Table ofContents

 

 

 

**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON,DC 20549**

 

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**FORM 10-Q**

 
| **(Mark One)**                                                                                                                                                                                                                                       |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **x**                                                                                                                                                                                                                                                | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                                                                                                 |
| **For the quarterly period ended November 1,  2008**                                                                                                                                                                                            |
| ** **                                                                                                                                                                                                                                           |
| **OR**                                                                                                                                                                                                                                               |
|                                                                                                                                                                                                                                                 |
| **o**                                                                                                                                                                                                                                                | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934** |
| ** **                                                                                                                                                                                                                                           |
| **For the transition period from                     to                 ** |
|                                                                                                                                                                                                                                                      |  |  |

 

**Commissionfile number 001-09338**

 

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**MICHAELSSTORES, INC.**

(Exact name ofregistrant as specified in its charter)

 

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

 

**8000Bent Branch Drive**

**Irving,Texas 75063**

(Address ofprincipal executive offices, including zip code)

 

**(972) 409-1300**

(Registrant’stelephone number, including area code)

 

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Indicate by check markwhether the Registrant: (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the Registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days.   Yes x**     **No o

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, a non-accelerated filer, or a smaller reporting company. Seethe definitions of “large accelerated filer,” “accelerated filer” and “smallerreporting company” in Rule 12b-2 of the Exchange Act. (Check one):

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

 

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

 

Asof December 8, 2008, 118,497,202 shares of the Registrant’s Common Stockwere outstanding.

 

 

 

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**Table of Contents**

** **

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

 
| **Part I—FINANCIAL  INFORMATION** | **3**                                                                                                                                     |
|---------------------------------------------|-------------------------------------------------------------------------------------------------------------------------------------------|
| **Item 1.**                            | **Financial  Statements**                                                                                                                 | **3** |
|                                        | Consolidated Balance Sheets at November 1, 2008,  February 2, 2008, and November 3, 2007 (unaudited)                       | **3** |
|                                        | Consolidated Statements of  Operations for the quarter and nine months ended November 1, 2008 and  November 3, 2007 (unaudited) | **4** |
|                                        | Consolidated  Statements of Cash Flows for the nine months ended November 1, 2008 and  November 3, 2007 (unaudited)             | **5** |
|                                        | Notes to Consolidated Financial Statements (unaudited)                                                                                    | **6** |
| **Item 2.**                            | **Management’s  Discussion and Analysis of Financial Condition and Results of Operations**                                           | **20** |
| **Item 3.**                            | **Quantitative  and Qualitative Disclosures About Market Risk**                                                                           | **26** |
| **Item 4.**                            | **Controls and  Procedures**                                                                                                              | **27** |
| **Part II—OTHER  INFORMATION**    | **28**                                                                                                                                    |
| **Item 1.**                            | **Legal Proceedings**                                                                                                                     | **28** |
| **Item 1A.**                           | **Risk Factors**                                                                                                                          | **28** |
| **Item 6.**                            | **Exhibits**                                                                                                                              | **29** |
| **Signatures**                              | ** **                                                                                                                                | **30** |

 

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**MICHAELS STORES, INC.**

**Part I—FINANCIAL INFORMATION**

 

**Item 1.  FinancialStatements.**

 

**MICHAELSSTORES, INC.**

**CONSOLIDATED BALANCE SHEETS**

**(Inmillions, except share data)**

**(Unaudited)**

** **
| ** **                                                                                                                                                                                                                                                                  | ** ** | **November 1,** | ** ** | **February 2,** | ** ** | **November 3,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------|------------|----------------------|------------|----------------------|------------|
| ** **                                                                                                                                                                                                                                                                  | ** ** | **2008**             | ** ** | **2008**             | ** ** | **2007**             | ** ** |
| **ASSETS**                                                                                                                                                                                                                                                                  |       |                 |       |                 |       |                 |       |
| **Current assets:**                                                                                                                                                                                                                                                         |       |                 |       |                 |       |                 |       |
| Cash and equivalents                                                                                                                                                                                                                                                        |       | $                    | 92         |                 | $          | 29                   |       | $ | 57 |   |
| Merchandise inventories                                                                                                                                                                                                                                                     |       | 1,083                |       | 845                  |       | 1,027                |       |
| Prepaid expenses and other                                                                                                                                                                                                                                                  |       | 83                   |       | 70                   |       | 74                   |       |
| Deferred income taxes                                                                                                                                                                                                                                                       |       | 30                   |       | 31                   |       | 35                   |       |
| Income tax receivable                                                                                                                                                                                                                                                       |       | 38                   |       | 5                    |       | 78                   |       |
| Current assets - discontinued operations                                                                                                                                                                                                                                    |       | —               |       | —               |       | 9                    |       |
| Total current assets                                                                                                                                                                                                                                                        |       | 1,326                |       | 980                  |       | 1,280                |       |
| **Property and equipment, at cost**                                                                                                                                                                                                                                         |       | 1,204                |       | 1,155                |       | 1,143                |       |
| Less accumulated depreciation                                                                                                                                                                                                                                               |       | (802                 | )          | (722                 | )          | (698                 | )          |
|                                                                                                                                                                                                                                                                        |       | 402                  |       | 433                  |       | 445                  |       |
| **Goodwill**                                                                                                                                                                                                                                                                |       | 94                   |       | 94                   |       | 116                  |       |
| **Debt issuance costs, net of accumulated  amortization of $35 at November 1, 2008; $22 at February 2, 2008;  and $18 at November 3, 2007**                                                                                                                  |       | 90                   |       | 103                  |       | 107                  |       |
| **Other assets**                                                                                                                                                                                                                                                            |       | —               |       | 4                    |       | 7                    |       |
| **Non-current assets - discontinued operations**                                                                                                                                                                                                                            |       | —               |       | —               |       | (1                   | )          |
|                                                                                                                                                                                                                                                                        |       | 184                  |       | 201                  |       | 229                  |       |
| Total assets                                                                                                                                                                                                                                                                |       | $                    | 1,912      |                 | $          | 1,614                |       | $ | 1,954 |   |
|                                                                                                                                                                                                                                                                        |       |                 |       |                 |       |                 |       |
| **LIABILITIES AND STOCKHOLDERS’  DEFICIT**                                                                                                                                                                                                                             |       |                 |       |                 |       |                 |       |
| **Current liabilities:**                                                                                                                                                                                                                                                    |       |                 |       |                 |       |                 |       |
| Accounts payable                                                                                                                                                                                                                                                            |       | $                    | 274        |                 | $          | 221                  |       | $ | 282 |   |
| Accrued liabilities and other                                                                                                                                                                                                                                               |       | 336                  |       | 332                  |       | 333                  |       |
| Current portion of long-term debt                                                                                                                                                                                                                                           |       | 432                  |       | 122                  |       | 445                  |       |
| Current liabilities - discontinued operations                                                                                                                                                                                                                               |       | 1                    |       | 4                    |       | 2                    |       |
| Total current liabilities                                                                                                                                                                                                                                                   |       | 1,043                |       | 679                  |       | 1,062                |       |
| **Long-term debt**                                                                                                                                                                                                                                                          |       | 3,751                |       | 3,741                |       | 3,736                |       |
| **Deferred income taxes**                                                                                                                                                                                                                                                   |       | 5                    |       | 4                    |       | 16                   |       |
| **Other long-term liabilities**                                                                                                                                                                                                                                             |       | 76                   |       | 80                   |       | 81                   |       |
| **Long-term liabilities - discontinued operations**                                                                                                                                                                                                                         |       | 1                    |       | 2                    |       | 1                    |       |
| Total long-term liabilities                                                                                                                                                                                                                                                 |       | 3,833                |       | 3,827                |       | 3,834                |       |
|                                                                                                                                                                                                                                                                        |       | 4,876                |       | 4,506                |       | 4,896                |       |
| **Commitments and contingencies**                                                                                                                                                                                                                                           |       |                 |       |                 |       |                 |       |
| **Stockholders’ deficit:**                                                                                                                                                                                                                                             |       |                 |       |                 |       |                 |       |
| Common Stock, $0.10 par value, 220,000,000 shares authorized; 118,376,402  shares issued and outstanding at November 1, 2008; 118,421,069 shares  issued and outstanding at February 2, 2008; 118,451,736 shares issued  and outstanding at November 3, 2007 |       | 12                   |       | 12                   |       | 12                   |       |
| Additional paid-in capital                                                                                                                                                                                                                                                  |       | 17                   |       | 12                   |       | 11                   |       |
| Accumulated deficit                                                                                                                                                                                                                                                         |       | (2,996               | )          | (2,926               | )          | (2,980               | )          |
| Accumulated other comprehensive income                                                                                                                                                                                                                                      |       | 3                    |       | 10                   |       | 15                   |       |
| Total stockholders’ deficit                                                                                                                                                                                                                                            |       | (2,964               | )          | (2,892               | )          | (2,942               | )          |
| Total liabilities and stockholders’ deficit                                                                                                                                                                                                                            |       | $                    | 1,912      |                 | $          | 1,614                |       | $ | 1,954 |   |

 

See accompanying notes to consolidated financialstatements.

 

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**MICHAELS STORES, INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**(Inmillions)**

**(Unaudited)**

 
| ** **                                                  | ** ** | **Quarter Ended** | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------------------------------|------------|------------------------|------------|---------------------------------|------------|
| ** **                                                  | ** ** | **November 1,**   | ** ** | **November 3,**            | ** ** | **November 1,** | ** ** | **November 3,** | ** ** |
| ** **                                                  | ** ** | **2008**               | ** ** | **2007**                        | ** ** | **2008** | ** ** | **2007** | ** ** |
| **Net sales**                                               |       | $                      | 906        |                            | $          | 934 |   | $ | 2,549 |   | $ | 2,561 |   |
| Cost of sales and occupancy expense                         |       | 584                    |       | 591                             |       | 1,623 |   | 1,602 |   |
| **Gross profit**                                            |       | 322                    |       | 343                             |       | 926 |   | 959 |   |
| Selling, general, and administrative expense                |       | 247                    |       | 261                             |       | 765 |   | 758 |   |
| Transaction expenses                                        |       | —                 |       | 8                               |       | — |   | 29 |   |
| Related party expenses                                      |       | 4                      |       | 4                               |       | 12 |   | 12 |   |
| Store pre-opening costs                                     |       | 3                      |       | 3                               |       | 6 |   | 6 |   |
| **Operating income**                                        |       | 68                     |       | 67                              |       | 143 |   | 154 |   |
| Interest expense                                            |       | 77                     |       | 95                              |       | 231 |   | 285 |   |
| Other (income) and expense, net                             |       | 3                      |       | (6                              | )          | 3 |   | (11 | ) |
| **Loss before income taxes and discontinued****operations** |       | (12                    | )          | (22                             | )          | (91 | ) | (120 | ) |
| Provision (benefit) for income taxes                        |       | 8                      |       | (9                              | )          | (21 | ) | (42 | ) |
| **Loss before discontinued operations**                     |       | (20                    | )          | (13                             | )          | (70 | ) | (78 | ) |
| Discontinued operations loss, net of income tax             |       | —                 |       | (5                              | )          | — |   | (7 | ) |
| **Net loss**                                                |       | $                      | (20        | )                               | $          | (18 | ) | $ | (70 | ) | $ | (85 | ) |

 

See accompanyingnotes to consolidated financial statements.

