sponsored by Bain andBlackstone, and the authority previously given to the committee has nowreverted to the new Board of Directors.

 

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*Internal Review of Stock Options Practices and Related Accounting*

 

Based on mediareports regarding historical stock options practices at other publicly tradedcompanies regarding allegations of “backdating” option grants, the Company’sAudit Committee conducted an internal review into the Company’s historicalstock option practices, including a review of the Company’s underlying optiongrant documentation and procedures and related accounting. The Audit Committee’sinternal review was conducted with the assistance of independent legal counseland outside accounting experts. The Company’s independent registered publicaccounting firm was informed about the internal review. The Company alsovoluntarily reported the commencement of this review to the SEC.

 

The AuditCommittee review has focused principally on the question of whether there mayhave been intentional wrongdoing in the Company’s historical stock optionsgranting practices. On August 25, 2006, the Audit Committee’s independentlegal counsel presented its final report to the Audit Committee, which statedthat the investigation conducted by independent counsel did not support aconclusion that there was intentional misconduct. Based on the independentcounsel report, the Audit Committee concluded that the results of theinvestigation did not support a finding of intentional misconduct.

 

In connectionwith the Audit Committee review, the Company has substantially completed aninternal review of historical stock options practices and related accountingissues from 1990 to the present. In this review, the Company has been advised, withrespect to specific Delaware law issues, by independent Delaware counsel and,with respect to specific Texas law issues, by independent Texas counsel.Management of the Company has discussed its current analyses and relatedjudgments, described below, with the Company’s independent registered publicaccounting firm and with the Audit Committee.

 

The Companyhas used its stock option program as a key component of compensation for bothits officers and a broad group of non-officer employees. Historically, theCompany has granted stock options principally, but not invariably, utilizing aprocess in which an authorized committee of the Board would approve stockoption grants from time to time through unanimous written consent resolutionswith specified effective dates that generally preceded the date on which theconsents were fully executed by members of the applicable committee. SinceOctober 2001, the Company has continued to use unanimous written consentresolutions to grant stock options but in a modified process based onestablished pre-determined effective grant dates and generally pre-determinedgrant levels for its stock option program. Prior to October 2001, some grantswere made on the basis of pre-determined grant dates and pre-determined grant levels;others were not. Most of the stock option grants during the period under reviewwere dated prior to the approval of the grants by the Board or a Boardcommittee for various reasons, including the design and use of the unanimouswritten consent process, delays in the initiation of the written consents,general administrative deficiencies, and actions taken to correct what theCompany believed were mistakes or omissions in the grant process.Notwithstanding that the Audit Committee concluded that the results of theinvestigation did not support a finding of intentional misconduct, the Companyhas identified accounting issues related to certain of the stock option grantsprior to October 2001.

 

The Companyhas historically considered the effective date specified in an option and theeffective date specified in the written consents by the applicable committee asthe accounting measurement date for determining stock-based compensationexpense under APB No. 25, *Accountingfor Stock Issued to Employees*. For all of the post-October 2001options grants and for many of the pre-October 2001 options grants, the Companyhas concluded that the accounting measurement date historically used wascorrect and appropriate, and that there is no unrecognized non-cash compensationexpense with respect to those grants. However, for certain grants that werereviewed in the period 1990 to 2001, based on the advice it received and itsown review of Company records, the Company currently believes that themeasurement date would likely be considered to differ from the measurement dateoriginally used in accounting for such grants. In connection with those grants,the Company is unable to definitively determine the actual measurement datebased on existing records. The Company estimated the measurement date based onits knowledge of the approval process, subsequent meetings that occurred, andestimates of the time that would have lapsed to obtain documented approval forthose grants. To the extent the exercise price of an option was less than thefair market value of the Company’s common stock on an estimated measurementdate different than the original measurement date, the difference representsthe Company’s estimate of the amount of non-cash compensation expense thatshould have been recorded over the vesting period of the option.

 

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Based on theCompany’s current analysis, the estimated amount of additional non-cashcompensation cost that should have been recorded was approximately $22.5 million,net of income taxes of approximately $13.5 million, all of which relatesto periods prior to fiscal 2001**.**Theamounts do not affect results of operations or the statement of cash flows inany period presented in this report or in the Company’s Annual Report onForm 10-K for fiscal 2005. As all stock options in question were exercisedprior to the end of fiscal 2005, the effect on the Company’s financial positionas of January 28, 2006 and as of October 28, 2006 as presented in thisreport would be an adjustment to both retained earnings and accumulated paid incapital in the amount of any unrecorded non-cash compensation cost, with noimpact on total stockholders’ equity. Based on the Company’s current analysisand judgments, any misstatement of the Company’s financial statements in anyperiod presented in this report or in its fiscal 2005 Form 10-K is notconsidered material.

 

As the Company’sreview is not complete as of the date of this filing, additional informationmay become available which could cause the Company’s current estimates andjudgments to change materially. However, the Company currently believes that arestatement of the Company’s prior period financial statements will not berequired.

 

The Company isalso evaluating whether previously deducted compensation related to exercisedstock options might be non-deductible under Section 162(m) of the InternalRevenue Code, which could result in additional taxes and interest related tothe prior deductions. The Company currently believes that the amount of taxdeductions it would be unable to recognize, if any, would not be material toresults of operations, cash flow, or the Company’s financial position, but hasnot finalized its assessment of this matter.

 

A number ofshareholder lawsuits have been filed against the Company, the then-current andcertain former directors, and certain then-current and former officers ofMichaels relating to the Company’s historical stock option practices. See “— ShareholderClaims” above. The Company has received a grand jury subpoena and has receiveda document production request from the SEC with respect to documents relatingto our historical stock option practices. See “— Governmental Inquires andRelated Matters—Stock Options Inquiry” above.

 

*General*

 

We are adefendant from time to time in lawsuits incidental to our business. Based oncurrently available information, we believe that resolution of all knowncontingencies is uncertain. There can be no assurance that future costs of suchlitigation would not be material to our financial position, results ofoperations, or cash flows.

 

**Note 8.  Segments**

 

We considerour Michaels, Aaron Brothers, and Recollections stores and our Star DecoratorsWholesale operations to be our operating segments for purposes of determiningreportable segments based on the criteria set forth in SFAS No. 131, *Disclosures About Segments of an Enterprise andRelated**Information.*Wedetermined that our Michaels and Aaron Brothers operating segments have similareconomic characteristics and meet the aggregation criteria in paragraph 17of SFAS No. 131. Our Aaron Brothers operating segment does not meetthe quantitative thresholds for separate disclosure set forth inSFAS No. 131, and our Recollections stores and Star DecoratorsWholesale operations are immaterial for segment reporting purposesindividually, and in the aggregate. Therefore, we combine all operatingsegments into one reporting segment.

 

25

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Our sales,operating income, and assets by country are as follows:

 
| ** **                              | ** ** | **Net Sales**      | ** ** | **Operating  Income** | ** ** | **Total Assets** | ** ** |
|-----------------------------------------|------------|-------------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                              | ** ** | **(In thousands)** | ** ** |
| **Quarter ended October 28, 2006:**     |       |                    |       |                  |       |                  |       |
| United States                           |       | $                       | 830,223    |                  | $          | 45,930                |       | $ | 1,877,496 |   |
| Canada                                  |       | 65,857                  |       | 9,507                 |       | 93,392                |       |
| Consolidated Total                      |       | $                       | 896,080    |                  | $          | 55,437                |       | $ | 1,970,888 |   |
|                                    |       |                    |       |                  |       |                  |       |
| **Quarter ended October 29, 2005:**     |       |                    |       |                  |       |                  |       |
| United States                           |       | $                       | 784,536    |                  | $          | 44,064                |       | $ | 1,776,102 |   |
| Canada                                  |       | 55,127                  |       | 6,753                 |       | 79,277                |       |
| Consolidated Total                      |       | $                       | 839,663    |                  | $          | 50,817                |       | $ | 1,855,379 |   |
|                                    |       |                    |       |                  |       |                  |       |
| **Nine months ended October 28, 2006:** |       |                    |       |                  |       |                  |       |
| United States                           |       | $                       | 2,326,538  |                  | $          | 139,804               |       | $ | 1,877,496 |   |
| Canada                                  |       | 170,287                 |       | 22,453                |       | 93,392                |       |
| Consolidated Total                      |       | $                       | 2,496,825  |                  | $          | 162,257               |       | $ | 1,970,888 |   |
|                                    |       |                    |       |                  |       |                  |       |
| **Nine months ended October 29, 2005:** |       |                    |       |                  |       |                  |       |
| United States                           |       | $                       | 2,264,724  |                  | $          | 161,792               |       | $ | 1,776,102 |   |
| Canada                                  |       | 141,448                 |       | 15,875                |       | 79,277                |       |
| Consolidated Total                      |       | $                       | 2,406,172  |                  | $          | 177,667               |       | $ | 1,855,379 |   |

 

Canada’soperating income includes corporate allocations, such as overhead, and amountsrelated to our distribution and Artistree operations. We present assets basedon their physical, geographic location. Certain assets located in the UnitedStates are also used to support our Canadian operations, but we do not allocatethose assets or their associated expenses to Canada.

 

**Note 9.  SubsequentEvent**

 

On October 31,2006, substantially all of the Common Stock of Michaels Stores, Inc. wasacquired through a merger transaction (the “Merger”) by affiliates of twoprivate investment firms, Bain Capital Partners, LLC and The Blackstone Group(collectively, together with their applicable affiliates, the “Sponsors”), withcertain shares retained by affiliates of Highfields Capital Partners (athen-existing shareholder of Michaels Stores, Inc.). As a result of the Merger,Michaels Holdings, LLC, an entity controlled by the Sponsors, ownsapproximately 93.6% of our outstanding Common Stock, which is no longerpublicly traded. We expect the Merger to be accounted for as a leveragedrecapitalization whereby the historical book value of the assets andliabilities of Michaels will be maintained with no push down accountingrequired.

 

The Merger wasfinanced by the issuance of debt as described in Note 5 to these consolidatedfinancial statements as well as:

 

•                  Equityinvestments from the Sponsors and the retention of certain shares held byaffiliates of Highfields Capital Partners, and

•                  Our availablecash as of the date of the Merger.

 

26

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The Mergeroccurred simultaneously with the closing of the financing and equitytransactions described above as well as the termination of our previous $300million senior unsecured credit facility with Bank of America, N.A (CreditAgreement). For further description of the financing transactions, see Note 5to these consolidated financial statements.

 

In connection with the completion of the Merger, weentered into management agreements with each of the Sponsors pursuant to whichthe Sponsors will provide management services to us until December 31, 2016,with evergreen extensions thereafter. Pursuant to these agreements, theSponsors will receive an aggregate annual management fee equal to $12.0million, and reimbursement for out-of-pocket expenses incurred by them inconnection with the Merger prior to the closing date and in connection with theprovision of services pursuant to the agreements. In addition, pursuant tothese agreements, the Sponsors received, in connection with the completion ofthe Merger, aggregate transaction fees of approximately $60.0 million inconnection with services provided by them related to the Merger. Finally, themanagement agreements provide that the Sponsors are entitled to receive fees inconnection with certain subsequent financing, acquisition, disposition and changeof control transactions of 1% of the gross transaction value of any suchtransaction. The management agreements include customary exculpation andindemnification provisions in favor of the Sponsors. The management agreementsmay be terminated by the Sponsors at any time and terminate automatically uponan initial public offering or a change of control unless we and the Sponsorsdetermine otherwise. Upon termination, each provider of management serviceswill be entitled to a termination fee calculated based on the present value ofthe annual fees due during the remaining period from the date of termination tothe tenth anniversary of the date of the Merger.

 

In connectionwith the completion of the Merger, we entered into a management agreement withHighfields Capital Management LP, an affiliate of the Highfields CapitalPartners, that provides for an annual management fee of $1.0 million forservices that Highfields Capital Management LP renders to us following thecompletion of the Merger.

 

During our fourthquarter of fiscal 2006, we will record additional costs related to the Merger,currently expected to range between $215 million to $220 million. Some of thesecosts will be expensed and some will be capitalized as part of the debtissuance costs. The allocation of the Merger costs is subject to our receiptand review of final invoices associated with the Merger. Our effective tax rateof 37.75% for the three and nine months ended October 28, 2006 includes the taxbenefit of certain Merger costs incurred through those respective periods. CertainMerger costs are not deductible for tax purposes. We expect to adjust oureffective tax rate in future periods to reflect the portion of Merger coststhat are not deductible for tax purposes, which we expect will result in ahigher effective tax rate.

