##### Table of Contents









UNITED STATES

SECURITIES AND EXCHANGE COMMISSION


WASHINGTON, DC 20549




---

FORM 10-Q

|                                                       |  |                                                                                             
|------------------------------------------------------ |  | --------------------------------------------------------------------------------------------
|(Mark One)                                             |  |                                                                                             
|þ                                                      |  | QUARTERLY REPORT PURSUANT TO SECTION 13
    OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 
|                                                      
|For the quarterly period ended
    October 30, 2004   
|                                                      
|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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MICHAELS STORES, INC.

(Exact name of registrant as specified in its
charter)


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




---

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

Indicate by check mark whether the Registrant is
an accelerated filer (as defined in Rule 12b-2 of the
Exchange
Act).     Yes þ          No o

Indicate the number of shares outstanding of each
of the Registrants classes of Common Stock, as of the
latest practicable date.

|                                       |  |                         
|-------------------------------------- |  | ------------------------
|                                       |  | Shares Outstanding as of
|Title                                  |  | December 3, 2004        
|                                       |  |                         
|Common Stock, par value $.10 per share |  | 134,783,296             



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MICHAELS STORES, INC.

FORM 10-Q


Part I FINANCIAL
INFORMATION

|                                                      |  |                                                                                                                                   |  |   
|----------------------------------------------------- |  | --------------------------------------------------------------------------------------------------------------------------------- |  | --
|Item 1.                                               |  | Financial
    Statements                                                                                                          |  |   
|                                                      |  | Consolidated Balance Sheets
    at October 30, 2004, January 31, 2004, and
    November 1, 2003 (unaudited)                       |  | 3 
|                                                      |  | Consolidated Statements of
    Income for the quarter and nine months ended October 30,
    2004 and November 1, 2003 (unaudited) |  | 4 
|                                                      |  | Consolidated Statements of
    Cash Flows for the nine months ended October 30, 2004 and
    November 1, 2003 (unaudited)         |  | 5 
|                                                      |  | Notes to Consolidated
    Financial Statements (unaudited)                                                                        |  | 6 
|Item 2.                                               |  | Managements
    Discussion and Analysis of Financial Condition and Results of
    Operations                                     |  | 11
|Item 3.                                               |  | Quantitative and
    Qualitative Disclosures About Market Risk                                                                    |  | 19
|Item 4.                                               |  | Controls and
    Procedures                                                                                                       |  | 19
|Part IIOTHER
    INFORMATION                        
|Item 1.                                               |  | Legal
    Proceedings                                                                                                             |  | 20
|Item 2.                                               |  | Unregistered Sales of
    Equity Securities and Use of Proceeds                                                                   |  | 21
|Item 5.                                               |  | Other
    Information                                                                                                             |  | 21
|Item 6.                                               |  | Exhibits and Reports on
    Form 8-K                                                                                              |  | 22
|Signatures                                            |  | 23                                                                                                                               
|3rd Amendment & Consent to Revolving Credit Agreement
|Certifications Pursuant to Section 302               
|Certifications Pursuant to Section 302               
|Certification Pursuant to Section 906                



2



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##### Table of Contents



MICHAELS STORES, INC.

Part IFINANCIAL
INFORMATION







|        |                      
|------- | ---------------------
|Item 1. | Financial Statements.

MICHAELS STORES, INC.




CONSOLIDATED BALANCE SHEETS


(In thousands, except share data)


(Unaudited)


|                                           |                                                                                                                                                                                                                      |                             |           |             |           |             |           |         |           |   |           |           |           | 
|------------------------------------------ | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | --------------------------- | --------- | ----------- | --------- | ----------- | --------- | ------- | --------- | - | --------- | --------- | --------- | 
|                                           |                                                                                                                                                                                                                      | October 30,                 |           | January 31, |           | November 1,
|                                           |                                                                                                                                                                                                                      | 2004                        |           | 2004        |           | 2003       
|                                           |                                                                                                                                                                                                                      |                             |           |             |           |            
|                                           |                                                                                                                                                                                                                      |                            
|                                           |                                                                                                                                                                                                                      | (Note 1)                   
|ASSETS                                    
|Current assets:                            |                                                                                                                                                                                                                      |                             |           |             |           |             |           |         |           |   |           |          
|                                           | Cash and equivalents                                                                                                                                                                                                 |                             | $         | 272,406     |           |             | $         | 341,825 |           |   | $         | 105,477   |          
|                                           | Merchandise inventories                                                                                                                                                                                              |                             |           | 1,096,400   |           |             |           | 892,923 |           |   |           | 1,103,527 |          
|                                           | Prepaid expenses and other                                                                                                                                                                                           |                             |           | 34,633      |           |             |           | 29,198  |           |   |           | 28,979    |          
|                                           | Deferred and prepaid income taxes                                                                                                                                                                                    |                             |           | 19,471      |           |             |           | 19,426  |           |   |           | 20,380    |          
|                                           |                                                                                                                                                                                                                      |                             |           |             |           |             |           |         |           |   |           |          
|                                           |                                                                                                                                                                                                                      | Total current assets        |           |             | 1,422,910 |             |           |         | 1,283,372 |   |           |           | 1,258,363 | 
|                                           |                                                                                                                                                                                                                      |                             |           |             |           |             |           |         |           |   |           |          
|Property and equipment, at cost            |                                                                                                                                                                                                                      |                             | 863,421   |             |           |             | 808,230   |         |           |   | 779,440   |          
|Less accumulated depreciation              |                                                                                                                                                                                                                      |                             | (469,867  | )           |           |             | (420,313  | )       |           |   | (402,628  | )        
|                                           |                                                                                                                                                                                                                      |                             |           |             |           |             |           |         |           |   |           |          
|                                           |                                                                                                                                                                                                                      |                             | 393,554   |             |           |             | 387,917   |         |           |   | 376,812   |          
|                                           |                                                                                                                                                                                                                      |                             |           |             |           |             |           |         |           |   |           |          
|Goodwill                                   |                                                                                                                                                                                                                      |                             | 115,839   |             |           |             | 115,839   |         |           |   | 115,839   |          
|Other assets                               |                                                                                                                                                                                                                      |                             | 16,810    |             |           |             | 14,519    |         |           |   | 13,603    |          
|                                           |                                                                                                                                                                                                                      |                             |           |             |           |             |           |         |           |   |           |          
|                                           |                                                                                                                                                                                                                      |                             | 132,649   |             |           |             | 130,358   |         |           |   | 129,442   |          
|                                           |                                                                                                                                                                                                                      |                             |           |             |           |             |           |         |           |   |           |          
|Total assets                               |                                                                                                                                                                                                                      | $                           | 1,949,113 |             |           | $           | 1,801,647 |         |           | $ | 1,764,617 |          
|                                           |                                                                                                                                                                                                                      |                             |           |             |           |             |           |         |           |   |           |          
|                                          
|LIABILITIES AND STOCKHOLDERS
    EQUITY  
|Current liabilities:                       |                                                                                                                                                                                                                      |                             |           |             |           |             |           |         |           |   |           |          
|                                           | Accounts payable                                                                                                                                                                                                     |                             | $         | 257,023     |           |             | $         | 172,708 |           |   | $         | 220,349   |          
|                                           | Accrued liabilities and other                                                                                                                                                                                        |                             |           | 222,248     |           |             |           | 194,395 |           |   |           | 189,976   |          
|                                           | Income taxes payable                                                                                                                                                                                                 |                             |           | 6,066       |           |             |           | 2,377   |           |   |           | 3,916     |          
|                                           |                                                                                                                                                                                                                      |                             |           |             |           |             |           |         |           |   |           |          
|                                           |                                                                                                                                                                                                                      | Total current liabilities   |           |             | 485,337   |             |           |         | 369,480   |   |           |           | 414,241   | 
|                                           |                                                                                                                                                                                                                      |                             |           |             |           |             |           |         |           |   |           |          
|9 1/4% Senior Notes due
    2009           |                                                                                                                                                                                                                      |                             | 200,000   |             |           |             | 200,000   |         |           |   | 200,000   |          
|Deferred income taxes                      |                                                                                                                                                                                                                      |                             | 27,550    |             |           |             | 28,241    |         |           |   | 21,515    |          
|Other long-term liabilities                |                                                                                                                                                                                                                      |                             | 41,256    |             |           |             | 36,628    |         |           |   | 34,004    |          
|                                           |                                                                                                                                                                                                                      |                             |           |             |           |             |           |         |           |   |           |          
|                                           |                                                                                                                                                                                                                      | Total long-term liabilities |           |             | 268,806   |             |           |         | 264,869   |   |           |           | 255,519   | 
|                                           |                                                                                                                                                                                                                      |                             |           |             |           |             |           |         |           |   |           |          
|                                           |                                                                                                                                                                                                                      |                             | 754,143   |             |           |             | 634,349   |         |           |   | 669,760   |          
|                                           |                                                                                                                                                                                                                      |                             |           |             |           |             |           |         |           |   |           |          
|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; shares issued and
    outstanding of 135,093,810 at October 30, 2004, 135,995,134
    at January 31, 2004, and 135,555,608 at November 1,
    2003 |                             |           | 13,509      |           |             |           | 13,600  |           |   |           | 13,556    |          
|                                           | Additional paid-in capital                                                                                                                                                                                           |                             |           | 438,850     |           |             |           | 489,110 |           |   |           | 503,410   |          
|                                           | Retained earnings                                                                                                                                                                                                    |                             |           | 733,069     |           |             |           | 660,365 |           |   |           | 572,511   |          
|                                           | Accumulated other comprehensive income                                                                                                                                                                               |                             |           | 9,542       |           |             |           | 4,223   |           |   |           | 5,380     |          
|                                           |                                                                                                                                                                                                                      |                             |           |             |           |             |           |         |           |   |           |          
|                                           |                                                                                                                                                                                                                      | Total stockholders equity  |           |             | 1,194,970 |             |           |         | 1,167,298 |   |           |           | 1,094,857 | 
|                                           |                                                                                                                                                                                                                      |                             |           |             |           |             |           |         |           |   |           |          
|Total liabilities and stockholders equity |                                                                                                                                                                                                                      | $                           | 1,949,113 |             |           | $           | 1,801,647 |         |           | $ | 1,764,617 |          
|                                           |                                                                                                                                                                                                                      |                             |           |             |           |             |           |         |           |   |           |          

See accompanying notes to consolidated financial
statements.

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MICHAELS STORES, INC.