 

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**MICHAELSSTORES, INC.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(Inmillions)**

**(Unaudited)**

** **
| ** **                                          | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------------|------------|---------------------------------|------------|
| ** **                                          | ** ** | **November 1,**            | ** ** | **November 3,** | ** ** |
| ** **                                          | ** ** | **2008**                        | ** ** | **2007** | ** ** |
| **Operating activities:**                           |       |                            |       |   |   |
| Net loss                                            |       | $                               | (70        | ) | $ | (85 | ) |
| Adjustments:                                        |       |                            |       |   |   |
| Depreciation and amortization                       |       | 94                              |       | 94 |   |
| Share-based compensation                            |       | 6                               |       | 4 |   |
| Deferred financing costs amortization               |       | 13                              |       | 13 |   |
| Accretion of subordinated discount notes            |       | 29                              |       | 25 |   |
| Impairment of discontinued operations               |       | —                          |       | 6 |   |
| Other                                               |       | 1                               |       | (1 | ) |
| Changes in assets and liabilities:                  |       |                            |       |   |   |
| Merchandise inventories                             |       | (250                            | )          | (188 | ) |
| Prepaid expenses and other                          |       | (5                              | )          | — |   |
| Deferred income taxes and other                     |       | 3                               |       | (14 | ) |
| Accounts payable                                    |       | 51                              |       | 56 |   |
| Accrued interest                                    |       | (9                              | )          | 10 |   |
| Accrued liabilities and other                       |       | 13                              |       | 39 |   |
| Income taxes receivable                             |       | (37                             | )          | (52 | ) |
| Other long-term liabilities                         |       | (5                              | )          | 13 |   |
| Net cash used in operating activities               |       | (166                            | )          | (80 | ) |
|                                                |       |                            |       |   |   |
| **Investing activities:**                           |       |                            |       |   |   |
| Additions to property and equipment                 |       | (66                             | )          | (86 | ) |
| Net cash used in investing activities               |       | (66                             | )          | (86 | ) |
|                                                |       |                            |       |   |   |
| **Financing activities:**                           |       |                            |       |   |   |
| Borrowings on asset-based revolving credit facility |       | 749                             |       | 793 |   |
| Payments on asset-based revolving credit facility   |       | (439                            | )          | (578 | ) |
| Repayments on senior secured term loan facility     |       | (18                             | )          | (18 | ) |
| Equity investment of Management                     |       | —                          |       | 8 |   |
| Repurchase of new Common Stock                      |       | (1                              | )          | (1 | ) |
| Payments of capital leases                          |       | (4                              | )          | (6 | ) |
| Change in cash overdraft                            |       | 9                               |       | (5 | ) |
| Other                                               |       | (1                              | )          | — |   |
| Net cash provided by financing activities           |       | 295                             |       | 193 |   |
|                                                |       |                            |       |   |   |
| **Net increase in cash and equivalents**            |       | 63                              |       | 27 |   |
| **Cash and equivalents at beginning of period**     |       | 29                              |       | 30 |   |
| **Cash and equivalents at end of period**           |       | $                               | 92         |   | $ | 57 |   |

** **

See accompanying notes to consolidated financialstatements.

 

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** **

**MICHAELS STORES, INC.**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

**For the Nine Months Ended November 1,2008**

**(Unaudited)**

 

**Note 1.  Summaryof Significant Accounting Policies**

 

*Basisof Presentation*

 

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

 

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

 

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

 

Becauseof the seasonal nature of our business, the results of operations for the threeand nine months ended November 1, 2008 are not indicative of the resultsto be expected for the entire year.

 

Thebalance sheet at February 2, 2008 has been derived from the auditedfinancial statements at that date but does not include all of the informationand notes required by generally accepted accounting principles for completefinancial statements. For further information, refer to the consolidatedfinancial statements and notes thereto included in our Annual Report on Form 10-Kfor the fiscal year ended February 2, 2008.

 

Wereport on the basis of a 52 or 53-week fiscal year, which ends on the Saturdayclosest to January 31. All references herein to “fiscal 2008” relate tothe 52 weeks ending January 31, 2009, and all references to “fiscal2007” relate to the 52 weeks ended February 2, 2008. In addition, allreferences herein to “the third quarter of fiscal 2008” relate to the 13 weeksended November 1, 2008 and all references to “the third quarter of fiscal2007” relate to the 13 weeks ended November 3, 2007. Finally, allreferences to “the nine months ended November 1, 2008” relate to the 39weeks ended November 1, 2008, and “the nine months ended November 3,2007” relate to the 39 weeks ended November 3, 2007.

 

*Changein Accounting Estimates*

 

Duringthe third quarter of 2008, we reduced our bonus expense accrual byapproximately $15 million primarily due to lower than planned results fromoperations given the soft macroeconomic environment. Bonus expense is includedin selling, general and administrative expense on the consolidated statementsof operations.

 

SeeNote 8 for further information on the change in our effective tax rate.

 

*Reclassifications*

 

Certainprior year amounts were reclassified to conform to current year presentation.These reclassifications consist primarily of the presentation of discontinuedoperations.

 

*RecentAccounting Pronouncements*

 

In September 2006, the Financial AccountingStandards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”)No. 157, *Fair Value Measurements*, which isintended to increase consistency and comparability in fair value measurementsby defining fair value, establishing a framework for measuring fair value andexpanding disclosures about fair value measurements. SFAS 157 was originallyeffective for financial statements issued for fiscal years beginning after November 15,2007, and interim periods within those fiscal years. In November 2007, theFASB placed a one year deferral for the implementation of SFAS 157 for nonfinancialassets and liabilities; however, SFAS 157 is effective for fiscal yearsbeginning after November 15, 2007 for financial assets and liabilities, aswell as for any other assets and liabilities that are carried at fair value ona recurring basis in financial statements. We adopted all requirements of SFAS157 as they relate to financial assets and liabilities on February 3,2008. See Note 7 for further information on the impact of this standard tofinancial assets and liabilities. The requirements related to nonfinancialassets and liabilities will be adopted on February 1, 2009, as allowed bySFAS 157. We have not yet determined the impact, if any, on our consolidatedfinancial statements for these nonfinancial assets and liabilities.

 

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

 

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

 

In March 2008, theFASB issued SFAS No. 161, *Disclosuresabout Derivative Instruments and Hedging Activities – an amendment of FASBStatement No. 133*. SFAS 161 requires qualitative disclosuresabout objectives and strategies for using derivatives, quantitative data aboutthe fair value of, and gains and losses on, derivative contracts, and detailsof credit-risk-related contingent features in hedged positions. The statementalso requires enhanced disclosures regarding how and why entities usederivative instruments, how derivative instruments and related hedged items areaccounted for in accordance with SFAS 133 and its related interpretation, andhow derivative instruments and related hedged items affect an entity’sfinancial position, financial performance, and cash flows. SFAS 161 iseffective for fiscal years and interim periods beginning after November 15,2008. We will adopt the new disclosure requirements of SFAS 161 in the firstquarter of fiscal 2009.

 

**Note 2.  DiscontinuedOperations**

 

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

 

The unaudited consolidated financial statements, accompanying notes andother information provided in this Quarterly Report on Form 10-Q reflectthese concept businesses as discontinued operations for all periods presented.

 

Summarized financial information with respect to the results ofoperations of these discontinued operations is as follows:

 

| ** **                                             | ** ** | **Quarter Ended**         | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------------------|------------|--------------------------------|------------|---------------------------------|------------|
| ** **                                             | ** ** | **November 3, 2007** | ** ** | **November 3, 2007**  | ** ** |
| ** **                                             | ** ** | **(in millions)**         | ** ** |
|                                                   |       |                           |       |                            |       |
| Net sales                                              |       | $                              | 6          |                            | $          | 16 |   |
|                                                   |       |                           |       |                            |       |
| Loss from discontinued operations before  income taxes |       | $                              | (8         | )                               | $          | (10 | ) |
| Income tax benefit                                     |       | 3                              |       | 3                               |       |
| Net loss from discontinued operations                  |       | $                              | (5         | )                               | $          | (7 | ) |

 

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**Note 3.  Share-BasedCompensation**

 

On February 15, 2007, our stockholders and Board of Directorsapproved the 2006 Equity Incentive Plan (“2006 Plan”), which provides for thegrant of share-based awards exercisable for up to 14.2 million shares of CommonStock. The table below sets forth a summary of stock option activity for thethree and nine months ended November 1, 2008 and November 3, 2007. Asof November 1, 2008, there were 187,467 shares of restricted stockoutstanding, 10.3 million share-based awards outstanding and up to 3.7 millionshares of Common Stock remaining available for grant under the 2006 Plan.

 
| ** **                         | ** ** | **Quarter Ended**         | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------|------------|--------------------------------|------------|---------------------------------|------------|
| ** **                         | ** ** | **November 1, 2008** | ** ** | **November 3, 2007**  | ** ** | **November 1, 2008** | ** ** | **November 3, 2007** | ** ** |
| ** **                         | ** ** | **(in millions)**         | ** ** |
|                               |       |                           |       |                            |       |   |   |   |   |
| Outstanding at beginning of period |       | 10.4                           |       | 11.4                            |       | 11.1 |   | — |   |
| Grants                             |       | 0.5                            |       | 0.4                             |       | 2.7 |   | 13.4 |   |
| Cancellations                      |       | (0.6                           | )          | (0.3                            | )          | (3.5 | ) | (1.9 | ) |
| Outstanding at end of period       |       | 10.3                           |       | 11.5                            |       | 10.3 |   | 11.5 |   |

 

Generally,awards granted under the 2006 Plan vest ratably over five years and expireeight years from the grant date. The exercise prices of the awards ranged from$15 per share to $52.50 per share, as determined by the Board of Directors. Share-basedcompensation expense associated with these awards was $2 million and $1 millionfor the third quarter of fiscal 2008 and 2007, respectively, and $6 million and$4 million for the nine months ended November 1, 2008 and November 3,2007, respectively.

 

**Note 4.  Debt**

 

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

 

| ** **                            | ** ** | **November 1, 2008** | ** ** | **February 2, 2008** | ** ** | **Interest Rate** | ** ** |
|---------------------------------------|------------|--------------------------------|------------|--------------------------------|------------|------------------------|------------|
| ** **                            | ** ** | **(in millions)**         | ** ** | ** **                     | ** ** |
|                                  |       |                           |       |                           |       |                   |       |
| Senior notes                          |       | $                              | 750        |                           | $          | 750                    |       | 10.000 | % |
| Senior subordinated notes             |       | 400                            |       | 400                            |       | 11.375                 | %          |
| Subordinated discount notes           |       | 322                            |       | 293                            |       | 13.000                 | %          |
| Senior secured term loan              |       | 2,303                          |       | 2,321                          |       | Variable               |       |
| Asset-based revolving credit facility |       | 407                            |       | 97                             |       | Variable               |       |
| Other                                 |       | 1                              |       | 2                              |       | Variable               |       |
| Total debt                            |       | 4,183                          |       | 3,863                          |       |                   |       |
| Less current portion                  |       | 432                            |       | 122                            |       |                   |       |
| Long-term debt                        |       | $                              | 3,751      |                           | $          | 3,741                  |       |   |   |

 

*Asset-basedrevolving credit facility*

 

Our senior secured asset-based revolving credit facility, which weentered into on October 31, 2006, with Banc of America, N.A. and otherlenders (the “Asset-based revolving credit facility”) provides senior securedfinancing of up to $1.0 billion, subject to a borrowing base as described inour Annual Report on Form 10-K. As of November 1, 2008, the borrowingbase was $989 million with $510 million of unused availability.