 

As a result ofthe recapitalization and issuance of the Notes and Senior Credit Facilities,our capitalization materially changed subsequent to October 28, 2006. Below isa comparison of our actual capitalization as of October 28, 2006, and ourcapitalization on a pro forma basis giving effect to the Merger. The unauditedproforma financial data was prepared on the basis that the Merger was accountedfor as a leveraged recapitalization and accordingly, there was no change in thebasis of assets and liabilities.  Theunaudited proforma financial data are based upon available information andcertain assumptions that we believe are reasonable.  The unaudited proforma data may materiallychange as more information becomes available with respect to Merger costs asdescribed above.

 
| ** **                                | ** ** | **As of October 28, 2006** | ** ** |
|-------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                | ** ** | **(in millions)**                         | ** ** |
| ** **                                | ** ** | **Actual**                                     | ** ** | **Proforma** | ** ** |
| Cash and equivalents                      |       | $                                              | 315.3      |   | $ | 79.5 |   |
|                                      |       |                                           |       |   |   |
| Total debt                                |       |                                           |       |   |   |
| Senior Notes                              |       | —                                         |       | 750.0 |   |
| Senior Subordinated Notes                 |       | —                                         |       | 400.0 |   |
| Subordinated Discount Notes               |       | —                                         |       | 250.0 |   |
| Asset-based revolving credit facility     |       | —                                         |       | 400.0 |   |
| Senior secured term loan facility         |       | —                                         |       | 2,400.0 |   |
| Total debt                                |       | —                                         |       | 4,200.0 |   |
|                                      |       |                                           |       |   |   |
| Total stockholders’ equity (deficit) |       | 1,357.6                                        |       | (2,844.9 | ) |
|                                      |       |                                           |       |   |   |
| Total capitalization                      |       | $                                              | 1,357.6    |   | $ | 1,355.1 |   |

 

27

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**Note 10. Recent Accounting Pronouncements**

 

In July 2006, the FASB issued FASB Interpretation No. 48, *Accounting for Uncertainty in IncomeTaxes — an interpretation of FASB Statement No. 109* (“FIN48”), which clarifies the accounting for uncertainty in income tax positions.FIN 48 requires that a company recognize in its consolidated financialstatements the impact of a tax position that is more likely than not to besustained upon examination based on the technical merits of the position. Theprovisions of FIN 48 will be effective for us, as of the beginning of fiscal2007, with early adoption permitted. Any cumulative effect recorded as a resultof adopting FIN 48 will be recorded as an adjustment to opening retainedearnings. We are currently evaluating the impact of adopting FIN 48 on ourconsolidated financial statements.

 

In September2006, the FASB issued Statement of Financial Accounting Standard No. 158, *Employers’ Accounting for Defined Benefit Pensions and OtherPostretirement Plans*(“FAS 158”), which requires an entity torecognize the overfunded or underfunded status of a defined benefitpostretirement plan as an asset or liability in its balance sheet and torecognize changes in that funded status in the year in which the changes occurthrough comprehensive income. It also requires an entity to measure the fundedstatus of a plan as of the date of its year-end balance sheet. As we have nopublicly traded securities (due to the Merger), FAS 158 is effective for us atthe end of fiscal 2007, with early adoption permitted. We plan to adopt FAS 158at the end of fiscal 2007, with no material impact expected on our consolidatedincome statement, balance sheet, shareholders’ equity, or cash flows statement.

 

28

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** **

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

 

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

 

**DisclosureRegarding Forward-Looking Information**

 

The followingdiscussion should be read in conjunction with our consolidated financialstatements and related notes included elsewhere in this Quarterly Report onForm 10-Q. The following discussion, as well as other portions of thisQuarterly Report on Form 10-Q, contains forward-looking statements thatreflect our plans, estimates, and beliefs. Any statements contained herein(including, but not limited to, statements to the effect that Michaels or itsmanagement “anticipates,” “plans,” “estimates,” “expects,” “believes,” andother similar expressions) that are not statements of historical fact should beconsidered forward-looking statements and should be read in conjunction withour consolidated financial statements and related notes in our Annual Report onForm 10-K for the fiscal year ended January 28, 2006. Specificexamples of forward-looking statements include, but are not limited to,statements regarding our forecasts of financial performance, capitalexpenditures, and working capital requirements. Our actual results could materiallydiffer from those discussed in these forward-looking statements. Factors thatcould cause or contribute to such differences include, but are not limited to:

 

•    our substantial leverage,which could adversely affect our ability to raise additional capital to fundour operations, limit our ability to react to changes in the economy or ourindustry, and expose us to interest rate risk to the extent of our variablerate debt;

 

•    our ability to service theinterest and principal payments of our debt;

 

•    restrictions contained in ourvarious debt agreements that limit our flexibility in operating our business,including compliance with the covenants contained therein;

 

•    our ability to remaincompetitive in the areas of merchandise quality, price, breadth of selection,customer service, and convenience;

 

•    our ability to anticipateand/or react to changes in customer demand and preferences for products andsupplies used in creative activities and the related potential impact tomerchandise inventories in categories that represent a significant portion ofour business;

 

•    changes in consumer confidenceresulting in a reduction in consumer spending on items perceived to bediscretionary;

 

•    the effectiveness of, orunexpected consumer responses to, our promotional programs;

 

•    unusual weather conditions;

 

•    the execution and managementof our store growth, including new concepts, the impact of new competitorstores in locations near our existing stores, and the availability ofacceptable real estate locations for new store openings;

 

•    the effective optimization andmaintenance of our perpetual inventory and automated replenishment systems andrelated impacts to inventory levels;

 

•    the identification andimplementation of enhancements to our supply chain to enable us to distributeadditional SKUs through our distribution centers;

 

•    delays in the receipt ofmerchandise ordered from suppliers due to delays in connection with either themanufacture or shipment of such merchandise;

 

•    transportation delays(including dock strikes and other work stoppages) and increases intransportation costs due to fuel surcharges and transportation regulations;

 

•    restrictive actions by foreigngovernments or changes in United States laws and regulations affecting importsor domestic distribution;

 

•    significant increases ininflation or commodity prices, such as petroleum, natural gas, electricity,steel, and paper, which may 

 

29

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adverselyaffect our costs, including cost of merchandise;

 

•    significant increases intariffs or duties levied on imports which may limit the availability of certainmerchandise from our foreign suppliers;

 

•    changes in political,economic, and social conditions;

 

•    significant fluctuations inexchange rates;

 

•    financial difficulties of anyof our key vendors, suppliers, or insurance providers;

 

•    the design and implementationof new management information systems as well as the maintenance andenhancement of existing systems, particularly in light of our continued storegrowth and the addition of new concepts;

 

•    our ability to maintain thesecurity of electronic and other confidential information;

 

•    our ability to maintaineffective internal controls over our newly implemented financial reportingsystem;

 

•    our ability to attract andretain qualified personnel to successfully execute our operating plans;

 

•    the seasonality of the retailbusiness;

 

•    other factors as set forth in “PartII. – Item 1A. Risk Factors” herein, in our Annual Report on Form 10-K forthe fiscal year ended January 28, 2006 (particularly in “CriticalAccounting Policies and Estimates” and “Risk Factors”), and in our otherSecurities and Exchange Commission filings.

 

We intendthese forward-looking statements to speak only as of the time of filing thisQuarterly Report on Form 10-Q and do not undertake to update or revisethem as more information becomes available.

 

**General**

 

All referencesherein to “fiscal 2006” relate to the 53 weeks ending February 3,2007 and all references to “fiscal 2005” relate to the 52 weeks endedJanuary 28, 2006. In addition, all references herein to “the third quarterof fiscal 2006” and “the first nine months of fiscal 2006” relate to the13 and 39 weeks ended October 28, 2006, respectively, and all referencesto “the third quarter of fiscal 2005” and “the first nine months of fiscal 2005”relate to the 13 and 39 weeks ended October 29, 2005, respectively.

 

The followingtable sets forth certain of our unaudited operating data:

 

30

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| ** **                                               | ** ** | **Quarter Ended** | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------------------------------|------------|------------------------|------------|---------------------------------|------------|
| ** **                                               | ** ** | **October 28,**   | ** ** | **October 29,**            | ** ** | **October 28,** | ** ** | **October 29,** | ** ** |
| ** **                                               | ** ** | **2006**               | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Michaels stores:**                                     |       |                   |       |                            |       |   |   |   |   |
| Retail stores open at beginning of period                |       | 905                    |       | 870                             |       | 885 |   | 844 |   |
| Retail stores opened during the period                   |       | 15                     |       | 19                              |       | 39 |   | 46 |   |
| Retail stores opened (relocations) during  the period    |       | 2                      |       | 7                               |       | 7 |   | 18 |   |
| Retail stores closed during the period                   |       | (1                     | )          | —                          |       | (5 | ) | (1 | ) |
| Retail stores closed (relocations) during  the period    |       | (2                     | )          | (7                              | )          | (7 | ) | (18 | ) |
| Retail stores open at end of period                      |       | 919                    |       | 889                             |       | 919 |   | 889 |   |
|                                                     |       |                   |       |                            |       |   |   |   |   |
| **Aaron Brothers stores:**                               |       |                   |       |                            |       |   |   |   |   |
| Retail stores open at beginning of period                |       | 165                    |       | 165                             |       | 166 |   | 164 |   |
| Retail stores opened during the period                   |       | —                 |       | 1                               |       | — |   | 2 |   |
| Retail stores closed during the period                   |       | —                 |       | —                          |       | (1 | ) | — |   |
| Retail stores open at end of period                      |       | 165                    |       | 166                             |       | 165 |   | 166 |   |
|                                                     |       |                   |       |                            |       |   |   |   |   |
| **Recollections stores:**                                |       |                   |       |                            |       |   |   |   |   |
| Retail stores open at beginning of period                |       | 11                     |       | 11                              |       | 11 |   | 8 |   |
| Retail stores opened during the period                   |       | —                 |       | —                          |       | — |   | 3 |   |
| Retail stores open at end of period                      |       | 11                     |       | 11                              |       | 11 |   | 11 |   |
|                                                     |       |                   |       |                            |       |   |   |   |   |
| **Star Decorators Wholesale stores:**                    |       |                   |       |                            |       |   |   |   |   |
| Wholesale stores open at beginning of  period            |       | 4                      |       | 4                               |       | 4 |   | 3 |   |
| Wholesale stores opened during the period                |       | —                 |       | —                          |       | — |   | 1 |   |
| Wholesale stores open at end of period                   |       | 4                      |       | 4                               |       | 4 |   | 4 |   |
|                                                     |       |                   |       |                            |       |   |   |   |   |
| Total store count at end of period                       |       | 1,099                  |       | 1,070                           |       | 1,099 |   | 1,070 |   |
|                                                     |       |                   |       |                            |       |   |   |   |   |
| **Other operating data:**                                |       |                   |       |                            |       |   |   |   |   |
| Average inventory per Michaels store (in  thousands) (1) |       | $                      | 1,005      |                            | $          | 1,110 |   | $ | 1,005 |   | $ | 1,110 |   |
| Comparable store sales increase (2)                      |       | 3.3                    | %          | 0.8                             | %          | 0.1 | % | 4.2 | % |
|                                                          |            |                        |            |                                 |            |  |  |  |  |  |  |  |  |

 

----

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

 

**RecentEvents**

 

On October 31,2006, substantially all of the Common Stock of Michaels Stores, Inc. wasacquired through a merger transaction (the “Merger”) by affiliates of twoprivate investment firms, Bain Capital Partners, LLC and The Blackstone Group(collectively, together with their applicable affiliates, the “Sponsors”), withcertain shares retained by affiliates of Highfields Capital Partners (athen-existing shareholder of Michaels Stores, Inc.). As a result of the Merger,Michaels Holdings, LLC, an entity controlled by the Sponsors, ownsapproximately 93.6% of our outstanding Common Stock, which is no longerpublicly traded. We expect the Merger to be accounted for as a leveragedrecapitalization whereby the historical book value of the assets and liabilitiesof Michaels will be maintained with no push down accounting required.

