U.S. Markets closed

Edited Transcript of MIK earnings conference call or presentation 4-Sep-19 1:00pm GMT

Q2 2019 Michaels Companies Inc Earnings Call

Irving Sep 12, 2019 (Thomson StreetEvents) -- Edited Transcript of Michaels Companies Inc earnings conference call or presentation Wednesday, September 4, 2019 at 1:00:00pm GMT

TEXT version of Transcript

================================================================================

Corporate Participants

================================================================================

* Denise A. Paulonis

The Michaels Companies, Inc. - Executive VP & CFO

* Elaine Locke

The Michaels Companies, Inc. - VP of IR & Treasurer

* Mark S. Cosby

The Michaels Companies, Inc. - Interim CEO & Director

================================================================================

Conference Call Participants

================================================================================

* Christopher Michael Horvers

JP Morgan Chase & Co, Research Division - Senior Analyst

* Elizabeth Lane Suzuki

BofA Merrill Lynch, Research Division - VP

* Laura Allyson Champine

Loop Capital Markets LLC, Research Division - MD

* Seth Ian Sigman

Crédit Suisse AG, Research Division - United States Hardline Retail Equity Research Analyst

* Simeon Ari Gutman

Morgan Stanley, Research Division - Executive Director

* Steven Paul Forbes

Guggenheim Securities, LLC, Research Division - Analyst

================================================================================

Presentation

--------------------------------------------------------------------------------

Operator [1]

--------------------------------------------------------------------------------

Good morning. My name is Kerry, and I will be your conference operator today. At this time, we'd like to welcome everyone to The Michaels Companies second quarter earnings conference call. (Operator Instructions) Please note, this event is being recorded. Thank you.

And now I'd like to turn the call over to your host, Elaine Locke, Vice President of Investor Relations and Treasurer. Ms. Locke, you may begin the conference.

--------------------------------------------------------------------------------

Elaine Locke, The Michaels Companies, Inc. - VP of IR & Treasurer [2]

--------------------------------------------------------------------------------

Thank you, Kerry. Good morning, and thank you for joining us today. Earlier this morning, we released our financial results for the second quarter of fiscal 2019. A copy of the press release and a few related slides are available in the Investor Relations section of our website at www.michaels.com.

Before we begin our discussion, let me remind you that today's press release and the presentations made by our executives on this call may constitute forward-looking statements and are made pursuant to and within the meaning of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 as amended. While these statements address plans or events, which we expect will or may occur in the future, a number of factors is set forth in our SEC filings and press releases could cause actual results to differ materially from our expectations. We refer you to and specifically incorporate the cautionary and risk statements contained in today's press release and in our SEC filings. You are cautioned not to place undue reliance on these forward-looking statements which speak only as of today, September 4, 2019. We have no obligation to update or revise our forward-looking statements, except as required by law, and you should not expect us to do so.

On today's call, we will reference non-GAAP financial measures, including adjusted operating income, adjusted net income and adjusted diluted earnings per share, all adjusted for restructuring charges primarily related to the Aaron Brothers and Pat Catan store closures, severance charges related to the departure of our former CEO, a write-off of an investment in a liquidated business, losses on early extinguishment of debt and refinancing costs, interest paid on our 2020 senior subordinated notes during a period between the issuance of our 2027 senior notes and the redemption of our 2020 senior subordinated notes and tax adjustments related to the 2017 Tax Act as applicable. A reconciliation of these measures to the corresponding GAAP measures are detailed in today's earnings release.

We'll begin this morning with prepared remarks from Mark Cosby, interim CEO; and Denise Paulonis, CFO. Following our prepared remarks, we will open the call for questions.

Now I'd like to introduce Mark Cosby for some initial comments. Mark?

--------------------------------------------------------------------------------

Mark S. Cosby, The Michaels Companies, Inc. - Interim CEO & Director [3]

--------------------------------------------------------------------------------

Thank you, Elaine, and good morning, everyone. This morning, we reported results for the second quarter that were above the guidance range we provided on our last earnings call. Comp store sales were positive 0.3%, adjusted operating income was $75 million and adjusted diluted earnings per share was $0.19.

In the last call, I said our #1 goal is to improve our sales performance, and we are pleased to see movement in that direction. In this call, I will talk about the actions we implemented to drive improvement in the second quarter and then provide a look at our new long-term strategy. You will see that the priorities for 2019 that are embedded in our strategy have started to have an impact on our results and will play a bigger role in our expected second half performance.

Let's start with a review of our Q2 results and progress. The foundation for all of the actions we took to improve our second quarter results is based on our shift to become much more customer-centric. We listen to our customer and implement an action plan to improve our results. The actions included promotion calendar process improvements, value perception enhancements, the expansion of our growth category initiative and enhancing our e-comm growth capabilities.

The enhancement in our promotion planning process focused on ensuring that our weekly promotions across all media work together to deliver our sales plans. We put comprehensive plans together for every week, particularly focused on our big events. An example was a very successful June lowest price of the season event, which featured a cohesive plan, including addressable TV, e-mail, digital, social, store presentations and store signage.

Another example was our first semiannual clearance event in early July that included a comprehensive media program and a powerful store presentation that was a big success with our customers. As mentioned on the last call, we identified an opportunity to improve our value perception based on our customer research. We took a number of steps to address this value perception issue. We eliminated the EDV program in all U.S. stores, and we reduced the number of products excluded from coupons to make it easier and less frustrating for customers.

We also launched a new tool to help us manage the distribution of digital coupons while maximizing the benefits of serialization and limiting coupon abuse. And we adjusted our drive aisle and endcap presentations to present a stronger value impression. These actions led to a reduction in customer complaints, improved our value perception rating and contributed to our improved sales trend. We recognized that we have more work to do on the value perception front. We are heading in the right direction.

Our first major project reset of the year came in April with tools and technology. In response to growing customer interest, we added 25 feet to this high-growth category. This effectively doubled the space to support an expansion of widely recognized brands like Cricut, Caesar and Oracle. With the additional space, we can display more machine samples, and we created a power wall of vinyl accessories. These changes allowed us to expand our leadership in this important DIY category, and we now offer the largest assortment of Cricut product of any retail store.