 

*Seniorsecured term loan facility*

 

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

 

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

 

Our comprehensive (loss) income is as follows:

 
| ** **                                         | ** ** | **Quarter Ended**         | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------------------------|------------|--------------------------------|------------|---------------------------------|------------|
| ** **                                         | ** ** | **November 1, 2008** | ** ** | **November 3, 2007**  | ** ** | **November 1, 2008** | ** ** | **November 3, 2007** | ** ** |
| ** **                                         | ** ** | **(in millions)**         | ** ** |
|                                               |       |                           |       |                            |       |   |   |   |   |
| Net loss                                           |       | $                              | (20        | )                               | $          | (18 | ) | $ | (70 | ) | $ | (85 | ) |
| Other comprehensive income (loss):                 |       |                           |       |                            |       |   |   |   |   |
| Derivative gain (loss)                             |       | 5                              |       | (2                              | )          | 7 |   | (2 | ) |
| Foreign currency translation adjustment and  other |       | (12                            | )          | 6                               |       | (14 | ) | 10 |   |
| Comprehensive loss                                 |       | $                              | (27        | )                               | $          | (14 | ) | $ | (77 | ) | $ | (77 | ) |

 

**Note 6.  DerivativeInstruments**

 

Weare exposed to fluctuations in exchange rates between the US and Canadiandollars, as the functional currency of our Canadian subsidiary is the Canadiandollar. During the second quarter of fiscal 2008, we executed foreign currencyforward contracts to mitigate the effects of currency fluctuations, which wedesignated as a cash flow hedge. The objective of the forward contracts is tohedge intercompany payments for forecasted purchases of inventory by ourCanadian subsidiary, which are denominated in US dollars. The term of this cashflow hedge extends through the first quarter of fiscal 2009.

 

Toachieve our objective and to minimize the risk of ineffectiveness, the notionalvalues represent a portion of our Canadian subsidiary’s forecasted intercompanypurchases. Hedge ineffectiveness is recorded in Other income, as required. Forthe quarter ended November 1, 2008, the ineffective portion of the hedgewas immaterial.

 

Forthe portion of the hedge that is effective, as defined, the change in fairvalue of that hedge will initially be recorded in Other comprehensive income. Asthe underlying inventory is sold to our customers, amounts will be reclassifiedfrom Other comprehensive income to Cost of sales and occupancy expense in thestatement of operations. The fair value of the hedge for the quarter ended November 1,2008 was $5 million.

 

The tablebelow provides the remaining quarterly notional values and the average CAD/USDexchange rate associated with the hedge

(dollars in millions).

 
| **Period**      | ** ** | **CAD Amount** | ** ** | **USD Amount** | ** ** | **Rate** | ** ** |
|-----------------|------------|---------------------|------------|---------------------|------------|----------|------------|
| Quarter 4, 2008 |       | $                   | 17.4       |                | $          | 17.4     |       | 1.001 |   |
| Quarter 1, 2009 |       | 12.2                |       | 12.2                |       | 1.001    |       |
|            |       | $                   | 29.6       |                | $          | 29.6     |       | 1.001 |   |

 

**Note 7.Fair Value Measurements**

 

As defined in SFAS No. 157, fair value is theprice that would be received to sell an asset or paid to transfer a liabilityin an orderly transaction between market participants at the measurementdate.  SFAS No. 157 establishes a three-level valuationhierarchy for fair value measurements. These valuation techniques are basedupon observable and unobservable inputs. Observable inputs reflect market dataobtained from independent sources, while unobservable inputs reflect our marketassumptions. These two types of inputs create the following fair valuehierarchy:

 

·                  Level 1 —Quoted prices for *identical*instrumentsin active markets;

·                  Level 2 —Quoted prices for *similar*instrumentsin active markets; quoted prices for identical or similar instruments inmarkets that are not active; and model-derived valuations whose significantinputs are observable; and

·                  Level 3 —Instruments whose significant inputs are *unobservable.*

 

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Thefollowing table presents net financial assets (liabilities) accounted for atfair value on a recurring basis as of November 1, 2008 (in millions):

 
| ** **                              | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** | **Total** | ** ** |
|-----------------------------------------|------------|------------------|------------|------------------|------------|------------------|------------|-----------|------------|
| Cash equivalents                        |       | $                | 52         |             | $          | —           |       | $         | —     |   | $ | 52 |   |
| Foreign Currency Derivative Instruments |       | —           |       | 5                |       | —           |       | 5         |       |
|                                         |            |                  |            |                  |            |                  |            |           |            |  |  |  |  |

 

Cash equivalents consist of highly liquid investments,with a maturity of 90 days or less at the date of purchase, including U.S.Treasury bills, various government obligations, and money market funds.

 

Derivativesin Level 2 are measured based on a variety of pricing factors, which includethe market price of the derivative instrument available in the dealer-market,which have been corroborated with market data. See Note 6 for additionalinformation on our derivative instruments.

 

**Note 8.Income Taxes**

 

TheCompany recorded an income tax provision of $8 million for the third quarter offiscal 2008. The expense relates primarily to a projected annual tax rate decreasedue to changes in our results of operations, combined with the Company’slimited ability to recognize foreign tax credits related to its profitableCanadian operations. During the third quarter of fiscal 2007, the Companyrecorded a tax benefit of $9 million at an effective tax rate of 39.0%.

 

TheCompany’s effective tax rate was 23.0% and 34.9% for the first nine months offiscal 2008 and fiscal 2007, respectively. The decrease in our effective taxrate is the result of the Company’s limited ability to recognize foreign taxcredits related to its profitable Canadian operations. Our effective tax rateis highly sensitive to changes as a result of the low base of expected incomeor loss for the period and the comparatively significant effect on the tax ratecaused by permanent differences.

 

Ourpolicy is to evaluate the appropriateness of our deferred tax assets and recorda valuation allowance to reduce the carrying amounts of deferred tax assetsunless it is more likely than not that such assets will be realized. Ifdifferent assumptions had been used, our tax expense, assets, and liabilitiescould have varied from recorded amounts. If actual results differ fromestimated results or if we adjust theses assumptions in the future, we may needto adjust our deferred tax assets or liabilities, which could impact oureffective tax rate.

 

**Note 9.  Commitmentsand Contingencies**

 

We are involved in ongoing legal and regulatory proceedings. Other thanthose described in the following paragraphs, there were no material changes toour disclosures of commitments and contingencies from our Annual Report on Form 10-Kfor the fiscal year ended February 2, 2008 and our Quarterly Reports on Form 10-Qfor the quarterly periods ended May 3, 2008 and August 2, 2008.

 

*Employee Class Action Claims*

 

*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 purported class proceeding against Michaels of Canada and MichaelsStores, Inc. on behalf of themselves and current and former employeesemployed in Canada. The Cotton claim was filed in the Ontario Superior Court ofJustice and alleges that the defendants violated employment standardslegislation in Ontario and other provinces and territories of Canada by failingto pay overtime compensation as required by that legislation. The Cotton claimalso alleges that this conduct was in breach of the contracts of employment ofthose individuals. The Cotton claim seeks a declaration that the defendantshave acted in breach of applicable legislation, payment to current and formeremployees for overtime, damages for breach of contract, punitive, aggravatedand exemplary damages, interest, and costs. In May of 2005, the plaintiffsdelivered material in support of their request that this action be certified asa class proceeding. Michaels filed and served its responding materials opposingclass certification on January 31, 2006. A hearing with respect tocertification has been set for early 2009. We intend to contest certificationof this claim as a class action. Further, we believe we have certain defenseson the merits and intend to defend this lawsuit vigorously. We are unable toestimate a range of possible loss, if any, in this claim.

 

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*Hernandez Claim*

 

On April 12, 2007, Antonio Hernandezand five other floor care contractor employees filed a purported class actionproceeding in Superior Court of California, County of Orange.  Theplaintiffs filed this action against Michaels Stores, Inc., Marshalls andTJ Maxx on behalf of themselves and all similarly-situated individuals inCalifornia.  The Hernandez suit alleged that they were joint employeeswith Michaels, Marshalls, TJ Maxx, and Creative Building Maintenance.  Thesuit also alleged that Michaels’ conduct violates California’s unfair competitionlaw.  The plaintiffs sought injunctive relief, damages for unpaidovertime, itemized wage statement penalties, meal and rest break penalties,interest, and attorneys’ fees.  The parties reached a settlement for animmaterial amount in September 2008, and on November 14, 2008, theCourt dismissed the case.

 

*ConsumerClass Action Claims*

 

*Carson Claim*

 

On August 15, 2008, LindaCarson, a consumer, filed a purported class action proceeding in Superior Courtof California, County of San Diego.  Carson filed this action againstMichaels Stores, Inc., on behalf of herself and all similarly-situatedCalifornia consumers.  The Carson suit alleges that Michaelsunlawfully requested and recorded personally identifiable information (i.e.,her zip code) as part of a credit card transaction.  The plaintiff seeksstatutory penalties, costs, interest, and attorneys’ fees.  We intendto contest certification of this claim as a class action.  Further, webelieve we have certain defenses on the merits and intend to defend thislawsuit vigorously.  We are unable to estimate a range of possible loss,if any, in this claim.

 

**Note 10.  Segments**

 

Weconsider our Michaels and Aaron Brothers operations to be our operatingsegments for purposes of determining reportable segments based on the criteriaof SFAS No. 131, *Disclosures About Segmentsof an Enterprise and Related Information*. We determined that ourMichaels and Aaron Brothers operating segments have similar economiccharacteristics and meet the aggregation criteria set forth in paragraph 17 ofSFAS No. 131. Therefore, we combine both operating segments into onereporting segment.