 

31

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**Resultsof Operations**

 

The followingtable sets forth the percentage relationship to net sales of each line item ofour unaudited consolidated statements of income. This table should be read inconjunction with the following discussion and with our consolidated financialstatements, including the related notes, contained herein.

 
| ** **                                                                 | ** ** | **Quarter Ended** | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------------------------------------------------|------------|------------------------|------------|---------------------------------|------------|
| ** **                                                                 | ** ** | **October 28,**   | ** ** | **October 29,**            | ** ** | **October 28,** | ** ** | **October 29,** | ** ** |
| ** **                                                                 | ** ** | **2006**               | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Net sales**                                                              |       | 100.0                  | %          | 100.0                           | %          | 100.0 | % | 100.0 | % |
| Cost of sales and occupancy expense                                        |       | 64.2                   |       | 63.7                            |       | 63.4 |   | 63.2 |   |
|                                                                       |       |                   |       |                            |       |   |   |   |   |
| **Gross profit**                                                           |       | 35.8                   |       | 36.3                            |       | 36.6 |   | 36.8 |   |
| Selling, general, and administrative  expense                              |       | 29.4                   |       | 29.9                            |       | 29.9 |   | 29.1 |   |
| Store pre-opening costs                                                    |       | 0.2                    |       | 0.3                             |       | 0.2 |   | 0.3 |   |
| **Operating income**                                                       |       | 6.2                    |       | 6.1                             |       | 6.5 |   | 7.4 |   |
| ** **                                                                 |       |                   |       |                            |       |   |   |   |   |
| Interest expense                                                           |       | —                 |       | —                          |       | — |   | 0.8 |   |
| Other (income) and expense, net                                            |       | (0.3                   | )          | (0.3                            | )          | (0.5 | ) | (0.3 | ) |
| **Income before income taxes and cumulative  effect of accounting change** |       | 6.5                    |       | 6.4                             |       | 7.0 |   | 6.9 |   |
| ** **                                                                 |       |                   |       |                            |       |   |   |   |   |
| Provision for income taxes                                                 |       | 2.5                    |       | 2.4                             |       | 2.6 |   | 2.6 |   |
| **Income before cumulative effect of  accounting change**                  |       | 4.0                    |       | 4.0                             |       | 4.4 |   | 4.3 |   |
| Cumulative effect of accounting change, net  of income tax                 |       | —                 |       | —                          |       | — |   | 3.7 |   |
|                                                                       |       |                   |       |                            |       |   |   |   |   |
| **Net income**                                                             |       | 4.0                    | %          | 4.0                             | %          | 4.4 | % | 0.6 | % |

 

*Quarter Ended October 28, 2006 Compared to the Quarter Ended October29, 2005*

 

*Net Sales*—Net sales increased for the thirdquarter of fiscal 2006 by $56.4 million, or 6.7%, over the third quarterof fiscal 2005. At the end of the third quarter of fiscal 2006, we operated 919Michaels, 165 Aaron Brothers, 11 Recollections, and four Star DecoratorsWholesale stores. The results for the third quarter of fiscal 2006 includesales from 39 Michaels stores that were opened during the 12-month periodended October 28, 2006, more than offsetting lost sales from the closure ofnine Michaels and one Aaron Brothers store during the same period. Sales at ournew stores (net of closures) opened since the third quarter of fiscal 2005provided incremental revenue of $28.8 million, while comparable storesales increased $27.6 million, or 3.3%.

 

Comparablestore sales increased 3.3% in the third quarter of fiscal 2006 compared to thethird quarter of fiscal 2005, reflecting an increase in the average ticket of3.5% that was partially offset by decreases in customer transactions and customframing deliveries of 0.1% each. A favorable Canadian currency translationadded approximately 0.4% to the average ticket increase for the third quarterof fiscal 2006 over the third quarter of fiscal 2005. Comparable store saleswere positively impacted by increases in domestic sales of regular andpromotionally priced merchandise at Michaels stores, with sales of clearanceproducts and Yarn significantly declining. Our strongest domestic departmentalperformances in Michaels stores came in General Crafts (primarily due toJewelry and Beads), ready-made Frames, Seasonal, and Ribbon and Wedding. Ourability to generate comparable store sales increases is dependent, in part, onour ability to continue to maintain store in-stock positions on the top-sellingitems, to properly allocate merchandise to our stores, to effectively executeour pricing and sales promotion efforts, to anticipate customer demand andtrends in the arts and crafts industry, and to respond to competitors’activities. The comparable store sales increase in our third quarter of fiscal2006 may not be indicative of our full year comparable store sales results.

 

*Cost of Sales and Occupancy Expense*—Cost ofsales and occupancy expense increased $39.9 million primarily due to the3.3% increase in comparable store sales, a 2.7% increase in the number ofstores operated in the third quarter of fiscal 2006 compared to the thirdquarter of fiscal 2005, and increases in certain occupancy expenses.

 

Cost of salesand occupancy expense, as a percentage of net sales, increased approximately50 basis points in the third quarter of fiscal 2006 compared to the thirdquarter of fiscal 2005. Occupancy costs, as a percentage of sales, increasedapproximately 100 basis points primarily due to a variety of increased costs,such as utilities, property taxes and insurance, and incremental costs of ourstore standardization/remodel program. Partially offsetting the increasedoccupancy costs were increases in our merchandise margins of approximately50 basis points, primarily due to higher margin rates of regular andpromotional merchandise and improved sourcing.

 

32

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*Selling, General, and Administrative Expense*—Selling,general, and administrative expense was $263.9 million, or 29.4% of netsales, in the third quarter of fiscal 2006 compared to $251.2 million, or 29.9%of net sales, in the third quarter of fiscal 2005. The expense increase wasprimarily due to expenses associated with the strategic alternative process(see – “Recent Events” above) and an increase in the number of stores weoperated compared to last year, partially offset by lower share-basedcompensation costs.

 

As apercentage of net sales, selling, general, and administrative expense decreasedapproximately 50 basis points, primarily due to an approximate 90 basispoint reduction in store operating expenses due to increased leverageassociated with the 3.3% increase in comparable store sales. In addition, lowershare-based compensation costs generated approximately 100 basis points ofincremental benefit. Share-based compensation costs declined because we did notaward annual stock option grants during the third quarter of fiscal 2006. Thesedecreases, as a percentage of sales, were partially offset by a 140 basis pointincrease in costs related to the strategic alternative process, stock option review,and responses to governmental inquiries.

 

*Operating Income*—Operating income increasedfrom $50.8 million, or 6.1% of sales, in the third quarter of fiscal 2005 to$55.4 million, or 6.2% of sales, in the third quarter of fiscal 2006.

 

*Interest Expense*—Interest expense of $225,000for the third quarter of fiscal 2006 was consistent with interest expense of$226,000 for the third quarter of fiscal 2005.

 

*Other Income*—Other income declined slightlyfrom $3.0 million in the third quarter of fiscal 2005 to $2.7 millionduring the third quarter of fiscal 2006. Other income for the third quarter offiscal 2005 contained a $2.2 million favorable settlement related to the VisaCheck/MasterMoney Antitrust Litigation.

 

*Provision for Income Taxes*—The effective taxrate was 37.75% for the third quarter of fiscal 2006 and 38.0% for the thirdquarter of fiscal 2005.

 

*Net Income*—As a result of the above, netincome increased from $33.2 million, or $0.24 per diluted share, in thethird quarter of fiscal 2005 to $36.1 million, or $0.27 per dilutedshare for the third quarter of fiscal 2006.

 

During ourfourth quarter of fiscal 2006, we expect to recognize between $215 million and$220 million of merger-related costs, including accounting, investment banking,legal, share-based compensation, and other costs. We also expect our interestexpense to materially increase in future periods as a result of the $4.2billion of debt incurred subsequent to the end of our third quarter of fiscal2006 to finance the merger. Also, our effective tax rate of 37.75% for thethree and nine months ended October 28, 2006 includes the tax benefit ofcertain Merger costs incurred through those respective periods. Certain Mergercosts are not deductible for tax purposes. We expect to adjust our effectivetax rate in future periods to reflect the portion of Merger costs that are notdeductible for tax purposes, which we expect will result in a higher effectivetax rate. Therefore, we expect a material decrease in net income as a result ofthese increased expenses. See Liquidity and Capital Resources below for furtherinformation concerning our financing structure and debt and related interestobligations.

 

*Nine Months Ended October 28, 2006 Compared to the Nine Months EndedOctober 29, 2005*

 

*Net Sales*— Net sales increased in the firstnine months of fiscal 2006 by $90.7 million, or 3.8%, over the first ninemonths of fiscal 2005. Sales at our new stores (net of closures) opened sincethe third quarter of fiscal 2005 provided incremental revenue of $89.1 million,while comparable store sales increased $1.6 million, or 0.1%. The comparablestore sales increase of 0.1% reflects an increase in the average ticket of 2.7%that was partially offset by decreases in customer transactions of 2.5% andcustom framing deliveries of 0.1%. Favorable Canadian currency translations inthe first nine months of fiscal 2006 added approximately 0.5% to the averageticket increase over the first nine months of fiscal 2005. Comparable storesales were positively impacted by significant comparable store sales increasesat our Recollections and Star Decorators Wholesale stores. Our strongestdomestic departmental performances in Michaels stores came in General Crafts(primarily due to Jewelry and Beads), Apparel Crafts, Impulse, and CustomFloral.

 

*Cost of Sales and Occupancy Expense*—Cost ofsales and occupancy expense increased $62.5 million primarily due to a2.7% increase in the number of stores operated in the first nine months offiscal 2006 compared to the first nine months of fiscal 2005, as well as anincrease in certain occupancy expenses.

 

Cost of salesand occupancy expense, as a percentage of net sales, increased approximately20 basis points through the first nine months of fiscal 2006 compared tothe first nine months of fiscal 2005. This increase was primarily a result ofincreases in a variety of occupancy costs totaling about 80 basis points, suchas utilities, property taxes and insurance, and incremental costs of our store 

 

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standardization/remodelprogram. Partially offsetting the increased occupancy costs was a 60 basispoint expansion of merchandise margins, primarily due to higher margin rates ofregular and promotional merchandise and improved sourcing.

 

*Selling, General, and Administrative Expense*—Selling,general, and administrative expense was $747.8 million, or 29.9% of netsales, for the first nine months of fiscal 2006 compared to$702.2 million, or 29.1% of net sales, in the first nine months of fiscal2005. The expense increase was primarily due to an increase in the number ofstores we operated compared to last year, in particular store operatingexpenses was approximately $26.3 million of the overall $45.6 millionincrease. Also contributing to the dollar increase were expenses associatedwith the strategic alternative process, stock option review, and responses togovernmental inquiries.

 

As apercentage of net sales, selling, general, and administrative expense increasedapproximately 80 basis points, with the entire increase attributable tocosts associated with the strategic alternative process, stock option review,responses to governmental inquiries, and post-employment benefits for ourformer CEO.

 

*Operating Income*—Operating income decreasedfrom $177.7 million, or 7.4% of sales, in the first nine months of fiscal 2005to $162.3 million, or 6.5% of sales, in the first nine months of fiscal2006.

 

*Interest Expense*—Interest expense decreased$20.2 million in the nine months ending October 28, 2006 compared to thenine months ending October 29, 2005 due to the early redemption of our 91⁄4% Senior Notes in the second quarterof fiscal 2005.

 

*Other Income*—Other income increased from $8.1million in the nine month period ending October 29, 2005 to $13.2 millionduring the nine month period ending October 28, 2006. This increase for fiscal2006 was primarily due to higher interest rates associated with our investedcash balances.

 

*Provision for Income Taxes*—The effective taxrate was 37.75% for the first nine months of fiscal 2006 and 38.0% for thefirst nine months of fiscal 2005.

 

*Cumulative Effect of Accounting Change*—Infiscal 2005, we changed our method of accounting for merchandise inventoriesfrom a retail inventory method to the weighted average cost method. As aresult, we recorded a non-cash charge of $88.5 million, net of income tax,or $0.64 per diluted share, in the first quarter of fiscal 2005 for thecumulative effect of accounting change on fiscal years prior to fiscal 2005.

 

*Net Income*—Net income, after the cumulativeeffect of accounting change, increased from $13.8 million, or $0.10 perdiluted share, in the first nine months of fiscal 2005 to $108.8 million,or $0.81 per diluted share for the first nine months of fiscal 2006.

 

**Liquidityand Capital Resources**

 

Our cash andequivalents decreased $137.2 million, or 30.3%, from $452.4 millionat the end of fiscal 2005 to $315.2 million at the end of the thirdquarter of fiscal 2006. Compared to the end of the third quarter of fiscal2005, cash and equivalents increased $202.7 million, or 180.2%, primarilybecause of cash generated by operations, partially offset by the repurchases ofour Common Stock and capital expenditures.

 

*Cash Flow from Operating Activities*

 

Cash flowprovided by operating activities during the first nine months of fiscal 2006was $19.0 million compared to $80.8 million used during the first ninemonths of fiscal 2005. The $99.8 million increase in cash provided byoperating activities was primarily due to a reduction in merchandiseinventories, net of accounts payable. The working capital leverage weexperienced with respect to inventories and accounts payable during the firstnine months of fiscal 2006 may not be indicative of full year results.

 

Inventoriesper Michaels store (including supporting distribution centers) decreased 9.5%from October 29, 2005 to October 28, 2006. We do not expect our current quarter’sdecreases in average inventory per store to be indicative of results as of theend of fiscal 2006.