This category helped drive sales and the rollout helped create some excitement in the arts and crafts community. We have built a strong partnership with the team at Cricut that included our exclusive launch of the infuseable ink products. The Cricut CEO also hosted many events at our stores that drew big crowds and created many large social media events.

The last big contributor to our sales improvement in Q2 was the success of our e-comm business. We have continued to focus on building our e-comm capabilities to drive sales while implementing initiatives to improve our profitability. This shift earlier this year to bring our fulfillment in-house has helped us improve our fulfillment cost, lower our shipping cost and leverage our fixed cost base.

And a rising Buy Online Pick-up In Store, or BOPIS, penetration has also been a big win for our e-comm profitability. We believe that the actions we took to improve our results in Q2 will continue to help us as we move into the second half of the year.

Now looking forward to the balance of 2019 and the future. I'm pleased to provide some insight into our updated long-term growth strategy. Late in Q4, the Board and our leadership team launched a comprehensive effort to define our growth strategy for 2020 and beyond. We engaged external partners combined with internal resources to help us identify and prioritize customer segments and customer solutions to drive long-term growth. In June, the Board approved our growth strategy, and we are now using it as a road map for planning future growth.

As mentioned in the last call, we have defined our target customer as the core maker. This is someone that is interested in DIY, crafting, creating fine arts or just injecting more creativity into their life. This target customer definition was the result of significant customer research looking at attitudes, behaviors and needs of our customers.

We divided them into different customer segments, identifying key characteristics and spend. Then we conduct another set of research to learn how the core maker shop with traditional quantitative surveys, immersive interviews of individual customers and focus groups. This research has led us to believe that we can better focus on this core maker and increase our overall market share. These core makers represent 2/3 of all arts and crafts spend and importantly indicate a strong desire to spend more on DIY projects. Historically, we have seen stronger growth over time with these enthusiast customers than we have seen with our novice customers. We believe that focusing on these maker segments will drive growth.

Our new purpose is we're here for the makers. This purpose will guide our path to growth and help us ensure that we have our customers in mind along with financial results when we make decisions. We have defined 3 big building blocks that will drive our maker strategy: Build the business better, leverage digital and data and reposition the business. We have initiatives in place for the project teams to drive these building blocks. The initiatives and support of building the business better and leveraging digital and data are many of the 2019 priorities that we discussed on our last call. We think of these initiatives as quick hits that we started well in advance of the finalization of our strategic planning process and will deliver results in the second half of this year.

There are 4 big initiatives under the build-the-business better building block: Build the stores' selling culture, create a customer-centric assortment, optimize pricing and promotions, and maximize marketing productivity. I'll provide you with a brief summary of each of these initiatives starting with Build a Solid Culture.

This initiative is designed to shift the store culture from task-minded activities to a focus on the customer and selling. The stores will have scorecards with metrics to reinforce priorities that show how they rank compared to other stores, creating some friendly competition. They will define action plans to improve their scorecard results based on the best practices of our top-performing stores, and there will be consistent coaching and recognition programs in place to motivate and inspire progress. This comprehensive program was rolled out to every store leader by the end of August, and we are expecting the program to improve our customer conversion and our basket size in advance of the holiday season.

We have also launched our Customer-Centric Assortment initiative with the goal of adding space to core maker categories with high growth potential. We launched the program in 3 phases starting with the previously discussed technology launch in May and the expansion of craft storage and fine art in July and August. The technology expansion continues to perform well and should be a sales driver for us in Q3 as well.

In July, we increased the selling space in craft storage to accommodate in this expanded assortment with a more prominent display for the customer, including a craft card wall. The response has been very positive, and our customers are sharing online how they use these new cards to create solutions for their storage needs.

When we marketed the new cards, we leaned into the teachers with back-to-school ideas for keeping the classroom organized. In August, we completed the reset of our supplies, expanding our assortment of drawing and painting categories by adding over 20 feet to display, including 1,000 new items in drawing and paint expanding several main brands such as Tombow, Sharpie and Micron.

The third Build the Business Better initiative is to optimize our pricing and promotions. This initiative supports improving both our customer value perception and our profitability. This pricing optimization work will also support the price element of our tariff mitigation effort.

In addition to the steps we have already taken to streamline and enhance our coupon strategy, we are taking a fresh look at our mix of promotions, coupons and regular price to determine how we can simplify the customer experience. We are creating new tools to help us evaluate the effectiveness of a discounting campaign and make sure we are getting the expected return on investment. A good example is the category assessment that informed us that we would improve our sales and margin by moving from buy one get one free promotion to buy one get one 50% offer. Our goal is to take action on larger scale as the year progresses to improve our value perception, eliminate unproductive discounting and improve sales.

The final initiative under Build the Business Better is to maximize our marketing productivity. This initiative is focused on optimizing our existing marketing spend to more effectively reach our core maker customer and to drive higher sales. We implemented a new tool that we will use to assess the productivity of all of our marketing vehicles and enable us to shift our spending to the highest productivity options. This will mean shifting funds from less productive mass media options such as newspaper to more productive options such as digital and addressable TV. We're also working to optimize within each type of marketing spend such as improving the productivity of our digital spending options and improving the efficiency of our organic search results.

The second building block of our maker strategy is to leverage digital and data. This building block is comprised of 2 initiatives: Enhanced CRM and profitable e-comm growth. The enhanced CRM initiative is focused on increasing our customer engagement through personalization of all customer messaging. The goal is to create category and inspiration-focused content, supporting more personalized and relevant communication across channels, beginning with e-mail followed by web and digital marketing.

We have an extensive collection of customer data, including 75 million customer records, 31 million active e-mail addresses and 38 million customers in our rewards program. Today, we can link more than 82% of our sales to a specific customer. We have continued to test proprietary models build to help us predict customer purchases based on interactions with our michaels.com, the Michaels app, e-mail and in-store purchase behavior. We started leveraging this data in May to personalize e-mails to customers based on their spending history. Our early results have been very encouraging with open and click rates almost 3x the rate of our typical mass e-mail.