CONSOLIDATED STATEMENTS OF INCOME


(In thousands, except per share
data)


(Unaudited)


|                                             |         |               |         |                   |  |             |         |             |  |   |           |      |  |   |           |      | 
|-------------------------------------------- | ------- | ------------- | ------- | ----------------- |  | ----------- | ------- | ----------- |  | - | --------- | ---- |  | - | --------- | ---- | 
|                                             |         |               |         |                  
|                                             |         | Quarter Ended |         | Nine Months Ended
|                                             |         |               |         |                  
|                                             |         | October 30,   |         | November 1,       |  | October 30, |         | November 1,
|                                             |         | 2004          |         | 2003              |  | 2004        |         | 2003       
|                                             |         |               |         |                   |  |             |         |            
|Net sales                                    |         | $             | 799,905 |                   |  | $           | 755,246 |             |  | $ | 2,208,691 |      |  | $ | 2,028,150 |     
|Cost of sales and occupancy expense          |         |               | 504,236 |                   |  |             | 479,471 |             |  |   | 1,395,492 |      |  |   | 1,282,807 |     
|                                             |         |               |         |                   |  |             |         |             |  |   |           |      |  |   |           |     
|Gross profit                                 |         |               | 295,669 |                   |  |             | 275,775 |             |  |   | 813,199   |      |  |   | 745,343   |     
|Selling, general, and administrative expense |         |               | 220,489 |                   |  |             | 208,474 |             |  |   | 633,348   |      |  |   | 589,741   |     
|Store pre-opening costs                      |         |               | 2,408   |                   |  |             | 3,702   |             |  |   | 7,534     |      |  |   | 7,045     |     
|                                             |         |               |         |                   |  |             |         |             |  |   |           |      |  |   |           |     
|Operating income                             |         |               | 72,772  |                   |  |             | 63,599  |             |  |   | 172,317   |      |  |   | 148,557   |     
|Interest expense                             |         |               | 5,042   |                   |  |             | 5,049   |             |  |   | 15,439    |      |  |   | 15,185    |     
|Other (income) and expense, net              |         |               | (1,077  | )                 |  |             | 77      |             |  |   | (2,743    | )    |  |   | (1,501    | )   
|                                             |         |               |         |                   |  |             |         |             |  |   |           |      |  |   |           |     
|Income before income taxes                   |         |               | 68,807  |                   |  |             | 58,473  |             |  |   | 159,621   |      |  |   | 134,873   |     
|Provision for income taxes                   |         |               | 26,319  |                   |  |             | 20,265  |             |  |   | 61,055    |      |  |   | 51,589    |     
|                                             |         |               |         |                   |  |             |         |             |  |   |           |      |  |   |           |     
|Net income                                   |         | $             | 42,488  |                   |  | $           | 38,208  |             |  | $ | 98,566    |      |  | $ | 83,284    |     
|                                             |         |               |         |                   |  |             |         |             |  |   |           |      |  |   |           |     
|Earnings per common share:                   |         |               |         |                   |  |             |         |             |  |   |           |      |  |   |           |     
|                                             | Basic   |               | $       | 0.31              |  |             | $       | 0.28        |  |   | $         | 0.72 |  |   | $         | 0.62 | 
|                                             |         |               |         |                   |  |             |         |             |  |   |           |      |  |   |           |     
|                                             | Diluted |               | $       | 0.31              |  |             | $       | 0.27        |  |   | $         | 0.71 |  |   | $         | 0.60 | 
|                                             |         |               |         |                   |  |             |         |             |  |   |           |      |  |   |           |     
|Dividends per common share                   |         | $             | 0.07    |                   |  | $           | 0.05    |             |  | $ | 0.19      |      |  | $ | 0.10      |     
|                                             |         |               |         |                   |  |             |         |             |  |   |           |      |  |   |           |     

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 30,                        |                                 | November 1,                                            
|                                                |                                                   | 2004                               |                                 | 2003                                                   
|                                                |                                                   |                                    |                                 |                                                        
|Operating activities:                           |                                                   |                                    |                                 |                                                         |        |          |          |        
|                                                | Net income                                        |                                    | $                               | 98,566                                                  |        |          | $        | 83,284  |       
|                                                | Adjustments:                                      |                                    |                                 |                                                         |        |          |          |         |       
|                                                |                                                   | Depreciation                       |                                 |                                                         | 65,756 |          |          |         | 61,632 |         
|                                                |                                                   | Amortization                       |                                 |                                                         | 294    |          |          |         | 299    |         
|                                                |                                                   | Other                              |                                 |                                                         | 780    |          |          |         | 844    |         
|                                                |                                                   | Changes in assets and liabilities: |                                 |                                                         |        |          |          |         |        |         
|                                                |                                                   |                                    | Merchandise inventories         |                                                         |        | (203,477 | )        |         |        | (294,109 | )      
|                                                |                                                   |                                    | Prepaid expenses and other      |                                                         |        | (5,435   | )        |         |        | (10,340  | )      
|                                                |                                                   |                                    | Deferred income taxes and other |                                                         |        | 757      |          |         |        | 2,435    |        
|                                                |                                                   |                                    | Accounts payable                |                                                         |        | 84,315   |          |         |        | 125,585  |        
|                                                |                                                   |                                    | Income taxes payable            |                                                         |        | 16,917   |          |         |        | (6,432   | )      
|                                                |                                                   |                                    | Accrued liabilities and other   |                                                         |        | 33,157   |          |         |        | 14,036   |        
|                                                |                                                   |                                    |                                 |                                                         |        |          |          |        
|                                                |                                                   |                                    |                                 | Net cash provided by (used in) operating
    activities |        |          | 91,630   |         |        |          | (22,766 | )
|                                                |                                                   |                                    |                                 |                                                         |        |          |          |        
|Investing activities:                           |                                                   |                                    |                                 |                                                         |        |          |          |        
|                                                | Additions to property and equipment               |                                    |                                 | (71,663                                                 | )      |          |          | (69,333 | )     
|                                                | Net proceeds from sales of property and equipment |                                    |                                 | 60                                                      |        |          |          | 31      |       
|                                                |                                                   |                                    |                                 |                                                         |        |          |          |        
|                                                |                                                   |                                    |                                 | Net cash used in investing activities                   |        |          | (71,603  | )       |        |          | (69,302 | )
|                                                |                                                   |                                    |                                 |                                                         |        |          |          |        
|Financing activities:                           |                                                   |                                    |                                 |                                                         |        |          |          |        
|                                                | Proceeds from stock options exercised             |                                    |                                 | 28,595                                                  |        |          |          | 28,556  |       
|                                                | Repurchase of Common Stock                        |                                    |                                 | (94,582                                                 | )      |          |          | (37,369 | )     
|                                                | Cash dividends paid to stockholders               |                                    |                                 | (25,867                                                 | )      |          |          | (13,439 | )     
|                                                | Proceeds from issuance of Common Stock and other  |                                    |                                 | 2,408                                                   |        |          |          | 1,766   |       
|                                                |                                                   |                                    |                                 |                                                         |        |          |          |        
|                                                |                                                   |                                    |                                 | Net cash used in financing activities                   |        |          | (89,446  | )       |        |          | (20,486 | )
|                                                |                                                   |                                    |                                 |                                                         |        |          |          |        
|Net decrease in cash and equivalents            |                                                   |                                    | (69,419                         | )                                                       |        |          | (112,554 | )      
|Cash and equivalents at beginning of
    period |                                                   |                                    | 341,825                         |                                                         |        |          | 218,031  |        
|                                                |                                                   |                                    |                                 |                                                         |        |          |          |        
|Cash and equivalents at end of
    period       |                                                   | $                                  | 272,406                         |                                                         |        | $        | 105,477  |        
|                                                |                                                   |                                    |                                 |                                                         |        |          |          |        

See accompanying notes to consolidated financial
statements.

5



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##### Table of Contents



MICHAELS STORES, INC.



NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS


For the Nine Months Ended October 30,
2004

(Unaudited)




|        |                      
|------- | ---------------------
|Note 1. | Basis of Presentation

The consolidated financial statements include the
accounts of Michaels Stores, Inc. and our wholly-owned
subsidiaries. All significant intercompany accounts and
transactions have been eliminated. All expressions of
us, we, our, and all similar
expressions are references to Michaels Stores, Inc. and our
consolidated wholly-owned subsidiaries, unless otherwise
expressly stated or the context otherwise requires.

The accompanying unaudited consolidated financial
statements have been prepared in accordance with accounting
principles generally accepted in the United States for interim
financial information and with the instructions to
Form 10-Q and Article 10 of Regulation S-X.
Accordingly, they do not include all of the information and
notes required by generally accepted accounting principles for
complete financial statements. In the opinion of management, all
adjustments (consisting of normal recurring accruals and other
items, as disclosed) considered necessary for a fair
presentation have been included. Because of the seasonal nature
of our business, the results of operations for the quarter and
nine months ended October 30, 2004 are not indicative of
the results to be expected for the entire year.

The balance sheet at January 31, 2004 has
been derived from the audited financial statements at that date
but does not include all of the information and notes required
by generally accepted accounting principles for complete
financial statements. For further information, refer to the
consolidated financial statements and notes thereto included in
our Annual Report on Form 10-K for the fiscal year ended
January 31, 2004.

Share and per share data (except par value)
presented for all periods reflect the effect of a two-for-one
Common Stock split, which was effected in the form of a stock
dividend on October 12, 2004, to stockholders of record as
of the close of business on September 27, 2004.

Certain reclassifications have been made to prior
periods to conform to current presentations.

All references herein to fiscal 2004
relate to the 52 weeks ending January 29, 2005 and all
references to fiscal 2003 relate to the
52 weeks ended January 31, 2004. In addition, all
references herein to the third quarter of fiscal
2004 and the first nine months of fiscal 2004
relate to the 13 and 39 weeks ended October 30, 2004,
respectively, and all references to the third quarter of
fiscal 2003 and the first nine months of fiscal
2003 relate to the 13 and 39 weeks ended
November 1, 2003, respectively.