 

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* *

*Cash Flow used in Investing Activities*

 

Cash flow usedin investing activities was primarily the result of the following capitalexpenditure activities:

 
| ** **                                          | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------------|------------|---------------------------------|------------|
| ** **                                          | ** ** | **October 28,**            | ** ** | **October 29,** | ** ** |
| ** **                                          | ** ** | **2006 (1)**               | ** ** | **2005 (2)** | ** ** |
| ** **                                          | ** ** | **(In thousands)**         | ** ** |
| New and relocated stores and stores not yet  opened |       | $                               | 25,800     |   | $ | 31,725 |   |
| Existing stores                                     |       | 42,454                          |       | 23,489 |   |
| Distribution system expansion                       |       | 12,371                          |       | 4,839 |   |
| Information systems                                 |       | 23,726                          |       | 17,485 |   |
| Corporate and other                                 |       | 3,328                           |       | 8,247 |   |
|                                                |       | $                               | 107,679    |   | $ | 85,785 |   |

 

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| (1)    |   | In the first  nine months of fiscal 2006, we incurred capital expenditures related to the  opening of 39 Michaels stores and the relocation of seven Michaels stores.  Capital expenditures for existing stores for the first nine months of fiscal  2006 increased $19.0 million over the first nine months of fiscal 2005  primarily due to incremental expenditures associated with our store  standardization/remodel program. |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| (2)    |   | In the first  nine months of fiscal 2005, we incurred capital expenditures related to the  opening of 46 Michaels, two Aaron Brothers, three Recollections, and one Star  Decorators Wholesale store, and the relocation of 18 Michaels stores.                                                                                                                                                                                         |

 

During the first nine months of fiscal 2005, weliquidated our investment in a Massachusetts business trust for proceeds ofapproximately $50.6 million, which was classified as a short-terminvestment for the fiscal year ended January 29, 2005.

 

*Cash Flow used in Financing Activities*

 

Proceeds fromthe exercise of outstanding stock options historically served as a source ofcash flow for us. Proceeds from the exercise of stock options were$35.6 million for the nine month period ending October 28, 2006 and$32.3 million for the nine month period ending October 29, 2005. As aresult of the Merger, we do not expect that stock option exercise proceeds willserve as a future source of cash flow.

 

Cash used forrepurchases of our Common Stock decreased $52.9 million from$119.1 million during the nine month period ended October 29, 2005 to$66.2 million during the nine month period ended October 28, 2006. As aresult of the merger agreement, we ceased the repurchase of our Common Stockunder the repurchase plans that were previously authorized by the Board ofDirectors.

 

We paiddividends of $0.12 per share during the fiscal quarter ended October 28,2006. We did not pay any dividends during the fiscal quarter ended October 29,2005, as that quarter’s dividends were paid during the fourth quarter of fiscal2005. For the nine months ended October 28, 2006 and October 29, 2005 we paiddividends of $0.32 per share and $0.27 per share respectively. The dividend of$0.12 per share declared during the third quarter of fiscal 2006 was paidduring our fiscal fourth quarter.

 

*Debt*

 

Prior to theMerger, our primary sources of short-term liquidity were cash generated byoperations and proceeds from stock option exercises. To finance the completionof the Merger, we issued 10% Senior Notes due 2014, 11 3/8% Senior Subordinated Notes due 2016, and13% Subordinated Discount Notes due 2016 (collectively, the “Notes”). We alsoexecuted an asset-based revolving credit facility as well as a senior securedterm loan facility (collectively, the “Senior Credit Facilities”). Subsequentto the Merger, we expect that our primary sources of liquidity will be cashgenerated by operations and borrowings under the asset-based revolving creditfacility. Borrowings under our asset-based revolving credit facility areinfluenced by a number of factors as more fully described below, includingworking capital (inclusive of inventory, credit card receivables, and gift cardliabilities) and stand-by letters of credit.

 

OnOctober 31, 2006, we issued (i) $750.0 million in principal amount of10% Senior Notes due November 1, 2014; (ii) $400.0 million inprincipal amount at maturity of 11 3/8%Senior Subordinated Notes due November 1, 2016; and (iii) $469.4million in principal amount at maturity of 13% Subordinated Discount Notes dueNovember 1, 2016. Interest on the Senior Notes and the Senior SubordinatedNotes is payable semi-annually in arrears on each May 1 andNovember 1, commencing on May 1, 2007. No cash interest is payable onthe Subordinated Discount Notes prior to November 1, 2011. Beginning onNovember 1, 2011, cash interest will accrue on the Subordinated DiscountNotes and is payable semi-annually in arrears on each May 1 andNovember 1 (the first cash 

 

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interestpayment is May 1, 2012). The Senior Notes are guaranteed, jointly andseverally, on an unsecured basis, the Senior Subordinated Notes are guaranteed,jointly and severally, on an unsecured senior subordinated basis, and theSubordinated Discount Notes are guaranteed, jointly and severally, on anunsecured subordinated basis, in each case, by each of our subsidiaries.

 

The indenturesgoverning the Notes contain covenants limiting, among other things, the Company’sability and the ability of the Company’s restricted subsidiaries to:

 

•                  incuradditional debt;

•                  paydividends or distributions on the Company’s capital stock or repurchase theCompany’s capital stock;

•                  issuestock of subsidiaries;

•                  makecertain investments;

•                  createliens on the Company’s assets to secure debt;

•                  enterinto transactions with affiliates;

•                  mergeor consolidate with another company; and

•                  sellor otherwise transfer assets.

 

Prior toNovember 1, 2009, we may redeem up to 35% of the aggregate principalamount of each of the Notes with the net cash proceeds of one or more EquityOfferings (as defined in the indentures governing the Notes) at redemptionprices that include a premium and subject to certain other terms andconditions, as described in the applicable indenture. The Notes are alsoredeemable in whole or in part, at our option, at any time at redemption pricesthat include varying premiums until a certain date. In addition, upon a changeof control, we are required to make an offer to redeem all of the Notes at apremium with accrued and unpaid interest.

 

*Asset-basedrevolving credit facility*

 

On October 31,2006, we executed a senior secured asset-based revolving credit facility withBank of America, N.A. and other lenders (“Asset-based revolving credit facility”).The Asset-based revolving credit facility provides senior secured financing ofup to $1.0 billion, subject to a borrowing base as described below. Uponconsummation of the Merger, the borrowing base was $930.3 million, of which weborrowed $400.0 million. Borrowing capacity is available for letters ofcredit and borrowings on same-day notice (“Swingline Loans”).

 

The borrowingbase equals the sum of (i) 90% of eligible credit card receivables and debitcard receivables; (ii) between 85% and 90% of the appraised net orderlyliquidation value of eligible inventory and of eligible letters of credit;(iii) a percentage of eligible in-transit inventory, less certain reserves;and, (iv) the sum of an additional 10% of the appraised net orderly liquidationvalue of eligible inventory and of eligible letters of credit plus anadditional 5% of eligible credit card receivables and debit card receivables(collectively, the “last out tranche”), up to a maximum amount of$100.0 million.

 

The Asset-basedrevolving credit facility provides us with the right to request up to $200.0 millionof additional commitments under this facility after successful syndication ofthe facility. The facility was since successfully syndicated. The lenders underthis facility are not under any obligation to provide any such additionalcommitments, and any increase in commitments is subject to customary conditionsprecedent. If we were to request any such additional commitments, and theexisting lenders or new lenders were to agree to provide such commitments, thefacility size could be increased to up to $1.2 billion, but our ability toborrow under this facility would still be limited by the amount of theborrowing base.

 

Borrowingsunder the Asset-based revolving credit facility bear interest at a rate perannum equal to, at our option, either (a) a base rate determined byreference to the higher of (1) the prime rate of Bank of America, N.A. and(2) the federal funds effective rate plus 1⁄2 of 1% or (b) a LIBOR ratesubject to certain adjustments, in each case plus an applicable margin. Theinitial applicable margin for borrowings is 0.50% for base rate borrowings and1.50% for LIBOR borrowings. With respect to any last out tranche borrowings,the initial applicable margin is 1.50% for base rate borrowings and 2.50% forLIBOR borrowings. The applicable margin is subject to adjustment each fiscalquarter based on the excess availability under the Asset-based revolving creditfacility. Swingline Loans bear interest at a rate per annum equal to the baserate plus the applicable margin.

 

We are requiredto pay a commitment fee of 0.25% per annum on the unutilized commitments underAsset-based revolving credit facility. We must also pay customary letter ofcredit fees and agency fees.

 

If, at anytime, the aggregate amount of outstanding loans, unreimbursed letter of creditdrawings and undrawn letters of credit under the Asset-based revolving creditfacility exceeds the lesser of (i) the commitment amount or (ii) theborrowing base, we will be required to repay outstanding loans and cashcollateralize letters of credit in an aggregate amount equal to such excess,with no reduction of the

 

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commitmentamount. If the amount available under the Asset-based revolving credit facilityis less than $100.0 million for five consecutive business days, or apayment or bankruptcy event of default has occurred, we will be required torepay outstanding loans and cash collateralize letters of credit with the cashwe are required to deposit daily in a collection account maintained with theagent under the Asset-based revolving credit facility. We may voluntarilyreduce the unutilized portion of the commitment amount and repay outstandingloans at any time without premium or penalty other than customary breakagecosts with respect to LIBOR loans. There is no scheduled amortization under theAsset-based revolving credit facility; the principal amount of the loansoutstanding is due and payable in full on October 31, 2011.

 

TheAsset-based revolving credit facility contains a number of covenants that,among other things and subject to certain exceptions, restricts the Company’sability and the ability of its subsidiaries to:

 

•                  incur additional indebtedness,

•                  pay dividends on the Company’s capital stockor redeem, repurchase or retire the Company’s capital stock or its otherindebtedness,

•                  make investments, loans, advances andacquisitions;

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

•                  engage in transactions with affiliates of theCompany;

•                  sell assets, including capital stock of theCompany’s subsidiaries;

•                  consolidate or merge; and

•                  create liens.

 

The covenantslimiting dividends and other restricted payments; investments, loans, advancesand acquisitions; and prepayments or redemptions of indebtedness, each permitthe restricted actions in an unlimited amount, subject to the satisfaction ofcertain payment conditions, principally that we must have at least$125.0 million of pro forma excess availability under the Asset-basedrevolving credit facility and that we must be in pro forma compliance with thefixed charge coverage ratio described in the next paragraph.

 

Although theAsset-based revolving credit facility does not require us to comply with any financialratio maintenance covenants, if we have less than $75.0 million of excessavailability under the Asset-based revolving credit facility at any time, weare not permitted to borrow any additional amounts unless our pro formaconsolidated fixed charge coverage ratio (as defined in the Asset-basedrevolving credit facility) is at least 1.1 to 1.0. The Asset-based revolvingcredit facility also contains certain customary affirmative covenants andevents of default.

 

*Seniorsecured term loan facility*

 

On October 31,2006, we executed a $2.4 billion senior secured term loan facility withDeutsche Bank A.G. New York Branch, and other lenders. The full amount wasborrowed on October 31, 2006. We are required to make scheduled quarterlypayments, each equal to 0.25% of the original principal amount of the termloans, for the first six years and three quarters, with the balance payable onOctober 31, 2013.

 

Borrowingsunder the Senior secured term loan facility bear interest at a rate per annumequal to, at our option, either (a) a base rate determined by reference tothe higher of (1) the prime rate of Deutsche Bank and (2) the federalfunds effective rate plus 1⁄2 of 1% or (b) a LIBOR rate, subject to certainadjustments, in each case plus an applicable margin. The applicable margin is2.00% with respect to base rate borrowings and 3.00% with respect to LIBORborrowings, subject to downward adjustment based on the leverage and ratingsthresholds set forth in the Senior secured term loan facility.

 

The Seniorsecured term loan facility requires us to prepay outstanding term loans with(a) 100% of the net proceeds of any debt issued by us or our subsidiaries(with exceptions for certain debt permitted to be incurred under the Seniorsecured term loan facility) and (b) commencing with the fiscal year endingFebruary 2, 2008, 50% (which percentage will be reduced to 25% if ourtotal leverage ratio is less than a 6.00:1.00 and will be reduced to 0% if ourtotal leverage ratio is less than 5.00:1.00) of our annual Excess Cash Flow (asdefined in the Senior secured term loan facility). We must also offer to prepayoutstanding term loans at 100% of the principal amount to be prepaid, plusaccrued and unpaid interest, with the proceeds of certain asset sales orcasualty events under certain circumstances. We may voluntarily prepayoutstanding loans under the Senior secured term loan facility at any timewithout premium or penalty other than customary breakage costs with respect toLIBOR loans.