Today, around 1% of our e-mails are personalized, and our goal is to move toward personalizing 15% of our e-mails by the end of this year and much higher as we move into 2020. We'll then move toward personalizing all of our customer messaging channels, including the website and digital messaging. The benefit will be improving engagement with our customers and driving higher sales results.

As an extension of this CRM initiative, we will be enhancing our rewards program in 2020 to create a more meaningful loyalty program. We will test components of this loyalty program later this year. So we are ready to launch the new program by the middle of next year.

The second leverage, digital and data initiative, is to create more profitable e-commerce growth. The goal is to maintain our rapid sales growth momentum while enhancing the profitability of our omnichannel options. We have a number of initiatives in place to continue our growth momentum, including optimizing our digital spending, enhancing our website capabilities and personalizing the website for our customers.

Today, our site is the same for every customer that visits. Later this year, the site will be customized to each site visitor based on their spending history. We also continue to see strong customer enthusiasm for Buy Online Pick-up In Store, or BOPIS. From a cost perspective, BOPIS is very attractive way to fulfill an e-commerce order as it does not include shipping costs. In Q2, BOPIS accounted for 44% of online sales and nearly 2/3 of online orders. We continue to use technology to facilitate BOPIS orders, and this quarter we rolled out near real-time inventory tracking to improve BOPIS fulfillment percentages.

In addition to our focus on driving omnichannel sales, we are also focused on improving the profitability of this important growth channel. We have initiatives in place to improve the gross margin, fulfillment and shipping cost for all the ways that we distribute products to our customers. We believe expanding our omnichannel presence is a critical piece of our long-term growth opportunity. We are actively working on plans that will improve our cost structure while enhancing the customer experience to drive longer-term profitable growth.

The third and final building block of our maker strategy is to reposition the business. This building block is focused on initiatives that will not help us in 2019 but will set us up for growth in 2020 and beyond. This building block today is comprised of 3 initiatives that are in development: A Michaels community, a maker-centered store experience and maker-centered categories. Let's take a quick look at these 3 growth initiatives.

Our extensive research over the last few months has shown us how important community is to our maker customers. These customers want to share and learn with our maker customers. We saw this come to life with the rollout of our tools and technology product we set in early May when our customers were sharing in social media, attending events and coming to our stores to take classes.

We are focusing on ways to build the community with our customers in stores and online. This will include work to take our existing successful community classroom to the next level and work to create an online community for maker customers.

We have also started work to creating maker-centered store experience. This initiative will include the development of our store design specifically to meet the needs of our maker customer. The store design will feature easier shopping experience, a curated assortment and enhanced service experience, full omnichannel capabilities, and it will bring the community experience to life. We will build this new concept in a lab environment this year and then open a few stores next year. The goal will be to learn from these stores and expand the best practices in a low-cost way across the system.

The third component of repositioning the business is our maker-centered category initiative. This initiative is focused on innovating our assortment and presentation targeting our maker customers. The work will lead to the development of the assortment for our new maker-centered store. The work will also form the basis for a new category management process that will leverage customer feedback to optimize our key product categories for our maker customer across all of our stores. This focus on the maker will translate into making shifts in some core assortments. Categories such as art, tools and technology and jewelry will become more important to us.

We will also modify categories to meet the needs of our makers. An example can be found in jewelry. When we were focused on bringing the novice into the store, we carried more finished jewelry and fashion watches in the assortment. With the DIY jewelry maker in mind, we will now be more focused on giving her the best assortment of jewelry pieces so she can assemble what she wants.

We will not be abandoning categories just making sure the mix within a category is right. Seasonal products come to mind as a question, but this category is very important to the core maker as they like to decorate for events. This maker-centered category initiative will be a big component of our future growth plans.

In closing, we are laser-focused on driving sales and improving profitability. We are pleased with the actions we have implemented have led to improved results in Q2. Our 2019 priorities comprised of our build-the-business better and our leverage digital and data initiatives are showing positive results and should set us up for continued improvement in the second half of this year. We also believe that we are here for the maker purpose and strong focus on the customer will position Michaels for stronger growth in 2020 and beyond.

Now I would like to turn the call over to Denise. Denise?

--------------------------------------------------------------------------------

Denise A. Paulonis, The Michaels Companies, Inc. - Executive VP & CFO [4]

--------------------------------------------------------------------------------

Thank you, Mark. As Mark said at the beginning of his comments, we're pleased with our Q2 results. We returned to positive comparable store sales posting a 0.3% comp, grew adjusted operating income 5.8% versus last year and grew adjusted EPS 26.7% versus last year. Second quarter net sales were $1.03 billion compared to $1.05 billion last year. The decrease in net sales for the quarter was primarily due to the closure of our Pat Catan stores in the fourth quarter of fiscal 2018 and was partially offset by our 0.3% increase in comparable store sales and sales from the operation of 11 net new Michaels stores during the quarter.

In Q2, the company opened 4 new Michaels stores, closed 2 Michaels stores and relocated 1 Michaels store. 0.3% increase in comparable store sales was driven by an increase in average ticket, partially offset by a decrease in customer transactions. Sales from michaels.com were strong again this quarter, driven by increased traffic and higher conversion rates with 44% of e-commerce sales and 62% of e-commerce orders fulfilled through our Buy Online Pick-up In Store or BOPIS, initiative. From a category perspective, tools and technology, crafts storage and art suppliers were our strongest categories this quarter, while traditional paper crafting supplies and kids crafts were more challenged.

Gross profit dollars for the quarter were $367 million compared to $373 million last year. As a percentage of sales, our gross profit rate for the quarter was 35.5% versus 35.4% last year, an increase of about 10 basis points. While the increase in gross margin was small, there were several factors that mostly offset each other, including benefits from our ongoing pricing and sourcing initiatives and improved occupancy cost leverage. The increase from these factors was offset by the impact of tariffs on inventory we purchased from China, an increase in promotional activity and a change in sales mix.