 

Ourchief operating decision makers evaluate historical operating performance, planand forecast future periods’ operating performance based on earnings beforeinterest, income taxes, discontinued operations, goodwill impairment,depreciation and amortization (“EBITDA”). In addition, an element of baseincentive compensation targets for certain management personnel are based onEBITDA. A reconciliation of EBITDA to loss before income taxes and discontinuedoperations is presented below.

 
| ** **

** **                                | ** ** | **Quarter Ended**         | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------------------------|------------|--------------------------------|------------|---------------------------------|------------|
| ** **                                            | ** ** | **November 1, 2008** | ** ** | **November 3, 2007**  | ** ** | **November 1, 2008** | ** ** | **November 3, 2007** | ** ** |
| ** **                                            | ** ** | **(in millions)**         | ** ** |
|                                                  |       |                           |       |                            |       |   |   |   |   |
| Loss before income taxes and discontinued  operations |       | $                              | (12        | )                               | $          | (22 | ) | $ | (91 | ) | $ | (120 | ) |
| Interest expense                                      |       | 77                             |       | 95                              |       | 231 |   | 285 |   |
| Interest income                                       |       | —                         |       | —                          |       | — |   | (1 | ) |
| Depreciation and amortization                         |       | 31                             |       | 31                              |       | 94 |   | 93 |   |
| EBITDA                                                |       | $                              | 96         |                            | $          | 104 |   | $ | 234 |   | $ | 257 |   |

 

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Our sales and assets by country are as follows:

 
| ** **                                   | ** ** | **Net Sales**     | ** ** | **Total Assets** | ** ** |
|----------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                   | ** ** | **(in millions)** | ** ** |
| **Quarter ended November 1, 2008:**     |       |                   |       |                  |       |
| United States                                |       | $                      | 833        |                  | $          | 1,801 |   |
| Canada                                       |       | 73                     |       | 111                   |       |
| Consolidated Total                           |       | $                      | 906        |                  | $          | 1,912 |   |
|                                         |       |                   |       |                  |       |
| **Quarter ended November 3, 2007:**     |       |                   |       |                  |       |
| United States                                |       | $                      | 856        |                  | $          | 1,850 |   |
| Canada                                       |       | 78                     |       | 104                   |       |
| Consolidated Total                           |       | $                      | 934        |                  | $          | 1,954 |   |
|                                         |       |                   |       |                  |       |   |   |
| **Nine Months ended November 1, 2008:** |       |                   |       |                  |       |
| United States                                |       | $                      | 2,342      |                  | $          | 1,801 |   |
| Canada                                       |       | 207                    |       | 111                   |       |
| Consolidated Total                           |       | $                      | 2,549      |                  | $          | 1,912 |   |
|                                         |       |                   |       |                  |       |   |   |
| **Nine Months ended November 3, 2007:** |       |                   |       |                  |       |
| United States                                |       | $                      | 2,364      |                  | $          | 1,850 |   |
| Canada                                       |       | 197                    |       | 104                   |       |
| Consolidated Total                           |       | $                      | 2,561      |                  | $          | 1,954 |   |

 

We present assets based on their physical,geographic location. Certain assets located in the United States are also usedto support our Canadian operations, but we do not allocate these assets toCanada.

 

**Note 11.  RelatedParty Transactions**

 

As previously disclosed, on October 31, 2006, substantially all ofthe Common Stock of Michaels Stores, Inc. was acquired through a mergertransaction (the “Merger”) by affiliates of Bain Capital Partners, LLC and TheBlackstone Group. We pay annual management fees to Bain Capital Partners, LLCand The Blackstone Group (collectively, together with their applicableaffiliates, the “Sponsors”) and Highfields Capital Management LP in the amountof $12 million and $1 million, respectively. We recognized $3 million ofexpense related to annual management fees during the third quarter of each offiscal 2008 and fiscal 2007, and $10 million during each of the nine monthsended November 1, 2008 and November 3, 2007. These expenses areincluded in related party expenses on the statement of operations.

 

Bain Capital owns a majority ownership stake in an external vendor weutilize to print our circular advertisements. Expenses associated with thisvendor during the third quarter of fiscal 2008 and fiscal 2007 were $10 millionand $11 million, respectively, and $26 million and $29 million for the ninemonths ended November 1, 2008 and November 3, 2007, respectively. Theseexpenses are included in selling, general and administrative expense on theconsolidated statements of operations.

 

During the first quarter of fiscal 2007, The Blackstone Group acquireda majority ownership stake in an external vendor we utilize to count our storeinventory. Expenses associated with this vendor during the third quarter ofeach of fiscal 2008 and 2007 were $2 million. Expenses for the nine monthsended November 1, 2008 and November 3, 2007 were $5 million and $4million, respectively. These expenses are included in selling, general andadministrative expense on the consolidated statements of operations.

 

During the third quarter of fiscal 2007, Bain Capital acquired anownership stake in an external vendor we utilize for non-merchandise supplies. Expensesassociated with this vendor during the third quarter of fiscal 2008 and thenine months ended November 1, 2008 were $1 million and $2 million, respectively.These expenses are included in selling, general and administrative expense onthe consolidated statements of operations.

 

During fiscal 2008, we began utilizing an external vendor for wastemanagement services that is partially owned by The Blackstone Group. Expensesassociated with this vendor during the first nine months of fiscal 2008 were $2million. These expenses are included in selling, general and administrative expenseon the consolidated statements of operations.

 

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The Company periodically provides officers of Michaels Stores, Inc.and its subsidiaries the opportunity to purchase shares of our Common Stock.There were no shares sold to officers during the first nine months of fiscal2008. During the first nine months of fiscal 2007, the Company sold 541,006shares to officers. Also, during the third quarter and first nine months offiscal 2008, we repurchased 6,000 and 111,334 shares, respectively, fromofficers who are no longer with the Company. During the third quarter and firstnine months of fiscal 2007, the Company repurchased 13,333 and 62,666 shares,respectively, from officers who are no longer with the Company.

 

In connection with the consummation of the Merger, the Company enteredinto a Separation Agreement with each of Charles Wyly and Sam Wyly, executiveofficers and directors of the Company prior to the Merger. Under the SeparationAgreements, each of Charles Wyly and Sam Wyly received a lump sum payment of$3.0 million in exchange for his agreement to adhere to certainnon-competition, non-solicitation and confidentiality restrictions. We areamortizing these Separation Agreements over two years. These expenses areincluded in related party expenses on the consolidated statements ofoperations.

 

**Note12. Condensed Consolidating FinancialInformation**

 

Allof the Company’s obligations under the Senior notes, Senior subordinated notes,Subordinated discount notes, Senior secured term loan, and Asset-basedrevolving credit facility are guaranteed by the Parent and Guarantorsubsidiaries. Currently, Aaron Brothers Card Services, LLC is a non-guarantorsubsidiary that was organized on July 11, 2008. As of November 1,2008, the financial statements of Aaron Brothers Card Services, LLC wereimmaterial.

 

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

 

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**Supplemental Condensed Consolidating BalanceSheet**

** **
| ** **                                                 | ** ** | **November 1, 2008** | ** ** |
|------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                 | ** ** | **Parent  Company**            | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|                                                       |       | **(in  millions)**             |       |
| **ASSETS**                                                 | ** ** | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Current assets:**                                        |       |                           |       |   |   |   |   |   |   |
| Cash and equivalents                                       |       | $                              | 86         |   | $ | 6 |   | $ | — |   | $ | 92 |   |
| Merchandise inventories                                    |       | 776                            |       | 307 |   | — |   | 1,083 |   |
| Intercompany receivables                                   |       | —                         |       | 410 |   | (410 | ) | — |   |
| Other                                                      |       | 97                             |       | 54 |   | — |   | 151 |   |
| Total current assets                                       |       | 959                            |       | 777 |   | (410 | ) | $ | 1,326 |   |
| **Property and equipment, net**                            |       | 294                            |       | 108 |   | — |   | 402 |   |
| **Goodwill, net**                                          |       | 94                             |       | — |   | — |   | 94 |   |
| **Investment in subsidiaries**                             |       | 517                            |       | — |   | (517 | ) | — |   |
| **Other assets**                                           |       | 76                             |       | 14 |   | — |   | 90 |   |
| Total assets                                               |       | $                              | 1,940      |   | $ | 899 |   | $ | (927 | ) | $ | 1,912 |   |
|                                                       |       |                           |       |   |   |   |   |   |   |
| **LIABILITIES  AND STOCKHOLDERS’ DEFICIT**            |       |                           |       |   |   |   |   |   |   |
| **Current liabilities:**                                   |       |                           |       |   |   |   |   |   |   |
| Accounts payable                                           |       | $                              | 30         |   | $ | 244 |   | $ | — |   | $ | 274 |   |
| Accrued liabilities and other                              |       | 258                            |       | 78 |   | — |   | 336 |   |
| Current portion of long-term debt                          |       | 432                            |       | — |   | — |   | 432 |   |
| Intercompany payable                                       |       | 410                            |       | — |   | (410 | ) | — |   |
| Other                                                      |       | (39                            | )          | 40 |   | — |   | 1 |   |
| Total current liabilities                                  |       | 1,091                          |       | 362 |   | (410 | ) | 1,043 |   |
| **Long-term debt**                                         |       | 3,751                          |       | — |   | — |   | 3,751 |   |
| **Other long-term liabilities**                            |       | 62                             |       | 20 |   | — |   | 82 |   |
| **Total stockholders’ equity (deficit)**              |       | (2,964                         | )          | 517 |   | (517 | ) | (2,964 | ) |
| Total liabilities and stockholders’ equity  (deficit) |       | $                              | 1,940      |   |   | $ | 899 |   |   | $ | (927 | ) |   | $ | 1,912 |   |
|                                                            |            |                                |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**Supplemental Condensed Consolidating BalanceSheet**

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

 

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**Supplemental Condensed Consolidating BalanceSheet**

 
| ** **                                                 | ** ** | **November 3, 2007** | ** ** |
|------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                 | ** ** | **Parent  Company**            | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                 | ** ** | **(in  millions)**             | ** ** |
| **ASSETS**                                                 |       |                           |       |   |   |   |   |   |   |
| **Current assets:**                                        |       |                           |       |   |   |   |   |   |   |
| Cash and equivalents                                       |       | $                              | 40         |   | $ | 17 |   | $ | — |   | $ | 57 |   |
| Merchandise inventories                                    |       | 756                            |       | 271 |   | — |   | 1,027 |   |
| Intercompany receivables                                   |       | —                         |       | 275 |   | (275 | ) | — |   |
| Other                                                      |       | 176                            |       | 20 |   | — |   | 196 |   |
| Total current assets                                       |       | 972                            |       | 583 |   | (275 | ) | 1,280 |   |
| **Property and equipment, net**                            |       | 316                            |       | 129 |   | — |   | 445 |   |
| **Goodwill, net**                                          |       | 94                             |       | 22 |   | — |   | 116 |   |
| **Investment in subsidiaries**                             |       | 320                            |       | — |   | (320 | ) | — |   |
| **Other assets**                                           |       | 97                             |       | 16 |   | — |   | 113 |   |
| Total assets                                               |       | $                              | 1,799      |   | $ | 750 |   | $ | (595 | ) | $ | 1,954 |   |
|                                                       |       |                           |       |   |   |   |   |   |   |
| **LIABILITIES  AND STOCKHOLDERS’ DEFICIT**            |       |                           |       |   |   |   |   |   |   |
| **Current liabilities:**                                   |       |                           |       |   |   |   |   |   |   |
| Accounts payable                                           |       | $                              | 40         |   | $ | 242 |   | $ | — |   | $ | 282 |   |
| Accrued liabilities and other                              |       | 255                            |       | 78 |   | — |   | 333 |   |
| Current portion of long-term debt                          |       | 445                            |       | — |   | — |   | 445 |   |
| Intercompany payable                                       |       | 275                            |       | — |   | (275 | ) | — |   |
| Other                                                      |       | (83                            | )          | 85 |   | — |   | 2 |   |
| Total current liabilities                                  |       | 932                            |       | 405 |   | (275 | ) | 1,062 |   |
| **Long-term debt**                                         |       | 3,736                          |       | — |   | — |   | 3,736 |   |
| **Other long-term liabilities**                            |       | 73                             |       | 25 |   | — |   | 98 |   |
| **Total stockholders’ equity (deficit)**              |       | (2,942                         | )          | 320 |   | (320 | ) | (2,942 | ) |
| Total liabilities and stockholders’ equity  (deficit) |       | $                              | 1,799      |   | $ | 750 |   | $ | (595 | ) | $ | 1,954 |   |