 

The Seniorsecured term loan facility requires us to maintain compliance with theconsolidated secured debt ratio that is no less than 4.0 to 1.0, with our firstcompliance date beginning with the twelve months ended February 2, 2008. Inaddition, the Senior secured term loan facility contains a number of negativecovenants that are substantially similar (but more restrictive in certainrespects) to those

 

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governing theNotes as well as certain other customary affirmative and negative covenants andevents of default.

 

In fiscal2001, we issued $200 million in principal amount of 91⁄4% Senior Notesdue July 1, 2009, which were unsecured and interest thereon was payablesemi-annually on each January 1 and July 1. On July 1, 2005, weredeemed the Senior Notes at a price of $1,046.25 per $1,000 of principalamount. This early redemption resulted in a pre-tax charge of$12.1 million in the second quarter of fiscal 2005, which represents acombination of a $9.3 million call premium and $2.8 million ofunamortized costs associated with the Senior Notes, which was recorded asinterest expense.

 

We requirecash principally for day-to-day operations and to finance capital investments,inventory for new stores, inventory replenishment for existing stores, andseasonal working capital needs. In recent years, we have financed ouroperations, new store openings, Common Stock repurchases, dividend payments,and other capital investments with cash from operations and proceeds from stockoption exercises. We expect that our available cash, cash flow generated fromoperating activities, and funds available under our Asset-based revolvingcredit facility will be sufficient to fund planned capital expenditures,working capital requirements, debt repayments, debt service requirements, andfuture growth through the end of fiscal 2007. As of December 6, 2006, ourborrowing base under our Asset-based revolving credit facility was $994.5million and we had $715.2 million of remaining availability under thatfacility.

 

**RecentAccounting Pronouncements**

 

In July 2006, the FASB issued FASB Interpretation No. 48, *Accounting for Uncertainty in IncomeTaxes — an interpretation of FASB Statement No. 109* (“FIN48”), which clarifies the accounting for uncertainty in income tax positions.FIN 48 requires that a company recognize in its consolidated financialstatements the impact of a tax position that is more likely than not to besustained upon examination based on the technical merits of the position. Theprovisions of FIN 48 will be effective for us, as of the beginning of fiscal2007 year, with early adoption permitted. Any cumulative effect recorded as aresult of adopting FIN 48 will be recorded as an adjustment to opening retainedearnings. We are currently evaluating the impact of adopting FIN 48 on ourconsolidated financial statements.

 

In September2006, the FASB issued Statement of Financial Accounting Standard No. 158, *Employers’ Accounting for Defined Benefit Pensions and OtherPostretirement Plans*(“FAS 158”), which requires an entity torecognize the overfunded or underfunded status of a defined benefitpostretirement plan as an asset or liability in its balance sheet and torecognize changes in that funded status in the year in which the changes occurthrough comprehensive income. It also requires an entity to measure the fundedstatus of a plan as of the date of its year-end balance sheet. As we have nopublicly traded securities (due to the Merger), FAS 158 is effective for us atthe end of fiscal 2007, with early adoption permitted. We plan to adopt FAS 158at the end of fiscal 2007, with no material impact expected on our consolidatedincome statement, balance sheet, shareholders’ equity, or cash flows statement.

 

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

 

We typicallyinvest cash balances in excess of operating requirements primarily in moneymarket mutual funds and short-term interest-bearing securities, generally withmaturities of 90 days or less. Due to the short-term nature of our investments,the fair value of our cash and equivalents at October 28, 2006 approximatedcarrying value.

 

Uponcompletion of the Merger, we terminated our $300 million Credit Agreement andissued certain debt securities and entered into certain agreements to financethe recapitalization. See “Part I. – Item 2. Management’s Discussion andAnalysis of Financial Condition and Results of Operations – Liquidity andCapital Resources – Debt.”  We havemarket risk exposure arising from changes in interest rates on our new SeniorCredit Facilities. The interest rates on our Senior Credit Facilities willreprice periodically. The interest rates on our Notes issued in connection withthe Merger are fixed.

 

**Item 4.  Controlsand Procedures.**

 

*Evaluation of Disclosure Controls and Procedures*

 

We maintain aset of disclosure controls and procedures (as defined in Rules 13a-15(e)and 15d-15(e) promulgated by the SEC under the Securities Exchange Act of1934). An evaluation was carried out under the supervision and with the participationof our management, including our President and Chief Financial Officer and ourPresident and Chief Operating Officer, of the effectiveness of our disclosurecontrols and procedures as of the end of the period covered by this QuarterlyReport on Form 10-Q. Based on that evaluation, our President and ChiefFinancial Officer and our President and Chief Operating Officer concluded thatour disclosure controls and procedures are effective to provide reasonableassurance that information required to be disclosed in the reports that we 

 

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file or submitunder the Securities Exchange Act of 1934 is recorded, processed, summarized,and reported within the time periods specified in SEC rules and forms. Suchcontrols and procedures are designed to ensure that information we are requiredto disclose in our reports is accumulated and communicated to our management,including our principal executive officers and principal financial officer, toallow timely disclosure decisions. We note that the design of any system ofcontrols is based, in part, upon certain assumptions about the likelihood offuture events, and there can be no assurance that any design will succeed inachieving its stated goals under all potential future conditions.

 

*Change in Internal Control Over Financial Reporting*

 

There has notbeen any change in our internal control over financial reporting (as defined inRules 13a-15(f) and 15d-15(f) as promulgated by the SEC under theSecurities Exchange Act of 1934) during our most recently completed fiscalquarter that has materially affected, or is reasonably likely to materiallyaffect, our internal control over financial reporting.

 

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**MICHAELS STORES, INC.**

**Part II—OTHERINFORMATION**

 

**Item 1.  Legal Proceedings.**

 

*Shareholder Claims*

 

*Fathergill Claim*

 

OnMarch 21, 2003, Julie Fathergill filed a purported stockholder derivativeaction, which is pending in the 192nd District Court for Dallas County,Texas. The lawsuit named certain former and then-current officers anddirectors, including all of Michaels’ then-current directors, as individualdefendants and Michaels as a nominal defendant. The derivative action relatedto actions prior to our announcement on November 7, 2002, that we hadrevised our outlook for the fourth fiscal quarter of 2002, adjusting downwardguidance for annual earnings per diluted share. The plaintiff alleged that,prior to that announcement, certain of the defendants made misrepresentationsand failed to disclose negative information about the financial condition ofMichaels while the individual defendants were selling shares of Michaels CommonStock. The plaintiff asserted claims against the individual defendants for breachof fiduciary duties, abuse of control, gross mismanagement, waste of corporateassets, and unjust enrichment. All of these claims were asserted derivativelyon behalf of Michaels. On November 7, 2005, the Court entered a writtenorder granting the defendants’ special exceptions and ordering that the casewould be dismissed with prejudice unless the plaintiff amended her petition tostate an actionable claim against the defendants.

 

OnDecember 8, 2005, the plaintiff filed an amended petition in which shereasserted many of the same factual allegations, but also added new allegationsquestioning, among other things, issues relating to Michaels’ inventory systemsand infrastructure, as well as transactions and holdings of Michaels CommonStock by certain trusts established by or for the benefit of two of Michaels’now former directors and/or their families. In her amended petition, theplaintiff continued to assert all her claims derivatively on behalf of Michaelsagainst the individual defendants for breach of fiduciary duties, abuse ofcontrol, gross mismanagement, waste of corporate assets, and unjust enrichment.

 

OnJuly 10, 2006, the plaintiff filed a Second Amended Shareholder Derivativeand Class Action Petition in which she reasserted many of the same factualallegations described above, added new derivative allegations regarding thegranting of stock options to certain officers and directors from 1994 through2000, and class action allegations regarding the then-proposed merger ofMichaels and entities sponsored by Bain Capital Partners, LLC (“Bain”) and TheBlackstone Group (“Blackstone”) (see Note 9 in the Notes to ConsolidatedFinancial Statements and “Managements Discussion and Analysis of FinancialCondition and Results of Operations—Recent Events” for additional informationregarding the merger, which has now been consummated) and added certainadditional former officers and directors as individual defendants. Among otherthings, the plaintiff sought (a) a declaration that the agreement and planof merger among Michaels and the entities sponsored by Bain and Blackstoneviolated the individual defendants’ fiduciary duties and therefore is unlawfuland unenforceable, (b) an injunction to prevent the consummation of the Merger,(c) an indeterminate amount of damages from the individual defendants,(d) certain corporate governance changes, (e) formation of aconstructive trust to hold the proceeds of defendants’ alleged tradingactivities and (f) restitution from, and disgorgement of proceeds derivedby, the named officers with respect to the alleged acts.

 

Bycourt order dated August 18, 2006, the Gottlieb and Schuman actions(discussed below) were consolidated with the Fathergill action. On October 4,2006, Fathergill, Gottlieb and Schuman filed a consolidated shareholderderivative class action petition that included the claims that had beenasserted in any of the three actions and named as defendants each of thedefendants that had been named in any of the three actions. We believe we havecertain meritorious defenses and intend to defend this lawsuitvigorously.  We are unable to estimate a range of possible loss, if any,in this claim.

 

*Gottlieb and Schuman Claim*

 

OnJune 9, 2006, Feivel Gottlieb and on June 12, 2006, Roberta Schumaneach filed purported stockholder derivative actions in the 191st and the14th District Courts for Dallas County, Texas, respectively. The lawsuitsnamed our former Chairman of the Board and Vice Chairman of the Board, both intheir capacities at the time as officers of Michaels and as directors, and allof Michaels’ other current directors as individual defendants and Michaels as anominal defendant. The plaintiffs asserted claims against the individualdefendants for breach of fiduciary duty, abuse of control, gross mismanagement,waste of corporate assets and unjust enrichment in connection with the grantingof stock options by Michaels between 1990 and October 2001 and sought, amongother relief, an 

 

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indeterminateamount of damages from the individual defendants and injunctive relief againstMichaels with regard to various corporate governance matters. All of theseclaims were asserted derivatively on behalf of Michaels.

 

OnJuly 5, 2006, each of Feivel Gottlieb and Roberta Schuman filed a FirstAmended Shareholder Derivative and Class Action Petition against theindividual defendants, Michaels as a nominal defendant, and against Bain andBlackstone. In addition to the derivative allegations described above, theseamended petitions added class action allegations against our then-currentdirectors for breach of fiduciary duty related to the then-proposed merger ofMichaels with entities sponsored by Bain and Blackstone, and a claim againstBain and Blackstone for aiding and abetting the directors’ alleged breach offiduciary duty. In addition to the relief previously sought by the plaintiffs,as a result of these new claims, the plaintiffs sought (a) to enjoin then-proposed merger (or declare it void, if consummated), (b) to require thedefendants to disgorge the property they received as a result of theirallegedly wrongful conduct and (c) an indeterminate amount of damages fromthe defendants, jointly and severally. As discussed above, by court order datedOctober 4, 2006, the Gottlieb and Schuman actions were consolidated with theFathergill action described above.

 

Bycourt order dated August 18, 2006, the Gottlieb and Schuman actions wereconsolidated with the Fathergill action described above. On October 4, 2006,Fathergill, Gottlieb and Schuman filed a consolidated shareholder derivativeclass action petition that included the claims that had been asserted in any ofthe three actions and named as defendants each of the defendants that had beennamed in any of the three actions.

 

*Dutil Claim*

 

OnSeptember 11, 2003, Leo J. Dutil filed a purported stockholder derivativeaction in the United States District Court for the Northern District of Texas,Dallas Division. The lawsuit named certain former and then-current officers anddirectors as individual defendants and Michaels as a nominal defendant. In thisderivative action, the plaintiff made allegations of fact similar to those madein the March 21, 2003 Fathergill petition described above. The plaintiffasserted claims against the individual defendants for breach of fiduciary duty,misappropriation of confidential information, and contribution andindemnification. All of these claims were asserted derivatively on behalf ofMichaels. On August 31, 2006, the plaintiff filed a notice of voluntarydismissal..****The Court issued anorder on September 7, 2006, dismissing the case in its entirety withoutprejudice.

 

*Hulliung Claim*

 

OnJune 19, 2006, Albert Hulliung filed a purported stockholder derivativeaction, which is pending in the United States District Court, Northern Districtof Texas, Dallas Division. The lawsuit named our former Chairman of the Boardand Vice Chairman of the Board, all of Michaels’ other then-current directors,one additional then-current officer and certain of our former officers asindividual defendants and Michaels as a nominal defendant. In connection withthe granting and repricing of certain stock options between 1993 and 2001, theplaintiff asserted claims of (a) breaches of fiduciary duty and violationsof Section 10(b) of the Securities Exchange Act of 1934 andRule 10b-5 promulgated thereunder against all the individual defendantsand (b) unjust enrichment against our then-Chairman of the Board,then-Vice Chairman of the Board, one other then-director and the otherthen-current officer and former officers named in the lawsuit. The plaintiffsought, among other relief, an indeterminate amount of damages from theindividual defendants and disgorgement of certain options and any proceedsderived therefrom from the defendants against whom the unjust enrichment claimwas asserted. All of these claims were asserted derivatively on behalf ofMichaels.