Of note, the elimination of our EDV program and return to a high-low strategy for certain items in our store as well as our first-ever semiannual clearance event contributed to the increase in promotional activity. Total store rent expense for the quarter was $98 million versus $101 million last year. The decrease in store rent expense was due to the Pat Catan's store closures partially offset by the impact of a net 11 additional Michaels stores.

For the quarter, SG&A expense, including store preopening costs and restructure charges, was $296 million or 28.6% of sales compared with $299 million or 28.4% of sales last year. The decrease in SG&A expense was primarily due to a $6 million decrease in expenses related to the closure of the Pat Catan stores, a timing shift in our performance-based compensation and a timing shift of marketing expenses till later in the year.

Additionally, in the second quarter of 2019, we reported a restructure charge of $3.9 million related to the closure of all of our Pat Catan stores during the fourth quarter of fiscal 2018. As a reminder, in the second quarter of fiscal 2018, we reported a $3.2 million gain related to the settlement of lease obligations associated with the closure of substantially all of our Aaron Brothers stores during the first quarter of fiscal 2018.

GAAP operating income was $71 million compared to $74 million in the second quarter of fiscal 2018. Excluding the restructure charges, adjusted operating income for Q2 of fiscal 2019 was $75 million compared to adjusted operating income of $71 million in the prior year, an increase of 5.8%.

For the quarter, interest expense was $40 million, about $3 million higher than the second quarter last year. This increase is primarily due to higher LIBOR rates associated with our variable rate term loan, the higher interest rate on our 2027 senior notes, double interest on both the 2027 senior notes and 2020 senior subordinated notes were outstanding for 21 days. The increase was partially offset with lower settlement payments associated with our interest rate swaps.

In July 2019, we redeemed our $510 million senior subordinated notes due in 2020 with cash on hand and proceeds from the issuance of $500 million in senior unsecured notes that mature in 2027 and bear an interest rate of 8%. Also, I'm pleased to announce that we have also just completed an amend-and-extend on our asset-backed revolver to move the maturity from May 2021 to August of 2024. Our nearest term maturity is now in 2023 for a term loan.

The effective tax rate was 18.9% compared to 24% in the second quarter last year. The effective tax rate in Q2 of this year includes the tax benefit associated with a state income tax settlement, partially offset by the vesting of restricted shares and the expiration of certain vested stock options.

On a GAAP basis, net income was $25 million or $0.16 per diluted share compared to $27 million or $0.15 per diluted share in the second quarter of fiscal 2018. Excluding the restructure charge associated with the closing of Pat Catan stores and the refinancing costs of our debt, including double interest for both our old senior subordinated notes and the new senior notes were outstanding for 21 days, adjusted net income was $30 million or $0.19 per diluted share compared to $26 million or $0.15 per diluted share in Q2 of fiscal 2018, an increase of 26.7%.

During the quarter, we purchased 3 million shares in the open market for $25 million as part of our previously announced share repurchase program. As of today, our total authorization remaining for future repurchases is approximately $373 million. As a reminder, our share repurchase program does not have an expiration date, and the timing and number of repurchase transactions under the program will depend on market conditions, corporate considerations, debt agreements and regulatory requirements.

In light of the current trading price of our common stock and our available capital resources and requirements, we currently view additional share repurchases as an attractive use of cash. We intend to continue to monitor our repurchase program and execute share repurchases opportunistically, subject to considerations referenced above.

Any such repurchases would without additional activity with respect to our stock increase the ownership percentages of our remaining shareholders including our sponsors Bain Capital and Blackstone. As a result, future repurchases may result in the sponsors holding in the aggregate more than 50% of our outstanding common stock.

Total merchandise inventory at the end of the quarter decreased 1.8% to $1.26 billion compared to $1.28 billion last year. The decrease in inventory was primarily due to the Pat Catan store closures, partially offset by additional inventory associated with the operation of 11 net additional Michaels stores.

Average inventory per Michaels store, including inventory for e-commerce, inventory and distribution centers and inventory in transit was 2.5% higher than at the end of Q2 last year, inclusive an approximate 170 basis point drag from duties associated with List 3 tariffs as well as increased inventory in transit this year as we pulled some items forward for delivery to avoid incremental tariffs.

We ended Q2 with more than $800 million in liquidity, including $131 million in cash on our balance sheet and $686 million available under our revolver. Total debt at the end of the quarter was $2.7 billion. Our total debt to adjusted EBITDA on a trailing 12-month basis was 3.3x, and our trailing 12-month interest coverage was 4.1x.

Capital expenditures for the quarter were $32 million, reflecting investments in technology projects, including investments to support e-commerce and our digital platforms and investments in new and relocated stores. For the full year, we continue to expect -- to invest approximately $135 million in capital expenditures.

With that as context, let me walk you through the guidance for the third quarter and the full year. As a reminder, our guidance excludes the impact of any remaining restructure costs associated with the closing of our Pat Catan stores, any additional costs associated with the departure of our former CEO, the onetime write-off of our Darby Smart investment and any onetime costs associated with debt refinancing.

For fiscal 2019, we now expect total sales will be between $5.16 billion and $5.19 billion. This reflects our expectation that full year comp sales will be approximately flat and our plans to relocate 13 Michaels stores and open 16 net new Michaels stores, inclusive of up to 12 Pat Catan stores we are rebranding as Michaels stores.

While we are pleased with our comp sales performance in the second quarter, we are cautious regarding the consumer environment in the second half of the year and the potential negative impact of 6 fewer shopping days between Thanksgiving and Christmas. Additionally, the timing of the openings for 3 new stores have shifted out of 2019 and into 2020, and we added 1 more store closure for 2019.

Adjusted operating income for the year is expected to be between $625 million and $645 million. This guidance now reflects the impact of lower estimated sales in the second half of the year, mostly offset by our second quarter performance and incremental cost savings that we have identified since the first quarter of the year.