6



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##### Table of Contents



MICHAELS STORES, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS (Continued)

For the Nine Months Ended October 30,
2004

(Unaudited)


Note 2.     Earnings
Per Share

The following table sets forth the computation of
basic and diluted earnings per common share:

|                           |                                                                                                                |                                       |   |                   |       |             |   |             |       |  |   |         |       |  |   |         |       | 
|-------------------------- | -------------------------------------------------------------------------------------------------------------- | ------------------------------------- | - | ----------------- | ----- | ----------- | - | ----------- | ----- |  | - | ------- | ----- |  | - | ------- | ----- | 
|                           |                                                                                                                |                                       |   |                  
|                           |                                                                                                                | Quarter Ended                         |   | Nine Months Ended
|                           |                                                                                                                |                                       |   |                  
|                           |                                                                                                                | October 30,                           |   | November 1,       |       | October 30, |   | November 1,
|                           |                                                                                                                | 2004                                  |   | 2003              |       | 2004        |   | 2003       
|                           |                                                                                                                |                                       |   |                   |       |             |   |            
|                           |                                                                                                                |                                      
|                           |                                                                                                                | (In thousands, except per share data)
|Numerator:                 |                                                                                                                |                                       |   |                   |       |             |   |             |       |  |   |         |       |  |   |        
|                           | Net income                                                                                                     |                                       | $ | 42,488            |       |             | $ | 38,208      |       |  | $ | 98,566  |       |  | $ | 83,284  |      
|                           |                                                                                                                |                                       |   |                   |       |             |   |             |       |  |   |         |       |  |   |        
|Denominator:               |                                                                                                                |                                       |   |                   |       |             |   |             |       |  |   |         |       |  |   |        
|                           | Denominator for basic earnings per common
    share-weighted average shares                                    |                                       |   | 135,550           |       |             |   | 134,622     |       |  |   | 136,138 |       |  |   | 134,044 |      
|                           | Effect of dilutive securities:                                                                                 |                                       |   |                   |       |             |   |             |       |  |   |         |       |  |   |         |      
|                           |                                                                                                                | Employee stock options                |   |                   | 3,246 |             |   |             | 7,076 |  |   |         | 3,119 |  |   |         | 5,880 | 
|                           |                                                                                                                |                                       |   |                   |       |             |   |             |       |  |   |         |       |  |   |        
|                           | Denominator for diluted earnings per common
    share-weighted average shares adjusted for dilutive securities |                                       |   | 138,796           |       |             |   | 141,698     |       |  |   | 139,257 |       |  |   | 139,924 |      
|                           |                                                                                                                |                                       |   |                   |       |             |   |             |       |  |   |         |       |  |   |        
|Earnings per common share: |                                                                                                                |                                       |   |                   |       |             |   |             |       |  |   |         |       |  |   |        
|                           | Basic                                                                                                          |                                       | $ | 0.31              |       |             | $ | 0.28        |       |  | $ | 0.72    |       |  | $ | 0.62    |      
|                           |                                                                                                                |                                       |   |                   |       |             |   |             |       |  |   |         |       |  |   |        
|                           | Diluted                                                                                                        |                                       | $ | 0.31              |       |             | $ | 0.27        |       |  | $ | 0.71    |       |  | $ | 0.60    |      
|                           |                                                                                                                |                                       |   |                   |       |             |   |             |       |  |   |         |       |  |   |        

Our purchase and subsequent retirement of
3.6 million shares of our Common Stock in the first nine
months of fiscal 2004 reduced the number of weighted average
shares outstanding by 2.7 million and 1.4 million
shares for the third quarter and first nine months of fiscal
2004, respectively. In addition, our purchase and subsequent
retirement of 2.5 million shares of our Common Stock in the
first nine months of fiscal 2003 reduced the number of weighted
average shares outstanding by 2.2 million and
1.7 million shares for the third quarter and first nine
months of fiscal 2003, respectively.



|        |                         
|------- | ------------------------
|Note 3. | Stock-Based Compensation

We have elected to follow Accounting Principles
Board Opinion No. 25, Accounting for Stock Issued to
Employees, and related guidance in accounting for our
employee stock options. The exercise price of our employee stock
options equals the market price of the underlying stock on the
date of grant and, as a result, we do not recognize compensation
expense for stock option grants.

Pro forma information regarding net income and
earnings per common share, as required by the provisions of
Statement of Financial Accounting Standards No. 123,
Accounting for Stock-Based Compensation, and
SFAS No. 148, Accounting for Stock-Based
Compensation Transition and Disclosure, has been
determined as if we had accounted for our employee stock options
under the fair value method.

7



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##### Table of Contents



MICHAELS STORES, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS (Continued)

For the Nine Months Ended October 30,
2004

(Unaudited)




|        |                                         
|------- | ----------------------------------------
|Note 3. | Stock-Based
    Compensation (Continued)

For purposes of pro forma disclosures, the
estimated fair value of the options is amortized over the
options vesting periods. Our pro forma information is as
follows:

|                                                   |                                                                 |                                       |        |                   |  |             |        |             |  |   |        |         |  |   |        |         | 
|-------------------------------------------------- | --------------------------------------------------------------- | ------------------------------------- | ------ | ----------------- |  | ----------- | ------ | ----------- |  | - | ------ | ------- |  | - | ------ | ------- | 
|                                                   |                                                                 |                                       |        |                  
|                                                   |                                                                 | Quarter Ended                         |        | Nine Months Ended
|                                                   |                                                                 |                                       |        |                  
|                                                   |                                                                 | October 30,                           |        | November 1,       |  | October 30, |        | November 1,
|                                                   |                                                                 | 2004                                  |        | 2003              |  | 2004        |        | 2003       
|                                                   |                                                                 |                                       |        |                   |  |             |        |            
|                                                   |                                                                 |                                      
|                                                   |                                                                 | (In thousands, except per share data)
|Net income, as reported                            |                                                                 | $                                     | 42,488 |                   |  | $           | 38,208 |             |  | $ | 98,566 |         |  | $ | 83,284 |        
|Stock-based employee compensation cost:            |                                                                 |                                       |        |                   |  |             |        |             |  |   |        |         |  |   |        |        
|                                                   | As if the fair value method were applied, net of
    income tax |                                       |        | 5,025             |  |             |        | 5,081       |  |   |        | 12,012  |  |   |        | 11,722  | 
|                                                   |                                                                 |                                       |        |                   |  |             |        |             |  |   |        |         |  |   |        |        
|Pro forma net income                               |                                                                 | $                                     | 37,463 |                   |  | $           | 33,127 |             |  | $ | 86,554 |         |  | $ | 71,562 |        
|                                                   |                                                                 |                                       |        |                   |  |             |        |             |  |   |        |         |  |   |        |        
|Earnings per common share, as
    reported:        |                                                                 |                                       |        |                   |  |             |        |             |  |   |        |         |  |   |        |        
|                                                   | Basic                                                           |                                       | $      | 0.31              |  |             | $      | 0.28        |  |   | $      | 0.72    |  |   | $      | 0.62    | 
|                                                   |                                                                 |                                       |        |                   |  |             |        |             |  |   |        |         |  |   |        |        
|                                                   | Diluted                                                         |                                       | $      | 0.31              |  |             | $      | 0.27        |  |   | $      | 0.71    |  |   | $      | 0.60    | 
|                                                   |                                                                 |                                       |        |                   |  |             |        |             |  |   |        |         |  |   |        |        
|Pro forma earnings per common share:               |                                                                 |                                       |        |                   |  |             |        |             |  |   |        |         |  |   |        |        
|                                                   | Basic                                                           |                                       | $      | 0.28              |  |             | $      | 0.25        |  |   | $      | 0.64    |  |   | $      | 0.53    | 
|                                                   |                                                                 |                                       |        |                   |  |             |        |             |  |   |        |         |  |   |        |        
|                                                   | Diluted                                                         |                                       | $      | 0.27              |  |             | $      | 0.24        |  |   | $      | 0.63    |  |   | $      | 0.52    | 
|                                                   |                                                                 |                                       |        |                   |  |             |        |             |  |   |        |         |  |   |        |        
|Pro forma weighted average shares
    outstanding: |                                                                 |                                       |        |                   |  |             |        |             |  |   |        |         |  |   |        |        
|                                                   | Basic                                                           |                                       |        | 135,550           |  |             |        | 134,622     |  |   |        | 136,138 |  |   |        | 134,044 | 
|                                                   | Diluted                                                         |                                       |        | 137,652           |  |             |        | 137,996     |  |   |        | 138,011 |  |   |        | 136,368 | 



|        |     
|------- | ----
|Note 4. | Debt

9 1/4% Senior Notes due
2009

In 2001, we issued $200 million in principal
amount of 9 1/4% Senior Notes due July 1, 2009,
which are unsecured and interest thereon is payable
semi-annually on each January 1 and July 1. The Senior Notes due
2009 are first callable, in part or in full, in July 2005. The
terms and conditions of the Senior Notes due 2009 require us to
comply with certain covenants, which primarily limit certain
activities, including, among other things, levels of
indebtedness, liens, investments, payments of dividends, Common
Stock repurchases, mergers and acquisitions, and sales of
assets. We are in compliance with all terms and conditions of
the Senior Notes due 2009.



| |                 
| | ----------------
| | Credit Agreement

In October 2004, we signed an extension to our
existing $200 million unsecured revolving bank credit
facility with Fleet National Bank and other lending
institutions, which now expires on April 30, 2006. The
Credit Agreement requires us to maintain certain financial
covenants and limits certain activities, including, among other
things, levels of indebtedness, liens, investments, payments of
dividends, Common Stock repurchases, mergers and acquisitions,
and sales of assets. In addition to extending the term of the
Credit Agreement, we obtained the consent of the lenders to
permit the prepayment of the Senior Notes due 2009 when they
become callable in July 2005, if we have liquidity
(defined as cash and equivalents

8



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##### Table of Contents



MICHAELS STORES, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS (Continued)

For the Nine Months Ended October 30,
2004

(Unaudited)




|        |                 
|------- | ----------------
|Note 4. | Debt (Continued)

plus unused availability under the Credit
Agreement) of at least $300 million. We are in compliance
with all terms and conditions of the Credit Agreement. We had no
borrowings under our Credit Agreement during either the third
quarter of fiscal 2004 or the third quarter of fiscal 2003 and
no borrowings were outstanding under the Credit Agreement at the
end of either quarter. Borrowings available under the Credit
Agreement are reduced by the aggregate amount of letters of
credit outstanding under the Credit Agreement
($26.1 million as of October 30, 2004).



|        |                     
|------- | --------------------
|Note 5. | Comprehensive Income

Our comprehensive income is as follows:

|                                   |                                                   |               |        |                   |  |             |        |             |  |   |         |       |  |   |        |       | 
|---------------------------------- | ------------------------------------------------- | ------------- | ------ | ----------------- |  | ----------- | ------ | ----------- |  | - | ------- | ----- |  | - | ------ | ----- | 
|                                   |                                                   |               |        |                  
|                                   |                                                   | Quarter Ended |        | Nine Months Ended
|                                   |                                                   |               |        |                  
|                                   |                                                   | October 30,   |        | November 1,       |  | October 30, |        | November 1,
|                                   |                                                   | 2004          |        | 2003              |  | 2004        |        | 2003       
|                                   |                                                   |               |        |                   |  |             |        |            
|                                   |                                                   |               |        |                   |  |            
|                                   |                                                   |               |        | (In thousands)    |  |            
|Net income                         |                                                   | $             | 42,488 |                   |  | $           | 38,208 |             |  | $ | 98,566  |       |  | $ | 83,284 |      
|Other comprehensive income (loss): |                                                   |               |        |                   |  |             |        |             |  |   |         |       |  |   |        |      
|                                   | Foreign currency translation adjustment and other |               |        | 5,154             |  |             |        | 3,401       |  |   |         | 5,324 |  |   |        | 7,557 | 
|                                   |                                                   |               |        |                   |  |             |        |             |  |   |         |       |  |   |        |      
|Comprehensive income               |                                                   | $             | 47,642 |                   |  | $           | 41,609 |             |  | $ | 103,890 |       |  | $ | 90,841 |      
|                                   |                                                   |               |        |                   |  |             |        |             |  |   |         |       |  |   |        |      



|        |                  
|------- | -----------------
|Note 6. | Legal Proceedings

Stockholder Class Actions

On various dates between February 4, 2003
and March 25, 2003, 10 purported class action lawsuits were
filed in the United States District Court for the Northern
District of Texas, Dallas Division, against Michaels Stores,
Inc. and certain of the current and former directors and
officers of Michaels. All of these lawsuits have been
consolidated. The suits assert various claims under
Sections 10(b) and 20(a) of the Securities Exchange Act of
1934 related to actions prior to Michaels announcement on
November 7, 2002, that, among other things, it had revised
its outlook for the fourth fiscal quarter of 2002, adjusting
downward its guidance for annual earnings per diluted share. The
consolidated complaint charges that, prior to that announcement,
Michaels and certain of the other defendants made
misrepresentations and failed to disclose negative information
about the financial condition of Michaels while the individual
defendants were selling shares of Michaels common stock. We
believe these claims are without merit and will vigorously
contest them. We are unable to estimate a range of possible
loss, if any, in these claims.



| |                  
| | -----------------
| | Derivative Claims

On March 21, 2003, Julie Fathergill filed a
purported stockholder derivative action, which is pending in the
192nd District Court for Dallas County, Texas. The lawsuit
names certain former and current officers and directors,
including all of Michaels current directors, as individual
defendants and Michaels as a nominal defendant. In this
derivative action, the plaintiff makes allegations of fact
similar to those made in the purported securities class actions
described above. The plaintiff asserts claims against the
individual defendants for breach of fiduciary duties, abuse of
control, gross mismanagement, waste of corporate assets, and
unjust enrichment. All of these claims are asserted derivatively
on behalf of Michaels. We believe these claims are also without
merit and will vigorously oppose them.