 

OnJuly 27, 2006, the plaintiff amended his complaint adding certain otherformer and then-current officers and one former director of Michaels asindividual defendants and including allegations similar to those set forth inthe second amended (July 10, 2006) Fathergill Petition, describedabove. The plaintiff asserted claims derivatively on behalf of Michaels for(a) breach of fiduciary duty and violations of Section 10(b) of theSecurities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder byeach of the individual defendants, (b) unjust enrichment against certainof the individual defendants who received stock options during the relevantperiod and (c) insider selling against certain of the individualdefendants who sold Michaels Common Stock during the time period. Additionally,the plaintiff purported to represent a class of Michaels’ shareholders. Theplaintiff sought, among other relief, (i) an indeterminate amount ofdamages from the individual defendants, (ii) restitution from, anddisgorgement of proceeds derived by, the individual defendants who receivedstock options, (iii) the imposition of a constructive trust against theindividuals who were alleged to have engaged in insider sales and(iv) other unspecified equitable relief.

 

OnNovember 7, 2006, the Ziolkowski action (discussed below) was consolidated withthe Hulliung action. On November 27, 2006, the plaintiffs in Hulliung andZiolkowski filed a Consolidated Class Action Complaint (“ConsolidatedComplaint”) against Michaels and certain of its former officers and directors.The Consolidated Complaint alleges that the defendants misrepresented and/oromitted material facts in Michaels’ annual proxy statements for 1993 through2006, including, among other things, failing to disclose Michaels’ and thedefendants’ alleged option backdating practices and the fact that Michaels andthe defendants had reported 

 

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falsefinancial statements as a result of those practices. The Consolidated Complaintalso alleges that the proxy statements failed to disclose: (a) that Michaelshad problems with its internal controls that prevented it from issuing accuratefinancial reports and projections; (b) that because of improperly recordedstock-based compensation expenses, Michaels’ reported financial resultsviolated GAAP; (c) that Michaels’ public disclosures presented an inflated viewof Michaels’ earnings by understating the Company’s past compensation expenses;(d) that Michaels faced substantial liability for its past and ongoingbackdating practices; and (e) that Michaels’ directors had received andacquiesced in the granting of backdated stock options. The plaintiff assertsclaims against all defendants for violations of Section 14(a) of the SecuritiesExchange Act of 1934 and Rule 14a-9 promulgated thereunder, and seeks, amongother relief, an indeterminate amount of damages from the defendants, as wellas an award of attorneys fees and costs. We believe we have certain meritoriousdefenses and intend to defend this lawsuit vigorously.  We are unable toestimate a range of possible loss, if any, in this claim.

 

*Ziolkowski Claim*

 

OnJuly 7, 2006, James and Christine Ziolkowski filed a purported stockholderderivative action, which is pending in the United States District Court,Northern District of Texas, Dallas Division. The lawsuit named certain formerand then-current officers and directors of Michaels as individual defendants,and Michaels as a nominal defendant. In connection with the granting of stockoptions to the named officers, the plaintiffs asserted claims of(a) breaches of fiduciary duty and violations of Section 10(b) of theSecurities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder byeach of the individual defendants, (b) aiding and abetting of the namedofficers’ breach of their fiduciary duties by the director defendants and(c) unjust enrichment and rescission against the named officers. Theplaintiffs sought, among other relief, (i) an indeterminate amount ofdamages from the individual defendants, (ii) restitution from, anddisgorgement of proceeds derived by, the named officers with respect to thealleged acts, (iii) rescission of all option contracts granted to thenamed officers, and cancellation of any current or future obligations ofMichaels under any executory contracts obtained by the named officers as a resultof the alleged acts, (iv) formation of a constructive trust to hold allexecutory option contracts issued to the named officers and (v) punitivedamages against the named officers. All of these claims were assertedderivatively on behalf of Michaels.

 

Asdiscussed above, by court order dated November 7, 2006, the Ziolkowski actionwas consolidated with the Hulliung action described above and on November 27,2006, the plaintiffs in Hulliung and Ziolkowski filed a Consolidated Complaint.

 

*Massachusetts Laborers’ Annuity Fund Claim*

 

OnSeptember 6, 2006, the Massachusetts Laborers’ Annuity Fund filed aputative class action on behalf of itself and all holders of Michaels CommonStock during the period of May 4, 2004 through the present. The lawsuit ispending in the United States District Court, Northern District of Texas, DallasDivision, and named Michaels and all of its then-current directors asdefendants. The plaintiff alleged that the defendants misrepresented and/oromitted material facts in Michaels’ annual proxy statements for 2004, 2005 and2006, including, among other things, that Michaels’ reported financial resultsinflated its reported earnings by not properly recording stock-basedcompensation expense relating to the granting of stock options, that problemswith Michaels’ internal controls prevented it from issuing accurate financialreports and projections, and that Michaels’ directors had received andacquiesced in the granting of backdated stock options. The plaintiff assertedclaims against all of the defendants of (a) violations ofSection 14(a) of the Securities Exchange Act of 1934 and Rule 14a-9promulgated thereunder and (b) violations of Section 20(a) of theSecurities Exchange Act of 1934. The plaintiff sought, among other relief, anindeterminate amount of damages from the defendants and equitable or injunctiverelief, including the rescission of stock option grants. We believe we havecertain meritorious defenses and intend to defend this lawsuitvigorously.  We are unable to estimate a range of possible loss, if any,in this claim.

 

*Employee Class Action Claims*

 

*Cotton Claim*

 

OnDecember 20, 2002, James Cotton, a former store manager of Michaels ofCanada, ULC, our wholly-owned subsidiary, and Suzette Kennedy, a formerassistant manager of Michaels of Canada, commenced a proposed class proceedingagainst Michaels of Canada and Michaels Stores, Inc. on behalf of themselvesand current and former employees employed in Canada. The Cotton claim was filedin the Ontario Superior Court of Justice and alleges that the defendantsviolated employment standards legislation in Ontario and other provinces andterritories of Canada by failing to pay overtime compensation as required bythat legislation. The Cotton claim also alleges that this conduct was in breachof the contracts of employment of those individuals. The Cotton claim seeks a 

 

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declarationthat the defendants have acted in breach of applicable legislation, payment tocurrent and former employees for overtime, damages for breach of contract,punitive, aggravated and exemplary damages, interest, and costs. In May of2005, the plaintiffs delivered material in support of their request that thisaction be certified as a class proceeding. Michaels filed and served itsresponding materials opposing class certification on January 31, 2006. Adate has not yet been set for the hearing with respect to certification. Weintend to contest certification of this claim as a class action. Further, we believewe have certain defenses on the merits and intend to defend this lawsuitvigorously. We are unable to estimate a range of possible loss, if any, in thisclaim.

 

*Clark Claim*

 

OnJuly 13, 2005, Michael Clark, a former Michaels store assistant manager,and Lucinda Prouty, a former Michaels store department manager, commenced aproposed class action proceeding against Michaels Stores, Inc. on behalf ofthemselves and current and former hourly retail employees employed inCalifornia from July 13, 2001 to the present. The Clark suit was filed inthe Superior Court of California, County of San Diego, and alleges thatMichaels failed to pay overtime wages, provide meal and rest periods (orcompensation in lieu thereof), and provide itemized employee wage statements.The Clark suit also alleges that this conduct was in breach of California’sunfair competition law. The plaintiffs seek injunctive relief, damages forunpaid overtime pay, meal break penalties, waiting time penalties, interest,and attorneys’ fees and costs. Under the Class Action Fairness Act, weremoved the case to federal court on August 5, 2005. The partiesparticipated in a voluntary mediation on October 16, 2006 and have reached atentative settlement of the case. Contingent on court approval, the partieshave agreed to a claims made process, with no material impact on our statementof operations, balance sheet, or cash flows for any period presented.

 

*Morris Claim*

 

OnNovember 16, 2005, Geoffrey Morris, a former Aaron Brothers employee inSan Diego, California, commenced a proposed class action proceedingagainst Aaron Brothers, Inc. on behalf of himself and current and former AaronBrothers employees in California from November 16, 2001 to the present.The Morris suit was filed in the Superior Court of California, County ofSan Diego, and alleges that Aaron Brothers failed to pay overtime wages,reimburse the plaintiff for necessary expenses (including the cost of gas usedin driving his car for business purposes), and provide adequate meal and rest breaks(or compensation in lieu thereof). The Morris suit also alleges that thisconduct was in breach of California’s unfair competition law. The plaintiffseeks injunctive relief, damages for unpaid overtime pay, meal break penalties,waiting time penalties, interest, and attorneys’ fees and costs. Morris filedan Amended Complaint on June 8, 2006 and now seeks to represent a class ofcurrent and former assistant managers only. We believe that the Morris claimlacks merit, and we intend to vigorously defend our interests. We are unable toestimate a range of possible loss, if any, in this claim.

 

*Governmental Inquiries and Related Matters*

 

*Non-U.S. Trust Inquiry*

 

Inearly 2005, the District Attorney’s office of the County of New York and theSEC opened inquiries concerning non-U.S. trusts that directly orindirectly held shares of Michaels Common Stock and Common Stock options. Thestaff of a U.S. Senate subcommittee and a federal grand jury requestedinformation with respect to the same facts. We are cooperating in theseinquiries and have provided information in response to the requests.

 

Certainof these trusts and corporate subsidiaries of the trusts acquired securities ofMichaels in transactions directly or indirectly with Charles J. Wyly, Jr.and Sam Wyly, who were, respectively, Chairman and Vice Chairman of the Boardof Directors prior to the consummation of the merger of Michaels and entitiessponsored by Bain and Blackstone, or with other Wyly family members. Inaddition, subsidiaries of certain of these trusts acquired securities directlyfrom us in private placement transactions in 1996 and 1997 and upon theexercise of stock options transferred, directly or indirectly, to the trusts ortheir subsidiaries by Charles Wyly, Sam Wyly, or other Wyly family members.

 

Weunderstand that Charles Wyly and Sam Wyly and/or certain of their familymembers are beneficiaries of irrevocable non-U.S. trusts. The 1996 and1997 private placement sales by us of Michaels securities to subsidiaries ofcertain of these trusts were disclosed by us in filings with the SEC. Thetransfer by Charles Wyly and/or Sam Wyly (or by other Wyly family members orfamily-related entities) of Michaels securities to certain of these trusts andsubsidiaries was also disclosed in filings with the SEC by us and/or by CharlesWyly and Sam Wyly. Based on information provided to us, our SEC filings did notreport securities owned by the non-U.S. trusts or their corporatesubsidiaries as beneficially owned by Charles Wyly and Sam Wyly prior to 2005.

 

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Followingthe filing by Charles Wyly and Sam Wyly of an amended Schedule 13D withthe SEC on April 8, 2005, stating that they may be deemed the beneficialowners of Michaels securities held directly or indirectly by thenon-U.S. trusts, we disclosed in a press release that, as ofMarch 31, 2005, under SEC Rule 13d-3, Charles Wyly may be deemed theowner of 6,045,818 shares, or 4.4% of our then outstanding Common Stock,and Sam Wyly may be deemed the beneficial owner of 4,822,534 shares, or3.5% of our then outstanding Common Stock. In our 2005 and 2006 proxystatements, we included the securities held in the non-U.S. trusts ortheir separate subsidiaries, as reported by the Wylys, in the beneficial ownershiptable of our principal stockholders and management, with appropriate footnotes.

 

CharlesWyly and Sam Wyly had not historically reported purchases and sales of Michaelssecurities by the non-U.S. trusts and their subsidiaries in reports filedby them with the SEC under Section 16 of the Securities Exchange Act of1934. In an April 2005 letter from their counsel, Charles Wyly and Sam Wylyundertook to file any additional required Section 16 reports and to pay usthe amount of any Section 16 liability. Counsel for Michaels and counselfor the Wylys have exchanged factual information and engaged in discussions oflegal issues. Charles Wyly and Sam Wyly have not filed additional or amendedSection 16 reports with respect to the transactions in question. Theyhave, however, since June 2005, reported on Form 4 filings the ownership ofMichaels securities by the non-U.S. trusts and their subsidiaries and the salesof such securities in connection with the merger involving Michaels andentities sponsored by Bain and Blackstone. In those filings, Charles Wyly andSam Wyly have disclaimed beneficial ownership of the securities except to theextent of a pecuniary interest in the securities.