Let me take a moment to comment more broadly on List 4 tariffs. Clearly, the situation remains fluid. And if List 4 China tariffs are fully implemented, we estimate the applicable direct import product costs subject to these duties are between $400 million and $500 million. Given the base return inventory, any material impact from the List 4 tariffs would not be recognized until 2020.

We're continuing to aggressively work our tariff mitigation plan. Our focus on broad-based cost controls, our annual sourcing savings efforts that have generated approximately $40 million of benefit in 2019, early success shifting sourcing out of China, currency moves, progress with vendor negotiations and price increases taken so far bode well for our ability to mitigate List 4 tariffs.

With all this work underway, it is too early to quantify exactly what portion we would expect to mitigate in 2020. We expect gross margin to be slightly down versus GAAP gross margin in 2018. As discussed on the last call, we do expect to see continued benefits from our ongoing pricing and sourcing initiatives and better management of promotions, offset by pressure from transportation headwinds, tariffs, the deleverage of occupancy costs given our comp guidance and continued strong e-commerce growth.

We continue to expect to leverage SG&A expense versus GAAP SG&A expense in 2018, driven primarily by the favorable impact of anniversarying the restructure charges in 2018, $16 million of investment spending in 2018 and incremental cost savings identified over the last quarter, partially offset by modest pressure from higher IT expense, reflecting our investments and a move to more hosting arrangements.

We expect interest expense will be approximately $153 million, reflecting the expectation of no additional rate increases this year. Our earnings outlook assumes an effective tax rate of between 23% and 24% for the full year. These assumptions translate to an adjusted diluted EPS range of $2.31 to $2.42 for fiscal 2019 on approximately 156 million diluted weighted average shares for the full year. Our fiscal 2019 capital expenditure plan is to invest approximately $135 million to support longer-term growth, including technology investments, new stores and relocations.

Turning to Q3. We expect comp store sales will be flat to up 1%. We plan to open 13 new stores, close 1 stores and relocate 5 stores in the quarter. The 13 new stores are 2 Michaels stores and 11 Pat Catan locations that will be rebranded as Michaels stores. 11 of these have already opened and the last 1 will open at the very end of the quarter for a total of 12 Pat Catan stores converting to the Michaels brand. For comparison purposes, in the third quarter of last year, we opened 5 net new stores and relocated 4 stores. Of note, for comparison and 2-year stack purposes, our comp in the third quarter of 2018 was positively impacted by 270 bps by the shift of a high volume week, the week of our Christmas tree event into the third quarter due to the 53rd week in 2017. That high volume week, the last week of the quarter remains in the third quarter in 2019.

We expect adjusted operating income for the third quarter will be between $133 million and $142 million. This guidance includes expectation that gross margin rate and SG&A rate will be flattish versus GAAP rates in Q3 2018. Our Q3 guidance for adjusted diluted earnings per share is $0.46 to $0.51 assuming a diluted weighted average share count of $155 million.

In closing, we made significant progress on our sales and profit performance in Q2 as our customer responded positively to the changes we made coming into the quarter, including value enhancements and the expansion of key categories. While we're early in the journey, we're excited and optimistic about the potential of our 2019 initiatives and our longer-term strategic priorities to continue to drive profitable growth.

Now I'd like to open the call to take your questions. Operator?

================================================================================

Questions and Answers

--------------------------------------------------------------------------------

Operator [1]

--------------------------------------------------------------------------------

(Operator Instructions) The first question will come from Steve Forbes with Guggenheim Securities.

--------------------------------------------------------------------------------

Steven Paul Forbes, Guggenheim Securities, LLC, Research Division - Analyst [2]

--------------------------------------------------------------------------------

I wanted to focus on the customer segmentation initiatives, right. I think you said in the prepared remarks that the core maker, as you defined it, represents 1/3 of industry sales. But can you discuss where your penetration rate is today with that customer base? And maybe expand on what those customers, right, are telling you about the current value proposition inclusive of the rewards program?

--------------------------------------------------------------------------------

Denise A. Paulonis, The Michaels Companies, Inc. - Executive VP & CFO [3]

--------------------------------------------------------------------------------

Steve, there's one point of clarification. The segmentation and the focus actually represents 2/3 of the arts and crafts industry spend. So just for that before I think Mark will go into a little bit more detail of the color on the segmentation.

--------------------------------------------------------------------------------

Mark S. Cosby, The Michaels Companies, Inc. - Interim CEO & Director [4]

--------------------------------------------------------------------------------

So we did an extensive survey touching 13,000 different customers ranging from surveys to in-depth interviews and came from that with the perspective that you heard on the call today that the focus on this core maker customer is our biggest opportunity. And our opportunity comes around the ability to leverage our expertise against this maker customer and differentiate over time. So I kind of walked you through all the different leverage points that we have with the customer. As Denise just said, that customer is in our stores today a lot. And we also believe that we have an opportunity to gain more share from them over time. And there are customers that are in that segmentation that are not in our stores as often as we'd like, and we believe we have an opportunity to gain more share from that perspective as well, leveraging all the tools that I mentioned on the call.

--------------------------------------------------------------------------------

Steven Paul Forbes, Guggenheim Securities, LLC, Research Division - Analyst [5]

--------------------------------------------------------------------------------

Yes. I think that was the point I was trying to ask. If you think about your sort of active members today or your active customers, how many would fall into that bucket? And what percentage of sales would they represent?

--------------------------------------------------------------------------------

Denise A. Paulonis, The Michaels Companies, Inc. - Executive VP & CFO [6]

--------------------------------------------------------------------------------

So Steve, I think we've talked historically when we're using the old definition of kind of the core versus the enthusiast -- the enthusiast customer versus the novice customer. At the time we talked about that enthusiast customer being the larger base of spend in terms of who shopped in our business today versus that casual customer, much of that enthusiast customer remains what we would now consider the core maker customer.

--------------------------------------------------------------------------------

Operator [7]

--------------------------------------------------------------------------------

Next question comes from Christopher Horvers from JPMorgan.