9



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##### Table of Contents



MICHAELS STORES, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS (Continued)

For the Nine Months Ended October 30,
2004

(Unaudited)




|        |                              
|------- | -----------------------------
|Note 6. | Legal Proceedings (Continued)

On September 11, 2003, Leo J. Dutil filed a
purported stockholder derivative action, which is pending in the
United States District Court for the Northern District of Texas,
Dallas Division. The lawsuit names certain former and current
officers and directors as individual defendants and Michaels as
a nominal defendant. In this derivative action, the plaintiff
makes allegations of fact similar to those made in the purported
stockholder class actions and the Fathergill derivative lawsuit
described above. The plaintiff asserts claims against the
individual defendants for breach of fiduciary duty,
misappropriation of confidential information, and contribution
and indemnification. All of these claims are asserted
derivatively on behalf of Michaels. We believe these claims are
also without merit and will vigorously oppose them.



| |             
| | ------------
| | Cotton Claim

On December 20, 2002, James Cotton, a former
store manager of Michaels of Canada, ULC, our wholly-owned
subsidiary, and Suzette Kennedy, a former assistant manager of
Michaels of Canada, commenced a proposed class proceeding
against Michaels of Canada and Michaels Stores, Inc. on behalf
of themselves and current and former employees employed in
Canada. The Cotton claim was filed in the Ontario Superior Court
of Justice and alleges that the defendants violated employment
standards legislation in Ontario and other provinces and
territories of Canada by failing to pay overtime compensation as
required by that legislation. The Cotton claim also alleges that
this conduct was in breach of the contracts of employment of
those individuals. The Cotton claim seeks a declaration that the
defendants have acted in breach of applicable legislation,
payment to current and former employees for overtime, damages
for breach of contract, punitive, aggravated and exemplary
damages, interest, and costs. We believe we have certain
meritorious defenses and intend to defend this lawsuit
vigorously. We are unable to estimate a range of possible loss,
if any, in this claim.



| |        
| | -------
| | General

We are a defendant from time to time in lawsuits
incidental to our business. Based on currently available
information, we believe that resolution of all known
contingencies is uncertain. There can be no assurance that
future costs of such litigation would not be material to our
financial position or results of operations.



|        |                                 
|------- | --------------------------------
|Note 7. | Recent Accounting Pronouncements

In November 2004, the Financial Accounting
Standards Board issued Statement of Financial Accounting
Standards No. 151, Inventory Costs, as an amendment
to ARB No. 43. SFAS No. 151 clarifies that abnormal
amounts of idle facility expense, freight, handling costs, and
wasted materials (spoilage) should be recognized as current
period charges and requires the allocation of fixed production
overheads to inventory based on the normal capacity of the
production facilities. SFAS No. 151 is effective for
inventory costs incurred during fiscal years beginning after
June 15, 2005. We are evaluating the provisions of SFAS
No. 151 to determine the impact on our consolidated
operating results or financial position.

10



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##### Table of Contents








|        |                                                                                           
|------- | ------------------------------------------------------------------------------------------
|Item 2. | Managements Discussion and Analysis of
    Financial Condition and Results of Operations.

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

Disclosure Regarding Forward-Looking
Information

The following discussion should be read in
conjunction with our consolidated financial statements and
related notes included elsewhere in this Quarterly Report on
Form 10-Q. The following discussion, as well as other
portions of this Quarterly Report on Form 10-Q, contains
forward-looking statements that reflect our plans, estimates,
and beliefs. Any statements contained herein (including, but not
limited to, statements to the effect that Michaels or its
management anticipates, plans,
estimates, expects,
believes, and other similar expressions) that are
not statements of historical fact should be considered
forward-looking statements and should be read in conjunction
with our consolidated financial statements and related notes in
our Annual Report on Form 10-K for the fiscal year ended
January 31, 2004. Specific examples of forward-looking
statements include, but are not limited to, statements regarding
our future cash dividend policy, forecasts of capital
expenditures, working capital requirements, and stock
repurchases. Our actual results could materially differ from
those discussed in these forward-looking statements. Factors
that could cause or contribute to such differences include, but
are not limited to:



| |   |                                                                                                                                                                                                                                      
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | our ability to remain competitive in the areas of
    merchandise quality, price, breadth of selection, customer
    service, and convenience;                                                                                       
|
| |  | our ability to anticipate and/or react to changes
    in customer demand and preferences for products and supplies
    used in creative activities and the related financial impact;                                                 
|
| |  | changes in consumer confidence resulting in a
    reduction in consumer spending on items perceived to be
    discretionary;                                                                                                         
|
| |  | the execution and management of our store growth,
    including new concepts, and the availability of acceptable real
    estate locations for new store openings;                                                                   
|
| |  | the effective maintenance of our perpetual
    inventory and automated replenishment systems and related
    impacts to inventory levels;                                                                                            
|
| |  | the identification and implementation of
    improvements to our supply chain to achieve efficiencies and
    cost reductions;                                                                                                       
|
| |  | delays in the receipt of merchandise ordered from
    our suppliers due to delays in connection with either the
    manufacture or shipment of such merchandise;                                                                     
|
| |  | transportation delays (including dock strikes and
    other work stoppages) and increases in transportation costs due
    to fuel surcharges and transportation regulations;                                                         
|
| |  | restrictive actions by foreign governments or
    changes in United States laws and regulations affecting imports
    or domestic distribution;                                                                                      
|
| |  | material increases in inflation or commodity
    prices, such as petroleum, steel, and paper;                                                                                                                                        
|
| |  | changes in political, economic, and social
    conditions;                                                                                                                                                                           
|
| |  | significant fluctuations in exchange rates;                                                                                                                                                                                          
|
| |  | financial difficulties of any of our key vendors,
    suppliers, and service providers;                                                                                                                                              
|
| |  | the design and implementation of new management
    information systems as well as the maintenance and enhancement
    of existing systems, particularly in light of our continued
    store growth and the addition of new concepts;

11



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##### Table of Contents





| |   |                                                                                                                                                                                                                                                         
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | our ability to comply with the terms and
    restrictions of our Credit Agreement and our Senior Notes due
    2009;                                                                                                                                    
|
| |  | the seasonality of the retail business; and                                                                                                                                                                                                             
|
| |  | other factors as set forth in our Annual Report
    on Form 10-K for the fiscal year ended January 31,
    2004, particularly in Critical Accounting Policies
    and Risk Factors, and in our other Securities and
    Exchange Commission filings.

We intend these forward-looking statements to
speak only as of the time of filing this Quarterly Report on
Form 10-Q and do not undertake to update or revise them as
more information becomes available.

General

All references herein to fiscal 2004
relate to the 52 weeks ending January 29, 2005 and all
references to fiscal 2003 relate to the
52 weeks ended January 31, 2004. In addition, all
references herein to the third quarter of fiscal
2004 and the first nine months of fiscal 2004
relate to the 13 and 39 weeks ended October 30, 2004,
respectively, and all references to the third quarter of
fiscal 2003 and the first nine months of fiscal
2003 relate to the 13 and 39 weeks ended
November 1, 2003, respectively.

Unless otherwise noted, discussions relating to
our Common Stock reflect the effects of a two-for-one Common
Stock split effected in the form of a stock dividend on
October 12, 2004, to stockholders of record as of the close
of business on September 27, 2004.

The following table sets forth certain of our
unaudited operating data (dollar amounts in thousands):

|                       |                                                          |               |  |                   |   |             |  |             |   |  |  |     |   |  |  |     |  
|---------------------- | -------------------------------------------------------- | ------------- |  | ----------------- | - | ----------- |  | ----------- | - |  |  | --- | - |  |  | --- | -
|                       |                                                          |               |  |                  
|                       |                                                          | Quarter Ended |  | Nine Months Ended
|                       |                                                          |               |  |                  
|                       |                                                          | October 30,   |  | November 1,       |   | October 30, |  | November 1,
|                       |                                                          | 2004          |  | 2003              |   | 2004        |  | 2003       
|                       |                                                          |               |  |                   |   |             |  |            
|Michaels stores(1):    |                                                          |               |  |                   |   |             |  |             |   |  |  |     |   |  |  |    
|                       | Retail stores open at beginning of period                |               |  | 827               |   |             |  | 780         |   |  |  | 804 |   |  |  | 754 |  
|                       | Retail stores opened during the period                   |               |  | 22                |   |             |  | 28          |   |  |  | 45  |   |  |  | 55  |  
|                       | Retail stores opened (relocations) during
    the period |               |  | 8                 |   |             |  | 7           |   |  |  | 30  |   |  |  | 16  |  
|                       | Retail stores closed during the period                   |               |  |                  |   |             |  |            |   |  |  |    |   |  |  | (1  | )
|                       | Retail stores closed (relocations) during
    the period |               |  | (8                | ) |             |  | (7          | ) |  |  | (30 | ) |  |  | (16 | )
|                       |                                                          |               |  |                   |   |             |  |             |   |  |  |     |   |  |  |    
|                       | Retail stores open at end of period                      |               |  | 849               |   |             |  | 808         |   |  |  | 849 |   |  |  | 808 |  
|Aaron Brothers stores: |                                                          |               |  |                   |   |             |  |             |   |  |  |     |   |  |  |    
|                       | Retail stores open at beginning of period                |               |  | 160               |   |             |  | 157         |   |  |  | 158 |   |  |  | 148 |  
|                       | Retail stores opened during the period                   |               |  | 4                 |   |             |  | 1           |   |  |  | 7   |   |  |  | 10  |  
|                       | Retail stores opened (relocations) during
    the period |               |  | 1                 |   |             |  |            |   |  |  | 1   |   |  |  |    |  
|                       | Retail stores closed during the period                   |               |  |                  |   |             |  |            |   |  |  | (1  | ) |  |  |    |  
|                       | Retail stores closed (relocations) during
    the period |               |  | (1                | ) |             |  |            |   |  |  | (1  | ) |  |  |    |  
|                       |                                                          |               |  |                   |   |             |  |             |   |  |  |     |   |  |  |    
|                       | Retail stores open at end of period                      |               |  | 164               |   |             |  | 158         |   |  |  | 164 |   |  |  | 158 |  
|Recollections stores:  |                                                          |               |  |                   |   |             |  |             |   |  |  |     |   |  |  |    
|                       | Retail stores open at beginning of period                |               |  | 5                 |   |             |  | 1           |   |  |  | 2   |   |  |  |    |  
|                       | Retail stores opened during the period                   |               |  | 3                 |   |             |  | 1           |   |  |  | 6   |   |  |  | 2   |  
|                       |                                                          |               |  |                   |   |             |  |             |   |  |  |     |   |  |  |    
|                       | Retail stores open at end of period                      |               |  | 8                 |   |             |  | 2           |   |  |  | 8   |   |  |  | 2   |  