** **

**Supplemental Condensed ConsolidatingStatement of Operations**

** **
| ** **                                                         | ** ** | **Quarter Ended November 1, 2008** | ** ** |
|--------------------------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                                                         | ** ** | **Parent  Company**                                    | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                         | ** ** | **(in millions)**                                 | ** ** |
| **Net sales**                                                      |       | $                                                      | 796        |   | 618 |   | $ | (508 | ) | $ | 906 |   |
| Cost of sales and occupancy expense                                |       | 554                                                    |       | 538 |   | (508 | ) | 584 |   |
| **Gross profit**                                                   |       | 242                                                    |       | 80 |   | — |   | 322 |   |
| Selling, general, and administrative  expense                      |       | 221                                                    |       | 26 |   | — |   | 247 |   |
| Transaction expenses                                               |       | —                                                 |       | — |   | — |   | — |   |
| Related party expenses                                             |       | 4                                                      |       | — |   | — |   | 4 |   |
| Store pre-opening costs                                            |       | 2                                                      |       | 1 |   | — |   | 3 |   |
| **Operating income**                                               |       | 15                                                     |       | 53 |   | — |   | 68 |   |
| Interest expense                                                   |       | 77                                                     |       | — |   | — |   | 77 |   |
| Other (income) and expense, net                                    |       | —                                                 |       | 3 |   | — |   | 3 |   |
| Intercompany charges (income)                                      |       | 23                                                     |       | (23 | ) | — |   | — |   |
| Equity in earnings of subsidiaries                                 |       | 73                                                     |       | — |   | (73 | ) | — |   |
| **Income (loss) before income taxes and discontinued  operations** |       | (12                                                    | )          | 73 |   | (73 | ) | (12 | ) |
| Provision (benefit) for income taxes                               |       | 8                                                      |       | 28 |   | (28 | ) | 8 |   |
| **Income (loss) before discontinued  operations**                  |       | (20                                                    | )          | 45 |   | (45 | ) | (20 | ) |
| Discontinued operations loss, net of income  tax                   |       | —                                                 |       | — |   | — |   | — |   |
| **Net income (loss)**                                              |       | $                                                      | (20        | ) | $ | 45 |   | $ | (45 | ) | $ | (20 | ) |
|                                                                    |            |                                                        |            |  |  |  |  |  |  |  |  |  |  |

 

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**Supplemental Condensed ConsolidatingStatement of Operations**

** **
| ** **                                                         | ** ** | **Quarter Ended November 3, 2007** | ** ** |
|--------------------------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                                                         | ** ** | **Parent  Company**                                    | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                         | ** ** | **(in millions)**                                 | ** ** |
| **Net sales**                                                      |       | $                                                      | 818        |   | 587 |   | $ | (471 | ) | $ | 934 |   |
| Cost of sales and occupancy expense                                |       | 555                                                    |       | 507 |   | (471 | ) | 591 |   |
| **Gross profit**                                                   |       | 263                                                    |       | 80 |   | — |   | 343 |   |
| Selling, general, and administrative  expense                      |       | 229                                                    |       | 32 |   | — |   | 261 |   |
| Transaction expenses                                               |       | 8                                                      |       | — |   | — |   | 8 |   |
| Related party expenses                                             |       | 4                                                      |       | — |   | — |   | 4 |   |
| Store pre-opening costs                                            |       | 3                                                      |       | — |   | — |   | 3 |   |
| **Operating income**                                               |       | 19                                                     |       | 48 |   | — |   | 67 |   |
| Interest expense                                                   |       | 95                                                     |       | — |   | — |   | 95 |   |
| Other (income) and expense, net                                    |       | (1                                                     | )          | (5 | ) | — |   | (6 | ) |
| Intercompany charges (income)                                      |       | 24                                                     |       | (24 | ) | — |   | — |   |
| Equity in earnings of subsidiaries                                 |       | 77                                                     |       | — |   | (77 | ) | — |   |
| **Income (loss) before income taxes and discontinued  operations** |       | (22                                                    | )          | 77 |   | (77 | ) | (22 | ) |
| Provision (benefit) for income taxes                               |       | (9                                                     | )          | 32 |   | (32 | ) | (9 | ) |
| **Income (loss) before discontinued  operations**                  |       | (13                                                    | )          | 45 |   | (45 | ) | (13 | ) |
| Discontinued operations loss, net of income  tax                   |       | (5                                                     | )          | — |   | — |   | (5 | ) |
| **Net income (loss)**                                              |       | $                                                      | (18        | ) | $ | 45 |   | $ | (45 | ) | $ | (18 | ) |
|                                                                    |            |                                                        |            |  |  |  |  |  |  |  |  |  |  |

** **

**SupplementalCondensed Consolidating Statement of Operations**

** **
| ** **                                                         | ** ** | **Nine Months Ended November 1, 2008** | ** ** |
|--------------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                                                         | ** ** | **Parent  Company**                                             | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                         | ** ** | **(in millions)**                                          | ** ** |
| **Net sales**                                                      |       | $                                                               | 2,227      |   | 1,554 |   | $ | (1,232 | ) | $ | 2,549 |   |
| Cost of sales and occupancy expense                                |       | 1,546                                                           |       | 1,309 |   | (1,232 | ) | 1,623 |   |
| **Gross profit**                                                   |       | 681                                                             |       | 245 |   | — |   | 926 |   |
| Selling, general, and administrative  expense                      |       | 673                                                             |       | 92 |   | — |   | 765 |   |
| Transaction expenses                                               |       | —                                                          |       | — |   | — |   | — |   |
| Related party expenses                                             |       | 12                                                              |       | — |   | — |   | 12 |   |
| Store pre-opening costs                                            |       | 5                                                               |       | 1 |   | — |   | 6 |   |
| **Operating (loss) income**                                        |       | (9                                                              | )          | 152 |   | — |   | 143 |   |
| Interest expense                                                   |       | 231                                                             |       | — |   | — |   | 231 |   |
| Other (income) and expense, net                                    |       | —                                                          |       | 3 |   | — |   | 3 |   |
| Intercompany charges (income)                                      |       | 57                                                              |       | (57 | ) | — |   | — |   |
| Equity in earnings of subsidiaries                                 |       | 206                                                             |       | — |   | (206 | ) | — |   |
| **Income (loss) before income taxes and discontinued  operations** |       | (91                                                             | )          | 206 |   | (206 | ) | (91 | ) |
| Provision (benefit) for income taxes                               |       | (21                                                             | )          | 47 |   | (47 | ) | (21 | ) |
| **Income (loss) before discontinued  operations**                  |       | (70                                                             | )          | 159 |   | (159 | ) | (70 | ) |
| Discontinued operations loss, net of income  tax                   |       | —                                                          |       | — |   | — |   | — |   |
| **Net income (loss)**                                              |       | $                                                               | (70        | ) | $ | 159 |   | $ | (159 | ) | $ | (70 | ) |
|                                                                    |            |                                                                 |            |  |  |  |  |  |  |  |  |  |  |

 

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**Supplemental Condensed Consolidating Statement of Operations**

 
| ** **                                                         | ** ** | **Nine Months Ended November 3, 2007** | ** ** |
|--------------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                                                         | ** ** | **Parent  Company**                                             | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                         | ** ** | **(in millions)**                                          | ** ** |
| **Net sales**                                                      |       | $                                                               | 2,244      |   | 1,400 |   | $ | (1,083 | ) | $ | 2,561 |   |
| Cost of sales and occupancy expense                                |       | 1,525                                                           |       | 1,160 |   | (1,083 | ) | 1,602 |   |
| **Gross profit**                                                   |       | 719                                                             |       | 240 |   | — |   | 959 |   |
| Selling, general, and administrative  expense                      |       | 664                                                             |       | 94 |   | — |   | 758 |   |
| Transaction expenses                                               |       | 29                                                              |       | — |   | — |   | 29 |   |
| Related party expenses                                             |       | 12                                                              |       | — |   | — |   | 12 |   |
| Store pre-opening costs                                            |       | 5                                                               |       | 1 |   | — |   | 6 |   |
| **Operating income**                                               |       | 9                                                               |       | 145 |   | — |   | 154 |   |
| Interest expense                                                   |       | 285                                                             |       | — |   | — |   | 285 |   |
| Other (income) and expense, net                                    |       | (2                                                              | )          | (9 | ) | — |   | (11 | ) |
| Intercompany charges (income)                                      |       | 58                                                              |       | (58 | ) | — |   | — |   |
| Equity in earnings of subsidiaries                                 |       | 212                                                             |       | — |   | (212 | ) | — |   |
| **Income (loss) before income taxes and discontinued  operations** |       | (120                                                            | )          | 212 |   | (212 | ) | (120 | ) |
| Provision (benefit) for income taxes                               |       | (42                                                             | )          | 74 |   | (74 | ) | (42 | ) |
| **Income (loss) before discontinued  operations**                  |       | (78                                                             | )          | 138 |   | (138 | ) | (78 | ) |
| Discontinued operations loss, net of income  tax                   |       | (7                                                              | )          | — |   | — |   | (7 | ) |
| **Net income (loss)**                                              |       | $                                                               | (85        | ) | $ | 138 |   | $ | (138 | ) | $ | (85 | ) |
|                                                                    |            |                                                                 |            |  |  |  |  |  |  |  |  |  |  |

 

**Supplemental Condensed Consolidating Statement of Cash Flows**

 
| ** **                                           | ** ** | **Nine Months Ended November 1, 2008** | ** ** |
|------------------------------------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                                           | ** ** | **Parent  Company**                                             | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                           | ** ** | **(in millions)**                                          | ** ** |
| **Operating activities:**                            |       |                                                            |       |   |   |   |   |   |   |
| Net cash (used in) provided by operating  activities |       | $                                                               | (176       | ) | $ | 113 |   | $ | (103 | ) | $ | (166 | ) |
|                                                 |       |                                                            |       |   |   |   |   |   |   |
| **Investing activities:**                            |       |                                                            |       |   |   |   |   |   |   |
| Cash paid for property and equipment                 |       | (59                                                             | )          | (7 | ) | — |   | (66 | ) |
| Net cash used in investing activities                |       | (59                                                             | )          | (7 | ) | — |   | (66 | ) |
|                                                 |       |                                                            |       |   |   |   |   |   |   |
| **Financing activities:**                            |       |                                                            |       |   |   |   |   |   |   |
| Net borrowings of long-term debt                     |       | 292                                                             |       | — |   | — |   | 292 |   |
| Intercompany dividends                               |       | —                                                          |       | (103 | ) | 103 |   | — |   |
| Other financing activities                           |       | 3                                                               |       | — |   | — |   | 3 |   |
| Net cash provided by (used in) financing activities  |       | 295                                                             |       | (103 | ) | 103 |   | 295 |   |
|                                                 |       |                                                            |       |   |   |   |   |   |   |
| **Increase in cash and equivalents**                 |       | 60                                                              |       | 3 |   | — |   | 63 |   |
| **Beginning cash and cash equivalents**              |       | 26                                                              |       | 3 |   | — |   | 29 |   |
| **Ending cash and cash equivalents**                 |       | $                                                               | 86         |   | $ | 6 |   | $ | — |   | $ | 92 |   |

 