--------------------------------------------------------------------------------

Christopher Michael Horvers, JP Morgan Chase & Co, Research Division - Senior Analyst [8]

--------------------------------------------------------------------------------

So couple of questions. The focus on the novice really started in '13, and one of the key parts of that was the expansion of seasonal and then Everyday Value program. So that expansion of the season was one reason why you tend to do better in the fourth quarter versus other parts of the year such as 2Q. So in terms of thinking about the long-term comp potential business, would you think the market growth rate is for that core maker customer Michaels has averaged a 1% comp over the past 19 years?

And then the second related question is, how do you expect to navigate the fourth quarter? I know that you mentioned that the makers engaged in seasonal as well, but you are implying a comp acceleration. So are you shifting marketing in the 4Q? Are you expanding the assortment around seasonal? How do you make sure that novice customer is not only engaged but growing as well?

--------------------------------------------------------------------------------

Mark S. Cosby, The Michaels Companies, Inc. - Interim CEO & Director [9]

--------------------------------------------------------------------------------

I can speak to the overall perspective and Denise can add anything she wants to on color around the numeric side. But as I mentioned in the comment, the research that we've done on the core maker indicates that they are very interested in seasonal product. So we don't really see a change. We set up this FMA program several years ago. That continues to be very successful for us in terms of how we position our seasonal product that will continue to be a big focus in everything that we do.

You mentioned mix of advertising. We have shifted some of our marketing support into the fourth quarter to continue to support the seasonal product but also because we think that the spending in the fourth quarter will be more productive than when we had it in the front half of the year.

So I wouldn't infer big changes. When we talk about the focus on this core customer versus this novice customer, I wouldn't expect big category shifts. It's more about taking the existing categories and fine-tuning them so that we have the right product within the category as opposed to thinking about big shifts in terms of how we assort the store category wise.

--------------------------------------------------------------------------------

Denise A. Paulonis, The Michaels Companies, Inc. - Executive VP & CFO [10]

--------------------------------------------------------------------------------

And the only thing that I would add is when you think about the things that we've been working on earlier in the year, they will ramp and produce more benefit for us in the third and the fourth quarter. So Mark commented on our CRM progress and what we hope to be doing by the end of the year, which should be a good contributor. We also have a full quarter benefit of the assortment resets that we did in tools and technology and fine arts and in craft storage that when you combine that with a healthy seasonal business supports what we've effectively said for the second half of the year is a flat to plus 1% comp.

--------------------------------------------------------------------------------

Christopher Michael Horvers, JP Morgan Chase & Co, Research Division - Senior Analyst [11]

--------------------------------------------------------------------------------

Got it. Then in terms of the guidance, it seems like at least relative to The Street the fourth quarter is coming down and then at the same time, you actually expanded operating income in 2Q for the first time since 4Q '17. So -- but you're implying operating income, I think, down for the third and fourth quarter. So just trying to understand what was unique to 2Q, where you could expand operating income and not do so in the back half? And what was the shift -- is there any shift in terms of how you're thinking about the fourth quarter?

--------------------------------------------------------------------------------

Denise A. Paulonis, The Michaels Companies, Inc. - Executive VP & CFO [12]

--------------------------------------------------------------------------------

No. I think if I step back one, we really think about the second half as an entire period of time that we're managing. I think it's important to note that just simply because of the shift of this high-volume week with our Christmas tree sales that happened moving that into the third quarter last year, it stays in the third quarter of this year. So we, in terms of the top line performance, always expected, I think, a bit more robust 3Q performance and a little lighter 4Q performance simply because of the loss of the shopping days between Thanksgiving and Christmas. So that was always our ingoing perspective.

In general, when you think about what happened on the operating income side, on the operating income side, in the third quarter, we delivered slightly positive gross margin. That starts to show the impact of all the goodness of our sourcing and pricing work that we're doing. We also got a little extra benefit from posting a better comp and having less occupancy deleverage that would happen in the quarter. But we did see negatives from sales mix and, of course, tariffs.

When you think about the third and fourth quarters of the year, we expect that, that sales mix impact will continue. We also expect that tariff impact will continue along with all the positives that I mentioned as well. So there is nothing outsized that shifts between the second quarter and the back half of the year in terms of our view of margins. It's just puts and takes on the margin for the items within that. But still expect $40 million in sourcing goodness from the year from all the work that we do every year around our sourcing program, still expect goodness from our CRM initiatives and what we will be able to do with discount management.

--------------------------------------------------------------------------------

Operator [13]

--------------------------------------------------------------------------------

The next question will come from Simeon Gutman of Morgan Stanley.

--------------------------------------------------------------------------------

Simeon Ari Gutman, Morgan Stanley, Research Division - Executive Director [14]

--------------------------------------------------------------------------------

I don't know if I missed this, but can you tell us in Q2 how much some of the clearance and promotions -- I guess, I think it was clearance specifically drove the second quarter comp. And then related to it, if we assume that the business should comp positively over time, let's just say, 1-ish or 1% to 2%, can you give us a sense of what we could expect from the gross margin line you mentioned goodness from pricing and sourcing, realized there's a return to high low. But what's the level of our gross margin? Is it flat? Is it up slightly that we could expect if the business does generate that consistent comp growth?

--------------------------------------------------------------------------------

Denise A. Paulonis, The Michaels Companies, Inc. - Executive VP & CFO [15]

--------------------------------------------------------------------------------

Yes. So on the first topic, the clearance event that we ran in the second quarter, it contributed about 15 basis points to comp. So while it was a big marketing event for us that got a lot of folks into the store, the actual impact of that in terms of clearance sales was very small. It was much more of a marketing handle that really had a reason for people to shop, when that's a very common theme from other retailers of getting people into the store.

More broadly speaking on the question of gross margin, we talked about for the full year, we expect it to be slightly down versus GAAP gross margin last year for all of those reasons that I described on the call kind of playing out on the ups and downs regarding that. We expect it to be generally flattish in the third quarter. We were posted slightly positive in the second quarter. So that's how we're kind of netting out right now. Too early to tell with 2020. I think we've got a lot of great plans in place to continue our sourcing benefit, continue our discount management work and all of those will kind of bring to bear to continue to drive the gross margin number.