12



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|                                   |                                              |               |       |                   |   |             |     |             |   |  |       |       |   |  |     |       |  
|---------------------------------- | -------------------------------------------- | ------------- | ----- | ----------------- | - | ----------- | --- | ----------- | - |  | ----- | ----- | - |  | --- | ----- | -
|                                   |                                              |               |       |                  
|                                   |                                              | Quarter Ended |       | Nine Months Ended
|                                   |                                              |               |       |                  
|                                   |                                              | October 30,   |       | November 1,       |   | October 30, |     | November 1,
|                                   |                                              | 2004          |       | 2003              |   | 2004        |     | 2003       
|                                   |                                              |               |       |                   |   |             |     |            
|Star Wholesale stores(1):          |                                              |               |       |                   |   |             |     |             |   |  |       |       |   |  |     |      
|                                   | Wholesale stores open at beginning of period |               |       | 3                 |   |             |     | 2           |   |  |       | 3     |   |  |     | 2     |  
|                                   | Wholesale stores opened during the period    |               |       |                  |   |             |     | 1           |   |  |       |      |   |  |     | 1     |  
|                                   |                                              |               |       |                   |   |             |     |             |   |  |       |       |   |  |     |      
|                                   | Wholesale stores open at end of period       |               |       | 3                 |   |             |     | 3           |   |  |       | 3     |   |  |     | 3     |  
|                                   |                                              |               |       |                   |   |             |     |             |   |  |       |       |   |  |     |      
|Total store count at end of period |                                              |               | 1,024 |                   |   |             | 971 |             |   |  | 1,024 |       |   |  | 971 |      
|                                   |                                              |               |       |                   |   |             |     |             |   |  |       |       |   |  |     |      
|Other operating data:              |                                              |               |       |                   |   |             |     |             |   |  |       |       |   |  |     |      
|                                   | Average inventory per Michaels store(2)      |               | $     | 1,213             |   |             | $   | 1,313       |   |  | $     | 1,213 |   |  | $   | 1,313 |  
|                                   | Comparable store sales increase(3)           |               |       | 1                 | % |             |     | 2           | % |  |       | 4     | % |  |     | 2     | %



---



|    |                                                                                                                                                                                                                                                                                                                                                                                                                   
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Opening store counts reflect a reclassification
    of our Los Angeles combination wholesale-retail store from a
    Michaels store to a Star Wholesale store. Beginning in fiscal
    2004, our Los Angeles wholesale-retail store is being managed as
    part of our Star Wholesale concept.                                                                                                                   
|   
|(2) | Average inventory per Michaels store calculation
    excludes Aaron Brothers, Recollections, and Star Wholesale
    stores.                                                                                                                                                                                                                                                                                       
|   
|(3) | 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.

Results of Operations

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

|                                             |  |               |       |                   |  |             |       |             |  |  |       |   |  |  |       |  
|-------------------------------------------- |  | ------------- | ----- | ----------------- |  | ----------- | ----- | ----------- |  |  | ----- | - |  |  | ----- | -
|                                             |  |               |       |                  
|                                             |  | Quarter Ended |       | Nine Months Ended
|                                             |  |               |       |                  
|                                             |  | October 30,   |       | November 1,       |  | October 30, |       | November 1,
|                                             |  | 2004          |       | 2003              |  | 2004        |       | 2003       
|                                             |  |               |       |                   |  |             |       |            
|Net sales                                    |  |               | 100.0 | %                 |  |             | 100.0 | %           |  |  | 100.0 | % |  |  | 100.0 | %
|Cost of sales and occupancy expense          |  |               | 63.0  |                   |  |             | 63.5  |             |  |  | 63.2  |   |  |  | 63.3  |  
|                                             |  |               |       |                   |  |             |       |             |  |  |       |   |  |  |       |  
|Gross profit                                 |  |               | 37.0  |                   |  |             | 36.5  |             |  |  | 36.8  |   |  |  | 36.7  |  
|Selling, general, and administrative expense |  |               | 27.6  |                   |  |             | 27.6  |             |  |  | 28.7  |   |  |  | 29.1  |  
|Store pre-opening costs                      |  |               | 0.3   |                   |  |             | 0.5   |             |  |  | 0.3   |   |  |  | 0.3   |  
|                                             |  |               |       |                   |  |             |       |             |  |  |       |   |  |  |       |  
|Operating income                             |  |               | 9.1   |                   |  |             | 8.4   |             |  |  | 7.8   |   |  |  | 7.3   |  
|Interest expense                             |  |               | 0.6   |                   |  |             | 0.6   |             |  |  | 0.7   |   |  |  | 0.7   |  
|Other (income) and expense, net              |  |               | (0.1  | )                 |  |             | 0.0   |             |  |  | (0.1  | ) |  |  | (0.1  | )
|                                             |  |               |       |                   |  |             |       |             |  |  |       |   |  |  |       |  
|Income before income taxes                   |  |               | 8.6   |                   |  |             | 7.8   |             |  |  | 7.2   |   |  |  | 6.7   |  
|Provision for income taxes                   |  |               | 3.3   |                   |  |             | 2.7   |             |  |  | 2.7   |   |  |  | 2.6   |  
|                                             |  |               |       |                   |  |             |       |             |  |  |       |   |  |  |       |  
|Net income                                   |  |               | 5.3   | %                 |  |             | 5.1   | %           |  |  | 4.5   | % |  |  | 4.1   | %
|                                             |  |               |       |                   |  |             |       |             |  |  |       |   |  |  |       |  



| |                                                                                  
| | ---------------------------------------------------------------------------------
| | Quarter Ended October 30, 2004 Compared
    to the Quarter Ended November 1, 2003

Net SalesNet
sales for the third quarter of fiscal 2004 increased
$44.7 million, or 6%, over the third quarter of fiscal
2003. At the end of the third quarter of fiscal 2004, we
operated 849 Michaels, 164 Aaron Brothers, eight Recollections,
and three Star Wholesale stores. The results for the third
quarter of fiscal 2004 included sales from 45 Michaels, seven
Aaron Brothers, and six Recollections stores that were opened
during the 12-month period ended October 30, 2004, more
than offsetting lost sales from the

13



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##### Table of Contents



closure of four Michaels and one Aaron Brothers
store during the same period. Sales at the new stores (net of
closures) during the third quarter of fiscal 2004 accounted for
$37.7 million of the increase in net sales. Comparable
store sales increased 1% in the third quarter of fiscal 2004
compared to the third quarter of fiscal 2003, which contributed
$6.9 million to the net sales increase. Customer traffic
increased approximately 2% and custom framing deliveries were
relatively flat in the third quarter of fiscal 2004 compared to
the third quarter of fiscal 2003, partially offset by a decline
in average ticket of 1%. Comparable store sales growth was
strongest in our needlework/yarn, impulse, books, and kids
crafts categories. Our ability to continue to generate
comparable store sales increases is dependent, in part, on our
ability to continue to maintain store in-stock positions on the
top-selling items, to properly allocate merchandise to our
stores, to be successful in our sales promotion efforts, to
anticipate customer demand and trends in the arts and crafts
industry, and to respond to competitors activities.


Cost of Sales and Occupancy
ExpenseCost of sales and
occupancy expense, as a percentage of net sales, decreased
approximately 50 basis points in the third quarter of
fiscal 2004 compared to the third quarter of fiscal 2003. Cost
of sales as a percentage of sales decreased as a result of an
improvement in the mix of sales. Sales of regular priced
merchandise as a percentage of total sales increased 5%, offset
by a corresponding decrease in sales of both promotionally
priced and clearance merchandise. Cost of sales was also
favorably impacted by better leverage on our distribution and
purchasing expenses. These reductions in cost of sales as a
percentage of sales were partially offset by costs of
approximately $2 million, recorded in the third quarter of
2004, associated with closing our Lexington, Kentucky
distribution center and opening a new distribution center in New
Lenox, Illinois. We expect that all significant costs associated
with this distribution center realignment project will be
recognized during fiscal 2004. The reduction in cost of sales as
a percentage of sales was also partially offset by increases in
occupancy expense as a percentage of sales. Occupancy expense in
the third quarter of 2004 includes incremental store closure
costs of approximately $2.4 million. Store closure costs
vary with the timing and extent of store relocation and closure
activities, and are driven primarily by the remaining lease term
and estimated sublease income associated with each closed store.

Selling, General, and Administrative
ExpenseSelling, general, and
administrative expense was $220.5 million, or 27.6% of net
sales, in the third quarter of fiscal 2004 compared to
$208.5 million, or 27.6% of net sales, in the third quarter
of fiscal 2003. The expense increase was primarily due to an
increase in the number of stores we operated compared to last
year, in particular store personnel costs, store operating
expenses, advertising expenses, and corporate overhead costs
totaling approximately $12.3 million of the expense
increase.

Store Pre-opening
CostsPre-opening expense
decreased $1.3 million, or 0.2% of net sales, from
$3.7 million, or 0.5%, in the third quarter of fiscal 2003
to $2.4 million, or 0.3%, in the third quarter of fiscal
2004, primarily due to the timing of our new store opening
program in the third quarter of fiscal 2004 compared to the
third quarter of fiscal 2003.

Provision for Income
TaxesThe effective tax rate was
38.25% for the third quarter of fiscal 2004 and 34.7% for the
third quarter of fiscal 2003. The effective tax rate for the
third quarter of fiscal 2003 was reduced from 41% to 34.7% due
to the resolution of certain tax issues pending with the
Internal Revenue Service. Our effective tax rate for fiscal 2003
was 37.6%.