 

CharlesWyly and Sam Wyly made a proposal to settle the issue, without admitting ordenying that they have or had, for Section 16 purposes, beneficial ownership ofMichaels securities that are or were held by the non-U.S. trusts or theirsubsidiaries. Following that proposal, on March 15, 2006, the Board ofDirectors appointed a special committee of the Board to investigate and makedecisions on behalf of Michaels with respect to the potential Section 16liability issue. The special committee was also given authority to makedecisions for Michaels relating to the allegations in the Fathergill derivativesuit related to the transactions and holdings of Michaels Common Stock bycertain of the non-U.S. trusts, and authority to investigate and respondto the governmental inquiries, described above. The special committee had retainedindependent counsel to advise it in these matters.

 

Inconnection with the consummation of the merger of Michaels with entitiessponsored by Bain and Blackstone, all the members of the Board of Directors,including the members of the special committee, resigned. As a result, thecommittee no longer exists, and authority concerning those matters has nowreverted to the new Board of Directors. The independent counsel retained by thespecial committee is now advising the Company. The Company and Charles Wyly,Sam Wyly and Evan Wyly entered into a tolling agreement, effective November 6,2006, suspending the running of applicable statutes of limitations and similardefenses to the potential Section 16 claims from November 6, 2006 throughFebruary 1, 2007.

 

*Stock Options Inquiry*

 

OnJune 15, 2006, following Michaels’ announcement that its Audit Committeehad initiated an internal review, described below, into the Company’shistorical stock option practices, Michaels received a letter from the Divisionof Enforcement of the SEC requesting that the Company preserve all documentsconcerning its granting of stock options from 1990 through the present andstating that the SEC intended to request production of such documents in thefuture. In a letter dated November 15, 2006, the Division requested thedocuments. A June 16, 2006 grand jury subpoena issued by the U.S. DistrictCourt for the Southern District of New York requesting documents relating tothe granting of stock options during the period 1996 to the present waswithdrawn in connection with a July 27, 2006 grand jury subpoena issued by theU.S. District Court for the Northern District of Texas on behalf of theFraud section of the Department of Justice requesting documents relating to thegranting of stock options during the same period. We are cooperating in theseinquiries and have provided information in response to the requests.

 

OnAugust 28, 2006, the Board of Directors appointed a special committee ofthe Board to investigate and make decisions on behalf of Michaels with respectto these subpoenas and any stock option grant issue raised by the SEC. TheBoard also designated the special committee to investigate and make decisionson behalf of Michaels with respect to allegations regarding Michaels’ historicalstock option practices asserted in each of the Fathergill, Gottlieb andSchuman, Hulliung and Ziokowski claims, described above under “ShareholderClaims.” This committee no longer exists as a result of the resignation of themembers of the Board of Directors, including the members of this committee, inconnection with the consummation of the merger of Michaels with entitiessponsored by Bain and Blackstone, and the authority previously given to thecommittee has now reverted to the new Board of Directors.

 

*Internal Review of Stock Options Practices andRelated Accounting*

 

Basedon media reports regarding historical stock options practices at other publiclytraded companies regarding allegations of “backdating” option grants, theCompany’s Audit Committee has conducted an internal review into the Company’shistorical stock 

 

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optionpractices, including a review of the Company’s underlying option grantdocumentation and procedures and related accounting. The Audit Committee’sinternal review was conducted with the assistance of independent legal counseland outside accounting experts. The Company’s independent registered publicaccounting firm was informed about the internal review. The Company also voluntarilyreported the commencement of this review to the SEC.

 

TheAudit Committee review focused principally on the question of whether there mayhave been intentional wrongdoing in the Company’s historical stock optionsgranting practices. On August 25, 2006, the Audit Committee’s independentlegal counsel presented its final report to the Audit Committee, which statedthat the investigation conducted by independent counsel did not support aconclusion that there was intentional misconduct. Based on the independentcounsel report, the Audit Committee concluded that the results of theinvestigation did not support a finding of intentional misconduct.

 

Inconnection with the Audit Committee review, the Company has substantiallycompleted an internal review of historical stock options practices and relatedaccounting issues from 1990 to the present. In this review, the Company hasbeen advised, with respect to specific Delaware law issues, by independentDelaware counsel and, with respect to specific Texas law issues, by independentTexas counsel. Management of the Company has discussed its current analyses andrelated judgments, described below, with the Company’s independent registeredpublic accounting firm and with the Audit Committee.

 

TheCompany has used its stock option program as a key component of compensationfor both its officers and a broad group of non-officer employees. Historically,the Company has granted stock options principally, but not invariably,utilizing a process in which an authorized committee of the Board would approvestock option grants from time to time through unanimous written consentresolutions with specified effective dates that generally preceded the date onwhich the consents were fully executed by members of the applicable committee.Since October 2001, the Company has continued to use unanimous written consentresolutions to grant stock options but in a modified process based onestablished pre-determined effective grant dates and generally pre-determinedgrant levels for its stock option program. Prior to October 2001, some grantswere made on the basis of pre-determined grant dates and pre-determined grantlevels; others were not. Most of the stock option grants during the periodunder review were dated prior to the approval of the grants by the Board or aBoard committee for various reasons, including the design and use of theunanimous written consent process, delays in the initiation of the writtenconsents, general administrative deficiencies, and actions taken to correct whatthe Company believed were mistakes or omissions in the grant process.Notwithstanding that the Audit Committee concluded that the results of theinvestigation did not support a finding of intentional misconduct, the Companyhas identified accounting issues related to certain of the stock option grantsprior to October 2001.

 

TheCompany has historically considered the effective date specified in an optionand the effective date specified in the written consents by the applicablecommittee as the accounting measurement date for determining stock-basedcompensation expense under APB No. 25, *Accountingfor Stock Issued to Employees*. For all of the post-October 2001options grants and for many of the pre-October 2001 options grants, the Companyhas concluded that the accounting measurement date historically used wascorrect and appropriate, and that there is no unrecognized non-cashcompensation expense with respect to those grants. However, for certain grantsthat were reviewed in the period 1990 to 2001, based on the advice it receivedand its own review of Company records, the Company currently believes that themeasurement date would likely be considered to differ from the measurement dateoriginally used in accounting for such grants. In connection with those grants,the Company is unable to definitively determine the actual measurement datebased on existing records. The Company estimated the measurement date based onits knowledge of the approval process, subsequent meetings that occurred, andestimates of the time that would have lapsed to obtain documented approval forthose grants. To the extent the exercise price of an option was less than thefair market value of the Company’s common stock on an estimated measurementdate different than the original measurement date, the difference representsthe Company’s estimate of the amount of non-cash compensation expense thatshould have been recorded over the vesting period of the option.

 

Basedon the Company’s current analysis, the estimated amount of additional non-cashcompensation cost that should have been recorded was approximately$22.5 million, net of income taxes of approximately $13.5 million,all of which relates to periods prior to fiscal 2001**.**The amounts do not affect results of operations or the statementof cash flows in any period presented in this report or in the Company’s AnnualReport on Form 10-K for fiscal 2005. As all stock options in question wereexercised prior to the end of fiscal 2005, the effect on the Company’sfinancial position as of January 28, 2006 and as of October 28, 2006 aspresented in this report would be an adjustment to both retained earnings andaccumulated paid in capital in the amount of any unrecorded non-cashcompensation cost, with no impact on total stockholders’ equity. Based on theCompany’s current analysis and judgments, any misstatement of the Company’sfinancial statements in any period presented in this report or in its fiscal2005 Form 10-K is not considered material.

 

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Asthe Company’s review is not complete as of the date of this filing, additionalinformation may become available which could cause the Company’s currentestimates and judgments to change materially. However, the Company currentlybelieves that a restatement of the Company’s prior period financial statementswill not be required.

 

TheCompany is also evaluating whether previously deducted compensation related toexercised stock options might be non-deductible under Section 162(m) ofthe Internal Revenue Code, which could result in additional taxes and interestrelated to the prior deductions. The Company currently believes that the amountof tax deductions it would be unable to recognize, if any, would not bematerial to results of operations, cash flow, or the Company’s financialposition, but has not finalized its assessment of this matter.

 

Anumber of shareholder lawsuits have been filed against the Company, thethen-current and certain former directors, and certain then-current and former officersof Michaels relating to the Company’s historical stock option practices. See“— Shareholder Claims” above. The Company has received a grand jurysubpoena and has received a document production request from the SEC withrespect to documents relating to our historical stock option practices. See“— Governmental Inquires and Related Matters—Stock Options Inquiry” above.

 

*General*

 

Weare a defendant from time to time in lawsuits incidental to our business. Basedon currently available information, we believe that resolution of all knowncontingencies is uncertain. There can be no assurance that future costs of suchlitigation would not be material to our financial position, results ofoperations, or cash flows.

 

**Item 1A.  Risk Factors.**

 

**We face risks relating to our historical stock optionpractices.**

 

Ourformer Audit Committee conducted an internal review, with the assistance ofindependent legal counsel and outside accounting experts, into our historicalstock option practices. The Audit Committee concluded that the results of theinvestigation did not support a finding of intentional misconduct. However, wehave identified accounting issues related to certain stock option grants priorto October 2001. Based on our current analysis and judgments, we do notcurrently believe a restatement of our prior period financial statements willbe required; however, our review is not complete as of the filing date of thisQuarterly Report on Form 10-Q. Additional information may become availablewhich could cause our current judgments and estimates to change materially. Inaddition, our historical stock option practices are under investigation by theDepartment of Justice, and the SEC has requested that we produce documentsconcerning the grant of stock options since 1990. It is possible that, as aresult of these investigations and inquiries or other guidance from the SEC,the SEC may direct us to, or we may conclude that we should, restate priorperiod financial statements or record a non-cash charge in the fourth quarterof fiscal 2006 for estimated unrecorded stock compensation expense. See “PartII.–Item 1.–Legal Proceedings–Governmental Inquiries and Related Matters–StockOptions Inquiry” and “Part II.–Item 1.–Legal Proceedings–Internal Review ofStock Options Practices and Related Accounting.”  In addition, our historical stock optionpractices are the subject of certain lawsuits. If any of these suits isresolved adversely, we may be adversely impacted.

 

**We face risks related to unresolved SEC staff comments.**

 

Wereceived written comments from the SEC staff regarding our Annual Report onForm 10-K for fiscal 2005 and our Quarterly Report on Form 10-Q for the threemonths ended April 29, 2006. The SEC staff requested further explanation of (a)the changes to our calculation for deferring costs related to preparinginventory for sale and vendor allowance recognition, (b) the transition toweighted average cost accounting, and (c) our current and deferred income taxbalances. If the SEC staff disagrees with our accounting treatment of thesematters, we might have to revise disclosures in future filings, amenddisclosures in our Annual Report on Form 10-K for fiscal 2005 andsubsequent periodic reports, or restate prior period financial statements. Wecontinue to believe that our accounting treatment with respect to these mattersis in conformity with U.S generally accepted accounting principles and that arestatement of our historical financial statements is not required.

 

**We face risks related to our substantial indebtedness.**

 

Oursubstantial leverage could adversely affect our ability to raise additionalcapital to fund our operations, limit our ability to react to changes in theeconomy or our industry, expose us to interest rate risk to the extent of ourvariable rate debt and prevent us from meeting our obligations under our Notesand Senior Credit Facilities. Our high degree of leverage could have importantconsequences to us, including:

 

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•                  making it more difficult for us to makepayments on our indebtedness;

•                  increasing our vulnerability to generaleconomic and industry conditions;

•                  requiring a substantial portion of cash flowfrom operations to be dedicated to the payment of principal and interest on ourindebtedness, thereby reducing our ability to use our cash flow to fund ouroperations, capital expenditures and future business opportunities;

•                  exposing us to the risk of increased interestrates as our borrowings under our Senior Credit Facilities are at variablerates of interest;

•                  restricting us from making strategicacquisitions or causing us to make non-strategic divestitures;

•                  limiting our ability to obtain additionalfinancing for working capital, capital expenditures, product development, debtservice requirements, acquisitions and general corporate or other purposes; and

•                  limiting our ability to adjust to changingmarket conditions and placing us at a competitive disadvantage compared to ourcompetitors who are less highly leveraged.

 

**Our debt agreements contain restrictions that limit ourflexibility in operating our business.**

 

OurSenior Credit Facilities and the indentures governing our Notes contain variouscovenants that limit our ability to engage in specified types of transactions.These covenants limit our and our restricted subsidiaries’ ability to, amongother things:

 

•                  incur additional debt;

•                  pay dividends or distributions on our capitalstock or repurchase our capital stock;

•                  issue stock of subsidiaries;

•                  make certain investments;

•                  create liens on our assets to secure debt;

•                  enter into transactions with affiliates;

•                  merge or consolidate with another company;and

•                  sell or otherwise transfer assets.