--------------------------------------------------------------------------------

Simeon Ari Gutman, Morgan Stanley, Research Division - Executive Director [16]

--------------------------------------------------------------------------------

And then my follow-up is not related to 2020. It would be more the next 12 to 18 to 24 months. You talked a lot about or Mark talked a lot about initiatives to reposition the business. Does the business have enough cost to take out that can be self-funded? Or do you have to go through an investment phase in order to make these investments happen?

--------------------------------------------------------------------------------

Denise A. Paulonis, The Michaels Companies, Inc. - Executive VP & CFO [17]

--------------------------------------------------------------------------------

Overall, we don't see the need for any outsized incremental investment to go after what we're talking about. We've said on the capital side, we expect to be 2% to 3% of sales. We've generally been the middle of that range. We'd still expect to be within the range of 2% to 3%. And then on the expense side, we're really looking at the places where we deprioritize some other things we've been doing in the business to fund the work that we want to do to drive the initiative. So nothing outsized that we can see on the near-term horizon.

--------------------------------------------------------------------------------

Mark S. Cosby, The Michaels Companies, Inc. - Interim CEO & Director [18]

--------------------------------------------------------------------------------

It's really more a matter of prioritization and deprioritizing things that maybe have less of an impact. So the 3 that we talked about, community, the store experience, these maker-centered categories, all of them will be tested. We'll learn from them what kind of sales driving power they have, and any investment that we do into those things will be warranted based on the returns that they deliver. And if we have to spend money against them, hopefully, we do spend money against them. That means we're taking money largely from other places and also believing that they will return in a solid way for us.

--------------------------------------------------------------------------------

Operator [19]

--------------------------------------------------------------------------------

The next question will come from Seth Sigman of Crédit Suisse.

--------------------------------------------------------------------------------

Seth Ian Sigman, Crédit Suisse AG, Research Division - United States Hardline Retail Equity Research Analyst [20]

--------------------------------------------------------------------------------

If you step back and look at what's weighed on comps over the last couple of years, I think it's been mostly transactions growth. Can you help us better understand if that's actual traffic? If there's a traffic issue, or is it more about conversion and underserving that customer that's coming in? And as you look at the progress here, obviously, comps improved this quarter through a lot with the changes that you're making. Where are you seeing that improvement? Is that better conversion, better traffic? And if you could also help us understand if that improvement is coming through store comps or online or both, that would be helpful as well.

--------------------------------------------------------------------------------

Denise A. Paulonis, The Michaels Companies, Inc. - Executive VP & CFO [21]

--------------------------------------------------------------------------------

Yes. So I'll start off and Mark can jump in with some additional color. So we are not able today to account traffic in our stores. We can only count transactions. We're hoping to be able to do more on the traffic side as we implement electronic article surveillance in our stores next year. But at this point, it's really transaction.

From everything that we know, we have an opportunity in conversion in the store in those transactions. So every customer that comes in from the survey data we have from the customer doesn't mean that they leave with a purchase. And so we do see that as an opportunity.

When you think about the improvement from the first quarter to the second quarter in the business, most of that improvement was driven by an improvement in transactions kind of on a sequential basis. So back to some of the things we changed in the first quarter and ramped into the second quarter, we were able to be converting more of those sales with the customer in the store, and so I think that that's a big benefit.

Both stores and e-commerce are contributors to our performance. And so we think about them a bit omnichannel simply because so much of our e-commerce sales are actually BOPIS sales that come through the store. But over time, when you think about where the opportunity is, the opportunity continues to be improving conversion and transactions in the store.

--------------------------------------------------------------------------------

Mark S. Cosby, The Michaels Companies, Inc. - Interim CEO & Director [22]

--------------------------------------------------------------------------------

Just a little color on that. I mean, as I described on the call, we are rolling out a significant selling program actually rolled out this past week to all of our stores. And one of the big components within that will be the ability to measure conversion and sent our team to deliver against conversion based on this new scorecard that's put in place.

Historically, we haven't differentiated that number. We haven't been able to measure that number, but we're putting tools in place that will enable us to do that this year, and then we're putting even better tools in place next year that will enable us to measure that. But importantly, we're putting a program behind really driving conversion within our stores by teaching our associates and incenting them, motivating them to convert itself within our stores.

--------------------------------------------------------------------------------

Seth Ian Sigman, Crédit Suisse AG, Research Division - United States Hardline Retail Equity Research Analyst [23]

--------------------------------------------------------------------------------

Okay. Just 2 clarifications on the model. So SG&A, can you guys size up the marketing and performance-based comp that shifted out of this quarter? And what goes into the back half of the year? And then just for the full year guidance, to clarify on tariffs, I just want to make sure I have this right. There's no incremental impact embedded here from List 4. Is that the right way to think about it?

--------------------------------------------------------------------------------

Denise A. Paulonis, The Michaels Companies, Inc. - Executive VP & CFO [24]

--------------------------------------------------------------------------------

Yes. So in reverse order, anything that's tied to tariffs is embedded in our forecast. So whether that is List 3 or List 4, all the 2019 is in the forecast as we would know it today. On your question about the timing shifts for performance-based comp and for marketing, as Mark indicated a bit earlier, we did plan for this year to shift more marketing dollars into the fourth quarter and take those out into the second quarter. So you're going to see those come back in the fourth quarter where we think we really do have an opportunity particularly with a shorter selling cycle between Thanksgiving and Christmas to leverage those marketing dollars. The performance-based comp shift will hit both Q3 and Q4. I would comment that in both of these cases, these are not outsized numbers. You can think about both of these being a couple of million dollars, not bigger shifts than that.

--------------------------------------------------------------------------------

Operator [25]

--------------------------------------------------------------------------------

The next question will come from Laura Champine of Loop Capital.