Net IncomeAs a
result of the above, net income for the third quarter of fiscal
2004 increased 11% to $42.5 million, or $0.31 per
diluted share, from $38.2 million, or $0.27 per
diluted share, for the third quarter of fiscal 2003.



| |                                                                                              
| | ---------------------------------------------------------------------------------------------
| | Nine Months Ended October 30, 2004
    Compared to the Nine Months Ended November 1,
    2003

Net SalesNet
sales for the first nine months of fiscal 2004 increased
$180.5 million, or 9%, over the first nine months of fiscal
2003. Sales at the new stores (net of closures) during the first
nine months of fiscal 2004 accounted for $101.5 million of
the increase in net sales. Comparable store sales increased 4%
in the first nine months of fiscal 2004 compared to the first
nine months of fiscal 2003, which contributed $79.0 million
to the net sales increase. Customer traffic increased
approximately 3% and custom framing

14



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##### Table of Contents



deliveries were relatively flat in the first nine
months of fiscal 2004 compared to the first nine months of
fiscal 2003. Average ticket increased approximately 1%, driven
primarily by better merchandise in-stock levels and a
strengthening of the Canadian dollar (contributing 29 basis
points). Comparable store sales growth was strongest in our
needlework/yarn, art, frames, and kids crafts categories.


Cost of Sales and Occupancy
ExpenseCost of sales and
occupancy expense, as a percentage of net sales, decreased
approximately 10 basis points in the first nine months of
fiscal 2004 compared to the first nine months of fiscal 2003.
Cost of sales as a percentage of sales decreased as a result of
an improvement in the mix of sales. Sales of regular priced
merchandise as a percentage of total sales increased 3%, offset
by a corresponding decrease in sales of both promotionally
priced and clearance merchandise. Cost of sales was also
favorably impacted by better leverage on our distribution and
purchasing expenses. These reductions in cost of sales as a
percentage of sales were partially offset by costs of
approximately $3.8 million associated with closing our
Lexington, Kentucky distribution center and opening a new
distribution center in New Lenox, Illinois. We expect that all
significant costs associated with this distribution center
realignment project will be recognized during fiscal 2004. The
reduction in cost of sales as a percentage of sales was also
partially offset by increases in occupancy expense as a
percentage of sales. Occupancy expense in the first nine months
of 2004 includes incremental store closure costs of
approximately $5.1 million. Store closure costs vary with
the timing and extent of store relocation and closure
activities, and are driven primarily by the remaining lease term
and estimated sublease income associated with each closed store.

Selling, General, and Administrative
ExpenseSelling, general, and
administrative expense was $633.3 million, or 28.7% of net
sales, in the first nine months of fiscal 2004 compared to
$589.7 million, or 29.1% of net sales, in the first nine
months of fiscal 2003. The expense increase was primarily due to
an increase in the number of stores we operated compared to last
year, in particular store personnel costs, store operating
expenses, advertising expenses, and corporate overhead costs
totaling approximately $30.7 million of the expense
increase. In addition, in the first nine months of fiscal 2004,
we incurred $7.5 million of higher workers
compensation insurance costs, as well as costs associated with
relocating the Aaron Brothers headquarters to the Dallas,
Texas area. In the second quarter of fiscal 2004, we also
established a $4.9 million reserve for claims that we
believe will not be covered due to the deteriorating financial
condition of an insurance company with which we previously
conducted business. This reserve amount represents our current
estimate of probable loss as determined in consultation with
third party experts. Our total gross claims exposure is
estimated to be $10.0 million, partially offset by
estimated recovery from state guaranteed funds. As actual claims
continue to be filed with the insurer or as existing claims are
fully resolved, it may be necessary for us to record additional
adjustments in order to be fully reserved for the estimate of
probable losses that we expect to incur, but we believe that all
significant costs have been recognized in fiscal 2004.

Store personnel costs, excluding the
workers compensation insurance charges described above,
and other store operating expenses decreased as a percentage of
net sales (approximately 60 basis points) primarily as a
result of a heightened focus on expense control during the first
nine months of fiscal 2004 and a leveraging of those expenses
against higher net sales. Advertising expenses decreased as a
percentage of net sales (approximately 20 basis points)
primarily as a result of adjustments we made to our fiscal 2004
advertising program.

Provision for Income
TaxesThe effective tax rate was
38.25% for both the first nine months of fiscal 2004 and the
first nine months of fiscal 2003.

Net IncomeAs a
result of the above, net income for the first nine months of
fiscal 2004 increased 18% to $98.6 million, or
$0.71 per diluted share, from $83.3 million, or
$0.60 per diluted share, for the first nine months of
fiscal 2003.

Liquidity and Capital Resources

Our cash and equivalents decreased
$69.4 million, or 20%, from $341.8 million at the end
of fiscal 2003 to $272.4 million at the end of the third
quarter of fiscal 2004. We require cash principally for

15



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##### Table of Contents



day-to-day operations and to finance capital
investments, inventory for new stores, inventory replenishment
for existing stores, and seasonal working capital needs. In
recent years, we have financed our operations, new store
openings, Common Stock repurchases, dividend payments, and other
capital investments with cash from operations and proceeds from
stock option exercises. In addition, borrowings under our Credit
Agreement may be an additional source of cash for us to finance
future growth and other capital investments.


Cash Flow from Operating Activities

Cash flow provided by operating activities during
the first nine months of fiscal 2004 was $91.6 million
compared to cash used in operating activities of
$22.8 million during the first nine months of fiscal 2003.
The increase in cash provided by operating activities of
$114.4 million was primarily attributable to our use of
$49.4 million less cash in the first nine months of fiscal
2004 compared to the prior year on merchandise inventories, net
of accounts payable, primarily as a result of the completion of
the implementation of our perpetual inventory system. In
addition, operating cash increased $15.3 million from the
increase in net income, $23.3 million from income taxes
payable due to the timing of payments for income taxes, and
$19.1 million from accrued liabilities and other, primarily
due to higher non-cash workers compensation insurance
accruals and the establishment of a $4.9 million reserve
for the estimated cost of claims that we believe will not be
covered due to the deteriorating financial condition of an
insurance company with which we previously conducted business.

Inventories per Michaels store decreased 8% from
November 1, 2003 to October 30, 2004. As a result of
the completion of the implementation of our perpetual inventory
and automated merchandise replenishment systems and the
corresponding improvement in inventory management, we now
anticipate average inventory per Michaels store at the end of
fiscal 2004 to decrease approximately 5% from the average
inventory per Michaels store of $1.045 million we reported
at the end of fiscal 2003.

Cash Flow from Investing Activities

Cash flow used in investing activities was
primarily the result of the following capital expenditure
activities:

|                                                   |  |                   |        |             |  |   |        | 
|-------------------------------------------------- |  | ----------------- | ------ | ----------- |  | - | ------ | 
|                                                   |  |                  
|                                                   |  | Nine Months Ended
|                                                   |  |                  
|                                                   |  | October 30,       |        | November 1,
|                                                   |  | 2004(1)           |        | 2003(2)    
|                                                   |  |                   |        |            
|                                                   |  |                  
|                                                   |  | (In thousands)   
|New and relocated stores and stores not yet opened |  | $                 | 41,296 |             |  | $ | 29,052 | 
|Existing stores                                    |  |                   | 8,270  |             |  |   | 15,527 | 
|Distribution system expansion                      |  |                   | 6,998  |             |  |   | 11,737 | 
|Information systems                                |  |                   | 11,917 |             |  |   | 9,360  | 
|Corporate and other                                |  |                   | 3,182  |             |  |   | 3,657  | 
|                                                   |  |                   |        |             |  |   |        | 
|                                                   |  | $                 | 71,663 |             |  | $ | 69,333 | 
|                                                   |  |                   |        |             |  |   |        | 



---



|    |                                                                                                                                                                                                                                                                                                                    
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | In the first nine months of fiscal 2004, we
    incurred capital expenditures related to the opening of 45
    Michaels, seven Aaron Brothers, and six Recollections stores,
    the relocation of 30 Michaels and one Aaron Brothers store, and
    the completion of our New Lenox, Illinois distribution center.
|   
|(2) | In the first nine months of fiscal 2003, we
    incurred capital expenditures related to the opening of 55
    Michaels, 10 Aaron Brothers, two Recollections, and one Star
    Wholesale store and the relocation of 16 Michaels stores.                                                                          

We anticipate capital expenditures for fiscal
2004 to be approximately $105.0 million. As of the end of
the third quarter of fiscal 2004, we completed our fiscal 2004
store opening and relocation activities.

16



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##### Table of Contents



Cash Flow from Financing Activities

On September 16, 2004, our Board of
Directors approved a two-for-one stock split that was effected
in the form of a stock dividend to stockholders of record as of
the close of business on September 27, 2004. The stock
dividend was paid on October 12, 2004.

Proceeds from the exercise of outstanding stock
options have served as a source of cash for us, and we expect to
receive proceeds from the exercise of outstanding stock options
and options to be granted under our stock option plans in the
future. Proceeds from the exercise of stock options were
$28.6 million in the first nine months of fiscal 2004 and
$28.6 million in the first nine months of fiscal 2003.

Cash used for repurchases of our Common Stock
increased $57.2 million from $37.4 million in the
first nine months of fiscal 2003 to $94.6 million in the
first nine months of fiscal 2004. The following table sets forth
information regarding our Common Stock repurchase plans as of
October 30, 2004:

|                                                        |  |                |            |             |  |               |             |   |  |  |           |    
|------------------------------------------------------- |  | -------------- | ---------- | ----------- |  | ------------- | ----------- | - |  |  | --------- | ---
|                                                        |  | Shares         |            |             |  | Shares       
|                                                        |  | Authorized for |            | Shares      |  | Available for
|                                                        |  | Repurchase     |            | Repurchased |  | Repurchase   
|                                                        |  |                |            |             |  |              
|December 5, 2000 repurchase plan (fixed
    portion)    |  |                | 4,000,000  |             |  |               | (4,000,000  | ) |  |  |          | (1)
|December 5, 2000 repurchase plan (variable
    portion) |  |                | 54,552     |             |  |               | (54,551     | ) |  |  | 1         | (2)
|September 11, 2002 repurchase plan                      |  |                | 2,000,000  |             |  |               | (2,000,000  | ) |  |  |          | (3)
|June 18, 2003 repurchase plan                           |  |                | 2,000,000  |             |  |               | (2,000,000  | ) |  |  |          | (4)
|February 2, 2004 repurchase plan                        |  |                | 5,000,000  |             |  |               | (2,719,749  | ) |  |  | 2,280,251 | (5)
|                                                        |  |                |            |             |  |               |             |   |  |  |           |    
|                                                        |  |                | 13,054,552 |             |  |               | (10,774,300 | ) |  |  | 2,280,252 |    
|                                                        |  |                |            |             |  |               |             |   |  |  |           |    