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**Supplemental Condensed Consolidating Statement of Cash Flows**

 
| ** **                                           | ** ** | **Nine Months Ended November 3, 2007** | ** ** |
|------------------------------------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                                           | ** ** | **Parent  Company**                                             | ** ** | **Guarantor  Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                           | ** ** | **(in millions)**                                          | ** ** |
| **Operating Activities:**                            | ** ** | ** **                                                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net cash (used in) provided by operating  activities |       | $                                                               | (123       | ) | $ | 149 |   | $ | (106 | ) | $ | (80 | ) |
|                                                 |       |                                                            |       |   |   |   |   |   |   |
| **Investing Activities:**                            |       |                                                            |       |   |   |   |   |   |   |
| Cash paid for property and equipment                 |       | (56                                                             | )          | (30 | ) | — |   | (86 | ) |
| Net cash used in investing activities                |       | (56                                                             | )          | (30 | ) | — |   | (86 | ) |
|                                                 |       |                                                            |       |   |   |   |   |   |   |
| **Financing Activities:**                            |       |                                                            |       |   |   |   |   |   |   |
| Net borrowings of long-term debt                     |       | 197                                                             |       | — |   | — |   | 197 |   |
| Intercompany dividends                               |       | —                                                          |       | (106 | ) | 106 |   | — |   |
| Other financing activities                           |       | (4                                                              | )          | — |   | — |   | (4 | ) |
| Net cash provided by (used in) financing  activities |       | 193                                                             |       | (106 | ) | 106 |   | 193 |   |
| ** **                                           | ** ** | ** **                                                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Increase in cash and equivalents**                 |       | 14                                                              |       | 13 |   | — |   | 27 |   |
| **Beginning cash and cash equivalents**              |       | 26                                                              |       | 4 |   | — |   | 30 |   |
| **Ending cash and equivalents**                      |       | $                                                               | 40         |   | $ | 17 |   | $ | — |   | $ | 57 |   |

 

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

 

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

 

**DisclosureRegarding Forward-Looking Information**

 

The following discussion should be read in conjunction with ourconsolidated financial statements and related notes included elsewhere in thisQuarterly Report on Form 10-Q. The following discussion, as well as otherportions of this Quarterly Report on Form 10-Q, contains forward-lookingstatements that reflect our plans, estimates, and beliefs. Any statementscontained herein (including, but not limited to, statements to the effect thatMichaels or its management “anticipates,” “plans,” “estimates,” “expects,” “believes,”and other similar expressions) that are not statements of historical factshould be considered forward-looking statements and should be read inconjunction with our consolidated financial statements and related notes in ourAnnual Report on Form 10-K for the fiscal year ended February 2,2008. Such forward-looking statements are based upon management’s currentknowledge and assumptions about future events and involve risks anduncertainties that could cause actual results, performance or achievements tobe materially different from anticipated results, prospects, performance orachievements expressed or implied by such forward-looking statements. Suchrisks and uncertainties include, but are not limited to:

 

·                  the continuation or further deterioration of thecurrent worldwide economic downturn;

 

·                  government**or consumer concerns about product safety and recalls or changes tolaws, including the recently enacted**ConsumerProduct Safety Improvement Act of 2008, **couldharm our reputation, financial position, earnings or cash flow**;

 

·                  if the Employee FreeChoice Act is adopted, it would be easier for our employees to obtain unionrepresentation and our businesses could be impacted as a result;

 

·                  changes in customer demand could materiallyadversely affect our sales, operating results, and cash flow;

 

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

 

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

 

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

 

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

 

·                  how well we manage our business;

 

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

 

·                  improvements to our supply chain may not befully successful;

 

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

 

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

 

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

 

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·                  our suppliers may fail us;

 

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

 

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

 

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

 

·                  our information systems may prove inadequate;

 

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

 

·                  competition could negatively impact our operations;and

 

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

 

For more details on factors that may causeactual results to differ materially from such forward-looking statements,please see Item 1A. Risk Factors of our Annual Report on Form 10-Kfor the fiscal year ended February 2, 2008, Item 1A of Part II to ourQuarterly Report on Form 10-Q for the quarter ended May 3, 2008, Item1A of Part II of this Quarterly Report on Form 10-Q, and otherreports from time to time filed with or furnished to the SEC. We disclaim anyintention to, and undertake no obligation to, update or revise anyforward-looking statement.

 

**General**

 

We report on the basis of a 52 or 53-week fiscal year, which ends onthe Saturday closest to January 31. All references herein to “fiscal 2008”relate to the 52 weeks ending January 31, 2009 and all references to “fiscal2007” relate to the 52 weeks ended February 2, 2008. In addition, allreferences herein to “the third quarter of fiscal 2008” relate to the 13 weeksended November 1, 2008 and all references to “the third quarter of fiscal2007” relate to the 13 weeks ended November 3, 2007.  Finally, all references to “the nine monthsended November 1, 2008” relate to the 39 weeks ended November 1,2008, and “the nine months ended November 3, 2007” relate to the 39 weeksended November 3, 2007, respectively.

 

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The following table sets forth certain of our unaudited operating data:

 
| ** **                                               | ** ** | **Quarter Ended** | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------------------------------|------------|------------------------|------------|---------------------------------|------------|
| ** **                                               | ** ** | **November 1,**   | ** ** | **November 3,**            | ** ** | **November 1,** | ** ** | **November 3,** | ** ** |
| ** **                                               | ** ** | **2008**               | ** ** | **2007**                        | ** ** | **2008** | ** ** | **2007** | ** ** |
| **Michaels stores:**                                     |       |                   |       |                            |       |   |   |   |   |
| Retail stores open at beginning of period                |       | 991                    |       | 938                             |       | 963 |   | 921 |   |
| Retail stores opened during the period                   |       | 22                     |       | 23                              |       | 50 |   | 43 |   |
| Retail stores opened (relocations) during the  period    |       | 3                      |       | 4                               |       | 9 |   | 11 |   |
| Retail stores closed during the period                   |       | —                 |       | —                          |       | — |   | (3 | ) |
| Retail stores closed (relocations) during  the period    |       | (3                     | )          | (4                              | )          | (9 | ) | (11 | ) |
| Retail stores open at end of period                      |       | 1,013                  |       | 961                             |       | 1,013 |   | 961 |   |
|                                                     |       |                   |       |                            |       |   |   |   |   |
| **Aaron Brothers stores:**                               |       |                   |       |                            |       |   |   |   |   |
| Retail stores open at beginning of period                |       | 164                    |       | 167                             |       | 166 |   | 166 |   |
| Retail stores opened during the period                   |       | —                 |       | —                          |       | — |   | 2 |   |
| Retail stores opened (relocations) during  the period    |       | —                 |       | —                          |       | 1 |   | — |   |
| Retail stores closed during the period                   |       | (1                     | )          | —                          |       | (3 | ) | (1 | ) |
| Retail stores closed (relocations) during  the period    |       | —                 |       | —                          |       | (1 | ) | — |   |
| Retail stores open at end of period                      |       | 163                    |       | 167                             |       | 163 |   | 167 |   |
|                                                     |       |                   |       |                            |       |   |   |   |   |
| Total store count at end of period                       |       | 1,176                  |       | 1,128                           |       | 1,176 |   | 1,128 |   |
|                                                     |       |                   |       |                            |       |   |   |   |   |
| **Other operating data:**                                |       |                   |       |                            |       |   |   |   |   |
| Average inventory per Michaels store (in  thousands) (1) |       | $                      | 1,022      |                            | $          | 1,023 |   | $ | 1,022 |   | $ | 1,023 |   |
| Comparable store sales (decrease) increase  (2)          |       | (6.5                   | )%         | 1.9                             | %          | (4.1 | )% | 0.7 | % |
|                                                          |            |                        |            |                                 |            |  |  |  |  |  |  |  |  |

 

----

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

 

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**Resultsof Operations**

 

The following table sets forth the percentage relationship to net salesof each line item of our unaudited consolidated statements of operations. Thistable should be read in conjunction with the following discussion and with ourconsolidated financial statements, including the related notes, containedherein.

 
| ** **                                                | ** ** | **Quarter Ended** | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------------------|------------|------------------------|------------|---------------------------------|------------|
| ** **                                                | ** ** | **November 1,**   | ** ** | **November 3,**            | ** ** | **November 1,** | ** ** | **November 3,** | ** ** |
| ** **                                                | ** ** | **2008**               | ** ** | **2007**                        | ** ** | **2008** | ** ** | **2007** | ** ** |
| **Net sales**                                             |       | 100.0                  | %          | 100.0                           | %          | 100.0 | % | 100.0 | % |
| Cost of sales and occupancy expense                       |       | 64.5                   |       | 63.3                            |       | 63.7 |   | 62.6 |   |
| **Gross profit**                                          |       | 35.5                   |       | 36.7                            |       | 36.3 |   | 37.4 |   |
| Selling, general, and administrative  expense             |       | 27.3                   |       | 27.9                            |       | 30.0 |   | 29.6 |   |
| Transaction expenses                                      |       | —                 |       | 0.9                             |       | — |   | 1.1 |   |
| Related party expenses                                    |       | 0.4                    |       | 0.4                             |       | 0.5 |   | 0.5 |   |
| Store pre-opening costs                                   |       | 0.3                    |       | 0.3                             |       | 0.2 |   | 0.2 |   |
| **Operating income**                                      |       | 7.5                    |       | 7.2                             |       | 5.6 |   | 6.0 |   |
| Interest expense                                          |       | 8.5                    |       | 10.2                            |       | 9.0 |   | 11.1 |   |
| Other (income) and expense, net                           |       | 0.3                    |       | (0.6                            | )          | 0.1 |   | (0.4 | ) |
| **Loss before income taxes and discontinued  operations** |       | (1.3                   | )          | (2.4                            | )          | (3.5 | ) | (4.7 | ) |
| Income tax provision (benefit)                            |       | 0.9                    |       | (1.0                            | )          | (0.8 | ) | (1.7 | ) |
| **Loss before discontinued operations**                   |       | (2.2                   | )          | (1.4                            | )          | (2.7 | ) | (3.0 | ) |
| Discontinued operations loss, net of income  tax          |       | —                 |       | (0.5                            | )          | — |   | (0.3 | ) |
| **Net loss**                                              |       | (2.2                   | )%         | (1.9                            | )%         | (2.7 | )% | (3.3 | )% |

 

*Quarter Ended November 1, 2008 Compared to the Quarter Ended November 3,2007*

 

*Net Sales*—Net salesdecreased for the third quarter of fiscal 2008 by $28 million, or 3.0%,compared to the third quarter of fiscal 2007. The results for the third quarterof fiscal 2008 include sales from 60 Michaels stores that were opened duringthe 13-month period ended November 1, 2008. Non-comparable sales increased$32 million, while comparable store sales decreased $60 million.

 

Comparable store sales declined 6.5% in the third quarter of fiscal2008 compared to the third quarter of fiscal 2007, reflecting a decrease incustomer transactions of 3.9%, a decrease in the average ticket of 2.8%, and a0.2% increase in custom frame deliveries. The fluctuation in the exchange ratebetween the United States and Canadian dollars adversely impacted the averageticket change by 70 basis points. Comparable store sales were negativelyimpacted by the current soft macroeconomic and retail environments,particularly in the home décor and seasonal categories.