--------------------------------------------------------------------------------

Laura Allyson Champine, Loop Capital Markets LLC, Research Division - MD [26]

--------------------------------------------------------------------------------

It's really a follow-on. So I believe last quarter that your guide included a $0.05 hit from tariffs, rescue me if I'm wrong there. Has that increased? And if so by how much? And then I totally understand that most of the impact of List 4 would impact 2020. Could you tell us -- just give us a perspective sense of how much of an impact that could have given all you know about your mitigation efforts as well as your sourcing cost increases of $400 million, $500 million which you laid out earlier in this call?

--------------------------------------------------------------------------------

Denise A. Paulonis, The Michaels Companies, Inc. - Executive VP & CFO [27]

--------------------------------------------------------------------------------

Yes. So first, the 2019 guide, just to reiterate, we've not changed the impact of tariffs in our guidance from the last call to this call. So our impact from the List 3, we believe, is consistent with what we had before and just because of the timing and our inventory turns, while List 4 is new since the last call, it will not impact us with any materiality in 2019.

When you look to 2020, you look to what's going on with the List 4 tariffs, I mentioned it was $400 million to $500 million of potential PO cost exposure from what we buy from China that would be on List 4. When we think about and I will lead in by saying we don't have an exact estimate of the puts and takes of what we will be able to do for mitigation versus the cost of those duties coming through. But I think the key message I want folks to take away is the list of options we have and what we're aggressively working to do to mitigate those costs coming through. So I mentioned it in a bit of my script, but kind of happy to walk through them again.

So annually we've been able to be generating sourcing savings in our business, so upwards of $40 million. We do have an anticipation that will continue into 2020 as well, so one key starting block in things that we can do to mitigate. Off of our List 3 tariffs, which we originally said we had about $400 million of exposure, we've already been able to shift about $75 million of that PO cost outside of China, and it's really early in the process of working through that.

It takes factories time to ramp up. It takes time to actually work through the sourcing process. So we're quite pleased with being able to have made that shift. And then you look at all the other levers, the core cost savings work that we're doing that really allowed us that while we were lowering comps a bit in the back half of the year to hold operating income this year, something we want to continue on as we look to the new year. The broader set of sort of sourcing alternatives where we can leverage our negotiation power, manage against currency fluctuations as well and then reengineer product are all additional levers beyond just moving product out of China today.

And then while we do this with a very cautious approach, implementing price increases where we believe they make sense and where given that we have a low average ticket, we have a minimal impact to the customer out there and play for us as well. So a really long list of things that we can do to go up against the headwinds that the tariffs could provide, assuming that tariff stays in effect as we continue through the months of the year here.

--------------------------------------------------------------------------------

Operator [28]

--------------------------------------------------------------------------------

Our last question today will come from Elizabeth Suzuki of Bank of America.

--------------------------------------------------------------------------------

Elizabeth Lane Suzuki, BofA Merrill Lynch, Research Division - VP [29]

--------------------------------------------------------------------------------

Great. I was just hoping if you could quantify the positives and negatives to gross margin in the quarter? I know sourcing initiatives were positive, occupancy cost on the higher comp was positive and then that was kind of offset by tariffs and mix and promotional activity. Could you quantify each of those buckets?

--------------------------------------------------------------------------------

Denise A. Paulonis, The Michaels Companies, Inc. - Executive VP & CFO [30]

--------------------------------------------------------------------------------

Yes. So we don't typically quantify the details of puts and takes. What I would just tell you is the things that were on the positive, as you already mentioned, was the sourcing benefit, pricing benefit, some benefit from occupancy leverage. Offsetting that would be the flow-through of some duties coming through sales mix and then a bit more promotional impact, which had a little impact from our clearance event but also had some impact as we moved away from EDV coming out of the first quarter. They were all kind of material impact hence why we call them out. But I think important note to me is that the net out to pretty much of flat gross margin, slightly positive gross margin versus last year.

--------------------------------------------------------------------------------

Elizabeth Lane Suzuki, BofA Merrill Lynch, Research Division - VP [31]

--------------------------------------------------------------------------------

Okay. And then you talked about how one of the options you have for mitigating tariffs is to increase some of your pricing on those low-ticket items. Have you tested out the elasticity of demand for some of those products that you're importing just to determine if there is any pushback from the consumer when you raised price there?

--------------------------------------------------------------------------------

Denise A. Paulonis, The Michaels Companies, Inc. - Executive VP & CFO [32]

--------------------------------------------------------------------------------

Yes. We take pricing on some items every year. So history tells us a bit about where there's more or less elasticity, and we certainly take that into account when we think about the pricing opportunity we have. To date, on any pricing increases we've taken this year, there should be no surprises about elasticity. We're really focused on managing to a more positive gross margin dollar outcome against the opportunity that we have when we take the price. And we've generally seen the results that we expected to see. Clearly, low ticket, private brand items provide us with a bit more opportunity than more visibly priced higher ticket items.

--------------------------------------------------------------------------------

Mark S. Cosby, The Michaels Companies, Inc. - Interim CEO & Director [33]

--------------------------------------------------------------------------------

The good thing is we put in more science around our ability to measure the impact of our pricing changes. We build the team to enable us to do that. And I think also importantly we've enhanced our ability to monitor our competitive pricing scenarios so that we know where we stand from a price perspective versus our competition better than we would have a few months back. So we are in a position to be able to make smart choices around pricing.

--------------------------------------------------------------------------------

Operator [34]

--------------------------------------------------------------------------------

This concludes our question-and-answer session. I would like to turn the conference back over to Mark Cosby, interim Chief Executive Officer for any closing remarks.

--------------------------------------------------------------------------------

Mark S. Cosby, The Michaels Companies, Inc. - Interim CEO & Director [35]

--------------------------------------------------------------------------------

Well, thank you for joining us this morning. We are pleased with our trend improvement in Q2, and we believe that we have the right priorities in place to continue the improvement in the back half of this year. We are also confident that our focus on the customer via our new maker strategy will set us up to deliver growth in 2020 and beyond. Thank you again.

--------------------------------------------------------------------------------

Operator [36]

--------------------------------------------------------------------------------

Thank you, sir. The conference has now concluded. Thank you all for attending today's presentation. You may now disconnect your lines. Have a great day.