---



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | On December 5, 2000, our Board of Directors
    authorized the purchase of up to 4.0 million shares of our
    outstanding Common Stock. By later resolutions, our Board of
    Directors provided that proceeds from the exercise of stock
    options under our 2001 General Stock Option Plan may be used to
    repurchase additional shares under the 2000 repurchase plan and
    that the maximum number of shares authorized to be repurchased
    under the 2000 repurchase plan may be increased to the extent
    necessary to so use the proceeds from such stock option
    exercises. As of April 2003, we had repurchased and subsequently
    retired a total of 4.0 million shares under the 2000
    repurchase plan at an average price of $11.13 per share
    and, as a result, we have used the entire fixed portion of the
    authority originally provided in the 2000 repurchase plan.
|   
|(2) | In the first nine months of fiscal 2004, we
    repurchased and subsequently retired 54,551 shares of our
    Common Stock at an average price of $27.03 per share using
    proceeds from exercises of stock options granted under the 2001
    General Stock Option Plan that were exercised in the first nine
    months of fiscal 2004.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   
|(3) | As of January 2004, we repurchased and
    subsequently retired the 2.0 million shares of our Common
    Stock authorized under the 2002 repurchase plan at an average
    price of $17.73 per share.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|   
|(4) | In the fourth quarter of fiscal 2003, we
    repurchased and subsequently retired approximately
    1.2 million shares of our Common Stock authorized under the
    2003 repurchase plan at an average price of $21.55 per
    share. In the first six months of fiscal 2004, we repurchased
    and subsequently retired 816,200 shares of our Common Stock
    authorized under the 2003 repurchase plan at an average price of
    $24.34 per share and, as a result, we have used the entire
    authority originally provided in the 2003 repurchase plan.                                                                                                                                                                                                                                                                                                                                                 
|   
|(5) | In the first nine months of fiscal 2004, we
    repurchased and subsequently retired approximately
    2.7 million shares of our Common Stock authorized to be
    repurchased under the 2004 repurchase plan at an average price
    of $26.93 per share and, as a result, we have
    2,280,251 shares available for repurchase under the plan as
    of October 30, 2004.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    

Since the end of the third quarter of fiscal
2004, we have repurchased and subsequently retired 380,000
shares of our Common Stock at an average price of $27.68 per
share. As of December 3, 2004,

17



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##### Table of Contents



we have a total of 1,900,252 shares available for
repurchase. We anticipate that we will continue to repurchase
shares of our Common Stock during the remainder of fiscal 2004.
Under the agreements governing our outstanding indebtedness, we
can only repurchase shares of our Common Stock if we maintain or
comply with specified financial ratios and other covenants. We
may also be restricted by regulations of the Securities and
Exchange Commission from making future repurchases during
certain time periods.


On March 16, 2004, our Board of Directors
approved a cash dividend of $0.06 per share that was paid
to stockholders of record at the close of business on
April 15, 2004. On June 17, 2004, our Board of
Directors approved a cash dividend of $0.06 per share that
was paid to stockholders of record at the close of business on
July 15, 2004. On September 16, 2004, our Board of
Directors approved a cash dividend of $0.07 per share that
was paid to stockholders of record as of the close of business
on September 27, 2004. On December 1, 2004, our Board
of Directors approved a cash dividend of $0.07 per share to be
paid on January 31, 2005, to stockholders of record as of
the close of business on January 17, 2005. These dividends
reflect our strengthening financial position and our Board of
Directors commitment to encouraging long-term investment
by a diverse stockholder base. We did not pay any dividends in
the first quarter of fiscal 2003; however, we paid a $0.05 cash
dividend in each of the second, third, and fourth quarters of
fiscal 2003.

Debt

In 2001, we issued $200 million in principal
amount of 9 1/4% Senior Notes due July 1, 2009,
which are unsecured and interest thereon is payable
semi-annually on each January 1 and July 1. The Senior Notes due
2009 are first callable, in part or in full, in July 2005. Based
on our current cash projections, we anticipate calling the
Senior Notes due 2009 in July 2005. The terms and conditions of
the Senior Notes due 2009 require us to comply with certain
covenants, which primarily limit certain activities, including,
among other things, levels of indebtedness, liens, investments,
payments of dividends, Common Stock repurchases, mergers and
acquisitions, and sales of assets. We are in compliance with all
terms and conditions of the Senior Notes due 2009.

In October 2004, we signed an extension to our
existing $200 million unsecured revolving bank credit
facility with Fleet National Bank and other lending
institutions, which now expires on April 30, 2006. The
Credit Agreement requires us to maintain certain financial
covenants and limits certain activities, including, among other
things, levels of indebtedness, liens, investments, payments of
dividends, Common Stock repurchases, mergers and acquisitions,
and sales of assets. In addition to extending the term of the
Credit Agreement, we obtained the consent of the lenders to
permit the prepayment of the Senior Notes due 2009 when they
become callable in July 2005, if we have liquidity
(defined as cash and equivalents plus unused availability under
the Credit Agreement) of at least $300 million. We are in
compliance with all terms and conditions of the Credit
Agreement. We had no borrowings under our Credit Agreement
during either the third quarter of fiscal 2004 or the third
quarter of fiscal 2003 and no borrowings were outstanding under
the Credit Agreement at the end of either quarter. Borrowings
available under the Credit Agreement are reduced by the
aggregate amount of letters of credit outstanding under the
Credit Agreement ($26.1 million as of October 30,
2004).

General

We believe that our available cash, funds
generated by operating activities, funds available under the
Credit Agreement, and proceeds from the exercise of stock
options will be sufficient to fund planned capital expenditures,
working capital requirements, and any anticipated dividend
payments or stock repurchases for the foreseeable future.

Recent Accounting Pronouncements

In November 2004, the Financial Accounting
Standards Board issued Statement of Financial Accounting
Standards No. 151, Inventory Costs, as an amendment
to ARB No. 43. SFAS No. 151

18



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##### Table of Contents



clarifies that abnormal amounts of idle facility
expense, freight, handling costs, and wasted materials
(spoilage) should be recognized as current period charges and
requires the allocation of fixed production overheads to
inventory based on the normal capacity of the production
facilities. SFAS No. 151 is effective for inventory costs
incurred during fiscal years beginning after June 15, 2005.
We are evaluating the provisions of SFAS No. 151 to
determine the impact on our consolidated operating results or
financial position.







|        |                                                                
|------- | ---------------------------------------------------------------
|Item 3. | Quantitative and Qualitative Disclosures About
    Market Risk.

We have market risk exposure arising from changes
in interest rates. The interest rates on the Credit Agreement
are repriced frequently, at market prices, which would result in
carrying amounts that approximate fair value. We had no
borrowings outstanding under the Credit Agreement at
October 30, 2004. In July 2001, we issued $200 million
of the Senior Notes due 2009 with a fixed interest rate of
9 1/4%. Generally, the fair market value of our fixed
interest rate long-term debt will increase as interest rates
fall and decrease as interest rates rise. Our market risk is
described in more detail in our Annual Report on Form 10-K
for the fiscal year ended January 31, 2004.






|        |                         
|------- | ------------------------
|Item 4. | Controls and Procedures.

Evaluation of Disclosure Controls and
Procedures

We maintain a set of disclosure controls and
procedures (as defined in Rules 13a-15(e) and 15d-15(e)
promulgated by the Securities and Exchange Commission under the
Securities Exchange Act of 1934). An evaluation was carried out
under the supervision and with the participation of our
management, including our Chief Executive Officer and our
Executive Vice President Chief Financial Officer, of the
effectiveness of our disclosure controls and procedures as of
the end of the period covered by this Quarterly Report on
Form 10-Q. Based on that evaluation, our Chief Executive
Officer and our Executive Vice President Chief Financial
Officer concluded that our disclosure controls and procedures
are effective to provide reasonable assurance that information
required to be disclosed in the reports that we file or submit
under the Securities Exchange Act of 1934 is recorded,
processed, summarized, and reported within the time periods
specified in Securities and Exchange Commission rules and forms.
We note that the design of any system of controls is based, in
part, upon certain assumptions about the likelihood of future
events, and there can be no assurance that any design will
succeed in achieving its stated goals under all potential future
conditions.

Change in Internal Control Over Financial
Reporting

There has not been any change in our internal
control over financial reporting (as defined in
Rules 13a-15(f) and 15d-15(f) as promulgated by the
Securities and Exchange Commission under the Securities Act of
1934) during our most recently completed fiscal quarter that has
materially affected, or is reasonably likely to materially
affect, our internal control over financial reporting.

19



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MICHAELS STORES, INC.




Part IIOTHER INFORMATION






|        |                   
|------- | ------------------
|Item 1. | Legal Proceedings.



| |                          
| | -------------------------
| | Stockholder Class Actions

On various dates between February 4, 2003
and March 25, 2003, 10 purported class action lawsuits were
filed in the United States District Court for the Northern
District of Texas, Dallas Division, against Michaels Stores,
Inc. and certain of the current and former directors and
officers of Michaels. All of these lawsuits have been
consolidated. The suits assert various claims under
Sections 10(b) and 20(a) of the Securities Exchange Act of
1934 related to actions prior to Michaels announcement on
November 7, 2002, that, among other things, it had revised
its outlook for the fourth fiscal quarter of 2002, adjusting
downward its guidance for annual earnings per diluted share. The
consolidated complaint charges that, prior to that announcement,
Michaels and certain of the other defendants made
misrepresentations and failed to disclose negative information
about the financial condition of Michaels while the individual
defendants were selling shares of Michaels common stock. We
believe these claims are without merit and will vigorously
contest them. We are unable to estimate a range of possible
loss, if any, in these claims.



| |                  
| | -----------------
| | Derivative Claims

On March 21, 2003, Julie Fathergill filed a
purported stockholder derivative action, which is pending in the
192nd District Court for Dallas County, Texas. The lawsuit
names certain former and current officers and directors,
including all of Michaels current directors, as individual
defendants and Michaels as a nominal defendant. In this
derivative action, the plaintiff makes allegations of fact
similar to those made in the purported securities class actions
described above. The plaintiff asserts claims against the
individual defendants for breach of fiduciary duties, abuse of
control, gross mismanagement, waste of corporate assets, and
unjust enrichment. All of these claims are asserted derivatively
on behalf of Michaels. We believe these claims are also without
merit and will vigorously oppose them.

On September 11, 2003, Leo J. Dutil filed a
purported stockholder derivative action, which is pending in the
United States District Court for the Northern District of Texas,
Dallas Division. The lawsuit names certain former and current
officers and directors as individual defendants and Michaels as
a nominal defendant. In this derivative action, the plaintiff
makes allegations of fact similar to those made in the purported
stockholder class actions and the Fathergill derivative lawsuit
described above. The plaintiff asserts claims against the
individual defendants for breach of fiduciary duty,
misappropriation of confidential information, and contribution
and indemnification. All of these claims are asserted
derivatively on behalf of Michaels. We believe these claims are
also without merit and will vigorously oppose them.



| |             
| | ------------
| | Cotton Claim

On December 20, 2002, James Cotton, a former
store manager of Michaels of Canada, ULC, our wholly-owned
subsidiary, and Suzette Kennedy, a former assistant manager of
Michaels of Canada, commenced a proposed class proceeding
against Michaels of Canada and Michaels Stores, Inc. on behalf
of themselves and current and former employees employed in
Canada. The Cotton claim was filed in the Ontario Superior Court
of Justice and alleges that the defendants violated employment
standards legislation in Ontario and other provinces and
territories of Canada by failing to pay overtime compensation as
required by that legislation. The Cotton claim also alleges that
this conduct was in breach of the contracts of employment of
those individuals. The Cotton claim seeks a declaration that the
defendants have acted in breach of applicable legislation,
payment to current and former employees for overtime, damages
for breach of contract, punitive, aggravated and exemplary
damages, interest, and costs. We believe we have certain
meritorious defenses and intend to defend this lawsuit
vigorously. We are unable to estimate a range of possible loss,
if any, in this claim.