 

We continue to develop a fully integrated pricing and promotionstrategy and may refine our existing strategy in future periods.  A significant component of our pricing andpromotion strategy involves changes in the breadth and depth of our promotionalprograms.  Given the current softmacroeconomic and retail environments, sales declines could adversely affectoperating income due to a deleveraging of operating expenses.  As a result, our historical trends may not beindicative of future results.

 

We continue to evaluate all options available to us for our AaronBrothers concept, which range from refining the concept to possible storerationalization.  Certain of theseoptions, if enacted, may result in material charges to our consolidatedstatement of operations in future periods.

 

*Cost of Sales and Occupancy Expense*—Costof sales and occupancy expense decreased $7 million from $591 million in thethird quarter of fiscal 2007 to $584 million in the third quarter of fiscal2008 primarily as a result of lower net sales. As a percentage of net sales,cost of sales and occupancy expense increased approximately 120 basis points inthe third quarter of fiscal 2008 compared to the third quarter of fiscal 2007.Occupancy costs increased by 130 basis points due to a deleveraging of fixedcosts on a decline in comparable store sales, partially offset by a 10 basispoint increase in our merchandise margin.

 

*Selling, General, and Administrative Expense*—Selling,general, and administrative expense decreased $14 million from $261 million inthe third quarter of fiscal 2007 to $247 million in the third quarter of fiscal2008. As a percentage of net sales, selling, general and administrative expensedecreased from 27.9% of net sales in the third quarter of fiscal 2007 to 27.3%of net sales in the third quarter of fiscal 2008 primarily due to a reductionin our bonus expense accrual of approximately $15 million, partially offset byan increase in advertising expense.

 

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*Transaction Expenses*—Transactionexpenses incurred during the third quarter of fiscal 2007 related primarily tobonus arrangements associated with the change in control that were ratablyrecognized for a period of one year following the Merger date, as well as othercompensation expenses arising from change in control agreements.

 

*Related Party Expenses*—Related party expenses were $4 million in each of the third quarters of fiscal2008 and fiscal 2007.  These costsconsist primarily of approximately $3 million of management fees and associatedexpenses paid to our Sponsors and Highfields Capital Management L.P. (“Highfields”).  Also included in the related party expenseswas approximately $1 million of amortization expense related to the SeparationAgreements as more fully described in Note 11 to the consolidated financialstatements.

 

*Interest Expense*—Interestexpense for the third quarter of fiscal 2008 decreased $18 million, from thethird quarter of fiscal 2007, to $77 million as a result of a lower averageinterest rate related to our variable-rate debt and lower average debt levels.

 

*(Benefit) Provision for Income Taxes*—Duringthe third quarter of fiscal 2008, the Company recorded a tax provision of $8million for the period.  The expenserelates primarily to a projected annual tax rate decrease due to changes in ourresults of operations combined with the Company’s limited ability to recognizeforeign tax credits related to its profitable Canadian operations.  During the third quarter of fiscal 2007, theCompany recorded a tax benefit of $9 million at an effective tax rate of 39.0%.  As a result of our projected low income base,our effective rate is highly sensitive to changes caused by permanentdifferences (i.e. differences between book income and tax income that are notexpected to reverse in future periods).

 

*Nine Months Ended November 1, 2008 Compared to the Nine Months EndedNovember 3, 2007*

 

*Net Sales*—Net salesdecreased in the first nine months of fiscal 2008 by $12 million, or 0.5%,over the first nine months of fiscal 2007. Sales at our new stores opened since the third quarter of fiscal 2007provided incremental revenue of $93 million, while comparable store salesdecreased $105 million.

 

Comparable store sales decreased 4.1% infiscal 2008 compared to fiscal 2007, reflecting declines in customertransactions of 2.9% and average ticket of 1.2%. The fluctuation in the exchangerate between the United States and Canadian dollars positively impacted theaverage ticket change by 30 basis points.

 

*Cost of Sales and Occupancy Expense*—Costof sales and occupancy expense increased $21 million due primarily to a4.3% increase in the number of stores. As a percentage of sales, cost of sales and occupancy expense increased110 basis points. Merchandise margin decreased approximately 40 basis pointsprimarily related to a greater sales mix of clearance items in the first ninemonths of fiscal 2008 compared to fiscal 2007. Also, occupancy costs increased70 basis points, as a percentage of sales, due to a deleveraging of fixed costson a decline in comparable store sales.

 

*Selling, General, and Administrative Expense*—Selling,general, and administrative expense increased $7 million to $765 millionfor the first nine months of fiscal 2008 compared to $758 million in thefirst nine months of fiscal 2007. The increase was primarily due to increasesin store count, corporate payroll and severance costs.  The increase was partially offset by reducedbonus expense and a decrease in instructor payroll, with the elimination ofclasses previously offered in Michaels stores. As a percentage of net sales, selling, general, and administrative expenseincreased from 29.6% in the first nine months of fiscal 2007 to 30.0% in thefirst nine months of fiscal 2008 primarily due to planned in-store investments,decreased leverage associated with the decline in comparable store sales and anincrease in severance expense, partially offset by a reduction in bonus expenseaccruals.

 

*Transaction Expenses—*Transaction expenses incurred during thefirst nine months of fiscal 2007 related primarily to bonus arrangementsassociated with the change in control that were ratably recognized for a periodof one year following the Merger date, as well as other compensationexpenses arising from change in control agreements.

 

*Related Party Expenses*—Relatedparty expenses were $12 million for each of the first nine months of fiscal2008 and fiscal 2007 consisting primarily of $10 million of management fees andassociated expenses paid to our Sponsors and Highfields.  Also included in the related party expenseswas approximately $2 million of amortization expense related to the SeparationAgreements as more fully described in Note 11 to the consolidated financialstatements.

 

*Interest Expense*—Interestexpense decreased $54 million in the nine months ended November 1, 2008compared to the nine months ended November 3, 2007, primarily due to alower average interest rate on our variable-rate debt and lower average debtlevels.

 

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*Benefit for Income Taxes*—Theeffective tax rate was 23.0% for the first nine months of fiscal 2008 and 34.9% for the first nine months of fiscal 2007. For fiscal 2008, the lowereffective tax rate is the result of the Company’s limited ability to recognizeforeign tax credits related to its profitable Canadian operations.  Our effective rate is highly sensitive tochanges as a result of the low base of expected income or loss for the periodand the comparatively significant effect on rate caused by permanent differences(i.e. differences between book income and tax income that are not expected toreverse in future periods).

 

**Liquidityand Capital Resources**

 

We require cash principally for day-to-day operations, to financecapital investments, inventory for new stores, and inventory replenishment forexisting stores, to service our outstanding debt, and seasonal working capitalneeds.  We and our subsidiaries,affiliates, and significant shareholders may from time to time seek to retireor purchase our outstanding debt (including publicly issued debt) through cashpurchases and/or exchanges, in open market purchases, privately negotiatedtransactions, by tender offer or otherwise. Such repurchases or exchanges, if any, will depend on prevailing marketconditions, liquidity requirements, contractual restrictions and otherfactors.  We expect that our availablecash, cash flow generated from operating activities, and funds available underour Asset-based revolving credit facility will be sufficient to fund plannedcapital expenditures, working capital requirements, debt repayments, debtservice requirements and future growth for the foreseeable future.

 

*Cash Flow used in Operating Activities*

 

Cash flow used in operating activities during the first nine months offiscal 2008 was $166 million compared to $80 million during the first ninemonths of fiscal 2007.

 

The $86 million change related primarily to our seasonal increase ininventory.  Careful inventory managementin fiscal 2007 enabled a 4.5% reduction in year-end average Michaels storeinventory as compared to the prior fiscal year. Additional inventory purchases for anticipated volume in the fourthquarter of 2008 brought average store inventory (including supportingdistribution centers) to a level approximately equal to the third quarter of2007.  In addition, inventory wasrequired to support a greater number of new stores this year.   In view of the current economic environment,we expect average inventory per Michaels store at the end of fiscal 2008 to bemoderately higher as compared to the end of fiscal 2007.    The change in cash flow related to accruedinterest and accrued expenses was primarily attributable to the timing ofpayments.

 

*Cash Flow used in Investing Activities*

 

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

 
| ** **                                          | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------------|------------|---------------------------------|------------|
| ** **                                          | ** ** | **November 1,**            | ** ** | **November 3,** | ** ** |
| ** **                                          | ** ** | **2008 (1)**               | ** ** | **2007 (2)** | ** ** |
| ** **                                          | ** ** | **(in millions)**          | ** ** |
| New and relocated stores and stores not yet  opened |       | $                               | 23         |   | $ | 23 |   |
| Existing stores                                     |       | 17                              |       | 26 |   |
| Distribution system expansion (3)                   |       | 3                               |       | 14 |   |
| Information systems                                 |       | 21                              |       | 22 |   |
| Corporate and other                                 |       | 2                               |       | 1 |   |
|                                                |       | $                               | 66         |   | $ | 86 |   |

 

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| (1)    |   | In the first nine months of fiscal 2008, we incurred  capital expenditures related to the opening of 50 Michaels stores in addition  to the relocation of nine Michaels stores and one Aaron Brothers store. |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                         |
| (2)    |   | In the first nine months of fiscal 2007, we incurred  capital expenditures related to the opening of 43 Michaels and two Aaron  Brothers stores in addition to the relocation of eleven Michaels stores.     |
|   |   |                                                                                                                                                                                                         |
| (3)    |   | The change in capital expenditures related to the  distribution system expansion is primarily related to 2007 expenditures  associated with our Hybrid distribution network.                                 |

 

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*Cash Flow provided by Financing Activities*

 

Cash flows provided by financing activities are related primarily toborrowings and repayments under our Asset-based revolving credit facility.Borrowings under the credit facility are used primarily to fund seasonalworking capital needs to support increased inventory levels going into theholiday season, to finance capital expenditures, and fund debt servicepayments.  During the first nine monthsof fiscal 2008, borrowings under the facility included an aggregate of $120million drawn on September 19, 2008, to prefund seasonal working capitalrequirements and to ensure that we had adequate liquidity in the event of potentialdisruptions in the debt markets. Approximately $52 million of such funds wereinvested in short term investments as of the end of the third quarter of fiscal2008. The borrowed amounts were primarily used to support seasonal workingcapital needs, as well as semi-annual interest payments..  The Asset-based revolving credit facilityprovides senior secured financing of up to $1.0 billion, subject to a borrowingbase. As of November 1, 2008, the borrowing base was $989 million with$510 million of unused availability.

 

**RecentAccounting Pronouncements**

 

In September 2006,the Financial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards (“SFAS”) No. 157, *Fair Value Measurements*,which is intended to increase consistency and comparability in fair valuemeasurements by defining fair value, establishing a framework for measuringfair value and expanding disclosures about fair value measurements.  SFAS 157 was originally effective for financialstatements issued for fiscal years beginning after November 15, 2007, andinterim periods within those fiscal years. In November 2007, the FASB placed a one year deferral for theimplementation of SFAS 157 for nonfinancial assets and liabilities; however,SFAS 157 is effective for fiscal years beginning after November 15, 2007for financial assets and liabilities, as well as for any other assets andliabilities that are carried at fair value on a recurring basis in financialstatements.  We adopted all requirementsof SFAS 157 as they relate to financial assets and liabilities on February 3,2008. See Note 7 to our consolidated financial statements for furtherinformation on the impact of this standard to financial assets and liabilities.The requirements related to nonfinancial assets and liabilities will be adoptedon February 1, 2009, as allowed by SFAS 157. We have not yet determinedthe impact, if any, on our consolidated financial statements for thesenonfinancial assets and liabilities.