 

Inaddition, under our Senior secured term loan facility, we will be required tosatisfy and maintain a consolidated secured debt ratio. Our ability to meetsuch a ratio can be affected by events beyond our control, and there can be noassurance that we will meet the required ratio.

 

Uponthe occurrence of an event of default under our Senior Credit Facilities, thelenders could elect to declare all amounts outstanding under the Senior CreditFacilities to be immediately due and payable and terminate all commitments toextend further credit. If we were unable to repay those amounts, the lendersunder the Senior Credit Facilities could proceed against the collateral grantedto them to secure that indebtedness. We will pledge a significant portion ofour assets as collateral under the Senior Credit Facilities. If the lendersunder the Senior Credit Facilities accelerate the repayment of borrowings, wemay not have sufficient assets to repay the Senior Credit Facilities, as wellas our unsecured indebtedness, including our Notes.

 

OurAsset-based revolving credit facility permits us to borrow up to $1.0 billion;however, our ability to borrow thereunder is limited by a borrowing base. Theborrowing base equals the sum of (i) 90% of eligible credit card receivablesand debit card receivables; (ii) between 85% and 90% of the appraised netorderly liquidation value of eligible inventory and of eligible letters ofcredit; (iii) a percentage of eligible in-transit inventory, less certainreserves; and, (iv) the sum of an additional 10% of the appraised net orderlyliquidation value of eligible inventory and of eligible letters of credit plusan additional 5% of eligible credit card receivables and debit cardreceivables, up to a maximum amount of $200.0 million. In addition, ourability to borrow under this facility is limited by a minimum liquidity condition,providing that, if excess availability is less than $75.0 million at any time,we are not permitted to borrow any additional amounts under the Asset-basedrevolving credit facility unless our pro forma Consolidated Fixed ChargeCoverage Ratio (as defined in the credit agreement for our Asset-basedrevolving credit facility) is at least 1.1 to 1.0. Moreover, our Asset-basedrevolving credit facility provides discretion to the agent bank acting onbehalf of the lenders to impose additional availability reserves, which couldmaterially impair the amount of borrowings that would otherwise be available tous. There can be no assurance that the agent bank will not impose such reservesor, were it to do so, that the resulting impact of this action would not materiallyand adversely impair our liquidity.

 

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** **

**Item 6.  Exhibits.**

 

(a) Exhibits:

 
| **Exhibit  Number** |   | **Description  of Exhibit**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|---------------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1                 |   | Amended  and Restated Certificate of Incorporation of Michaels Stores, Inc. (previously  filed as Exhibit 3.1 to Form 8-K filed by Registrant on November 6, 2006, SEC  File No. 001-09338).                                                                                                                                                                                                                                                                                                                                                                                 |
|                |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 3.2                 |   | Amended  and Restated Bylaws of Michaels Stores, Inc. (previously filed as Exhibit 3.2  to Form 8-K filed by Registrant on November 6, 2006, SEC File No. 001-09338).                                                                                                                                                                                                                                                                                                                                                                                                        |
|                |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 4.1                 |   | Senior  Indenture, dated as of October 31, 2006, among Michaels Stores, Inc., the  guarantors named therein and Wells Fargo Bank, National Association, as  trustee (filed herewith).                                                                                                                                                                                                                                                                                                                                                                                        |
|                |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 4.2                 |   | Senior  Subordinated Indenture, dated as of October 31, 2006, among Michaels Stores,  Inc., the guarantors named therein and Wells Fargo Bank, National  Association, as trustee (filed herewith).                                                                                                                                                                                                                                                                                                                                                                           |
|                |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 4.3                 |   | Subordinated  Discount Indenture, dated as of October 31, 2006, among Michaels Stores,  Inc., the guarantors named therein and Wells Fargo Bank, National  Association, as trustee (filed herewith).                                                                                                                                                                                                                                                                                                                                                                         |
|                |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 4.4                 |   | Registration  Rights Agreement for the Senior Notes, dated as of October 31, 2006, among  Michaels Stores, Inc., the guarantors named therein and Deutsche Bank  Securities Inc., J.P. Morgan Securities Inc., Banc of America Securities LLC  and Credit Suisse Securities (USA) LLC (filed herewith).                                                                                                                                                                                                                                                                      |
|                |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 4.5                 |   | Registration  Rights Agreement for the Senior Subordinated Notes, dated as of October 31, 2006,  among Michaels Stores, Inc., the guarantors named therein and Deutsche Bank  Securities Inc., J.P. Morgan Securities Inc., Banc of America Securities LLC  and Credit Suisse Securities (USA) LLC (filed herewith).                                                                                                                                                                                                                                                         |
|                |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 4.6                 |   | Registration  Rights Agreement for the Subordinated Discount Notes, dated as of October 31,  2006, among Michaels Stores, Inc., the guarantors named therein and Deutsche  Bank Securities Inc., J.P. Morgan Securities Inc., Banc of America Securities  LLC and Credit Suisse Securities (USA) LLC (filed herewith).                                                                                                                                                                                                                                                       |
|                |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 4.7                 |   | Registration  Rights Agreement, dated as of October 31, 2006, among Michaels Stores, Inc.  and certain stockholders thereof (filed herewith).                                                                                                                                                                                                                                                                                                                                                                                                                                |
|                |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.1                |   | Stockholders  Agreement, dated as of October 31, 2006, among Michaels Stores, Inc. and  certain stockholders thereof (filed herewith).                                                                                                                                                                                                                                                                                                                                                                                                                                       |
|                |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.2                |   | Management  Agreement, dated as of October 31, 2006, among Michaels Stores, Inc., Bain  Capital Partners, LLC and Blackstone Management Partners V LLC (filed  herewith).                                                                                                                                                                                                                                                                                                                                                                                                    |
|                |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.3                |   | Management  Agreement, dated as of October 31, 2006, between Michaels Stores, Inc. and  Highfields Capital Management LP (filed herewith).                                                                                                                                                                                                                                                                                                                                                                                                                                   |
|                |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.4                |   | Credit  Agreement, dated as of October 31, 2006, among Michaels Stores, Inc., as lead  borrower, the facility guarantors named therein, Bank of America, N.A., as  administrative agent and collateral agent, Deutsche Bank Securities Inc., as  syndication agent, Credit Suisse, JPMorgan Chase Bank, N.A., Wells Fargo  Retail Finance, LLC, as co-documentation agents, the lenders named therein,  and Banc of America Securities LLC, Deutsche Bank Securities Inc. and J.P.  Morgan Securities Inc., as joint lead arrangers and joint bookrunners (filed  herewith). |
|                |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.5                |   | Credit  Agreement, dated as of October 31, 2006, among Michaels Stores, Inc.,  Deutsche Bank AG New York Branch, as administrative agent, the other lenders  named therein, JPMorgan Chase Bank, N.A., as syndication agent, and Bank of  America, N.A. and Credit Suisse, as co-documentation agents, and Deutsche  Bank Securities Inc., J.P. Morgan Securities Inc. and Banc of America  Securities LLC as co-lead arrangers and joint bookrunners (filed herewith).                                                                                                      |
|                |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 31.1                |   | Certifications  of Jeffrey N. Boyer pursuant to §302 of the Sarbanes-Oxley Act of 2002 (filed  herewith).                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
|                |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 31.2                |   | Certifications  of Gregory A. Sandfort 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).                                                                                                                                                                                                                                                                                                                                                                                                                                  |

 

48

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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/  Jeffrey  N. Boyer |   |
|   |                   | Jeffrey  N. Boyer |
|   |                   | President  and Chief Financial Officer |
|   |                   | (Principal  Financial Officer) |

 

Dated: December7, 2006

 

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**INDEX TO EXHIBITS**

 
| **Exhibit****Number** | ** ** | **Description of  Exhibit**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
|-----------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1                   |       | Amended and Restated Certificate of Incorporation  of Michaels Stores, Inc. (previously filed as Exhibit 3.1 to Form 8-K filed  by Registrant on November 6, 2006, SEC File No. 001-09338).                                                                                                                                                                                                                                                                                                                                                                                 |
|                  |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 3.2                   |       | Amended and Restated Bylaws of Michaels Stores,  Inc. (previously filed as Exhibit 3.2 to Form 8-K filed by Registrant on  November 6, 2006, SEC File No. 001-09338).                                                                                                                                                                                                                                                                                                                                                                                                       |
|                  |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 4.1                   |       | Senior Indenture, dated as of October 31, 2006,  among Michaels Stores, Inc., the guarantors named therein and Wells Fargo  Bank, National Association, as trustee (filed herewith).                                                                                                                                                                                                                                                                                                                                                                                        |
|                  |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 4.2                   |       | Senior Subordinated Indenture, dated as of October  31, 2006, among Michaels Stores, Inc., the guarantors named therein and Wells  Fargo Bank, National Association, as trustee (filed herewith).                                                                                                                                                                                                                                                                                                                                                                           |
|                  |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 4.3                   |       | Subordinated Discount Indenture, dated as of  October 31, 2006, among Michaels Stores, Inc., the guarantors named therein  and Wells Fargo Bank, National Association, as trustee (filed herewith).                                                                                                                                                                                                                                                                                                                                                                         |
|                  |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 4.4                   |       | Registration Rights Agreement for the Senior  Notes, dated as of October 31, 2006, among Michaels Stores, Inc., the  guarantors named therein and Deutsche Bank Securities Inc., J.P. Morgan  Securities Inc., Banc of America Securities LLC and Credit Suisse Securities  (USA) LLC (filed herewith).                                                                                                                                                                                                                                                                     |
|                  |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 4.5                   |       | Registration Rights Agreement for the Senior  Subordinated Notes, dated as of October 31, 2006, among Michaels Stores,  Inc., the guarantors named therein and Deutsche Bank Securities Inc., J.P.  Morgan Securities Inc., Banc of America Securities LLC and Credit Suisse  Securities (USA) LLC (filed herewith).                                                                                                                                                                                                                                                        |
|                  |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 4.6                   |       | Registration Rights Agreement for the Subordinated  Discount Notes, dated as of October 31, 2006, among Michaels Stores, Inc.,  the guarantors named therein and Deutsche Bank Securities Inc., J.P. Morgan  Securities Inc., Banc of America Securities LLC and Credit Suisse Securities  (USA) LLC (filed herewith).                                                                                                                                                                                                                                                      |
|                  |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 4.7                   |       | Registration Rights Agreement, dated as of October  31, 2006, among Michaels Stores, Inc. and certain stockholders thereof (filed  herewith).                                                                                                                                                                                                                                                                                                                                                                                                                               |
|                  |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.1                  |       | Stockholders Agreement, dated as of October 31,  2006, among Michaels Stores, Inc. and certain stockholders thereof (filed  herewith).                                                                                                                                                                                                                                                                                                                                                                                                                                      |
|                  |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.2                  |       | Management Agreement, dated as of October 31,  2006, among Michaels Stores, Inc., Bain Capital Partners, LLC and Blackstone  Management Partners V LLC (filed herewith).                                                                                                                                                                                                                                                                                                                                                                                                    |
|                  |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.3                  |       | Management Agreement, dated as of October 31,  2006, between Michaels Stores, Inc. and Highfields Capital Management LP  (filed herewith).                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|                  |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.4                  |       | Credit Agreement, dated as of October 31, 2006,  among Michaels Stores, Inc., as lead borrower, the facility guarantors named  therein, Bank of America, N.A., as administrative agent and collateral agent,  Deutsche Bank Securities Inc., as syndication agent, Credit Suisse, JPMorgan  Chase Bank, N.A., Wells Fargo Retail Finance, LLC, as co-documentation  agents, the lenders named therein, and Banc of America Securities LLC,  Deutsche Bank Securities Inc. and J.P. Morgan Securities Inc., as joint lead  arrangers and joint bookrunners (filed herewith). |
|                  |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.5                  |       | Credit Agreement, dated as of October 31, 2006,  among Michaels Stores, Inc., Deutsche Bank AG New York Branch, as  administrative agent, the other lenders named therein, JPMorgan Chase Bank,  N.A., as syndication agent, and Bank of America, N.A. and Credit Suisse, as  co-documentation agents, and Deutsche Bank Securities Inc., J.P. Morgan  Securities Inc. and Banc of America Securities LLC as co-lead arrangers and  joint bookrunners (filed herewith).                                                                                                     |
|                  |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 31.1                  |       | Certifications of Jeffrey N. Boyer pursuant to  §302 of the Sarbanes-Oxley Act of 2002 (filed herewith).                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
|                  |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 31.2                  |       | Certifications of Gregory A. Sandfort 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).                                                                                                                                                                                                                                                                                                                                                                                                                                  |

 

50

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