20



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##### Table of Contents





| |        
| | -------
| | General

We are a defendant from time to time in lawsuits
incidental to our business. Based on currently available
information, we believe that resolution of all known
contingencies is uncertain. There can be no assurance that
future costs of such litigation would not be material to our
financial position or results of operations.






|        |                                                                 
|------- | ----------------------------------------------------------------
|Item 2. | Unregistered Sales of Equity Securities and
    Use of Proceeds.

On December 5, 2000, our Board of Directors
authorized the repurchase of up to 4.0 million shares of
our outstanding Common Stock. By later resolutions, our Board of
Directors provided that proceeds of the exercise of options
under our 2001 General Stock Option Plan may be used to
repurchase shares under the 2000 repurchase plan and that the
maximum number of shares authorized to be repurchased under the
2000 repurchase plan may be increased to the extent necessary to
so use the proceeds from such option exercises.

On September 11, 2002, our Board of
Directors authorized the repurchase of up to 2.0 million
shares of our outstanding Common Stock. On June 18, 2003,
our Board of Directors authorized the repurchase of up to
2.0 million shares of our outstanding Common Stock. On
February 2, 2004, our Board of Directors authorized the
repurchase of up to 5.0 million shares of our outstanding
Common Stock.

The following table sets forth our repurchases of
Common Stock for each fiscal month in the third quarter of
fiscal 2004:

Issuer Purchases of Equity
Securities

|                                         |  |              |           |            |  |                  |       |                 |  |  |           |  |  |  |           | 
|---------------------------------------- |  | ------------ | --------- | ---------- |  | ---------------- | ----- | --------------- |  |  | --------- |  |  |  | --------- | 
|                                         |  |              |           |            |  | Total Number     |       | Maximum        
|                                         |  |              |           |            |  | of Shares        |       | Number of      
|                                         |  |              |           |            |  | Purchased as     |       | Shares That    
|                                         |  |              |           |            |  | Part of Publicly |       | May Yet Be     
|                                         |  | Total Number |           | Average    |  | Announced        |       | Purchased      
|                                         |  | of Shares    |           | Price Paid |  | Plans or         |       | Under the Plans
|                                         |  | Purchased(1) |           | per Share  |  | Programs(1)      |       | or Programs(2) 
|                                         |  |              |           |            |  |                  |       |                
|August 1, 2004 through August 28, 2004   |  |              | 407,800   |            |  | $                | 26.29 |                 |  |  | 407,800   |  |  |  | 3,296,676 | 
|August 29, 2004 through October 2, 2004  |  |              | 1,043,500 |            |  |                  | 27.55 |                 |  |  | 1,043,500 |  |  |  | 2,280,252 | 
|October 3, 2004 through October 30, 2004 |  |              |          |            |  |                  |      |                 |  |  |          |  |  |  | 2,280,252 | 
|                                         |  |              |           |            |  |                  |       |                 |  |  |           |  |  |  |           | 
|Total                                    |  |              | 1,451,300 |            |  | $                | 27.19 |                 |  |  | 1,451,300 |  |  |  | 2,280,252 | 
|                                         |  |              |           |            |  |                  |       |                 |  |  |           |  |  |  |           | 



---



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Repurchased and subsequently retired
    27,075 shares under the variable portion of the 2000
    repurchase plan, and 1,424,225 shares under the 2004
    repurchase plan.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|   
|(2) | Under our 2000 repurchase plan, the Board of
    Directors authorized us to repurchase up to 4.0 million
    shares of our outstanding Common Stock, with the ability to
    increase the maximum number of shares authorized to be
    repurchased under the plan to the extent necessary to use the
    proceeds from stock options exercised under our 2001 General
    Stock Option Plan to make repurchases. We have used the entire
    4.0 million share fixed portion of the authority originally
    provided in the 2000 repurchase plan. In the third quarter of
    fiscal 2004, we repurchased and subsequently retired
    27,075 shares of our Common Stock at an average price of
    $27.31 per share using proceeds from exercises of stock
    options granted under the 2001 General Stock Option Plan that
    were exercised in the third quarter of fiscal 2004. As of
    October 30, 2004, we had 2,280,252 shares available
    for repurchase under the 2004 repurchase plan.






|        |                   
|------- | ------------------
|Item 5. | Other Information.

On December 1, 2004, the Compensation
Committee of our Board of Directors approved the purchase of a
new automobile for use by R. Michael Rouleau, our President and
Chief Executive Officer, as part of his compensation, and
authorized the transfer to Mr. Rouleau of title to an older
automobile formerly used by him, also as part of his
compensation.

21



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|        |                                      
|------- | -------------------------------------
|Item 6. | Exhibits and Reports on
    Form 8-K.

(a) Exhibits:

|     |  |                                                                                                                                                                                                                                                                                                                                                         
|---- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|10.1 |  | Revolving Credit Agreement, dated May 1,
    2001, between Michaels Stores, Inc. and Fleet National Bank and
    the other lenders named therein (previously filed as
    Exhibit 10.1 to Form 10-Q for the period ended May 5,
    2001, filed by Registrant on June 19, 2001, SEC File No.
    000-11822).                                            
|10.2 |  | First Amendment and Consent to Revolving Credit
    Agreement, dated as of December 31, 2001, among Michaels
    Stores, Inc., Fleet National Bank, and the other lenders named
    therein (previously filed as Exhibit 10.16 to Form 10-K for
    the year ended February 2, 2002, filed by Registrant on
    April 12, 2002, SEC File No. 000-11822).
|10.3 |  | Second Amendment and Consent to Revolving Credit
    Agreement, dated as of December 31, 2003, among Michaels
    Stores, Inc., Fleet National Bank, and the other lenders named
    therein (previously filed as Exhibit 10.20 to Form 10-K for
    the year ended January 31, 2004, filed by Registrant on
    April 2, 2004, SEC File No. 000-11822).
|10.4 |  | Third Amendment and Consent to Revolving Credit
    Agreement, dated as of October 6, 2004, among Michaels
    Stores, Inc., Fleet National Bank, and the other lenders named
    therein (filed herewith).                                                                                                                                             
|31.1 |  | Certifications of R. Michael Rouleau pursuant to
    §302 of the Sarbanes-Oxley Act of 2002 (filed herewith).                                                                                                                                                                                                                                           
|31.2 |  | Certifications of Jeffrey N. Boyer pursuant to
    §302 of the Sarbanes-Oxley Act of 2002 (filed herewith).                                                                                                                                                                                                                                             
|32.1 |  | Certification pursuant to 18 U.S.C.
    §1350, as adopted pursuant to §906 of the
    Sarbanes-Oxley Act of 2002 (filed herewith).                                                                                                                                                                                                                      



| |     |                                                                                                                                        
| | --- | ---------------------------------------------------------------------------------------------------------------------------------------
| | (b) | Reports on Form 8-K. The following reports
    were filed or furnished by the Registrant during the quarter
    ended October 30, 2004:

|   |  |                                                                                                                                                                                 
|-- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|1. |  | Report on Form 8-K, dated and furnished to
    the Securities and Exchange Commission on August 5, 2004,
    reporting information pursuant to Item 12.                         
|2. |  | Report on Form 8-K, dated and furnished to
    the Securities and Exchange Commission on August 25, 2004,
    reporting information pursuant to Item 2.02.                      
|3. |  | Report on Form 8-K, dated and filed with the
    Securities and Exchange Commission on September 16, 2004,
    reporting information pursuant to Item 8.01 and 9.01.            
|4. |  | Report on Form 8-K, dated and filed with the
    Securities and Exchange Commission on September 28, 2004,
    reporting information pursuant to Items 1.01, 8.01, and
    9.01.

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MICHAELS STORES, INC.




SIGNATURES


Pursuant to the requirements of the Securities
Exchange Act of 1934, the Registrant has duly caused this report
to be signed on its behalf by the undersigned thereunto duly
authorized.



| |                      
| | ---------------------
| | MICHAELS STORES, INC.



| |     |                     
| | --- | --------------------
| | By: | /s/ JEFFREY N. BOYER

| |                                                      
| | -----------------------------------------------------
| |                                                      
| | Jeffrey N. Boyer                                     
| | Executive Vice President Chief Financial
    Officer
| | (Principal Financial Officer)                        

Dated: December 7, 2004

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INDEX TO EXHIBITS

|        |      |                        |  |                                                                                                                                                                                                                                                                                                                                                             
|------- | ---- | ---------------------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |      |                       
|Number  |      | Description of Exhibit
|        |      |                       
|        | 10.1 |                        |  | Revolving Credit Agreement, dated May 1,
    2001, between Michaels Stores, Inc. and Fleet National Bank and
    the other lenders named therein (previously filed as
    Exhibit 10.1 to Form 10-Q for the period ended
    May 5, 2001, filed by Registrant on June 19, 2001, SEC
    File No. 000-11822).                                                
|        | 10.2 |                        |  | First Amendment and Consent to Revolving Credit
    Agreement, dated as of December 31, 2001, among Michaels
    Stores, Inc., Fleet National Bank, and the other lenders named
    therein (previously filed as Exhibit 10.16 to
    Form 10-K for the year ended February 2, 2002, filed
    by Registrant on April 12, 2002, SEC File
    No. 000-11822).
|        | 10.3 |                        |  | Second Amendment and Consent to Revolving Credit
    Agreement, dated as of December 31, 2003, among Michaels
    Stores, Inc., Fleet National Bank, and the other lenders named
    therein (previously filed as Exhibit 10.20 to
    Form 10-K for the year ended January 31, 2004, filed
    by Registrant on April 2, 2004, SEC File
    No. 000-11822).
|        | 10.4 |                        |  | Third Amendment and Consent to Revolving Credit
    Agreement, dated as of October 6, 2004, among Michaels
    Stores, Inc., Fleet National Bank, and the other lenders named
    therein (filed herewith).                                                                                                                                                 
|        | 31.1 |                        |  | Certifications of R. Michael Rouleau pursuant to
    §302 of the Sarbanes-Oxley Act of 2002 (filed herewith).                                                                                                                                                                                                                                               
|        | 31.2 |                        |  | Certifications of Jeffrey N. Boyer pursuant to
    §302 of the Sarbanes-Oxley Act of 2002 (filed herewith).                                                                                                                                                                                                                                                 
|        | 32.1 |                        |  | Certification pursuant to 18 U.S.C.
    §1350, as adopted pursuant to §906 of the
    Sarbanes-Oxley Act of 2002 (filed herewith).