 

In February 2007, the FASB issued SFAS No. 159, *The Fair Value Option for Financial Assets and Financial Liabilities*,which permits companies to measure certain financial instruments and otheritems at fair value (at specified measurement dates) that are not currentlyrequired to be measured at fair value. Any unrealized gains or lossesapplicable to those items measured at fair value shall be reported in earnings.The decision to apply fair value shall generally be made on an instrument byinstrument basis, is irrevocable, and is applied only to an entire instrument.We adopted SFAS 159 on February 3, 2008, and there was no impact on ourconsolidated financial statements as we did not choose to measure any eligiblefinancial assets or liabilities at fair value.

 

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

 

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

 

**Item 3.  Quantitative andQualitative Disclosures About Market Risk.**

 

Weare exposed to fluctuations in exchange rates between the US and Canadiandollars, as the functional currency of our Canadian subsidiary is the Canadiandollar.  During the second quarter offiscal 2008, we executed foreign currency forward contracts to mitigate theeffects of currency fluctuations, which we designated as a cash flow hedge. Theobjective of the 

 

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forwardcontracts is to hedge intercompany payments for forecasted purchases ofinventory by our Canadian subsidiary, which are denominated in US dollars.  The term of this cash flow hedge extendsthrough the first quarter of fiscal 2009.

 

Toachieve our objective and to minimize the risk of ineffectiveness, the notionalvalues represent a portion of our Canadian subsidiary’s forecasted intercompanypurchases.  Hedge ineffectiveness isrecorded in Other income, as required. For the quarter ended November 1,2008, the ineffective portion of the hedge was immaterial.

 

Forthe portion of the hedge that is effective, as defined, the change in fairvalue of that hedge will initially be recorded in Other comprehensiveincome.  As the underlying inventory issold to our customers, amounts will be reclassified from Other comprehensiveincome to Cost of sales and occupancy expense in the statement ofoperations.  The change in fair value ofthe hedge for the quarter ended November 1, 2008 was $5 million.

 

The table below provides the remaining quarterly notional values andthe average CAD/USD exchange rate associated with the hedge (dollars inmillions).

 

| **Period**      | ** ** | **CAD Amount** | ** ** | **USD Amount** | ** ** | **Rate** | ** ** |
|-----------------|------------|---------------------|------------|---------------------|------------|----------|------------|
| Quarter 4, 2008 |       | $                   | 17.4       |                | $          | 17.4     |       | 1.001 |   |
| Quarter 1, 2009 |       | 12.2                |       | 12.2                |       | 1.001    |       |
|            |       | $                   | 29.6       |                | $          | 29.6     |       | 1.001 |   |

 

**Item 4.  Controls andProcedures.**

 

*Evaluation of Disclosure Controls and Procedures*

 

We maintain a set of disclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) promulgated by the SEC under the Securities Exchange Act of1934). An evaluation was carried out under the supervision and with theparticipation of our management, including our Chief Executive Officer and ourChief Financial Officer, of the effectiveness of our disclosure controls andprocedures as of the end of the period covered by this Quarterly Report on Form 10-Q.Based on that evaluation, our Chief Executive Officer and our Chief FinancialOfficer concluded that our disclosure controls and procedures are effective toprovide reasonable assurance that information required to be disclosed in thereports that we file or submit under the Securities Exchange Act of 1934 isrecorded, processed, summarized, and reported within the time periods specifiedin SEC rules and forms. Such controls and procedures are designed toensure that information we are required to disclose in our reports isaccumulated and communicated to our management, including our principalexecutive officer and principal financial officer, to allow timely disclosuredecisions. 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 canbe no assurance that any design will succeed in achieving its stated goalsunder all potential future conditions.

 

*Change in Internal Control Over Financial Reporting*

 

There has not been any change in our internal control over financialreporting (as defined in Rules 13a-15(f) and 15d-15(f) aspromulgated by the SEC under the Securities Exchange Act of 1934) duringthe quarter covered by this Quarterly Report on Form 10-Q that materiallyaffected, or is reasonably likely to materially affect, our internal controlover financial reporting.

 

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**MICHAELSSTORES, INC.**

**Part II—OTHERINFORMATION**

 

**Item 1.  LegalProceedings.**

 

Information regarding legal proceedings is incorporated herein byreference from Note 9 to our Consolidated Financial Statements.

 

**Item 1A. Risk Factors.**

 

Information regarding the Company’s risk factors appear in Item 1A.Risk Factors disclosed in our Annual Report on Form 10-K for the fiscalyear ended February 2, 2008.

 

There have been no material changes from the risk factors previouslydisclosed in our Annual Report on Form 10-K for the fiscal year ended February 2,2008 other than the risk factors set forth below:

 

*TheEffect of General Economic Conditions and the Current Financial Crisis*

 

Ifthe worldwide economic downturn continues or deteriorates further, it couldadversely impact our results of operations, cash flows and financialcondition.  The downturn in the economymay continue to adversely affect consumer confidence and retail spending,decreasing demand for our merchandise. Current economic conditions also make it difficult for us to accuratelyforecast future demand trends which could cause us to purchase excessinventories, resulting in increases in our inventory carrying cost, orinsufficient inventories, resulting in our inability to satisfy our customerdemand and potentially lose market share. In addition, we are experiencing significant worldwide disruptions incredit markets.  As discussed under “Liquidityand Capital Resources,” we believe that our current liquidity resources areadequate for the near term.  Although theCompany does not anticipate needing additional sources of capital in the nearterm, continued disruption in the capital markets could make it difficult forus to raise additional capital, when needed, or to eventually refinance ourexisting indebtedness, on acceptable terms or at all.  Similarly, if our suppliers face challengesin assessing credit when needed or otherwise face difficult businessconditions, they may become unable to offer us the merchandise we use in ourbusiness causing reductions in revenues, or may demand more favorable paymentterms, all of which could adversely affect our results of operations, cashflows and financial condition.

 

**Governmentor consumer concerns about product safety and recalls or changes to laws, couldharm our reputation, financial position, earnings or cash flow.**

 

Weare subject to a variety of product safety regulations by federal, state andinternational regulatory authorities. Much of our merchandise is manufactured in foreign countries andimported either directly or through domestic sources.  One or more of our suppliers might not adhereto product safety requirements or our quality control standards, and we mightnot identify the deficiency before merchandise is shipped to ourstores. Product safety concerns or recalls could result in the rejectionof our products by our customers, damage to our reputation, lost sales, andincreased costs. Moreover, changes in product safety or other consumerprotection laws could lead to increased costs to us for certain merchandise, oradditional labor costs associated with readying merchandise for sale. Long leadtimes on merchandise ordering cycles increase the difficulty for us to plan andprepare for potential changes to applicable laws.  The recently enactedConsumer Product Safety Improvement Act of 2008 imposes significant new requirementson manufacturing, importing, testing and labeling requirements for ourproducts. In the event that we are unable to timely comply withregulatory changes, significant fines or penalties could result, andcould adversely effect on our reputation, financial position, earnings orcash flow.

 

*If the Employee Free Choice Act isadopted, it would be easier for our employees to obtain union representationand our businesses could be impacted.*

 

Currently, none of our employees arerepresented by unions. However, our employees have the right at any time underthe National Labor Relations Act to form or affiliate with a union. If some orall of our workforce were to become unionized and the terms of the collectivebargaining agreement were significantly different from our current compensationarrangements, it could increase our costs and adversely impact ourprofitability.

 

TheEmployee Free Choice Act of 2007: H.R. 800 (“EFCA”) was passed in theU.S. House of Representatives last year. This bill or a variation of itcould be enacted in the future and could have an adverse impact on ourbusinesses. The EFCA 

 

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aimsto amend the National Labor Relations Act, by making it easier for workers toobtain union representation and increasing the penalties employers may incur ifthey engage in labor practices in violation of the National Labor RelationsAct. As currently drafted, the EFCA requires the National Labor Relations Board(“NLRB”) to review petitions filed by employees for the purpose of creating alabor organization and to certify a bargaining representative without directingan election if a majority of the bargaining unit employees have authorizeddesignation of the representative. The EFCA also requires the parties to beginbargaining within 10 days of the receipt of the petition, or longer timeif mutually agreed upon. In addition, if the union and employer cannot agree uponthe terms of a first collective bargaining agreement within 90 days, whichcan be extended by mutual agreement, either party can request federalmediation, which could lead to binding arbitration if an agreement still cannotbe reached after an additional 30 days which can be extended by mutualagreement. EFCA would also require the NLRB to seek a federal injunctionagainst an employer whenever there is reasonable cause to believe that theemployer has discharged or discriminated against an employee to encourage ordiscourage membership in the labor organization, threatened to discharge orotherwise discriminate against an employee in order to interfere with,restrain, or coerce employees in the exercise of guaranteed collectivebargaining rights, or engaged in any other related unfair labor practice thatsignificantly interferes with, restrains, or coerces employees in the exerciseof such guaranteed rights. The EFCA adds additional remedies for suchviolations, including back pay plus liquidated damages and civil penalties tobe determined by the NLRB not to exceed $20,000 per infraction.

 

**Item 6.  Exhibits.**

 

(a) Exhibits:

 
| **Exhibit  Number** | ** ** | **Description of Exhibit**                                                                                                                 |
|---------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------|
| 31.1                |       | Certifications of Brian C. Cornell pursuant to §302 of the  Sarbanes-Oxley Act of 2002 (filed herewith).                              |
|                |       |                                                                                                                                       |
| 31.2                |       | Certifications of Elaine D. Crowley pursuant to §302 of the  Sarbanes-Oxley Act of 2002 (filed herewith).                             |
|                |       |                                                                                                                                       |
| 32.1                |       | Certification pursuant to 18 U.S.C. §1350, as adopted pursuant  to §906 of the Sarbanes-Oxley Act of 2002 (filed herewith). |

 

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**MICHAELSSTORES, INC.**

**SIGNATURES**

 

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

 
|                               | MICHAELS STORES, INC. |
|------------------------------------|-----------------------|
|                               |                  |   |
|                               | By:                   | /s/ Elaine D. Crowley |
|                               |                  | Elaine D. Crowley |
|                               |                  | Executive Vice President - Chief  Financial Officer |
|                               |                  | (Principal Financial Officer) |
| ** **                         | ** **            | ** ** |
| Dated: December 10, 2008 | ** **            | ** ** |

 

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**INDEX TO EXHIBITS**

 
| **Exhibit  Number** | ** ** | **Description of Exhibit**                                                                                                                 |
|---------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------|
| 31.1                |       | Certifications of Brian C. Cornell pursuant to §302 of the  Sarbanes-Oxley Act of 2002 (filed herewith).                              |
|                |       |                                                                                                                                       |
| 31.2                |       | Certifications of Elaine D. Crowley pursuant to §302 of the  Sarbanes-Oxley Act of 2002 (filed herewith).                             |
|                |       |                                                                                                                                       |
| 32.1                |       | Certification pursuant to 18 U.S.C. §1350, as adopted pursuant  to §906 of the Sarbanes-Oxley Act of 2002 (filed herewith). |

 

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